Pension investing for young professionals

Pensions are a thing of the past.  The young professionals of today are truly responsible for establishing their own long-term savings plans.  When pension plans were commonplace, the money you put away was managed for you. The reality of today is that not only are we in charge of being disciplined savers, we are also responsible for making our own investment decisions. As a young investor entering the market for the first time, what should you do?

Don’t try to beat the market

An index is a grouping of stocks that has been designed to represent a market. The S&P/TSX Composite is the major index used to represent the Canadian market. Beating the market is the action of selecting a grouping of stocks that is different from the index with the intention of having better returns than the index. One of the biggest mistakes that young investors make is using intuition, tips from the media, and other predictive methods to try and beat the market. Very few people (professionals included) have been able to consistently beat the market throughout history, and trying to do so tends to lead to poor performance. Instead of trying to beat the market, you can buy the market using inexpensive tools like Exchange Traded Funds and index funds.

Watch your fees

A large portion of Canadian investment vehicles are actively managed mutual funds. These are mutual funds with a professional money manager and team of analysts deciding how to invest your money in an effort to beat the market. In Canada, these types of funds charge an average fee of 2.5%. That fee comes right out of your investment no matter how the fund performs. It would make sense if this fee could be justified by superior performance, but actively managed funds tend to underperform the index over the long term. Exchange Traded Funds that hold the market index can be bought for as little as .05%. You can pay 2.5% for something that hopes to beat the market, or buy the market for .05%.

Diversify

It’s easy to be attracted to investing in companies that you know in the country that you live in, but there is a world of opportunity out there. We can’t predict the future to determine which types of stocks in a given country will be strong performers, but holding a diverse basket of different types of stocks in multiple countries allows you to capture the performance of markets around the world while reducing the potential impact of any single market performing poorly.

Understand risk and return

Portfolios usually contain both stocks and bonds. A stock is a piece of ownership of a company, and a bond is a piece of debt that a company owes you and pays you interest on. Stocks are riskier than bonds, but they also produce greater long term returns – more risk means more return in the long run. Not everyone can stomach a large drop in their investments, so managing your own behaviour starts with allocating the appropriate amounts to stocks and bonds.

Set allocations and rebalance

When a diversified portfolio is initially constructed there is a decision around how the portfolio will be split between stocks and bonds, and between domestic and foreign content. Once these allocations are set, it is important to rebalance the portfolio. If US stocks perform better than Canadian stocks the US allocation will grow; rebalancing is selling some of the US portion and buying more Canadian to get the allocations back to their original state. Rebalancing is done between the different types of stocks, but also between stocks and bonds, and it serves to decrease the overall volatility in the portfolio while removing emotions from the decision to buy or sell.

Don’t pay for advice unless you need it

Whether the costs are obvious or not, you are paying for financial advice when you meet with an advisor. Unless you have a large amount to invest or have an otherwise complex situation, you can save on the cost of advice until your assets have grown and your situation has become more complicated.

A simple way of implementing these steps can be elusive in Canada because neither financial advisors nor financial institutions stand to make the juicy profits that they are accustomed to when you invest this way. Currently, the two simplest ways to implement this in Canada are Tangerine Investment Funds and TD e-series funds. TD e-series are less expensive at about .45% for an equal mix of US, Canada, and International funds, but rebalancing and diversifying is left up to you. Tangerine will cost you 1.07%, but they take care of the rebalancing and diversification. Both of these options are index based, low fee, don’t have the cost of advice built in.

Full disclosure: I am in no way compensated by TD or Tangerine

Original post at theyoungprofessionaltimes.com

Nest Wealth, the start of a Canadian robo revolution?

Canada's investment industry is trailing the rest of the world. Not only do we have some of the highest mutual fund fees, we are also stuck in the age of embedded commissions. These industry issues have fallen under scrutiny from the media and the public causing many investors to seek fee based advice, or avoid working with an advisor altogether. In either case, people want low cost, globally diversified, and rebalanced portfolios. Not everyone needs a professional advisor in their corner, but not everyone is equipped to properly manage their own portfolio, either. The US had similar problems once, but in true capitalist fashion they have seen a wave of start ups appear to fill the gap. Online services like Wealthfront and Betterment offer portfolio construction, rebalancing, and tax-loss harvesting for a fraction of the cost of working with an advisor, but what about us Canadians? We don't currently have an option that fills the gap between paying for advice and managing a portfolio solo, and it really is a problem for small investors. I have seen plenty of people attempt to go the DIY route only to see managing their ETF portfolio become akin to cleaning the garage or doing the taxes.

Enter Nest Wealth. Nest Wealth is an online portfolio manager that should be available to investors later this year, according to moneysense.ca. Nest Wealth is subscription based, so if your account grows your fee doesn't increase. The cost has been set at $40 per month for investors under 40, and $80 per month for investors over 40 with an additional $20 per month for extra accounts like TFSAs and RRSPs. Just like a professional advisor's fee, Nest Wealth's fee is on top of the fees of the ETFs that they use in building their portfolios. For investors, a service like Nest Wealth is an excellent option for professional portfolio management without the cost of high level advice. Nest Wealth is currently only registered in Ontario.

So how does their fee compare with a professional advisor? If we look at a 30 year old investor with $100,000 in savings split between a TFSA, RRSP, and non-registered account, they would be paying .96% per month in fees to Nest Wealth as opposed to 1% per month to work with a professional advisor. The beauty of Nest Wealth, though, is that as the account increases the fee as a percent of assets effectively decreases. At $500,000 the fee has dropped to .19%. As long as investors understand that they are only getting portfolio management and not the thoughtful advice of a professional, this is a great deal. I envision a situation where online portfolio management becomes a pathway for people to build assets to the level where professional advice is warranted.

