Tuesday, 29 December 2009

How to Fix Overconfidence, the Worst Investing Attitude Problem

Corralling and correcting one's own behaviour avoids investing disappointment and leads to financial success.

The Overconfidence Problem
Believing oneself to be an expert when one is not, or thinking that one knows the outcome when one does not, is said to be the most common and costly fault of investors. Overconfidence manifests itself through excessive trading, over-extended bull markets and speculative bubbles as research summarized on Behavioural Finance tells us. Overconfidence is not a problem of stupidity - intelligent people are no more or less susceptible than others. Men investors are apparently more prone to overconfidence than women (according to a famous study by Barber and Odean, who are men, it might be noted)! So are highly educated people and professionals like engineers, doctors and lawyers (so says Richard Deaves in his book What Kind of Investor Are You?). The underlying causes of overconfidence: a) too much trust in one's intuition and b) taking the shortcut of looking for and finding patterns, which are sometimes real, sometimes imaginary, and then thinking without questioning that they will continue or be repeated. If you say, "not me, I'm not overconfident", try this amusing little test from Tim Richardson.

1) Feedback - Learning from experience was found to lessen overconfidence by Russo and Schoemaker in Managing Overconfidence. Learning only happens when there is feedback so that a person compares original assumptions and logic against what actually happened. An investor should compare expected vs actual results and ask why they are different. An annual portfolio checkup is one possible occasion to do this. Any buy or sell point is another opportunity. It is important to write things down to avoid mis-remembering things, as we are woefully prone to do (see Rosy retrospection error in previous post Five Common Investor Judgement Errors and How to Counter Them)

2) Counter-arguments - Seek the contrary viewpoint to your own before taking action. Look at whatever free research your online broker provides on a company. Search online investment forums like Financial Webring, OnlineTradersForum, Motley Fool, Canadian Business and post a question. If you are a man, ask a woman, you may well get a valuable alternate viewpoint.

3) Awareness - Merely being told that overconfidence is a danger apparently helps according, again, to Russo and Schoemaker. As the hoary expression goes, recognizing that there is a problem is the first step towards a solution. Consider yourself told.

4) Homework - A source of the gap between what people believe about their own ability and the reality of their ability is whether or not work has gone into a decision. Thus, you may ask yourself "have I worked hard at getting and checking my decision and have I done all that I can?" The more work you do, the less overconfident you become and the better the decision in terms of outcome. If an investment looks easy or obvious, you should worry that you over-looked something. You should be able to list pros and cons. You will improve the odds that Larry Kersten's witticism refers to - "Overconfidence - Before you attempt to beat the odds, be sure you could survive the odds beating you.

In investing terms, survival is short and long term. Big and small investments both count. Repeated small investing losses that are not each individually disastrous, can add up to big losses and that is often what happens. Taking steps to control overconfidence brings one closer to a proper level of confidence.

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

Tuesday, 22 December 2009

Dollar Cost Averaging - the Good Truth and the Bad Myth

Investopedia defines Dollar Cost Averaging (DCA) as "The technique of buying a fixed dollar amount of a particular investment on a regular schedule, regardless of the share price. More shares are purchased when prices are low, and fewer shares are bought when prices are high. ... Dollar-cost averaging lessens the risk of investing a large amount in a single investment at the wrong time." Part of DCA so-defined makes good investment sense and part of it is bad, faulty thinking.

The Bad, Faulty Logic
The idea that you can lower risk and get either the same return or a better risk-adjusted return by spreading your security purchases out instead of making one lump sum investment is wrong. The reason it is wrong is that markets more often go up than down, just over 50% of the time day to day, with the percentage rising steadily as the interval goes up to weeks, months, years and decades. The sooner you are invested in the market, the more the odds favour making more money. That doesn't mean you would never be better off doing DCA - if markets head down then it can pay off. But if you do DCA then it means you think the odds are more that it will go down till you are finished putting in money as you end up buying more low. Most of the time, you will end up buying higher as prices move up, i.e. probably some "buy low" and more "buy high".

Both in practice and in theory, studies demonstrate, as referenced in the excellent Wikipedia article on DCA, that DCA does not benefit an investor who has the choice of investing today or tomorrow.

If you are worried about the market tanking or need the money within a few years, you are far better off just keeping it in cash.

The Good Investment Sense
Following a regular, sustained automatic program of saving money and investing it whether monthly, quarterly or annually is a great strategy since it overcomes the fundamental problem with so many people (been there myself) of just not getting round to setting aside the money.

Investing the money when it is available adheres to the basic principle of not trying to outguess or time the market. In many cases, recommendations on various investment websites to do DCA mean only automatic periodic investment to avoid market timing, a smart strategy. They do not assume the presence of a lump sum investment alternative, such as when an inheritance is received. When a large lump sum is at issue, DCA makes no sense.

