The Loonie Portfolio: Asset allocation and half-year performance

The bloggers over at TheMoneyWriters have been posting their investment portfolio performance for the first half of 2008, in many cases including their asset allocation as well. I thought I'd throw together my own data, to share my own performance over the last six months.

Allocation

My entire investment portfolio is in RRSP accounts, one self-directed account at my discount brokerage and a group RRSP through my employer. These accounts have the following asset allocation:

Self-Directed RSP

• Canadian Equity Fund (S&P/TSX Composite): ~50%
• US Equity Fund (S&P 500): ~10%
• International Equity Fund (MSCI EAFE ND): ~20%
• NASDAQ Fund (NASDAQ 100): ~10%
• Canadian Bond Index Fund: ~10%

Employer Group RRSP

• Employer Stock: 100%

I contribute to the employer group RRSP on a bi-weekly basis through payroll deduction. Note that my employer's stock is not factored into the percentages in the self-directed account.

Performance

I started the year with a portfolio value of $42,266.23, and the following asset allocation:

• Canadian Equity Fund (S&P/TSX Composite): 47.1%
• US Equity Fund (S&P 500): 9.0%
• International Equity Fund (MSCI EAFE ND): 18.4%
• NASDAQ Fund (NASDAQ 100): 9.5%
• Canadian Bond Index Fund: 9.7%
• Employer Stock: 6.3%

In the last six months, I have contributed $10,478.82 to my RRSPs, including direct contributions, employer matching contributions, and DRIP payments. Excluding these contributions, the "organic" current value of my portfolio is $40,991.66 (the June 30 value of the shares I held on December 31). This represents a loss of $1,274.57 (3.02%), due to an across-the-board decline in the value of my investments.

When I include my recent contributions, my portfolio value increases to $51,799.51, with the following asset allocation:

• Canadian Equity Fund (S&P/TSX Composite): 45.8%
• US Equity Fund (S&P 500): 8.0%
• International Equity Fund (MSCI EAFE ND): 16.6%
• NASDAQ Fund (NASDAQ 100): 8.7%
• Canadian Bond Index Fund: 8.1%
• Employer Stock: 12.9%

My employer's stock now makes up 12.9% of my total investment portfolio, so I'll have to keep an eye on how high this proportion gets. Overall, I'm down $945.54 from where I would be by adding my $10,478.82 in contributions to my starting balance of $42,266.23. If I take $47,505.64 = $42,266.23 + $10,478.82 / 2 as a proxy for my starting balance (basically assuming that half my contributions were invested for the full six months), then this represents a negative annualized growth of -3.94%.

Impressions

4% negative annual returns aren't too great, but there are a few mitigating factors here:

• Only $8,803.48 of the $10,478.82 in contributions was actually out-of-pocket money on my part; the other $1,675.34 came from employer matching and DRIPs, so that makes me feel a little better about the $945.54 loss.


• When I compare my current portfolio to where I would be if I had kept my concentrated position in my employer's stock, I'm up by over $2,500. This alone is enough to make me feel better; I'm a lot better off than I could be, and it's as a result of a conscious choice I made.


• All the markets are down. In fact, the S&P/TSX Composite has dropped nearly 4%, and the Dow Jones, S&P 500 and NASDAQ are all down more than 10% over the last 6 months. My 2% loss over the same period doesn't look too shabby.


• I'm still buying. By continuing my bi-weekly contributions, I'm getting some great dollar-cost-averaging going on, so I'm picking up some great bargains on stocks.

How are your investments doing so far this year?

Comparisons in the air

Over at Four Pillars, there have been a couple of great posts recently comparing Canadian and American investment accounts. So far, the following comparisons are available:

• Canadian RRSP Vs. U.S. 401(k) Retirement Account Comparison


• Education Investment Accounts: Canadian RESP Vs. American 529 Comparison


• Updated: Canadian TFSA Vs American Roth IRA

The next post will compare Canada's new TFSA to the American Roth IRA.

This sort of cross-border comparison is exactly the kind of content I was looking for when I decided to start this blog. In fact, I've posted similar comparisons in my own lexicon series, as well as a post dedicated to comparing retirement and education accounts. Although I didn't go into as much detail with specific rules on the accounts, it's nice to see that I at least got my general facts straight (not surprising, considering I pulled a number of my RESP facts from Four Pillars' series on RESPs).

I have to hand it to the folks at Four Pillars for posting the content in a more Google-friendly format than my own comparisons; I'm frankly a little embarrassed to see my "Loonies And Savings Plans" title next to the likes of "Canadian RRSP Vs. U.S. 401(k) Retirement Account Comparison" and "Education Investment Accounts: Canadian RESP Vs. American 529 Comparison". Which do you think is more likely to come up in a Google search?

