Category: Investing

Categories
Investing

Three Investing Mistakes

I’ve been tagged by The Dividend Guy to name my top three investing mistakes. I ended up going on a bit of a rant with one of them so I’ll just quickly mention that the first two mistakes are:

  1. Selling equities when the market went down.
  2. Not knowing anything about investing or the funds that I was investing in until a couple of years ago.

and the third mistake…

Investing for tax reasons

Way back in the late 1990’s there were a pile of new investment funds available called Labour Sponsored Investment Funds. These funds had some pretty good tax breaks because they invested in start up companies and the government wanted to promote investment in that area. For some reason these funds had to have an association with a union for this tax break to occur which should have been a red flag right there. They invested in small companies which could either be private or public.
I invested in these mainly because of the tax break but also because of the potential of the unproven companies. I figured since I had a long investment timeline then I could handle any amount of risk right?

Well, thanks to the long vesting period of these funds – you have to hold them for eight years otherwise the tax credit has to be paid back, I still own these dogs. The funds have changed names several times but it’s still a little bit of my money. Another great thing about these LSIFs is that the MERs on these funds are usually around 4%. I’m so happy that while my investment dwindles – some crooks…errr, I mean investment managers are getting fat off my money.

Interestingly enough the book value of my LSIFs is $15,500 and the current market value is about $5500. Keep in mind – the average purchase date was around 1998.

I calculated a while back that if I had taken the equivalent amount of money (without the extra tax credits) and just invested in a normal Canadian mutual fund (high fees and all) I would have about $30,000 right now so this mistake cost me around $25,000.

As you might have guessed, even a whisper of the words “labour sponsored funds” makes my blood boil. Recently the government announced that they would stop the extra tax credits for LSIFs investments which is a great move but I wish they would have investigated some of these funds to find out exactly where the money went. I suspect if you could interview friends and neighbours of these “fund managers” you might find that quite a few of them had rather unsuccessful start up companies in the late 90’s paid for of course, by LSIF funds.

I’m going to tag the following bloggers:

Canadian Dream – I don’t recall Tim talking about any of his investing mistakes..maybe he hasn’t made any?

Million Dollar Journey – This guy is into every type of investment and trading strategy you can think of so I’m sure not all of them have worked every time.

The Dough Roller – Another big time investor – I’m sure he has a story or two.

Categories
Investing

Greedy Management and the Decline of Equity Returns

About a year ago I read Stephen A. Jarislowsky’s “The Investment Zoo” and the idea behind this post was stolen from it, and has been bouncing around in my head long enough that I feel like it’s my own. If you feel like reading a far better presentation of it (along with a bunch of other killer ideas), check out the original source.

Supposedly up until 20 years ago or so, upper management (CEOs and whatnot) were paid about 40 times what the average worker earned. High income without being obscene. People would work their way up the corporate ladder, have a very affluent lifestyle, and typically do the work they loved to do (run a large business).

As athletes commanded increasingly insane salaries, top CEOs started saying that as the “superstars” of the business world they deserved similarly extravagant salaries. Boards and shareholders bought in to this idea, and competition pulled up compensation packages for upper management to the nose-bleed inducing heights they’ve reached.

A favourite way of hiding how much they’re raping their business is for upper management to issue themselves stock options. Presented under the guise of “rewarding the management for increasing shareholder value” this lets the company buy back shares (pretending this is a good thing for shareholders), issue these shares to themselves (without having to dilute outstanding shares) and over time steal a major portion of the company from the owners (they’re buying shares for themselves with money that belongs to the shareholders). Apparently Jack Welch and his cronies went from owning nothing of the company to 30% of GE when he retired.

People like to say that the expected nominal return from stocks is 10% over the long term. Whenever the market exceeds this and they say “the rules are different this time” a correction hits and brings us back down to Earth. Any time you hear that phrase or get stock tips from a shoe shine boy it’s time to sell.

I wonder if this time the rules ARE different, and we’re having part of our 10% return stolen from us by the people we’ve entrusted to grow it?

Categories
Investing

REIT ETF? Or REIT Investment Trusts?

I’ve been pondering buying some REITs in order to increase the real estate allocation of my portfolio which is currently at zero. Several options have popped up:

  1. XRE – iShares REIT ETF which is made up of Canadian REITs.
  2. Buying just the top REIT (RioCan) in XRE.
  3. Buying the top three REITs in XRE.
  4. Buying the top eight REITs in XRE.
  5. American REITs most notably Vanguard REIT ETF (VNQ).

