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Smoke and Mirrors Myths, Part 3

March 12th, 2007 · 15 Comments

In the series of posts (Part 1, Part2) examining the financial myths mentioned in David Trahair’s book Smoke and Mirrors, let’s take a look at the third myth:

Don’t worry about your investments; you’ll be fine in the long run

Mr. Trahair is sceptical of stocks for the long run and says that over the twenty years from Sept. 1986 to Sept. 2006, the TSX averaged 7.1% and 8.2% for the ten year period from 1996. Meanwhile, the average prime rate for the last ten years has been 5.4%.

I find this to the lamest of Mr. Trahair’s myths because for a chartered accountant, he makes an elementary mistake. He ignores the fact that you earn dividends from equities and return calculations should be made assuming these dividends are reinvested. While he rightly points out mutual fund fees reduce investment returns, he doesn’t explore ETFs and index mutual funds in any depth.

Using the Stingy Investor website’s return calculator, we find that the TSX returned 10% over the 20-year period and 9.97% over the 10-year period ending in 2006, significantly better than the figures used in the book. A simple diversified portfolio of 20% bonds, 30% Canadian and 50% US equities would have 20-year returns of 10.45% and 10-year returns of 8.25%. Not bad for a portfolio that takes fifteen minutes to construct and five minutes every year to maintain!

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15 responses so far ↓

  • 1 Mike // Mar 12, 2007 at 11:24 pm

    You’re right, not counting the dividends is pretty lame. One common theme of these books is that the authors tend to slant things to fit their story – sometime to the point of being silly.

  • 2 Dave // Mar 13, 2007 at 12:34 am

    That’s partly why I’m so hard on the guy…He’s a bloody accountant. In his (in)famous “don’t invest in an RRSP before paying down your mortgage” article he assumes that the investments inside the RRSP will grow 5% per year. Seems really odd since he assumes a mortgage rate of 6%.

  • 3 Phil S // Mar 13, 2007 at 11:18 am

    * Note: Past results are no guarantee of future returns. – is a disclaimer that most investment management companies apply on their advertisements. Whereas on a mortgage, you are guaranteed to lose 6% interest of cash from your pocket on your outstanding mortgage balance if that is your fixed rate.
    So, it all boils down to what you’re comfortable with – a volatile stock market vs. underperforming bond market or a guaranteed loss on a mortgage. Are you a conservative investor or a risk tolerant investor? The conservative investor will always say to pay down your mortgage first because that is guaranteed money lost from your pocket whereas stock market gains are not guaranteed. A risk tolerant investor would say to make an RSP contribution first (then put your tax return into your mortgage) because they would argue that the RSP in the stock market will outperform the money paid out in mortgage, which means that you would be increasing your total net worth.

  • 4 Mike // Mar 13, 2007 at 12:07 pm

    In that case why would the risk-tolerant investor put the tax refund into the mortgage, why wouldn’t they invest the refund as well?

  • 5 Calin // Mar 13, 2007 at 12:14 pm

    {…return calculations should be made assuming these dividends are reinvested]: this is a debatable assumption.
    How much cash should come as dividends to make the brokerage expenses negligible? (Even when a DRIP is available.) What transaction charges are included in these calculations and for what numbers of shares?

  • 6 Canadian Capitalist // Mar 13, 2007 at 12:44 pm

    Calin: I disagree that assuming dividend reinvestment is a debatable assumption. You are right that investment costs are ignored in my figures but a passive investor should be paying less than 50 bps to maintain their portfolio. Deduct the 50 bps from the annualized returns and you are still well ahead of the numbers DT quotes in the book.

  • 7 Mike // Mar 13, 2007 at 3:06 pm

    Of course u have to count the dividends, they are part of the return of the investment. Not counting them would be like not counting the interest on a GIC in the return.

  • 8 Calin // Mar 13, 2007 at 3:37 pm

    Counting the dividends as cash: no contest; I have some questions around the reinvesting assumption.
    Let’s assume one has 200 shares at $50 each, with 3% yearly dividend.
    That’s $75 a quarter. If no fractional shares purchase possible, one could buy then 1 (one) share and keep $25 minus the transaction fee.
    Even at $8 as transaction fee that’s 16% off.
    Reinvesting the dividends might of course look different when having, let’s say, 10,000 shares.
    Not sure where the “passive investor – 50 bps” comes from – and I don’t challenge it, my point is that many statistics don’t fit a smaller investor.

