WHY BOTHER MAKING YOUR OWN INVESTMENT DECISIONS?
||Reasons Why To Make Your Own Decisions
- No one cares about your money as much as you do. Why would
anyone think otherwise?
- The advice you get will always be slanted. It's human nature.
- Stockbrokers will recommend trades to generate commissions.
- Financial Planners will recommend ETF's to keep you away from brokers.
- Income Trust promoters will lie about 'return of capital' and pretend that hard cash equals true income.
- Friends won't tell you until after they sell a stock they previously recommended. They want to get their own best price first.
- Etc, etc.
- There is no way to know in advance who is trustworthy, AND
has technical training, AND has application skills.
- Accreditation measures only test-writing skills.
- Church members are scam targets because they think trust is a good personal quality. One could better argue the importance of unremitting suspicion when dealing with money.
- Inevitably, the decision to hire an advisor is based on whether you LIKE the
person. How irrelevant! As J.K. Galbraith wrote, there is a tendency to confuse good manners and good tailoring with integrity and intelligence.
is human nature to accept 'as factually valid' the ideas that agree
with your own preconceptions, or the ideas that are simple to
understand and repeat. You hire advisors who agree with you and don't make you feel stupid.
- 99.9% of professional advisors are incompetent. The proof that lies in their RRSP advice. RRSPs have been (until the TFSA) the bedrock of Canadians' saving-investing-planning since the 1970s. Yet most all the advice given is either wrong in its conclusion, or wrong in its justification (leading you to wrong conclusions when you apply the same understanding in different circumstances).
The detailed argument showing their errors is on the page Nitty-Gritty of RRSP. There have been NO e-mails to the site questioning the math or pointing out errors. Advisors are simply closed-minded, self-satisfied, and don't care whether their advice is right or wrong.
- The cost.
You cannot offload your work without paying upwards of 2%. The beauty of
compounding interest (when you earn it), is how that interest gets
magnified over time. The corollary is that the 2% charge is NOT a
yearly charge you can forget about once made. It will also be magnified
over time by compounding.
Upscale services and vehicles like hedge funds carry an even higher
cost. The Banks have done a great job of marketing their advisory
services by making them available only to 'high net-worth individuals'.
Because they are restricted, we want them more. We want to 'mention'
them at cocktail parties (to brag about our wealth). These services are
no better (or worse) than those offered to poor sods at lower prices.
- You can do just as good a job
as the professionals. They must earn an excess to the 'market returns'
in order to cover their fees. Statistics show they don't do it (except
for small-cap funds). Their compensation is based on asset
values, not performance. Given the choice between a guaranteed return
equal to the market (using index ETFs), or a 50:50 chance of earning
higher (OR LOWER) mutual fund returns, which would you chose?
Academia and the industry are keen to prove you get better performance when using 'a professional'. But the measurement of this proof is difficult. A 2014 paper "Don't Answer The Phone" gets rid of problems distorting other studies. It found that (i) investors traded more frequently after broker-initiated contacts, (ii) that investors' personal security selections had better returns, and (iii) that advisors had little effect preventing behavioral biases. Worryingly, it found that investors continue to accept the advice of advisors even after past advice had been proven poor.
- False promises. Investing is not a simple process. It is not paint-by-numbers. Procedural rules cannot generate gains. Yet that is exactly the promise from advisors and the media. Always, the procedures are claimed (or at least implied) to increase your returns ... no thinking involved. These promises are challenged in various places on this website. Most often it can be shown that there is NO income gain from the process - just a reduction in risk (if even that).
- But..it's too much work. Well, no.
How much time you spend depends on how much you enjoy stock picking. If
you 'have a life' you can simply buy a few large-cap ETF's
and then walk away and forget it (see the Couch Potato portfolio). Or you can ground your portfolio with
index ETFs for solid beta, and take a flyer with a smaller percentage
of your assets for the fun of earning some alpha.
||Let Your Winning Stocks Run : Don't Hang Onto Losers ... FALSE
While one expert says "let your winning stocks run", another will say "no
one ever lost money by selling at a profit.. . Another will say "you haven't made a profit till you sell". So which is it? Advisors choose which to trot out according to hindsight. All the following examples are of the same class, impossible to be useful in real-time, so very patronizing, and insultingly simplistic.