How the investment industry sees advice

A few weeks ago I had the opportunity to speak with John Wilson, CEO of Sprott asset management. We were both attending an alumni dinner, I was there as an alum and he was there as the headline speaker. We bumped into each other during the pre-dinner mingle and took immediate mutual interest due to each other’s name tags. I would have never guessed who he was, so his title of “CEO Sprott Asset management” piqued my interest; John noticed my title of “Investment Advisor” and enthusiastically asked if my firm uses Sprott funds. I almost felt bad telling him that we would never consider using Sprott funds. I explained the idea of a market based investment philosophy and mentioned Dimensional funds and he proceeded to laugh that I had drank the kool-aid. He asked me why I would would want to buy index funds when there are managers that outperform the market? I rebutted that it is next to impossible to consistently determine which fund manager is going to outperform. The conversation went on and finished with John’s final point that it is the job of the investment advisor to find the fund managers that are going to outperform the market. If a client is with a good investment advisor, they will consistently be in the funds that perform well. If their advisor doesn’t pick winning funds, they are not good advisors.

It is not uncommon for advisors to pitch their value as their ability to pick the winning manager ahead of time. Is that investment advice? As a client, do you want the person that you are paying to manage your money to spend their time picking which mutual fund manager is going to be able to beat the market in the future? In reality, investment advice is not about picking the next hot stock or the winning fund manager. Investment advice is about applying an evidence based approach to markets to help people achieve their financial goals while managing their concerns. An advisor that is focused on researching fund managers or picking stocks is only fuelling the emotions that lead to poor investment decisions.

How do you invest?

What’s the first thing that comes to mind when you think about an investment professional? They must be able to pick the best stocks, the best industries, and the best geographies to invest in over a given time period. “Apple is hot right now”, and “China is going to be huge this year!” might be things that you expect me to be able to tell you. I don’t think that anyone can do that, especially consistently, and the data agrees with me. Only a small percentage of people that try to pick stocks and time the market end up having performance that is better than the market itself, especially after the costs of trading and research associated with this style of investing. Finding the small percentage of people that will outperform the market before they actually do it is equally challenging. So if the traditional method of trying to beat the market doesn’t work, it makes sense to accept the returns of the market at a low cost using inexpensive tools that hold the whole market, like ETFs. That makes sense, and it’s easy to do, but the question of which market we are going to buy comes next. Just like we don’t want to bet on any one stock, we don’t want to bet on any one market. The solution is to build a portfolio that is globally diversified; by not betting on any single market we are reducing the overall volatility of the portfolio while positioning ourselves to avoid missing unexpected growth. Not many people expected US markets to perform so well in 2013, potential for a large missed opportunity. To further eliminate placing emphasis on any single market, we build globally diversified portfolios with equal equity allocations split between US, International, and Canadian markets. Coming back to the US market in 2013, it would have been very easy to become emotionally attached to the strong performance. Buying more US stocks seemed like the smart thing to do. We eliminate emotional investment decisions like that by rebalancing the portfolios back to their target allocations. Rebalancing is a systematic process of selling off asset classes that are performing well and buying asset classes that are performing poorly; it is a rules based system of selling high and buying low, and it decreases portfolio volatility while increasing expected returns.

The last piece of this story comes from robust academic research performed on all of the available data from markets around the world. It has been found that certain types of stocks exhibit stronger performance than others. Research has shown that throughout history, small stocks and value stocks have outperformed the market. When we invest in a market, we add a tilt toward these types of stocks. A tilt is best described as an increased amount of these types of stocks relative to the market. If the US market has 4% small value stocks, our portfolio might have 11%. In the same way, research has shown that large growth stocks have lower expected returns than the market, so we tilt the portfolio away from these types of stocks. If the US market has 17% large growth stocks, the portfolio might contain 5%. Our style of investing is market based, globally diversified and rebalanced, with tilts toward small cap and value.

The 2014 CFA Society Ottawa Forecast Dinner was terrifying

Last night I attended the 2014 CFA Society Ottawa Annual Forecast Dinner. I have a tremendous amount of respect for CFA charterholders and the work that the CFA Institute does to further the integrity of capital markets, and I am a CFA candidate. Much of the material in the CFA program is focused on prediction, yet I believe that predicting the future consistently is impossible. Entering the Forecast Dinner with skepticism gave me an opportunity to have a few quiet laughs, but it also allowed me to observe the extent to which people want to invest with their emotions over logic.

The main event of the evening was a panel of three economists; Patricia M. Mohr from Scotiabank, Derek Burleton from TD, and Pierre Cleroux from BDC were each asked a series of questions and given the opportunity to share their insights. Each of these economists play a major role in creating the recommendations that are used throughout their organizations. The thing that blew my mind was that each of these economists had completely different outlooks on some of the issues that were discussed. They had different opinions because they interpret data differently due to differences in their training and intuition. If any single person’s way of thinking is so great that their forecast will surely be correct, why isn’t everyone already following their advice? People are constantly hopeful that they have found the next oracle that will make them rich. The one person that does seem to have the intuition necessary to consistently beat the market is Warren Buffet, but his intuition also tells him that investors should just buy index funds. The more I thought about the way that these economists’ outlooks differed, the more disturbed I became. The emotional attraction to a super star economist or portfolio manager is so strong that people will push their logic aside for a great story. They want someone that will turn their humble investment into a vast fortune. If a person can speak well and has knowledge of economies and markets, they will be able to convince some people that they can predict the future. In the years that their predictions are wrong they will have great explanations for what threw off their forecast. In years they are right they will be heroes.

As an investor I’m sitting there listening to these three intelligent people debate about where different sectors are going, and I’m wondering how I would pick which one I should listen to. How does a portfolio manager decide which one they will listen to? How does an analyst decide whether or not they agree with their lead economist’s outlook on China’s economy? It’s all a big guessing game and even the smartest people with the greatest amount of resources are playing it. The terrifying part is that investors are so easily sucked into the stories that economists and fund managers tell them about what they should be investing in that they continue to follow their advice. It’s comparable to a big group of people throwing darts at a dart board and assuming that the person that hits the bullseye four times in a row will be able to hit it a fifth time. I would be furious knowing that I am relying on this type of prediction when there exists a scientific approach to investing that eliminates the need for this artistry.

