Wealthsimple

Very broadly speaking, there are two basic approaches to investing: active and passive. So what’s the difference?

What it’s not

Some people might (incorrectly) suggest that an active investor is someone who makes frequent trades (up to multiple times a day), while a passive investor is someone who makes infrequent trades (once a month or less). But frequency of trades really isn’t the best way to understand active vs passive investing.

Others might (also incorrectly) suggest that an active investor is someone who handpicks their stocks based on market conditions every time they buy, while a passive investor is someone who buys the same securities repeatedly. This, also, isn’t the best way way to understand active vs passive investing.

What it is

In simple terms, an active investor is someone who is trying to beat the market, while a passive investor is someone who is trying to replicate the market (or a market segment). The movement of a market is measured by weighing all the individual stocks in that market and averaging out their direction. So when you hear that the TSX is down 2%, it means that while some of the stocks may have gone up and others gone down, overall, the average stock price fell 2%.

As of writing this post, the TSX is up 4.61% compared to a year ago. A passive investor looks at that number and says “yeah, I could settle for that.” An active investor says “nah, I could do better.”

How it works

Again, the key to all of this is that a stock market’s average return is literally just the combined return of all the stocks on that market. This means that if you bought a portfolio 1 year ago of all the stocks on the TSX, weighted by their market share, your return over the past year would be 4.61%. It’s really just junior high level math.

So, a passive investor chooses to guarantee themselves a return equal to the average market return. An active investor attempts to predict which stocks will outperform the market average. If the average return of their portfolio is higher than the average return of the market - boom, they won.

This is why the first two definitions of active vs passive investing are faulty. An active investor could buy $10,000 worth of a few stocks and hold for a year, in the hopes that they outperform the market, while a passive investor could buy $20 worth of the market every day for a year. Frequency doesn’t matter.

Similarly, an active investor might keep buying Tesla over and over, while a passive investor will continually rebalance their portfolio to align with the market.

So which is better?

The answer is a little bit complicated (but only a little bit). If you want to get rich quick, passive investing ain’t gonna do it for you. But for my money, I’d choose passive investing over active investing any day. And that’s because it turns out humans are awful at predicting what stocks will over-perform. In fact, over the past 20 years, about 90-95% of active investors failed to beat the market.

The situation gets even worse when you consider that a lot of active investors are actually paying someone else a management fee to pick stocks for them, which takes even more off the top. On the other hand, there are plenty of low-cost ETFs which attempt to replicate segments of the market, like the well-know-and-loved VGRO or XGRO. (portfolios like these are called “index funds”).

Of course, the real answer is that we should all just keep buying GameStop.

Non-registered accounts (previously personal accounts)

This is your basic, run-of-the-mill investing account. Nothing really special about it. You’ll pay taxes on all dividends, interest, and capital gains from investments inside this account, and be eligible for a tax credit if you experience capital losses. It’s the baseline to which everything else is compared.

Advantages: The only real advantage to a non-registered account is its flexibility. You can deposit, withdraw, and trade within it as often as you damn well please.

Disadvantages: The obvious disadvantage of a non-registered account is that you don’t get any tax incentives.

When should you use this account? If you’re into day-trading (good luck), this is probably the best account for you to use. If your strategy is to buy-and-hold, then you should probably only use this account if you have no contribution room left in any of the relevant registered accounts listed below.

TFSA (Tax-Free Savings Account)

Calling this a “savings account” is a bit misleading, because a TFSA can hold any investment that a non-registered account can. The TFSA is like a magic circle you draw around some of your investments that make them invisible to the CRA. You won’t pay taxes on interest, dividends, or capital gains, and you won’t get tax credits on capital losses. You’ll also be putting post-tax money into a TFSA, which means you don’t get anything back during tax season.

Advantages: Being able to invest without taxes means you’ll be able to save much faster than if you had to pay taxes. You get to keep more of your money. Beautiful.

Disadvantages: It’s illegal to day-trade in a TFSA, so don’t even think about it. There’s also a contribution limit for your TFSA that starts accumulating the year you turn 18, even if you don’t open a TFSA until years later. The contribution counter doesn’t reset until January 1 of the next year, so if you deposit $1,000, immediately withdrew it, and then deposit it again, you’ll have used $2,000 of your contribution room, even though your balance has only grown by $1,000.

When should you use this account? A TFSA is a great vehicle for mid-to-long-term savings. There are no rules about making withdrawals, so it’s flexible enough to use for saving for education, a down payment, retirement, or a backpacking trip across Europe. If you have contribution room, this should probably be your default account for investing.

