Archive for January, 2009

I continue to be impressed by the resilience of people. We have much to be thankful for in North America but one of the great strengths we rely on is our attractiveness as a better home for people from all corners of the world. We attract the best and the brightest because of the opportunities that our society provides. Recently, I spoke to the Indo Canadian Ottawa Business Chamber (ICOBC). This is a group formed to promote better business and social ties between Canada and India. They meet regularly to provide support to efforts around increased trade and entrepreneurship. The Chamber membership is populated by professional in the public and private sphere. These people are making significant contributions to their adopted country and providing a conduit for access to the rapidly developing India. Their efforts, combined with many other organizations like them, are the basis for solving the economic problems in which we are currently embroiled.

As a follow-up to statements in recent blogs, here is my take on the discount brokerage (DB) model.

If lower trade costs result in better, more efficient portfolio’s then I am all for discount brokerage. There isn’t a large body of evidence aggregating results for investors in DB accounts since none of that data is released by the sponsoring companies. The data that does exist supports the position that investors should steer clear. In my opinion there is little incentive for DB firms to release data as it would be unflattering to their client base.

One notable exception was written by BRAD M. BARBER and TERRANCE ODEAN “Trading Is Hazardous to Your Wealth: The Common Stock Investment Performance of Individual Investors”, in the Journal of Finance, April 2000. The article considered position statements and trading activity for 78,000 households at a large discount brokerage firm over a six-year period ending in January 1997. As the title implies the results were not encouraging. There was strong evidence of under performance when compared to the broad market return. In addition, this under performance was enhanced (synonymous with lower returns) in the group of accounts that traded  most.

There are several implications.

Firstly, even though stock trading costs are lower in discount brokerage accounts somehow this advantage is not exploited for better client returns. The authors suggest over-confidence in trading strategies explains the drop in return. The correcting behavior recommended is lower cost transacting. When that doesn’t work, the individual  usually feels the need to try harder. More effort is made on understanding the research. More time is spent staring at the screen to find meaning in the trading patterns. This can and often leads to more trading. A virtuous circle is created, from the point of view of the DB.  A highly stressful and time consuming role is created for the investor-client (you).

Secondly, costs to DB clients are not lower for most asset classes, while the over-confidence factor presumably still operates. For example:  the biggest DB wire house doesn’t currently rebate clients the fees for advice that are embedded into mutual funds. Instead the fees are collected as revenue though no advice is given. In addition, in my opinion, spreads or commission on fixed income securities such as CDs and GICs are collected by the firm though they are intended as compensation for professional advisers. The same can be said of bonds and syndication revenue,  in which compensation for advice and distribution is simply absorbed into profits of DBs. As I said I’m for lower costs for investors. DB’s are simply not sharing the lower costs implied by their model with investors like you.

Thirdly, watch any ad for a discount brokerage firm and you will find that it exploits the view that lower transactions on stock trades equates to higher returns for investors. The clear parallel is drawn between superior trading strategies and their proprietary research resulting in confidence and better results. To me this is clearly a red herring. Most revenue streams, all of which are borne by their investors, are not disclosed. In addition, behaviors that reduce the likelihood of investor success are glamorized. Whereas behaviors that lead to better returns, like lower transaction counts and passive investment approaches are often discouraged through the introduction of additional fees. The overall result is that the incentives for DB and their clients are usually at odds.

Finally, DBs have institutional clients as well as retail clients (like you) who are often on the other side of aggregated small transactions. The research they provide is conflicted to the extent that DBs  are efficient in terms of their institutional clients if they can provide liquidity. While no advice is provided to individual clients, advice is aggregated and released to many in the form of independent research.  While no direct relationship exists, the overall effect is the same if it results in large numbers of small clients transferring one large position to a big institution.

My bias is clear. Advisors provide the best source of independent, professional advice specifically tailored to the best interest of the client. DBs may appear to present a cheaper option, but they are driven by profit motives and are generally profit centers for larger concerns. If your assets are important to you I advise you to choose a professional not a profit center, for your source of investment advice.

