Some Good Advice During Bad Times

At the time of writing this article, the S&P/TSX Composite index sits at approximately 8,600 points, down almost 45% from the high point achieved in June 2008. The dramatic decline in Canadian and global stock markets has left many investors, and even some advisors, confused about how we’ve arrived at this point and uncertain about what to do going forward. While there is no singular answer that will address how each individual should now position their portfolio, there are a number of rational steps and realizations to be considered during these irrational times.

Check your Emotions

A common behavioural mistake that investors make is to fixate on the highest value that their portfolio achieved before the credit crisis began. This is known as anchoring, and is completely irrelevant for making current portfolio decisions. The past is the past and you will not be well served focusing on mistakes that were made vs. what needs to be done going forward. Yet many people are so fixated on their portfolios high point that even today they are willing to take on additional unnecessary risk in the hopes of regaining what they’ve lost. An example would include taking a concentrated position in a stock or sector in the hopes of hitting a portfolio home run. Remain focused on the present and how your portfolio could best be structured now given the present market conditions. Fear and greed are powerful forces and research has shown that investors that exhibit stronger emotions towards gains and losses exhibit poorer portfolio performance over time vs. those who remain disciplined.

Have a Plan

Now more than ever, you need a documented investment plan. You are more likely to make mindful choices when you have a well laid out plan against which you can weigh your investment decisions. A documented plan will help you understand what is necessary to make progress towards your goals and how to rationally respond to the present crisis we find ourselves in and future market or personal ‘what if?’ scenarios. Inside this plan be cognizant that ‘average’ returns rarely occur as both annual stock and bond returns can fluctuate widely around their historical mean return. Planning as though market returns are constant creates false expectations about your portfolios performance and its expected future value.

Should you move to cash?

Many of you are understandably nervous about whether the markets will continue to fall over the next year or years and wonder if you should move your portfolio to cash. If you’re suffering true physical discomfort or are satisfied with lower expected portfolio returns, then the answer may be yes. I would only council this move though if it is going to be permanent or at least long-term in nature. Moving in and out of the stock market is a very tricky affair. Tricky because you need to be satisfied that when you exit we are not at or near the bottom of this downturn and confident that you will be able to move back into the markets before they rise. If you feel bad about stock markets at their present levels, when will you likely feel good about moving your portfolio back into the market? If you answer this question honestly, then you will probably say when they have recovered and are trading above the present level. Selling low to buy back high is never a prudent strategy.

Take Action

There are two simple yet effective actions that you can immediately implement in your portfolio today. The first is to ensure that you have a truly diversified portfolio that will position you to participate in any market recovery. The pundits, for the most part, were unable to predict the present market conditions. I believe they will be equally successful in predicting which country or sector will lead the recovery. Therefore it’s best to have a diverse mix of assets in multiple markets so that you will participate in any recovery no matter where it occurs. Secondly evaluate the taxes and fees that you’re paying for your investments. Are your highly taxable securities (bonds, money market funds, etc…) held in your registered accounts so as to defer the taxes? Does your broker or mutual fund manager turnover the stocks you hold outside of your registered account excessively, creating annual capital gains liabilities for you? Are there tax loss selling opportunities in your accounts? Tax optimizing your portfolio and reducing the fees you pay, can have a immediate positive impact on your future net returns. One Final Thought If the thought of either staying invested or moving additional funds into the stock market is unappealing and you don’t want to earn the low interest rates being paid in savings accounts or short-term GICs, then consider using some funds to retire outstanding debt. If you don’t feel that the return in your overall RSP will be greater than the current interest rates you are paying, then any debt with non-deductible interest becomes a candidate to be paid down including credit cards, lines of credit and even your mortgage.

Fantastic Take on the Value of Market Pundits

Jon Stewart’s rant about the value of CNBC and their market pundits is hilarious. If nothing else, the comedic humour should bring a smile to your face during these difficult times.

Jim Cramer, whom this clip takes multiple shots at, has agreed to appear on Jon’s show tomorrow. The verbal exchange between Jim and Jon should be priceless.

Bond Investing: Risks and Bond Funds vs. Individual Bonds

As RSP season comes to a close, investors are looking to deploy their contributions, with many preferring the relative safety of bonds and money market securities vs. the equity markets. Yesterday Greg Hebert and I discussed some of the risks associated with bond investing and the differences between building a portfolio of individual bonds vs. investing in a bond fund. If you have any questions about this topic, please post a comment below and I would be happy to respond.

The interview is available here -> biznight-andrewbaechlerfeb2609

Buyer Beware: Tax Gifting Arrangements

Tax avoidance schemes are most definitely a case of buyer beware.

