Tuesday, September 24, 2013
Friday, September 6, 2013
Wednesday, August 21, 2013
Jim Parker - Broccoli and Pizza Portfolio
This article, written by Jim Parker of Dimensional Fund Advisors, is made available strictly for educational purposes only and should not be considered investment advice or an offer of any security for sale.
For some of us, it’s hard to give up on the idea that investing should be exciting. Picking stocks can be fun, after all, and there’s nothing like getting your timing right and bragging about it later with friends.
For all the accumulated wisdom about asset allocation, risk, diversification, and discipline, some people seem bound to see investing as an end in itself rather than a means to an end. For these folks, picking stocks is a hobby. They follow the gurus and soak up the financial media. Despite evidence to the contrary, they’re convinced they can build a consistently winning strategy by exploiting perceived mistakes in market prices.
Part of the reason is the human tendency toward overconfidence. For instance, we all like to think of ourselves as above-average drivers, when that’s simply not possible. Likewise in investing, many of us believe we have powers of foresight not evident in the wider population. A Duke University study of corporate executives published in 2010 found a dismal record of prediction among a group you might think would do well. Indeed, of 11,600 forecasts for the S&P 500 over nine years, the survey found executives’ estimates of future returns and actual outcomes were negatively correlated.1 (This is a technical way of saying the executives were hopeless forecasters).
Research also suggests the tendency to trade a lot and make confident forecasts about stocks has a gender bias. Whether it’s a testosterone-driven instinct among men to boast or something else, study after study shows men find it harder to accept that they are unlikely to “beat” the market.2 For these red-meat eaters, an investment approach that advocates working with the market, diversifying around risks related to an expected return, trading efficiently, exercising discipline, and watching fees and taxes is going to sound like the financial equivalent of a broccoli and walnut salad: healthy but boring.
Surely the point of investing is to try hard and, Don Quixote-like, to charge at those market windmills? Are we not men? There are a couple of ways of confronting this mindset. One is to hope for a change in human nature and persuade each would-be master of the universe to separate his urge for ego gratification from his need to build wealth patiently and efficiently. This is not impossible, of course. But one suspects it would take some time and would require a lot of face saving.
A second approach is to separate the investment nest egg from the play money. If someone really wants to speculate, he can be allowed to do that with the proviso that long-term retirement money be invested the boring way. This way, the investor can buy some (expensive) entertainment and accumulate a few war stories to share at his next golf game without compromising the asset allocation painstakingly designed for him and his family.
It’s understandable that investing is a kind of a hobby for some people. After all, this is what keeps much of the financial services industry and media in business. But in separating the concepts of speculation and investing, you can still enjoy the occasional treat while maintaining a balanced diet. Call it the broccoli and pizza portfolio.
--------------------------------------------------------------------------------
1. Ben-David, Itzhak, John R. Graham, and Campbell R. Harvey, “Managerial Miscalibration,” Duke University (2010).
2. Barber, B.M., and T. Odean, “Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment,” Quarterly Journal of Economics 116 (2001).
For some of us, it’s hard to give up on the idea that investing should be exciting. Picking stocks can be fun, after all, and there’s nothing like getting your timing right and bragging about it later with friends.
For all the accumulated wisdom about asset allocation, risk, diversification, and discipline, some people seem bound to see investing as an end in itself rather than a means to an end. For these folks, picking stocks is a hobby. They follow the gurus and soak up the financial media. Despite evidence to the contrary, they’re convinced they can build a consistently winning strategy by exploiting perceived mistakes in market prices.
Part of the reason is the human tendency toward overconfidence. For instance, we all like to think of ourselves as above-average drivers, when that’s simply not possible. Likewise in investing, many of us believe we have powers of foresight not evident in the wider population. A Duke University study of corporate executives published in 2010 found a dismal record of prediction among a group you might think would do well. Indeed, of 11,600 forecasts for the S&P 500 over nine years, the survey found executives’ estimates of future returns and actual outcomes were negatively correlated.1 (This is a technical way of saying the executives were hopeless forecasters).
