Market Efficiency: Implications for the Individual Investor

How many times have you read that the stock market is efficient and that therefore you cannot beat the market? What do such statements mean and what are the investing lessons for the individual?

Academic researchers, beginning with Eugene Fama in the mid 1960s, set out the Efficient Market Hypothesis as the notion that stock prices at any moment reflect all available information. The information can include, first, past stock prices, second, all publicly available published data such as accounting reports, analyst reports, news, economic forecasts or anything else that might affect the price, and third, all insider information known only to company executives. The hypothesis states that prices adjust instantly when new information comes out. Since new information is unpredictable, prices are as likely to go down as up, leading to the oft-seen statement that prices follow a random walk.

The conclusion drawn by many is that trying to find winners by active stock picking is a lost cause and the individual investor should simply buy and hold passive index funds. Passive index investing through ETFs or mutual funds is certainly one viable course of action, especially for those who want to spend little time and effort and are content with average market returns, which are usually positive over the long run, though not perhaps in any given year e.g. 2008!

Is there no further possibility? Many believe incorrectly that there is no hope for any investor to outperform the market and that prices are as correct as they can be at any moment. But there is hope and to see why, the key is to understand that efficient markets do not imply that all stocks are correctly valued at all times. Efficient markets only require that prices be fair and unbiased, meaning that they are as likely to be too high as too low. Prices can also deviate enormously from true values. The very mechanism that brings about market efficiency is the action of investors in detecting bargains and investing in schemes to profit. Inefficiencies and mis-pricing are constantly springing up to be devoured and eliminated by investors.

It is best to measure how efficient markets are (and different markets like the NYSE and the TSX are likely to vary in efficiency), and not say that they are black or white efficient or inefficient. A neat summary of Market Efficiency by NYU finance professor Aswath Damodaran tells us the key features that contribute to efficiency - more accessible, reliable and voluminous information; lower transaction costs, higher liquidity and trading volumes, practicality of trading. The opposite conditions mean inefficiency that can be exploited for profit.

Research tests of market efficiency have also uncovered several anomalies: small firm stock returns outperform those of large firms in January; less liquid / less traded stocks and those not widely held by large institutional investors outperform their opposites (which more or less equates to small firms); firms with low accounting book-to-market ratios outperform. Such anomalies signal possible investing strategies for the individual, even allowing that markets have a high degree of efficiency.

Widely followed, highly visible large companies on major exchanges are unlikely
to give the individual investor the best opportunities to make significant excess profits. Instead, the best place to search is amongst the neglected, the less-known where there are fewer of the highly skilled professional institutional investors against whom the individual investor must compete.

Efficient Market Implications:
1) Best Investing Possibilities for Outperformance by the Individual Investor:

• smaller companies - do a sort by market cap size and pick the low end
  
• companies with little or no analyst following - most discount brokers show analyst ratings so focus on companies with no ratings
  
• companies with low trading volume - check the trading volume on the market info about a stock
• January - do your buying then, especially at the beginning of the month
• companies with low book-to-market ratios - this does not mean every such company will experience good returns, many are real dogs
• emerging markets - where information is harder to obtain
• what you know - popularized by Peter Lynch in his classic book One Up on Wall Street, the idea is that the average person may be able to have an information advantage over even the pros in a specific sector or about a specific company

2) Where Outperformance is Unlikely

• technical analysis and the detection of patterns in stock price movements alone has, unfortunately, never proved successful in any proper examination so this is likely not a good method to look for excess returns
• large companies in highly efficient markets of developed countries - USA, Europe, Canada; passive index funds are a surer route
  
• one stock only is very risky; diversify - even the best stock pickers amongst the professionals have some losers amongst their big winners so it is unwise just to have one or two holdings; against this is the fact that in-depth knowledge becomes impossible with dozens of holdings. It is a trade-off and there is no perfect guide.

The suggestion that the above areas are the more promising does not mean that automatically any such stock is a good buy. The due diligence collection and analysis of information is essential to realizing those better odds.

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

The Annual Investment Review: Part 2 - Tax Matters

The preceding post contained suggestions for an annual review and revision of investing goals, performance, savings and withdrawal rates, portfolio structure and rebalancing. This second post completes the proposed annual review by listing some ways where income taxes can enter into plans for the coming year.