Today I will look at the first three options – feel free to suggest any others.

XRE – iShares Canadian REIT Sector Fund Index is my first choice for REITs. It replicates the S&P/TSX Capped REIT Index and fits very well with my (mostly) passive investment choice. The only problem with this particular ETF is that it has a high MER of 0.55%. Now 0.55% is not totally outrageous but it seems a bit high considering that you can buy the top three REITs in the index and get 50% of the market capitalization of XRE. Another option is to buy the top eight REITs and get 85% of the capitalization of XRE.

The amount I’m planning to own for REITs is about $20,000 which is about 8% of our portfolio. For the purposes of this comparison I’ll assume a 10 year investment time horizon.

  1. Paying 0.55% management fee of XRE per year will result in $110 per year in fees.
  2. Buying just RioCan (REI-UN.TO) will result in a $4.95 purchase fee which works out to $0.50 per year in fees. Problem is that this stock only covers 25% of the REIT index so diversification might not be good enough.
  3. Buying the top three Reits (RioCan, H&R, Can) will result in about $1.50 in fees per year. This will give me about 50% of the capitalization of the index which isn’t bad.
  4. Buying the top eight Reits (RioCan, H&R, Can, Boardwalk, Calloway, Chartwell Seniors Housing, Canada Apartment Properties, Primaris Retail) will result in about $4.00 in fees per year. This will give me about 85% of the capitalization of the index which is pretty darn good.

When I look at the numbers it’s pretty obvious that as long as I don’t care about following the REIT index too closely, buying XRE is a bit of a ripoff. I could probably buy every single REIT in the index and still save money on it’s MER. Buying the top REIT, the top three and the top eight are all pretty much the same cost given that they are all chump change. I think that the extra diversification of buying the top eight is worth the extra couple of bucks per year. With 85% of the index covered, that’s good enough for me. I’ve ignored rebalancing costs but since I’m not too concerned about following the index exactly, I don’t think those will be very much.

I still have to consider US REITs but that will be for another day.

Conclusion

For the amount of REITs I want to buy ($20k) and my trading fees ($4.95) I think that buying the top eight REITs in the REIT index will give me adequate diversification (85% of index) and low costs ($4 per year).

If anyone has any thoughts on my analysis then I’d love to hear them.

Categories
Investing

Index Funds VS. ETFs

As a low cost investor I like researching different low cost options and trying to decide which is best for my situation. One question that comes up frequently from investors with small portfolios is whether they should buy low cost index fund such as the TD e-series or by ETFs which have lower mers than the index funds but you have to pay a minimum of $4.95 per trade. Other blogs have covered this topic and based their answer mainly on the portfolio size. If your portfolio is significantly less than $25k then start an account at TD and around $25k mark, transfer it to a discount broker like Questrade and buy ETFs. This is definitely the cheapest strategy but it involves setting up two accounts and doing one transfer.

One problem with that method is that I suspect a lot of investors will set up the account at TD but they won’t switch to a discount brokerage at the right time or at all which means in the long run they will end up paying more fees compared to if they had just started buying ETFs even when the account was fairly small.

To avoid this problem I would suggest that another strategy to consider is to pay the higher costs of a discount brokerage right from the beginning because it won’t be long before you will be saving money and can recoup the extra expenses from earlier on. What I did was to set up a model which will tell me if an investor has a small portfolio then how much money per month do they need contribute to make this strategy worthwhile. There is a link to my spreadsheet at the bottom of the post.

Another part of this idea is to start with Questrade because it’s the cheapest discount brokerage available but alter your trading habits – if you contribute monthly then only buy one ETF per month. Another great idea is to only buy an ETF every second or third month, especially in the beginning.

What we are really looking at is the idea of doing either TD or Questrade and seeing how long it takes for the break even point to occur. If the point is fairly soon (ie less than 5 years) then it might be an idea to just go with the ETFs if you don’t think you will make the switch from TD to Questrade down the road.

This chart indicates the final numbers. The second row has the portfolio size, the second column has the monthly contributions and the other numbers are the number of years until the break even point. Keep in mind that the break even point is when all the losses in the early years are made up for.

For example if you have a starting portfolio of $10k and you contribute $250 per month then after eight years the total costs of ETFs (for all eight years) is the same as the cost of index funds.