In the scientific approach to investing there is a data backed consensus on the single most effective way to invest, while the art of investing contains thousands of different and conflicting opinions. Maybe I'm biased due to my background in engineering, but when it comes to investing I want science, not art.

Original post at pwlcapital.com

Beating the spread

If a bookie presented you with the opportunity to bet on a basketball game between the Raptors with a 5-0 record and the Bobcats with a 0-5 record, which team would you bet on? The obvious answer is that the Raptors with their undefeated record will trump the Bobcats who have not won a game; this outcome is very easy to predict. If bookies allowed people to bet like this they would not make any money, so they use something called the spread. It’s not nearly as easy to predict the outcome If I present you with the same betting opportunity but the Raptors don’t just have to win, they have to win by 30 points. That 30 point differential, or the spread, is what allows bookies to make money. The bookie will go to great lengths to create a spread that has about a 50% chance of being beaten. If this is done properly, the bets on each side of the spread will cancel each other out and the bookie will profit from the premiums people paid to place their bets. When they create the spread, bookies will know everything about the teams in a match; they will know what the star player had for dinner, whose girlfriend is in town, the weather forecast, everything. Once the spread has been set, it will be the new information that develops throughout the course of a game that determines if the spread will be beaten; an injury, a lucky shot, or a bad call could all be the difference makers. In investing, the collective knowledge of the markets is the bookie, and the price of a security is the spread. Every day highly motivated market participants act on massive amounts of information and in doing so they inject the information they have into market prices, effectively setting the spread. It’s easy to look at a company and see that it is well managed, pays a strong dividend, and is positioned to dominate a growing market, but all of this is included in the market price.  Whether the price goes up (beats the spread) or goes down will depend on the development of unpredictable new information. Investing isn’t about picking the winning company, investing is about beating the spread.

Original post at pwlcapital.com

The risk story behind expected profitability

Investors demand higher returns for taking on more risk.  Small stocks and value stocks have exhibited performance that exceeds that of the broad market over the long term which can be explained by the increased riskiness of these asset classes above and beyond the risk of the market.  The science behind small cap and value is peer reviewed, evidence based, and it makes sense with relation to risk and return.  The idea of tilting a portfolio towards expected profitability in pursuit of higher expected returns does not have the same logical flow; how does profitability relate to risk?  If a company is profitable, wouldn't the market include that information in the price?  To explain this, expected profitability should be thought of as a filter rather than a standalone factor of higher expected returns.  When it is applied in conjunction with the size and value factors, the risk story of expected profitability becomes very clear.

All else equal, the market will place a higher relative price on a company with higher expected profitability.  If Company A has higher expected profitability and the same relative price as Company B, the market has priced in additional risk in Company A.  Holding size and value constant, the additional risk uncovered by expected profitability can be observed in the higher expected returns that these stocks have shown throughout time and across markets.  So you can’t treat expected profitability as an asset class like small and value, but once a portfolio has been tilted towards small and value, expected returns can be further increased using profitability as a filter.

The efficacy of this filter is directly observable as it relates to the performance of the small cap growth asset class.  This asset class was previously limited in portfolios based on its consistent underperformance and high volatility relative to other asset classes, but it was considered an anomaly that could not be explained by the three factor model.  It has now been found that the poor performance of small cap growth companies can be explained by low profitability.  This filter adds another cost effective method of pursuing higher expected returns and avoiding low expected returns based on robust data that is persistent through time and pervasive across markets, and it makes sense as related to risk and return.

Original post at pwlcapital.com

Why a robot will never take my job

The growth of algorithm based investing services in the US has raised questions about the future of the professional financial advisor.  These automated services provide investors with a high level of convenience in building a sophisticated portfolio at a low cost.  Two of the largest providers are Wealthfront and Betterment.  Wealthfront charges a .25% advisory fee, while Betterment charges .15-.35%. These fees are charged over and above the fees attached to the ETFs used in portfolio construction, and they cover the cost of advice, transactions, trades, rebalancing, and tax-loss harvesting (on accounts over $100k).  Both services have succeeded in automating important processes, but there are elements missing that will not soon be replaced by a machine.

Clarity on your whole financial situation – a human advisor is able to have a meaningful conversation around things like deciding to use an RRSP vs. a TFSA, renting or buying a home, and how much income to take in retirement.  If all an advisor/robo-advisor is advising on is optimal portfolio structure, there could be missed opportunities in other areas.

Knowledge of more than just your money – managing a portfolio is one thing, but good financial advice goes beyond tax-loss harvesting and rebalancing.  A financial advisor should know your personality, your family situation, your dreams, and your frustrations.  This type of relationship ensures that recommendations are in line with all aspects of your life, and it also gives continuity to your finances in the event that something happens to you.

Integration with other professionals – an established advisory practice will have relationships with professionals in adjacent fields.  When you are considering something as important as your financial situation, having a team of professionals that trust each other and have experience working together is highly valuable.

Peace of mind – it’s great to have a robust algorithm making sure that your portfolio is being managed efficiently, but that does not mean that your overall financial situation is optimized.  The knowledge of an experienced advisor overseeing all aspects of your financial situation is not something that a computer can effectively replace.

For a .15-.35% fee robo-advisors offer great value, and take the DIY investor to a new level of sophistication.  When (if) these services do arrive in Canada they could become a tool that firms use to make their portfolio management processes more efficient, but they will not replace the high level work that well trained professional financial advisors do for their clients.

Original post at pwlcapital.com

High Frequency Trading

The promotion of Michael Lewis' new book has caused a significant amount of discussion in the media around whether or not High Frequency Trading (HFT) causes harm to the integrity of financial markets.  The debate is very interesting.  One argument says that HFT makes markets more efficient and expedites the arbitrage of the occasional inefficiency, while the other says that it is a big scam causing investors to lose out on profits.

