Posts Tagged ‘Personal Finance’

Many conversations about investing this year are centered on what is wrong with stock markets in 2011. The assumption underlying this concern is that markets are only acting correctly when prices move higher, like in 2009/10, and are therefore defective when they move lower.

There are however, periods of time when economic risk is higher; the global debt problems and Japan’s difficult natural disaster come to mind. In some time periods earnings are generally not growing. If markets are discounting higher risk then it stands to reason there should be some additional volatility and in this past quarter at least, uncertainty has resulted in lower stock prices.

Markets work properly when they can move both higher and lower. If common stock prices were simply pegged higher each quarter then they would not well reflect the variant conditions of the economy and society in general.

From 1970 to the end of 2010, total returns to stocks in Canada (S&P/TSX) and the US (S&P 500) have increased at a compounded rate greater than 10%. Inflation has been about 4% so real returns for the period are about 6% and investors have been well paid for accepting the risk of holding stocks. Not all decades are equal. The past 10 years have been less giving. In Canada the average returns since 2001 have been 6.6%. Inflation averaged 2.4% for a net of 4.2% in real inflation adjusted return. So the premium for holding risky assets has been below average.

How should this recent result impact our future expectations? Even in a below average return decade, patient investors did okay. They were rewarded with real returns and grew their money. While a definition of risk can be a future where “you don’t know the outcome,” long term averages should be attributed some predictive power. It seems to me that it makes more sense to consider a bigger sample (more years) than assume the recent experience will continue into the future.

There is plenty of risk in stock markets that is well rewarded and a source of good compensation for investors. There is also lots of risk assumed by the investment community that has no or perhaps negative compensation. Our investment focus is the elimination of risk that has no payoff.

Public stock market indexes have been a source of dramatic returns in excess of inflation for more than a hundred years. Investors can capture the returns to indexes at very low cost. However, there are problems with indexes. The S&P 500 for example is dominated by large growth companies. The calculation of the index has a bias toward large capitalization stocks. These features represent risk without compensation.

Another prominent example of non-compensated risk is assuming that stock markets provide risk free return by selecting only stocks that go up. Focus lists of investment houses are typical examples of this type of approach. The problem with these list approaches is they are not investable. You can’t be the first into the stock choices and the first out so the “return to the list” is not the investor experience. In my view, non-compensated risk like this should be minimized since they ultimately do not support the goals of investors.

Simple index returns can be improved upon. A better exposure to risk provides better compensation. We spend our time working at identifying risk worth taking and where possible, eliminating risk that doesn’t pay.

Patrick

September 9, 2011

I am not a fan of sequels.  It seems to me that little new is added to our understanding of the main characters, and the plot outcome seems predictable from the start. Many observers say sequels are never as good as the original hit, the exception perhaps being Godfather II.

The volatility and pressure in world stock markets is regrettable. Risk has manifested in providing little if any return for the past decade. It seems to me that this current downturn has been triggered by the perception of a lack of effective leadership on the part of governments around the globe.

Of the three main players in the economy – individuals, corporations and governments – the investment markets are concerned primarily with corporations. At this point, North American corporations as a group are much better off – as measured by balance sheet financial strength – than previous median levels. Companies have less debt and more cash than we expect them to have. This is a good thing that should be a source of investor confidence. On the other hand, many of the world governments are bankrupt: Iceland, Greece and Ireland come to mind.

Investment markets are concerned with predicting the future. In the bond markets, payback (yield) for investing in 10 Year Government of Canada Bonds is about two and a half percent. The same is true of 10 year U.S. treasuries.  Investors buying these yields are willing to take a return, after inflation, of less than zero for 10 years. That number looks worse after taxes. It is worth noting that in the case of Canada and the U.S., investors in government debt appear unconcerned about default.

Individuals in North America have more debt than usual and the unemployment rate remains relatively high. The recent recession has been a difficult and persistent one for consumers.

The agreement to extend US Government debt was essential in that all financial interests were served and every investor would have experienced losses if it had not been confirmed. The US Government is too big to fail. Essentially, all countries in the G10 are too big to fail.

