How to Spot and Avoid Investing Scams

Notorious cases like Bernie Madoff in the USA and Earl Jones in Canada highlight the necessity for vigilance to avoid losing one's hard-earned money to investing scam and fraud operators. The danger is not confined to the newbie investor. Indeed, as the Madoff and Jones cases illustrate, experienced and knowledgeable investors are just as susceptible. Read this cautionary tale Why we keep falling for scams in the Wall Street by Stephen Greenspan, a university professor psychologist specialising in gullibility who was one of the victims of the Madoff rip-off. In fact, a research study by the University of Exeter for the Office of Fair Trading in the UK found that "... scam victims often have better than average background knowledge in the area of the scam content"!

The recent investing environment, which has seen a huge slump in returns in 2008, may make some especially anxious to jump on opportunities that promise large returns in a short time. People who are approaching or who have just started retirement may be particularly at risk if they have a big shortfall in funds needed for their retirement years since they may not have other means to make up the deficit.

How then can one spot a scam and more important, avoid being taken in?

Scam Spotting - don't take it from this blogger whom you do not really know, take it from known trustworthy verifiable sources (get the hint?!), which have excellent guides to scams like Ponzi and Pyramid schemes, or those involving legitimate-sounding investments such as exempt securities, forex, offshore investments, prime bank notes, gold and silver mines, oil wells, coins and precious metals, RRSP or Locked-in RSP tax-free withdrawal.

The sources below also review typical inducements and techniques used by the fraudsters: no-risk and high return, insider tips and get-in-now-before-it's-too-late, high pressure sales, investment seminars (such events are not necessarily fraud vehicles), invitations to invest with the smart/expert money, pressure to do like your friends/social group/church (especially odious IMHO) and a need for secrecy.

• Investored.ca (site sponsored by the regulatory Ontario Securities Commission) How do I know that I'm investing in a safe place?
  
• State of Hawaii - How to Spot an Investment Scam
• Government of Canada's Office of Consumer Affairs Scam/Fraud page including online quiz to measure your own susceptibility
• Canadian Securities Administrators Avoiding Fraud page, including Scam artists pursue adults over 50
  
• The Canadian Guide to Protecting Yourself from Identity Theft and Other Fraud by Graham Waters and Gary Ford from Insomniac Press is worth reading for its broad coverage, including online and investment scams
  

How to Avoid and Resist Being Taken
Though the above documents and websites contain many useful tips to follow, antidotes also need to consider a few surprising findings in the Exeter study: scam victims report that they analyzed scam content more than non-victims; scam victims are more likely to be taken in again for another scam and victims in general are not poor decision makers and are often successful in their professional or business field. Victims often have an inkling and a gut feeling that things are not right or as promised - but they go ahead anyway!

The reason according to psychiatrist David Krueger in his recent book The Secret Language of Money is that scams only work with our willing participation. That's due to our emotional vulnerabilities. Our fantasies, our need to be special, to appear knowledgeable/ not look stupid, to belong, to cooperate and obey legitimate authority, to be taken care of, our susceptibility to impulse and our desire to put one over sabotage our judgement by allowing the emotional parts of our brain to overwhelm the rational part.

Suggested tactics:

• trust your gut instinct, it's usually right
  
• ask yourself what you could lose, not what you could gain; ask what could go wrong
• ask yourself why you are the chosen lucky one to participate in this investment
  
• if this is such a sure-fire scheme, why isn't everyone else doing it?
• ask yourself if the scheme is too good to be true
  
• always give yourself a time gap before acting; make it a rule to sleep on it
  
• talk to someone else you trust who is neutral, not familiar or involved with the idea and run it by them
• question the authority and genuineness of the person contacting you - how do I know you are who you say you are? - invoke your sceptical self
• become a little paranoid because the assumption that you are too smart or informed to be conned can be an Achilles heel
  
• when in a times of personal crisis, such as divorce, job loss, death in the family or economic downturn, vulnerability to the urge to have someone take care of you is greater - be aware of that, tell yourself that and confront the feeling as the illusion it is
  

Having a good head on your shoulders for investing means both being well informed and rational in judging facts, and it also means recognizing and properly harnessing your emotions.

Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations.

Simple Portfolios Compared

Suppose you admit you are lazy or that you simply have better things to do with your time than poring over financial information to manage your investments, yet you want an effective and sustainable investment strategy. What is out there to help attain that aim?

Factors That Make Things Easier / Better or Not: what are the trade-offs to consider in deciding which approach is best for yourself?