This week is all about setting a new agenda - Obama style. His star will indeed have to shine bright in order to pierce the hazy veil of bad news and worry that is today’s abundance. It seems the world is waiting for him and at least in the short term, looking forward to the honeymoon.

The leader is responsible for setting the vision. This president appears to have the unique set of skills to get this done and done well.  Governments will and have provided the liquidity to the banking system. There may be more to come. The executive office is charged with providing leadership and confidence to the system.

I think the interesting part of any global transformation  will come from entrepreneurs. A return to a “normal” economy will require compensation for risk taken. This risk premium makes our world go round and has been missing for many months. It seems to me that entrepreneurs as a group are responsible and eager to figure out how to re-establish return.  Borrowing money and investing in businesses employs people, provides consumers’ money and normalizes the stock markets. Governments and bureaucratic institutions provide the platform but it’s the small and medium sized businesses that get the job done. Given the size of the problem we all have significant contributions we should and will make.

I am pleased to point out that Capital Stories is receiving some recognition from peers. Guy Kawasaki’s Alltop site has included us as “best of the best” in  personal finance. Guy Kawasaki is co-founder of Alltop, an online magazine rack, managing director of Garage Technology Ventures, an early-stage venture capital firm and a columnist for Entrepreneur Magazine. Guy is the author of nine books including Reality Check, The Art of the Start, Rules for Revolutionaries, How to Drive Your Competition Crazy, Selling the Dream, and The Macintosh Way. He states on his website that he is a hockey addict. Everything is relative, of course, so this is for a Hawaiian – we need to invite him to Hockey Country!

Chris Brogan has stamped us a “Rock Star” on his website.  Chris is a ten year veteran of using social media and technology to build digital relationships for businesses, organizations, and individuals. Chris speaks, blogs, writes articles, and makes media of all kinds at chrisbrogan.com.

You can find out more about each of these social networking gurus by clicking on the logos at the RH side of this page.

Like many of  you I hate it when someone tells me I can’t do something. My last post can be taken, though not intended, as an admonishment of all those who are investing for themselves, by themselves. It was not meant to be so. Clearly, as an investment adviser I’m partial. I think investors should use competent advisers.  I have seen that most investor portfolio’s perform better  for people and their families as a result. I understand that there are of course exceptions; bad fits and incompetence are a real option out there when choosing an adviser with whom you can work.

However, if you choose to go it alone it is important that you choose to play a game you can win.  Opportunistically picking stocks by consistently finding mispriced securities that you, and only you, are able to recognise is a loosing game. It simply doesn’t work and brings in a high probability of dramatic under-performance. While random out-performance is possible, it is not probable.  Fortunately, there is a game you can win. It seems to me that a passive return to the markets in which you invest will outperform just about every other approach available to you. In his 2007 chairman’s letter to shareholders, (pg 19) Warren Buffet makes a similar point about “know nothings” winning. His conclusion is that the vast majority of investors would be much better off buying low cost index funds. I agree. If you want to improve your situation, that should be the starting point… the benchmark for other strategies that you are considering.

Bob Keyes, on January 7th, 2009 at 3:32 pm

Patrick, as an investment advisor, how do you balance the risks and need of an individual investor who is trying to make a return in a market dominated by big players/hedge funds/institutions who have a very different risk profile and appetite than a small investor has. Seems to me that the small guy is just along for the ride, be it good or bad, and has to try to anticipate the risk profile of those who dominate the markets because they are the players that will ultimately determine how well markets perform and react to events.

I think this is a great comment and reflects the attitudes of many small investors especially when reviewing the results of 2008. It seems to me that the central concern is… how can a small investor compete? The assumption here is that the bigger players have the advantage and seem to be the biggest influence in establishing prices. Lets look at some of the evidence.