Far better is to split up the lump sum immediate investment and parcel it according to your target portfolio allocations (see previous posts on Asset Allocation and A Written Investment Policy). That way the risk is spread amongst a number of types of assets and holdings. This is a good way to lessen the anxiety of making the wrong choice, which is likely at the root of DCA's enduring popular appeal as a supposed risk reduction tactic despite the debunking it has already received.

Along this latter line of thought, famous finance professor Kenneth French puts forward, in this short video on Dimensional Fund Advisors, the idea that DCA can help the investor. He says the economic argument is clearly against DCA but the avoidance of an over-reaction to a big market drop after a single large investment lends some support to DCA. Since the series of DCA investments will not have as much shock effect as one big downward move, a kind of emotional risk diversification is apparently achieved. The investor is less likely to permanently and entirely turn away from the market.

Transaction costs are an issue for the regular saving investor. Mutual funds do not charge such fees but buyers of ETFs or individual stocks must pay commissions so small purchases may entail significant relative costs, even at low discount broker rates - e.g. a $10 commission on a $200 trade is a 5% burden that must be recouped in the rise of the investment. There is no hard and fast optimal percentage at which to buy since markets may move slowly or quickly, but in my view it makes sense to accumulate enough contributions to lower the transaction cost to a maximum - 1% is my rule of thumb.

The bottom line: if you are contemplating doing dollar cost averaging, make sure you are doing it for the right reason.

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

Thursday, 17 December 2009

Emerging Market ETFs Compared - Canadian-Traded ETFs

The preceding post introduced Emerging Market ETFs and compared the mainstream alternatives traded in US markets. This post now looks at the EM funds traded in Canada and gives my overall opinion.

ETFs Traded in Canada

The main choices below are clones of the US funds. They offer a Canadian investor the convenience of being traded in Canadian dollars, which means avoiding the foreign exchange conversion fee (implicit in the buy vs sell rates) of about 0.5% charged by discount brokers. That, plus convenience features like automatic free dividend reinvestment (DRIP), pre-authorized chequing contributions (PACC) and systematic withdrawal plans (SWP) may offset the annual extra expense ratio of 0.1 to 0.3% compared to the US version of the fund. All are very recent, having been launched in 2009.
  • BMO Emerging Markets Equity ETF (ZEM) - newest entrant in October 2009 and still tiny, consists primarily of VWO with other ETFs to boost holdings in India, Taiwan and Russia. Boasts the lowest MER amongst the Canadian ETFs
  • iShares CDN MSCI Emerging Markets Index Fund (XEM) - holds only EEM; and adds only 0.10% to that fund's MER. The strength of the Canadian dollar and/or the weakness of the USD vis-avis Emerging Market currencies is evident in this chart showing how XEM, in CAD, has under-performed EEM, in USD
  • Claymore Broad Emerging Markets ETF (CWO) - holding 100% VWO and is hedged to USD, but is this the right currency to hedge? see assessment of hedging by CanadianFinancialDIY Hedging imposes costs on the fund and CWO is already significantly under-performing the US parent VWO as this chart shows
Comparison Table

Which is the best EM ETF for the Canadian investor? (my opinion only, see disclaimer below!)
For someone with a reasonably large EM holding of $10,000 or more, or who can avoid currency fees by either having an account that can hold US currency or through doing wash trades (see TaxTips.ca's explanation for registered accounts), I prefer iShares' EEM for its close tracking of the MSCI, and its good diversification. ADRE is an interesting large cap alternative with low costs and good historical performance.

For small holdings and to trade in Canadian dollars, two ETFS I find to be fairly equal: XEM for its mimicing of the US alternative I like best and ZEM for its low MER and DRIP, though its size is (till it attracts investors) a disadvantage.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation and that past performance may not continue, costs may change and other comparative factors like taxes may alter their value to you. Do your homework before making any decisions.

Tuesday, 15 December 2009

Emerging Market ETFs Compared - US-Traded ETFs

What are Emerging Markets?
Emerging Markets (EM) are those countries with less advanced economies, the lower half of the world per capita income spectrum. Led by the big four, so-called BRIC countries, of Brazil, India, China and Russia, the list also includes South Korea, South Africa, Argentina, Chile, Czech Republic, Egypt, Hungary, Indonesia, Israel, Malaysia, Mexico, Pakistan, Poland, Taiwan, Thailand, and Turkey.

There are several providers used by the various ETFs to construct an index to represent the countries and the companies to include, just as the S&P TSX Composite is used to benchmark the Canadian equity market.

