Category: Investing

This article was originally posted on Blueprint for Prosperity.

A lot of inexperienced investors who invest in stocks either through mutual funds, index fund, ETFs or owning the stocks directly want great returns with minimal or no losses in the bad times. Unfortunately this isn’t possible for the simple reason that you can’t get great rewards in the equity game without taking great risks. Risk means that your investment could go either way. Your stock fund might get 10% this year or 30% or -30%. In 1929 the Dow lost 90% of it’s value – I’m sure that was a bit of a downer and not just for the guys stepping off window sills. Should you just buy GICs and not worry about the ups and downs of the markets? I would not recommend that because there is no guarantee that fixed income products will keep up to inflation.

Here are some of the things you can do to invest in the stock markets and get a good night’s sleep at the same time.

Own some fixed income – This could include bonds, gics, high interest savings accounts etc. When the market is crashing this part of your portfolio will hold steady and will reduce your decrease in portfolio value. How much you own is based on your tolerance for volatility.

Diversify – A lot of ex-Enron employees couldn’t sleep at night because their skyrocketing retirement accounts made them giddy – until the company went bankrupt and they were left with nothing. The idea behind diversification is to keep your many eggs in many baskets. If your investment in a buggy whip company isn’t doing so well then perhaps your automaker stocks will make up for it. If your telegraph stocks are dipping then maybe your phone company investments will make up for that.
You need to look at your investments and understand if you are diversified or not.
Things to diversity by are:

• Company – one rule is not to have more than 10% of your portfolio in one company, especially if you work for that company.
• Industry – owning 12 bank stocks is not diversified – The US market has a lot of different industries so buying a broad market index fund or ETF is very diversified.
• Country – although a good part of the S&P500 profits come from overseas – it doesn’t hurt to add some more foreign exposure.
• Currency – this kind of goes with the country diversification. While some people would prefer to purchase currency neutral foreign funds it’s not a bad idea to own different currencies.

Treat your portfolio like a portfolio – When looking at your gains or losses – do it for the whole portfolio and not each security. If you are properly diversified some of the investments will be doing better than others most of the time. If you own ten mutual funds and two of them are cratering but the other eight are doing well then you are probably doing ok.

History – Research the history of the stock market or read the following statement. Stock market goes up, stock market goes down – over the long run, stock market goes up. If you sell when it goes down and then buy on the way up then you are buying high and selling low – don’t do this. Another thing to be aware of is past bubbles – the more you know about them the more you can avoid them.

Keep track of your portfolio performance – If your portfolio goes up 15% per year for the last four years and then drops 20% this year – should you panic? No – you haven’t ‘lost’ anything and your best bet is to hang on.

Ignore the media – The media is not there for your education or to keep you informed. Their job is to sell newspapers, ads etc and that’s it. If the market falls 2% then it’s a “mini-crash”, if it goes up 2% then it’s a “strong day on Wall street”. I’ll leave you with a quote from Preet that I read on another blog which I like.

I remember someone saying that if you left the design of elevator buttons to the financial media, there would be no “Up” and “Down” buttons – they would read “SOAR!” and “PLUNGE!”.

In the blogosphere there seems to be a lot of excitement about peer-to-peer lending which is the ability to lend money to other individuals through companies such as Prosper and Lending Club. While I can understand how some investors will always be interested in a new investment product I don’t really understand the widespread excitement and interest level for this one.

Some of the things people should think about when considering P2P lending:

Diversification

Lending to one person is kind of like investing in a very small risky stock such as a junior mining company or a startup biotech company. You really don’t know much about that borrower and if something happens to them such as a medical emergency then your loan to them might be at risk. You can mitigate this risk by lending using a portfolio plan but I suggest that while this does reduce your risk, it doesn’t change the basic asset class which is still quite risky. A portfolio of p2p loans is like a mutual fund with numerous junior mining companies). You reduce the risk of any one company failing but aren’t protected against events that affect all junior mining companies ie falling metal prices.
One of the big risks that I would be concerned about is if interest rates go up. Presumably people who borrow on p2p are people who can’t get the loan from a bank at a normal rate – I would assume these people have already maxed out their credit or at a minimum have a lot of debt which makes them very vulnerable if interest rates increase.