Some experts tell you to only trade after trends are confirmed. They
say "wait until a bottom is confirmed by a 10% move up" and "use stop
losses trailing at 10%". According to this advice you would earn only
7% for every 30% price movement (see figure to right). You would earn nothing if the price
moved 'only' 20%.
After a stock falls sharply one expert will say "you missed a
beautiful buying opportunity" if you did NOT buy and the stock rebounded. Another expert will
call you a "sucker for buying on a dead-cat-bounce", if you bought and
the stock continued down.
Some experts tell you to "protect your capital above all". But
the only way to do that is to buy risk-free government debt. Buying
equities involves sitting through falling prices. If you sell every
time the price falls you will only provide more data for the researchers who have shown that "no one can time the
Some experts criticize investors for "buying high and selling low" (as if people buy because they think the price will fall, or sell because they think the price will rise.) ... yet others advise the opposite: "buy stocks on a break-out" and "never catch a falling
To criticize Retail Investors for not executing to this hind-sight
perfection.!!!. At each and every point in time, all investors ask
themselves; "Is this price move a blip, or a new trend?"; "Will this reverse, or just
keep going?". Neither we nor the experts can know for sure. There is
not one piece of trading advice that does not have its exact opposite,
to be trotted out in hindsight. Do your best and ignore the experts.
||Rule #1 - Don't Lose Money ... FALSE
The saying "There are two rules of investing. Rule #1 - Don't lose money. Rule #2 - Never forget Rule #1" has been attributed to Warren Buffett. But that is no reason to accept it as gospel. The rule is wrong in three ways.
The difference between savings products and investments is the near certainty that the value of any investment will change over time. It will increase AND DECREASE. Hopefully it ends up higher than when it was bought, but in the interim everyone must accept the reality that the price may fall. If you have any delusions about this please read about Price Volatility on the Risks page. The only way to avoid price pull-backs and possible losses is to never invest in the first place.
This saying reflects two measurement 'conventions', not realities of the real world on which to base your decisions. The first measurement convention is to report gains/losses yearly. If the year-end falls immediately after a price decline - there may be a reported loss (chart above). But if a price decline early in the year recovers before the year-end - presto! there was no loss (chart below). It is fate that determines whether the loss gets recorded or not.
The second convention concerns the math for measuring gains and losses - which will appear unequal. E.g. you have to double your money to recover from a 50 percent loss. The $75 gain and loss are the same in $$ terms, but not percentage terms because of the lower/higher denominator (chart below).
75 / 150 = 50% loss
75 / 75 = 100% gain.
This is the issue discussed in the 'Average Returns - arithmetic vs geometric' section of the Rates of Return page.
But who cares about an artificial measurement convention? A lot of people make a big thing about this difference in percentages (Example). They claim "It is harder to recover from a loss because losses have a disproportionate impact on compound interest". They make this issue an investing objective with claims that "Volatility in asset returns acts as a drag on ending wealth" and "Lowering a portfolio's standard deviation of returns will move the compound annual return up". (Reference "Dividend-Growth" (Gerber Vol14, No1,2013).
Garbage. Math is only an attempt to measure reality. It is not a causal factor. A calculation does not change reality.
E.g. the returns of small-cap indexes are well known to be more volatile than large-cap's. But they manage to more-than-recover from downdrafts, and outperform over time. While their Beta is generally higher than the market's, it changes over time becoming larger in bull markets.
E.g. a business that loses one $100,000 customer equaling 25% of total revenues, will recover by finding another $100,000 customer. It needs to replace one customer with exactly the same sized new customer. It is not 'harder' for the company to find the new customer just because they now represent a 33.3% addition to existing sales.
E.g. If your $100,000 portfolio underperforms the benchmark by 5% it makes no difference if you ended with a 4% loss (when the benchmark return was 1%), or if you earned a 10% profit (when the benchmark return was 15%). Your portfolio is smaller than it should be by $5,000 in either case. Losses are just continuations down the scale from gains. They don't have a bigger impact.
