When it comes to investing, there’s a common misconception that you need to have tens of thousands of dollars to start an investment portfolio. In fact, you don’t need that much. Also, investing sooner rather than later means you have time on your side and you’ll be able to take advantage of compounding returns and interest.
Some of the most common types of investments are GICs, stocks, and index funds. Many people don’t understand the difference between these three types of investments or how the risk profiles differentiate them.
GICs are one of the safest types of investments. But safer investments often produce lower rates of return. With a GIC, you won’t lose your principal investment. Also, most GICs are insured by the Canada Deposit Insurance Corporation (CDIC) or provincial deposit insurers, which means your investment is protected in the unlikely event that your financial institution fails.
GIC terms are typically between 90 days and five years. The rate of interest you’ll receive rises as the term of the GIC increases. But there are downsides of investing in GICs.
One disadvantage is your money is locked in for the term of the GIC. That means you won’t have access to the money invested in the GIC until it matures. You can pull out your money early but you’ll forfeit some or all of the interest you would have received.
Risk-adverse investors are typically drawn to GICs because of their guaranteed return. While they can make up a portion of your investment portfolio, putting all of your money in GICs might mean you’re actually losing purchasing power over the long run due to inflation.
Stocks are much riskier than GICs. But with greater risk comes the potential for better returns. To purchase stocks, you’ll need to open a brokerage account. Most banks have online discount brokerages.
Owning a stock—such as McDonald’s or Coca-Cola—means you own a piece of the company. As a shareholder, you’ll profit from the company’s growth as its share price increases.
The downside of purchasing individual stocks is volatility. If the company has a bad year, the stock price will usually drop. And if the overall stock market declines, your shares will also often fall. In addition, investing in a single company magnifies this risk. When purchasing stocks, it’s best to own a number of them (10 or more) in order to have a more diversified portfolio. If that sounds too difficult, you can purchase index funds instead.
Index funds are a type of mutual fund. Index funds are passively managed and designed to track a specific bond or stock index (like the S&P/TSX Composite Index or S&P 500). An index fund’s assets aren’t traded frequently so the annual management fees are typically low (usually 0.30% to 1.1%). But most mutual funds are actively managed and designed to outperform an index. This fund’s assets are traded frequently and the fund is run by a manager who’s usually backed up by a team of research analysts, which means the annual management fees are much higher (usually 1.5% to 2.5%).
Index funds are a low-cost alternative to buying regular mutual funds. They’re also a great way to diversify your portfolio because you’re holding a basket of stocks (or bonds) instead of an individual stock. Index funds can produce better returns than GICs but they’re riskier. And like stocks, index funds aren’t insured and you can lose a significant portion of your initial investment.
The bottom line
Before deciding what to invest in, you should determine your risk tolerance, your investment time horizon, and how active you want to be in managing your portfolio. Doing this can help you make a more informed decision on what type of investments you should hold in your portfolio.
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Flickr: Iman Mosaad