Sunday, November 21, 2010

The easy way to make x% return without too much risk

Disclaimer: this blog is my personal opinion only. Information presented is accurate to the best of my knowledge. This blog does not provide any personal financial advice or solication to buy/sell securities or financial services. I do not take any responsibility for any actions you take as a result of reading this blog.

Ok I haven’t been posting much recently due to new computers, baby and busy rediscovering the joys of Medieval 2: Total War.  This will also the last post related to Garth's post, I will start posting actual personal investing related topics starting next week.  Now on to the topic.

This is something that appears often in marketing materials, TV, newspapers, and pretty much anywhere the average person seeks investment advice: With a diversified portfolio and a long term horizon you should expect an annual return of x%, which is the average return of the last y years. The number x and y changes depending on who you talk to. In the case of Garth, it’s 6%. A very reasonable sounding number especially compared to 8% or 10% being touted earlier in the decade. However how reasonable is it?

Well, let’s start with some of Garth’s assumptions and strategy. You can find his comments about how to build this portfolio here –

Some specifics copy and pasted include:
  1. Cash in existing investment assets and use the money to dump your mortgage or your boat loan or your student loan or your RV loan. Then borrow the same amount and use it to repurchase your investments. Now your loan is tax-deductible, and you’ll have liquidity.
  2. If you don’t have fixed income investments in your portfolio, get some. Interest rate increases will obviously moderate or stall for a while (after the two we’ve already had), which means bond prices are probably going up. In an uncertain world, why not have investments that pay you to own them? 
  3. That includes my beloved preferreds, of course. I can’t understand why everyone wouldn’t want to make 5.85% on blue chip assets that pay you dividends which are taxed 80% less than GICs. But maybe that’s just me being weird.
  4. Don’t buy stocks. Buy ETFs. Unless you have millions to invest, picking individual securities simply exacerbates risk. Every schlep with an online trading account and a few equities they’ve read about in a marginal blog (unlike this inconsequential one) is pissing money away. If you can afford to lose it, then be a philanthropist and do something useful.
  5. Deflation won’t deflate equity markets, but it will fuel volatility. So index funds are a bad idea. Sector ETFs are not. 
  6. Volatility, by the way, is the investor’s friend. If you buy on those days everyone is moaning about imminent death, you’ll usually do fine. Sell on any day you hear someone say, “this time it’s different!” 
  7. Deflation plus liquidity equals party. Deflation plus debt equals divorce.
So let’s analyze how well his strategy will do.
  1. Leverage helps increase return on the upside and magnify loss on the downside. If you don’t have a track record in making consistent rate of return that’s higher than the interest rate on your home equity line of credit or mortgage, you are much better off just paying back the debt.
  2. Most bond ETF and mutual funds will currently not return more than 5% after fees. I have been checking individual bond offerings from Scotia iTrade and I haven’t seen a lot bonds rated A- or above paying more than 6% and matures less than 15 years. So it is unlikely you will make 6% return here. That means you will have to make more than 6% on preferred shares and equity to a portfolio return of 6%.
  3. I will take Garth’s word that bank preferred shares were yielding 5.8% so let’s just assume you can make a 6% dividend yield here. That means equities will still have to make more than 6% return to compensate for the lower bond yield return.
  4. I agree that the average investors should stay away from stocks and buy ETFs. However just which ETFs will give an almost risk-free 6% return? Most dividend and income oriented funds has less than 6% yield and are concentrated in REITs and financial sectors. I’m guessing Garth is implying a good advisor would be able to buy and sell sector ETFs with proper time to generate capital gains as per his point #5. So scroll down and read what I think that strategy.
  5. In my view and experience, this statement is just bullshit, pure and simple.
    1. Deflation wouldn’t deflate equity market? Hello? Is anyone there? So why did the stock market tank in the 30s during the Great Depression? Or the Japanese equity market falling from over 40,000 to about 9,000 today over the last 2 decade? Deflation was rampant in both cases and equity market got slaughtered. The very definition of deflation is a fall in prices of goods and in the overall level of GDP. Equity market depends on growing profits and price to earnings ratio. Both of these conditions are absent in a deflationary environment. So what would propel equity market to go higher in deflation?