Same as the old bank

Brip Blap wrote an interesting post on P2P which indicates that the lender “is the bank”. I have to disagree with this because I think Prosper or Lending Club is the bank. The only thing that really changes is that the p2p lender gets to choose who the borrower is which is not the case when you give money to a regular bank to get interest. Another issue I have is that Prosper and Lending Club seem to be spending a lot of money to get clients – advertising, free money giveaways. Where does this money come from? As far as cutting out the middle man – P2P institutions charge for the loans so I don’t really see how they are very much different from banks.

Statistics

Another concern I have is that I think the interest rates are too good to be true. If a borrower is willing to take my money for 10% then I know that they couldn’t get that same loan at a bank. This is problematic for two reasons –

1. The banks are far better at analyzing debtor risk than you or I (too bad they couldn’t analyze subprime securitization loans) so if they don’t feel the person is worth the risk at 10% then you are not getting a deal – you are getting a high risk loan.
2. If the person seems to have reasonable credit then they might have maxed out all their available credit which implies to me that their credit score is meaningless in that situation.

The fact that p2p has not been around very long also means that any default rates are probably understated. A loan can go into default at any time in the three year term so looking at default rates before three years is not going to be very accurate. Also – with the default rates do they do it by time periods? ie years? if not then any new loans will decrease the default rate dramatically.

Taxation

In the US, interest income is treated as regular income for taxation purposes. Dividends and capital gains are given preferential treatment and you will pay less than than on interest. You will be better off taxation wise to have all three of those investment types in a tax-sheltered account such as a 401(k) or ROTH account. If however you have investments in a taxable account then ideally it should not be fixed income such as bonds or P2P loans. Since P2P loans are not eligible for tax sheltered accounts then the extra taxes will reduce returns significantly.

Asset allocation

Asset allocation or the type of assets you invest in (ie stocks, bonds, cash) is a critical step in the investment process. Personally I have 25% of my investments in fixed income and 75% in equities (stocks). Regardless of the expected rate of return, P2P lending is considered fixed income and it should fit into your desired asset allocation.

Basic economics

If something is too good to be true then it probably isn’t. Currently you can get approximately 4% interest on guaranteed certificates or accounts. If you invest in P2P loans and have an expected return of 10% then that puts you in a much higher risk level and there is a reasonable chance that you could lose 10% or more (much like equities).

Bottom line

I have no plans to invest in p2p loans anytime soon because they don’t fit my investment plan. I do want to make it clear that I’m not suggesting that p2p loans should be avoided or that they are a bad thing. If you know what you are investing in and it fits your investment objectives then go ahead and lend away!

More peer-to-peer lending posts

Moolanomy questions if peer-to-peer lending is ready for the big time.
Cash Money Life answers Moolanomy in his post as to whether p2p lending is safe.

The Personal Financier wrote a very interesting post on the idea that long term equity investments are not risk free which is not a popular opinion for most investors.

A lot of the investment books that I’ve read often quote a long term equity return figure of 10% for equities. The idea is that while volatility will ensure that the short term returns will be all over the map, if you wait long enough then things will even out and you will get your 10%. If this was perfectly true then you should leverage every bit of money you can get your hands on and buy some equities (assuming that you are reasonably young).

Past returns of equities and stocks

The idea that you can get 10% annual return on equities is based on studies where they measured the equity performance of American stocks for a good part of the last century (about 80 years). As Bernstein pointed out in his Four Pillars of Investing book, this particular time period was a pretty good one for US securities. Another thing he points out is that if you include other countries in the world which went through various wars and natural disasters during that same time period, the world returns would be much lower. There is nothing wrong with looking at the past but you have to keep it in perspective and don’t write the 10% return in stone.

Fees

Another key point that a lot of investors seem to be unaware of is that the 10% return figure is a gross returns. In other words they did not include any kind of trading fees like you would incur on stock or ETF trades or the management fees that are charged on mutual funds, which is how most investors buy equities. In the U.S. it appears that most equity mutual funds charge about 1.5% per year which would mean a net return of only 8.5% – not 10%. Here in Canada, I’m proud to say that we have the highest mutual fund fees in the entire world and they average about 2.5% for retail funds which would bring out expected return down to 7.5%. Over the long haul, these lower returns will make a huge difference in the amount of money you have in retirement. Taxes are another issue but the assumption (which I think is valid) is that with proper financial planning, you shouldn’t be paying excessive taxes on your retirement funds withdrawals.