It's great to see this sort of analysis being posted. I think it's useful for people on both sides of the border to see how the other side has structured things. Knowing the similarities and differences between the two systems helps to understand how to get the most benefit out of your own investments.

The ETF dilemma

One of my goals for this month was to decide whether to switch my retirement investments from the index funds I currently hold to an ETF-based portfolio. For the uninitiated, here's a quick rundown of the two types of funds:

• Index Funds - These are mutual funds that track a specified stock index. You can purchase these funds either directly from the company that manages the fund, or through a broker, and the price of the fund is updated at the end of each day. Since these funds have fairly low turnover, their management expense ratio (MER) is lower than for actively managed funds. Index funds are not usually subject to loads or trading commissions, although they often have a minimum purchase amount. Because there are no transactional costs to purchase these funds, they are popular for dollar-cost-averaging.


• Exchange Traded Funds - Like index funds, ETFs track a stock index, but the funds are traded directly on the stock exchange, and must be purchased through a broker. The price of an ETF fluctuates with its associated index throughout the trading day. These funds have even lower MERs than index funds, but they are subject to the broker's trading commissions, so there is a cost to buy or sell the funds. As a result, ETFs are more popular for lump sum investing, since they save money when transactions are less frequent.

It's taken me a while to get my head around the index fund vs. ETF debate, and I've got a few factors to consider:

• Cost - This really gets to the heart of the difference between the two investment vehicles. The index funds I currently hold are reasonably low-cost, with a blended MER of 0.39% for my whole portfolio. However, if I were to switch into the ETF equivalents of these funds, I could reduce this further to 0.19%. On a portfolio of $50,000, that difference translates to a savings of $100 per year. In order to switch over to ETFs, however, I will have to pay the commission for each fund that I buy. At the current size of my portfolio, it will take 1-2 years for the reduced MER to offset the trading commissions.


• Tracking - The price of my current index funds remains fixed throughout the trading day, but ETFs have intra-day fluctuations as they track changes in their associated index. This means that ETFs would facilitate a more real-time tracking of my portfolio's value. While this appeals to me from a dataholic perspective, it scares me a bit to be able to track to-the-minute variations in my long-term investment value.


• Timing - Although I use the innocuous word "switching" to describe what I'm contemplating here, what I'm really considering is cashing in all my investments, and then immediately buying back into the market. This exposes me to market fluctuations between when I sell and when I buy. I know that the difference is not likely to be significant, and you can never guarantee that your timing will be perfect, but I'm uneasy with the prospect of performing this switch on my entire portfolio, especially in our current market conditions.


• Choice - The decision of whether to switch aside, I also need to decide which ETFs I'll buy if I make this change. Fortunately, there's lots of discussion on this topic, and a handful of Vanguard and iShares (for Canadian indices) funds should work just fine.

My portfolio is right on the verge of making this change worthwhile from a cost perspective. With the MER savings paying back my commissions within 2 years, it seems like the right time to make the switch. However, I just rebalanced my portfolio a few months ago, and given the volatility in the market at the moment, I really don't want to "cash out" with this much uncertainty.

I think the best thing to do is to hold off until early 2009, and make the switch then. This will put me on an annual rebalancing schedule, and will also allow me to incorporate my year-end bonus (if any) into the transaction. Of course, I'm making the assumption that I'll be more confident about my decision six months from now, but by committing to this plan today, I have time to research my choices, and a deadline to complete the transaction.

So, in the interest of checking off another goal this month, my decision is to switch my retirement investments to an ETF-based portfolio by February 28, 2009.

On an unrelated note, I'd like to apologise in advance to the author of next February's Loonies And Sense posts for any stress he may feel over the next several months.

How do you think of the stock market?

The first time I heard of the stock market was while reading Gordon Korman's novel Go Jump In The Pool when I was eight years old. The story is about students at a boys' boarding school trying to raise money to install their own swimming pool. The students <SPOILER> finally make it happen when "George Wexford-Smyth III", the token rich boy, uses his stock market wizardry to grow their meager earnings to the $64,469.64 they need for the pool</SPOILER>.

This resolution to the plot confused the heck out of my young mind. Where did all this extra money come from? What's a stock? What does a silver mining company have to do with building an olympic pool?

I asked my parents about this, and they gave me a brief explanation of the stock market: you buy part of a company, and when people get excited about that company, the part you own gets more valuable, so you can sell it for more than you bought it for, and that means you've earned extra money. They also focused pretty heavily on the downside: if people lose confidence in the company you own, you might lose money if you have to sell for less than you paid for it. The message I took from this (reinforced by the fictional headmaster in the book) was that stock market investing is basically gambling, and you shouldn't invest money that you can't afford to lose.