    2. His second point that general index fund is a bad idea but sector ETF are due to deflation and volatility is also just bad. In deflation, everything falls over time. Granted some items might rise for a time and then fall while other items rise, being able to time the change properly and make money from it is a totally different ballgame. If it were easy to make profits from trading then there would be lots of millionaires who got rich from stock trading. All those day traders from the tech bubble days wouldn’t have disappeared when the bubble burst since they could have moved on to trading other stocks. The sad fact is that most people will not consistently make profit from trading even in a good market, never mind a bear market or a volatile market like we have now. Those who can make consistent profits are generally making huge sums of money running big hedge funds, instead of working as a financial advisor managing portfolios for people with less than $1M in assets. Generally advisors who buy/sell ETFs/stocks for small clients (remember any account less than $1M is considered small) simply follow the market up or down with regular rebalancing that helps them take some profit when markets go well. When the market tanks, most will not be able to avoid massive losses by selling before the crash. Similarly when market goes on a bull run, most will not be prescient enough to put extra money into the market before the Bull Run. Again, if it were easy to make profit trading, why aren’t there more people who got rich by trading? Why do great trader make obscene amount of money? Because it is not easy, that’s why.
  6. Following from point 5.2, volatility is not an investor friend! For most investors and even traders, volatility kills because it is very hard to trade properly in a volatile market over any medium to long time horizon. Sure it’s easy to say buy when everything is doom and gloom and sell when everything is rosy but how likely are you able to do it? Everyone knows the mantra buy low sell high. A lot of people know to buy when everyone else is selling and sell when everyone is buying. But why isn’t everyone doing it? Because it’s hard! Again, if it is were easy to buy and sell at the right or close to the right time then why aren’t the majority of people making lots of money from investing? The only way you can say you will profit from volatility is if you are better than the majority of the investors including a good portion of professional fund managers, hedge funds, Wall Street traders, etc. If you are that good, why aren’t you rich yet and still working in a non-financial job?
  7. Deflation plus debt equals divorce but yet Garth is advocating people getting line of credit (debt) to invest? Ok it’s “liquid” but that’s still debt is it not? Cash/purchasing power is good when you can buy items to rock bottom prices. However liquidity which is the ability to turn an asset, financed by debt or equity, into cash does not always translate into buying power. Why? Because in a bear market/deflation, all asset prices fall including those you own! Thus you cannot count on being able to sell your existing assets at a good price to purchase undervalued assets or even recover the money you borrowed. In a deflation/bear market, the value of everything falls against money/currency used to purchase those assets. So you need cash/money/currency on hand, not tied up in readily marketable liquid asset because those assets will have their prices fall the fastest since everyone else is selling those assets to raise cash. Also a line of credit is not a true or even a good substitute for cash on hand in a deflationary environment. In fact it can be an extreme liability that rears its ugly head at the worst possible time.
In summary, I think you cannot expect to achieve 6% portfolio return with very low risk unless using Garth’s strategies, unless you think you can generate profits from trading through sector ETFs. Unless you are lucky enough to trade properly, or hook onto the bull market in gold and didn’t get out at the wrong time, following his strategy will in my opinion more likely end up in tears and a big drop in your net worth. I could be wrong and I have been wrong more than a few times but that has taught me what works and what does not. I don’t believe his advice will work in the current market. It might work in a bull market like the one from 1980 to 2000, or 2002 to 2007. In a bear market or even a range bound market, it’s a recipe to get slaughtered.

Tuesday, August 3, 2010


Disclaimer: this blog is my personal opinion only. Information presented are accurate to the best of my knowledge. This blog does not provide any personal financial advice, or solication to buy/sell securities or financial services. I do not take any responsibility for any actions you take as a result of reading this blog.

Garth when asked/challenged about making 6% return from a diversified portfolio often tells his readers that they need to find a good advisor to handle their investments for them. Furthermore, he often states that do it yourself investing is almost a recipe for disaster as well as missing out on securities not available to the average investor. So just how important are financial advisors, what do they do, and does the average investor need one?