It is disingenuous to pretend investors SHOULD not lose money, either temporarily or on individual positions within a portfolio. You WILL lose money. It comes with the territory. The objectives of investing are much more long-term than any individual year that may experience a loss. And your objectives should focus on your total portfolio returns, not just one particular losing position.
||Asset Allocation Determines 94% of Your Investment Returns ... FALSE
The claim that asset allocation determines 94% of returns continues to be widely used by industry in selling both (surprisingly) active and passive products. It is a sales pitch. The advice industry needs a 'service' to sell. The asset allocation recommendation
- is a cheap product to offer. It is computer generated from simple data from a standard questionnaire.
- cannot be 'proved' right or wrong in hind-sight.
- fits into the parameters of good advertisements - a simple and easy to understand product.
- does not involve any other professional (like a stockbroker) who might take away your custom.
- purposefully creates the misunderstanding that your returns will increase after proper asset allocation.
So of course the industry thinks it is really important! It's really important to their business model.
The asset allocation decision does not determine returns. Your expected returns are determined by what assets you own and your ability to realize their expected returns. Different asset classes have different risk - e.g. equity is more volatile than debt. Generally, the higher the risk of the asset class, the higher return that is expected. You increase your expected returns by increasing the portion of more risky assets you own. The asset allocation decision should position you along the risk-return continuum. It does not increase your risk-adjusted return.
The benefit of asset allocation: The asset allocation decision process should attempt
to measure your personal tolerance for falling prices. Theoretically, to maximize returns you hold 100%
high-risk/high-return equities. This does not work in practice because you never realize all the returns. Once the threshold of your tolerance for risk is passed, and you are
tested by market losses, your decisions will become counter productive.
You may sell at temporary market lows, or you may freeze like a deer in the headlights and fail to sell when you should.
In real life your optimal
asset allocation puts you just inside the far edge of your tolerance for falling prices. The process always reduces the theoretically possible returns, but allows for your own risk tolerance. It optimizes the returns that you personally can
You need not allocate between asset classes to adjust your risk. Within each asset class there are securities with widely differing risks. Within common stocks there are steady blue chips offering decent returns and volatile small caps promising huge returns. Same for bonds. Government bonds are very safe but low yielding, while high yielding corporate debt can be very risky.
Problem 1: How accurately do the advisors measure
your personal risk tolerance? They have a computer program and a series
of factual questions, but your answers give no insight into your risk
tolerance. None of the questions ask you to assess your possible
reactions to loss, or evaluate your mental toughness.
The computer program spits out an allocation between equities, debt,
real estate and commodities. But there is no way to back test how
optimal that allocation really was. There is no way to test "how you
would have reacted" given a different allocation - "what your returns
would have been" if the allocation had been different.
In April 2011, many years after this article was originally written, the Journal of Financial Planning finally (a LITTLE late) admitted that "The overwhelming majority of people ... actually have no clue what risk tolerance is until it whacks them in the face. It really can’t be shaped other than through repeated experience." "Risk tolerance questionnaires. They’re silly." In 2015 the CFAs are still admitting that "questionnaires are found to be highly ureliable and typically explain less than 15% of the variation in risky assets between investors."
No one but you yourself can find out how much risk you can stomach. You can only find out by experience. Since falling markets only happen every few years, you must move slowly into risky assets, allowing time to show how you react in falling markets. Sitting down with an adviser when owning only GICs, and walking out holding 50% common stocks because you were given that asset allocation is nuts.
Problem 2: The concept of asset allocation is
grounded in presumptions of long-run returns and risks for different
asset classes. In the long-run stocks outperform bonds, value stocks
outperform growth stocks, small caps outperform large caps. But in the
long-run we are all dead.
In the medium term: E.g. It took 14 years before the market got back
to its starting point after the 1929 crash. Fourteen years of 0%
returns for equities. E.g. From 1966 to 1982 (16 years) the Dow Jones
returned a total 1.2% loss. In the mean time inflation increased 7%.
