Archive for the ‘investing’ Category

Financial marketers know that human wiring encourages us to judge decision-making skill based on the recent outcome. This is true even if that outcome is a random result. So in the investment world, tossing a coin and producing heads three times in a row is seen as skillful. Predicting the wrong result of a toss is viewed as a repeatable and flawed approach, and this is true even though the probabilities for the next toss remain unchanged. My take is that it is much easier to focus on short term results than to try and uncover whether-or-not an approach is increasing the probability of success for a significant period of investment results. Counting and sorting random results has the illusion of a scientific method. It can also encourage manipulation of meaningless periods of data so as to infer skillful management and decision-making. It opens the door to manipulation by inference.

Unfortunately, from a purely statistical basis it takes about 30 years of data to make a confident assessment of skill for investment management.  The evidence of “beating the street” simply cannot be identified in one, three and five year tables.  For practitioners, this presents a big problem as 30 years is an investment lifetime. Also, the skillful manager is generally about to retire once you have confidently identified his or her ability. It would be much more convenient if we could confidently identify future out-performance. Unfortunately, there is always uncertainty. If we knew the outcome, returns on stocks would be equal to returns on bonds.

In my opinion, the time and effort to identify a hot hand is better spent on good portfolio construction. Good financial advisors have processes that generally guide clients towards strategies designed to minimize errors of judgement. They focus on cost control. They provide guidance around matching fixed income from your portfolio to income you require from the accounts in retirement. Good advice often encourages investors to patiently allow stock market return to be realised by the portfolio in a consistent repeatable approach. There is generally much less of a focus on market timing. They recognise that the recent past offers little in the way of predictive power.

In our practice we focus on repeatable investment success. Our portfolio approach has been refined through more than thirty years of combined, on the job, experience. If we are already working with you great – if not, let’s meet to see if we can be of service.

Patrick

A review of the US monetary System – Suppliers, Dealers and Users

As Children, we should all be taught to aspire to own a commercial bank (dealer). Dealers have a very interesting and sustainable business model. Essentially, they lend money they don’t have, which creates money in the hands of the borrower. This “miracle of capitalism” is created by the fractional reserve system of the Federal Reserve. The interest paid on these loans is earnings for the commercial bank. The leverage to assets is big; the Fed requires a 10 percent reserve so that a commercial bank can loan up to ten times its asset base.

In the US, commercial banks and investment banks were divided by the Glass-Steagall Act of 1933.  After the depression is was thought that risky investment banking activities needed to be separate from the Fed-backed activities of commercial banks. Glass-Steagall also introduced deposit insurance on deposits (FDIC), further protecting the interests of depositors. The act (not FDIC) was repealed in 1999 in an effort to allow US dealers to compete on a level field with Great Britain. Margaret Thatcher’s “big bang” deregulated the UK financial system in 1986. Canada followed in the late 1980s and dissolved the restrictions for commercial and investment bank mergers. Trust companies were also deregulated. Insurance companies maintained some of their independence though Canada’s big 6 retail banks are finding ways to capture market share in the insurance business as well.

Given the extremely low cost of capital and advantaged position banks share with respect to the Fed, it is difficult to compete with dealers as a group.

The promise of Big Bang and deregulation was reduced cost of capital for customers. In addition, reduction of regulatory involvement was seen as a method of increasing competition and innovation by combining access to debt and equity capabilities. Stanley Hartt, deputy Minister of Finance for Canada 1985-88 summarizes the view at that time as “the banks felt they had to grow to survive”.

These conclusions have been greatly challenged by the financial crises of 2008-09.  Leading up to the Fall of 2008, one stop financial supermarkets were able to securitize debt, selling it off to institutional investors to raise additional cash assets. This in turn allowed for more leverage to earnings and more risk assumed. The system was clearly out of equilibrium. In September 2008, perhaps precipitated by the collapse of Lehman Brothers, the system froze. Banks would no longer lend to one another for fear of undisclosed liabilities (non-visibility) reducing the real credit worthiness of the borrowing parties and increasing the likelihood of default.

Big isn’t better, and in some cases as we have recently experienced, it is much worse. Canadian banks have faired better than most. A major contributing factor is that they didn’t get their wish about eliminating foreign ownership restrictions.  Canadian banks are limited to 10% foreign ownership. It seems to me that as a group they should be grateful for the failure in their lobby effort to have that restriction eliminated. It saved their asset base and our banks and protected them from much more of the downside of the credit crises of 2008-09. Instead, in 2009 the Canadian economy and financial system has experienced strong relative growth compared to the international competition.

Commercial banks are too big to fail because of the unique arrangement they have with taxpayers. FDIC (CDIC in Canada) insures assets to 250k (100k). If they default, the government, backed by tax revenues, guarantees the liability. This call on tax dollars creates an incentive to accept more risk, in an effort to maximize shareholder profit, since Banks are credited with the positive return to risk but are insured for losses.

For banks it is very unlikely if not impossible to reorganize under bankruptcy protection. Unlike other corporations like airlines, for banks bankruptcy is equal to liquidation.

Clearly there is something wrong with this system. The old idea of building scale to eliminate the competition appears to be in conflict with the best interests of the economy as a whole.

We could try to use a 1930s solution and disentangle commercial banks and investment banks or perhaps more realistically, the consequences of bank failures could be minimized. To my thinking the latter approach is more likely. New regulation can be introduced to reduce potential claims on taxpayers.