Sellers in the stock market will see much slower growth in the future. In terms of national accounts, aggregate demand is a function of buying power. The pessimistic view is that individual consumers and governments are tapped out. Companies who might otherwise be expanding are reluctant to do so if, in the future, there are fewer customers willing to buy their products. The thinking is that with fewer customers there is no growth. This is an important assumption that may prove to be incorrect.

In my view, predictions of future corporate earnings are a poor guide to investment decisions. This poor predictive power holds true for those that use so-called top down (aggregate economy based) analysis or bottom up (individual company) focus. Professional analyst predictions are frequently wrong and show little persistence when they do get it right. I think the balance of investment return for appropriate risk assumed will re-establish. Stocks will outperform bonds in the future, just as they have in the past. Good companies will innovate to find new customers and are already doing so.

We will re-balance our allocations once things settle down and we can confirm how this recent decline has impacted the plans for your portfolio. We re-balance when we have the evidence to do so and avoid the trap of attempting to generate investment returns by predicting short term outcomes.

Thank you for being our client and please pass this along to any friends or colleagues who could use a little reassurance and understanding.

Best Regards,

Patrick

For a change of pace today’s entry is from guest blogger Ryan Leroux. Ryan is an intern on our team and had completed the second Level of the CFA program. Ryan correctly points out that all successful investment approaches are built on savings.

Over generations, the concept of saving has been instilled in most Canadians as a top priority.  Many of us were taught early on the value of a dollar and to save for a rainy day. Sadly, saving has become a mere afterthought to thousands of Canadians.  Looking at this graph, you can see just how bad the savings rate has declined, from a high of 20% in the early 1980s to less than 4% in 2010. With the savings rate declining and the population aging quickly, the situation doesn’t bode well for the adults of this generation and baby boomers.

Source: Statistics Canada. Sector Accounts, Persons and Unincorporated Businesses. CANSIM Table no. 380-000.

With the CPP and OAS providing retirees with a minimum level of income and employment pension plans shrinking, it is becoming more and more important for individuals to take control of their personal financial plans if they want to have a comfortable retirement.

The government provides many incentives to invest through the RRSP program. Contributions are tax deductible, thereby decreasing the tax bill and all taxes are deferred on savings and interest until retirement.  In reality, Canadians are not taking advantage of these incentives and are letting the benefits slip away.  Over the last 50 years Canadians have made more than $600 billion in RRSP contributions yet have unused RRSP contributions totalling an additional $500 billion. During the last decade, the percentage of individuals who have made contributions to the RRSP program has fallen from 41% to 34%.  During a time when people should be saving more, the opposite is actually occurring.

Consumption has been the main cause of the declining savings rate.  Just like our neighbours to the south, Canadians have become mass consumers.  People are putting an emphasis on current consumption rather than future savings.  In addition, volatility in the market and disappointing performances in the past has had a profound affect on the behaviour of Canadians. They would prefer to spend their money today rather than lose it in the market.  But, by making sacrifices in the present and taking a long term view to consumption, savers will, over time, have more money and have the ability to enjoy it longer.

Many Canadians have problems saving money.   They do not have a budget or a well thought out savings plan.  Without a plan, expenses and debt can spiral out of control and makes saving impossible.  The implications of this situation are far reaching and easily avoidable.  Not only do these people miss out on the magic of compounding, but also the tax incentives that occur yearly. Having a feasible plan in order and sticking to it takes discipline and time.  But, the future rewards are well worth it

Success in investing begins with individuals saving for the future.  As a group, savers build up cash flow headroom through discipline and sacrifices. Savers become great investors because they have time on their side and the cash to take advantage of opportunities.  They have the flexibility to ride out volatility in the market and set their sights on the long term without letting short term issues get in their way.  To most people, saving is a part of life and a way to watch their money grow over time.  But, to many Canadians, the lifestyle of consuming and spending now will only lead to a future of cutting back and making great sacrifices in their golden years.

