Category: Investing

This is a “part II” for my original post called “How to Deal With Market Volatility” which I posted last week. I wanted to try to make a spreadsheet to show the effects of someone who “panics” when the market goes down and then later on gets back into the market when it starts going up. Please note that I’m not referring to investors that have specific buy and sell scenarios and follow their own investment plans, but rather people who don’t really have a plan and react to events in the market.

I’ve created a spreadsheet in which I created a rather contrived example of a market that goes up 17% per year for two years and then drops 10% in the third year. This repeats over and over again for a long term return of 8.1%.

I’ve also created three types of investors:

1. “Buy and hold” has 100% equities and never changes their portfolio.
2. “Market panicker” has 100% equities when he/she is in the market and a high interest account paying 4% when not in the market. This investor only gets into the market when it’s doing well and sells when it’s doing poorly. When the market drops he switches all his money to a low cost money market mutual fund halfway down, then he sits in cash until the market goes up for a year and then gets back in.
3. “Conservative buy and hold” has 65% equities and 35% cash and never changes their portfolio except to rebalance once a year.

I started all three of my investors off with $100,000.

According to my calculations:

The buy and hold investor ends up with $478,700 for a return of 8.1% which matches the market (let’s assume no fees).

The market timer investor starts off ok by participating in the first two up years but then after that he continually switches all his money to money market halfway down the crash (so he gets -3% for those years since his equities go down -5% and then he gets half a year of interest), then he sits out the first year of the up market and only get 4% when he could have gotten 17%, then he gets back in the market and enjoys the 17% the next year before the cycle repeats. As a result of this market timing he only gets 6.8% return which gives him $370,100 after 20 years.

The more conservative buy and hold investor has 65% equities and 35% cash which pays 4%. He gets 12.5% in the good years and loses 5.1% in the bad years. This person ends up with $377,600 which works out to a return of 6.9% which is slightly higher than the market timer.

In the end, the buy and hold investor who has 100% equities has an investment account which is worth 23% more than the market timer.

The point of this example is to show that you don’t need to have 100% equities to do well in the markets and that if you are going to panic every time the markets drop and then buy on the way up, you are better off picking a more conservative mix which will reduce your volatility and quite possibly improve your returns by allowing you to stick with your investment plan and stay invested.

I got tagged by BripBlap to give my MOMA or “my one money advice” which is supposed to be the one piece of advice you would give if you could only give one piece…luckily I’m not normally so constrained!

First of all, I wanted to say a few things about BripBlap which is one of my favourite blogs. It’s written by a New Yorker and covers all sorts of topics, some of which are financial, some not. This post totally changed how I read to my son and the choice of reading material.

That said – on with the advice! My advice is to make sure that when you are making a financial decision of some sort ie buying something, entering into a service agreement etc that you spend an appropriate amount of time researching and thinking about it. Some people will spend incredible amounts of time trying to get the best phone plan on their cell phones which might save them a few hundred dollars at best per year but they won’t spend any time researching the best ways to buy a new car. If you know what you are doing then you can potentially save thousands on a new car compared to if you went into the dealership cold.I’m not saying you shouldn’t worry about the cost of your daily latte or the price of bananas but things like houses, renovations, cars, investment costs etc are the big things that will affect you the most so you should spend the most time on those items trying to get the best deal. Cell phone plans do fit on the financial priority list but just make sure you know where it is on the list and how much time to spend on it.

I’m a big fan of William Bernstein who wrote the book “Four Pillars of Investing”. One of the main points of the book is the idea that whatever your asset allocation is (ie 50% equities, 50% bonds) , you have to maintain the equities portion of your portfolio regardless of what happens to the market. This is easy enough to do when the market is flat or going up, but when it drops then it gets a lot harder.

His suggestions to accomplish this are as follows:

Study history: If you are familiar with the equity markets then you know that the long term trend is upward which means that regardless of what happens in the short term, over a long enough time period you will get through the ups and downs and achieve a decent positive return. Another part of history that is important to know about is market manias and the ensuing crashes. Knowing the history of these events from the tulip bulb mania of the 1600’s to the dot.com mania of the late 1990’s will allow you to know that the market always recovers and even if you do get caught up in a mania, if you stay invested in equities then you will do fine. Note that that by “equities” he’s talking about a widely diversified portfolio of equities.