Research also suggests the tendency to trade a lot and make confident forecasts about stocks has a gender bias. Whether it’s a testosterone-driven instinct among men to boast or something else, study after study shows men find it harder to accept that they are unlikely to “beat” the market.2 For these red-meat eaters, an investment approach that advocates working with the market, diversifying around risks related to an expected return, trading efficiently, exercising discipline, and watching fees and taxes is going to sound like the financial equivalent of a broccoli and walnut salad: healthy but boring.
Surely the point of investing is to try hard and, Don Quixote-like, to charge at those market windmills? Are we not men? There are a couple of ways of confronting this mindset. One is to hope for a change in human nature and persuade each would-be master of the universe to separate his urge for ego gratification from his need to build wealth patiently and efficiently. This is not impossible, of course. But one suspects it would take some time and would require a lot of face saving.
A second approach is to separate the investment nest egg from the play money. If someone really wants to speculate, he can be allowed to do that with the proviso that long-term retirement money be invested the boring way. This way, the investor can buy some (expensive) entertainment and accumulate a few war stories to share at his next golf game without compromising the asset allocation painstakingly designed for him and his family.
It’s understandable that investing is a kind of a hobby for some people. After all, this is what keeps much of the financial services industry and media in business. But in separating the concepts of speculation and investing, you can still enjoy the occasional treat while maintaining a balanced diet. Call it the broccoli and pizza portfolio.
--------------------------------------------------------------------------------
1. Ben-David, Itzhak, John R. Graham, and Campbell R. Harvey, “Managerial Miscalibration,” Duke University (2010).
2. Barber, B.M., and T. Odean, “Boys Will Be Boys: Gender, Overconfidence and Common Stock Investment,” Quarterly Journal of Economics 116 (2001).
Monday, July 29, 2013
Tuesday, July 9, 2013
Two Great Articles
(NY Times) Investment Plans and Forecasts Don’t Mix
Forecasts about the future of the market are very likely to be wrong, and we don’t know by how much and in which direction. So why would we use these guesses to make incredibly important decisions about our money?
Forecasts about the future of the market are very likely to be wrong, and we don’t know by how much and in which direction. So why would we use these guesses to make incredibly important decisions about our money?
(WSJ) The Intelligent Investor: Saving Investors From Themselves
One of the main reasons we are all our worst enemies as investors is that the financial universe is set up to deceive us. Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.
One of the main reasons we are all our worst enemies as investors is that the financial universe is set up to deceive us. Approximately 99% of the time, the single most important thing investors should do is absolutely nothing.
Friday, June 28, 2013
Canadian Index Instruments - Pros and Cons
Last post we discussed what exactly is the TSX Composite Index.
Most investments containing Canadian equities are in some way measured against that index. Is this justified or not and, as discussed here, is an active or passive vehicle the best one to choose for an investor?
Let's talk about this for a minute with a hypothetical scenario. Let's say that it is 1999 and you own the TSX Composite Index in the traditional market-cap weighted manner. You own technology stocks, including Nortel Networks, JDS Uniphase, and others. These technology companies comprise over 1/3rd of your Canadian Equity holdings. Did you want that exposure? How did that work out for you? Is there a solution to avoid overexposure to one stock or a sector of stocks?
Enter the Capped Index or Equal Weighted Index. These have been created so investors can track equity performance without the 'bubbly' excesses of overinvestment and hype involved with many stock market manias. Investors are also able to purchase active or passive instruments that track these indexes.
There are also other new entrants into the index creation methodology including factor driven, intrinsic value, low volatility, income weighted, fundamental weighted indices and more. These all have instruments available for purchase that track them.
Now that we are fully confused about all of these options and choices what is an investor to do? What is the 'right' index to follow?
For example, if your objective is high income and low volatility than a strategy employing instruments that use those indices may be best. If your objective is to avoid bubbly market excesses, maximize growth, and take advantage of the small cap premium and value premium than a strategy employing those instruments may be best.
In short, finding a fee-based advisor who works with low cost index tracking instruments like Exchange Traded Funds could help the most, provided the advisor listens to your needs. Most importantly, it is vital to match your objectives with the indices and instruments that most closely fit what you are looking for in light of proper portfolio construction methods.