History is full of these exceptions to the rules. No one knows what
future markets will be like. Portfolio allocation between asset classes
is not going to help predict it. Nor will it protect you from the
Problem 3: If you accept that the point of asset
allocation is to manage your risk tolerance, then rebalancing is
necessary. The risky assets, with a higher theoretical return, will
grow faster than the others. Their weighting in the portfolio will grow
until your threshold for risk is exceeded.
Academic studies show that more frequent rebalancing decreases
returns. Higher returns come from less frequent rebalancing, even to
four year intervals. The conclusion generally accepted is that
rebalancing should be done only when the risk profile gets seriously
out of whack, because you pay for peace of mind with lower returns.
Similar to the misrepresentation that asset allocation increases returns, it is also said that rebalancing increases returns. You can see the actual results from Canadian data in the graphs on Sheets 14 and 15 of this spreadsheet. There is no income gain. Rather the costs involved reduce returns.
Problem 4: It is now common to hear people say "Oh,
my returns were much lower than the market index this year ... but
that's OK because my financial plan shows I don't NEED to earn great
returns in order to meet my objectives". Wrong, wrong, wrong. Equity
markets are unpredictable. You need to make hay while the sun shines because it will rain tomorrow. Accepting
sub-standard returns today will not earn you higher returns next year. You
must make use of the better years to offset the lesser years. Don't be misled by averages.
Problem 5: The advisors' emphasis on asset
allocation detracts from the more important issue of removing emotions
from the management of equity portfolios. Your emotional reaction to falling values is hugely influenced by self-knowledge and self-control -
by creating an investing 'process' that acknowledges your emotional
vulnerability and controls it. See the discussion at Emotions Destroy Returns
Problem 6: The academic research on the best asset allocation for sustainable retirement funding has only been modeled for 30 year timeframes. In reality many people retiring at 55 will live to 100. That is a 45 year timeframe. For more on the retirement funding see Retirement - Got Enough?.
Problem 7: Asset allocation advice always comes in the form of "percent in asset class 1, percent in asset class 2, etc. But the first allocation everyone should make is measured in dollars, not percentages - the specific dollars you will need on a specific date. E.g. if your savings are earmarked for a child's university tuition, a recommendation to hold 10% bonds, without specifying the maturity date or dollar value, is useless. The price volatility of an asset exposes you to the risk that its value is depressed at exactly the time you need to cash out. When you need surety, you must hold the type of asset that can guarantee that cash.
Problem 8: Nearly none of the asset allocation models incorporate the mortgage on your personal residence. Yet they almost always tell you to hold debt. It makes no sense to purchase Government Bonds paying 4% while owing a mortgage costing 5%. There would be an immediate gain from selling the bonds to pay down the mortgage.
Problem 9: Nearly none of the asset allocation models incorporate your ownership of a home, or annuities, or a company pension, or government benefits like Canadian CPP. These should offset allocations to debt because they are so risk-free and certain.
The "94% of Investment Returns" assertion comes from Brinson, Hood, and Beebower (1986, 1991) that stated, “…investment policy [static asset allocation] dominates investment strategy (market timing and security selection), explaining on average 93.6 percent of the variation in total plan return.” This original statement has been distorted two ways. First, Brinson was measuring variation in returns (volatility), not returns. Second, his word 'explains' [from regression analysis of correlation] has been changed into 'determines' [implying causation]. Roger Ibbotson's short piece tries to explain what was actually stated and proved, and more importantly what was NOT.
It is generally accepted that the paper's choice of metrics means it can conclude only that the average pension in the sample adhered very closely to its asset allocation policy and used broad diversification within asset classes. In other words they were closet indexers. The closer your portfolio mimics the index being benchmarked, the closer the volatility of your returns will be to that benchmark. When you own the benchmark ETF for each asset class then 100% of the volatility of your returns will be determined by your asset allocation.
What is the impact of asset allocation on returns? That is the question most people want answered. Ibbotson concludes that for passive buy-and-hold indexing type investors, returns will be 100% determined by the returns of the asset classes they own - as you would expect. You buy the index - you get the index returns. "The idea that asset allocation policy in aggregate explains 100 per cent of the “level” of return before cost is not a profound idea." (Bill Jahnke). If you include enough portfolios within your sample, your sample BECOMES the market index benchmark, so of course there is 100% explanatory power.
