If you’re reading this Monday morning, you have roughly two-and-a-half days to do certain things to optimize wealth or minimize tax before they close the books on calendar 2014.
For convenience and one-stop shopping purposes, here it is below:
By Jonathan Chevreau
With 2014 destined for the record books at midnight Wednesday, there’s not a lot of time left to optimize your investing and tax health. As noted here a week ago, it’s already too late to benefit from tax-loss selling, which had to be executed by Christmas Eve.
Even so, if you’re reading this on Dec. 29th or even Dec. 30th or 31st, there are still a few actions you can take to maximize your wealth or at least minimize tax due in April but you’ll have to complete them well before you start singing Auld Lang Syne. Continue Reading…
We’re delighted to run the first of what we hope will be many contributions from the popular Boomer & Echo blog. The topic is something I suspect many investors can relate to if they have an intellectual understanding of the powerful reason for indexing but are unable to fully commit to it because of the behavioural biases Robb Engen so eloquently describes. Robb is the “Echo” part of Boomer & Echo and you can read all about him here. The piece originally ran in September. Link to the original is below.
By Robb Engen, Boomer & Echo
Special to the Financial Independence Hub
I’ve spent the last five years convincing myself – and many of you – that I’m a sophisticated do-it-yourself investor with a sound strategy that will outperform the market over the long run.
My dividend growth investment approach has indeed performed well, returning over 16% per year since 2009. But the stock market in general has also been red hot over that time. It’ll take another bear market cycle to determine whether my investment returns were skill, luck, or something in between.
In the meantime, since launching our fee-only planning business earlier this year, I’ve been recommending a couch potato investment approach to anyone who’ll listen. I truly believe that 99% of investors would be better off indexing their portfolio with three or four low cost, broadly diversified ETFs.
So lately I’ve started to wonder, what makes my situation so special? Why stick with a strategy that I don’t even recommend to my clients?
The answer lies in a whole bunch of hidden behavioural biases that cloud my judgement – framing, recency bias, home country bias, and overconfidence.
Framing
It’s difficult to part ways with a successful investing approach. Selling a portfolio of winning stocks – my babies that I’ve nurtured through this five-year bull market – just doesn’t feel right. But if I were sitting on $100,000 in cash instead of stocks I’d have no problem starting a couch potato portfolio today.
Recency bias
As the bull market rages on and my investments continue to perform well, it gets harder and harder to recall what a bear market feels like and what I might do if my investment returns start to lag my benchmark.
This year my portfolio has trailed its benchmark by about one per cent – not huge, but enough to make me pause and reconsider my approach.
Home country bias
When I started my DIY portfolio, I bought the 10 highest yielding stocks on the TSX. While I’ve refined my stock-picking approach since then, I’ve stuck with Canadian dividend payers even though Canadian firms make up a tiny slice of the global economy.
Making matters worse, instead of keeping my Canadian dividend stocks in a TFSA or non-registered account, they’re held inside my RRSP. Not an optimal strategy when it comes to tax efficiency.
Overconfidence
It’s hard not to be overconfident when you’ve beaten your benchmark by a full 3% per year over the last five years. But even the best investors will eventually suffer periods of underperformance.
Why wait for that to happen before accepting the inevitable? Indexing gives me the best chance of achieving my investment goals over the very long term.
No shame in becoming an indexer
Norm Rothery had a great piece in the Globe and Mail in mid-September about a DIY investor whose U.S. stock picks had under-performed the market by a good 3% per year since 2007. The investor decided to stop picking U.S. stocks and move to index funds instead – opting for Vanguard’s FTSE All-World ex Canada ETF (VXC) to get his U.S. exposure.
Rothery goes on to write:
Scott’s decision to stop picking U.S. stocks is an uncommon one. Most self-directed investors remain far too confident in their abilities for far too long. Instead, disappointing long-term results are often attributed to misfortune or peculiar circumstances rather than the lack of a competitive edge.
There is no shame in admitting that you’re not the next Warren Buffett. The vast majority of investors aren’t. Those who figure it out are likely to improve their returns dramatically by following simple low-cost mechanical methods such as investing in low-fee index funds.”