It's amazing how truths you learn as a child can stick with you: this is how I thought of investing all through my university years. While I was in university, cell phones really started to become popular, and Qualcomm was a rising star of the NASDAQ. My roommate at the time was watching this stock with a keen eye, and explained to me the concept of a stock split (Qualcomm split 16:1 between 1994 and 2000). He discussed his plans to invest in the stock, and I asked what he would do if the stock went down after he bought it (in my mind, this scenario meant that you sold your investment at a loss to stop the bleeding).

He countered that he would simply buy more of the stock at the lower price. This concept was completely foreign to me: why would you buy something when it was dropping in value? He explained that when the stock rebounded, he would make an even bigger return on his investment, since he had acquired additional shares so cheaply.

That conversation with my roommate was my first practical exposure to how to buy low and sell high. Granted, he was loading up heavily with a single stock, which was amplifying his risk considerably. While you don't expect every piece of a diversified portfolio to collapse completely, a concentrated position in a single stock can quite conceivably lose most or all of its value in a matter of months or even days. Still, where I had always seen the "buy low, sell high" strategy as a total crapshoot, here was an approach to at least managing the buying side of the plan.

Qualcomm has gone from under $4 to nearly $50 in the last ten years (a 29% annual return). My roommate was right about this stock, and although his strategy was very risky in its lack of diversification, he introduced me to the idea of dollar cost averaging.

I think that an investor's ability to ride out an uncertain market depends on how they see the market. Is it all a house of cards that could come crashing down at any moment, or is it a robust, ever growing system that can be expected to provide consistent positive returns over the long run?

I happen to believe the latter, and I owe it all to Gordon Korman.

Hats off to my brave colleagues

As I mentioned last week, Jeremy at Generation X Finance has a new series of posts called "From The Front Lines", in which he chronicles his first-hand experiences with investors' reaction to our current market conditions. So far, he has two posts in the series:

1. From the Front Lines: Investors Selling Stocks in Favor of Fixed Accounts


2. From the Front Lines: Changing Your Risk Tolerance Based on a Bear Market

A lot is being written these days about this being a buying opportunity, but I've recently heard a lot of talk from a few of my colleagues about aggressively timing the market.

I'm sure that, with all the ups-and-downs we've had recently, there is a lot of money to be made (and lost), but I just don't have the courage or recklessness to keep getting in and out and making big wagers with my retirement savings (which currently form the vast majority of my investable assets). I won't go quite so far as to call this a stupid move on my colleagues' part; they're all in their late-20s or early 30s, and have time on their side if they make a misstep. However, I personally can't handle the stress of day trading, whether in a bear or bull market, and I don't have the energy to track stock prices as closely as they do.

No, I think buy-and-hold index investing is right for me. I'm happy with my asset allocation, and I'll keep paying off my debts and dollar-cost-averaging my RRSP contributions.

I wish my colleagues well with their investing adventures, and look forward to some vicarious thrills over the next few months.

Intestinal fortitude: living with a bear market

Jeremy at Generation X Finance has started a mini-series of posts detailing his first-hand experience with investors' reactions to current market conditions (Jeremy's a retirement planning specialist). His first post is on investors fleeing stocks in favour of bonds. He points out the well-worn truth of how much this can hurt your portfolio's long-term performance.

There's no denying how painful it is to watch your investment returns seemingly evaporate as the market takes a dive. It's understandable to want to do something to "stop the bleeding." However, the strategy of dumping your stocks and moving into bonds to ride out the slump is exactly the opposite of "buy low, sell high." Meg at The World Of Wealth illustrated this in a post about her grandparents selling some bonds to help her finance the closing on her new investment property without cashing out her investments at the bottom of the market.

It's still early days, but so far I seem to be able to follow this advice of staying the course. I'm anxious about what the next several months have in store for my investments, but I'm fortunate enough to have decades to recoup any "losses" during this and other down periods. As much as I hate to see my balances drop, the thought of cashing out and moving into "safe" investments at this point makes me physically ill. So I'll be hanging on by my fingertips, and doing my best to enjoy the ride.

On a lighter note, The Consumerist posted this advice today on surviving a bear market:

Investopedia says the best thing to do when you see a bear in the market is the same as when you see one in the woods: "Tuck in your arms and play dead!" In other words, don't go crazy selling stocks at a loss. In both cases, fighting back can leave you bleeding, although toughing it out won't be a pleasant experience either. And if you have money leftover after filling up your car, it's actually a buying opportunity. Which I guess is like playing dead in front of the momma bear while your buddy gathers up all the cubs while mamma is occupied and then later you and your buddy train them to harvest honeycombs for you.

I couldn't have said it better myself.

How cool am I?

So yesterday morning, I demonstrated to the world at large just how cool I am in the face of punishing market drops. My take? The recent slide is nothing to worry about, and we're still in line with long-term forward movement.

Then the S&P/TSX Composite index drops 3% in one day, and I watch my retirement savings shed another $1,300 in market value.

Ouch.

