Building Wealth

For the first 30 or so years of working, saving and investing, you’ll be first in the mode of getting out of the hole (paying down debt), and then building your net worth (that’s wealth accumulation.). But don’t forget, wealth accumulation isn’t the ultimate goal. Decumulation is! (a separate category here at the Hub).

Meeting a Market Wizard

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Noah Solomon and Larry Hite

By Noah Solomon

Special to the Financial Independence Hub

Last month, I had the privilege of meeting legendary investor Larry Hite.

Larry was born into a lower middle-class family, had a major learning disability, did poorly in school, and was completely blind in one eye and half blind in the other. In his own words, “I was not handsome. I was not athletic. Whatever I did, I sucked at it badly.”

In 1981, after dabbling as a music promoter, actor, and screenwriter, Hite founded Mint Investments. Mint was a true pioneer, eschewing human judgment and instead basing its investment decisions on a purely systematic, rules-based approach rooted in statistical analysis.

By 1988, Mint registered average annual compounded returns of over 30%. In its best year, Mint registered a gain of 60% (1987, the year of the stock market crash), and in its worst year, it produced a gain of 13%. By 1990, Mint was the biggest hedge fund in the world, with a record-breaking $1 billion under management.

When it awarded Larry the Lifetime Achievement Award, Hedge Fund Magazine wrote:

“Larry Hite has dedicated the last 30 years of his life to the pursuit of robust statistical programs and systems capable of generating consistent, attractive risk/reward relationships across a broad spectrum of markets and environments and has inspired a generation of commodity trading advisers and systematic hedge fund managers.”

Although Hite began his investing career in the early 1980s, his philosophy of markets and approach to investing are remarkably similar to our own, which are summarized below.

Failure: A Foundation for Success

Hite maintains that his early failures were instrumental in his eventual success. He believes that accepting that failure is sometimes inevitable led him to develop an investment strategy that would limit losses.

In his book, The Rule, he wrote:

“I believe the success I’ve had arrived because I always expected to fail big. Solution? I engineered my actions so that a failure could not kill me. I won because I expected to lose. Failure became my advantage. Once you understand your potential for failure – that is, there are times you can’t win – you know when to fold your cards and move on to the next. You will do this more quickly than others who stay in the game too long, hanging on and hoping that their losing bet will turn around.”

It’s not all about Being Right

Many investors focus on being right as much as possible – on maximizing their ratio of winning vs. losing investments. On its face, this seems like a good idea – all else being equal, if you win more than 50% of the time, then over time you will make money.

Hite takes a different approach. Whereas he has no issue with trying to be right as often as possible, he is far more focused on maximizing the average magnitude of his winning positions relative to that of his unsuccessful ones, asserting that:

“Becoming wealthy and successful isn’t simply about being right all the time. It’s about how much you win when you are right as well as how much you lose when you are wrong…. The Mint trading system did not prioritize being right all the time. We prioritized not losing a lot when we lost but winning big when we won. But as a result, we were frequently wrong. We understood and expected this and taught our clients the wisdom too.”

Risk: A No Fooling Around game

Hite places a greater emphasis on risk management than on generating profits, claiming that mistakes regarding risk can lead to catastrophic results. He asserts that, “Risk is a no fooling around game; it does not allow for mistakes. If you do not manage the risk, eventually it will carry you out.”

His approach to investing clearly reflects his respect for risk. Specifically, Hite divulges that “We approach markets backwards. The first thing we ask is not what we can make, but how much we can lose. We play a defensive game.”

One of my favorite anecdotes regarding risk is Hite’s reflection on a conversation he had with one of the world’s largest coffee traders, who asked, “Larry, how can you know more about coffee than me? I am the largest trader in the world. I know where the boats are; I know the ministers.” Larry responded, “You are right. I don’t know anything about coffee. In fact, I don’t even drink it.” The coffee mogul then inquired, “How do you trade it then?”, to which Larry answered, “I just look at the risk.”

Five years later, Larry heard that this magnate lost $100 million in the coffee market. Upon reflection, Hite states, “You know something? He does know more about coffee than I do. But the point is, he didn’t look at the risk.”