In my opinion, if you want to be successful in investing, you absolutely need an excellent investment manager. Preferably a dedicated investment manager to manage your assets and hiring sub managers for specialized investment needs. However, there is a problem, a huge problem for the average investor. That is unless you have over $5M, you will not be able to hire someone like that.

Also notice I said an investment manager, not an investment advisor. Why the distinction? To me an investment manager is a professional whose main focus is on asset management and making investment decisions. An investment advisor usually is more focused on client facing, servicing, liaison and sales than making actual investment decisions and portfolio management. This is a big difference.
To illustrate the difference it is important to first explain the investment management industry and job a little bit. At risk of sounding harsh, the vast majority of financial advisors are basically just salesperson selling products. For example, financial advisors working at a bank generally are only allowed to sell for that bank's mutual funds and have a quota to meet. Same with financial advisors associated with mutual fund companies like Freedom 55. Even many so called independent financial advisors are really just sales people as they sell mutual funds and collect a big commission doing so. They are independent in the sense they sell funds from multiple companies. Even some fee only advisors, who are supposed to be professionals like lawyer and offer their advices for a fee only, often double dip by charging their clients an hourly fee and also collect commissions on mutual funds they sell to clients.
Lastly there are financial advisors who are really just stock brokers who make money based on stock/bond trading commissions. While they may provide advice on what to buy, ultimately if you don't trade they don't make any money. So again, they are really just sales people. There have been more than a few cases where brokers with discretionary trading power on clients account engage in churning (ie. doing a lot of trades) simply to make more commissions for themselves at the expense of their clients.
For an average person with less than $500K to investment, these are the only type of financial advisors they have access to. Sales people motivated more by commission than anything else. There is another tier of financial advisors generally referred to as private client portfolio managers. These are generally investment professional who will only take clients with a minimal of $500K to $1M+ to invest. These might be the kind of investment advisor Garth talks about and they are suitable for boomers who have sold their house and sitting on a hundred thousand to $1M+ in cash. However, even with this type of advisors, there are still some important distinctions.
You see, almost all investment professional make their money based on assets under management since they charge a fee that's based on how much assets they manage. So the goal is to get as much assets under management as possible. You can do this by either having lots of clients each with small assets (say $500K) or fewer clients with large assets (eg. $5M+). When it comes to portfolio management, managing $5M is not any more difficult than managing $500K, possibly even easier as it is a lot easier to be properly diversified with a $5M portfolio than a $500K portfolio. Off course, a $5M account pays a lot more in fees than a $500K account, yet has similar work and expenses required to service the account. So who do you think good investment professional going to choose to work with?
What this means are financial professionals who see clients with $500K to $5M in assets generally having up to 100 or more clients. Thus they don't actually do much investment research, portfolio management, and related activities themselves. Rather the companies they work for have a separate research team that performs these functions, sets out model portfolios for various risk levels, recommended stock buy lists, etc. What these portfolio managers actually do is more about client relationship management, keeps up to date with clients’ changing financial needs and circumstance, and updates their risk level and use appropriate model portfolio. Generally these managers have limited ability to deviate from model portfolios created by their company's research team. This can be a good thing since one person cannot do everything required in portfolio and investment management. Having a good independent research team is essential. What it does mean is that the client needs to be aware of exactly what their portfolio account manager does and that the bulk of investment decisions are done by others.
Finally we have investment professionals that cater to ultra-wealth clients generally with $5M+ to invest. These are generally the best investment professionals that an individual or family can access. They generally do a lot of investment management decisions themselves with a dedicated support team of professionals for research. They also generally have good long term track records and most often find clients by word of mouth rather than mass advertising. They also have very demanding clients who don't like losing money and thus their focus is more about preserving wealth, followed by generating income and growing wealth as a secondary concern.
The last statement in the preceding paragraph is an extremely important statement. Go back and read it again! The wealthiest people who can most afford to take risk are more worried about preserving wealth and to a lesser extent generating income than gaining more of it. While the average person who have much lesser ability to take risk and lose money are often focused exclusively on growth through capital gains. Think about that for a minute and then rethink that tale about a rabbit and a turtle. As well, investment professional serving wealthy clients in generally are also less likely to tell their clients that it’s easy to achieve a 6% return with little risk using a diversified portfolio. Those serving clients with less than $500K seem to be more eagerly telling their clients to invest in equity/funds/etc to increase the chances to make 8%, 10% or even higher annual returns with just a little extra risk that will decrease if you invest for the long term.