How long is the long term?

Another misconception is the length of the “long term”. I’ve seen posts where people mention that equities are good for investment as long as you will be invested at least five years or ten years. It’s hard to imagine how someone can look at a return figure from an 80 year study and assume it applies for a ten year period. I don’t have an answer to this question but what I do know from my limited statistics knowledge is that the odds of meeting your expected return increase over time. This means that if you are investing for a 20 year time period and you are expecting a return of 7% then the odds of meeting or exceeding that return are higher than for a 10 year time period. By the same token – investing for a 40 year time period will increase your odds compared to the 10 or 20 year time periods.

Most Canadians are probably familiar with the company BCE (Bell Canada Enterprises) since it is the biggest telephone provider in the country. Last June, the Ontario Teacher’s fund made the winning bid of $42.75 per share for BCE for a total of $35 billion dollars. Since that time the collapse of the credit market has made the deal less profitable for the banks providing the loans which include Citigroup, Deutsche Bank AG and Royal Bank of Scotland. There have been many rumours regarding the deal and if it would go through or not. This is one of the reasons why the stock has been trading between $32 and $38 in recent months which seems pretty cheap considering the shares should be worth $42.75 when the deal is finalized June 30.

Yesterday it was announced that a lawsuit by BCE bond holders was successful in a Quebec court which could mean that the deal doesn’t get done. The lawsuit was intended to block the takeover which the bond holders feel is unfair to them. The case will now go to the Supreme Court of Canada which will delay the takeover at a minimum.

Last fall when the stock was trading at about $38, Mr. Cheap and I had a conversation about BCE and if it was “free” money to buy it at a discount to the takeover purchase price. We both thought it was, but at the same time there was the risk that the deal wouldn’t go through for whatever reason. If that happened we figured the stock would go back to it’s pre-takeover price of around $30 which would be a big loss from a $38 purchase price. Given the limited upside at the time, neither of us went for the “sure thing” and it looks like we made the right choice.
Only time will tell but considering that the banks lending the money want out of the deal and the fact that telcos in general have lost value over the past year (the deal might be valued too high), there are a lot of good reasons why this deal might not happen. Telus which is another large Canadian telco has lost a quarter of its value over the last several months.

What is stopping the BCE takeover deal?

Basically, the investors who own the BCE corporate bonds are upset because the buyout will mean the new BCE will have a lot more leverage (debt) than the old BCE which will reduce the quality of the bonds thereby lowering the bond values. The bond holders want more say in the deal or to get compensation. BCE is arguing that the bond holders should have known there was a risk of a takeover and subsequent down grading of the bonds.

What do the banks think about BCE?

The banks that are providing the financing for the deal are Citigroup, Deutsche Bank AG and Royal Bank of Scotland. Since the deal was created, the credit markets have taken a beating and the banks will likely lose money on the loans. While they are still obligated to go through with the deal, they have a lot of incentive to withdraw if given the ability to do so.

BCE takeover history

pre-2007 – BCE stock price languishes for many years.

February 2007 – two groups make bids for BCE. One bid involved the Teachers, the other the CPP (Canada Pension Plan). Both were turned down.

April 2007 – BCE puts itself up for auction.

June 2007 – Teacher’s group puts in the winning bid of $42.75 per share.

Jan 2008 – BCE bond holders go to court to kill the deal since the bond values have dropped a lot.

Mar 2008 – bond holders lose court case but will appeal.

May 21 – bond holders win key court case to block deal.

A while ago I hit a bit of a milestone with my stock portfolio, and collected my 2000th dividend dollar, which has made me somewhat retrospective. I’ve gotten more used to having the dividends roll in, but I still feel a happy rush whenever they show up in my E*Trade account. Because I’m leveraging my account (buying on margin), most of the dividend payments have gone to pay the interest on what I’ve borrowed, so I certainly haven’t made $2000.

My (horribly non-diversified) portfolio consists of BMO, ROC, NA, RUS, and BAC. I bought WM without really understanding the company. I thought they were a conservative, long-term dividend payer, but instead they’re a growth bank (which is why they got hit so hard by the sub-prime fallout – they were in a VERY aggressive growth mode). There was a temporary rally with WM, which let me sell for a little more than a bought it for, which is when I moved into BAC.

