This is where your finance takes place

I thought I would share this interesting theory with my fellow investors

We have a tendency of creating trends

Human brains are one of the most powerful machines it has ever existed. However, powerful doesn’t mean useful in some situation! For example, when an event happens twice or three times in a row, our brain will automatically search to create a trend. It will release dopamine which makes you euphoric. Then, you will believe that you can predict what is going to happen next time the event occurs.

This is totally applicable to the stock market; if you buy a stock that rise two or three times in a span of 3 months, you will automatically be tempted to think it will continue its ascension as there is a “strong” historical trend.

As the stock goes up and down, your brain will create more dopamine so your can be kept in your “bubble”. When you see your investments taking a big hit, your heart will accelerate and the panic will become your new best friend.

Internet has greatly contributed to make you loose money

Based on this premise, the fact that you have now instant and live access to any quotes on the market is catastrophic for your investment strategy. How many times to you look at the stock market in a day? Do you feel bad when you can’t access to your stock quotes for a few hours?

Even thought I am trying to not trade on emotions, I still look-up my stocks 2 to 3 times a day. It is usually once in the morning, once at lunch time and at night, once the markets are closed. Is it useful? Absolutely not! In fact, it just adds more pressure to make trades… irrational trades

Mr. Graham made a great example with properties. Have you ever call a real estate agent in the morning to know what is the value of your house? And then, call him the next day to make sure it hasn’t change? Would you ever consider selling your house if it losses 3% in six months?

You should have bought your house for a long term need and should not worry too much about its value in the meantime. This should also be applicable to your investment portfolio.

image source: ChrisL_AK’s photostream

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As it is the case with the Klondyke, linked notes may seem delicious during the first lick but it hides trans fat and a thousand of calories. This is the price to pay to have performing guaranteed investments ;-).

How does it work for the client?

The client purchases the note and the amount is frozen for a 5 to 8 years term. The note is linked to a predetermined asset (i.e. TSX index or a basket of international stocks). At the end of the term, the client is 100% assured to get his capital back, plus the investment return of the asset, minus management fees. At mid term, the bank usually has a clause allowing the financial institution to buy back the notes (if the underlying asset outperforms their prediction). If they do so, they have to pay a predetermined return to the client (let say 9-10% per year).

How does it work for the bank?

In order to cover their risk, they take about 60% to 70% of the money and invest it in fixed income at a 5% to 6% rate. In 8 years, this amount will give enough to pay back the client’s capital. The other part (the 30% to 40% of the amount) is invested in the market (without management fees since they manage the money for themselves). So if the underlying asset does 11%, they make the 11% and take off about 3% in management from the client. This is the price to pay for having capital guaranteed investment doubled with unlimited potential of return. If the asset did more than 9% at mid term, they simply buy back the note from the client and take the difference from themselves. If investments (both on the fixed income side and the market side) are done carefully, this could be a very profitable business for both the client and the bank.

So is it an evil product or not?

Depending on the type of investor you are, linked notes maybe represent your only chance to beat the 3.5% GIC rates without taking risks or it could result in a total waste of potential return. In theory, if you invest 70% of your investment into fixed income and invest the difference in the asset yourself, chances are that you will make as much or more than the linked note. However, if you can’t stand fluctuation, you will probably choke after 6 months of bear market, sell everything and then, cry that you didn’t make money with the stock market. If it’s your case, then, the linked note is a really good investment for your portfolio. If you are able to take market fluctuations without losing your sleep, then, linked notes are totally useless.

Nothing is black or white in the world of investment…

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I know several people who have non-registered and registered investments. Most of the time, they have about the same investment profile, i.e. the same asset allocation inside and outside their RRSP (the equivalent as 401(K) for our US readers). However, tax laws are way different for these two types of account.

In fact, registered investments are not until they are withdrawn from their account. Therefore, one should have his highly taxable investments (such as interest income) within his RRSP Portfolio and leave capital gains and dividend income in his non-registered account.

If you are trading on your own, making this shift should not be a big problem. You simply have to sell your bonds, GIC’s and other fixed income paying interest in your non-registered account in order to buy more stocks or high paying dividend investments (such as financials?). Then, you repeat the operation in your registered account but by selling stock to buy back bonds.

The good news is that this technique won’t trigger much tax by flipping your investments around. Selling fixed income doesn’t trigger much capital gains and selling stocks within your registered portfolio won’t trigger any tax at all.

If you have mutual funds, the operation is a bit different. Let’s presume that you have a balanced portfolio for both accounts. Then, you should sell your balanced portfolio within your non-registered account in order to buy more aggressive funds. Than, you sell your registered portfolio to buy a more conservative funds. The purpose of these transactions is to remain with the same global profile but with a tax efficient strategy.