With regard to advisors having access to investments not available to individual investors, this is true to a certain degree. A lot of private client managers (eg those who has clients with more than $1M+ to invest) have access to private placements, venture capital, RE investments, etc that the average person don't have access to. However when it comes to bonds and stocks, there really isn't much difference. Whatever bond and stocks your portfolio manager can buy; you can generally buy directly in discount brokerage as well. The only caveat is that for bonds, generally investors who buy/sell regularly in large amounts will have price advantage over the retail investors who would only buy/sell bond in smaller amounts. However when I say big amounts, I mean at least $500K or $1M bond face value. Most investment managers for personal accounts cannot purchase that much for a single bond issue. So while they have advantage over retail investors, it’s not that much.
I have now gone through the 3 general classes of investment advisors/professionals that individuals can hire to manage their money. They range from purely sales people for people with less than $500K to invest, to professionals for affluent with $500K to $5M to invest, and for ultra-wealthy with $5M+ to invest. Where you fit in that wealth scale determines what kind of investment professionals you are going to get. Having a good investment manager is no guarantee you can achieve 6% with little risk (more on that in a later post). So you still think Garth's advice that getting a good financial advisor will solve all your investment headaches and make you 6% minimum with little risk applies to you?

Monday, July 19, 2010

Risk, what exactly is it? Why take it?

Disclaimer: this blog is my personal opinion only. Information presented are accurate to the best of my knowledge. This blog does not provide any personal financial advice, or solication to buy/sell securities or financial services. I do not take any responsibility for any actions you take as a result of reading this blog.

One common theme in many of Garth’s posting is that the real risk for people, especially baby boomer is not stock market risk but the risk of outliving one’s money. Therefore one must invest to mitigate that risk and can do so by creating a diversified portfolio that invests in financial assets that will grow and earn at least 6% return, all with minimal risk. People should not be afraid of the risks associated with investing in stocks & bonds, especially those with long time horizon.
So what exact is risk as related to stock & bond investing? Is it important?

Risk in financial industry is actually a very complicated subject with volumes upon volumes of research papers and horrendously looking mathematical formulas devoted to measuring and quantify it, optimizing, and making money from it. There are also many kinds of risk including market risk, liquidity risk, counterparty risk, and credit risk to name just a few.

The topic of risk will almost come up one way or another when someone sees an investment advisor. Often, the person will get some combinations of the responses below:
  1. You need to take a certain level of risk to achieve your target return.
  2. You should increase/decrease your portfolio risk to fit your risk profile.
  3. Higher risk means higher return.
  4. You need to have a diversified portfolio to lower risk and volatility. 
Generally though there is no explanation of what risk means and how it relates to your investments. Most people think of risk as how likely am I to lose money and how much can I lose. However this is not the risk that investment products prospectus/financial advisors refers to. Risk when mentioned in this context usually refers to how volatile the investment’s price or daily return is. If the price of a stock does not fluctuate much on a day to day basis then that stock would be considered to be low risk, regardless of its actual return. Conversely a riskier stock is one whose price fluctuates widely on a day to day basis. This applies in general to any investments you can buy. The more widely an investment’s daily price or return fluctuates, the more volatile the investment is considered to be and the riskier the investment is considered to be.