Larry Hite

Market Predictions, Storytelling, & Good Copywriters

Larry is skeptical that anyone can predict markets. He in no way bases his approach to investing on making predictions, which he believes is an exercise in futility. In his own words:

“I respect the sheer intelligence and devotion of economists who have attempted to develop a unifying theory of market dynamics. But I don’t believe any such theory will hold up to scrutiny in the real world of money on the line. When you start believing you have remarkable market predicting powers, you get into trouble every single time.”

Hite is also critical of Wall Street research reports, claiming that they possess little investment value and are designed to exploit people’s natural tendencies to listen to entertaining narratives, stating:

“Stories began at the dawn of human society to entertain and instruct the next generation. We are wired to learn from well told stories. And unfortunately, Wall Street preys off our basic human weakness to want stories.”

In his typically blunt and straightforward manner, he adds, “When you start following slick reports filled with predictions, you’re just finding out who has good copywriters.”

A Computer can’t get up on the wrong side of the bed in the morning

Larry was a pioneer in his exclusive reliance on a data-driven, systematic approach, using statistical analysis of historical data to develop trading rules, which are the basis of his investment decisions. When he launched Mint Investments in 1981, his goal was “to create a scientific trading system that would remove human emotion from buying and selling decisions and rely instead on a purely statistical approach built on pre-set rules.” Continue Reading…

Small Business: How revised Corporate Passive Income Rules impact your Corporate Tax Planning

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Lowrie Financial/Unsplash

By Steve Lowrie, CFA

Special to the Financial Independence Hub

Proactive Business Owners Can Manage Corporate Investments and Income for Optimal Tax Efficiency

As a small business owner, you no doubt have active interests in your bottom line. That’s why it’s worth knowing about some recent changes to the tax treatments on corporate passive income.

For those currently creating passive income through corporate investments, we’ll describe how this income might impact your small business tax planning, and offer some corporate tax strategies for keeping more of that money in your coffers.

Even if you are not currently generating corporate passive income, some of these same tax strategies remain sound. After all, smart tax strategies and sensible corporate tax planning is perennially popular. At the end of a busy work day, the more of any sort of income you get to keep, the better off you and your small business will be.

The Highlights: What has Changed about Corporate Passive Income and How Does It Impact You?

How have corporate passive income rules recently changed?

Starting in 2019, the CRA adjusted corporate tax rates and broadened the definition of passive income.

How do the changes impact your corporate passive income?

These changes brought good news and bad. Under the broader definitions for passive income, you may exceed the passive income limits to qualify for the coveted small business deduction (SBD). Corporate tax strategies that may have worked for you in the past may no longer be ideal for optimal tax integration. But with the tax rate changes, some applicable corporate tax strategies are even more powerful.

That’s the broad sweep. Now let’s take a closer look.

The Details: Small Business Tax Planning and Passive Corporate Income Changes

Small business owners typically manage two interests in their owner/individual roles. Rather than earning your keep by working for someone else, you create corporate wealth. You then decumulate that wealth by transitioning it from your corporation to yourself and your family. Once the dust settles, the goal is to retain as much wealth as possible by being deliberate and tax-efficient throughout the process. Broadly speaking, there are a couple of ways to take wealth out of your business for personal use:

If you take your annual CCPC income as a salary:

  • Your corporation takes it as a deduction, so no corporate tax is due on the income.
  • Instead, you pay personal tax on the income at your graduated personal tax rate.

If you take your after-tax CCPC income as a dividend:

  • Initially, your annual CCPC income will be subject to corporate tax.
  • That year or in the future, you can distribute the after-tax income as a dividend to yourself.
  • In the year you receive the dividend, you’ll pay personal tax on the distribution at your graduated marginal tax rates.

Which is better?

As you might expect, it all depends, and typically requires you to crunch your particular numbers to see how they compare. By design, how you take the money is supposed to end up being a tax-planning wash … at least as far as the CRA is concerned. However, the ability to tax-defer dividends to future years has often been beneficial as part of overall corporate tax-planning.

What’s changed?

The concern is, business owners in general, and small business owners in particular, may have had an unfair advantage over individual taxpayers. By deferring a salary or dividend payments while building up wealth within your corporation, you also can defer paying annual personal taxes, which are typically at higher rates … especially if you qualified for Small Business Deferral (SBD) rates. Continue Reading…

When was the last time you Rebalanced?

