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 – http://www.greaterfool.ca/2010/08/08/deflated/

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.

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