For short-term traders in individual stocks, asset allocation is less important - as you would expect. Daily volatility - no matter what stock or sector or asset class - becomes most important. When the market as a whole has a good day, most stocks rise together, but selective stocks may rise more, or less, or even fall in price.
Surz concludes essentially the same. Asset allocation "explains approximately 100% of investment returns. If a manager succeeds in adding value, this can decrease to as low ... as 75% on a risk-adjusted basis. On the other hand, if the manager fails to add value, policy can explain as much as ... 165%." In other words the returns of an actively managed portfolio will be rooted in the index's returns with an overlay of
- 33% upside if successfully beats the index [(1-75%)/75%] , or
- 39% downside if underperforms the index [(1-165%)/165%].
A group of academics have approached the issue by trying to measure the relative importance of the decision (policy asset allocation) versus decisions on market timing (tactical asset allocation) and security selection. They measure the dispersal of outcomes resulting from different decisions. The most important decision is the one where the spread between the best and worst percentile of excess returns is largest - where there is more opportunity for improving returns by making a good decision, and risk of destroying returns by making a bad decision. These authors come to different conclusions - especially when comparing actual decision outcomes vs. theoretically possible decisions. References - Tokat, Kritzman, Assoe, Assoe
Another side of this issue falls within the active vs. passive portfolio management debate - which outperforms? It should be noted that twenty years after the original Brinson publication, the co-author Hood revisits their original paper. He makes the point "Nothing in the original paper suggests that active asset management is not an important activity." This comment is important because the paper has became part of the pro-passive camp's arsenal.
None of all that academic work has any bearing at all on your own decision on what asset classes to own or in what proportion.
||There's A Rebalancing Bonus ... FALSE
Everyone would love a simple procedural rule that miraculously improves your investment returns. Rebalancing your asset weightings back to a static asset allocation is one of the services that financial advisors sell as just that. The common understanding is that rebalancing is always a good thing. The belief that it produces an income gain is now entrenched. This is wrong.
For proof look only at history. While no general rules can be drawn from the one situation that happened to be history, any rule proposed MUST be validated by that one known situation if it is to be correct. The Canadian data for a portfolio of 50:50 debt:equity from 1960 to 2015 shows that rebalancing sometimes increased returns, especially during periods of recession. Other times it decreased returns.
The US data from 1926 to 2015 shows a large negative rebalancing bonus.
This misperception has its roots in academic work that has been mis-represented to the public. The most widely quoted source is William Bernstein. He first presented the 'Rebalancing Bonus' in the 1996 piece, again in a 1997 paper and then again in 2000. Fanning the flames was a quote from David Swensen's 'Unconventional Success' page 198 " In fiscal year 2003, Yale executed approximately $3.8 billion in rebalancing trades, roughly evenly split between purchases and sales. Net profit from rebalancing amounted to approximately $26 million, representing 1.6% return on the 1.6 billion equity portfolio."
The Vanguard Group published a study that showed on Table 3 that average returns were better without rebalancing for some rebalancing schedules, and worse than others:
Then Schwab weighed in with a study showing that rebalancing reduced volatility AND increased returns.
- 9.655% when never rebalanced
- 9.495% when rebalanced monthly
- 9.669% quarterly
- 9.612% annually
But it is reasonable to question these results. There is a saying that "If you torture data long enough it will confess to anything". Why was the data only from 1970 when Ibbotson's data goes WAY back? Why choose this particular set of assets? This particular result does not prove anything other than exactly 'what' was measured for 'the time period' measured. Schwab's results could be from chance.
In 2003 SmithBarney Consulting reviewed the literature and came to the conclusion that returns are sometimes better, sometimes worse, and you cannot know ahead of time.
Despite of the lack of evidence, the idea of a rebalancing bonus has found a permanent home in the passive-indexing camp. Once convinced, many people conclude that rebalancing ever-more frequently is ever-more better. Others consider the volatility of an asset a good thing - because it will increase the bonus.