Speaking of Buffett, the ‘Oracle of Omaha’ has famously touted the benefits of a low cost, broadly diversified investment approach, saying that most investors would be better off in an index fund rather than trying to beat the market by picking stocks or actively managed mutual funds.
Final thoughts
The more I read about, write about, and teach others about investing, the more I’m convinced that passive investing is the right approach.
It’s not that I stopped believing in a dividend growth strategy – it’s a fine approach that many investors will have success with – but it’s not ideal for my RRSP. And frankly, the time and effort needed to manage it properly may not be worth it in the long run.
I suspect it’s only a matter of time before I pull the trigger and become a full-fledged indexer.
Robb Engen is a fee-only planner and personal finance blogger at Boomer & Echo. He lives in Lethbridge, Alberta with his wife and two children.
If you missed the one-hour live web chat about Tax Free Savings Accounts (TFSAs) at the Financial Post, you should be able to read the transcript here. It was a fairly spirited chat, seeing as Garry and the Post have been breaking story after story lately about the CRA’s move to audit overly aggressive, excessively traded TFSA accounts with massive gains in them.
At the other end of the scale, and as Garry has pointed out, the big losers in TFSAs tend to be those who take the GIC default products and end up making it paltry 1 or 2% in interest income. Even worse, as GMP Richardson’s Chris Cottier has pointed out, are those making this pittance in the TFSA while paying out upwards of 20% in credit-card charges.
Also on the chat presenting the financial industry’s perspective was Rubina Ahmed-Haq. The chat was sponsored by PC Financial.
Good piece by fee-for-service planner Jason Heath on the MoneySense website today. At age 66, “Bob” has reached retirement and has savings in an RRSP and TFSA, as well as a holding company. He normally takes dividends from the holding company, which makes this a bit more complex drawdown problem than normal salaried employees. Heath says the corporation adds flexibility, which I’d agree with. Continue Reading…
Making smarter investment choices is one of the key elements in building up adequate retirement savings. [1] People are constantly inundated with sales pitches for investment opportunities from banks, insurance companies, and their friends and relatives. For those with limited investment knowledge, this can be intimidating. The natural inclination is to seek advice from a professional investment advisor; however, many investment advisors may be motivated to recommend the investment vehicles that pay them the highest commission. In this environment, it’s wise for individual investors to have a basic knowledge of investments. This paper aims to provide seven fundamental principles that should lead to smarter investment decisions.
1. Ignore ‘hot’ investment tips
Investments are inherently risky; some have lower risk, others have higher risk. It is socially common for co-workers, friends, or relatives to announce that they have the inside scoop on an investment opportunity that is going to have a high return, if it is acted on immediately. To compound this, people tend to discuss their winning stock picks publicly, but do not readily disclose their losers. The media often provides flashy investment advice that may not be right for a vast majority of investors, while sensationalizing world events in the context of stock markets. There are constant psychological triggers to buy and sell securities without adequate knowledge built into everyday life, and acting on these triggers can be the single biggest threat to the long-term financial health of an investor.
Conclusion: Acting immediately on information from friends, family, and the media may lead to a bad investment experience.
2. Have a basic knowledge of investment vehicles
There are many ways for individuals to invest their savings in financial markets. The most common ways to invest include stocks and bonds, mutual funds, and exchange traded funds (ETFs).
Individual stocks and bonds are inherently risky investments requiring in-depth knowledge of the underlying company being considered. It is highly unlikely that individual investors will have the time, background, or resources to conduct the necessary analysis on enough companies to build a portfolio that is positioned to outperform a passive investment in a benchmark index – even professional money managers have trouble achieving this consistently[2]. An alternative is to invest in a basket of stocks and bonds in such a way that diversifies away the risk associated with any individual company. The exact number of securities that it takes to build an optimally well-diversified portfolio is up for debate, but it is safe to say that buying a handful of stocks and hoping for the best is not ideal.