  • S&P Emerging BMI Index - 21 countries, excludes South Korea (considered developed); 2252 stocks; goes down to the smallest and least liquid companies of the three indices

Why Emerging Markets?
Growth: Emerging Markets countries are harder and harder for the Canadian investor to ignore. In July Bloomberg reported that Emerging countries now constitute 24% of world equity market capitalization, up from 18% from only the start of the year. EM stock markets have bounced back much more strongly from the 2008 crash during 2009 than any of Canada, the USA or Europe.
Diversification: Not only have such countries offered faster economic growth and stock appreciation than developed countries, they offer Canadian investors companies in sectors weakly represented in Canada's TSX equity index, such as information technology, health care, industrials and utilities. As a result of the different industry structure, economic policies and exchange rate fluctuations, the equity returns from these countries do not move in perfect lockstep with Canadian or US returns, allowing an investor to construct a more stable portfolio by including such holdings.
Risks: EM countries are less stable economically, less well regulated financially and more prone to corruption and other problems that make stock investing riskier. The swings of their stock markets, individually and even as an group, have been much more pronounced, which is the prime reason to reduce risk through an ETF with many company and country holdings and to not go overboard as a proportion of portfolio.

ETFs Traded on US Markets
The largest and best established ETFs available to Canadian investors are traded on US markets. Though that means they are denominated in US dollars (USD), the real currency exposure is, since none are hedged against currency shifts, to the combination of all the EM countries, not the USD (see CanadianFinancialDIY's explanation). The list below includes only broad market ETFs. There are many others available, ranging from individual country funds, to groups of countries (e.g. BRIC), to leveraged bull and bear funds - see the Stock-Encylcopedia's Emerging Markets list.

  • Vanguard Emerging Markets ETF (symbol: VWO) - massive fund with lowest expense ratio and broadest actual diversification - most companies held, least concentration by country
  • iShares MSCI Emerging Markets Index Fund (EEM) - the big daddy fund, largest and most liquid; high expense ratio but has done best job tracking its chosen index, the MSCI and has out-performed VWO, which tracks the same index, by a cumulative 8% since 2005, as this Google Finance chart shows
  • Powershares FTSE RAFI Emerging Markets Portfolio (PXH) - unique strategy selects holdings based on accounting value factors; highest expense ratio of the lot but has outperformed all the others by a bit since its founding in 2007 (see chart below)
  • BLDRS Emerging Markets ADR 50 Index Fund (ADRE) - focused on a few large companies and thus least diversified, but its ADR holdings get the benefit of being obliged to meet higher accounting and reporting hurdles; has performed better than both VWO and EEM since 2005
  • SPDR S&P Emerging Markets ETF (GMM) - quite new with 2007 start-up, having trouble tracking its index and trading at a very high discount to NAV of 1.4% as of 31 Oct 2009; lots of holdings, not concentrated but excludes Korea
Comparison Table

That's already a good selection of Emerging Market ETFs for the Canadian investor to choose from. The next post will review the Canadian-traded ETFs.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation and that past performance may not continue, costs may change and other comparative factors like taxes may alter their value to you. Do your homework before making any decisions.

Thursday, 10 December 2009

Tax Loss Selling Explained: What, Why and How

Tax loss selling is a strategy often recommended to investors but seldom explained. Let's explore how and why can investors benefit.

What is Tax Loss Selling?
It is the sale of investments whose value has dropped below their original cost in a taxable non-registered account. The purpose is to realize a capital loss in order to offset a capital gain. The loss must be applied first against current year gains and after those have been wiped out, the investor may apply the loss against gains within the past three years, (gains further back are not eligible, which is the reason for meeting the 2009 deadline so that possible 2006 offsets are not lost), or may carry it forward indefinitely. Income taxes paid on capital gains in prior years will be refunded to the investor upon filing the proper forms. The capital loss only applies against capital gains. It cannot offset employment income, interest or dividends.

Why do it?
The tax refund is attractive in itself - it is money in the pocket. Beyond that, for investors who intend to stay invested, who do not want to spend the capital or the refund, tax loss selling can provide a significant benefit. For example, imagine an investment that dropped a lot during the 2008 crash and has not yet recovered. The investor is in for the long haul and thinks it or a similar investment will recover and so wants to stay in the market. The following table shows how the numbers can work for the investor by a comparison of a) tax loss selling or, b) continuing to hold the investment that has gone down.

Example Assumptions:
  • $5000 capital gains in previous years - tax was paid at the time
  • $5000 paper loss on current investments is realized through a sale
  • loss is claimed against previous gains, netting a tax refund
  • tax refund is reinvested
  • investment is then held for ten years; both tax loss sale and hold get the same subsequent return
  • scenario 1 - low growth of 3.3% per year
  • scenario 2 - faster growth of 6% per year
Example Table

Example Results:
  • tax loss sale produces higher after-tax wealth (see the green cells) whether the investment grows slowly or quickly afterwards, even when the "hold" investor has no taxes to pay at all down the road
  • the higher the rate of growth in the investment, the more tax loss selling pays off in eventual net wealth
  • the higher tax bracket of the investor, the greater the benefit because there would be a larger refund to re-invest
  • tax loss selling (example not shown in table) even pays off when the investor moves into a much higher tax bracket by the time of cashing out
Tax loss selling gets its advantage the same way that RRSPs do. The combination of getting a tax refund, which creates a larger initial investment amount if the refund is re-invested, plus the tax-deferred growth of that larger initial amount (highlighted in the orange cell) generates greater net wealth down the road.