The Generally Accepted Version
What most people agree is that:
- A POTENTIAL rebalancing bonus is determined by two assets' relative variances and covariance. These metrics are developed by averaging historical returns, which are no guarantee of future results in the short term or long term. E.g. debt is traditionally thought to be negatively correlated to equities, but during the 'Great Moderation' they were positively correlated.
- The bonus would be maximized by a 50:50 weighting between the two assets. But that is not to say any particular portfolio SHOULD have that weighting.
- The bonus is greater when each asset's price swings widely, so that each rebalancing creates an entry point at a very low cost relative to the trend. But price volatility is not a desirable attribute of any asset.
- The bonus is greater when the prices of both assets are increasing at roughly the same trend rate of return. If one asset's growth is much lower, each rebalancing would push money from the winning asset into the losing (or lesser return) asset.
- The bonus is greater when returns are negatively correlated and revert to their mean on the same cycle as the rebalancing takes place.
- The big benefit from rebalancing comes from a reduction in risk, not any increased return. Without rebalancing the asset with the largest return will outgrow and take over the whole portfolio. In the data series used in the graph above, the 50:50 allocation degraded to 20:80 debt:equity in 1980 when not rebalanced.
The optimal rebalancing bonus described above would look like chart (A) below where two assets' returns are negatively correlated. The rebalanced portfolio is far above the portfolio blended at the start and never touched. Even when one of the assets has consistently lower returns, as in chart (B), there is still a rebalancing bonus. It is only in chart (C) when the assets' returns are perfectly correlated that the bonus disappear. All well and good theoretically.
Problems with the theory appear in other situations. Not only is there no bonus, but rebalancing reduces returns. In chart (D) every rebalancing moves money from the higher return asset to the lower return asset because the slow-growth asset has no high-growth periods. In chart (E) each rebalancing moves $$ from the high earner to the low earner because Asset B's periods of high-growth exactly correlate to times when money has been moved to Asset A. This situation is common when considering debt and equity. If the assets' returns were negatively correlated, but using the same data, there would still be a negative rebalancing bonus.
A fun piece refuting any rebalancing bonus based on pure logic is published in ReoCities. Unfortunately it depends on your acceptance of the Efficient Market Hypothesis that markets always correctly incorporate all public/private information.
A good overview of the different methods for rebalancing is articulated by WiserAdvisor .
Tactical changes to an asset allocation policy are presented by ResearchAffiliates and by James Montier . TAA is not at all what is considered when discussing any rebalancing bonus.
The advice to rebalance comes hand-in-hand with advice to asset-allocate, from advisors looking for a rules-based approach to investing. You should question their objectives. Either they think there is a 'rebalancing bonus' or they think rebalancing reduces risk. Advisors publicly claim to be in the risk-management camp.
Asset allocation positions your portfolio according to your risk tolerance. Without periodically rebalancing back toward that original allocation your portfolio soon becomes heavy in the asset class that has recently outperformed. This is usually (but not always) the more risky asset - common stocks. Rebalancing will reduce risky when you sell some of those outperforming stocks and buy more debt.
But what happens when your 'safe' asset class has outperformed, and now overpowers your portfolio? Rebalancing will not reduce risk because you are INCREASING the risky asset class. Stock markets tank when the economy is in crisis. Debt does well as a 'safe haven'. 2008 is an excellent example. But no one reduced risk by exchanging debt for more stocks at 2008's year end - a time when stocks were the most risky they have been in a living memory. Certainly, advisors later crowed about telling their clients to make the switch. They ridicule the clients that refused. They point to the market's subsequent recovery as proof that markets ALWAYS recover and rebalancing 'works'. (Example).
What exactly worked? What worked was 'market timing' (if they caught the market bottom and did not recommend more stock in (say) September 2008, in time for further drops). They generated excess returns by assuming MORE risk and stepping into stocks at their darkest hour. Yet, when confronted with the reality of the extra risk they put clients in, their response is to deny, deny, deny.
While they SAY they rebalance to reduce risk, in reality they are believers in market timing. They believe that a rules-based approach to rebalancing creates a rebalancing bonus. At the same time, they will ridicule rules such as 'Exit stocks when the index crosses below the 200 DMA.' - a rule explicitly to reduce risk.
