Guest Articles

The Amateur Investor Manifesto, Part 2

December 11, 2008


Reader J has set himself a goal of being financially secure in another 10-15 years. In Part 1 of his financial plan, he talked about his investment goals and today he shares his thoughts on his asset allocation strategy.

Ready, Set, Go
Now I am at the point of transition, where I actually craft an asset allocation and implement it. I find this step to be rather difficult, so I will share my thoughts and hopefully get some feedback.

Dimensional Fund Advisors
Several smart people I’ve bumped into lead me to the path of a slightly different indexing strategy by Dimensional Fund Advisors that isn’t cap-weighted. Their research and track record in the US looks very promising that they can build a better index with lower risk and higher returns. Being a [new] money nerd, I get turned off their requirement to only sell through advisors — I have a bad history with them; from now on I want to be more involved. DFA Canada also doesn’t seem to be performing as well as its US parent, but if I had the choice to use them to build my own portfolio held at a discount brokerage, I would have. In fact the first step to choose my risk tolerance comes from the quiz I took from the IFA website which only sells DFA funds. I fit into the “Indexfolio 70” which gives me a start to my asset allocation with 20% bonds, 80% stocks. In stocks I’ve tried to keep generally the same allocation as follows:
16% — Canadian stocks
27.5% — United States
24.25% — International (developed)
4.25% — Emerging Markets
8% — Real Estate
20% — Bonds & Cash

Fund Selection
Without DFA my fall back choices are using traditional low costs indexes from iShares, Vanguard and maybe also “Fundamental” indexes from Claymore which are sort-of like DFA. Vanguard is instantly appealing because of their great history and ultra-low fees. I just wish they operated in Canada. iShares seems pretty good and has fairly low fees. Claymore costs more, is less liquid, and seems like more of a risk because their implementation hasn’t performed as well as their back-testing, but hopefully over the long term they will outperform a normal index. I’m hoping that by mixing these different styles of fund I can lower the weighted MER and possibly a little get a better return and/or little less volatility.

Amateur Versus Sleepy
Compared to the sleepy portfolio this allocation has significantly less Canadian exposure. I understand that based on the cap weighting Canada only makes up about 3% of the global market, but we overweigh it because of home bias, currency risk and local dividend tax advantages. But where does a 24% or 16% allocation number come from? I generally agree that currency hedging is a performance drag, but is it possible that by using some indexes with a currency hedge to US/foreign markets that this would in a way help bridge the 16% to 24% currency risk discrepancy of Sleepy vs. Amateur?

Do any nerdy individual investors go so far as to do mean variance optimization as described in the Intelligent Asset Allocator? Is there some a practical way to build and test asset class correlation and other metrics like alpha, beta, standard deviation? Without knowing how to do this myself, I’ve decided to copy IFA which probably has measured these technical indicators to back test their risk based performance.

Continued in Part 3…

The Amateur Investor Manifesto, Part 1

December 9, 2008


Reader J is 26 years old, married, has two kids and dreams to be financially secure with a paid-off house and enough investment income to support his lifestyle in 10-15 years. It is an aggressive goal but he is off to a great start and has accumulated a tidy nest egg for someone his age. He has devised a detailed financial plan and wants feedback on his investment strategy. Part 1 is featured today and I’ll run the rest of his plan in the near future.

I’ve known of passive investing with index funds for several years, but I’ve never trusted my own intuition to do it. Even though my gut was telling me my “financial advisor” wasn’t adding value and wasn’t able to time the market, I never spent enough time to really research indexing enough to make my mind agree with my gut. I felt at the time it was better than nothing since I was preoccupied with work and family.

Starting in 2008 I made it my goal to begin to manage my own personal finances. I quickly found out it is actually a very interesting topic and a natural extension to my nature of being a “saver” and a nerd. So I’ve spent much of year reading books and blogs, taking my time to understand and not feel rushed into making any decisions. As Buffet says, it’s better to “move like a sloth”.

I’ve not invested anything extra with my advisor for probably 2 years, so at the beginning of the year one of my major concerns was “time risk” of investing a lump sum of cash. As we see now that risk was very significant, and just by pure dumb luck, I missed a lot of the pain. I feel like there needs to be more information on how to make this transition. I probably would have used dollar cost averaging or value averaging, but now that the market is already so much lower I think the risk is much tolerable and timing won’t make a significant impact on future returns.

Reason for Sharing

What I’d most like back from posting my plan is just feedback of any sort. Let me have it, the plan is personal but put yourself in my shoes and let me know why it doesn’t make sense or that you think it’s a good idea. I wish there was a place to post and compare investment plans and asset allocations, leave comments and track the performance over time.

Investment Goals

Before writing this plan down on paper I was talking about “the 10-year plan” that we would continue saving but also buy a house with a 10-year fixed-rate mortgage that we would aggressively pay down in those 10 years. The goal being we would have the safety and shelter of a paid for house plus by that time our investments and savings would have grown at an assumed 8% real return to provide enough income (assuming a continued 8% return) to “financially retire” with a modest life style living on $40,000 in today’s dollars.
But is that really retiring when most people only assume a 4% real return / withdrawal rate in retirement? Doesn’t that mean in years like we are currently in the retirement would fail and necessitate new income from “having” to work again? Is it possible to retire extremely early if you have to assume this rate of return, or should I be more realistic and say the goal is “early semi-retirement”? It’s a personal question, but I still wonder which is appropriate since I’m so far outside the normal realm of how average people save, invest and plan to retire.

