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Graham Westmacott CFA

Portfolio Manager

Susan Daley CFA

Associate Portfolio Manager
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  • 1.877.517.0888
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  • Waterloo, Ontario N2L 1T2

Basic Financial Terminology Explained

November 17, 2014 - 2 comments

Like many industries, the finance industry has its own vocabulary. All the acronyms and jargon can get confusing for investors, especially if you’re just starting out. In my last post, I outlined my intent to create a series of blogs that address financial issues facing young professionals. The following gives a very brief overview of some of the basic terms I will refer to in future posts in this series.

Account Types

Tax Free Savings Account (TFSA)

The TFSA is a tax-sheltered account to allow your money to earn a return tax free. Despite its name, a TFSA is much more than just a savings account. Most banks market it as a simple high interest savings account, but in reality, you can hold many different investments in these accounts, including stocks, bonds, GIC’s, ETF’s, and mutual funds.

When investing in a TFSA, you contribute after-tax dollars as if you were saving in any other savings or investment account. Any investment return you earn is not taxed, and you can take your money out tax-free, at any time. This account is great for individuals who want flexibility in withdrawals.

Registered Retirement Savings Plan (RRSP)

As the name suggests, the purpose of this account is to save for retirement. When you contribute to this account, you use pre-tax income. For example, if you make $90,000 gross income in one year, and contribute $15,000 to your RRSP that year, you are only taxed on income of $75,000, reducing your taxable income by the amount of the contribution. When you take money out of the RRSP, the withdrawal is fully taxed as income. This account allows you to defer taxes for many years, allowing your investments to grow even more. Typically, individuals’ marginal tax rates are lower in retirement than their tax rate while working, leading to further tax savings.

There are two ways you can withdraw money early from your RRSP without having to pay tax on it. The most popular way is through the Home Buyers Plan – where you can withdraw up to $25,000 from your RRSP to purchase your first home, and pay it back over 15 years. The second way to withdraw from an RRSP is through the Lifelong Learning Plan, where you can withdraw up to $20,000 in order to pay for full-time training or education. These two plans are essentially interest-free loans to yourself.

Like the TFSA, an RRSP is a type of account set up by the government to encourage savings. It is not a product itself, but rather an account that can hold investments like stocks, bonds, GIC’s, mutual funds, etc.

Registered Education Savings Plan (RESP)

RESP’s are accounts that allow you to save for your children’s education.  Each year, you can receive a grant for 20% of your contribution per beneficiary (up to a maximum grant of $500, i.e. a contribution of $2,500) from the government to supplement your savings. The total grant is capped at $7,200 / beneficiary. You do not get a tax refund for the contributions made, but the investments grow tax free until the money is taken out. Withdrawals that are a repayment of the contributions are not taxed. Withdrawals that are attributed to the grant and investment return are taxed in the beneficiary’s name, and since most post-secondary students don’t earn much income while they are in school, taxes on these amounts are small, if not zero.

Non-registered Investment Account

Investments in this type of account do not receive any preferential tax treatment by the government. They are the most flexible, meaning that there is no limit on contributions or withdrawals. Again, you can invest in stocks, bonds, ETF’s, mutual funds, etc. in this account.

It is important to understand the above accounts to minimize taxes, and remain within the rules to avoid penalties.

Investment Vehicles

Individual Securities

These are the most common securities people think of when investing. The common stock of publicly traded companies, like Google (GOOG) and Apple (APPL) are some typical individual securities. Individual securities also include fixed income investments such as GIC’s or individual bonds.

Exchange Traded Funds (ETFs)
ETFs are a basket of individual securities. They typically track an index which means that the ETF provider (e.g. Vanguard) will purchase shares of securities with investors’ money in the same proportion as each security in the index. When you purchase one unit of an ETF, you are essentially splitting your money into many investments (up to thousands) in individual securities. Take the Vanguard FTSE Canada Index ETF (VCE) for example. This ETF tracks the FTSE Canada Index ETF, which is comprised of 75 Canadian stocks. When you purchase a share of VCE for $31.36 (price as of Nov 12, 2014), you are purchasing those 75 Canadian stocks in the same proportion as the index. RBC’s proportion in the FTSE Canada Index is 8.16%, so with your one share of VCE, you have invested $2.56 in RBC; TD Bank makes up 7.26% of the index, therefore you’ve invested $2.28 of your $31.36 in TD. This is an example of a Canadian Stock ETF, though there are ETF’s for multiple geographical regions, asset classes (such as bonds, real estate, etc.), and industry sectors.

Mutual Funds

Most Canadians are familiar with mutual funds. Like ETF’s, they include a basket of securities that you can invest in through one product. There are nuances to the structure of mutual funds and ETF’s and how they are traded, but they are similar in providing broad exposure to a particular segment of the market. There are two main types of mutual funds: active mutual funds and passive (or index) mutual funds. Active mutual funds are the most prominent kind in the Canadian market. These are funds where portfolio managers choose which individual securities (stocks, bonds, etc.) should be included in the fund at any particular moment. Conversely, index mutual funds follow an index which uses mostly consistent and objective rules to include in the index. For this reason, index mutual funds require fewer analysts and therefore have lower management fees (MER’s). Securities within an index fund change far less often than those in active mutual funds, which typically means the investor pays less tax.

Asset Classes

Equities (aka stocks)

Purchasing stocks give investors an ownership interest in the company. When the company does well and earns profits, each shareholder gets a piece of those profits. These profits can be distributed to the shareholders most commonly through dividends, but also through the company purchasing the stocks back from investors. Profits can also be reinvested in the company to expand or pay for new projects. Reinvesting money in the company is expected to produce higher future profits, making the shares more valuable, thus increasing the price of the stock.

We typically classify equities by broad geographical regions like Canadian equities, US equities, and International equities (which includes emerging markets).

Fixed Income (aka bonds)

When you invest in bonds, you are lending money to governments or companies. In return, the governments/companies pay you interest on your loan. This is similar to going to a bank and taking out a loan, and having to pay interest on it. Companies and governments that have low risk of not paying the money back are considered investment grade bonds. Because they have lower risk, these bonds pay lower returns. Companies that are riskier are considered non-investment grade or junk bonds. Because there is a chance that they might not be able to pay back their debts, investors demand a higher return. Just like if you had bad credit and wanted to borrow money to pay for a car, you would have to pay higher interest on that loan. GIC’s are also considered fixed income, because you loan money to the bank, which pays a set interest rate to you over the term. GIC’s, unlike most bonds, are typically not liquid and should be purchased with the intention of holding to maturity. If you take money out before the GIC matures, you will likely lose any interest you’ve earned on the investment.

 

Other Resources

The Investor Education Fund is a great resource for Canadians to learn more about investing, and I would highly encourage those wanting to learn more about personal finance to check it out.

I am also happy to answer questions and provide additional resources. I can be reached at sdaley@pwlcapital.com.

By: Susan Daley with 2 comments.
Comments
  17/10/2016 10:30:54 AM
Susan Daley
Hi Thomas,

Thanks for the positive feedback! If there are any other topics you'd like me to cover in future posts, let me know!
 
  14/10/2016 2:03:43 PM
Thomas Ritto
Thanks for making such a cool post which is really very well written.
 



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