 

 

Portfolio size

 

 

 

 

$0.00

$10,000

$20,000

Contribution

$100

30

13

4

 

$250

13

8

3

 

$500

8

5

2

 

$750

6

3

1

 

$1000

4

3

1

 

As you can see, the monthly contribution is a big factor in this decision – if you are contributing larger amounts then even if you start with nothing, the Questrade option is better. Another factor of course is the starting portfolio size – if you already have $20k then it’s probably better to start at Questrade . The reverse of course is true – if you are contributing $100 per month then you are probably better off with TD unless you have close to $25k.

This is definitely a personal decision but I would think that unless you are super keen to save every cost possible then consider doing Questrade from the beginning if the break even point is less than about 5-7 years.
Keep in mind as well that a lot of the initial trading costs can be saved by contributing to the Questrade account monthly but only buy ETFs infrequently.

I’m also using a very simplified portfolio that is equally weighted among the securities. If you want more securities that are not equally balanced then that may add to the trading costs with the Questrade option. Even there if you want a small emerging market exposure you can just make one purchase a year for example in that class. You might not have your desired asset allocation at all times, but if you portfolio is very small then that probably doesn’t matter that much.

This analysis assumes that you value low costs above convenience – one big advantage of an index fund is that you can set it up to take the money from your account and make the index fund purchases automatically. This can’t be done with ETFs so you have to login every month and make a purchase.

Conclusion

If you are a big contributor with a small portfolio and are keen (but not superkeen) to save costs then it might make sense to start at a discount brokerage instead of at TD and then switching.

I suspect for a lot of investors however it might make sense to just go with TD and only switch over when they have a significantly large amount say over $50k. Another plan might be to accumulate $50k or $100k at TD and then transfer to Questrade if they will pay for the transfer costs. Meanwhile you keep accumulating at TD.  The choice between index funds vs ETFs is not an easy one.

This is the spreadsheet I used.

More information

Should I Buy ETFs Or Index Funds?

Categories
Investing

Mutual Funds

A while back I was at a dinner with a bunch of people. A fetching young lady and I started talking finances (Mr. Cheap knnoowwwsssss what the ladies like…) and I referred to ETFs as “the thinking man’s mutual fund”. My father, who has been an avid mutual fund investor for decades gave me a bit of a hurt look, and I felt bad (I didn’t think he was listening to me).

I got talking to a buddy who, on the advice of HIS father, was hot-to-trot to invest in a Spectrum mutual fund. I told him to get a diversified group of ETFs instead – pointing him towards Canadian Capitalist’s “Tour of ETFs” and “Sleepy Portfolio” (as well as Money Sense’s couch potato portfolio). When I told him that a diversified ETF portfolio should average a 10% nominal return over the long haul (this is retirement money he’s looking to put away), he asked why he’d settle for 10%, when the Spectrum fund had averaged 36% over the last three years.

One of the best things about teaching someone something is that your fundamental assumptions are occasionally questioned. It can be a great way to expand your understanding in a direction that you didn’t even realize you were deficient in if you’re unable to answer their question (in which case you should probably go educate yourself until you can answer their question).

My response to him started with the idea that past returns don’t guarantee future returns. I talked a bit about mean reversion (the idea that often an area that has been recently hot may go into a slump in the near future, or an area that has been in a slump may take off). He agreed with this in theory, but then asked “isn’t the manager a smart guy who knows how to move in and out of areas to make lots of money, leading to an ongoing above-average market returns?”.

I agreed that this was usually the story mutual fund companies liked to sell, but I talked about how research had shown that mutual funds UNDERPERFORM the market on average. Since people aren’t just randomly chosen to run mutual funds (these are all professional investors), it makes the whole system pretty suspect if the average PROFESSIONAL can’t beat the market.

I followed this up with the problem of popular (high performing) funds attracting lots of money, and how its harder to get high returns once a fund gets too big. The basic idea is that if they find a good deal, they can’t buy as much of it (as a proportion of their portfolio) as a small fund could. It may be worthwhile for an individual to shop at garage sales for bargains, but it doesn’t make sense for Walmart to do this (they wouldn’t be able to find enough bargains to stock their shelves).