With the right investment philosophy, there is no need to be overly concerned by either side of this debate.  The ability of High Frequency Traders to rapidly create small profits using superior technology is not a new phenomena; it is an issue that is generally present when dealing with market orders and order routing.  As an example, an active manager who wants to trade specific securities within a short period time would be affected by these issues.

A market based approach to investing does not require large market orders, and it does not require rapid trade execution. Investing in asset classes rather than the latest hot issue means that individual stocks with the right characteristics become interchangeable parts in a much broader strategy.  The flexibility in this approach eliminates the need for the immediate liquidity that HFT is able to profit from.

Original post at pwlcapital.com

Does Canada need more investor education, or more advisor education?

At the end of a recent meeting, a client asked me if I ever wonder why everyone in Canada isn’t investing in low cost index based funds.  The conversation usually goes that way when people hear the story of a passive investment philosophy and fee based business model, but it isn’t something that I wonder about.  The vast majority of Canadian investors use a financial advisor to invest, and about 75% of Canadian financial advisors are only licensed to sell mutual funds.  Getting mutual funds licensed is much easier than getting securities licensed, and finding a commission based job selling mutual funds is much easier than finding a job with an independent fee-based brokerage firm.  I started my career in financial services as a commission based mutual fund salesperson.  I will be forever impressed by the quality of sales and financial planning training that was given to newly recruited financial advisors, but there was a massive disconnect when it came time to make an actual investment recommendation. 

Advisors with next to zero knowledge of financial markets are expected to choose from thousands of available funds while under pressure to make commissions.  Making it worse for the client is the fact that only high-fee mutual funds pay the commissions that new advisors need to make a living.  With strong sales skills and a knowledge of financial planning the product becomes less important and being a financial advisor becomes a matter of managing relationships, something that people with little to no knowledge of financial markets can do successfully.  A highly skilled and motivated sales force that does not always fully understand what they are selling, and an investing public with minimal financial education, make it obvious to me why Canadians have been relatively slow to adopt low-cost tools like index mutual funds and ETFs.  I meet plenty of people who are fed up with the fees they have been paying and the service they have been receiving, but the market is still slow to get away from high fee mutual funds sold by commission hungry financial advisors.

Original post at pwlcapital.com

Is Picking Mutual Funds any Different from Picking Stocks?

Today I received an email from an advisor that continues to work with actively managed mutual fund providers to serve his clients.  He sent me a document that a fund company had produced for him showing that actively managed mutual funds have consistently beaten their benchmark ETFs, and asked me what I thought.  My response follows:

Thank you for thinking to send this over.

I think it’s very interesting that the active management vs. ETF/passive debate is important enough for this fund company to have made this document.  I think it is even more interesting that they are pushing their advisors to sell their active funds while they are also making ETFs on the side.

But look, the thing you have to understand is that there will be funds that outperform just like there will be stocks that will outperform. I could go and find a bunch of stocks that have beaten a benchmark over the last ten years and say that it’s possible to beat the market.  It's important to understand that with a mutual fund, any time you are not holding the whole benchmark there can be periods when you outperform and periods when you underperform.  I could go and find a bunch of funds that have not beaten their benchmark over the last ten years just as easily as they found ones that did.

The key though, is that you or I, or even the fund managers don’t know when they will be winners or when they will be losers.  You can go and say "ok, the XX was up 11% over the S&P/TSX last year, I’m going to put my client in that one". But you know as well as I do that past performance does not indicate future performance.  You are betting on that fund doing well on your client’s behalf based on how well it did last year; you have no idea if it will be up or down in the future.  If you don’t know what the fund will do in the future, why not just accept the market’s returns and get rid of the high MER instead of hoping that the fund happens to be up during the period that your client is invested?

Picking funds is on the same level as picking stocks in my opinion.  You can say "well this manager has tons of experience and the fund has done well in the past" and so on, but that’s no better than looking at the financials of a company and saying "oh they have strong earnings, good management, and a stable dividend I will pick that one".  There is simply too much information in both cases to make an accurate prediction AND your clients are paying high fees for you to place these bets... it just doesn’t sit well with me.

Original post at pwlcapital.com

Searching for yield in all the wrong places

The current low-yield environment has made it very easy for investors to question the value of holding bonds in their portfolios.  With interest rates staying low as long as they have, concerns have surfaced around frustratingly low yields, and the fear of rising interest rates decimating the value of bonds.  If bond yields can be matched by GICs, and GICs won’t lose value if interest rates rise, why would anyone hold bonds at all?  Let’s consider this question while ignoring the interest rate environment altogether. 

Bonds reduce volatility in a portfolio and provide an asset class that does not move in lock step with equities; they are not added to a portfolio to produce higher expected returns, but to allow investors to weather the inevitable swings in the equity markets.  When an investor looks at their fixed income allocation as a source of yield rather than a source of risk reduction, they are looking for yield in the wrong place.

In a strong economy with low yields, some investors begin to feel that they can simply replace their bond allocation with dividend paying stocks.  This strategy eliminates the risk reducing effects of a fixed income allocation and leaves the investor fully exposed to fluctuations in the equity market.  When investors begin searching for yield in their fixed income portfolio, they end up taking on additional risk rather than managing it.  Looking at bonds strictly as a risk management asset class changes the nature of the yield discussion.

Nobody can predict the future.  It is obvious that interest rates are low today, but nobody knows what they will be tomorrow.  When you are building a portfolio, it is important to focus on taking risks that have proven to have higher expected returns on the equity side while keeping a bond allocation in place to manage overall portfolio volatility.  By getting your mindset away from chasing yield in bonds, it becomes possible to construct a bond allocation using investment and higher grade short-term bonds.  These securities will have lower yields than low-grade or long term bonds, but they also carry less volatility.  Implementing this fixed income strategy allows investors to reduce interest rate risk in their bond allocation while also maintaining the liquidity that is necessary to systematically rebalance - something that is lost with GICs.