 

The Canada Revenue Agency (CRA) recently posted this warning on their website:

 

“Warning: Canada Revenue Agency has denied over $2.5 billion in tax shelter gifting arrangement donations.”

 

Despite this and other related warnings from CRA, I’m sure many Canadians will still claim tax credits from gifting arrangements on their 2008 income tax filing. Everyone should note that tax shelter numbers are assigned for identification purposes. Even though a gifting arrangement may have a tax shelter number, it does not guarantee that you are actually entitled to any proposed tax benefit or credit. I recently read that the CRA is reviewing 65,000 tax returns where the filer participated in some sort of gifting arrangement. While not every one of these 65,000 cases will necessarily result in punitive action, I’m sure there will be a lot of negative outcomes from a taxpayer perspective.

 

If you participated in any of these types of tax shelters, you may be able to avoid penalties and prosecution if you contact CRA before they undertake your audit.   

 

As a rule of thumb, whenever you are presented with any type of tax avoidance arrangement, I would consult with a tax expert who is not associated with the proposed arrangement about its eligibility.  

Do Most Canadian Equity Funds Beat the TSX?

As you’ve probably gathered from my previous postings, I and PWL believe that asset class exposure and not active stock picking explains the vast majority of investment portfolio returns. This belief is based on academic research and is a main driver behind our overall investment philosophy.

 

Every quarter, Standard and Poor’s releases an update to their SPIVA report. The SPIVA report documents the performance of active mutual fund managers vs. their respective benchmark index.

 

I just finished reading this report, and, as in the past, our investment approach was further supported by the fact that the majority of active managers underperformed their benchmark in 2008. Of the eight fund categories that S&P tracks, only Canadian Dividend fund managers (89.66%) outperformed their index. While Canadian Dividend fund managers did have an exceptional 2008, over a longer five-year period only 3.23% of these same dividend managers outperformed their benchmark.

 

This morning the Globe and Mail published an article titled “Most Canadian Equity Funds Beat the TSX”.  The article’s author arrived at this conclusion because 53.2% of active managers beat the S&P/TSX Composite index OVER THE LAST 3 MONTHS OF 2008. 

 

However, when you look at 2008 as a whole, only 42% of Canadian equity funds beat the S&P/TSX Composite index. Similar to the Canadian Dividend fund managers above, over the past 5 years less than 12% outperformed the index. Also incredible is the fact that over the same 5 year period, 45% of Canadian Equity Funds ceased to exist altogether. This is primarily due to poor performing funds being either shut down or rolled into another better performing fund so that poor fund performance no longer needs to be reported by the parent fund company.

 

Many investors want to believe that active management really shines in down markets, and that during a financial crisis a good manager will earn his or her keep.  I think this report paints a very different picture.

 

I encourage you to read this report, and to pass it on to your friends and colleagues.  I have met a number of referrals lately, who were looking for a second opinion, and while not necessarily surprising, it is disappointing to me that none of them had any indexed exposure in their portfolio, only actively managed mutual funds, the majority of which were sold to them with high deferred sales charges.

 

 

Some Excellent Thoughts from Michael Lewis

Michael Lewis is a journalist and best-selling author whose notable books include: Liar’s Poker, Moneyball and Blind Side: Evolution of a Game. Based on his experiences as former Salomon Brothers bond trader, Michael’s writing provides a fascinating look at Wall Street’s culture, its characters and its history.

 

Michael was recently interviewed by Big Think (www.bigthink.com) where he shared his thoughts about the mindset he feels an individual investor needs to adopt today. I would encourage you to watch and share his short interview below.

 

The Risks of Going Riskless

As negative news about the global markets compounds, many investors are contemplating reducing or eliminating the equity holdings in their portfolio. While this strategy will eliminate the equity market risk in their portfolio, the decision carries other consequences that many investors overlook. On this week’s “Science of Investing” segment, Greg Hebert and I discuss whether it is rational to sell in a down market and the additional risks that an investor takes on when they reduce their market exposure. 

You can listen to the interview here.

A Lesson Learned During the Financial Crisis

There are many lessons that investors can takeaway from the current financial and market crisis. Recently I wrote an article that covered the need to always understand the various risks that are present in our portfolios. This is something that American International Group (AIG) neglected to do on their own balance sheet, and this oversight led the company to the brink of bankruptcy. The original article is below and a  version that appeared in Ontario Dentist is available for download below.