Mutual funds are vehicles that allow investors to obtain a well-diversified portfolio through a pre-packaged product. For this service, investors pay a fee to the mutual fund company, referred to as management expense ratio (MER). The MER pays for the fund’s manager and other expenses. Many mutual fund companies claim that their managers have special predictive insights and the ability to find stocks that are poised to increase in price more than their peers. These actively managed funds have significantly higher fees than a mutual fund that simply buys all of the stocks in an index, called an index mutual fund, or index fund. The high fees paid to actively managed mutual funds could be warranted if they produced superior performance, but an overwhelming amount of evidence shows that superior long-term performance is not likely[3]. Currently, 98.5% of the assets invested in Canadian domiciled mutual funds are invested in actively managed mutual funds[4].
ETFs, like index mutual funds, invest passively in an index. ETFs tend to have much lower fees than mutual funds due to their underlying structure, while still allowing investors to invest in a well-diversified basket of securities.
Conclusion: It is not practical for the average investor to build a well-diversified portfolio using individual stocks and bonds. There is sufficient empirical evidence to show that actively managed mutual funds, on average, do not show any superior performance over index mutual funds. Investors are likely better off investing in index ETFs or low cost index mutual funds.
3. Understand the risk-return trade-off
Most investors build their portfolio using some mix of stocks and bonds; this is known as their asset mix. Stocks tend to be riskier than bonds, as measured by the standard deviation of their returns. Riskier investments must have higher expected returns to attract investors, and it follows that stocks must have higher expected returns than bonds.
In a recent white paper, PWL’s Raymond Kerzerho and Dan Bortolotti used historical data and current market expectations to demonstrate the expected returns for portfolios with various mixes of stocks and bonds. The results demonstrate the relationship between risk and return – portfolios with higher expected returns also have a higher expected standard deviation. Statistically, it can be expected that in 65% of trials, the returns of a portfolio will fall within one standard deviation of the average return; in 95% of trials, the portfolio returns will fall within two standard deviations of the average return.
To ensure a desirable risk-return expectation, investors must decide how much volatility they are willing to bear, while understanding that less volatility means lower long-term expected returns. Selecting the right asset mix is one of the keys to sticking with an investment plan.
Conclusion: Higher returns are associated with higher risk, as measured by standard deviation. Investors need to understand, and be comfortable with, the risk and return expectations of their portfolio.
4. Know your time horizon
In a given year, the return on a portfolio has a 95% chance of being within two standard deviations of the expected average return. As an example, the one year return on a 60% equity, 40% fixed income portfolio could be expected to fall between -9.8% and 21.4%. If an investor has a one year time horizon, this wide range of returns is not likely to be suitable. As the investor’s time horizon gets longer, it becomes more likely that the realized average return on the portfolio will be close to the expected average return. Investors can have different time horizons for various investment goals, but the funds associated with each goal must be invested appropriately to achieve a successful investment experience. In his book, Playing the Winner’s Game, Larry Swedroe outlines some suggested asset mixes based on investment time horizon.
Conclusion: A long time horizon gives investors the ability to withstand the short-term volatility that accompanies the higher expected returns of stocks. A short time horizon means that less risky investments must be chosen to avoid realizing losses.
5. Focus on time in the market, not timing the market
Timing the market is the action of timing buy and sell decisions in an attempt to gain additional profits by buying low and selling high. Data for US mutual fund cash flows and global equity returns from the Investment Company Institute shows how investors tend to fare at market timing; when markets were doing well, investors were pouring money into equity mutual funds, and when markets were doing poorly they were selling. This buying high and selling low behaviour is driven by the fear and greed that underlie investor psychology. These actions have extremely negative effects on the performance of a portfolio.
A simple solution to avoid market timing impulses is dollar-cost averaging, systematically investing the same amount each month. This method of entering the market alleviates the stress associated with market timing, and suits investors with a fixed amount available to invest each month.
Some investors may have a large lump sum to invest from a settlement, prize, or inheritance. Research from the Vanguard Group has shown that approximately two-thirds of the time, lump sum investing has resulted in superior risk-adjusted performance as compared to dollar-cost averaging[5]. Based on this research, if an investor is comfortable with their asset mix and its risk and return characteristics, it is statistically prudent to invest the full lump sum immediately. If the investor is more concerned about protecting against short-term losses and feelings of regret, then dollar-cost averaging is appropriate.