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https://advisor.wellington-altus.ca/standupadvisors/

By John De Goey, CFP, CIM

Special to the Financial Independence Hub

There are several approaches that individual investors and advisors alike might take to portfolio management.  One of those is rebalancing.  In simple terms, rebalancing is simply selling a portion of something that is up and re-positioning the proceeds into something that is down (or perhaps merely up relatively less).  It is a longstanding, tried and true approach to both portfolio management in general and risk management, in particular.

Now that we are in October with a steady stream of portfolio gains booked into most peoples’ accounts, it might be worth your while to consider taking a few profits from those things in your portfolio that have done particularly well of late and using the proceeds to be a value investor who buys things that are currently out of favour.

Trading more reduces both Risk and Return

Some people offer suggestions as to what should be sold and bought.  I won’t, because everyone’s holdings are different.  Some people will offer suggestions as to what the thresholds ought to be.  I won’t, because there is no obvious right answer.  Trading more reduces both risk and return while increasing transaction charges.  Doing so less frequently typically leads to the opposite outcome. Continue Reading…

Debunking a bogus Stock Market prediction

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By Michael J. Wiener

Special to the Financial Independence Hub

It would be much easier to plan for the future if we knew what stock prices were going to do.  Bank of America has a chart with seemingly solid evidence that stocks will lose a total of about 8% over the next 10 years.  I’m going to show why this evidence is nonsense.  But don’t worry; I’ll do it without making you try to remember any of your high school math.

The Bank of America chart [shown on the left] looks intimidating to non-specialists, but I’ll summarize the relevant parts in easy-to-understand language.  The basic idea is that for each month since 1987, they looked at how expensive stocks were that month and compared that to stock market returns over the 10 years following that month.  They found that the more expensive stocks were, the lower the next decade of returns tended to be.  The hope is that we can just use the chart to look up today’s stock prices to see what stock returns we’ll get over the next 10 years.

In the chart, each dot represents one month from 1987 to 2010.  Notice that the dots are fairly close to forming a straight line.  Statisticians get excited when they see a strong relationship like this.  If the line were perfectly straight, we could just look up how pricey today’s stocks are (using a measure called the P/E or price-to-earnings ratio), and read off the average annual stock return we’ll get over the next 10 years.

The line isn’t perfectly straight, but it’s fairly close.  One measure of how close to a straight line we have is called R-squared.  For our purposes here, we don’t need to know much about R-squared other than 100% means a straight line, and as this percentage drops toward zero, the cloud of dots spreads out.  The chart indicates an R-squared of 79%, which is a strong relationship.

Also indicated on the chart is the prediction that stocks will lose an average of about 0.8% each year over the next decade.  However, if we imagine an oval surrounding the full range of dots, this chart predicts annual stock returns between about -3% and +2%.  If we knew future stock returns really would fall in this range, most people would sell their stocks.  But can we count on stock returns falling in this range?  It turns out that we can’t because the chart is deeply flawed, as I’ll explain below.

Problems

The first thing to observe is that this chart is based on about 34 years of stock market data, a little over 3 decades.  Because we’re talking about 10-years returns, you might wonder why there are more than 3 dots on the chart.  The answer is that it uses overlapping periods.  There is a dot for January 1987, then February 1987, and so on.

Consider the ten years of returns starting in January 1987 and compare this to the ten years of returns starting in February 1987.  They are the same in 119 of 120 months.  Each decade of returns starting monthly from 1987 to 2010 overlaps with 119 other decades.  There is a huge amount of redundancy in the chart.  Somehow we went from a 3-dot chart to one with hundreds of dots.

Using overlapping data isn’t always a bad thing, but it is in this case because there is just too little independent data to have any statistical significance.  To show this, I ran some simulations.  I created random stock market data and measured R-squared values.

The method I used for creating this simulated stock market data created returns that ignored stock valuations.  This means that using P/E values to predict stock market returns is futile with this simulated data; the R-squared value of the underlying probability distribution used in the simulations is zero.  To confirm this, I generated a million years of stock market data, and measured the R-squared value.  In a thousand repetitions of this experiment, all R-squared values were less than 0.02%.

However, coincidences are common when you examine very small amounts of data.  I ran simulations of 34 years of stock market data.  I repeated this experiment 100 million times.  Amazingly, in just over one-tenth of the simulations the R-squared value was above 79%, and in 51% of the simulations the R-squared was above 50%.  These seemingly strong correlations are what you get with small amounts of random data, even though the underlying probability distribution has no correlation at all (R-squared equal to zero).