Some perspective on a month of -38% returns

From May 31 to June 30, the market value of my retirement savings dropped from $53,547.77 to $51,463.61. That's a decrease of $2,084.16, or 3.9%, which represents an annualized rate of return of -37.8%. Let's ignore, for a moment, the fallacy of predicting annual returns based on one month's performance. Let's also overlook the fact that I added $642.10 in contributions to my RRSP during this period, which actually makes this an even larger negative return.

The point is, June was not a great month for someone invested in the stock market.

When I look at a chart of my retirement savings over time, however, I see something interesting:


I have already commented on the fluctuations in my retirement and liquid savings, but this past month's performance is worth singling out.

The straight line approximation of my retirement savings growth over time goes right through the middle of the June 2008 point. That means that, based on data starting in April 2007, last month's performance was entirely consistent with the rate of growth I've seen over the past year.

This view is a bit simplistic, since I've really only got just over a year of history on which to base my rate of growth. However, it does serve as a good illustration of the fact that my savings growth is dependent on both contributions and investment growth. I need to manage both of these factors in order to stay on track.

Make no mistake: June still sucked from an investment return point of view. However, it was not nearly the deathblow that the -3.9% monthly growth would suggest.

Time changes everything

Back in March, I posted about the dismal returns I was seeing on my retirement investments. When taking into account my bi-weekly ESP payroll deductions, my investment performance from April 2007 through February 2008 represented a 0.98% annualized growth rate. When I added in my employer's matching contributions, this actually dropped to -4.29% annualized growth.

Well, that was before the market rally that began in mid-March. Since February 29, my retirement balance has increased by $3,383.21, with only $856.12 in contributions during the intervening two months. When I put this in terms of a one-year growth rate, I now come out ahead whether I include the employer match or not. Without the match, my growth rate for the past 12 months is 6.86%, compared to 1.19% when I include the match.

It's unnerving to see such a wide swing in market performance during a one-year period. Two months of bullish growth has taken my annual growth rate from 0.98% to 6.86%. In order to turn around the previous slump, my annualized growth rate during those two months was actually 36.62%. That's a big change from the decline we saw earlier in the year.

I find it fascinating that your view of market performance can vary so widely based on the window you look at. Canadian Capitalist has a great post today about looking at your response to the recent market dips as a gauge for your actual risk tolerance. If your gut reaction to the widespread price drops was to sell, then you should probably consider a more conservative portfolio.

Personally, I was content to ride out the market swings. This may be because these investments are largely academic to me at this point. Since this is all strictly "future money", I'm able to stay relatively cool about my investment performance. As I get closer to actually planning to use this money, however, and when I eventually build up a non-retirement investment portfolio, we'll see just how calm I remain through future market adjustments.

The market can make you crazy.

Interesting Money posted recently about his nasty habit of obsessively checking his investment balances. I have to admit that I share this tendency to over-track my retirement accounts, whether out of excitement, concern, or morbid curiosity.

In spite of my daily ritual of checking my account balance, I've generally been able to keep a cool head during the market turmoil that started last summer. I haven't done anything drastic like selling off my investments or switching to an all-bond portfolio. In fact, I seem to have been pretty lucky with my timing in diversifying my asset allocation using low-cost index funds. Given my still-negative net investable assets, the single biggest factor in my net worth trend over time is my ongoing debt reduction. As a result, although investment performance does have an impact on my overall financial picture, this effect is often overshadowed by my progress in paying down my debts.

I was looking at my history of monthly snapshots at NetworthIQ, and thought I'd have a look at my retirement account history. Since I started tracking my monthly progress, my retirement balance has gone from $36,087.43 to $46,914.08, an increase of $10,826.65. That's not a bad balance growth, but let's not forget that I've been steadily contributing to my RRSP during this time. In total, I've added $10,487.76 in book value (meaning actual out-of-pocket contribution value) to these accounts, so my actual investment "returns" really amount to $338.89. If I factor in my employer's matching contributions of $1,856.03 over the same timeframe, I'm actually behind by $1,517.14.

To get a (very rough) idea of the rate of return represented by these numbers, I'm adding half my contributions to my April 2007 balance, and using that as my starting amount. Therefore, I get the following 10-month rates of return:

• Without Match: $338.89 / ($36,087.43 + $5,243.88) = 0.82%


• With Match: ($1,517.14) / ($36,087.43 + $6,171.90) = -3.59%

This is equivalent to annual rates of return of 0.98% and -4.29%, respectively.

Even the positive 0.98% is not exactly kicking inflation's butt.

As I look at these numbers, I remind myself constantly of the words of encouragement offered to any long-term investor:

• The real asset at this point is the stock/fund shares themselves, not their dollar value. These investments are generating dividend and interest income, which is in turn being used (through a DRIP) to buy more shares.