Most investments containing Canadian equities are in some way measured against that index. Is this justified or not and, as discussed here, is an active or passive vehicle the best one to choose for an investor?
Let's talk about this for a minute with a hypothetical scenario. Let's say that it is 1999 and you own the TSX Composite Index in the traditional market-cap weighted manner. You own technology stocks, including Nortel Networks, JDS Uniphase, and others. These technology companies comprise over 1/3rd of your Canadian Equity holdings. Did you want that exposure? How did that work out for you? Is there a solution to avoid overexposure to one stock or a sector of stocks?
Enter the Capped Index or Equal Weighted Index. These have been created so investors can track equity performance without the 'bubbly' excesses of overinvestment and hype involved with many stock market manias. Investors are also able to purchase active or passive instruments that track these indexes.
There are also other new entrants into the index creation methodology including factor driven, intrinsic value, low volatility, income weighted, fundamental weighted indices and more. These all have instruments available for purchase that track them.
Now that we are fully confused about all of these options and choices what is an investor to do? What is the 'right' index to follow?
For example, if your objective is high income and low volatility than a strategy employing instruments that use those indices may be best. If your objective is to avoid bubbly market excesses, maximize growth, and take advantage of the small cap premium and value premium than a strategy employing those instruments may be best.
In short, finding a fee-based advisor who works with low cost index tracking instruments like Exchange Traded Funds could help the most, provided the advisor listens to your needs. Most importantly, it is vital to match your objectives with the indices and instruments that most closely fit what you are looking for in light of proper portfolio construction methods.
Wednesday, May 29, 2013
Canadian Index Primer
When you hear the news that "S&P/TSX Composite is up 102 points today" most people have no idea what that means. Today I hope to break it down so we can have further discussion about the instruments that replicate or compare against the index.
For starters the index is a creation of financial professionals for the purpose of having a widely agreed upon measuring stick which we are able to compare similar investments. This allows people to see if the investment they have is under- or out-performing the index in question. Here are some of the details about the TSX Composite Index -
We can see a couple very basic facts about the 'TSX' -
1) It largely consists of financial, energy, and materials companies .
2) It contains 237 companies and the top 10 biggest companies make up over 30% of the index.
Up next . . . . how to buy the TSX.
For starters the index is a creation of financial professionals for the purpose of having a widely agreed upon measuring stick which we are able to compare similar investments. This allows people to see if the investment they have is under- or out-performing the index in question. Here are some of the details about the TSX Composite Index -
Index Characteristics
| Number of Constituents | 237 |
| Adjusted Market Cap (C$ Billion) | 1,522.984 |
| % Weight Largest Constituent | 6.09% |
| Top 10 Holdings (Market Cap Share - C$ Billion) | 524.864 |
| Currency | CDN Dollars |
Inclusion Criteria
- Listing: Only stocks listed on Toronto Stock Exchange are considered for inclusion in this index.
- Domicile: Only securities which are Canadian incorporated, established in the case of income trusts, or formed in the case of limited partnerships, under Canadian federal, provincial, or territorial jurisdictions are eligible.
- Market Capitalization: Stocks are assessed based on their float adjusted market capitalization. A company's float adjusted market capitalization is calculated by removing control blocks of 10% or more.
- Liquidity: Only stocks that are actively and regularly traded are considered for inclusion in any S&P/TSX index. A stock's liquidity is measured relative to liquidity thresholds
| Sector | Weight % |
|---|---|
| Financials | 33.97 |
| Energy | 25.02 |
| Materials | 13.88 |
| Industrials | 6.96 |
| Telecommunication Services | 5.57 |
| Consumer Discretionary | 5.30 |
| Consumer Staples | 3.07 |
| Health Care | 2.55 |
| Utilities | 2.04 |
| Information Technology | 1.65 |
We can see a couple very basic facts about the 'TSX' -
1) It largely consists of financial, energy, and materials companies .
2) It contains 237 companies and the top 10 biggest companies make up over 30% of the index.
Up next . . . . how to buy the TSX.