What can we conclude from these experiments?  Continue Reading…

The Dividend Aristocrats for Retirement

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By Dale Roberts, cutthecrapinvesting

Special to the Financial Independence Hub

The Dividend Aristocrats are U.S. stocks (members of the S&P 500) that have increased their dividends for at least 25 years or more. That index methodology will find incredible quality and it also offers a large cap bias. Large cap (capitalization) means that the companies are at the higher end with respect to what it would take to buy the company outright. It is the number of shares multiplied by the share price. The Aristocrat methodology has outperformed the market, and with lesser volatility. That might make it a solid approach for the U.S. stock component for a retiree, or for one who seeks better risk-adjusted returns. We’re looking at the Dividend Aristocrats for retirement, on The Sunday Reads.

Now certainly, when we bring up the subject of dividend investing, that will split many investors and stock market watchers into two separate camps. Many feel that it is a superior form of investing. At the other end of the entrenched opinion – dividends have absolutely nothing to do with investment success. They will argue that it is a zero sum game, the company is simply giving you money by way of a dividend and that reduces the value of the company by an equal amount.

What do those dividends find?

If we want to think of dividends or dividend investing as a factor, the argument can be that dividends find certain kinds of companies. Of course dividend investing will almost always find profitability (unless they’re faking it). Most dividends seek dividend growth and that can find companies with a longer history of increasing profits and increasing free cash flow. And when you stretch that dividend growth history to 10, 15, 20, 25 or 50 years that can find higher quality companies with incredible track records, sustainable moats and durable business models. While certainly not foolproof, the approach can lessen the chance of failure within a stock or large basket of stocks.

This post from S&P Global, the importance of stable dividend income offers this quote and fact …

Across all of the time horizons measured, the S&P 500 Dividend Aristocrats exhibited higher returns with lower volatility compared with the S&P 500, resulting in higher Sharpe ratios.

Better risk adjusted returns is appealing for many. But it can have even more importance for the retiree, as we have that sequence of returns risk.

Ploutos, Seeking Alpha

On Seeking Alpha, author Ferdis tracks and measures the quality of each Dividend Aristocrat. Here’s the most recent Dividend Aristocrats ranked by quality scores.

Readers will know that for our U.S. stock portfolio the approach has found many U.S. Dividend Aristocrats, so I like to check in on the Ferdis reports to see where our Aristocrats stand on the Ferdis scale. I continue to find that our Aristocrats are in the top echelons of quality. In fact the only stock at the bottom of the scale is our only loser – Walgreens.

The Dividend Achievers skims

From that U.S. portfolio link you’ll see that I skimmed 15 of the largest cap Achievers in early 2015. That index methodology insists on at least 10 years of dividend growth, and the Dividend Achievers (Appreciation) index applies proprietary financial health screens. Our stock performance suggests that the index skimming exercise found enough growth and truly excelled at that quality ‘thing’. Within the original mix of stocks were several Dividend Aristocrats.

I took a look at our U.S. portfolio returns and then offered this comment on the Ferdis post …

From my 2015 start date I beat the Aristocrats Index (ETF NOBL) by about 2.7% annual with much better risk adjusted returns. So ya, quality works. In the COVID correction I had about 35% less draw down. Dale’s Achievers were down by less than 21% in the correction.

Solid returns with lesser volatility and less draw down in major corrections was exactly the rationale for embracing the Achievers and Aristocrats for retirement.

And then when you add in a few solid quality U.S (no brainer) picks with decent growth prospects.

Our total U.S. returns are even more exaggerated as the 3 picks beat the Appreciation fund by 7.5% annual. They are AAPL, BLK and BRK.B (as a defensive stock market correction hedge – that’s an underperformer for the period).

That growth kicker has contributed greatly to the wonderful performance. As always past performance does not guarantee future returns.

Here’s the summary in chart form.

And setting the table for retirement.

Equal weight by stocks or ETF

An additional ‘bonus’ is that you can choose to equal weight the stocks. And that’s exactly what also happens within the Dividend Aristocrat Index. Here’s the current sector mix. The index is equal-weighted, that can contribute to a value tilt as well (finding greater current earnings accompanied by generous growth prospects). Continue Reading…