• The 4.29% "loss" I see when I take into account my employer's matching contributions is currently only a loss on paper. Provided I don't get cold feet and sell now with prices at their current lows, there's a very good chance that I'll more than recoup this drop over the next couple of decades.


• Even though my investment returns over the past 10 months have been poor, I'm still nearly $11,000 ahead of where I was last April. That's nothing to sniff at.


• I wish, oh how I wish, that I had some extra cash lying around to snatch up some of the investments that are currently "on sale".

I'll say this much: it's certainly shaping up to be an interesting year.

Rebalancing for the first time

My employer allows us to direct up to 85% of our year-end incentive into a group RRSP to reduce our taxation on the bonus. Under this group plan, we can choose from a variety of low-MER mutual funds, or invest in the company's stock. I deferred a big chunk of this year's bonus into this plan, and then proceeded to transfer the balance into my brokerage self-directed RSP account.

As of last night, I had a large cash balance sitting next to my index funds in the brokerage account, and this morning I placed orders to use this cash to buy more units of my index funds. To determine how much of each fund to buy, I used a spreadsheet similar to Canadian Capitalist's rebalancing spreadsheet. Within a couple of days, these orders should be filled, and I will be the proud owner of a freshly rebalanced retirement portfolio.

Let's see whether my spotless record of timing the market continues.

Getting the most from a group RRSP

Canadian Capitalist has a nice post on the benefits of participating in an employer group RRSP. The gist is that, if your employer provides a match to your contributions, then you are leaving money on the table by not signing up for the plan. Many personal finance experts list this as a priority even while paying off debt: contribute enough to your employer's retirement plan (group RRSP for Canadians; 401(k) for Americans) to get the maximum employer match.

My employer has a group RRSP in which they match half of employee contributions, up to an annual maximum. In my case, the employer match is only available for purchases of the company stock. We also have a portfolio of low-MER mutual funds that we can contribute to through payroll deductions, but there is no match on these funds. Still, having an immediate return of 50% on my investment every two weeks is a great deal, even if it is all invested in my employer's stock. Unless the value of the stock suddenly drops by more than 30%, I end up ahead.

One of the benefits given by Canadian Capitalist is the up-front tax refund you get if you contribute to your employer's group RRSP through payroll deduction. Because you're making the RRSP contribution directly from your paycheque, your employer withholds less income tax, so the impact of the deduction is lessened. Plus, you aren't making the dreaded interest-free loan to the government.

Of course, this up-front tax refund also means you aren't in for a juicy refund cheque when you file your taxes in the spring, because you've already realized the tax savings. The RRSP advertising through January and February of every year is counting on the appeal of a big tax refund resulting from a lump-sum contribution to bring your money through the bank's door. However, if you've been contributing a portion of each paycheque all year long, you may not have this lump sum available.

There is a way you can "trick" yourself into giving yourself a refund for your group RRSP contributions. If you multiply your paycheque deduction by your marginal rate, and set up a recurring transfer of the resulting amount to an online savings account, then when tax season comes around, you will have a virtual tax refund sitting in this account.

For example, if you contribute $150 every two weeks to your employer's group RRSP, and your marginal tax rate is 40%, then you would set up a bi-weekly transfer of $60 to an online savings account. At the end of the year, not only will you have $3,900 (plus applicable employer match) in your RRSP, but you'll have $1,560 sitting in a savings account, as your reward for saving so well.

Changes coming to RESPs?

This week, the House of Commons passed a bill that would provide a tax deduction for RESP contributions. The bill still needs to be approved by the senate, but it's an interesting idea.

Currently, RESP contributions are made with after-tax dollars, and compound tax-free until they are withdrawn by the beneficiary for post-secondary education purposes. At withdrawal, the investment income is taxed to the beneficiary, at their (usually low) marginal rate. Under the proposed bill, up to $5,000 in annual contributions would qualify for a tax deduction, similar to RRSP contributions. This would represent a fundamental change in the tax treatment of these plans, and potentially provide a much greater incentive for parents to contribute to their children's plans.

I've written before about the benefits of contributing to RESPs, essentially looking at this plan as a sort of "education insurance", but this new bill would significantly change some of the assumptions. Let's look at a simple example to determine what the impact of this change might be:

Assumptions

• One-time RESP contribution of $5,000


• CESG match of $500


• Contributor marginal tax rate = 43.41%


• Beneficiary marginal tax rate = 22.15%


• Investment growth = 8%


• Inflation = 3%


• 18 year investment period

The $5,000 contribution would generate an immediate tax savings of $2,170.50 for the contributor. In future dollars (i.e. after 18 years' inflation at 3%), this would be $3,695.13. The $5,500 (contribution plus CESG match) would grow to $21,978.11 after 18 years of 8% growth. Assuming that the beneficiary withdrew this entire amount for education purposes at the 18 year mark, they would pay $4,868.15 in taxes (since taxes would presumably be paid on both the contribution and the investment income). This represents $1,173.02 in net taxes paid (i.e. taxes paid by the beneficiary minus taxes saved by the contributor).