Volatility can be measured in terms of daily price change or daily return, and how widely it fluctuates around the average price or daily return. For example if investment A has a 10 days daily return of: -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1%, -0.1% for a total 10 day return of -1%. Investment B has a 10 day daily return of 1%, 2%, 0%, 1%, 0%, 1.5%, 0%, 1%, 2%, 0% for a total return of 7.5%. However in this case investment A is considered to be a low risk investment because it’s daily return volatility is almost 0. Investment B even though has a higher return is considered to be higher risk because its daily return fluctuates much more than investment A. As well, investment A’s daily price is very close to its 10 day average price while investment B’s daily price fluctuates much more around its 10 day average price (look up standard deviation on wikipedia if you want more information). So risk when discussed in context of investing in stocks, bonds, mutual funds, etc, refers only to how widely the daily price or return the investment you are investing in fluctuates.

Note, in the example above, I’m merely trying to illustrate the point that low risk investments do not mean you will not lose money. However higher risk does NOT equal higher return! This is an extremely important point!

High price or return volatility means you are more likely to have large price movements, either positive or negative, making it harder to predict with reasonable accuracy what likely total return or value of the investment will be in the future. You can estimate a likely range of the investment’s total return or value in the future using statistical techniques but the range will be wide. For a no risk 5 GIC paying 3% interest per year, you can be fairly certain what your return will be each year and how much money you will have after 5 years. With a stock however, it is almost impossible to predict your yearly return or how much your investment will be worth after 5 years. 

So risk and return are linked but the important thing to recognize is one does not guarantee or imply the other. High risk does not mean you will get higher return for taking the risk. Taking high risk merely gives the chance to get higher return but at the price of a higher, potentially, much higher chance of losing a lot of your money! Remember, if you lose 50% of your principle, you will need a 100% return to just breakeven. So if a high risk investments gives 30% chance to make 25%, a 30% chance of 0% return, and a 40% of losing 15% each year, is it really a good investment to make? Is it guaranteed to do better than say a low return investment like GIC paying 3% a year after 10 years? The answer is no, there is no guarantee a high risk, potentially higher return investment will do better over the long term compared to a low risk low return investment. An easy example is the total return of 5 year GIC compared to the S&P 500 Index from 2000 to present. Someone employing a buy and hold strategy or even a dollar cost averaging strategy (purchasing a set amount regularly) buying 5 GIC would probably be ahead of another person invested in the general stock market.

Similarly, while combining a risk free investment with a high risk investment lowers the portfolio risk, it does not eliminate it. Having risk free investments do not mean you can invest rest of your money in high risk, potentially high return assets and achieve a high return or at worst breakeven. 

Risk taking does not in any way guarantee higher return. If high returns are guaranteed just from taking the risk then why is it even risk? Something is high risk because there is a good chance you will lose a lot or all of your money. If there is no risk of loss then it’s not risk!

Lastly, market risk is simply one type of risk in the investment worlds and there are many other risks that are equally or sometimes even more important. Thus, when making investing decisions, just looking at historical return and risk profile is not sufficient to make a decision.

Sunday, July 4, 2010

Thoughts on more investing claims

Disclaimer: this blog is my personal opinion only. Information presented are accurate to the best of my knowledge. This blog does not provide any personal financial advice, or solication to buy/sell securities or financial services. I do not take any responsibility for any actions you take as a result of reading this blog.

Originally I was planning to write about personal bond investing, however I decided to postpone that for now. I read this blog called Greater Fool ( daily. I first started reading when searching around for Vancouver Real Estate bubble. While I agree with the author, Garth Turner, assessments of Canadian’s RE market and some of his thoughts on economy and government policies, I find myself getting quite worked up over some of his financial/investing advices he gives out to his readers. A lot of his claims about stock market and investing are not suitable for the average person and some of them are just frankly dangerous in my view & experience. Yet these claims are given out almost as financial laws/truism. A lot of his readers look up to him as an expert and follows his advice for their real estate and personal finance decisions. I feel a lot of them are likely to be very disappointed!