Every investor should appreciate the effects of exposure to riskier asset classes with higher expected returns, but it is important to understand that regardless of their yield there is no replacement for bonds in a robust portfolio.  So what do you do if interest rates rise and the value of your bond allocation goes down?  Rebalance by buying more high quality short-term bonds at the new, higher rates.

Original post at pwlcapital.com

How Hard is it to Beat the Market?

How hard can it really be to beat the market?  If I say that all available information is included in the price of a security, it follows that someone had to act on the available information in order for it to be included in the price.  Someone had to get the information, make a decision to buy or sell the security, and then execute a trade for that information to be included in the price.  So every time someone can be the first to act on new information they must make a profit, right?

In 1945, F.A. Hayek pointed out that there are two types of information:

1. general information that is widely available to all market participants, and
    

2. specific information about particular circumstances of time and place, including the preferences and needs of each unique investor. 

As a pricing mechanism, the market is able to aggregate all information into a single metric.  That metric is the price, and it is constantly influenced by participants competing with each other to be the first to bring information to the market in order to make a profit.  As hard as they try, no single market participant can have the full set of information because new information is being randomly generated constantly.  If someone overhears a conversation between two Apple employees, they are in possession of information that nobody else has; if someone sees an oil tanker sink in the middle of the ocean, they have unique information; if a pension fund manager goes on a site visit to a mine and hears something before everyone else, they have specific information particular to their circumstances – there is an infinite amount of information like this being constantly generated, and due to the nature of the market, people want to use their information to profit.  What does this mean for investors?  It means that all available information can be included in the price of a security without any single provider of information being able to profit from the information that they contributed.

So in short, it’s really really hard to beat the market.

Original post at pwlcapital.com

12 Entertaining Finance Movies that will Teach you Finance

Finance is a broad subject with many facets that make learning it a large undertaking for anyone.  These films, watched in order, will lead to a relatively comprehensive understanding of what finance is, how it works, and how it affects our society.

Foundations of money, finance, and the corporate structure:

1. The Ascent of Money: A Financial History of the World (2009)
   This is literally a full history of how finance has developed through time.  From the first currencies ever used, to financing wars with bonds.  Watching this film beginning to end really does create a strong foundation for understanding how finance has developed through time.
    
2. The Corporation (2003)
   One of the most important concepts that drives modern finance is the corporation.  Understanding how the corporate structure influences business decisions is fundamental to grasping the general ideas of finance.
    
3. Capitalism: A Love Story (2009)
   The social effects of the corporate structure on a capitalist society are examined in this film.  Widening income gaps have often been attributed to finance.  This film furthers the ideas introduced by The Corporation and applies them directly to a real financial crisis.
   
   Failures in the financial system, fraud, greed, and regulatory issues:
    
4. Enron: The Smartest Guys in the Room (2005)
   A comprehensive look at how a corporation was able to defraud thousands of people with its accounting practices leading to massive changes in the regulatory systems for financial reporting.
    
5. Too Big to Fail (2011)
   Understanding the actual finance behind finance is only half of the battle in truly understanding finance.  This dramatization of the fall of Lehman Brothers, and the beginning of the financial crisis, shows how personalities, government decisions, and personal relationships all play a massive role in driving the financial markets.
    
6. Margin Call (2011)
   When the US financial institutions began to crumble, they began to unload their worthless securities to other institutions and clients to avoid their own collapse.  This film gives further insight into the decisions that nearly collapsed the financial markets.
    
7. Inside job (2010)
   Further reflection on the 2008 financial crisis with insights from global policy makers and academics.  This film further reinforces the concepts introduced in Too Big to Fail and Margin Call, but it is not a drama.
   
   How financial markets actually work, the buying and selling of securities, and the retail environment:
    
8. Floored (2009)
   This documentary looks at floor traders, the people buying and selling securities on an open outcry trading floor.  Although this film gives plenty of insight into this part of the financial markets, floor traders have been replaced by electronic trading.
    
9. Money and Speed: Inside the Black Box (2011)
   The level of influence that automated trading has on the financial markets today is intimidating.  This is an area that is constantly evolving and will continue to evolve.  Eugene Fama argues that the algorithms used in this type of trading make markets more efficient.
    
10. Boiler room (2000)
    This movie does not by any means depict every stock broker.  It does, however, give insight into the way that the business works at the retail level, and shows how sales driven the industry can be.
     
11. Wolf of Wall Street (2013)
    Similar to Boiler Room, this film shows an extreme case of how sales driven financial markets are.  The film is quite wild, but it does offer another opportunity to see how securities are created, bought, and sold.
     
12. The Retirement Gamble (2013)
    From the perspective of an investor, this film is the most important.  It shows how all of the pieces fit together to make the investment climate for retail investors extremely difficult to navigate.

21 Rules for Young Professionals

You just broke into the workforce as a professional.  Your first real job in the real world.  It won’t always be easy to navigate, or obvious what to do.   This list of timeless rules can serve as a guide to anyone hoping to survive their first foray into the life of a young professional.

1.       Understand failure
It is a thing that will happen.  Be prepared for it, and be prepared to learn from it.

2.       Embrace criticism
There’s nothing worse than seeing a person pout after they receive negative feedback.  You’ve just been given an opportunity to get better, use it. 

3.       Live outside of your comfort zone
Hate public speaking? Look for opportunities to speak in public.  No good at writing? Start a blog. 

4.       Stay humble
Everything that you have achieved up to this point is great, but it means a whole lot less if you start to act entitled.  Let your results speak for themselves.

5.       Have confidence in your work
There may be times when you feel like you have no idea what you're doing, but you landed in your role because someone trusted your ability to figure it out.

6.       Be reliable
There's no substitute for being on time, and being prepared.  Whether it's a meeting, a presentation, or drinks after work, show up on time and be organized.