Compare this with the current rules, where the beneficiary would pay tax only on the $16,478.11 investment income, for a net taxation of $3,649.9 (since the contributor does not have any up-front tax savings). This is $2,476.88 more than the taxes paid under the proposed system.

Based on this example, it seems that the proposed tax deduction would result in a much more tax-efficient way to save for education, especially if the contributor were to put the $2,170.50 tax refund in a TFSA for some additional tax-free growth.

What do you think about this idea? Have I missed anything?

Happy Bissextile Day!

Now, before you all jump on me, saying that Bissextile Day is in June, I'm talking about the extra day that gets added in a Leap Year. Apparently, in the Julian Calendar, this extra day was initially an extension of the "sixth day before the calends of March", resulting in a "sixth day" that was twice as long as usual, thus the "bissextile", or "twice sixth" day. Phew. That's a lot of quotes and calendrical conventions.

Anyway, if you haven't done so already, today is your last chance to make a 2007 RRSP contribution (you can make a contribution tomorrow, but it can't be counted as a deduction on your 2007 tax return). If you're planning to make an in-branch contribution today, then expect some line-ups: today is the RRSP deadline and a Friday and the last day of the month, so banks will be just a bit busy.

Enjoy...

Looking into RESPs

The Loonie clan has seen a number of new additions recently, with births and pregnancies abounding. As a result, I've been thinking about RESP options, and decided to learn a little more about the workings of this plan. I've written briefly about RESPs in my Loonies And Savings Plans post, and other Canadian bloggers have posted great guides to RESPs, so I won't be delving too deeply into the intricate workings of these accounts. Instead, I'll look at a few of the rules, and lay down my decision on participating in the plan.

The Basics

When you set up an RESP, you register two individuals under the plan:

• The contributor (you) is the subscriber


• The future student is the beneficiary

The subscriber can contribute after-tax money to the plan, up to a lifetime limit of $50,000 per beneficiary. In contrast with RRSP contributions, the subscriber does not receive a tax deductions for any RESP contributions. However, the plan does have a couple of tax advantages:

• Provided that the beneficiary attends a university or college, withdrawals from the plan are taxed at the marginal rate of the beneficiary, not the subscriber. Since the beneficiary, as a student, should be in a low tax bracket, they will pay very little tax on these withdrawals


• The subscriber has already paid tax on the contributions, so only the growth in the investments is taxable. Combined with the first point, this means that RESPs can provide over 20 years of nearly tax-free growth

In addition to being a fairly tax-efficient way to save for a child's post-secondary education, there is the additional benefit of the CESG, which matches 20% of subscriber contributions, up to an annual maximum of $500 and a lifetime limit of $7,200. The CESG matching contributions count as investment growth, and are not taxed when withdrawn by the beneficiary. This represents an immediate tax-free 20% return on the first $2,500 in annual contributions.

The Big "If"

The big question with RESPs is, what happens if the child doesn't pursue post-secondary education? In this case, you "collapse" the plan, meaning that you, as the subscriber, close the account and withdraw the funds. Since you can have over 20 years of investment growth in the plan, there will clearly be some taxes to be paid. Here's the rundown:

• Your contributions are not taxed, since you made them with after-tax dollars


• You must refund any CESG that you received, immediately knocking up to $7,200 off your investment growth


• You must pay a 20% penalty on your investment growth (excluding CESG)


• You must pay taxes on your investment growth (excluding CESG) at your marginal rate

That's a pretty big tax hit to look at, but there are many factors to consider.

An Example

Suppose you contribute the $50,000 maximum, receiving the $7,200 CESG maximum, and over the years your investments grow to a total of $100,000. If the beneficiary attends university or college, then they have access to $57,200 in tax-free money, plus $42,800 in investment returns that, if used for education, will be taxed at their (low) marginal tax rate.

If the beneficiary does not pursue post-secondary education, then the plan must be collapsed, and the funds revert to the subscriber. If the subscriber's marginal tax rate is 40%, then they will have to pay the following:

• 0% tax on $50,000 contributions = $0


• $7,200 in refunded CESG


• 20% penalty on $42,800 investment growth = $8,560


• 40% taxes on $42,800 investment growth = $17,120


• Total paid = $32,880

This leaves the subscriber with $67,120 ($50,000 contributions plus $17,120 growth) out of the $100,000 that was built up in the plan. The 20% penalty, combined with the loss of favourable tax treatment of investment income, result in a huge tax hit to the subscriber in the event of a collapsed plan. However, there is some rationale behind these penalties:

• The 20% penalty is meant to offset any investment growth that you realized based on the CESG matching. Since your contributions were topped up by 20% each year, 20% of your investment growth is essentially due to this grant. So, having to pay back the CESG plus 20% of your returns makes sense


• The RESP can be looked at as a sort of "education insurance", where you pay an annual premium so that you have "coverage" in the event that the beneficiary pursues post-secondary education. Unlike most insurance policies, however, you get back all of your contributions at the end, with interest, if the plan is collapsed


• The $17,120 in net investment returns in the example given above should still be better than inflation, so even though you paid a big chunk to taxes, your contributions have still more than kept their value over time


• You were essentially willing to "gift" all of your contributions to the beneficiary anyway, so getting back your nominal contributions is a pretty nice consolation prize

The Verdict

For me, it really comes down to this: an RESP is a way of saying to a child, "I'm willing to help you out if you decide to pursue post-secondary education." If the child takes you up on the offer, then they have a great resource to help them through their education. If not, you've passed up some potential investment opportunities, but you more than recoup your contributions, and you know that you were there to support the child. There's nothing to stop you from giving them some of this money anyway, if that's what you want to do.

I'll be looking into setting up RESPs for some of my young relatives over the next couple of years.

Investing and Taxes

Until this year, I never really considered myself an investor. Even though I have been making bi-weekly contributions to an RRSP for the past seven years, I've only recently begun to think about how my investments are allocated, both across asset classes and across markets.

There are a couple of reasons for this:

• The Employee Savings Plan under which I make my regular contributions has a two-year vesting period. This means that, until you've been enrolled in the plan for two years, you have to leave your shares untouched, or else you forfeit the employer's matching contributions. As a result, I spent my first two years deliberately ignoring my ESP account, and this habit survived beyond the end of my vesting period.


• I'm in debt. This has automatically put me in the mindset of trying to reduce my debts, rather than grow my assets.

Because of my limited exposure to investing, I haven't had to deal with tax considerations around my investments, beyond declaring RRSP deductions on my tax return.

As I get my financial machine running more smoothly, I'm starting to see the light at the end of the tunnel, and am beginning to imagine myself having investments outside my RRSP. As a result, I need to wrap my head around the tax concerns faced by investors.

There are several ways to derive income from investments:

• Interest income from bonds, savings accounts, etc.


• Dividends paid to shareholders


• Capital gains from the sale of investments (stocks, rental property, etc.)

These three types of investment income are treated very differently from a tax point of view, and I thought I'd go into the details.

Interest Income

The first type of income has the simplest, but least favourable, tax treatment. Essentially, every dollar of interest that you earn is treated as regular income, and added directly to your taxable income for the year. This means that, if you have a marginal tax rate of 35%, and you earn $100 in interest, you will pay $35 in tax.

In Canada, interest paid on a mortgage for your primary residence is not tax-deductible. In general, interest paid on loans is only tax-deductible if the loan is used to buy investments. There is also a technique, known as the Smith Manoeuvre, which can convert your primary mortgage interest to tax-deductible status through leveraged investing.

Dividend Income

Dividends paid by Canadian corporations have a favourable tax treatment, although the formula for calculating dividend tax is quite convoluted.

Dividend income is "grossed up" by 45%, so that a $100 dividend adds $145 to your taxable income. If your marginal tax rate is 35%, then you pay $50.75 (35% of $145) on every $100 in dividend income. The flip-side, however, is the dividend tax credit. This is made up of a 27.5% credit at the federal level, as well as a provincial credit ranging from 8-18%. The Ontario dividend tax credit for 2008 is 10.15%, so the credit for a $100 dividend would come to $37.65. This means that the net tax on dividend income for our Ontario taxpayer at 35% would be $13.10. In low-income tax brackets, this net dividend tax can actually be negative, which can offset other taxes owed.

Capital Gains

A capital gain results from selling an investment from more than you initially paid for it. 50% of capital gains are added to your taxable income, so if your marginal rate is 35%, then you will pay $17.50 in taxes on every $100 in capital gains.

The nice thing about capital gains is that, with certain restrictions, they can be offset by capital losses (resulting from selling investments at a loss). So if our 35% taxpayer had a $200 capital gain and a $100 in capital loss, they would pay $17.50 on the $100 net capital gain.

Note that, just as mortgage interest on your primary residence is not tax-deductible, the sale of your primary residence does not result in a capital gain (or loss).

Diversified Income

Just as it's recommended to hold diverse investments to control risk, it's recommended to hold your income-generating investments in the most tax-efficient vehicle. Of the three types of income, interest is the least favourable, as seen below for an Ontario taxpayer with a 35% marginal rate:

• Interest: $35 tax per $100 income


• Dividends: $13.10 tax per $100 income


• Capital Gains: $17.50 tax per $100 income

For this reason, interest-generating investments should only (or at least primarily) be held in a tax-sheltered account like an RSP. Since income from an RSP at retirement is already fully taxed at the marginal rate, interest income is no less favourable than dividends or capital gains in this kind of account. In a taxable account, however, dividends are the most tax-efficient type of income, followed by capital gains, so a taxable account is an ideal place for dividend-paying stocks.

