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In continuing the discussion of the concept of fairness, lets now look at lotteries. Lotteries are different; we don’t seem to demand fairness to participate. In a series of fair lotteries below the gross proceeds are evenly distributed among the participants. (For a review of my definition of fairness see my previous post).

Mean is the average payout: (total payout/ number of players). For all the three lotteries above the mean is 1, or your money back. Though this doesn’t describe what we see in the chart very well. For all lotteries above, mean returns look okay, no matter the payoff distribution or skew.

Median is the middle value of a series; the median is useful when distributions have extreme values which skew the mean value. In this example the median return for series 2 and 3 is zero. Median is a better approximate of the probable payout for those games.

Lottery payoffs are best represented by series 3 – one winner of all the money. It is unlikely that anyone would be motivated to play game 1, since simply getting you money back plus a little is not a very exciting proposition.

If we had our lottery promoter hat on, it is likely that we would prefer to sell tickets for lottery two or three rather than one. My take is that random large rewards are viewed as exciting.

In 2006, average proceeds for all US state lotteries were distributed as follows:

• approximately 65% in winnings payout
• 4% Sales General and Administrative expenses
• 31% retained by the state treasury.

Perhaps the old line “you can’t win if you don’t play” should be modified to “they can’t win if you don’t play.”

This is why economists refer to lotteries as a form of voluntary tax. In the case of all US State lotteries, initial government take of 35% compares favourably to regular income tax rates since most lottery participants pay less than 35% in average tax rates. In many instances, the proceeds are also taxed for an additional win for the sponsor state, when they receive essentially a double taxation dip of more than 50% of the bets.

So why do we suspend our sense of fairness to play these games? In the case of charity lotteries it is perhaps the excuse we need to give to a good cause. For regular lotteries, it appears that lottery operators are successful at building excitement by focusing on the mean and highlighting skewed results. This is how lottery tickets are sold. In our example more tickets will be sold for the next draw if a picture of player 10 appears in a newspaper advertisement with the proceeds check, smiling for the camera. The advertising campaigns are celebrations of non-probable random events. We don’t expect fairness in this type of game; we are satisfied with buying the excitement.

Unfortunately, we can draw many parallels to financial services from lottery marketing schemes. Instead of focusing on the plentiful returns available to market indexes, and building portfolios to capture those profits, financial service companies focus on the excitement of beating the averages. The incentives appear unbalanced. High fees paid to capture random large rewards don’t work in your investment accounts, though it may be more exciting.

The term ‘credit crisis’ seems to imply that we can expect a resumption to normal market conditions, and economic growth, as a direct result of increased lending by banks…maybe, but things haven’t worked out that way before.

Much of the recession fighting efforts by central bankers and global political administrations is focused on a forced expansion of credit. In 2007-2008, a ceasing of credit markets was crippling to economic activity. De-leveraging of global markets resulted in a sharp reduction in economic output and a pervasive global recession. The reaction by central bankers was to create conditions where bank-to-bank lending was possible again. To a great extent, and at incredible expense,  this has been accomplished. Indeed in the past few weeks we have seen credit market spreads expand. A positive indicator, since banks are probably using their own capital to lend to clients rather than simply passing on the fire hose of cash flow from the Fed.

While resumption of a normalized credit market is a precondition to ending this recession, the evidence suggests that credit expands only after the economy has rebounded. The effect is to further fuel an already expanding economy. In every recession since 1960 real bank credit didn’t peak until several quarters after the end of each recession. While this time may be different, it is likely that the same economic principles apply today as they have the past 50 years. Banks typically tighten credit as a result of loan losses. This is a reasonable response to limit losses and participate less to the downside of an economic cycle. These normal incentives operate to limit the expansion of credit prior to some clear evidence of economic expansion. When the economy begins to expand lenders expand their efforts to capture the growing market shares. It is unlikely that policy makers will be able to engineer conditions where lenders will lead a meaningful expansion in the economy. At some point incentives should switch in favour of the consumer and creating conditions for expanded demand to replace liquidity concerns as the primary focus of economic leaders.

Here is  a related short essay by Kevin Kliessen, Economist with the  Federal Reserve Bank of St. Louis  http://research.stlouisfed.org/publications/mt/20090301/cover.pdf

U.S. President Barack Obama is visiting my cold and overcast city today. With this visit Canada becomes the first foreign destination for the new President. This has generally been the case for his predecessors as well. I understand that we won’t get to see him as he will be hidden from view for the 6 hours or so that he spends on Canadian soil. From a foreign policy perspective our hope is that this is the start of a friendly and mutually beneficial relationship between President Obama and Prime Minister Harper. Everyone needs someone they can confide in, especially when the challenges are many (to use Obamaspeak). This is just a meet and greet but if we could submit some questions…

For President Obama

1. Why stimulus? Are tax cuts simply a non starter?  The Regan-Thatcher years were a required response to big deficits and inflation problems of the 1970 and 80s.  Could we jump to a solution that actually worked?

2. How long do we hold the spigot open? Financials, Autos  … who is next?

3. Could we just give the auto workers the money and cut out the middleman? Would this cost less? Has anyone done the math?