RRSP (Registered Retirement Savings Plan)

The original tax-advantaged account. As the name suggests, an RRSP is primarily meant for retirement savings, though it does have allowances for withdrawing from it for education and down-payments. Your deposits into an RRSP are supposed to be pre-tax, except for since most people never actually get to touch their pre-tax money, the government makes up the difference by adjusting your taxable income at tax season, meaning you get a bigger tax refund. The interest, dividends, and capital gains and losses in your RRSP aren’t taxed, however, withdrawing from your RRSP when you’re retired counts as taxable income, which means it’s basically a “save-now-pay-later” kind of situation.

Advantages: Like the TFSA, the big advantage of an RRSP is the tax incentives. It’s a great vehicle for retirement savings.

Disadvantages: The RRSP has some restrictions on withdrawals, which makes it harder to access your money once you’ve deposited. If you toss $5,000 into your RRSP and then your car breaks down the next day, you’re out of luck. Additionally, you'll have contribution limits, which will be 18% of your annual income, up to $29,210.

When should you use this account? If you compare saving in an RRSP to saving in a TFSA, you’ll find that you end up with exactly the same amount of money at the end of the day, assuming your marginal tax rate doesn’t change between now and retirement. The RRSP wins out against the TFSA if your retirement income will be lower than your current income, and loses against the TFSA if your retirement income will be higher than your current income. As a rule of thumb, if your pre-tax income is more than $100,000, you should prioritize saving for retirement in an RRSP over a TFSA.

RESP (Registered Education Savings Plan)

It may come as a surprise to you to learn that this account is meant to help pay for education - though typically not your education. While you can open an RESP for yourself as an adult, the intention is that you’ll open an RESP for a beneficiary, usually your child/grandchild/niece/nephew. There are a few flavours of RESPs, but the big idea is that your investments get to grow tax-free until the beneficiary withdraws them for post-secondary education.

Advantages: In addition to tax-free growth, the government will also match 20% of your contributions, up to an annual limit of $500 (meaning you’ve contributed $2,500). And hey, free money is free money. With some extra cash, you’ll save money even faster than you would in a TFSA. Additionally, withdrawing your own contributions is tax-free, while withdrawals of the rest of the funds are taxed as income for your beneficiary, who, as a student, will likely have a low income, meaning they’ll pay little-to-no tax on the withdrawals.

Disadvantages: If your beneficiary chooses not to attend post-secondary, you still get your contributions back tax-free, but the government will take back their money, and you’ll have to pay a hefty tax rate on withdrawing the accumulated interest (your regular income tax rate plus 20%). So, your money won’t be totally lost, but you’ll be worse off than if you’d saved in a TFSA.

When should you use this account? The RESP is hands-down the best vehicle for saving for a loved one’s education. The only hangup is the penalties on getting your money back if they don’t attend post-secondary. You’ll have to decide if that risk is worth it for you or not.

FHSA (First Home Savings Account)

The new kid on the block, the FHSA combines the best of both worlds from the RRSP and the TFSA. Not only do your contributions reduce your taxable income, all your interest, dividends, and capital gains/losses are tax-free, and the withdrawals are tax-free, too! Of course, there’s the big restriction that you can only withdraw from the FHSA tax-free if you’re withdrawing for a down-payment on your first home.

Advantages: So many. Assuming you invest the refunds you get at tax season from contributing to this account, this is quite literally the fastest way to save for your first down payment. And get this - even if you end up not purchasing a home (or never intended to in the first place), you can staple this account onto your RRSP as an expansion, without using up any of your RRSP’s contribution limit.

Disadvantages: The only real downside to an FHSA is that you’ve only got 15 years from when you open it to withdraw your money. That’s a generous window, but if it takes you longer than 15 years to save your down payment, you’ll lose either have to send your savings to your RRSP or make a taxable withdrawal. Ouch. Additionally, there’s an annual contribution limit of $8,000, which carries forward for a single year, and doesn’t start accumulating until you open the FHSA, which means you actually want to open the FHSA before you intend to start saving for a down payment. There’s also a lifetime contribution limit of $40,000.

When should you use this account? The real question is when should you not use this account? If you’re at all interested in buying a home in the next 15 years, you should be opening up one of these bad boys ASAP. Even if you don’t buy a home, you get to add your investments to your retirement savings, so there’s really no losing here. Saving for short-to-mid-term goals other than buying a home should still be done in a TFSA or RESP, but otherwise, this should be the first account you’re contributing to.

Did I miss anything? Get anything wrong? Let me know in the comments and I’ll update the post.