Friday, May 24, 2013
Market Factors - Size and Value
One of the things I have noted over my years of investing is that research points to some notable premiums that can be captured when investing in equities.
The small cap and value premiums are well established over various time horizons in US market history. See Fama and French Three Factor Model.
The table shows that the average value and small cap premiums in the US equity market have been positive over the indicated periods. The return premiums have been volatile, as indicated by the standard deviations. While the averages have been positive, the annual return differences have been negative for several of the years in the historical record.
The value premium is defined as the difference between the average returns of value stocks and growth stocks (value minus growth). Value is defined as the top 30% of stocks ranked by book-to-market ratio (high-BtM stocks); growth is defined as the bottom 30% of stocks ranked by BtM (low-BtM stocks). NYSE firms are used to determine the breakpoints for value and growth; AMEX and NASDAQ stocks are then added to the NYSE stocks to form the value and growth indexes. The small cap premium is defined as the difference between the average returns of small cap and large cap stocks (or small minus large). The size breakpoint each year for small and large is the median NYSE market equity (i.e., the bottom 50% for small and top 50% for large). AMEX and NASDAQ stocks are added to the NYSE stocks to form the small cap and large cap indexes.
The table shows arithmetic averages of annual premiums. For example, from January 1946 to December 2012, the returns of value stocks exceeded those of growth stocks by an average of 4.56% per year. The return difference had a 13.83% annual standard deviation during this period.
The small cap and value premiums are well established over various time horizons in US market history. See Fama and French Three Factor Model.
The value premium is defined as the difference between the average returns of value stocks and growth stocks (value minus growth). Value is defined as the top 30% of stocks ranked by book-to-market ratio (high-BtM stocks); growth is defined as the bottom 30% of stocks ranked by BtM (low-BtM stocks). NYSE firms are used to determine the breakpoints for value and growth; AMEX and NASDAQ stocks are then added to the NYSE stocks to form the value and growth indexes. The small cap premium is defined as the difference between the average returns of small cap and large cap stocks (or small minus large). The size breakpoint each year for small and large is the median NYSE market equity (i.e., the bottom 50% for small and top 50% for large). AMEX and NASDAQ stocks are added to the NYSE stocks to form the small cap and large cap indexes.
The table shows arithmetic averages of annual premiums. For example, from January 1946 to December 2012, the returns of value stocks exceeded those of growth stocks by an average of 4.56% per year. The return difference had a 13.83% annual standard deviation during this period.
Wednesday, May 22, 2013
First Post - Why Indexing?
In terms of portfolio construction, after determining client needs, asset mix and a financial plan, currently, I almost exclusively use index based solutions when building client portfolios with only a few exceptions for tax or other planning reasons.
My hope with this blog is to deepen my own understanding of the plethora of index based products available to Canadian investors by featuring and analyzing the various products from time to time. Additionally, I hope to provide insight to readers that will help them understand why index based investments are the preferred method of portfolio construction after developing a suitable asset mix. Lastly, I hope to profile why fee-based financial planning, in combination with a passive investment approach, works out exceptionally well for clients over the long-term.
Enjoy
And to finish today's post I quote William Sharpe:
"Today's fad is index funds that track the Standard and Poor's 500. True, the average soundly beat most stock funds over the past decade. But is this an eternal truth or a transitory one?"
"In small stocks, especially, you're probably better off with an active manager than buying the market."
"The case for passive management rests only on complex and unrealistic theories of equilibrium in capital markets."
"Any graduate of the ___ Business School should be able to beat an index fund over the course of a market cycle."Statements such as these are made with alarming frequency by investment professionals1. In some cases, subtle and sophisticated reasoning may be involved. More often (alas), the conclusions can only be justified by assuming that the laws of arithmetic have been suspended for the convenience of those who choose to pursue careers as active managers.If "active" and "passive" management styles are defined in sensible ways, it must be the case that(1) before costs, the return on the average actively managed dollar will equal the return on the average passively managed dollar and(2) after costs, the return on the average actively managed dollar will be less than the return on the average passively managed dollarThese assertions will hold for any time period. Moreover, they depend only on the laws of addition, subtraction, multiplication and division. Nothing else is required.
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