If you are switching funds within the same family (i.e. Mackenzie balanced to Mackenzie aggressive for example), there are chances you won’t have to sell much of your portfolio. In fact, several diversified funds include funds of different categories that were blended together. So they might be able to simply sell a part of the fixed income funds to buy more equity funds.

I recently did the math for a 300K account and you would easily save $500 per year by doing such strategy. While 300K seems to be a big number, I am sure that you will reach that point by investing on a steady basis year after year. Even if you have a 50K portfolio and you save $100, it’s still a good dinner at a restaurant

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In the other day’s column, there was a very interesting comment made by Richard about two additional things you would be looking into when investing in a fund. I thought they were good points although I wanted to make a few precisions so here you go, an entire post about the two.

So what are beta and alpha? They are two measures made on historical returns of a specific fund (beta also applies very well to individual securities). First off, beta. A beta is the correlation between an asset and an index. When talking about a beta, it is important to know what it compares to. Usually, when giving out a beta, it will be against a broad index such as the TSE60 or S&P500. Richard was saying that you were looking for a low beta. Well, to a degree yes. But not necessarily. To give you a more concrete idea of what beta is, let’s pretend you are investing in a fund, here are the expected returns given a 10% market performance:

Beta Performance

Beta -1 -10%

Beta 0 0%

Beta 1 10%

Beta 2 20%

So generally you would be looking to diversify your portfolio and in that case, as Richard said, you would want a low beta, that will help you gain good returns no matter what the market does. However, you could very well wish to add more risk and go for a fund that has a high return. So I would not agree entirely with Richard just because it depends on circumstances, but in general yes investors are looking for a low beta.

A side note would be to note that generally beta is only related to equity indexes and thus you will not see how diversified your portfolio will be with other asset classes such as bonds and commodities.

As for Alpha, no doubt here, the more the better. Again, this is a historical mesure. Generally, it is calculated by taking funds that have a similar level of risk. Given that, any return above that return is considered alpha and thus certainly something any investor would be looking for. However, it’s not the only criteria obviously as numerous research papers have showed how past performance is not very correlated with future returns for managers (apart from the very talented ones which are a lot more rare than you could imagine).

All for now, thanks for the comment Richard

“I hear a lot of people talking about the turnover ratio in mutual funds. How exactly does the buying (and more specifically) the selling of funds by clients, affect the overall performance of a mutual fund.

Another concern of mine is the whole issue surrounding MERs and fees associated with mutual funds. If my fund is reporting a 10% rate of return, isn’t that After the 1.5% or 2.3% MER has been deducted? Meaning, if a fund reports 10% rate of return it really did 12 %or 13% before fees were deducted? The reason I ask is because, if my fund is averaging 10% after fees, why do I care about the fees? 10% is 10%. Ultimately, that is the goal I am concerned with - hitting 10% or better on my overall performance. So, even if the MER was 5%, if the fund is averaging 10% over a 20 year period, should I really care?”

Turnover Ratio

There are actually 2 types of turnover ratio. The first one is related to the assets within the mutual funds. A higher turnover ratio means that the fund manager is trading more actively and changes his positions on a regular basis. If you believe in passive investing, this is probably not the right fund for you. The other impact is that you will have a lot of capital gains showing on your income tax form every year (unless he is losing money!). Since one of the major advantage of capital gains is to be reported in the future, there is not much incentive to cash in your capitals gains years after years.

When we are talking about turnover ratio in regards to the number of fund units being traded on the market, it has no or little influence on the fund performance itself. Most mutual funds are big enough to overcome daily trades and not to sacrifices good investment in order to reimburse holders of the mutual funds. It could affect the fund’s return if there are too many units for sell at the same time compare to the size of the funds. I guess you would see such phenomenon for small and private funds.

MER’s

MER’s in Canada is always an interesting topic since we are one of the countries with the highest management fees charged to clients. V, you are right to not care about the MER’s if your fund returns after them is over your investment objective. It is more important to achieve your investment goal than to focus on other aspects such as taxes or MER’s.

However, you have to be certain that your funds post after MER’s returns (some of them don’t). The other thing to consider is that those fees are always grabbing a part of your profit. Therefore, if they are too high, they might impact the long term performance of your funds. If you are paying a 3% MER’s and you barely makes the Index, it means that the fund manager is making money on your back and you simply get an additional risk compared to ETF’s.

I hope I answered all your questions, if not, please feel free to add your comments

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