One of his examples from the book “Four Pillars of Investing” uses the great crash of 1929 to demonstrate that if someone retired at the peak of the market in 1929 and had mostly equities in their portfolio (which lost 90% of their value), although they would have had a few lean years afterwards, if they had stayed invested in equities then they would have done just fine and wouldn’t have run out of money. If they panicked and switched into bonds or cash after the value of the portfolio went down, then they would have eventually run out of money.

Another psychological point Bernstein talks about is picking an asset allocation that you are comfortable with even in the bad times. He says you are best off having an equity allocation of 50% to 75% with the higher number being preferable in order to beat inflation. However if you can’t handle the volatility and switch out of equities after the markets crash and then wait until they are up again before switching back in, then you are losing money and you should lower your allocation of equities. You are better off with a lower allocation of equities that you can maintain during a market crash rather than a higher equity allocation that causes you to panic in bad times.

Some of my suggestions are:

Don’t focus on individual securities:

If you are going to monitor your investments then look at the total value of your portfolio including cash, fixed income, equities etc. Don’t just look at the individual funds. If you have a diversified portfolio then not everything will have the same loss so the total value is the relevant number to watch. Not all stock indexes dropped the same amount recently and if you have a portion of your portfolio in fixed income or money market funds then they should have held their value (unless of course you own National Bank money market funds).

Put market drops in the proper context:

Keep a record of your historical portfolio balance. You can either include contributions or not for this exercise. Investors who watch their investments closely in an up market tend to remember the highest recent value that the portfolio gets to and when it falls, they compare the new lower value to the recent high. If you keep track of your total portfolio value and write it down say every six months then you can get a more realistic picture of your investments. For example I know that my portfolio is down around 7% from it’s recent high but I also know that it’s still up about 0.5% from the beginning of the year. If I look at my records (I do a yearly performance analysis) then I can see that I’m still up about 15% (not including contributions) from Jan 1, 2006. Taken in that context, the 7% drop is not that big a deal.

Measure the volatility of your portfolio before it crashes:

You can’t have volatility on the upside without having it on the downside as well. There are many advanced mathematical tools to figure out the volatility of your portfolio but one simple rule is to measure how much your portfolio goes up in a good year and be prepared for it to drop that much in any given year. If that amount doesn’t appeal to you then choose a more conservative asset allocation.

People keep going on about how important asset allocation is. I left the party when they claimed that a stock & bond mix would perform better over the long-haul then an all stock portfolio. They acknowledged that the stocks would do better on average, but that the mix would somehow magically outperform the all stock.

This didn’t make any sense to me. If you leave two investments for 30 years and get the average stock return on the all-stock portfolio and the average bond return on the all-bond portfolio, how is the return greater if you mix them together instead of keeping them separate?

The only way I thought it could possibly make sense is the idea that you’d have funds available in the bond portion of your portfolio to use to buy stock after a crash. The primary advantage from this perspective would be that the bonds aren’t correlated with the stocks, so you could use one to buy the other. Asset evangelists don’t talk about this though, and since you’d have to actively capitalize on this, it seems like something they’d mention as a necessary step to get the good returns promised by asset allocation.

The realization finally hit me when reading “Four Pillars” this morning: The benefit comes from using the assets within your portfolio to determine when the other parts of your portfolio are cheap, then buying them. E.g. if you have a 90% stock, 10% bond portfolio, you’d expect that the stocks will outperform the bonds. If you’re re-balancing (say by adding money) and your portfolio has 85% stock, then clearly the stocks are selling cheap (relative to your bonds) and its worth buying more of them (which you’ll do to re-balance). When you add money, you’d normally expect to be buying more than 10% bonds (since on average the stocks will outperform the bonds and push them to a lower proportion of your portfolio), but if the stocks REALLY outperform the bonds, then you’ll buy even more then normal (and take advantage of the bonds being cheap relative to the stock).

Basically, asset allocation is just an easy way to determine when the investments you want to buy are cheap (relative to your other investments), then buy more of them. You could accomplish the exact same “benefit” from tracking when your investments are cheap or expensive and buying them directly, however this would be a lot more work. You could also just track the different assets within your portfolio and have the return for the last year and the return for the lifetime of the portfolio. When the last year’s return is lower then the lifetime return you’d put more of the money you’re adding to that portion – again not quite as easy but uses the same idea.

e.g.