This logic indicates the circumstances when tax loss selling should be done or not:
  • do it to claim against past capital gains on which you have paid income tax
  • do it if you have realized capital gains in the current year against which you have paper losses that can be realized and applied to reduce or eliminate income tax on the gains
  • defer realization of capital gains as long as possible - the longer you can keep the investment and defer taxation, the more the full amount can grow. Of course, if you think the investment's prospects are negative or you have a much better investment in mind, then selling also makes sense. Letting your investing be driven by taxes is a mistake. It's better to make a profit and pay tax than to make a loss and pay no tax.

How to do it
Carrying out tax loss selling properly must conform to the rules of the tax authority, the Canada Revenue Agency (CRA). That can be tricky. Here are a few resources to help:
The December 31st deadline for transactions (trades of stocks and mutual funds at latest Dec.24th) to count in the 2009 tax year is fast approaching. Take a look at your taxes for past capital gains and your portfolio for paper losses to see if there is an opportunity to gain from tax loss selling.

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.

Tuesday, 8 December 2009

ETF Comparison: Canadian Large Cap Equity Funds

ETFs are steadily rising in popularity as Larry MacDonald described recently in ETFs Pulling Ahead on Canadian Business. The traditionally dominant iShares funds are starting to get some significant competition, first from Claymore Canada, which entered the market a few years ago, then from Horizons BetaPro and most recently from BMO Financial Group.

It is an opportune moment to compare the ETF entrants in one of the main portfolio building blocks - Canadian Large Cap Equity, which makes up just over 70% of the total value of TSX listed stocks. In Canada, the usual measure of large cap is the 60 largest companies by market capitalization on the TSX.

  1. iShares™ CDN LargeCap 60 Index Fund (Symbol: XIU) - the ETF that has attracted the most investor money by far and the oldest too. As a passive tracker of the S&P TSX 60 index, it mimics the TSX 60 as closely as possible.
  2. BMO Dow Jones Canada Titans 60 Index ETF (ZCN) - the newest entrant, on the market only since May 2009 but backed by financial industry heavyweight BMO Financial Group. Another passive index tracker though it uses the Dow Jones Index which also adjusts for the market float and trading volumes differently than the S&P method, though the holdings end up very similar to XIU and so will the performance.
  3. Claymore Canadian Fundamental Index ETF (CRQ) - has been around for a few years and tracks a different index, called the FTSE RAFI Canada Index, whose methodology relies on accounting factors to weight which companies are worth investing more or less in. As a result, its 65 holdings and market performance diverge considerably from the other three ETFs.
  4. Horizons AlphaPro Managed S&P/TSX 60 ETF (HAX) - launched in January 2009 it is one of the first actively managed ETFs, where the managers use their wiles to try to outperform through picking and choosing from the top 60 stocks. Some drastically different weightings result.
Key Comparison Factors (click on table below for details):

Management Expenses (MER) - BMO's ZCN is lowest by a hair at a miniscule 0.15% versus iShares XIU's 0.17% while the other two are significantly higher - by 0.5% or more.

Trading and Rebalancing - With an index that rebalances only annually, ZCN should incur less trading commission costs (which are borne directly by the fund and are not included in the MER) and possibly even fewer capital gains distributions than XIU or CRQ and a lot less than Horizons' HAX, which can be expected to have much higher turnover from its active management strategy. Time will tell tell if that turns out to be true.

Size, Liquidity, NAV Discount - Size does matter with ETFs. A bigger fund means tighter bid-ask spreads (i.e. a slightly higher price when you sell at market and a lower price when buying at market), easier trading of larger amounts of shares and a smaller difference between the net asset value (NAV) per ETF share and its market price. As a small fund, ZCN is at a disadvantage compared especially to XIU, which is easily the best on these factors, but that may change if (as?) ZCN grows to a respectable size. CRQ also suffers from a size disadvantage compared to XIU. HAX is tiny, almost to the point of not being viable.

Holdings - ZCN and XIU are much less concentrated than CRQ and HAX. The top 10 holdings make up only 47% of the total portfolio while CRQ and HAX are up around 55%. ZCN and XIU hold almost all the same companies - only seven are different in the two lists - and very closely in the same order and weightings (green cells in the chart below). CRQ and HAX are quite different from each other. HAX's latest published list (a demonstration of its lesser transparency compared to the other three ETFs, which update their online holdings list on a daily basis) of September 30th holdings suggest that the managers are bullish on gold and energy, with significantly higher allocations to gold mining and energy companies.

