What is DIY Investing? The Basics.

When people first decide that they want to get a better handle on their investing, DIY investing may seem foreign and scary. That is on purpose. There are vested interests in making investing look more complicated than it should be. This page provides some basic knowledge about what DIY investing is, how it fits into a financial plan, and how it works.

Financial Planner & Investment Manager Roles

When people think about financial advisors, the usually think about investing. That is partly because most people’s experience consists of speaking to an advisor, who then recommends some funds. They then give the advisor some money, and it is done. It is like shopping. Because this bundled model is common in banks and wealth management firms, many people don’t realize that the tasks of financial planning and investing are linked, but different. Often, there is also a focus on the products and not as much on the other aspects of a financial plan.

A good financial planner helps with goal setting, building a comprehensive financial plan to get there, and the coaching required for various aspects of that. The investment management task involves assessing risk tolerance, building a portfolio to achieve the goals without excessive risk, and then maintaining the course. Crafting a solid financial plan and coaching clients is labor-intensive. In contrast, for investing, less effort and complexity generally yield better results. Ironically, the bundled models make most of their profit based off of the investment portfolio.

Splitting the advisor and manager roles.

DIY investing means splitting the advisor and portfolio manager roles to take on the portfolio manager tasks yourself. There are different ways to approach this job. Counter-intuitively, less complex and lower labor-intensive approaches usually work best. More on that later.

For the financial planning tasks, you can also learn, build, and implement your own financial plan. That may be simple early in your financial life, or it may already be challenging. Either way, you can get input and coaching from a fee-only (flat-rate) planner as needed. However, you still need to enact the plan. Whether you use a full-service bundled advisor or DIY, you still have to meet with insurance brokers, your accountant, and managing your cashflow regardless.

Since the profit of bundled advice models is driven by the investments, the savings from DIY investing are huge. However, financial advisors can potentially add value that counterbalances some of the cost. That value varies depending on the quality of the advisor, their pay model, the size/complexity of the situation, and the client.

Basic Process & Decisions for DIY Investing

When you take on the portfolio manager role, you have to make some decisions and execute a number of tasks. These decisions and tasks are often made to be more complex than they need to be. Or even should be, if following the best evidence. The projected value of complexity is commonly higher when the education is being provide by someone whom you may hire, if you think it is too hard.

My bias is towards DIY investing because that is what I do, I am partnered with Qtrade (a brokerage focused on DIY investors), and I know the evidence well. This section provides some of the basic education that you need to decide whether to hire someone or to do it yourself.

Step 1: Have money that you can and should invest.

Before you can invest, you must pay down your debt and/or build your savings to a secure level. That level is when you can both sleep at night and manage unexpected expenses. Investing is a long-term strategy, and you don’t want to sell prematurely due to a cashflow crunch. Money that you may need in the next few years should be saved and not invested.

Step 2: Open accounts to put investments into.

Investment accounts are simply containers that you then buy investments in. There are registered accounts such as an RRSP, TFSA, or RESP. These are your tax-sheltered accounts, and they have rules about what they can hold. Fortunately, that is just about anything that you would normally invest in. Unfortunately, they are small, and you may need to use some taxable accounts too. These tax-exposed non-registered “cash” or “margin” (if allowed to use some credit) can be personal or owned by a corporation. You can open them at an advisor brokerage, discount brokerage, or bank.

An important misconception is that you “buy” an RRSP, TFSA, or RESP. This confusion arises when people go to banks for advice where they try to bundle opening an account with filling it with their fee-laden products.

Step 3: Assess how much risk to take and a mix to match that.

The first part of this step is assessing your risk tolerance. Then, you select a mix of investments (asset allocation) to maximize your potential return without exceeding your risk tolerance.

Assess risk tolerance

Assessing risk tolerance can be as simple as doing the 15-minute Vanguard survey.

Estimating your risk tolerance is important to get close. We end up putting numbers to it, but it is not an exact science. Further, you may make gentle adjustments as your experience grows and your tolerance changes. So, I have also made a comprehensive risk assessment option as part of my interactive guide to DIY investing.