The opinions expressed in these articles are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

There is currently a good deal of discussion about the speed at which the Canadian population is aging. This aging affect is expected to accelerate in the next 20 years (see chart below). As has been the case at every stage of their generational life, boomers are going to have a dramatic impact on Canadian society as they retire. In twenty years, fully a quarter of the population will be drawing CPP and OAS. For many people, government pensions won’t be enough to cover spending requirements.

Source: Statistics Canada. Estimates of Population, Canada, the Provinces and Territories (Persons). CANSIM Table no. 051-0001; and Statistics Canada. Population Projections for Canada, Provinces and Territories (2005-2031). CANSIM table no. 052-0004.

As a nation, we are challenged to provide a financially comfortable and healthy lifestyle after retirement. Public Pension funds, CPP and OAS are designed as a safety net, providing only a basic standard of living. Personal savings and private pension plans are expected to make a significant contribution.

Private Defined Benefit (DB) pension plans participation rates have been dropping. DBs are stressed by smaller contributions from a shrinking population of workers and recently by volatility in the investment markets. According to actuarial estimates by Mercer, by the end of 2008 more than 70% of DB plans had solvency ratios under 80%. This means the total assets of these pension plans offset only 80% of the liabilities.  An unfunded liability is ultimately backed by the earnings of sponsor companies. Fortunately, that recent underfunded status has been largely reversed by positive investment returns in 2009/10.

The volatility in plan assets is a concern for corporate Canada and there remains considerable incentive for companies to reduce exposure to pension risk by converting existing DB plant to Defined Contribution (DC) pension plans. In DC plans the investment risk is borne by the employee-retiree. For private company sponsored plans in 2008 alone the number of participants in DB plans declined by 7.8%. Given the incentives, it is reasonable to expect this trend to continue. It is worth noting that public DB plans are headed in the opposite direction, with an increase of 4% of participants during 2008.

The overall result is that most Canadians are responsible to provide for their own retirement. Investors bear both the risk of managing assets and benefit from the rewards to getting it right. To a significant extent, our current wealth management strategies define our future lifestyles.

Our Policies Support Your Goals

As a leading Private Family Office (PFO) we think we have a role to play in providing a platform for successfully discharging the demands of your family’s wealth management.

We are focused on getting wealth management to work for you. Our clients understand the challenge and like most investors, prefer to work with a professional advisor. They understand that the skill set required to grow wealth is often very different from the skills needed to preserve wealth and the purchasing power of that wealth.

While financial success comes with responsibility, enjoying your wealth is best experienced once those responsibilities are satisfied. Our purpose is to help clearly define your important goals and bring you considered strategies to achieve success. We use trusted relationships though our network of professionals who are experienced at tax, legal, insurance and estate issues. We would also be pleased to work with your current trusted advisors.

We typically work with a larger percentage of the assets of our clients so that our strategies and approach can make a difference in their financial lives. We think costs matter, taxes matter and current cash flow requirements are probably not diminished in retirement. We have the tools to define a family’s unique requirements and the evidence-based investment approach to confidently get it done. Our joint responsibility is your investment success; we have a proven approach tested through many market cycles.

The motto, “our policies support your goals” refers to both our unbiased investment approach as well as to the professional standards of care of the Chartered Financial Analyst (CFA) designation which defines our business practice. We enjoy what we do and would be pleased to discuss your requirements.

Patrick

The opinions expressed in these articles are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

At this time of year many of us plan to improve. Diets are popular, the gyms are full and, perhaps randomly, a disproportionate number of spouses file for divorce. Beginning of year activities tend to align to specific goals, and policies are set to support the desired outcomes. Unfortunately, many of these policies are temporary. Experience suggests that gyms are much quieter come March. Of all these goals, divorce proceedings may be one of the more persistent policy changes. I should note that I have no personal experience to draw on here.

From an investor viewpoint, net worth can be checked against previous levels to hopefully see some progress. Improvement often means more money to draw on, as more is better when it come to supporting future lifestyle choices.

Let’s assume a primary financial goal is increased retirement income. Do your actions support your goals?  Future retirement income is positively affected by savings and growth on those savings. So an important policy to support your new financial success is to create some savings, or perhaps spend less.