Following closely on the idea of big funds having trouble outperforming the market, I talked about how mutual fund companies start a large number of “incubator” funds. They let the managers of these small funds take whatever crazy risks they want. The hope is that some of their funds will wildly outperform the market (and, of course, if you have enough funds doing different things some will), they then promote that fund as their “flagship” product, promote its amazing returns in all the financial papers / magazines, roll over the poorly performing funds into it (and get tons of new investors in it). Since they know at this point they probably won’t keep getting lucky again, they then track the market as much as possible (so they don’t lose tons of money and annoy all the new investors), and prepare the next batch of mutual funds to create the “hot fund” of the future.

For some strange reason, these monsters funds tend to give you a return of [market – expenses]. Isn’t that curious :-).

At this point, ETFs offering [market – small expenses] look appeals, and that’s what I recommended buying. My friend still seemed somewhat hesitant, and I encouraged him to talk to his father further. I offered to buy him a copy of “Four Pillars of Investing” but he immediately told me under no circumstances would he read it. I felt kind of bad that I hadn’t been able to convince him of the value of ETFs, but the next time I saw him I asked him if he’d bought the Spectrum fund and he told me “No, I’m looking into ETFs”.

For those who used to invest in mutual funds and stopped, what convinced you to bail on them? If you’re a fellow ETF / Index Fund evangelist, what do you like to say to people to convince them to consider ETFs? If you’re a mutual fund fan, which parts of this post do you think I’m mistaken about (remember that “you’ve got it ALL wrong, mister!” is often a fair response to Mr. Cheap’s rants).

Categories
Investing

Why Retirees Need Equity In Their Portfolios

One of the standard pieces of advice for retirees is that they have to have a very conservative portfolio since they are too old to take any chances with equities. There are “rules” around what percentage of fixed income (ie bonds) a retiree should have. “90 minus your age” is one that I’ve heard a lot.

These rules were probably pretty good guidance at a time when your average retiree finished work at 65 and could reasonably be expected to live for another ten years or so. With a short term investment horizon it didn’t make sense to invest a lot of money in equities because the retiree wouldn’t live long enough to recover from any major losses. Inflation was also not a major concern since the time line was fairly short.

Fast forward to now and there are two major differences in retirees – first of all they are retiring earlier which lengthens the retirement time and they are living longer which of course also increases the retirement time which in turn means that they have a longer investment time horizon so a higher allocation of equities is appropriate. Typically most financial planners will assume an estimate lifetime of around 90, so if an investor retired at aged 60 and lived until age 90 – that’s a 30 year time horizon.

You might be asking – who cares how long the retirement lasts for? Shouldn’t you just be conservative and buy guaranteed fixed income products or annuities and live off the payments? One problem is that while retirees might be living longer once retired, they aren’t working longer, in fact they might even have slightly shorter careers on average so current retirees might not have any more money saved (adjusted for inflation) than someone who retired a generation or two ago and they are less likely to have any kind of company pension plan to help fund the retirement.

The reality is that historically equities have outperformed bonds by a long shot. According to William Bernstein – author of “The Four Pillars of Investing”, two reasons to invest in equities are for the higher expected return and because equities can keep up to rising inflation. If you are retired and your portfolio is entirely fixed income (or annuity) you might run into the problem of a steadily lower standard of living if inflation increases.

Other reasons to invest in equities are that interest is taxed at a higher rate than dividends and capital gains (in Canada and USA) so you will probably be better off if you can only pay dividend and capital gains taxes rather than income tax on interest payments.

What to do?

The answer is two fold. First of all, retirees should have a significant equity holding in their portfolio. Bernstein recommends anywhere between 50% to 75% equities depending on your tolerance for risk. One of the key points that Bernstein emphasizes is that whatever asset allocation you choose, you have to stick with it so pick an allocation that you can handle in rough times. If you choose a higher percentage of equities and then sell when the equities drop and then buy back in when they go up, then you will be further behind compared to if you had just picked a more conservative portfolio and stuck with it. Even if you choose to have an equity allocation of less than 50% then stick with that allocation.

Tomorrow we’re going to discuss the 4% withdrawal rule which will help determine when you can retire.

Categories
Investing

Low Level Venture Capital

For those not familiar with it, venture capital is typically a firm that provides early stage funding for new companies (Paul Graham has extensive ideas about funding startups). Think of the TV show “Dragon’s Den” if you’ve seen it. Venture capital firms like to “swing for the fences” and would rather have a small chance of owning part of the next Google instead of a good chance of owning part of a moderately profitable company (which is at odds with the perspective of most founders).