• Securities to Buy - the fewer there are, the less work it is to manage but it is often at the sacrifice of diversification
  
• Diversification & Asset allocation - most of the portfolios take a balanced view using something between 60/40% to a 40/60% split between the two major asset classes of equity and fixed income, though some are a bit more unbalanced. A few of the funds of funds are able to include a very broad variety of other types of assets such as real estate, commodities, gold, foreign bonds and emerging market equities.
  
• Rebalancing - how automated and frequent is the rebalancing - in some cases you must do it once a year yourself (is 30 minutes work too much?) or it is done for you by the fund company. Most use an annual rebalancing schedule.
• Deposits and withdrawals - can you set up automated regular purchases for additional investment, or automated withdrawals?
• Reinvestment of dividends/distributions - can dividend income be automatically reinvested for you or does it sit around idle?
• Active vs passive investment strategy - does the ETF/fund passively follow an index or does the investor attempt to do better through active security buying and selling?
• Tax tracking - if investments are held in a registered account this factor doesn't matter, but in a taxable account one must report the different types of income like dividends, interest and capital gains - is the tracking done for you or do you have to it yourself?
• Fees and commissions - how much does the portfolio cost in management and trading commissions? Higher costs can make a huge difference in net results over the long term. In the case of ETFs, broker trading commissions will be incurred whenever money is added to the portfolio and purchases must be made, or when rebalancing is to be done. If the commission is $10, then adding money to or rebalancing a $10,000 portfolio with three securities will cost $30 (3 x $10), which amounts to a 0.3% annual cost
  

The Sampler of Simpler Portfolios - there certainly is a variety of evocative names coined by the inventors!

• Couch Potato - created originally by journalist Scott Burns in the USA with results and fancier versions here, there is a Canadian version described on the Canadian Business MoneySense magazine website. It has a pretty good performance record, beating the TSX stock index from 1976 to 2008.
  
• One-Minute RRSP - journalist Larry MacDonald's version, the only one to attempt active management using a couple of simple rules for the bond vs equity allocation
  
• Simple Recipe - McMaster University finance prof Richard Deaves proposes this portfolio in his book What Kind of Investor Are You?
• Easy Chair - this one is from University of Toronto finance Professor Eric Kirzner and is described in a Toronto Star article and again here
  
• Lazy Investor - author Gail Bebee describes her version in her book No Hype: The Straight Goods on Investing Your Money.
• Balanced Mutual Funds - a selection of several hundred is available through the GlobeFund filter for either equity balanced or fixed income balanced funds. Most companies offer either a Canadian or an international/global balanced fund and it would be necessary to combine at least two but one example of an all-inclusive fund is ING Direct's Streetwise Balanced Fund.
  
• Portfolio ETFs - both iShares Canada and Claymore Canada now have a couple of ETFs which contain a variety of other ETFs within e.g. iShares' Growth Core Portofolio Builder and the Claymore Balanced Growth Core Portfolio. CanadianFinancialDIY compares and rates the two.

Table 1 Compares Couch Potato, One-Minute RRSP, Simple Recipe, Easy Chair and Lazy Portfolios

Table 2 Compares the ING Balanced Mutual Fund, Claymore Balanced Growth CorePortfolio and iShares Growth Core Portfolio Builder


How well do these simple portfolios perform? As the above links to commentary on the ones that have been around for some time attest (like the Couch Potato and the Easy Chair), they perform quite well with no spectacular gains but no huge declines either. Whether that suits your personal investing goals and attitudes is a matter for you to decide.

Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations.

Book Giveaway and What is the Next Big Investment Threat?

As a reward to readers, this blog is offering a free copy of The Cost of Capitalism by Robert J. Barbera, an engaging and thought-provoking account of the causes and signs of the bubbles and financial crises that have repeatedly plagued our economy, including the 2008 crash. His argument is that such crises are part of the capitalist system and are bound to re-occur. The book got very positive reviews on Amazon and I really like it too.

The book helps the individual investor to detect the indicators like rising debt levels and over-confidence that show a crisis is building. Perhaps this can allow preventative action ... though timing when to get out and back in has been shown to be extremely difficult. (Such is not Barbera's goal anyway. His thrust is to explain and suggest policy to prevent future crisis rather than to tell the investor how to protect him/herself.) Building a diversified portfolio that can weather market storms, or perhaps we should say, hurricanes is probably a more realistic objective. At the least, we can learn to bear such crises with slightly better equanimity.

To be in the random draw for the book, leave a comment with some unique name (i.e. don't comment as "anonymous"). The draw closes a week today, on Thursday, November 19th at midnight EST. The winner will be announced on the blog with a request to email a mailing address and the book will then be shipped out to any Canadian address.