If you are using an advisor, then they should use a comprehensive approach rather than just a questionnaire. That is part of why you pay them.

The potential risk and return of stocks and bonds.

The most basic and important asset allocation decision is the stock:bond (equity:fixed-income) ratio. Investment risk and return are joined at the hip. If you are pitched an investment where that is not apparent, then you are missing an important aspect.

Equities (stocks) are owning a share of a company’s assets and future earnings. That has unlimited potential return but can also go to zero. The price fluctuates minute by minute as the information about factors affecting the company’s future prospects change. That price fluctuation is called volatility. The more volatile an investment is, the harder it is for us to resist buying more while it is desirable (expensive) or selling when unpopular (cheap). That is emotionally driven behavior and hard-wired into humans. Increased volatility increases that behavioral risk.

Buying bonds is a way to own debt payments and interest. Bonds have limited upside potential (the interest paid and the price of the bond at maturity). However, that also means that they are less volatile in price. The price of bonds before maturity fluctuates inversely to prevailing interest rates. Bond value can also drop precipitously if there is the threat of bankruptcy. In the event of bankruptcy, assets are sold, and bondholders get paid first. Government bonds are backed by a country’s ability to tax its population and all of its resources. So, government bonds are the safest and least volatile.

Choose a stock:bond asset allocation.

To match your risk tolerance to a stock:bond allocation, you try to balance investment risk and behavioral risk. In practice, that translates to taking equity risk to maximize potential return, balanced by enough bonds to stabilize volatility at a level that you can stick to the plan.

There is also risk at each extreme. An all-equity portfolio will have dramatically more volatility for a miniscule increased potential return. At the other end of the spectrum, using only fixed-income has a low potential return and may not keep pace with inflation or the growth needed to achieve your goals.

Some common allocations in between would be “conservative” (<50% stocks), “balanced” (50-70% stocks) or “growth/aggressive” (80% stocks).

Step 4: Choose products to match your asset allocation & diversify.

The stock:bond allocation balances the investment risk with behavioral risk. However, there is also specific risk. That is the risk that a single company or bond poses. The average investment risk of a pool of investments is compensated with its expected return. In contrast, the specific risk from a stock, due to it not meeting expectations, or its price volatility bucking you off the ride, is not compensated. You only want to take risks that you get compensated for taking!

Diversify to mitigate uncompensated risk.

Diversification means holding multiple companies or bonds. If they have a similar average expected risk/return, but don’t move in tandem, then diversification mitigates specific risk without lower expected return. The only “free-lunch” in investing. The more holdings that you have and the less correlated they are to each other; the more diversification reduces specific risk and volatility-induced behavioral risk. The chart below shows the effect of diversification using poorly correlated assets.

Unfortunately, most equity markets have correlation co-efficients of 0.80 to 0.90. Further, the stocks within those markets are clustered amongst industries. So, in practice, more than 1000 stocks are required to diversify.

Bonds are poorly correlated to stocks, with government bonds actually having a negative correlation. That is why bonds dampen volatility so effectively when added to a stock portfolio. Still, many bonds with different maturity and default risks are required to diversify.

Alternative investments such as real estate, private equity, or personal businesses are often touted as ways to diversify beyond stocks and bonds. However, they also have more specific risk and management costs by their nature. They usually have a single or small number of underlying assets (specific risk), plus the risk of how well management executes net of their fees (management risk). The potential risks and rewards are usually both magnified by the use of debt (leverage). The claims of low correlation to publicly traded markets and increased returns with less volatility for private equity breaks down once leverage, fees, illiquidity, and the infrequent pricing are accounted for.

Building a diversified portfolio from individual stocks is hard and usually less effective.

You can try to build a diversified portfolio by picking a variety of individual stocks and bonds. However, to do that in practice means buying hundreds of them to achieve diversification across industry, geography, politics, and other factors. That is usually cost prohibitive. A study of 90 years of market history showed only 4% of stocks account for the net market gain, more than half have a negative life-time return, and the most common outcome for a stock is a 100% loss. You had better hope that you pick the few winners. Further, the winners are constantly changing. The top companies today and in the past are completely different. The bigger problem is that you have to pick those 4%ers before they become the winners to capture their gain!