Similarly, I didn’t really understand that RUS was cyclical (and hence the dividend isn’t as safe as I expected when I bought it). They haven’t cut their dividend, but they certainly could if we enter a prolonged recession. I’ve been planning to sell it when it goes above what I paid for it (I know, I know this is a fallacy – I should either keep it or sell it and ignore the current price vs what I paid).

So I’ve massively misunderstood 33% of the stocks I’ve bought so far – not too shabby, eh? 🙂

Other then those two, I’ve been happy with the stocks I own, even though they’ve lost about $4k of their value. My plan was alway to hold them long term, and collect the dividends (ala Derek Foster & Tom Connolly). The only two events that would make me consider selling are 1) they cut their dividend (like WM) or 2) the price goes so high without a corresponding increase in the dividend that the yield drops dramatically (at which point I *might* consider selling it and using the proceeds to buy another stock with a much higher dividend yield). Currently the securities are worth $58,632.04, I owe $33,922.79 (for a net value of $24,709.25). This puts my portfolio at 58% on margin. Margin calls occur at 70% (which I’ve had 2 small ones). With hindsight being 20/20, I clearly bought too early during the sub-prime meltdown.

Originally my plan was to maintain a large debt in the account, and to use the preferred taxation of dividends, along with the deductibility of investment debt, for tax planning. If you go to the Morningstar marginal tax rate calculator and put in an income of $80k, you see that the marginal taxation of public dividends is 20.24%. Since the marginal tax rate is 43.41%, if you bought a dividend paying stock on margin, and the interest rate was equal to the dividend yield (as it was recently for BMO), it will act as a 23.17% “tax sink” (after the dividend pays the interest, you get a 23.17% tax credit). This is only for Canadian dividends, this wouldn’t apply to BAC or WM dividends.

Now that I’m back at school, and not earning anywhere close to $80k (plus, given that grad students don’t have to pay taxes on most of their funding), this doesn’t make as much sense anymore. I’ve shifted gears and am now working on paying down the margin debt rather than expanding the portfolio (as I was planning to do when I was working – I was going to target keeping the portfolio at about 50% on margin). I’m somewhat sad as I think I’ve missed an incredible buying opportunity in the recent months.

If someone had the choice between a $1,000 / month or a 1% monthly increase on their investments, which is the better choice?

The correct answer, of course, is “it depends”. If someone had $100,000 than 1% monthly would be $1,000. So if you have more than $100k, the increase is better, and if you have less than this the fixed amount would be better.

Mike touched on this in a previous post (Do you really “earn” your investment income?), but I think it bears repeating.

Some PF bloggers spend tons of time analyzing stocks and devising sophisticated strategies that incorporate geopolitical issues and long term forecasts of economics trends. Then you read that their portfolio is worth $24,000. Any benefit from their work is going to be minimal, simply because they have so little to work with. If they were to go out and earn minimum wage from their time, they’d be far further ahead than trying to “juice” the returns on a small investment.

At a certain point it DOES become more lucrative to try to enhance your returns instead of earn a salary. Warren Buffet earns $100,000 / year running Berkshire Hathaway. This is a tiny, tiny fraction of his 62 billion dollar worth. Clearly he isn’t going to work for this salary. He’s goes into work because he enjoys it and to increase the return of the money he has invested in his company. If he can enhance B.H. returns by 1% a year, he increases his net worth by 620 million (many, many times his salary).

For people trying to manage their finances, I think that when their net worth is low, they are better served to try to increase their income and not worry about their investment returns. Go with something simple like a high yield savings account, a money market fund, or a broad market index fund. Any effort you want to put into your finances will be best served earning or saving more dollars, rather than trying to maximize your return. If you have a negative net worth, paying down your debt is almost certainly the best place for your money, and I’d say it would be a no-brainer that you should just keep earning as much as you can, spend as little as you can, and apply the difference to your debt. If this won’t dig you out of your hole anytime soon, perhaps it’s time to look into bankruptcy.

The more your net worth grows, the more you should shift gears to try to find better returns. This could mean investment real estate, more sophisticated stock selection, asset allocation, or any of the other popular personal finance topics.