In the comment, if you are so inclined, share your opinion and say what is currently your single greatest investment worry - be it another crisis, inflation, government deficits and likely rising taxes, very low growth and future returns etc.

A thank you to McGraw-Hill Canada for the complimentary copy.

Adjusting RRIFs and RRSPs to the New Reality

Let's say a few years ago you figured your savings could support your retirement and you decided to opt for early retirement. A new reality unexpectedly descended last autumn when markets crashed, decimating all portfolios, even prudently balanced ones. As a result, you and many others, according to BMO Retirement Institute's Boomers Revise Their Retire-By Date as Financial Landscape Changes, have opted either to delay retirement or reverse course, to begin working again to generate savings to rebuild the portfolio and allow the portfolio time to recover. BMO's Retirement Transition Illustrator can help you figure out how much longer you might need to work.

Let's say you had converted your RRSP into a RRIF. This presents two problems.

1. With a RRIF you are obliged to withdraw a legislated minimum percentage each year based on your age (details are in Canada Revenue Agency's IC78-18R6 and TaxTips.ca's RRSP/RRIF calculator will work out the exact amount using the formula 1/(90-age) for the years prior to age 71 - e.g. if you are 60, the percentage is 3.33% so you must withdraw $3330 for every $100,000 balance in your RRIF as of Dec.31st of the year before).
2. You are not allowed to make any additional contributions to a RRIF to build up your portfolio.

The simple solution for those under age 71, which is the age when it is mandatory to convert an RRSP to a RRIF: transfer all, or part, of the RRIF back into an RRSP. There is no cost and no tax consequence of doing so, as long as the transfer is done directly, from registered account to registered account. DO NOT withdraw the whole amount from the RRIF as it would all be taxable income that year and you could only recontribute back into an RRSP to the extent of having contribution room. If you have a sizeable RRIF such an action would be very costly in taxes.

To do the transfer properly, you should contact the customer service folks of the broker - in fact, a phone call may suffice to do the transfer. If your RRSP and RRIF accounts are with the same broker they do not need to fill in the transfer forms. It is a definite convenience to have multiple accounts with the same firm.

For those aged 65 to 71, it may be worthwhile to have both a RRSP and a RRIF open (it is entirely acceptable to have both RRSPs and RRIFs open at the same time) since a withdrawal from a RRIF from age 65 onwards qualifies for the pension income tax credit, which offsets the tax and allows one to receive tax-free up to $2000 of such RRIF income. A withdrawal from an RRSP is not eligible for the pension tax credit. TaxTips explains this on How to create pension income. If you don't need this income to spend it could be put into a TFSA account, where it will remain tax-free.

Though the income tax rate is identical on RRSP and RRIF withdrawals, RRIFs have another small advantage in that there is no tax withheld at the time of withdrawal for the minimum required RRIF payment. Tax may still be payable but the moment of reckoning is deferred to the annual April 30th deadline for income tax returns. In the meantime, you get to keep all the money.

The key to rebuilding a retirement portfolio for those just at the point of retirement is working longer, saving money and giving the market time to recover. But it is useful to know some ins and outs of RRSPs and RRIFs that can help. Every little bit helps.

If you are not sure how to carry out these tips, consult a competent financial planner or an accountant.

A Sustainable Portfolio Withdrawal Rate: the 4% Solution

From 1900 to 2008, the compounded before-inflation return on Canadian equities came to an impressive 9.1%, with bonds at 5.2% according to the Credit Suisse Global Investment Returns Yearbook 2009. Assuming that the past is a reasonable guide to the future over the long term, does that mean a mixed portfolio could sustain on-going yearly retirement withdrawals in the range of 7 or 8%?

The answer unfortunately is NO. Someone looking to take money out for 30 or 40 years, say 7% or $35,000 of an initial nest egg of $500,000 and adjusting upwards for inflation every year, will most likely have no portfolio left long before then. One big problem is inflation: the real after-inflation return on equities was 5.9% and on bonds only 2.1%. The other significant reason is that several bad years of returns in row, such as happened in the 1970s and in 2001-2003, especially when they occur at the beginning of the drawdown period, so diminish the portfolio that it never recovers, even if strong returns follow.

Sustainable (Safe) Withdrawal Rate
A sustainable rate is around 4%. Many researchers and planners have taken different approaches and assumptions to estimating this rate, often also called the safe withdrawal rate. The range of estimates varies from as low as 3% up to about 6%. Such a big range is obviously of interest since it can mean double the income. Thankfully some of the factors involved are under the control of the investor, unlike future market returns. What are the factors affecting the sustainable withdrawal rate?