Conclusion: The simplest solution for investors to avoid market timing is to invest the same amount every week, month, or quarter without worrying about the short term movement of the market. When lump sum investing is deemed appropriate, the investor must be comfortable with the risk/return characteristics of their portfolio.
6. Costs impact wealth accumulation
If an investor decides to invest in an actively managed mutual fund, they are subject to management fees, which are especially high in Canada[6]. The fees, typically in the range of 1.5 to 2.5% of the account value on an annual basis, have a significant impact on wealth accumulation[7]. This can be best illustrated with an example. Assume that both an active mutual fund (2% annual fee) and a passive ETF (0.5% annual fee) generate the same long-term investment return, less their fees. If the market produces an assumed rate of return of 5% over 25 years, and an investor invests $10,000 each year in an RRSP, the value of the savings invested in the active mutual fund would be $364,593, whereas the value of the passive ETF investment would be $445,652. This is a difference of $81,059, or 18%, in favor of the low cost passive investment.
Conclusion: Costs can have a dramatic effect on wealth accumulation. Ask for all possible fees to be disclosed when working with a professional, and look for investments with low upfront and ongoing costs.
7. Utilize tax advantaged accounts
In Canada, we have a handful of tax advantaged accounts that can be used to hold qualified investments. The various accounts have different purposes, but both large and small investors can benefit from using them. For a long-term investor planning for retirement, two of the most useful account types are the Registered Retirement Savings Plan (RRSP), and the Tax Free Savings Account (TFSA).
Contributions to the RRSP are deducted from taxable income in the year they are made, in most cases result ing in a tax refund. Investment growth and income build inside the RRSP tax free, and any withdrawals are taxed as income in the year they are withdrawn. The idea is that investors will contribute when they are in a high tax bracket, and withdraw when they are in a lower tax bracket. RRSP room builds based on 18% of the previous year’s earned income and can be carried forward indefinitely.
For the TFSA, there is no deduction from taxable income when money is added to it, and there is no tax payable on withdrawals. Like the RRSP, investment income and growth build tax free. Every Canadian resident starts building TFSA room when they turn 18, and currently all eligible people build $5,500 of new room each year.
Until both these accounts have been maximized, there are very few logical reasons to start investing in taxable accounts.
Conclusion: Before investing in taxable accounts, maximize the user of registered, tax-advantaged savings plans.
Becoming a smart investor
Acting on these principles is likely to be beneficial, but they all need to be tied together with a clear investment strategy. One method for sticking to an investment strategy is the creation of an Investment Policy Statement (IPS), which becomes a guideline for future investment decisions.
The IPS is created based on risk-return requirements, time horizon, and investment preferences; it sets rules for how much of each type of security should be held. An example of an IPS could be 20% Canadian stocks, 20% US stocks, 20% International stocks, and 40% bonds. When designed thoughtfully, an IPS allows the investor to separate their emotions from buy and sell decisions, instead basing decisions on the predetermined rules. When the portfolio strays from its targets due to market movement, it must be rebalanced to match the allocations set out in the IPS.
With a strategy in place, a smart investor will revisit their personal situation periodically (annually at least) to see if they should be modifying their IPS or their holdings. It is possible that new investment vehicles with lower costs or increased tax efficiency have been introduced, or that the investor’s time horizon or risk tolerance has changed due to a life event. Managing the optimal use of tax advantaged accounts must also be revisited periodically.
Tying these seven principles together and sticking to a consistent and methodical strategy can result in a pleasant, stress free investment experience, and long term wealth creation.
[1] Vijay Jog, “Investment Performance and Costs of Pension and other retirement Savings Funds in Canada: Implications on Wealth Accumulation and Retirement,” Department of Finance Canada, 2009
[2] Mark Carhart, “On Persistence in Mutual-fund Performance,” Journal of Finance, March 1997
[3]Aye M. Soe, “The Persistence Scorecard,” S&P Dow Jones Indices, June 2014
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If you’re reading this Monday morning, you have roughly two-and-a-half days to do certain things to optimize wealth or minimize tax before they close the books on calendar 2014.
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