Features - CRQ offers the investor the most convenience through optional plans to have dividends automatically reinvested (DRIP), or for automatic purchases through pre-authorized chequing (PACC), or for automatic regular withdrawals (SWP - Systematic Withdrawal Plan). These also save the investor the commission cost for buying or selling. ZCN offers an optional DRIP, while HAX makes dividend reinvestment mandatory. XIU has no such features at all.

Tracking Error - this is the measure of how well the ETF mimics its index, obviously, closer being better. XIU does best on this score with a very small annual under-performance. ZCN's has been quite high over and under in its short existence. Will ZCN's improve with time? Claymore does not supply a tracking error chart for CRQ, a negative in this writer's view. For HAX tracking error is not relevant since it explicitly does not aim to track any index.

Performance - so far, at least, HAX is not living up to its objective to outperform the TSX 60 index, as shown by this Google Finance chart.

On a year to date basis to October 2009, CRQ has done far better than XIU or HAX, as this chart shows.

Great, we might think, that's the best fund. Just a minute, here is a longer term chart going back to the 2006 start-up of CRQ. There was a time in 2008 that XIU leaped far ahead of CRQ and overall XIU and CRQ have provided about the same return in the past four years. What will the future bring?

Which ETF is Best?
In the absence of proven long term superiority of the alternate RAFI index or of active management, my preference is for the lesser concentration and the lesser costs of XIU and ZCN. XIU is a proven performer but ZCN is a credible alternative and has the additional convenience, not available for XIU, of automatic no-commission dividend reinvestment. The other convenience features of CRQ (SWP and PACC) may be attractive to some investors. HAX is for those who have faith in the unproven ability of its mangers to outperform and justify its higher fees. Hopefully, this comparison gives readers a sound footing for making their own choice.

Whatever your preference, all investors can only benefit from the increased choice of types of funds and from the competition amongst suppliers.

Disclaimer: this post is my opinion only and should not be construed as investment advice. Readers should be aware that the above comparisons are not an investment recommendation and that past performance may not continue, costs may change and other comparative factors like taxes may alter their value to you. Do your homework before making any decisions.

Thursday, 3 December 2009

The Historical Effect of Inflation and Currency on a Canadian Investor's International Portfolio

To figure out whether a portfolio has made any real gains, an investor must subtract inflation and include any currency gains or losses on international holdings.

Let's look at some past actual data, taken from a downloadable spreadsheet by Norbert Schlenker at Libra Investment Management.

Performance of an International Portfolio 1992 - 2009
The portfolio: growth-oriented combination of
- 35% fixed income (5% Canadian T-Bills, 30% All Canadian Bonds)
- 65% equities, of which 25% is Canadian (TSX Composite) and 40% is foreign (15% S&P 500, 15% EAFE developed countries, 10% Emerging Markets)
This portfolio would have achieved a 4.6% real annual compound return. That might seem low until one remembers that in most such comparisons inflation has not been removed and inflation accounted for about 1.8% return lost each year in this period.

The chart below for the test portfolio exhibits some typical benefits of holding a mix of different types of assets:
  • bonds and t-bills dampen and stabilize the swings of the total portfolio
  • individual equity classes have much wilder swings year to year than fixed income
  • the portfolio does better than T-bills and bonds alone
  • individual equity classes move together in some years and in opposite directions in other years, the non-correlation that provides diversification benefits

Inflation and Currency Effects
The real return chart above includes not just the market returns of the assets, it has taken account of inflation and currency swings.

The following chart shows how significant these factors can be. Inflation is a constant, unavoidable, always negative drag on the real value of investment returns. Currency shifts have been quite significant, both as a positive boost to, and as a negative reduction of, foreign returns. About half the time, the currency effect was positive (8 out of 18 years). In several years when most stock markets tanked worldwide, like 2000, 2001 and especially 2008, the currency swing benefited the Canadian investor.

It seems that the historical data does support the conclusion that currency hedging is not necessary for a longer term investor, as explained in our recent post Foreign Investment: to Hedge or Not to Hedge Currency, which discussed the pros and cons of hedging and how to do it if so desired.

The above charts still do not reflect exactly what an investor could have done in practice. To more accurately simulate a true investor experience, there would need to be a few more downward adjustments: 1) deduction of management fees, averaging around 0.3% per year for typical ETFs that cover these asset classes 2) rebalancing trading commissions to keep the portfolio at its target allocations in each asset class (e.g. 5 annual rebalancing trades at $10 each would be $50, or 0.1% yearly cost to a $50,000 portfolio). ETFs for all these asset classes did not exist in 1992 and higher cost mutual funds would have been the only investment vehicle. But today they are available, so such historical "what if" reconstructions can serve to form reasonable expectations of what might happen to a Canadian investor with an international portfolio.