A dose of reality

It's been a bit painful watching the slide in the markets over the past month. So far, my retirement investments have dropped by more than $3,000 in 2008. That's not an easy thing to watch. Granted, I likely have 30 years of market growth to get my money back, but it's hard not to cringe at such a big drop.

Until last fall, I was an extremely passive investor. That's not to say that I had any kind of diversification or strategy; quite the opposite. My approach to investing was to have 6% of my bi-weekly paycheque deducted before taxes, and used to buy my shares of my employer's stock in a group RRSP. I left the shares where they were, so technically I was a "buy-and-hold" investor, but I was really walking a tightrope by holding all of my retirement savings in my employer's stock.

In September, I diversified my investments using low-cost index funds. Since then, I've generally seen better performance than in my old, concentrated portfolio, and I'm very happy with the change. However, it's frustrating to have made a measured, informed decision, and still end up losing so much ground.

John Bogle says that anyone who can't imagine a 20% drop in the markets shouldn't invest in stocks, and my gut reaction to my recent investment performance really underscores this point. I've lost about 8% of my portfolio's value in less than three weeks, and this is turning into a great test of my ability not to panic. I'll be invested in these markets for decades, so I need to learn how to weather some bad times.

The silver lining is that, with dollar-cost-averaging through bi-weekly contributions, I can likely look forward to a period of low-cost purchases in the near future.

Discovering common sense in investing

Since I converted my RSP from a concentrated stock position to low-cost index funds, I was pleased to see that, in the following weeks, my "old" portfolio performed significantly less well than my new diversified holdings. Given that my old stock holdings were banks, it's not surprising that they've been in relative free-fall for the past couple of weeks, in anticipation of the end of this "all-about-sub-prime" fiscal year. I have to admit that, as I've watched my index funds hold steady relative to the sliding bank stocks, I've felt more than a little cocky about my decision to diversify.

Well, today I've had a dose of common sense to cut me back down to size. Canadian bank stocks are on the rebound in the wake of Bank Of Montreal's year-end results, as investors can finally start to quantify the impact of the sub-prime mess on the Canadian market. I'm now seeing the down-side of a diversified portfolio: just as index funds drop in value more slowly than individual stocks, they are also slower to rise in value.

There's no question in my mind that diversification was the right move. My exposure to radical price swings in individual stocks is greatly reduced, and the fact that 90% of my holdings are in equities means that I still have a pretty aggressive portfolio. I just have to accept that, although I should do well in the long-run, there may be times where my "old" portfolio will leave me in its dust.

Another cross-border parallel

The recent rumblings about E-Trade's credit loss woes have a lot of investors (specifically, E-Trade's brokerage customers) worried about what might happen if E-Trade were actually to go bankrupt.

This is not the same thing as a bank failing, where cash deposits (up to the applicable limit) are insured under either the CDIC or FDIC (depending on which side of the Canada-US border you frequent). Investment assets (such as stocks and bonds) are not covered by CDIC/FDIC.

However, I was interested to read at My Money Blog that there is a corporation that protects investment assets. The SIPC provides protection of investment assets up to a limit.

Thanks to Canadian Capitalist for pointing out that, once again, we Canucks have a similar corporation, namely the CIPF.

So there's one more piece of cross-border financial arcana sorted out. Here are the links to the two corporations' websites:

CIPF
SIPC

Investing and the perception of risk

Money Smart Life has an interesting post today on extreme investing. Basically, the idea is that you take a small portion of your investable assets, money that you are willing to lose, and invest outside your usual comfort zone. The key here is that everyone's comfort zone is different, so this doesn't mean making margin trades on penny stocks for everyone; rather, take your "extreme" money and use it to try a new kind of investment.

This post got me thinking about the recent change in my own investment "strategy". For the last seven years, all of my invested money has been in my employer's stock. I didn't feel that I understood enough about investing to make smart choices in allocating my investments, so I left the money in the stocks (two stocks because I've had two employers). It wasn't until September that I sold the stocks and purchased index funds, coming up with something resembling a real asset allocation. It took a lot of hemming and hawing to make this switch, but I'm happy with the result.

The irony, of course, is that I was thinking of this switch in asset allocation as somewhat risky, when in fact I was significantly reducing the risk in my portfolio. I've gone from being invested in exactly two stocks to owning five index funds. I still may not have the ideal allocation, but my eggs are now spread across several baskets, which is a nice feeling.

I just found it amusing that my "bold move" served to diminish my risk. Extreme? maybe not. But I'm sleeping better now.