A while back I wondered if there was a way to invest in something like this at a lower level. Instead of trying to fund the next Google, might an interesting investment be helping people start small, traditional businesses (like launching a McDonald’s franchise or opening a bed-and-breakfast) in exchange for shared ownership (instead of a straight loan).

I’m not talking about something like Kiva, this would be an investment, not a donation. Instead of being paid back, the investor would retain ownership of a percentage of the company and collect that percentage of the profits.

I’d be shocked if people aren’t already doing something like this, but I haven’t heard of it if they are. Arguably I’m doing this with the building I’m a silent partner in, but I’m more thinking of a person or organization who does MANY deals like this every year, not just a one-off with a friend. Basically you come to me (an investor with money), show me your plans for the business and convince me you’ve thought this through and are making a commitment to launch. We both put money in (ideally) and work out some sort of shared ownership of the resulting enterprise.

A while back I bounced around the idea of starting a Subway franchise. It seems like most franchisees save or get a bank loan to purchase the franchise, apply to head office and then carry through with launching. For someone who couldn’t qualify for a bank loan but nevertheless had the interest and abilities to start it, it seems to me that friends and family would be their only choice to raise the cash.

The obvious downsides for the investor would be that the business owner might not be able to profitably run the business or that they might lose interest before it got to the point where it was making money. The downside for the owner is that they would obviously pay out the investor far more in shared profits than they would have paid on a loan (since the investor should be compensated for the extra risk).

What would you do if you wanted to start a business, needed money, and were turned down by banks, friends and family? Is there anyone or anywhere that you think you could present a business case to them, show them the figures and get funding in exchange for shared ownership? Do most communities just have rich, old guys that fund stuff like this? Is it hard to get money out of local, rich, old guys? If you met some young go-getter who wanted to start a busines, would you want to the a rich, old (wo)man and fund them?

Categories
Investing

Do You Really “Earn” Your Investment Income?

I met an acquaintance a while back who told me that he was day trading while in between jobs. I was quite curious about his strategies and how much he was making but he wouldn’t give me many details and I didn’t know him well enough to push. He did tell me on several different occasions though that he “was making good money” with the day trading.

The reason I wanted to know what kind of returns he was getting was because I was skeptical that he was doing as well as he said he was, and also because I wanted to point out to him that in a year when the market goes up around 18% as it did that year, it’s not hard to “make good money” by doing pretty much any kind of investing.

Stock markets go up and down over time. The main reason people invest in them is because they believe that over time, the stock market goes up more than it goes down, which has held true since the beginning of time (or stock markets). The reality is that nobody can accurately predict what the market is going to do any given year. It might go up 10%, it might stay flat or there could be a big loss. The phrase “A rising tide floats all boats” applies very well to equities. In years when the market gives double digit returns, everyone looks like a great investor. In years when the markets drop, almost everyone is a loser.

My point is that someone who is invested in equities in a market that goes up 10% and gets 10% on their investments didn’t really “earn” anything because of their investing prowess since they only got the market return which is easily obtainable with a basic ETF or index fund.

I think that all active investors should measure how much value they are adding by choosing their own stocks or mutual funds by comparing their returns to some kind of index or passive alternative based on an index such as an index fund or exchange traded fund. This would apply regardless of if you are trading stocks hourly or buying stocks for the long run (hello Siegel!).

For example if you trade your own stocks or bought active mutual fund and got a 10% return in a year, that sounds pretty good but is it? Did you really “earn” 10% by picking your own investments? What if the index returned 8% that year. Then I would say that your stock picking really only earned 2%, not 10%. Conversely, what if the index returned 12% that year. I would then say that your active management cost you 2% of your potential portfolio that year.

To accomplish this comparison if you trade stocks and/or buy mutual funds is to find an ETF that covers similar stocks. If you are an investor who likes to buy large American companies then you might want to look at an ETF like Vanguard Large-Cap ETF (VV) or even just look at the entire American stock market with Vanguard Total Stock Market Index VTI (the “American” is silent). ETFs and index funds charge a small fee so they will never match the index but should be pretty close.

Another thing to think about is the absolute amount of dollars you are earning from your investments.  If you spend a lot of time trading stocks or planning investments and you are really only earning say a 2% premium return on your investments per year then how does that work out per hour?  If you are investing $10 million dollars then 2% is $200k which is well worth the effort.  But if you only have a couple of hundred thousand then 2% is only $4k which is not a lot of money if you spend a lot of time on your investments.