Due to the number of claims/statements Garth makes this will be the start of a series of posts. This is a good thing as there are a lot of important topics that I can cover and hopefully clear up some misconceptions. For this post I will just list some of the common claims related to financial investing by Garth in his commentary or responses to reader/commenter questions.
  1. Inflation will be a concern.
  2. Interest rate will be going up.
  3. One should have a percentage of assets in gold as a hedge against inflation.
  4. One should stay liquid.
  5. GIC is not an answer going forward and one should not be keeping money in GIC, a guaranteed loss after inflation and taxes.
  6. It’s easy to build a diversified portfolio earn 6% return in the current environment using preferred shares, medium/long term bank/corporate bonds, sector funds and individual stocks.
  7. Buy and hold is not going to work, active trading is required.
  8. Just buying the index will not work, you need to be nimble and buy specific stocks.
  9. Owning bank preferred shares, or bonds can easily get a 6% pre-tax return and they are safe as none of the Canadian banks will fail, and Canadian banks have never suspends dividends on preferred shares.
  10. Owning medium/long market bonds from big corporations are perfectly fine, even for short term, as they are 100% liquid and safe. Even short time frame of less than 5 years.
  11. One should buy preferred shares due to the high dividend yield and tax advantages, even in a rising interest rate environment.
  12. Keep bonds inside RSP, high growth stocks in TSFA, and dividends stocks & preferred share in non-registered accounts.
  13. Do it yourself investing is almost guaranteed to fail, one should find a good financial advisor to handle the investments.
  14. 6% return is a minimum one should get in this market without much risk and any advisor who says it can’t be done should be fired.
  15. The real risk is not losing money but outliving your money.
Well that’s a very long list and covers a lot of important areas. For this post I will simply state my view on each point. Later posts will go into details for those points that I don’t agree with.
  1. Agree – I think inflation might be a big concern going forward, especially if governments and central banks decide to print, print, print.
  2. Agree – Too much debt chasing too little money.
  3. Agree – but not for the same reason. Gold is actually not a good inflation hedge based on performance from 1980s to 2000. However gold is in a bull market and is real money! Understand difference between real money versus fiat currency versus debt-based monetary system and you will know why owning gold is a good idea. Also understand the difference between money, currency, and wealth.
  4. Agree – when there is too much debt and everyone is borrowing, staying liquid is a good idea. However one has to understand what it means to be liquid.
  5. Disagree – While GIC rates are low and heavily taxes, GIC can be a very valuable and useful tool. In fact, over the decade, GICs have beaten the S&P500 and likely TSX300 Indices total return (dividends included). Not bad for something that’s guaranteed a loss after inflation and taxes. I will write more about GIC in a future post as for most people, more often than not, they will do better by having a big chunk of their money in GIC.
  6. Disagree – with long term bonds rates and dividend yields less than 6%, getting a 6% total return after-tax with a balanced portfolio and limited risk is very hard in the current environment. Now if interest rate for long term government bond goes back up to 8% then 6% portfolio return is possible.
  7. Partial Agree – Buy & Hold will likely not work going forward, but timing the market correct is extremely tough, more luck than skill.
  8. Partial Agree – Stock investing takes a lot of time and effort to research the companies to buy and at what prices. Expecting high return simply from buying individual stock or sector funds without realizing the time, efforts, and risk involved is recipe for large losses.
  9. Disagree - Buying bank preferred shared is not without risks. Currently available preferred shares on the market are unlikely to be paying 6% yield. As well, if the preferred are without risk then why aren’t the rich buying them all up? Why did the banks issue them paying such a high rate for something with no risk? How did Citibank and Bank of America’s preferred shares issued in 2007 and 2008 do? A lot of "impossible" things happened during the credit crisis in 2008.
  10. Disagree - Corporate bonds are not liquid and for individual investors, selling them can be impossible sometimes. They are marketable but that’s not the same as being liquid! Bond has a lot of risks that most people do not realize and it’s not easy for the average investors to buy and sell corporate bonds like stocks.
  11. Partial Agree – Purchasing income producing investment in a rising interest rate environment only works if you re-invest dividends, keeps purchasing, and don’t plan on selling. Income producing securities move inversely with interest rates.
  12. Partial Agree – Bonds should be kept in RSP accounts. However keeping high growth stocks in TSFA maybe not the best option for various reasons. Portfolio tax planning is not as simple as where to put different types of investments, even though these are good general guidelines.
  13. Partial Agree – Most people do not know enough, have enough discipline, or have enough time to manage their own portfolio. However the average investors will not be able to access competent, never mind good financial advisors. Those are only available to high net worth clients, those with $5M or more. The average person with less than $500K to invest is not going to be able to hire a good financial advisor; there just aren’t enough of those around. The ones who are good aren’t going to bother with small time clients when they can get clients with $5M, $10M, or more to invest.
  14. Disagree – If your advisor tells you that, keep him/her because he’s telling you the truth! That’s a very rare trait as most advisors will not tell clients any possible bad news or things their clients don’t want to hear.
  15. Partial Agree – Outliving your money is a problem but nothing guarantees that more than risking and losing a lot of it! Risk does not guarantee reward!