 

Market Turbulence – A Lesson Learned

 

If you recall, back in June I asked whether you thought the bull market in commodities would continue unabated, and I’m sure many of you thought that indeed it would. Oil was climbing towards $140 USD a barrel and their seemed to be nothing stopping its hockey stick shaped increase. Now I wonder if you think oil will even trade above $100 in the next 12 months. We as humans suffer from a recency bias, which means that we project current market conditions much too far into the future and forget about long-term market trends and cycles. We observe the most recent pattern and extrapolate it into being a new long-term trend. Presently we’re experiencing a major selloff in the world’s financial markets and I’m sure many of you have a pessimistic view that the markets will continue to fall or trade sideways for a very, very long time. While I cannot predict if the global financial markets will correct themselves over the next 1-3 months, I am confident that over the next 1-3 years the system will have washed itself out and we will look back on this crisis as just one of many that we had to endure as investors in a capitalist economy.  Many of you cannot envision these greener financial pastures, but they will return, and when things begin to go well again in the market, your recency bias will cause you to forget a valuable lesson we can learn from the present market crisis. So please file this article away and reference it again once the markets have recovered and you feel like the markets will only ever go up, up and up again.

 

So what is the key lesson that I would like you to remember in the next boom time? Let me explain using the recent market example of American Insurance Group (AIG). The principal reason that the world’s largest insurance company, AIG, recently found itself on the brink of bankruptcy was that it didn’t understand the risks that it was taking on its own balance sheet. AIG underwrote a huge number of derivative contracts, called credit default swaps (CDS), which work like insurance in that they guarantee against a company failing to pay back their debts. If I was concerned that Wal-Mart might go bankrupt, I could purchase a CDS to cover any investments I might have made in Wal-Mart bond. AIG’s CDS contracts insured a whopping $441 billion of fixed income investments, including $57.8 billion in securities tied to subprime mortgages. What is the lesson learned here? Well in boom times these CDS contracts were highly profitable for AIG, but when the good times ended, having a balance sheet with a large number of complex, high-risk financial products on it, spelled financial ruin. So my question to you is: Do you or your advisor completely understand all of the securities that you’re invested in? If not, how can you be certain that they’re:

 

a) appropriately matched to your investment goals,

b) not liable to self-destruct and

c) will recover along with the markets in the future?

 

You or your advisor must absolutely understand the risk/return relation that each and every investment opportunity presents you. Earning a huge return on your investments is great, but if you don’t understand the underlying risk of those investments, you could be setting your portfolio up for economic disaster a la AIG.

 

The list of complicated products that are sold to individual investors each and every day is extensive and includes: hedge funds, principle protected notes, exchange traded notes, index-linked GICs, flow through shares, labour sponsored funds and guaranteed minimum withdrawal benefit annuities. If you have the time, I would encourage you to either read the prospectus or information statement that should accompany the above investments or have your advisor fully explain all the associated risks. I would also encourage you to inquire how your advisor is compensated by the products he sells you. Some products, notably hedge funds, do not have to make any type of information disclosures to you. To me this should be an immediate red flag. Your being marketed a product most likely because of its previous historical returns. Remember AIG above and how beneficial it was to make a great return when you don’t understand the associated risks. If you presently hold some of these products I’ve mentioned and are unsure of their risks, seek out the guidance of someone who can explain them to you and make an objective recommendation about their suitability to you and your investment goals.

 

 

 

Article as it appeared in the December 2008 issue of Ontario Dentist.

Fama/French Forum

The foundation of the investment strategy used at our firm, PWL Capital Inc., has come out of extensive research, over many years, by financial economists Eugene Fama Sr. and Kenneth R. French.  Their work over the years is nothing short of incredible, and has been an important part of Dimensional Fund Advisors, our key investment partner, investment strategy.

Today I wanted to highlight a new web site, put together by Dimensional, where you now have access to the thinking of these two brilliant academics.

 

If you have questions such as:

 

• Is the market turmoil a sign that markets are not efficient?
• How useful is an approach based on historical data when the current situation appears to be unprecedented?

Then I think you will find this site interesting: http://www.dimensional.com/famafrench/

 

In addition to an excellent Q & A, there are links to many other fascinating articles, for those who want to dig into more details.

 

The January Effect

Are stock market returns in January typically higher than the other eleven months of the year?

The so-called January Effect has been discussed in academic literature and the popular press since the 1970’s. Today on Ottawa radio station CFRA, Business @ Night host Greg Hebert and I reviewed the January Effect, its possible causes and how individual investors may or may not be able to capture excess January market returns.

The audio recording is available here.

If you have any thoughts or comments about the January effect, please post them below.