Tax-related actions aim to help save on taxes in the short or long term. Actions to consider:

• RRSP catch-up contributions and loan - pull out the CRA's confirmation letter from last year's tax return to see how much RRSP room you have; if there is too much room for your cash on hand, this might be an especially favorable year to take out a loan to do the catch-up since RRSP loan rates are as low as 2.5 to 3.25% at some financial institutions. RRSP loans generally pay off if either the loan is repaid within a year or if the tax refund from the contribution is reinvested, as CanadianFinancialDIY analyzes in RRSP Loans: What to Do and Not to Do.
• Charitable donations through donation in kind of securities with capital gains, since there is no capital gains tax to pay on in-kind donations, as opposed to selling shares and having to pay tax on gains, or to using cash on which income tax has already been paid. CanadaHelps.org even provides a convenient online service to make the in-kind donation to virtually any registered charity in Canada.
• Loan to a lower income spouse for him/her to invest, due to the current low level of interest rates that CRA accepts (1% as of 4Q09 - see CRA page updated once per quarter). TaxTips.ca's Income Splitting discusses ins and outs, pros and cons.
• Create pension income by converting an RRSP into a RRIF - At age 65, if not receiving $2000 of pension income from other sources, consider converting enough of RRSP or LIRA to a RRIF to obtain the pension tax credit as TaxTips.ca describes in detail.
• TFSA contribution - another $5,000 in contribution room for has become available for all taxpayers as of January 1st (to which can be added $5,000 for 2008 if no contribution was made last year), providing another opportunity besides the RRSP for investments to grow tax-free.
  
• RRSP/LIRA Conversion to RRIF/LIF at age 71 - if this is the year you turn 71, then the conversion must take place by Dec. 31, 2010, or else nasty penalties apply, so it is good to note and plan for this at the start of the year (see TaxTips again for details).
• Fixed Income in Tax-Sheltered Accounts, Stocks in Taxable Accounts - to the extent possible when you have multiple accounts and within the target asset allocations, fixed income investments that produce primarily interest should be in TFSAs, RRSPs and other types of tax-sheltered accounts, while a taxable account should contain equity investments that create dividends and capital gains.
• RESP Contribution - the new year for investing tax-deferred money to fund higher education and to obtain the government's CESG grant of 20% on contributions up to $2500 for 2010 was January 1st. The earlier the investment is made and the grant is received the longer the funds have to grow sheltered from tax.
• RRIF & LIF Withdrawals - the dollar amount for the 2010 withdrawal minimum (for RRIFs and LIFs) and maximum amounts is set by the standard percentages applied to the year-end account balance. It helps the year's planning to see early on when year end statements are available what those amounts will be.

That's a fair amount to keep the DIY online investor busy but the effort is worth it in taking advantage of all the opportunities as early as possible and making life easier throughout the year.

Disclaimer: this post is my opinion and for information only and should not be construed as investment advice or recommendations. Nor is it to be taken as tax advice, merely information to get started. To be sure, consult an accountant.

The Annual Investment Review: Part 1 - Review Goals & Performance, Rebalance

At least once a year, it is a good idea to take stock of progress on investments and plan any required adjustments. The beginning of a new year offers a convenient time since account statements and year-end market statistics are available for review, and since many funds and ETFs distribute cash that can or should be reinvested and new contributions to RRSPs and TFSAs may be made. Here is a suggested process to follow. This first part deals with general investment planning while the second part to follow talks about tax-related matters.

1) Review Investment Goals
Are the objectives set in your plan (see Setting Investment Objectives post on how to do this) - retirement, house purchase, vacation, vehicle, education etc - still valid as to dollars required and timing? A new child, a death, an illness, or some other life event may trigger changes to financial priorities and the investment plan must adjust. Money that will be needed within the next few years should be in highly stable, secure and liquid forms. like cash, money market funds, T-bills, or perhaps GICs if the spending date is far enough away and fixed.

2) Tally Performance and Total Savings or Withdrawals The next step is to see how the year has gone towards meeting investment goals by taking all year end account statements (RRSP, Regular taxable, LIRA, TFSA etc) and summing account value. The grand total portfolio is what matters not the performance of individual holdings or accounts. Compare 2009 not just against 2008 since the huge down then up swings cannot give an accurate picture of the longer term trend. Go back four or five years to compare.