Year 1 $90,000 stock, $10,000 bonds
Year 2 $96,300 stock (7% return), $10,300 (3% return)

Say we’re adding $1,000, in order to rebalance the asset allocation, we’d be putting $540 into stocks and $460 into bonds (bringing them back to 90/10).

Year 2 $96,840 stock, $10,760 bonds (after adding $1000 and re balancing)
Year 3 $96,840 stock (0% return), $11,082.8 bonds (3% return)

Say we’re adding $1000 again in order to re balance, in order to get back to the 90/10 split, we need to sell $192.52 of bonds and buy $1,190.52 of stock (we’re buying lots of stock since it had such an awful year that we now feel that its cheap).

Year 3 $98,030.52 stock, $10,892.28 bonds (after adding $1000 and re-balancing).

Part of me feels like “supporting” under-performing bond returns just for the information of when stocks are cheap doesn’t seem like the best approach, but maybe there’s more to it then I’m seeing. I’d be tempted to construct a portfolio and assign it the expected return for each asset class. When an asset doesn’t live up to expections, add money to it to bring it in line with where it “should be”. For example, in the above portfolio with 90% and 10% with an expected stock return of 7% and an expected bond return of 3%, after 10 years you’d expect the stock portion to make up 93.4% of the portfolio. *THIS* is what you’d use to re-balance, not 90%. This way you’d get the information that an asset class was under-performing and have the opportunity to buy it cheap, without unduly subsidizing the weaker portions of your portfolio.

Please correct me if I’ve missed the point. Given my current understanding, I’m far more convinced of the value of asset allocation.

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I have a good friend who lives in the states who is looking to get serious about her retirement saving. She wants to put about $250 / month into a 403K (tax sheltered retirement savings at a non-profit, like a 401K or an RRSP). She’s read some investing books, but isn’t really interested in the subject and often finds them confusing.

She’s been looking for a vehicle she can set up, pay into every month and ignore (with as little monthly / annual maintenance as possible). She’ll be looking to start cashing it in when she retires in 3 decades or so.

Originally I was advocating buying “dividend aristocrats” that have a high yield, but obviously this takes research and more of an ongoing awareness (how are the businesses you own doing these days?). Also, there’s definitely a risk in having your retirement savings concentrated on a handful of companies (even if they’re great long-term companies).

Instead, I’ve recommended Vanguard’s Balanced Fund (60% equities in broad US market index, 40% bond funds – 0.2% MER, 9.34% average return over the last 5 year) as a way to put money away, not worry about it, and expect to have a nice nest egg to retire from. She would buy this on auto-pilot, and ignore it.

Given that the bulk of this blog’s readers are clearly smarter then I am, would you agree with this recommendation? Any alternatives you’d encourage her to consider? For Canadians, what would your retirement savings look like if you lived in America?

I’ve been reading quite a bit recently about how owners of BCE (outside their rrsp) will be getting nailed with capital gains taxes once the takeover is complete. Jonathan Chevreau wrote a post about this in his blog, the Wealthy Boomer. In his comments, I noted that given the recent increase in price of the stock due to the impending takeover, the capital gains shouldn’t be a factor since the $12 price increase will cover any capital gains tax bill. This is true, assuming of course that the stock would have stayed in the $30 range for the next little while.

My worst case capital gains estimate is as follows:

If an investor has one share with an ACB of zero (worst case scenario) they will receive $42.75 for that share. Because of the capital gains tax they have to declare $21.37 as income. Let’s assume 50% income tax to keep it simple. They would then pay $10.68 in tax which means they would net $32.07 for a share that was only trading at about $30 up until a few months ago. I would argue that the final outcome of this transaction is a tax-free switch from BCE to say BMO (Bank of Montreal) with a $2 bonus tossed in (to pay the accountant?).

Chevreau made a great point about how there should be different rules for involuntary taxable events (sells) which prompted me to propose the following:

The government should change the taxable event rules to exclude involuntary switches from one Canadian company to another. Ie if you own a Canadian public company like BCE and it gets taken over and you buy another Canadian company with the proceeds then there should be no taxable event incurred and the adjusted cost base from your original shares will be transferred to the new Canadian company shares.