We know that in the aggregate, the returns available to all investors is the return to the markets. That’s all there is. On average then, if costs are lower for those getting the market return, the average return to “passive investors” will be greater than the average return the “active investors” receive when costs are considered. This  simple important point was perhaps first introduced by Bill Sharpe in his 1991 article titled the Arithmetic of Active management.

There are several implications to consider:

Star Hedge Fund, portfolio managers and large institutional investors spend all of their time and effort trying to outperform their contemporaries. They spend money employing managers and analysts. They have marketing staff and advertising budgets. They trade to exploit opportunities so as to gain relative advantage. All of these initiatives cost money.  So if  manager A gets some advantage then, by definition, the other managers must do worse. The costs employed in these efforts  reduces the total return available to the group.  Though it may seem intuitive, it is worth noting that despite  the considerable “advantages” and effort employed, as a group they under-perform the return provided by the markets in which they invest . They must because of the costs of their operations.

Some active managers will do better, though any innovation is quickly adapted by the competition. It’s a big arms race and we all benefit in the outcome as prices of assets are refined. It helps our markets operate more efficiently. We need active managers to ensure that prices are fair. Their efforts act as a kind of subsidy to all investors, ensuring a reasonable relationship between risk and return. We need not jump to the conclusion the prices are always “correct” but there is significant pressure brought to bare so that investments move to equilibrium value, where risk and return are in balance.

It’s really tough to compete as an active manager. These people are smart, committed and well financed. The dream of opening a discount brokerage account and competing with these folks is probably going to turn into a nightmare. The occasional exception, like a lottery winner, doesn’t change the math. Unless you are born into this world wealthy, building your own hedge fund probably happens after you retire from you life’s work. Discount brokerage accounts have helped to reduce the costs for individuals to trade stocks.  But bringing a knife to a gunfight is not my idea of a relaxing retirement plan.  You have to look at the incentives. Discount brokerages do better when clients trade more.  Clients do worse when they trade more. It doesn’t matter if the cost of the transaction is zero. I will provide more on this in a future post.

Our mandate is to help small investors win by putting them at an advantage. We focus on capturing the return provided by the asset classes in which we invest. We focus on keeping costs down and minimizing taxes. We focus on providing service on financial issues outside of investment returns.  We play a winning game not a losing one.

It is always great to enjoy New Years Eve with friends and family. This years’ festivities were highlighted by a real desire to see the end of what has been a very trying year for just about everyone I can think of. The only thing in doubt for our Canadian equity market, the S&P TSX,  on the last trading day was whether-or-not we would beat 1931 as the worst percentage return year on record. A 100 point down day would have captured the dubious honour. We avoided this ” insult on injury” finishing 150 points higher, down about 33% for the year .

In the investment industry, risk is usually defined as volatility or differences in return experience when compared to the average expected value. If monthly returns are plotted, we would expect most values would cluster around the middle -  average value of  about one percent with progressively fewer values as we move away from the average.  This normal distribution would imply that values outside plus or minus 10%  should occur a couple of time every 100 years.   The stock market is different. There are many more large numbers – both positive and negative. Behavior finance experts explain some of this experience in term of investor psychology. In statistical terms this is a fat tail distribution. More values  appear at the extremes and the average value is less descriptive of actual experience. In 1987 the Dow dropped 23% in one day. That shouldn’t happen in our lifetimes, but it did.

Individual stocks are much more volatile than broad markets. The returns are similar, you just capture more risk to get similar returns and there is a big cost to getting it wrong. Yet risk to these approaches is often defined in terms of average volatility to broad market indexes. This is very misleading and causes a good deal of unnecessary confusion when portfolios don’t perform as advertised. It seems to me that an important part of our job as investment advisors is to minimize risk. We don’t try to manage money for improbable events, even if it would have worked last year. We mange assets so as to capture expected return with the highest probability of success. Fat tails shouldn’t alter that effort.