For those who might like to play around and try out various combinations of types of assets, more scenarios and portfolio options can be tested out using the excellent spreadsheet. The spreadsheet includes all the basic building block asset classes like Canadian T-bills, short and long term bonds, real return bonds, TSX equities, the S&P 500 large cap, the Wilshire total US market, the MSCI EAFE (Europe, Australasia Far East developed countries), MSCI Emerging Markets and even gold. Foreign returns have been translated into Canadian dollars and yearly inflation effects are shown in tables of nominal and real (inflation removed) returns. The annual data has been updated to the end of 2008 and it goes as far back as 1970.

Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations. It is merely an examination of historical factors that an investor may wish to consider in making his/her own decisions.

Tuesday, 1 December 2009

Foreign Investments: To Hedge or Not to Hedge Currency

Investors who take up the advice to diversify by broadening their investments to foreign holdings must face the issue of whether to hedge the foreign exchange.

Hedging means an attempt to remove the effects of foreign currency fluctuations so that, for instance, a 10% gain in a US equity fund denominated in US dollars (USD), remains a 10% gain when translated into Canadian dollars (CAD). Without hedging, a 10% rise in the Canadian dollar would completely offset the US fund gain. Of course, the effect works the other way too - a falling Canadian dollar boosts foreign returns. Last fall the drastic fall in the Canadian dollar against the USD cushioned the effect of the market crash, as noted in a post at the time A Falling Canadian Dollar Can be an Investor's Friend. Given the two-way potential of foreign currency influences, is hedging worth doing for the average individual investor?

For and Against:
  • over long periods of 15 years or more, academic research shows that there is little or no difference in returns between hedged and unhedged portfolios except for hedging costs - e.g. Hedging Currencies with Hindsight and Regret and Currency Risks in International Equity Portfolios
  • within the short term, such as a few years, currency shifts can be quite large and the shifts can reverse course quickly, possibly overwhelming the actual stock or fund return. Compare the following two charts from RatesFX of the CAD vs other major currencies as of October 26, 2009 where blue indicates CAD appreciation and red, depreciation - over one year CAD was up 18% over the USD, 2% over the Euro, 17% over Pound Sterling and 12% over the Japanese Yen. These rises would be all bad for the Canadian investor. Over the past three years, the story changes: the rise was only 7% against the USD, 20% over the GBP but there was decline of 11% versus the Euro and 19% versus the Japanese Yen. It is a mixed bag - the CAD appreciation being bad, the declines good.

  • foreign currency shifts are very hard if not impossible to predict so deciding to hedge when expecting CAD appreciation is a strategy prone to a lot of uncertainty and error
  • from the perspective of inflation, not hedging makes sense - when the CAD falls foreign goods cost more, so getting a boost from unhedged foreign returns benefits the investor/consumer while CAD appreciation lowers inflation, offsetting some of the lowered investment return.
  • along the same lines, if you spend in a foreign currency, for example travelling or living in the US or Europe, then having assets tied to those foreign currencies alleviates currency risk
  • foreign equities have had positive returns both during multi-year periods when the CAD was appreciating or when depreciating. Keith Matthews' excellent book The Empowered Investor has a table showing that in 1985 to 1991 while the CAD appreciated, returns in Canadian dollars on both US and international equities nevertheless far outstripped returns from Canadian companies
  • hedging costs money to implement and it does not do a perfect job as the discussion below on how to do hedging shows, most often resulting in reduced returns
  • currency shifts themselves appear to account for a portion of the non-correlated movement of non-Canadian securities (see Table 4 Co movements from UBC Sauder School of Business Pacific Exchange Rate Service); thus, currency exposure enhances the risk-reducing diversification within a portfolio
Ways to Hedge
  • currency futures, forward contracts and options used by companies and institutional investors are not really practical for individual investors
  • the most common and easiest way to hedge is to buy ETFs or mutual funds that are labelled "hedged" or "currency neutral". Two such popular ETFs and their corresponding ETFs traded in the US are listed below. The costs of hedging manifest themselves in higher fund MERs and tracking error, as Larry MacDonald explains in a piece on Seeking Alpha called On Currency Hedging and the US Dollar. The graphs show the recent under-performance of hedged funds compared to the reference benchmark that is often the result.
  1. iShares CDN S&P 500 Hedged to Canadian Dollars Index Fund (TSX symbol XSP) and iShares S&P 500 Index Fund (NYSE: IVV). XSP's return lags IVV's, but without the hedging, a Canadian investor in IVV would have gained only 1.8% since January 1st, 2009 (not including the 1% or so further that would be lost when paid to the broker to convert an IVV sale in USD to CAD) instead of the 19% gain of XSP.
  2. iShares CDN MSCI EAFE Hedged to Canadian Dollars Index Fund (TSX: XIN) and iShares MSCI EAFE Index Fund (MYSE: EFA)
Bottom line: though the number of arguments appear to favour not hedging foreign holdings, the key is having a long time horizon since in the short term, there is the possibility of drastically lowered or even negative returns (though it can go the other way too). In the short term, it's just a lot more risky. Again, the investor needs to keep objectives and time horizons in mind to make a good decision on whether or not to hedge.