  • 9 Mike // Mar 13, 2007 at 3:59 pm

    I see what you mean Calin.

    However – I think the whole ‘including reinvested dividends’ idea is a theoretical standard so that various investments can be compared. If you try to compare investments without reinvesting the divs it can get pretty complicated – ie if you have a stock that pays 12 cash dividends over a 3 year period then should you also try to account for the fact that the cash divs should make interest or something during that period?

    It may not be perfect or even realistic but kind of like those gas mileage estimates on cars – it’s just a method of comparison.

  • 10 Canadian Capitalist // Mar 13, 2007 at 8:52 pm

    Calin: The assumption in the Stingy Investor calculator is that dividends and interest are collected and invested at the beginning of the next year.

    I agree that dividend reinvestment has a steep cost for directly investing in stocks in smaller portfolios. However, it is simple and easy to do with index mutual funds. My 0.5% figure comes from a portfolio of TD eFunds.

  • 11 David // Mar 13, 2007 at 10:04 pm

    CC Said: TSX returned 10% over the 20-year period and 9.97% over the 10-year period ending in 2006, significantly better than the figures used in the book. A simple diversified portfolio of 20% bonds, 30% Canadian and 50% US equities would have 20-year returns of 10.45% and 10-year returns of 8.25%. Not bad for a portfolio that takes fifteen minutes to construct and five minutes every year to maintain!

    Your comment caused me to do some research (usually a good thing) so I wanted to compare the Index performance to a few common shares:

    Over the period 1996-2006 the following familiar equities increased by (simple calculation):

    S&P500 (USA) 100%
    Fortis (my electric supplier) 250%
    Royal (my bank) 350%
    Petro Can (who we all love to hate) 400%
    CNR (who wakes me every night) 525%
    Telus (my phone) 0%
    (The puirchase of Telus during their 2002 low, would have realized 800% over the approx. 5 years since. During the summer of 2002 Telus was embroiled in a major resturcturing.)

    The reason I point these out, is that they are all commonplace companies that we are familiar with, are in the Canadian news on a regular basis. Thus a little time researching these companies, some of whom operate their own DRIP, and creating a protfolio should allow even the most timid and inexperienced investor to realize a satisfactory return on investment. All except Telus outperformed the index, and even Telus was a clear BUY in mid-summer 2002, so adding to your holdings should have been a relatively simple decision.

    While ETF seem the newest commodity, it seems clear that plain ole equities, properly chosen, and allowed to grow without sleepless nights, or rebalancing, have the potential to far outpace Trahair’s gloomy predictions.

    These figures drawn from finance.yahoo.com, and of course were chosed with the full benefit of hindsight.

    My parents are wiser than I; they were invested in a number of these, or equivalent, blue chips over the period discussed. They have also decided to spend my inheritance :-(

    Finally, have a look at another Canadian icon Tim Horton’s!

    David

  • 12 John // Mar 13, 2007 at 10:13 pm

    What I don’t see in this type of discussion is the tax implication. You can only reinvest all the dividends and interest, assuming its not an RRSP or similar tax deferred account,if you pay the tax out of other funds. Isn’t that the equivalent of investing additional capital?

  • 13 Mike // Mar 13, 2007 at 10:47 pm

    John, if you wish you can factor in an hourly charge for the time to actually get the dividends reinvested, your dividend taxes filed, the time spent wondering if you should put said dividends toward big tv fund or reinvest back in stock or maybe to buy a case of beer.

    Anyways – it’s just a standard. You can’t implicate taxes because everyone’s tax situation is different.

  • 14 Canadian Capitalist // Mar 13, 2007 at 10:55 pm

    David: You raise a good point. I am not militant at all about ETFs or index funds. In fact, I’ve been mostly invested in equities so far and I want to move to ETFs just because I don’t have the time to invest in researching stocks any more. Still, I am only going the ETF route for bonds, US and foreign equities. I plan to capture Canadian equity exposure using a handful of stocks.

    John: I am simply pointing out the flaw in Mr. Trahair’s argument. In fact, he implies that GICs are better than stocks and interest income has the worst tax treatment.

  • 15 jt // Sep 20, 2009 at 5:06 pm

    Re retrun calculator: Stingy Investor states:

    This tool is much like a scalpel. In competent hands it is useful but the amateur may wind up cutting themselves. The amateur should seek professional advice.

    We are all amateurs and we have recently seen how the “pros” have done. I’ll stick to my own mistakes, thanks.

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