7.       Become an expert in your field
School's over, and the skills you need for your job won’t always come from your education in the classroom.  Taking the initiative to master your role  can be the difference between a job and a career.

8.       Invest in your appearance
A professional appearance means a lot more when you’re 25 and don’t have ten years of workplace performance to back you up.  Nice clothes, shoes, and a haircut are all good places to start.

9.       Keep your work area clean
Whether you are in an office, a cubicle, or working out of your apartment, people can see your workspace and it reflects directly on your professionalism.

10.   Under promise, over deliver
Doing what you say you will do is one of the straightest paths to credibility.  No amount of education or connections will be able to overcome the damage of failing to follow through.

11.   Use your network, and let it use you
Who you know can make a world of difference, especially when you’re starting out.  Ask for help, ask for introductions, and be prepared for people in your network to ask you for the same.

12.   Handle yourself appropriately in social situations
It’s ok to have drinks with colleagues, even a few, but people never forget the time you make a fool of yourself.  One rough night can be a career limiting move.

13.   Always maintain your integrity
Compromising yourself for any short term gain is not an option, it will be outweighed by the repercussions and become a permanent part of your reputation.

14.   Be a great teammate
Help, support, and encourage everyone that you work with.  Whether they are peers, superiors, or interns, everyone is working toward the same goal.

15.   Manage your online presence
One of the first things someone will do when they want to know about you is Google your name.  Clean up Facebook (or make it private), put some time into your LinkedIn, and be responsible on Twitter.

16.   If you don’t know the answer, admit you don’t know
Honesty defines credibility, ignorance will dig a hole you can’t crawl out of.  Telling someone that you will get back to them with an answer will be understood and appreciated.

17.   Get your hands dirty
If you’re asked to do something, do it.  Nothing is below you at this point in your career, and you will learn something from every task you complete.  If you’re stuck doing paperwork for a week, get really good at doing paperwork.

18.   It’s ok to start small
No matter where you start, it will be your persistence, patience, and consistent effort that will lead you to success.

19.   Learn from your mistakes
You will make mistakes, it is normal and acceptable. Mistakes only become problematic if you make the same ones multiple times.

20.   Own your mistakes
When something goes wrong, deflecting responsibility makes your trustworthiness and dependability evaporate.

21.   Be a good person
Everything else in this list is moot if you’re not a good person, and being a good person is the best networking you will ever do.  Help people, volunteer, say thank you, leave a tip, and hold the door open.  You never know who is watching.

Contributors to this post:

@theaearl (Shopify)

@simonwlove (Ernst & Young)

@Marius_Felix (Brentwood College)

@beesureman (CBRE)

@MaxLanePWL (PWL Capital Inc)

Risks Worth Taking

Wealth creation takes place when cash flow is steady, there is time to recover losses, and risk is tolerable. 

It's not uncommon for the ability to take risk in the market to be confused with the desire to gamble.  There are some risks worth taking, and some risks that can turn an investment account into a sophisticated platform for placing bets.

Of course, it's a lot of fun to do research and be immersed in the latest information about a company or an industry with the hopes of taking action before the market does.  Consider, though, the amount of other individuals, and more importantly institutions and mutual funds, that are trying to do the same thing.

By the time you read a Bloomberg News headline, the market has already reacted.  By the time the company you're following discovers a new reserve, institutions have already started trading.  The ability of the collective players in the market to price a security as soon as new information develops is intimidating.

It's easy to think that with enough research, it should be possible to outsmart the market by predicting new information before it happens, but new information develops randomly.  If we could predict all new information accurately we wouldn't need the market to create wealth.

So what's a risk worth taking?   It has been proven through years of research that small cap and value stocks produce superior returns over the long term.  Constructing a portfolio tilted toward these asset classes can increase expected returns without relying on speculation.  With these tilts in place, diversifying globally, and across asset classes can almost eliminate non-systematic risk.  You may never make 200% on a speculative bet, but major losses will likewise be reduced.

In creating wealth, the sequence of returns is just as important as the returns themselves.  It's very difficult to beat the long term compounded returns of a robust portfolio with a series of speculative bets.

This may not sound exciting, and it shouldn't.  Well documented research stands behind these remarks - I'm talking about using science to invest, and science is not nearly as exciting as gambling. 

Market Based Investing

In 1991 William Sharpe wrote an article in the Financial Analyst’s Journal titled The Arithmetic of Active Management.  The main point of the article is that after costs the return on the average actively managed dollar will be less than the return on the average passively managed dollar.

Sharpe is only addressing the average actively managed dollar, so there must be some actively managed dollars that are outperforming the market.  Over the five years from 2007 to 2012, actively managed Canadian equity funds only outperformed the S&P/TSX Composite 9.8% of the time, and actively managed US equity funds over the same period only outperformed the S&P 500 4.6% of the time.  It would be great to be able to pick these outperformers ahead of time, but predicting the future would offer many other benefits, too.

I am happy to disagree with the idea of predictive investment management, but don’t condone the idea of passive investing either. I stand behind a strategy called market based investing.  It is the idea of harnessing what the market has to offer, while taking advantage of asset classes within the market that have been shown over the long term to produce higher returns than the market itself. The idea is to hold the entire market, and then increase the proportion of certain asset classes relative to the market to take advantage of their higher expected returns. Trying to determine which markets would be the best to apply this strategy at any given time would be betraying a scientific approach in favor of prediction. The solution is to build globally diversified portfolios in order to capture the returns of markets around the world while reducing the impact of any single market.

These globally diversified portfolios tilted towards specific asset classes are then rebalanced systematically to eliminate predictive and emotional tendencies as markets move. Implementing this rules-based system ensures that emotions and predictions are removed from investment decisions, and sets a market based portfolio apart from the active vs. passive debate.

Follow @Benwfelix

Understanding the Stock Market

Why People Invest

I already explained what a stock is, so I should have the foundation to go ahead and discuss what the stock market is in some detail.