A group has been formed to provide recommendations on just that line of thinking. The Squam Lake Working Group on Financial Regulation is a group comprised of 15 leading academics who want to bring the system back into equilibrium. The thinking is that if the incentives of scale are reduced and the costs to society of banks failures are minimized, then a better equilibrium will be established for the financial system and by extension, the economy as a whole. The group had developed several practical solutions to improve the systemic problems. It appears the US administration is listening.

US stocks represented by S&P500 were up 8.44% for the month of March. The Canadian S&P TSX60 grew by 7.99%. Morgan Stanley’s EAFE was 3.74% higher. While we are still 49% lower than the high in November of 2007, we have rallied 8% off the low point earlier in March.

While most of the worries and economic turmoil persists, there has been some measure of relief to the stock markets. We are at a point of growing divergence between wall street and main street. More evidence is expected of shrinking economies in North America and overseas yet these backward looking measures were not reflected in the recent buoyant return to stocks across the world.

The short term return to investment returns is random but momentum trends do make themselves known. For this positive return environment to continue investors will have to ignore the results from main street. They will have to ignore the fact that consumers are saving more and deferring large purchases. The market will have to rally in the face of lower earnings reports from companies and yes more bankruptcies and higher unemployment figures. There are no assurances, risk is pervasive even from these price levels. If this is the beginning of a turnaround in fortune for the stock markets then it would be consistent with the beginning of other bull markets, shrugging off the bad news and climbing higher in spite of the evidence.

Today’s  Opening Value

We posted new lows last week and the S&P 500 is priced at less than half of the value in November 2007.  The recent investment experience has been brutal. Last week was one of the worst in terms of stock market performance that we have seen in the past couple of years and just about everyone is looking for the misery to continue.

Last Thursday Bank of Montreal economist Douglas Porter, suggested the worst was over and we should begin to consider the prospects of a better economy by the end of 2009. His opinion wasn’t appreciated by those that offered comment. Practically no one agreed with his point of view. The average opinion was outright critical and many dismissed his thoughts as someone who is shilling for a bank, his opinion therefore bought and paid for. I don’t know Douglas Porter other than by his reputation as a good economist.  I do have some respect for his decision to release information to the hostile crowd. He was, I think,  aware of the probable feedback. So what is going on here? Is everyone so sure that they know the future will be a continuation of the recent past? Is Porter simply rolling the dice with other people’s money (risk) to generate profit for his bank? It seems to me that investors understand there is higher risk in the investment markets. Their recent experience is bad and they look for this to continue. The idea that economists or financial analysts can predict the bottom for investment markets is a source of irritation bordering on anger.

For the sake of clarity here are some basic financial principles in which we can rely:

• Higher return comes with higher risk. The risk premium or compensation for risk is higher when things are not going well.
• Investment decisions should be made on a forward-looking basis not by looking at the recent past as prologue.
• It is improbable to predict or time the turn in the investment markets.
• Short term returns from a trough, or market low,  is very high.
• Selling after a significant drop in prices means you will probably give up significant short term return when the market recovers.
• Some short term traders will correctly predict the turn in the market but only by chance.

It’s 3 o’clock, an hour before the close of the markets. I really don’t prescribe to technical analysis for stock trading, but like reading your horoscope, it makes you feel better to see a five star day.  We are currently equal to the old low from last November. Optimists (bulls) cling to the notion that this value represented a low level from which the markets would slowly and carefully resume an new upward trajectory. So to avoid a problem I am posting this before the close of market trading. Maybe the market (world) cares about the S&P 500 staying above 752 or maybe not. Intellectually I know it doesn’t make any difference. Emotionally I could use the boost.

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.

Background
In 2003 the Canadian Federal government agreed to investigate whether an  account would be a useful and appropriate way to help Canadians save more money. This undertaking eventually led to the introduction of the tax free savings account (TFSA) for 2009. It has borrowed from the Roth IRA in style and intent.

Rules For TFSA

Contributions are not tax deductible. You must be 18 years of age or older, a Canadian resident and be able to supply a valid social insurance number to participate. Initial contribution limits are $5,000.00 per year and will be indexed to inflation. Excess contributions will be taxed at 1% per month so this is something you really want to avoid. Unused contributions will be carried forward indefinitely. Contributions are not related to earned income. Any amounts withdrawn are added to the contribution room the following year.

Income and capital gain are not taxable while retained in a TFSA or when withdrawn. Income earned or amounts withdrawn will not be added to income tested benefits or credits delivered through the tax system. In addition these amounts will not effect OAS, GIS or Employment insurance benefits.

The qualified investments mirror RRSPs. Arms length entities such as stocks, bonds, mutual funds etc… . Small private shares may qualify subject to certain conditions. Interest on borrowed money to fund TFSA is not deductible., though a TSFA can be used as collateral for a loan.

No attribution rules apply so the TFSA will be used for income splitting purposes. The tax free status is lost at death though a tax free roll-over is possible if a spouse or common law partner is named as beneficiary.

Strategies

These flexible plans do not replace RSPs. They will be used most effectively in conjunction with pension type investments.  If you contribute a maximum to an RRSP and have savings outside that plan then the TFSA should be maximized.

Perhaps the best uses will be around family income splitting strategies. Parents or Grandparents can transfer up to $5,000. per year for each young adult or grandchild. Recipients can take the money out without tax and new room will be created for future savings.

This is also a welcome new vehicle for those who have high pension adjustments and have little use for RRSPs.

Other Notes

For young adults, a  tax return is required to build TFSA contribution room

Anti Avoidance rules apply to guard against transactions designed to shift taxable income to TSFA

This introduction will be supplemented by additional strategies in future posts.