• Flexibility in the annual withdrawal amount - instead of rigidly taking out the same inflation-adjusted amount year after year, which means annual increases, freezing the withdrawal (no inflation increase) after a year of negative returns (e.g. 2008) can allow 0.8% more, or when combined with a rule that inflation increases would never exceed 6% up to 1.4% more - i.e. a total of 5.4% annually - per Jonathan Guyton's Withdrawal Rules: Squeezing More from Your Retirement Portfolio at the American Association of Individual Investors. Paul Merriman's popular book Live It Up Without Outliving Your Money proposes rules that boost withdrawals down or up depending on portfolio success which would have supported eventual on-going rates of 6% using historical data from 1970 to 2007. To carry out such a strategy it helps for retirees to have a budget which differentiates between essential living spending and nice-to-have extras to see how much wiggle room there is.
  
• Diversification of a portfolio using different asset classes such as foreign equities and bonds, real return bonds, REITs, value and small cap stocks reduce portfolio volatility. Reducing the downward jolts is crucial. Diversification then allows a higher withdrawal rate. Guyton's article shows about a 0.4% increase in a successful withdrawal rate in the more effective portfolio.
• Lessening the duration of withdrawals by delaying the start of drawdowns, one obvious way being to work longer and retire later. Funding a 20 year retirement obviously costs less than a 25 year retirement. Table 3 in the famous Trinity study by Phillip Cooley, Daniel Hubbard and Daniel Walz shows how the probability of success rises with shorter payout periods. For example, a 10 year reduction in payout period (25 to 15 years) allows an increase in withdrawal rates from 4% to 5% for a portfolio split 50-50 between stocks and bonds.
  

There is of course a tradeoff - a low withdrawal rate that is sure to last forever means restricted income. We only live once and regret over not doing the things we desire from being too cautious may be a sad way to live in retirement. On the other hand, there may a strong desire to pass along funds to the next generation. Knowledge and confidence of the likely results of a particular withdrawal rate forms the basis for informed decisions.

Resources:
Bogleheads' Safe Withdrawal Rate summarizes and links to US research
ByloSelhi's annotated links on Sustainable Withdrawal including Canadian content, fund companies, media, government, calculators

Ins and Outs of International Bonds

Bonds don't exist only in Canada. The world bond market is vast - at least as large as the equity market.

Why buy foreign bonds

• Diversification - just as foreign equities move up and down in different patterns than Canadian markets, so do foreign bonds. This non-correlation will dampen volatility when incorporated in a portfolio. Roger Gibson describes the effect in his classic book Asset Allocation. The Google Finance chart below shows how differently an international bond fund (NYSE symbol: BWX) behaved during the 2008 market meltdown compared to both the TSX composite equity index and a Canadian index bond fund (TSX symbol: XBB). If one were to factor in the big drop in the Canadian dollar vs the US dollar that occurred (since BWX is sold on a US exchange and denominated in USD) during late 2008, then the beneficial effect for a Canadian holding BWX would be even more pronounced.

• Inflation hedge - the study Can Canadian Investors Still Benefit from International Diversification: A Recent Empirical Test from Simon Fraser University modeled international bonds within a portfolio during 1996-2006 and found that they provided inflation protection to Canadian investors
• Income - like any other bond, international bonds generate interest income at rates that are likely to be comparable to Canadian bonds of similar quality - XBB's average coupon is currently 5.29% and yields 3.25%, while BWX's coupon average is 4.32% and yields 3.85%

Risk factors and other considerations

• Credit/default risk - the chance the issuer won't pay back the principal as promised; may not be a big factor as some funds hold only developed country government bonds - will the UK, Japan or France likely default? Check the fund holdings and its investment policy. Individual bond risks are always minimized by buying a fund rather than an individual government or company bond.
• Interest rate risk - if rates suddenly move up in a country, bond values will go down. Movements tend to average out over many countries.
  
• Liquidity risk - an individual bond may be hard to sell and if so, a seller will get a lower price
• Currency risk - a key factor, as exchange rate shifts usually far outweigh any other factor. Some funds eliminate this factor by hedging, which adds cost of course. In the long term and over many countries, many but not all, researchers say the currency swings cancel out. In the short term, the swings can provide the basis for the portfolio-rebalancing strategy of buying low and selling high (see renowned Yale University Chief Investment Officer David Swensen's explanation here)
• Costs and Expense Ratios - transaction commissions for discount brokerage customers appear in the form of the buy-sell spread, the difference between the price the broker will buy from you or sell to you; the greater the spread, the costlier this is, though if you hold a bond to maturity, the cost as averaged over many years can be small i.e. constant buying and selling of individual bonds will cost a lot and eat up much of your returns. Expense ratios (MERs) are published for funds and the basic principle is, the lower the better.