Before I do that, I need to explain why we want to invest in the first place.  In the chart below you can see some different lines.  The ones to focus on for right now are the orange line, which is a representation of a dollar invested in the US stock market, and the light green line, which is a representation of a dollar invested in US treasury bills.  It is obvious that a dollar invested in the stock market will grow more than a dollar invested in a treasury bill, but why is that?  A treasury bill is issued by the US government and is what is referred to as a risk free investment because it is very unlikely that the US government will fail to pay someone holding a treasury bill.  Being invested in the stock market is riskier because you are owning pieces of companies which can go down in price, even go to zero if the company goes bankrupt.  Investors need to be compensated for taking risks when they are investing in companies, otherwise they would only invest in the treasury bills.

The difference in returns between the treasury bills line and the stock market line is called the market premium, or the amount of investment return over and above a risk free investment that can be expected for investing in stocks.  So when you are saving for a long-term goal, it can make sense to invest in stocks because they will give you a higher expected return over time.  The chart below shows the returns of the total US stock market minus the returns of US treasury bills every year from 1927-2012.  On average, the market premium was 8.05%.  This means that on average, being invested in stocks meant that you could expect a return 8.05% higher than the return from being invested in treasury bills.  Notice that the red bars are years where stocks had negative returns; that is the risk of being invested in stocks rather than treasury bills.

The Market

We know stocks are pieces of ownership of companies that allow individuals to partake in the company's growth and losses.  Partaking in the growth and losses of a company by buying an ownership stake is called investing in the company, and investors receive higher expected returns for being invested in companies because of the risk involved.  All of the investors that buy stocks need a place to buy and sell their stocks, and that is where the idea of the stock markets becomes important.  If there was not a stock market, people that wanted to buy and sell stocks would have to find each other manually; it would be like Craigslist for stocks.  Having consolidated public stock exchanges makes it much more certain that a stock will be available to buy when you want to buy, and you will be able to sell when you want to sell.  This makes stocks much more liquid, or much easier to convert back into money.  If stocks became illiquid they would go down in value drastically because people would not be able to convert their ownership in a company into money when they need to.  The integrity of the stock market is a very important part of investing, and there are safeguards built into public exchanges to ensure that the markets remain liquid.  So it's easy enough to understand that the stock market is just a big public marketplace where investors can buy and sell stocks, but what are people talking about when they say the market is up or down?  Or when they talk about beating the market?  There are different stock markets around the world, and within different markets there are different stock exchanges.  So what is the market that people talk about in the media?

To explain this further I need to explain what an index is.

How an Index Works

You might have heard about the S&P 500, or the S&P/TSX Composite.  These are indexes.  An index is a grouping of stocks that has been selected to represent a particular market.  The S&P 500 is one of the best known indexes in the world; it is 500 stocks that have been selected by Standard and Poor's (a financial research company) to represent the US stock market.  When you hear that the S&P 500 is up, it means that the overall value of all of the 500 stocks included in the index is up.  It is important to keep in mind that although the S&P 500 has been selected by the very smart people at Standard and Poor's to represent the US market, it only contains 500 of the largest, most well known companies that are traded on public exchanges in the US; overall, there are about 5000 companies with stock that trades on public exchanges in the US.  One of the major uses of an index like the S&P 500 is benchmarking.  Benchmarking is using the performance of an index as a tool to compare the performance of other groupings of stocks, or individual stocks.  When you invest in a mutual fund, or have a broker tell you that they will build you a portfolio that will beat the market, they are saying that they will pick a stock or a grouping of stocks that is different from their benchmark index that they think will allow your investment to perform better than investing in the companies in the index.  If a fund invests in American companies it will likely use the S&P 500 as a benchmark index, and a fund that invests in Canadian companies will likely use the S&P/TSX Composite as a benchmark index.  The whole idea here is that if someone has the ability to predict which companies within a market will perform well, they can buy those companies instead of buying the companies in the benchmark index so that their fund will perform better than the index.  Now, because there is a lot of research involved in deciding which stocks will do well and which ones will do poorly, there are fees that have to be paid to the investment manager if they are going to try and beat the market for you.

Investing in the Market

You can choose to invest in an index that has been built to represent a given market for a very minimal cost, or you can choose to pay a significant cost to invest in a fund that is going to try and do better than the index.  It is very easy to invest using both of these methods.  You can buy something called an Exchange Traded Fund (ETF) which will track an index, or an index mutual fund which will do the same.  Companies like Vanguard and iShares allow people to invest in an index of their choice for a very low cost; you can choose to invest in the S&P 500 which we know is 500 of the largest companies listed on US exchanges, or the Russell 3000 which is an index that is designed to represent all  of the companies in the US market, or the MSCI EAFE which represents all developed markets outside of the US and Canada, and the possibilities of indexes to invest in go on forever.  Investing in a fund that will try and beat the market is equally easy to do, companies like Fidelity have plenty of different funds with different strategies designed to outperform a given index.  To illustrate the difference in cost of these two strategies, the Vanguard Total Market Index which invests in 3000 American companies designed to represent the total US market costs you .05% of your investment account to hold, and the Fidelity US All Cap fund which is designed to "seek the best in US equity opportunities" costs you 2.4% of your investment account to hold.  Both of these funds allow you to invest in the American market, but one is designed to do whatever the market does, and the other is designed to beat the market.

Remember Efficient Markets?

I write about markets being efficient often.  Remember that if markets are efficient, all available information is included in the price of a stock.  With that in mind, let's look at the idea of trying to pick which stocks will be the best ones to invest in.  The people that are picking the stocks that will be included in a portfolio that is trying to beat the market are using massive amounts of information to make their investment decisions.  These people will know everything that there is to know about a stock before they select a company to invest in.  But think about all information.  That's a lot of information, and there's new information coming out all of the time.  Even if an analyst does know everything about a stock before they buy it, it is impossible to predict all new information, and all new information will be included in the price of the stock as soon as it becomes available to the public.  So, we should try and get information about stocks before the information is public? No.  That is insider trading which is illegal.  Point is, all information is included in the price of a stock, and new information is random, so stock prices are random.  Still want to try and pick the stocks that are going to beat the market?  Good luck.  My opinion is that if you can't beat them, join them.  Indexes are beautiful tools that should be taken advantage of when constructing a portfolio.  Which indexes?  That will have to be another day's post.