Any thoughts? Is this a reasonable policy for the government or is a forced sale and resulting capital gains a normal and foreseeable risk of owning equities?

One of the things I’ve read in many investment books and articles is that you should create an investment plan, write it down if necessary and stick with it regardless of what happens in the markets. At this point I don’t have a finalized investment plan set in stone, but one of the negative investment behaviours that I’ve identified in my investment past is chasing returns.

Chasing returns usually refers to the activity of switching from a poorly performing (or average performing) investment into one that has an extraodinary recent return. This kind of investment philosophy is probably the quickest way into the poorhouse. It’s been proven in many studies that funds that perform very well in the short term rarely continue that success.

Last fall I purchased some units of a China mutual fund. At this point in time I was already on my way to becoming a low cost diy passive investor but for some reason I thought I should catch a short ride on the China express. As it turns out the fund actually went up about 20% over two months after I bought it which is a pretty incredible return. Towards the end of January this year I made the decision to sell the fund because I decided that the fund was too risky and was not the type of investment I wanted to own plus the reason I bought it was because I was chasing returns which I didn’t want to do anymore.

I figure that if I do the passive investing method properly then I could set myself up for a good retirement and I didn’t need to try for any home runs along the way. This new Canadian blog explains this baseball analogy much better than I ever could.

Since I sold the fund, it has bounced around quite a bit and currently stands at about 10% above where I sold it. In the past I would have been steamed that I had “lost out” on that 10% gains but now I honestly don’t care.

I love it when a good idea comes to fruition. I thought about starting up Craigslist in Canada before they came here (I’d used it in San Francisco and loved it – I even registered a domain for it!). I was going to build a dating site based on collaborative filtering, and I wanted to start a Canadian P2P Lending site like Lending Club and Zopa, and someone has finally done it!

In case you haven’t read about P2P lending, its basically eBay for banking. Instead of borrowing (or saving) money through a bank, the borrowers and lenders communicate directly and cut out the middle man. In theory, the massive profits that the big banks make should go into giving both sides better rates and leading to a more efficient capital market.

We’re still in the infancy, so I wouldn’t say we’re quite at that point yet, but its still a very exciting new place to borrow and invest. Through an American friend I managed to set up a Prosper account and have been scraping by with around a 5.5% return on our investment there (we’ve had MASSIVE defaults).

One of the best things about these types of sites (from an operator perspective), is that lending laws are different in every country (and often from province-to-province or state-to-state). This gives the chance to set up a “local” version in your country, and not have to compete with the current site dominating the market (as would be the case if you tried to start a local auction site or a local classifieds site).

I have my fingers crossed that CommunityLend will improve on the business models of Lending Club, Prosper and Zopa. Even if they don’t, I’m happy that at least we’ll have a Canadian version available to us.

In case you’re reading this and wondering why I’m happy people made money on “my” ideas, my feeling is that ideas are cheap. With a company, creation and operation is the hard part (and deserve the bulk of the returns). Frank Herbert (the author of Dune) once had a guy come up to him and say “I have a great idea for a book, I’ll tell you, you write it, and we’ll split the profits 50/50”. Mr. Herbert said “no way, coming up with ideas is the fun and easy part, writing the book is hard work!”.

People have made similar observations about video games. If there’s any market for ideas, I certainly haven’t found it (please tell me where it is so I can cash in and retire!). The only way you can “sell” an idea is to find someone naive enough to give value to ideas on their own merit, convince them to do all the work and give you equity for your initial idea (“you build it and we’ll split the profits 50/50), hope that they are naive but very bright and productive (I haven’t met many people who would fit this bill), then sell the results and cash in.

An idea that I had (that no one has actually done yet) was to build a website, say “ideasarecheap.com”. On it people could write up their ideas for businesses, post a business plan if they have it, and list what resources they bring to the table (what portion of the start-up capital they have, skills they possess, contacts, etc.) and what resources they don’t have but would need. People with those resources (or people just wanting to offer advice), could connect with the budding entrepreneurs. Money could be made off of advertising (I know, I know, this business model is *SO* 1999).

Anyone have $1000 / month to front me while I build it? 😉

Other resources

• Lending Club – Why I Chose Not To Invest
• Investment Recommendations for Friends,
• Canadian Peer-to-Peer Lending
• Is Lending Club Bankrupt?