For people in savings mode, there should be an increase, perhaps not since 2008, but certainly since 2005. One way to benchmark is to compare your own portfolio performance with those of simple, standard portfolios, as described in this previous post. Refine this by removing inflation to see if there has been a real after-inflation increase (get inflation figures from the Bank of Canada Inflation Calculator). Check also the net contributions to accounts against what was planned in last year's review. The idea is to decide how much you need to put aside in the coming year to attain goals and to make adjustments to current spending and savings rates.

For people in retirement pulling money out of accounts, multi-year totals that show the portfolio increasing are very reassuring as that indicates long term sustainability. Where there is a net portfolio reduction, the key is to have kept the amount of withdrawals as close as possible within the sustainable rate e.g. for a portfolio to last indefinitely, taking out about 4% a year is sustainable as this previous post discusses.

3) Alter Portfolio Structure (if required) Major changes to financial fortunes or life circumstances during the past year may either increase or decrease the capacity to take on investment risk and consequently the mix of investments. A large inheritance may suggest a shift to a more stable, less risky and lower return portfolio since higher returns are no longer required to reach investment goals. A new job with a high salary, enabling a higher savings rate, but which is in a volatile sector, may also suggest a shift to a lower risk portfolio with no connection or correlation to the industry of the job.

4) Rebalance Portfolio to Target Asset Allocations The next step is to plan the purchase and sale of securities in the portfolio to get back to the target allocations as originally set up, or as newly modified. Previous posts on Asset Allocation and on Rebalancing discuss this in detail and give examples of how it is done.

Rebalancing can be quite simple during saving and investment accumulation years. During retirement years, when cash is being withdrawn, it need not be much more complicated. A portfolio can be designed from scratch to produce income - see the example in Generating Cash form the High-Yield Couch Potato Portfolio. Or, it may be done as part of asset allocation - see Generating Cash with Global Couch Potato Portfolio.

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

Company Risks - Pension Plans and the Z-Score

Bankruptcies and underfunded pension plans are painful not just for pensioners but for investors too. Pension plan underfunding is one company risk indicator that an investor should examine closely. Underfunded pension obligations that become too onerous may cause a liquidity crisis in a weakened company and may be a catalyst for bankruptcy. Companies are obligated to make up pension underfunding with extra catch-up payments, which can harm the company's chance of survival. Westlaw's Bankruptcy Risk: Pension Underfunding in Overdrive describes the difficult situation in some of Canada's best-known companies like Air Canada and AbitibiBowater.

Recently, Rob Gerlsbeck at MoneySense evaluated the status of pensions at 181 public Canadian companies in The Top 22 Pensions in Danger. His table (which can be downloaded as a spreadsheet for further sorting and filtering) uses two very useful figures to assess pensions in danger: the percent underfunding (pension plan liability vs pension assets) and the Altman Z-score, which estimates the risk of near-term bankruptcy using accounting figures. This table can help an investor screen in, or out, potential investment targets.

The Altman Z-score is a reasonably reliable predictor of company bankruptcy according to the Wikipedia article on the subject but extensive lists where the calculation has been done are not readily available to the online investor. Investopedia's Z Marks the End walks through the example of how the Z-score foretold of trouble at WorldCom and discusses limitations of the metric. To do one's own Z-score calculations, there is an online calculator at CreditGuru, or one can build one in a spreadsheet with the formula. The required accounting data is found in company financial reports.

The crash of 2008 hit pension plans hard through lowered values of the shares which comprise much of the assets of such plans. The recession added to stress on company operations and drove some famous names like GM and AbitibiBowater into bankruptcy. There has been modest recovery in pension solvency during 2009 along with the stock market but the federal pension regulator, the Office of the Superintendent of Financial Institutions, said that the average solvency of the 400 plans it monitors rose only from 85% in December 2008 to 88% in June 2009. This is still lower than any other point since 2003.

Averages cover a wide range of individual company situations, from the desperate like Extendicare REIT, to the extremely solid like Corby Distilleries, as the MoneySense table shows. Further digging may also reveal a different picture, such as the fact that Zarlink's pension plan, though unfunded and described as in danger by MoneySense, has been protected in other ways as CanadainFinancialDIY writes. Investors, like pensioners, need to monitor this risk hot spot when buying or selling stocks.

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