Posts Tagged ‘Personal Finance’

Please join us for a focused discussion on Investment Returns as part of our 2010 Educational Luncheon Series.This will be a great opportunity to explore what has happened in the financial markets over the past 10 years and how returns have affected the retail investor.

We will explore what some people are afraid to talk about: Actual Historical Returns, What Do They Mean? What did we learn? How do we apply these realities to our future investment decisions?

Please be our guest over lunch and learn about how you can improve your chances. This is also a great opportunity for you to bring along a family member, friend, or colleague to engage in our discussion.

Speaker: Patrick Mullins CFA, Director- Wealth Management, Richardson GMP

Date: Tuesday, September 21st (added due to demand) and September 22nd, 2010 Time: 11:50 a.m to 1:00 p.m

Location: 343 Preston Street, Suite 300 Ottawa, ON K1S 1N4

Lunch will be served

Please RSVP to Lisa Beartup. lisa.beartup@richardsongmp.com or 613-788-8015.

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

Final Instalment of the Review of the US Monetary System

Economists assume we all want more money. This makes analysis of their data easier. It seems to me this simplifying assumption creates misunderstanding. Money is important to the extent that it provides the things we want. While some may want the largest accumulation, most users of money don’t see simple accumulation as satisfying a higher order need. However they are concerned that they may run out. They want to ensure that their lifestyles are protected. They would like to have some financial flexibility if events don’t unfold as expected. Hording and having “the most” is usually not top of mind for consumers in general.

Users of money are concerned with purchasing power and therefore, perhaps indirectly, inflation – and rightly so. The rate of US inflation in the past 50 years has averaged about 3.3% per year. Today’s dollar has the same buying power as 8 cents in 1929 money. In the past 15 years, purchasing power of the dollar has dropped to 67 cents. By comparison, Canadian inflation has been higher in the seventies and eighties, somewhat lower since. But how have consumers generally faired in North America?

Behavioural finance is increasingly interested in relative personal consumption expenditures (PCE). The chart below suggests a strong relationship between real disposable personal income (DPI) and real consumption. This chart illustrates an inflation adjusted income of $5,000 in 1929 continues to be worth $5,000 today. Currency in this example is held constant at year 2000 levels so that the average gain in consumption to 2008 for an American is a real $22,000 (27,000-5,000). This equates to a 2% real gain in spending power each year. If you simply kept up with inflation, you would be able to consume only 20% of the amount of your neighbours and keeping up with the Joneses would become impossible.

Per Capita Real Disposable Personal Income (DPI) and Personal Consumption Expenditures (PCE) 1929-2008

North American consumers have done very well. But what has been the source of the excess buying power? Some of the gains are the result of increased wages. The attribution of wage increases can include such things as better labour participation rates and higher education levels leading to better paying jobs. Investment gains have also contributed to higher disposable incomes. Below is a review of excess returns to the public investment markets. These are positive returns after removing inflation and PCE changes of about 2% per year.

Improvements in living standards are a good thing. But people who don’t fully participate in the growth can quickly start to feel left behind. Fully diversified fixed income investments have generally reduced disposable income. An investment in a fully diversified stock portfolio has added to disposable income.  Taxes, fees and concentrated portfolios with higher volatility have probably reduced the benefits to consumers of this affect. Since diversification reduces volatility a sensible approach would include both stocks and bonds in the mix.

Patrick

The top rated banking system in the world – Canada, really?  I guess it had to happen sometime. It seems after the recent global carnage, banks that leveraged their assets the least have won. European Banks had borrowed more than fifty times their assets to increase the size of their operating business.  So a 2% loss in net operations pretty much wiped out their equity. The U.S. banks levered north of 25 times so it took a 4% net asset write off. Canada at 15 times has a 6 % cushion. It should be noted that much of the global bank liabilities are guaranteed through deposit insurance, reducing the risk. As we have recently found, relatively small, highly risky ventures can spin out of control. You and I can’t get a loan with 2% equity backing the note. If we did we might be too big to fail as well.

Last week Chancellor of Queen’s University and former Governor of Bank of Canada, David Dodge spoke at a lunch presented by the Canadian International Council (CIC). His topic -Rebuilding the Global economic and financial Order. He had a couple of insightful statements about leverage. In his view changes to accounting standards (FASB)  are adding volatility to stock markets in marking assets to market while leaving debt largely at cost. If debt isn’t repriced  as equity on the balance sheet then you get bigger reductions in earnings in recessions and larger growth in earnings in good times.  Higher highs and lower lows add risk without a corresponding increase in return since debt and equity will end up priced at liquidation value in any case. Transparency is always desired but only if  assets and liabilities ares  treated equally. Mark-to-market is really made up numbers since you only really know what something is worth when someone else pays to buy it.