I have found discussing spending habits to be something of a buzz kill.  Some people tell me that they are better at making more money than budgeting. Making more money can work, but there still has to be some savings, and spending cuts are more predictable that earnings growth.

Once you have some savings, and are in the habit of creating an ongoing supply, it’s time to consider money growth strategy.

Investment management fees and expenses do not support the goal of growing your savings. On the other hand, properly constructed portfolios do a better job of wealth creation than throwing money at the markets and hoping and praying. Some fees pay for experience and judgment. Some fees end up paying for other people’s entertainment.  You should have a policy of supporting investment advice and minimizing entertainment expenses.

As a guideline, the Canadian Pension Plan Investment Board pays about three quarters of one percent per year in fees and expenses to manage their 120 billion dollar fund. For most of us it is reasonable to expect to pay a little more to have our money managed. Your policy should be to pay a right amount and yes, lower fees are better.

Your growth expectations should be supported by the investments you hold. For example, if the long term return to equities is 12 percent, expecting 20 plus percent return is bad policy. You may indeed have periods when you achieve the big number, but there is no sense being disappointed at what is a highly probable outcome. If you expect to achieve more return than is available, you should have a policy of investing in assets that provide higher return than stock markets.

Leverage doesn’t increase only the positive return; you get more of the bad as well. A leveraged portfolio expected return has a broader range of possible outcomes. If you are paying incentive fees, like many hedge fund models, then the most probable outcome is a lower number than if no leverage is applied. Your investment policy should consider the math of your approach and check to see that the incentives support your goals.

We are focused on our goal of building the finest platform for investment advice. I am convinced we are on the right track with policies that directly support the goals of our clients. Let’s chat about your investment policies. This is the year, now is the time.

Patrick

The opinions expressed in these articles are the opinions of the author and readers should not assume they reflect the opinions or recommendations of Richardson GMP or its affiliates.

When I was at University, my first-year economics readings included many things that were interesting – some intuitive and some others that were a stretch and unbelievable. One of the less believable but core economic assumptions is that individuals act rationally and generally consider all available information before making a decision. The thinking is that in the rare case where they do not act rationally, market forces quickly correct behaviour.

Though this assumption is a key building block allowing economists to model and predict future outcomes, to me this never rang true. Even the casual observer realises that this isn’t the case. People don’t always consider all the available information prior to making a decision. We just are not that sensible. Some people are predisposed to ‘just wing it.’ Individuals often make the same mistakes over and over again; we sometimes refer to this as being in a rut. Marketers can rely on this type of myopic behaviour to increase market share and build brand awareness and loyalty.

In a rational world there is no free lunch. Individuals quickly act to eliminate anomalies like free money or free return since they act rationally when they see it. Behavioural Economics, on the other hand, is based on the idea that people don’t always act rationally. These economists borrow from other disciplines such as psychology and sociology and measure people’s actions. They study how people actually behave and attempt to suggest alternative strategies which may be more successful. For the behaviour economist there are many ways to improve decisions made so there is a free lunch for individuals if they behave better financially.

In my practice we are focused on building and sharing tools that promote better decision-making around the things that our clients tell us would make them more successful. We are sensitive to the idea that most of us resent being told what to do with our hard-earned money. This fierce independent streak isn’t something we like to challenge. However if we frame the discussion in terms of how deferring some immediate gratification can improve the quality of their golden years then we think we’re on the right track.

Generally, spending as much as possible right now isn’t the most rational of approaches. While procrastination can be a benefit it is particularly troubling when applied to retirement savings. The key for us is to provide factual evidence in support of a better policy promoting self control. While we can’t tell you how your life will be better with 20 percent more money it can be useful to know the probability of running out of money in the future. We think part of our contribution is to identify and encourage replacing current activities and policies that do not support your important goals.

There is a great book that builds on some of these ideas; Predictably Irrational, by Dan Ariely. He tests behaviours against what we think would rationally take place and often finds humour and insight in the results. I especially liked his discussion of Social Norms versus Market Norms. Also, “free” isn’t nearly as attractive to me now.

For our current clients and friends thank you, we are on the right track. There is always room for others to join us; patrick.mullins@richardsongmp.com

Patrick

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.