I had recently written about my decision to buy some REITs (Real Estate Investment Trusts). REITs are a good way to add diversification to your portfolio since they are not closely correlated with equity returns. In the last post I looked at an ETF and several individual Canadian REITs. I’ve been thinking that I will put half of my REIT allocation into American REITs. The 50/50 split is a vary arbitrary number – there are lots of good reasons why I should own more US REITs compared to Canadian and there are lots of more good reasons why I should focus on Canadian REITs. That will be a discussion for another day.

One of the problems with the ishares REIT ETF (XRE) is the higher management fee of 0.55% which is high for a general REIT. I took a look at the Vanguard ETF lineup to see if it had a similar product for U.S. REITs and sure enough I found VNQ – Vanguard REIT ETF.

VNQ management fee (MER)

This ETF has a management fee of only 0.12% which is very reasonable, so in my opinion if you want to index with U.S. REITs then this ETF is a better choice than trying to buy a pile of individual securities.

What the VNQ REIT covers

According to the Vanguard VNQ strategy and policy page, VNQ tracks the MSCI US REIT Index which is a benchmark that tracks approximately two-thirds of the U.S. REIT market.

Summary

This ETF looks like the right one for me. I will be purchasing some VNQ (amex:vnq) in the near future and it will make up one half of my REIT allocation. Stay tuned for the exciting conclusion of what I finally decide to buy for my Canadian REIT allocation.

A man I knew a few years back got seriously into real estate after reading “Rich Dad, Poor Dad” and inheriting a million dollars (his father-in-law died). He had been living in Toronto, and after discovering how much cheaper property was in smaller towns (duh) he started buying anything he could get his hands on (this is the guy who evicted me when I wouldn’t loan him money).

I was talking to him after he’d bought one building with a commercial store front. I asked him if there was a tenant in it when he bought it and he said “no”. I then asked him if he had a tenant who would go into it after he fixed it up, he again said “no”. He followed this up with saying there was a non-profit group he could let use it in order to get a tax credit. I asked him why he bought it if there wasn’t any clear way to make money with the building, and he said that it was so cheap, he couldn’t lose. After he fixed it up he could just resell it for a lot more than he paid if he couldn’t find a tenant (although he expected to have people want to rent from him).

At the time this didn’t add up in my mind, but I figured I must not have a proper understanding of real estate. If the property was selling cheap now, it’s because there wasn’t much of a demand for store fronts in the small town. It just seemed to me that he was buying a rock around his neck to get the property, pour a lot of time and money into it, then have it sit empty for him (like it was for the person who sold it to him).

He proceed to buy up a bunch of properties, went looking for more money to keep buying (enter Mr. Cheap) and just recently, a few years later, I’ve found out that (surprise, surprise) it hasn’t worked out very well for him.

There’s a funny thing when people first get into a new investment, they seem to convince themselves that they’ve somehow stumbled in on it at exactly the best possible time. He was convinced that for some reason real estate was available at an unbelievably good price and he needed to buy as much as he could get his hands on.

I’m throwing rocks in a glass house here, as I got into dividend stocks in mid May last year, and as soon as there was a dip I bought a bunch more on margin (I thought I was being conservative, but I got hit with 2 small margin calls).

If anything, chances are good that if you learn about a new investment strategy, it’s probably been doing well recently (given that people are writing or talking about it and advocating / teaching new investors about it). From just a reversion-to-mean perspective, it’s probably LESS LIKELY to do well in the near future, BECAUSE it’s been doing well recently (like real estate and dividend stocks right now). Perhaps the best investment strategy would be to read 10 year old “get rich quick” books and copies of the Wall Street Journal? 😉

I’ve seen the pattern repeatedly where people learn about a new strategy, think it’s great, then bet the farm on it before they’re knowledgeable enough to really assess the risk / reward trade-off being offered. Cooler heads wrote early on that the bank stocks were probably going to keep falling, and I could have saved myself thousands of dollars if I had waited a few more months to buy.

My fear was that I’d miss the dip and be kicking myself for not buying when they were higher.

I’m not sure if this is a general problem for anyone learning a new strategy, or just an issue for certain personality types. The rational approach would obviously be to start small with a new investment strategy, test the waters, and gradually increase your investment as you learn more. People (in my experience) don’t do this, and seem to fall into two camps: either they don’t invest at all (all money sits in GICs and savings accounts), or they seem to over-invest early in their self-education.

Do you think putting too much money in an investment while you’re still a novice is a common investor problem, or do you think Mr. Cheap is just trying to project his issues on the rest of the investment community?