Explaining Stocks

I write because it helps me to understand concepts.  I do think it's neat to have a blog so that I have a medium to share my thoughts, but the main purpose is to give myself a reason to write stuff.  I didn't think anyone really read the things I post.

I have now had multiple people tell me that they read my blog posts, and that they actually enjoy reading them.  Too many of the people that told me this said that they enjoyed reading my writing despite not knowing what I'm talking about.  After hearing that feedback, I took it as a challenge to explain the things that I write about in terms that people can comprehend.

I won't stop writing about heavy finance things, but I want to try to bit by bit explain the fundamental concepts of finance to the non-finance people that grace my website with their presence.

Where to start?  I will first give my rendition of what a stock is.  Establishing what a stock is will give me the foundation to go into detail about lots of other things.

What is a Stock?

A stock is a piece of ownership of a company.  When we say that a stock is publicly traded, it means that the pieces (shares) of that company are able to be bought and sold by anyone in the public marketplace, something that we refer to simply as the market.

Understanding that a stock is a piece of a company should be easy enough, but how and why a stock comes into existence is a little bit more complicated.  It all comes back to money (capital).  Companies need capital to do business.  If a company sells coffee they need money to buy coffee beans, cups, machines, and pay employees and rent space.  That capital can come from lots of different places (which I will have to discuss in another post), but once things are going the company should eventually be able to make enough money selling coffee to pay its expenses and buy more supplies to sell more coffee.  If this business decides that it wants to open another location, the capital that the first location is producing by selling coffee might not be enough to open a second location; they need more capital.  To get this capital, they can choose to sell part of their company on a stock exchange.  When a company chooses to do this, they are going public.  A company consisting of two coffee shops would not likely go public, but for the sake of the example they do decide to go public.  When a company decides to go public they have to be underwritten to determine the price that the public might pay for their shares.  This is where an investment bank comes in; so our coffee company would approach Goldman Sachs and tell them that they want to issue shares to the public in an initial public offering (IPO).  Goldman Sachs will examine the company very closely to try and determine how much the public will pay for shares of this company, and then they will either buy all of the share themselves with the intention to resell them to the public (a bought deal), or they will do their best to sell as many of the shares as they can to the public without giving our coffee company any guarantee that all of their shares will be sold.  This initial sale into the market is referred to as the primary market.  Once these shares have been sold into the market for the first time, they can be bought and sold by anyone in the market.  The market after the first sale is called the secondary market, and that is where most people buy and sell stocks.

So now we have these shares, these pieces of a company, that can be bought and sold by people very easily.  As they are bought and sold by people, the price of these shares will move based on a bunch of factors.  It's like  anything else that can be bought and sold, the more people want to buy it, the more the price will go up.  There is an infinite amount of information that can affect the price of a stock, and there are people researching as much of the information as they can all the time to try and predict where the price of a stock is going to go so that they can make money by buying it at one price and selling it at another.  It is also possible to make money by betting that a stock will go down in price, but that is another story.  I often write about efficient markets, and when you understand how stocks get their prices the idea that markets are efficient makes a lot of sense.  If markets are efficient it just means that all available information has been taken into account in the price of any stock at any given time.  This happens because of all of those people that are out there researching stocks to try and make money; they collectively influence the price of a stock until it ends up at a value that reflects how much all of the people in the market will pay for it based on all of the information that is available.

I feel like that was harder to explain than I wanted it to be.  If you read this explanation and have questions, please ask me,  I love answering questions about this stuff.

Using Visual Basic for Financial Modelling

I learned a fair amount of programming when I studied mechanical engineering, and it is always fun when I get to apply those skills to problems that I see in finance.

I was recently asked to determine if a particular client would be better suited to deposit money into an RRSP or to leave it in non-registered investments.

The problems I had to solve revolved around the following issues:

• Minimizing taxes
• Minimizing OAS clawback
• Maximizing net income

But which strategy would produce superior cash flows based on these parameters?  I structured my model as I would structure a discounted cash flow analysis for a company, selecting my inputs to match an individual.  Gross income became a proxy for revenue, and then I added minimum RRIF payments after age 71, and CPP and OAS benefits at age 65.  I treated taxes and OAS clawback like cash outflows .  I calculated taxes based on marginal tax rates, and OAS clawback based on 15% of any income over $70,954 in any year OAS is received.

I wrote functions in visual basic to find the appropriate tax bracket for a given income, to find the minimum RRIF payment based on age and RRIF amount, and to find the amount of OAS clawback.  The calculations in the model lead to two numbers: the present value of the free cash flow in each scenario.  I was able to link the difference between these two numbers to a sensitivity analysis; using scenario 1 (no RRSP contribution) minus scenario 2 ($31,000 RRSP contribution) shows that when the result is negative (red) it makes more sense to make an RRSP contribution, and positive means it is better to forego RRSPs.

The value of writing these programs did not come in creating the original spreadsheet; I could have realistically input all of that data by hand.  The value in coding a fully linked model is that it allowed me to perform the sensitivity analysis for varying growth rates, inflation rates, and levels of CPP income.

I had hoped that there would be a conclusive answer to the initial question, but the result shows that it all depends on what the market does.  If market performance is strong, the RRIF becomes so large that taxes and OAS clawback are overpowered, but with lower market returns, the tax savings make avoiding the massive RRIF accumulation a better option.

For some context, the client is 47 today and will live to 100.  They are making a one time $31,000 RRSP contribution.  The RRSPs value today before any new contribution is $100,000.  Earned income is $110,000.

My very boring and simple code is linked here.