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

Thursday, 26 November 2009

Five Common Investor Judgment Errors and How to Counter Them

Humans are hardly the rational decision makers of classical economic theory. Researchers have catalogued numerous systematic and repeated errors of judgment that people make when investing. Far from being considered outlandish such conclusions are now mainstream. The research has already garnered a Nobel prize in 2002 for Daniel Kahneman and Vernon Smith. It has also become confusingly vast - see the scores of entries in Wikipedia's List of Cognitive Biases and on the Behavioural Finance webpage.

That's all well and good, but the average investor wants to know what are some of the common mistakes and, more importantly, what can be done to minimize or avoid the bad effects.

1) Loss Aversion - often manifesting itself as refusing to admit to a mistake (which some Nortel investors who hung on too long may relate to), it arises from the curious fact that a loss apparently is felt twice as much as a corresponding gain. The pain of losing a dollar is perceived as much worse than the pleasure of gaining. As a result, investors typically hang on too long to losing stocks and sell too soon after a gain.
Countermeasure: establish buy and sell points in advance when first making the investment. This can be a price target, both on the upside and the downside, which can be made automatic with limit orders. Or the buy/sell trigger can be a financial ratio such as Price/Earnings. The mere act of trying to figure out the action point will probably improve the quality of the initial decision in addition to avoiding the psychological trap of loss aversion.

2) Extrapolation Error - this is the mistake of blindly projecting into the future the pattern of the past, especially the most recent past. This error can consist of extending a negative trend, like "the market is crashing, it won't stop or go back up", or a positive trend, as in the technology bubble that many thought could not end. The error can also apply to individual stocks - assuming that a company which has done well for many years will continue to do so may not be realistic. Witness the post on the comings and goings of the top companies in the TSX over the years.
Countermeasure: a) examine assumptions directly - ask yourself what has underlain the success or failure of the past and question whether that will continue to be the case; b) build best case and worst case scenarios and see whether you would still be comfortable with the outcome if it should happen, especially on the downside; it may be necessary to revise the worst case downwards as conditions evolve - again, the downward progression of Nortel over the last eight years may be instructive. In the early years its demise did not seem at all probable but as successive management teams failed to right the company the outcome became more likely.

3) Anchoring - we all set a point of reference against which to make judgments, often whether we realize it or not, as MIT professor Dan Ariely reveals in his popular book Predictably Irrational with some amusing examples of experiments he conducted. The reference point may be misleading. That having the thought of a higher social insurance number in one's mind could influence upwards the price that savvy MBA students would be willing to pay for unrelated items like wine and computer equipment sounds unlikely and incredible, yet that is what happened. As investors we can trick ourselves into judging whether a price is high or low by looking at the wrong indicator. For instance, the 52 week high-low range of a security's price is a dangerous measure of whether the current price is cheap, whether one anchors on the high or the low. Those past bounds give no guide to the future.
Countermeasure: research the true value of the security, such as by working bottom up with fundamental analysis methods to estimate the price of a security.

4) Nostalgia aka Rosy Retrospection - this error consists of shifting the blame for our portfolio losses to "the market" rather than our choice of investments. And on the positive side, we may take all the credit for good outcomes, whether or not that was true.
Countermeasure: at the outset, make written notes on expectations and the reasons behind them. Later it will then be possible to examine the result against the real initial thinking, as opposed to our faulty rosy memory. To learn from mistakes is a mark of any good investor and we should all seek to do so - e.g. the acknowledged top investor Warren Buffett almost revels in fessing up to his blunders.

5) Optimism Bias - this is the forward-looking counterpart to rosy retrospection. Good outcomes are judged to be more likely than they merit while the possibility of bad outcomes is downplayed. People who are successful in one field, like physicians, engineers, lawyers, athletes etc are especially at risk of thinking they can easily repeat their success in investing.
Countermeasure: look at both positive and negative aspects of an investment. List the pros and the cons, and especially the possible things that could make an investment go wrong. If there are no cons in the list, that should tell you that you have almost surely missed something as there are few free lunches in this world. A question to ask: "if I am willing to buy, why are other people willing to sell at this price?"

A few other sources to amuse and inform on how our brains can mislead us:
  • The Secret Language of Money by David Krueger, M.D. and John David Mann - a psychologist explores how our thinking goes awry and offers practical advice on how to improve judgement in handling money and investing.
  • Mean Markets and Lizard Brains by Terry Burnham - explains the irrational errors made by our "lizard brains" of our evolutionary past and then incorporates current macroeconomic factors to give specific tips on how an investor can thereby profit.
Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations.

