Mutual Funds and Fixed-income Investments
Many RRSPs are simply registered mutual funds or registered fixed-income instruments such as a GIC. The type of mutual fund or fixed income investments and their mix as a percentage of the total investment portfolio are choices of the investor, so these are known as self-directed RRSPs.
Fixed Income Investments
Fixed-income investments are generally very safe investments. When you purchase a fixed-income investment such as a bond, you are actually loaning your money to a government, large corporation or financial institution in return for a promise to pay interest according to a pre-set schedule and retirement of the loan on a fixed date. The rate of interest paid is based upon the strength of the borrower so the greater the interest rate, the greater the risk. When comparing fixed-income investments to equity investment, remember interest on loans are paid out to lenders before a dividend is paid to equity holders.
What many investors seem to have a difficult time understanding or fail to realize is that bonds rarely return their face or stated percentage rate. This is because bonds are bought and sold on the open market and therefore reflect current interest rates. When interest rates rise, bond prices fall and when interest is falling, bond prices increase. You end up betting on which way interest rates are going in the future.
Fixed-income investments are a good alternative to equity investment when stock markets are volatile. They offer some growth potential and income. In Canada, the fixed-income market is approximately 40 times larger in dollar value trading volume than stocks, they just don’t grab the dramatic media attention.
Mutual Funds are an excellent investment phenomena that can be used to great advantage by the self-directed RRSP investor. There exists such a wide array of fund types on the market, an investor can pick and choose, mix and blend levels of security that can at times even exceed the surety of fixed-income instruments.
Mutual funds can be completely equity based, money market based, or fixed-income based and any imaginable mixture in between. Consider the common advice of a portfolio manager suggesting investments to a player in the markets. Most will recommend investment in small-cap, medium-cap, and large-cap stocks for good equity balance. Some money should go into fixed-income instruments such as government bonds, high yield bonds and corporate bonds. Most advisors insist investments are not properly diversified unless investments are made into many different geographic areas to take advantage of different global markets. It can get pretty complicated.
Advantages of Mutual Funds
Investors whose RRSP contributions are limited will likely achieve a more diversified investment portfolio through an investment in a mutual fund. More people are turning to equity investing because they are looking for higher returns and mutual funds are the vehicle for most. Certainly, mutual funds do offer more than just long term protection against inflation.
Inside an RRSP, the growth of a mutual fund benefiting from tax deferral, the power of compounding can be quite astounding. By putting just $3,500. per year for 30 years into a mutual fund yielding a 12% compound rate of return, earnings will exceed $3,000,000. Suppose that same investor is in a 45% tax bracket and makes the identical investment outside of an RRSP. Earnings will only be in the neighborhood of $500,000.
The power of a mutual fund lies in its diversity and the insightful expertise of its manager. It is a simple thing for an investor to check and compare performances of various funds (the track record over long periods of time) just by consulting their growth charts. What you are getting when you buy into one that is right for you is small piece of an extremely well managed investment portfolio. It is highly doubtful an individual working on their own, buying and selling in the equities markets of the world could match their performance.
All the requisite ideals of healthy investment – diversification, balance, stability, etc – can be covered off under the security blanket of the right mutual fund. Earlier on in this article, reference was made to using mutual funds in place of direct fixed-income instruments. There are mutual funds out there that put their money into nothing but these forms of investment. Imagine the level of security and growth achieved in this type of fund opposed to going it alone.
With the right guidance and a little diligence, mutual fund investment offers a very solid roadway to a financially sound retirement.
You might be interested to learn about account management fees associated with mutual funds, because they play a large role in selecting the right mutual fund, more can be read on this topic here.