Nothing is what it seems.
||Time In The Market Beats Timing The Market ... FALSE
Variations on this warning are heard from advisors: "All the market's returns in a year come from just a few days. If you are not invested on those days your returns are zero.". It is a perpetual refrain.
Clearly it is in the self-interest of advisors that we believe this. They know that once you exit the market you may not return TO THEM. Regardless, they lose their commissions in the interim. They want you to believe it cannot be done.
Maybe there are valid arguments to prove that market timing cannot be done, but THIS argument is false. It is false because, if returns are REDUCED by missing the few biggest up-days, then returns must be INCREASED by missing the few biggest down-days. Advisors never tell you the potential gains from market timing.
It should be obvious that the market-timer's objective is to avoid the down-days, not the up-days. Yet this argument relies on statistics that assume you will accomplish the exact opposite of your intentions. An assumption of failure cannot be the starting point for any logical proof that market timing will not work. The assumption ensures the wanted (wrong) conclusion.
Consider also the period of time used in the argument - most frequently a single day. Technically 'market-timing' could be applied to everyone except buy-and-hold indexers, but mostly it is used in reference to investors who adjust their asset allocation according to changing economics and broad market sentiment changes. These investors don't exit and re-enter daily. They will exit the market for weeks and months, not days. The choice of 'days' in this argument ignores reality.
So what are the benefits from exiting the markets during the worst down-months? Robert Shiller's monthly data on US markets has been used on the last three sheets of this spreadsheet (Excel or OpenOffice). The percent returns were calculated and sorted. The most extreme (up-month and down-months) 5 and 10 percent were deleted as if the investor had exited the market. The resulting returns were calculated assuming three scenarios compared to a buy-and-hold investment.
| || ||40 Years' ||107 Years' |
| || ||% Returns ||% Returns |
|Buy and Hold the Index ||7.4 ||5.2 |
|Perfect Foresight: Miss down months || || |
| ||worst 5% months ||13.1 ||- |
| ||worst 10% months ||15.9 ||15.7 |
|Unsuccessful: Miss down months and up months || || |
| ||5% worst and best ||8.1 ||- |
| ||10% worst and best ||7.5 ||6.5 |
|Accomplish reverse of objective: Miss up months|
| ||best 5% months ||2.7 ||- |
| ||best 10% months ||neg 0.4 ||neg 3.2 |
Financial advisors use only the bottom numbers in their argument, assuming you accomplish the opposite of your objective. It is no surprise the returns have been wiped out. But the objective was to miss the down-markets, and the data shows perfect foresight would have doubled your returns. What is surprising is the returns when investors exited the market on all the worst down-months but also missed the best up-months. The returns were better than the buy-and-hold strategy.
Be clear that no one says this analysis proves anything useful. Obviously no one knows ahead of time which months will have great returns, and which will post losses. What it proves is that this argument is bogus from start to finish.
||Options Are Risky ... FALSE
Analogy #1:You bought insurance for your house. When it
DIDN'T burn down, did you consider that you had lost 100% of your
investment (the premium)? Would that industry
decide the insurance was 'too risky'? Would the industry prohibit you from
buying any. Buying house insurance is directly analogous to buying a
'PUT' option on a stock. And yet your broker will not allow you to make
the purchase without getting special permission, jumping through
multiple hoops, and passing a test, if at all.
Analogy #2:You bought a lottery ticket. When it didn't
win, did you consider that you had lost 100% of your investment? NO. In
your mind, you had expensed it when it was bought. You never considered it 'an asset'. Buying a lottery
ticket is directly analogous to buying a 'CALL' option on a stock. And
yet your broker will not allow you to make the purchase without getting
special permission, jumping through multiple hoops, and passing a test,
if at all.
The situation is discriminatory and unacceptable. REVOLT.