Tuesday, 24 November 2009

Taxes on Foreign Investments

Investors who have taken the step of expanding their horizons by diversifying internationally, for example by buying foreign stocks or ETFs, need to be aware of the tax ins and outs, 1) to keep the tax folks at the Canada Revenue Agency (CRA) satisfied and 2) to put such assets in the right type of account.

The first point to recognize is that investing abroad is not a way to escape taxes. Canadian residents are taxable on their worldwide income, including all their foreign income and gains, which probably means taxes to pay unless protected by registered accounts.

Registered Accounts
  • retirement-related accounts like RRSPs, LIRAs, RRIFs, LIFs do not pay any Canadian income taxes while the foreign holdings and associated profits received from sales, dividends and interest remain in the account. That's very convenient as it means there is no tax reporting or tracking to do.
  • TFSAs and RESPs do not pay any Canadian tax while the funds/holdings are inside and so there is no reporting or tracking for them either ... but unlike the retirement accounts above they are subject to 15% non-resident withholding taxes levied by the USA on any dividends or fund distributions (see Canadian Tax Resource's TFSA & Non-Resident Withholding Taxes), which cannot be claimed or recovered.
Non-Registered / Taxable Accounts
A general rule is that for tax purposes, everything must be calculated in Canadian dollars when transactions occur, or in the case of trades, when they settle, normally three days after the trade date.
  • Capital Gains and Foreign Currency - when buying and selling foreign securities (stocks, ETFs and bonds) on foreign exchanges like the NYSE, AMEX and NASDAQ, it is necessary to track and report both the currency conversion in and out, and the actual trades. Canadian Tax Resource (who is an accountant) walks through an excellent example in Exchange Rates, Investments and Income Tax. To be able to report this you will have to keep records of the Adjusted Cost Base (the CRA term for the running total of an asset in Canadian dollars) for each foreign security. The brokerage Book Value cost cannot be relied upon as accurate (through no fault of their own) if there are dividend reinvestments, capital gains distributions and return of capital as explained in a previous post ETFs and Mutual Funds - Calculating Capital Gains. A spreadsheet is a convenient way to track this - CanadianFinancialDIY has a model - go to the bottom of the blog to the My Main Portfolio Google docs spreadsheet and click on the Cost Base tab.
  • Foreign Currency Rate - CRA accepts either a Bank of Canada rate, or the actual one applied by the broker.
  • Foreign Dividends and Tax Credit - all dividend income is treated as ordinary income and taxed at the highest marginal rate like interest by the CRA. It does not benefit from the lower tax rates on dividends from Canadian companies (which excludes those Canadian-traded funds mentioned below). The US and most countries have tax treaties with Canada that result in a 15% withholding tax being deducted from distributions. To avoid double taxation, the CRA allows a Canadian taxpayer to claim a tax credit for this amount - TaxTips.ca explains how this works in Foreign non-business income tax and foreign tax credit
  • Foreign Interest - the CRA taxes such income as ordinary income at the highest marginal rate, just like Canadian interest. The US does not levy any withholding tax on interest from investments. For both interest and dividends, the foreign currency rate to be applied is when the funds are received, though the CRA does allow an annual average rate from the Bank of Canada to be used.
  • Canadian-traded Investments in Foreign Countries - there are many ETFs and mutual funds which hold foreign securities and part of their attraction is that they trade in Canadian dollars, which means the fund companies do all the foreign currency conversion and thus they report to you the investor, with tax slips and the like, in Canadian dollars. There is still the job of tracking the ACB since the funds sometimes distribute Return of Capital (e.g. as did in 2008 the Claymore International Index ETF, TSX symbol: CIE). An alternative to doing one's own spreadsheet for Canadian-traded securities is to subscribe to ACB Tracking Inc., which covers some 700 Canadian income trusts, closed-end funds and ETFs. It is still necessary to enter one's buys and sells.
  • US Estate Taxes - high net worth investors (US$1 million plus) with US holdings may be subject to US estate taxes even if not resident or citizens of the USA. Taxtips.ca explains in US Estate Tax May Be Payable by Canadians.
Which account for which foreign securities?
  • Fixed income is best in a registered account
  • Equities are best in a taxable account to take advantage of the foreign tax credit and the capital gains treatment
Disclaimer: this post is my opinion only and should not be construed as investment advice or recommendations. Nor is it to be taken as professional advice, merely information to get started. To be sure, consult an accountant.

Monday, 23 November 2009

Book Giveaway Winner - It's Lyne!

The draw is done. Congratulations Lyne!! You are the winner of the book. Please contact me by email at jean.lesperance at googlemail.com with your postal details so I can send you the book.

Thanks to all for their investment threat suggestions. Good ideas for future posts on what an investor can do to protect against the threats.

Thursday, 19 November 2009

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.
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.

Tuesday, 17 November 2009

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!
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.

Thursday, 12 November 2009

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.

Tuesday, 10 November 2009

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.