4. What engineering superiority are we protecting by maintaining the auto industry as currently configured?

5. How does cutting salaries for Bank Presidents repair the economy?

For Prime Minister Harper

1.  What’s the plan for minimizing the environmental impact of the Alberta Tar Sands? How can we continue to supply this enormous quantity of oil at prices that we do not control without properly matching  all of the costs to the revenue stream?

2. Do you have a plan for Cap and Trade?

3. Do we believe in the gains from trade? What is the Canadian government doing to improve our position in emerging markets like India and China?

4. Now that the North American stock markets are down again this year, any more market timing suggestions you would like to share with us?

5. Who is going to win hockey’s  Stanley Cup this year?

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.

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.

Here are some timely videos. You may remember Henry Blodget in a previous role as an influential technology analyst. Ken French is  is the Carl E. and Catherine M. Heidt Professor of Finance at the Tuck School of Business at Dartmouth.  These three short  interviews cover the basis of our approach and cut through a good deal of noise in current internet driven investment opinion.

Stock Picking vs index

Timing the market

Commodities

I think increased regulation of the financial services is here to stay. We simply can’t afford another episode like our current financial turmoil. We need to ensure transparency. Back room (off balance sheet) deals need to be minimized, if not eliminated. The big but here is that care should be taken to ensure that entrepreneurs are given the latitude to re-energize the economies of the world. Bureaucratic institutions can’t be expected to be effective in that role. There should be a market discipline to the spending and hiring so that small business is not crowded out by large numbers coming out of governments.

Dan sullivan of the Strategic Coach has a definition of entrepreneurs as true creators of value. He quotes 19th century economist Jean-Baptiste Say: “An Entrepreneur is someone who takes resources from a lower level of productivity to a higher level of productivity.” I like this  definition becuase it speaks to the fundimental role of the entrepreneur as a creator of value for the economy.

It seems to me that the world has been thinking a good deal about risk and money lately. We manage money for families. We think of our roll as that of supporting our clients in achieving their stated goals. This is an important contribution, one that we don’t take lightly, and I can say very rewarding when it works as designed. Unfortunately, today is the most challenging period for wealth management of my generation. As I write this entry I realize I am writing these posts on Capital Stories to remember this time and what we did and thought as we passed through it. This is as much then for me as it is for those of you who choose to read.

In my view, fixed income investments have been a significant contributor to the financial circumstances in which we find ourselves today. As interest rates fell to 30 year lows, smart people occupied themselves finding ways to increase yield. They captured more and more risk to do so. When this risk manifested itself, investors and the sponsors of these engineered products took the hit.

Our clients have to be confortable with what we do now. Confidence is the key to future performance in that rash, emotional decisions without vision will cause the greatest losses. What we should review is our allocation to the fixed income asset class. For our clients we will concentrate on arranging maturities so that guaranteed assets mature each year to satisfy their income requirements from the portfolio. It seems to me that if a family can see where their spending money is coming from 3, 4 , 5 and perhaps 6 years in the future, our suggestion is that with the remaining capital, they can have the confidence it takes to let their longer term return assets run the course.

Liquidity…give them what they want

Behavioral finance is the study of how we make financial decisions. Finance professor Dr. Meir Statman spoke at a conference I attended last year and his basic argument is that we are all wired to act poorly as investors. Our fight or flight heritage gets in the way so we need rules and guidelines to overcome financially costly basic human tendencies. Meir generously shares his research and thoughts on his website and through his blog. – Santa Clara University – Leavey School of Business -Statman Profile

One of these rules or policy that I try to keep in mind is to be a liquidity provider. When the market is falling as it is this year, we should think about granting the emotional investor their wish. While the math may seem obvious it is a great mental check to categorize the liquidity preference of your strategy. Are you offering your position with the herd in flight or are you getting a preferred price by buying your position from those who want out…at whatever it takes. When stocks are rising the principle still holds. If a position is unbalanced and investors are fighting to get into what appears to be a can’t lose investment , give them what they wish for. Trading costs will be reduced since you will likely be selling at the offer or better and buying at the bid or better. In addition, your asset allocation decisions will be greatly advantaged by using this mental check.

(Click on the chart to see a bigger version)

This chart represents my attempt at defining a normal or ”equilibrium” return to equity markets. The data starts in 1970.  Each value represents a 15 year compounded return for a portfolio comprised of one  third Canadian equity, one third US equity and one third international equity.  I think this is a reasonable period in that each data point considers at least two market cycles.The lowest 15 year period equals 8.5% and the highest, just shy of 20% compounded return. If this year ended at the values we are at today the 15 year return will be about 6%.

So how can this data help us?  Should we expect better return in 2009 and can we define what that amount might be? Unfortunately, with all due respect to market strategists and technical analysts, the investments markets are not so easily mined . The risk to equities is not altered by recent experience. We continue to have a random outcome in the short term. Cheaper doesn’t mean less risky. As my friend Brad Steiman from Dimensional Fund Advisors likes to say “stock prices have no memory.” While our expected return may be higher after a large correction  it comes with the cost of higher risk.

I think the most sensible approach is to build more efficient portfolios. If we focus getting the return provided by  the broad markets we end up with ample reward to our efforts. Our investment success should not be determined by “when” the return shows up but rather by how we participate when it does.

I will provide more detail on how we build better portfolios in future posts.