Tuesday, June 8, 2010

Debunking Some Stock Investing “Axioms” – Part 2

Disclaimer: this blog is my personal opinion only. Information presented are accurate to the best of my knowledge. This blog does not provide any personal financial advice, or solication to buy/sell securities or financial services. I do not take any responsibility for any actions you take as a result of reading this blog.

The 4 almost universally accepted investing “axioms” from last post:
1. Stocks have returned 10% per year on average.
2. US/CAD stocks have never lost money over any 10 year period, so invest for long term and ignore the short term fluctuations. It’s time in the market not timing the market.
3. You must invest in stocks for growth so you will have enough money for retirement.
4. Stocks return is always higher than bond returns over the long term and investing long term will smooth out the volatility in equity.

Last time we examines point 1 and 2, let’s examine the remaining point 3 and 4.

Point 3 - You must invest in stocks for growth so you will have enough money for retirement. Well I wonder if this has anything to do with the fact that the MER on equity funds are anywhere from 0.5% (general market funds) to 1.5% or even 2% (specialty sector funds/foreign equity funds) higher than the MER on bond funds. The question you really need to ask yourself is how much do I really need to save for retirement and how much can I save? If you only need say $2M for retirement that’s 40 years down the road and you can save a large portion of your money every month, then do you really need to invest in equities hoping to get 10% per year? If you only need a 5% returns then why take the risk with equity when bonds and GIC can provider sufficient return? Why chase higher return with the risk of losing money when you can achieve your goal with certainty.

Point 4 - Stocks return is always higher than bond returns over the long term and investing long term will smooth out the volatility in equity. This point has been taken as pretty much the gospel/axiom/absolute truth in investing. Stock always returns more than bonds over the medium to long term. However that’s actually not true. Based on the Andex charts, the returns for S&P500 Total Return Index, US Long term bonds, TSX Total Return Index and Canadian Long term bonds are shown in the table below ending in year 2009:

Source – Andex Charts – Ending in 2009

Source -

As you can see, while the 1980s and 1990s were characterized by large, unprecedented equity market return, the bond funds didn’t that badly relatively speaking. In 2000s, the bonds vastly outperformed the stock market. Taking the market crash of 08 into account, bonds has outperformed stocks over the last 10, 20, 30 years! Even the lowly T-Bills have outperformed the S&P 500 Total Return Index for 2000-2009. So much for the claim that stocks always outperform bonds over the long term!

Sunday, May 30, 2010

Debunking Some Stock Investing Axioms – Part 1

Disclaimer: this blog is my personal opinion only. Information presented are accurate to the best of my knowledge. This blog does not provide any personal financial advice, or solication to buy/sell securities or financial services. I do not take any responsibility for any actions you take as a result of reading this blog.

Ok, since I do get ask a lot of finance related questions and I do like to read these stuff, I thought it would be a good idea to try to do a blog on topics in this area. This way I can hopefully educate some people about finance, clear up misconceptions of which there are many in this field, explain some of the common things you hear and what they actually mean, and answer a few questions along the way as well.

I do tend to output massive amount of information and write a lot of stuff, so I will try to do my best to keep each post short (less than 1000 words, except for this first one) and interesting. Hopefully I will improve my write style as I go along. You are welcome to post feedback and suggestions to me either on the blog or via email.

