Creating the Positive Feedback Loop

Updated: Feb 16, 2021

Money can follow many paths. Which path is most efficient for your money depends on your particular circumstances. Today, let's look at few different paths your money could follow and go over the basic pros and cons of each.

First, in order to get us thinking about the ways our money can go, I created a flow chart that visualizes the different paths money can take.

Follow the Paths, Find the Loops

One of the most difficult things to do is make visual representations of ideas in finance. Every time I try I ultimately lose some important detail, often the impact of time.

I think that this flowchart, despite its shortcomings, has one really important lesson to teach. Look for positive feedback loops! This flowchart does just that. It shows us some of the different loops we can form where investments feed themselves in an ever-expanding loop.

Loop 1) The RRSP loop

The RRSP loop is located at the top left of the flowchart.

The two key things to notice are that the RRSP flows directly into the investment account without passing through our tax block. Within the investment account, the loop/compounding can run free of taxes! Unfortunately, the loop does end at the taxation point, the good news is this could be after 30+ years of time spent in the investment account.

Loop 2) The TFSA Loop

The TFSA loop offers a great example of the concept of a positive feedback loop.

let's follow the money. The money leaves our after-tax income and goes into the TFSA, from there we invest in a dividend-paying stock. When the dividends are paid it is essentially like we are getting new after-tax income that flows right back into the TFSA. This process can go on and on, the sum getting bigger each and every time, with virtually no limit. Just wait and watch.

On the other leg, we have the zero dividend investment made using the TFSA. If an investment doesn't pay a dividend then the positive feedback loop must happen inside the company. This works because the company makes investments that produce income for the company, itself reinvested, creating a loop within the company not requiring dividend payments.

Loop 3) Unsheltered Loops

Unsheltered loops are the least tax-efficient. Of the two investment choices, dividend-paying investments are the least efficient of all.

As we see below, the dividend-paying investment made in a non-tax-sheltered account offers neither the advantages of being tax-free nor an income deduction when money is placed in the account. In this loop, you have to pay $200 every time you cross go instead of receiving it. It serves as a massive speedbump on the track, not eliminating the wealth-building effects but slowing them.

On the right, we see that the zero dividend investment does not pass through the tax box, and a loop forms as a result of the business compounding within your accout. Theoretically, zero dividend investments held in unsheltered accounts for long periods of time are the most tax-efficient strategy in these kinds of accounts. Additionally, should an investor choose to sell some small portion of the stock, to in effect pay themself a dividend, they would pay only the lower capital gains tax.

The zero divined investment seems an obvious choice but oftentimes holding investments for long periods of time (10+ years) can be a test of an investor's nerves. It is reasonable to expect that over a holding period of this length an investor will experience at least one extremely scary period in the markets where they are tempted to sell and walk away. Investors who habitually hop in and out of the market will find themselves losing money to capital gains left and right. The moral of the story is to buy quality companies that you are very comfortable with and be prepared to push through the scary times when they inevitably come.