Mr. Dodge is also a proponent of good regulation. He thinks that Canadian Banks may have ended up in a deeper problem without strong  federal guidelines. He concludes that upcoming G20 meetings present the best opportunity to co-ordinate meaningful global improvements in the economy.

In my opinion,  Canadian Banks would find themselves in the same position as  U.S. Banks had they been allowed to operate unfettered from regulation. For example, foreign ownership limits are federally imposed on the sector. Canadian banks lobbied to have them removed so that they might merge and invite larger interests to invest. It is lucky for them that they were unsuccessful in that effort.

All good and bad things come to an end. This financial crisis will as well. So to track the progress we have to first define the beginning. My metric is the last high of the market as defined by the S&P 500.  So the bear market began October 9, 2007 closing at 1565. A bear market is commonly defined as a 20 percent decline in the index. This is the 7th bear market of the past 40 years and by measure of decline the only S&P 500 drop to exceed 50%.  The lowest point was 741 on November 21, 2008, a 52% decline. Today we are down 47% from the 2007 high. Stock prices are immediate measures and are often referred to as leading indicators or predictors of where the economy might be going.

This bear market began as a financial problem and is now a full blown world wide recession. A recession is 2 consecutive quarters of negative real GDP. Recessions are backward looking measures as it takes time to collect the data.  This predictive ability comes with a degree of error as many more recessions have been predicted by the market than have come to pass.

The U.S. recession officially began in December 2007. The  National Bureau of Economic Research publishes some good data on past recessions. Peak to trough since the Second World War, the average recession has lasted 10 months. The range is large however: the longest peak to trough was experienced through the U.S. Civil War at 65 months. In the 1930s the duration was 43 months.  Unfortunately, there isn’t enough computing power in the world to confidently predict the end of a recession. The economy is simply too complex.

I think the stock markets will rebound. Optimism has always won in the end. The S&P 500 first hit 100 in 1968. Today, we worry as the Index has fallen below 900. This isn’t gravity, it’s a measure of growth in the economy. The economy is larger, the population has grown, companies make  more money, and these fundamentals are eventually reflected in the value of the index.

In future posts I will continue to review the evidence to try to determine when the uphill swing begins. Stay tuned…

The financial press appears to be drawing parallels between our current financial challenges and the depression of the 1930s. To some it may seem reasonable. Yesterday, British Prime Minister Gordon Brown, in the House of commons, referred to the economic environment as a depression, though he later explained that he simply got the words wrong meaning to say recession. This is how rumours start.

While drawing parallels may make it easier to explain complex subject matter, there are many differences between now and then.

1. In the 1930s there was no social security. Today these cheques, delivered monthly, provide a basic level of subsistence.

2.  Peoples’ savings are protected from bank failures through federal deposit insurance. In the 30s investors lost their savings when banks defaulted.

3. Governments around the globe have lowered interest rates in response to a weak economy. In the 30s the U.S. actually raised rates simply getting the monetary policy wrong. These rate cuts are significant. The Bank of England is currently at 1% for fed funds, the lowest level since the Bank was established in the the 1700s . Japan has lowered the rate to zero. Canada and the U.S. are at 1%.

4. There has been a global increase in money supply unlike the contraction experienced in the 30s.

5. International trade agreements now promote trade between economies. The escalating trade barriers introduced in the thirties had the opposite effect.

6. As a global trend, corporate and individual taxes are low when compared to the rising tax environment which typified the 1930s.

7. We now have single digit unemployment. In the thirties unemployment exceeded 20% in North America.

8. Governments have acted quickly, introducing a fiscal stimulus package in a globally co-ordinated effort. In the 30s Roosevelt’s “New Deal”  took several years to launch.

9. We have the experience of the depression as our guide.

For a great read and perspective of economic cycles I recommend The Ascent of Money by British Historian  Niall Ferguson. It it densely written, and therefore a moderately difficult read but gives an excellent review of how governments have dealt with crises beginning with the advent of money.

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.

I  recently finished reading Andrea Mandel-Campbell’s book on Canada’s international competitiveness. It’s not a flattering view. A journalist,  Mandel-Campbell provides a well referenced view of the drivers and influences on the development of world class brands. She compares the experience of successful countries to that of Canada in the recent past but also traces the root causes of our marketing paralysis. I like that she interviews several Canadian businessmen to get their take. There is good discussion on framing the problems though not quite enough about prescriptions for  future improvement.  It seems to me  she acurately points out that government policy in this country will have to change from a mandate of redistribution of wealth to one of supporting the drivers of wealth creation.  For more information, you can visit the author’s website.

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.