Now one thing to be clear, whatever I write is my own personal opinion. Nothing here is intended as professional advice, or solicitation for buy or selling securities, or as personal financial advice of any kind. Nor do I guarantee that my understanding and explanations are always correct, though I try my best. Lastly, don’t expect to get rich reading this blog! This is not a stock picking newsletter. I take no responsibility as a result of anything you do after reading this blog.

Ok, got all the preamble and disclaimer out of the way, let’s move on to the first blog post!

We have probably all read/heard the 4 points below, usually in marketing materials and from TV commentators. They are almost to be accepted as investing axioms:

  1. Stocks have returned 10% per year on average.
  2. US or CAD stocks have never lost money over any 10 year period, so invest for long term and ignore the short term fluctuations. It’s time in the market not timing the market.
  3. You must invest in stocks for growth so you will have enough money for retirement.
  4. Stocks return is always higher than bond returns over the long term and investing long term will smooth out the volatility in equity.

So let’s examine point 1 and 2 in turn in this post while point 3 and 4 will be analyzed in the next post.

Point 1 – Stock have returned 10% per year on average. This really depends on your starting point and the stock market index chosen. Usually it is the S&P500 Total Return Index that’s chosen for US stock market and TSX 300 Total Return Index for Canadian stock market. The starting point chosen for this claim is either right after WW2 or 1980 when the stock market level was really low. Following WW2, the western economies have been in a general growth trend with the baby boomer generation driving and increasing the size of the economy. Along the way we had large bouts of inflations and a couple recessions. In general however the economy has grown from population increase due to baby boomers generation, generation X, Y & Z, and scientific progress. The other common starting point of 1980 just happens to be the start of a great 20 year stock market bull run that ended around 1999/2000 with the bursting of the technology bubble.

However if you picked 1999/2000 as your starting point then the stats would look very different. Instead of 10% per year you would be look at about a -1% return in US$ for the S&P500 Total Return Index (source: Andex chart 2009 US Edition), and about 4% return in CAD$ for TSX 300 Total Return Index (source: Andex chart 2009 CAD Edition). Quite different from the 10% per year return that people were expecting and probably counting on from the stock market! If you were a Canadian investor who invested in S&P 500, your return in Canadian $ would be even worst at about -4% per year (source: Andex chart 2009 US Edition)!

As the mutual fund/investing industry is fond of saying: past performance is no guarantee for future performance. This warning applies extremely well to this situation, just because stock markets has returned 10% per year on average for the last 40 years doesn’t mean it will continue to do so! As the years 2000 to 2009 has now shown, the stock market return has fallen far short of what’s advertised.

Point 2 – Stock market has never lost money over a 10 year period so invest for the long term and ignore the short term fluctuations.

Well this is really nice for the mutual fund companies because they want you to keep your $$ with them so they can charge one of the highest MER in the world year after year. But as has just been shown, if you had invested in the S&P for the last decade, you lost money! So much for the guarantee that investing long term means you wouldn’t lose money in the market.

For an even worse example, take a look at the Japanese stock market. If you invested in Japanese equities back in late 80s/early 90s, you probably have lost money for 2 decades straight! That’s right; Japan’s Lost Decade is now officially running 20 years and shows no sign of stopping! Everyone who bought into the Nikkei when it was at its high of 40000 lost a lot of money! Even buying when the index is at 30000, or even 20000 would still probably cost you money!

The current US and Canadian stock market valuation of greater than 20 P/E ratios is generally associated with market tops, not market bottoms! There has been several research shown that when P/E are as high as 20, the return for the next decade is generally very low, between 0% to 5% (will do a more detailed post on this later).

So in summary for this post, don’t believe the marketing slogan! As well don’t assume the past well be repeated in the future. The only constant in the market is the cycle of fear to greed and back to fear that drives the market down to unbelievable lows and great values and then swing back up into unbelievable highs via greed and the back to another low as greed gives way to fear and the cycle repeats again.