Some will tout strategies to pick the winners and avoid the losers (stock-picking). Generally, that means taking more uncompensated specific risk. That could pay off, if you know things that the other market-participants don’t. There are secretive closed quant funds and institutional market-makers that do have an edge, but that is not likely you. Even if you research a lot or buy some You-Tube-Dude’s Secret Sauce. So, the best path for most investors is to use broadly diversified index-tracking funds.

Exchange traded funds provide convenient and effective diversification.

To make diversification simple, we can buy bundles of companies or bonds using funds. Mutual funds are usually actively managed and sold via a dealer. That results in higher fees. Exchange traded funds (ETFs) tend to be passively managed (track an index) and very low fee. Data shows that >80% of active managers trail the market, higher fees are associated with worse returns, and trying to pick the recent top managers underperforms moving forward. This makes ETFs my preferred choice for convenient and effective investing.

Step 5: Buy the products.

This is the easiest part. At an advisor brokerage, they will do this for you. You pay for that via their fees. At a bank, they will also take care of this for you as long as you are buying their mutual funds (with embedded fees). They can even make this process look scary and complicated by calling into their trade center while you watch and verify. The process reminds me of calling in a military airstrike.

A discount brokerage means that it is like an online self-check-out. You load your basket & check out. That can save time by not having to deal with a human, and money by not having to pay the cashier’s wages. After doing it a few times, it is simple and boring. However, the first few times, it can still seem scary and then make you feel powerful after you succeed.

Don’t get hung up on tax-optimized asset location. For now. Maybe forever.

One other aspect of portfolio management that comes up is trying to optimize which types of investments to hold in each account type. Investment types and account types each have different tax characteristics and trying to match them optimally is called asset location. This is an attractive notion because taxes are the other sure thing in life besides fees and death.

The reality of implementing asset location is actually very complex and the potential benefit negligible for most people. There could also be added costs and execution risks. Even amongst professionals. Hence, the advice to ignore it as a DIY investor and its controversy amongst professional managers. Asset location is also something that you can learn more about later, when your experience and portfolio size shifts the balance. I have built educational material and tools to help into my interactive DIY investing guide.

You can simply ignore asset location by buying the same thing in each account type. For example, if your stock:bond allocation is 80:20, then buy and 80:20 ETF mix in each account. This is the best approach to start DIY investing.

Step 6: Minimize maintenance.

The two main maintenance tasks are rebalancing and buying/selling investments as you add or need money. These can take a minimal amount of time and be of minimal hassle.

Rebalancing is trimming what has grown more and buying more of what hasn’t to keep your target asset allocation. We rebalance to manage risk so that it does not creep too far off target over longer timeframes. In practice, that usually means buying more of what is lagging when you add money to your accounts. The good news is that you do not have to rebalance precisely or frequently. The even better news is that you can simply use an All-in-One Asset Allocation ETF to even do that for you!

Investing Decision Process Map

The Major DIY Investing Decisions

This overview of the basics of DIY investing above is the first step to deciding if and how you want to do it. The big decisions are summarized below. Don’t worry, you do not need to know it all to proceed. This information is reviewed and expanded on as needed for each step of the process, if you decide to use my guide to start DIY investing.

Next Steps for Your DIY Investing Journey

Learn more about the different ways to use advisors and DIY.

First, learn more about the potential savings of DIY investing vs the cost and value of different advisor models. I want you to make confident and informed decisions. If you are then committed to trying out DIY investing, the learn more about what to expect.

Check out the resources on Loonie Doctor to help you along the way.

I have also built an interactive guide to DIY investing using Qtrade to help you along the way. With screenshots and “just-in-time” embedded tools and educational material relevant to each step of the process. I built it for use with Qtrade’s processes. However, much of the information is extrapolatable to competitor platforms like Questrade etc. So, you can use whatever you want. My main goal is to help people take control of their finances. However, there are reasons why I chose to partner with Qtrade.