Continued in Part 2…

Are you a De-Value Investor?

December 8, 2008


Today’s guest post is courtesy of Brad, who writes on the excellent Triaging My Way to Financial Success blog. You can subscribe to the feed here.

My father always taught me that there are three ways to do things in life: the Easy Way, the Hard Way and the Smart Way.

Investing based on this principle has provided me with more consistent success than I would expect if I had strictly stuck to the traditional two ways of doing something. Whenever I encountered failure early in my life my father would repeat these three methods and often later in reflection the best path to correcting my mistake would become evident. Often the Smart Way was a combination of the Easy Way and Hard Way found through collaboration, teamwork and looking at the bigger picture of interpreting my surroundings differently.

The Smart Way is a different interpretation of how things come together to make better sense and achieve higher efficiencies. My investment motto of “allow money and debt to work for you instead of against you” is based on this principle. When you invest you want to do things that make sense, are fundamentally sound and require very little effort or energy to maintain.

My interpretation of value investing is much more than simply looking at a stock’s quantitative value, underlying fundamentals and financial position. To me it’s about assessing all aspects of a business and asking myself if the intrinsic value of that company is more or less than the market price. Often there are times when I don’t need a massive stack of financial statements, insights into global operations or a tour of a manufacturing plant to get a sense within the first hour or two whether an investment is something that fits my style or requirements to own.

Based on the Smart Way principle I want to highlight some introductory areas that many individuals get caught up in when investing. A De-Value Investor is an individual investor who de-values their investments and opportunities for creating wealth by ignoring basic fundamentals and avoiding the bigger picture or Smart Way.

After each quote and explanation ask yourself if you are a Value Investor or De-Value Investor in each situation based on what you might do or already do. Each of the following statements I have heard in person within the last year.

“I’m going to borrow money this year to invest in my RSP.”

Any money you borrow to invest in your RSP will not be tax deductible in comparison to borrowing to invest in a non-registered account. While this may appear to be a great idea proposed by your bank or financial advisor any loan taken to borrow money to invest in your RSP will have no tax savings on the interest. Receiving a tax rebate for your RSP contribution to pay down onto the loan may make sense, but ask yourself how far ahead you might be if you are in the highest marginal tax bracket and paying full interest on your loan. Examining this situation the Smart Way could show you how you might save almost half your interest cost.

“An extra mortgage payment? I’ve got 25 years to pay off my mortgage. I need a new TV instead.”

On a $250,000 mortgage at 6.5% interest amortized over 25 years the total interest paid will be almost $252,400 – that’s only interest!

You’ve essentially paid for two homes: one in principal and one in interest. Pre-paying one additional payment of $1600 each year would decrease your interest to $203,500. You could save nearly $49,000 in interest and have your mortgage paid off in 21 years just adding an extra payment each year. Have you ever used a mortgage calculator to see how you can meaningfully decrease your interest?

“Why would I need to diversify? I don’t need to diversify! I hold only as much stock as I can hold in one hand.”

While being over diversified can negatively impact returns, not being diversified at all can leave an investor exposed and vulnerable to unexpected events in one sector, industry, country or investment. Effective diversification is ensuring you have exposure to investments that behave differently in various market conditions and buffer your overall portfolio against extremes of volatility and risk.

“They don’t need profit…the company is going to the moon! I have to invest in this stock…just look at that chart!”

Trees never grow to the sky and the fundamentals of gravity dictate that what goes up must come down. Speculation has high rewards, but also a high potential for losses. Companies without profits are dangerous because they’re burning through more cash than they can generate and this eventually catches up to a company.

“Oh…that’s what that company does?”

Do you understand what you’re buying? Do you know what factors can influence changes within the market a company operates? Is there sustainable demand for products or services? Are their operations complex? Can you explain what they do in a single sentence? What are the risks?

“I can’t sell…there’s still potential…plus I’m only down 40%.”

Knowing when to buy is always easy; knowing when to sell can be painful and difficult to ascertain. Do you have a rule, guideline or minimum loss (percentage or dollar amount) that you can tolerate on your investments? How important is capital preservation to you? Do you have as much confidence in yourself to sell as you do to buy?

“I’ve procrastinated for years with saving and investing. Now I feel I need to catch up.”

There are a lot of investors in this boat and the sea can be rough and unforgiving. Do you have a tolerance for risk? What is your definition of risk? How much risk can you tolerate? Have you ever asked yourself these questions?

“This stock has gone nowhere in 4 months! I need to sell. The analyst said that this stock should have doubled by now!”

Adequate patience and realistic expectations are hallmarks of successful long-term investing. Analysts have two knocks against them: they are paid for an opinion and view the business from external sources. What you need to do, in any situation, when receiving advice is ask yourself who stands to benefit most from the advice being given. If the quick answer is not “you” than you have to question if there’s a conflict of interest that is impacting the opinion you are receiving.

“I haven’t met with my advisor for almost two years. I like them because they send me chocolates at Christmas each year.”

When you pay for a product or service you should expect to receive something tangible in return. If you’re paying a premium to receive advice and no advice is being given than you should be asking why you’re paying that premium in the first place. How much is a 3% MER on your portfolio worth to you? 3% over ten years is 30% of your potential returns that you’ve paid for a service – are you getting a value-added service or performance? Whose interests are being served as a priority?