What is available to buy

• Individual Bonds - there is excellent choice of bonds of US issuers, sold in USD through the same web online self-serve menus as individual Canadian bonds.
• Global / International Bond Mutual Funds - sold by Canadian mutual fund companies, there is a choice of about 80 funds listed on GlobeFund with MERs ranging from 0.16% up to 3.04%. Most are actively managed and many of the lowest MER funds (1% or less) have a very high minimum initial investment like $100,000 or they are sold only through financial advisers, not directly to DIY investors.
  
• ETFs - unfortunately, there are no international bond ETFs available from Canadian providers. Thankfully, there is a big choice of ETFs sold on US markets (Stock Encyclopedia lists most of them here)- 1) US-bond only funds e.g. the biggest whole-of-market funds are AGG and BND, 2) Emerging Market (higher yield and higher risk) like EMB and PCY; 3) Developed Country funds that exclude the USA like IGOV and ISHG and: 4) Whole of World funds that include Canada, the USA and emerging countries like BWX and BWZ (see IndexUniverse's International Bond ETFs Compared). As is typical of most ETFs, most of these funds have low MERs (0.50% or lower) due to passive tracking of an index. Most are also not hedged and most of the bonds within are government bonds. Note that despite being denominated in USD, the unhedged international funds' currency risk is NOT the USD vs CAD shift but that of the origin country currencies combined as CanadianFinancialDIY explains in Clarification of Foreign Exchange Risk on International ETFs.
  

In today's global village, a savvy investor should not shy away from foreign bonds merely because they come from elsewhere. There's a whole wide world out there.

Disclaimer: This is presented as an investing idea, not as advice. Whether you take up the opportunity is always up to you the DIY investor.

Losing Sleep over Stocks? Figure Out Why Before Bailing Out

"If you cannot sleep at night for worry about your investments, then you need to reduce your allocation to stocks and increase fixed income or GICs." This common measure of risk aversion and advice needs examination. Not being able to sleep is a fear reaction and surely a bad thing that should be dealt with, but the under-lying reason can suggest completely different fixes.

In his book Live It Up Without Outliving Your Money, Paul Merriman provides useful ideas to examine the issue: "Risk is a possibility that you invite into your life in which you could lose something important." He also says: "There are two categories of risk: objective risk, which can be measured, and emotional risk, which depends on each person's perceptions."

With that in mind, here are a few ways in which perceptions might be incorrect and some suggestions for anti-dotes:

• What is the objective risk of stock volatility and returns? - if you were surprised that the 2008 market crash could ever happen, then learning about the short term variability and the long term returns of stocks and those of other asset types will greatly reduce the anxiety - read books such as Richard Deaves' What Kind of Investor Are You? and Keith Matthews' The Empowered Investor.
  
• Will you lose? - your time horizon is critical. For a person investing for the long haul 25 or 30 years down the road to retirement, even a big drop in a year can and will be regained by sticking to it. Fixed income has its own risks such as inflation, interest rate, downgrade/default and reinvestment risk, which the investor also needs to consider.
  
• Do you know the importance of the potential loss? - do you really know what the negative impact of the loss will be? If you do not, then it is likely you do not have a plan in place and the solution is to make an investment plan for life goals, as previously discussed in Setting Investment Objectives. Perhaps taking the risk is necessary. As Merriman says, "Take too much, and you can compromise your future by incurring big losses that you can't afford. Take too little, and and you can compromise your future by depriving yourself of the return you need." You need to know where you stand first. Then you may decide to sacrifice a possibly wealthier future for a more certain but less prosperous one, or vice versa. Of course, the golden rule is always that if you don't need to take the risk, then don't take it.
  

There is a big difference in emotional reaction between consciously facing known risks or adversity and having them appear as a nasty surprise. People constantly face tough situations with equanimity and sleep very well when they know what is going on and when they feel they have made the best decision possible, even when they cannot control the situation, such as stock market ups and downs. Loss of sleep over investments may be a sign of true danger or a reflection of a correctable phobia. Knowing the difference enables one to take the right corrective action. A shift into fixed income may or may not be worthwhile. Maybe it is not sleeplessness but falling asleep at the wheel that one should really worry about.