P.S. Just in case you are weak in logic - the statement "Options Are Safe" would also be wrong. No one is saying that.
||The Upside of Shorting Stocks is Limited to the Stock Price ... FALSE
You hear portfolio managers of long-only mutual funds
saying "The upside of shorting stocks is limited to the stock price".... right after they say "Losses from shorting are
unlimited". They are hoping to convince you that you SHOULD
NOT WANT to short stocks. Why? Because they are not ALLOWED to short within their portfolio's mandate. So is shorting stocks a valid strategy?
What matters to any investor is the dollar $$ return he can earn given his limited $$ principal to invest. Shorting requires no $$ principal. No capital needs
to be drawn from another opportunity. Percentage returns are irrelevant because every penny of gain (or loss) is a 10,000% profit (or loss). Yes the upside is limited to the dollar value of the stock. But each of those dollars is incremental to the returns being earned on long positions.
Yes the downside is unlimited in dollars. And any short position going wrong becomes a
larger (not smaller) part of your portfolio. But only if you are silly enough to stick
around for so long. Why assume such stupidity and present it as an argument? You must manage your losses whether you are long or short a stock.
There are three correct points made against shorting. First is the event-risk. Unlike long positions, a short position when bad things are happening to a company is exposed to the possibility of the company's takeover. The immediate jump in the stock's price goes against your position. Second, the short seller must pay to the person from whom he borrowed the shares, the amount of any dividends paid by the company. So there is a cost to shorting stocks with dividends. Third, in Canada gains and losses are fully taxed like interest (IT479R line 18) - not as capital gains.
Why say "no" to an additional $$ return? Why not short the index instead of selling your individual holdings during falling markets?
||Capital Gains Are Taxed At Half The Income Rate ... FALSE
Canadian income tax on capital gains is levied on only half the
gains. It is common to hear people interpret this in their
conversations and calculations as being "taxed at half the normal
rate". This interpretation is correct when talking about the marginal
tax rate, which is the tax rate on the next dollar of income. But for
many decisions, it is not the marginal rate that should be considered.
The average rate is the correct calculation. In those situations the interpretation is wrong.
The point being missed is the doubling of the width of the incremental tax
brackets when income is capital gains. You may have to read that last sentence a second time. Canada's progressive
income tax means that the tax rate applied to the last dollar earned is higher than the tax rate on the first dollar earned. By taxing only half the capital gain, twice the actual gain can be earned
in each tax bracket, before the next higher rate is applied. So not
only is the income taxed at half the rate, more of it is taxed at lower
tax brackets. This magnifies the benefits of capital gains, and makes
after-tax comparisons of investment returns more complicated than simply applying
half the tax.
Using the tax rates of 2006 (the point doesn't change with different rates),
the weighted average tax levied on the first $100,000 of income is 11%
for capital gains and 29% for interest income.
The marginal tax rate for capital gains, at that point, is still the
2nd tax bracket. It is the 3rd tax bracket for interest income.
|Cap gains||Taxable||Tax rate||Tax pay |
|Tax rate 1||$55,078||27,539||23%||6,334 |
|Tax rate 2||$27,244||13,622||33%||4,495 |
|Sum Total||$100,000||11% avg||10,829|
|Interest||Tax rate||Tax pay |
|Tax rate 1||$27,539||23%||6,334|
|Tax rate 2||$36,378||33%||12,005 |
|Tax rate 3||$27,244||39%||10,625 |
|Sum Total||$100,000||29% avg||28,964|
While we are on this subject, look at the average tax burden (6%) on the first $100,000 of
dividend income. In this case, you are pushed into higher tax brackets FASTER
because you are taxed on a grossed-up value of your actual dividends. But the tax credit for
taxes already paid by the corporation leaves you in the best possible
|Dividends||Taxable||Tax rate||Tx debit||Tx credit||Tax pay |
|Personal ||$6,096 ||8,839 ||0% ||0 ||2,515 ||(2,515) |
|Rate 1||$18,992 ||27,539||23%||6,300||7,834 ||(1,535)|
|Rate 2||$25,088 ||36,378||33%||12,005||10,349 ||1,656 |
|Rate 3||$31,399 ||45,529||39%||17,756||12,952 ||4,804 |
|Rate 4||$18,424 ||26,715||44%||11,621 ||7,600 ||4,021 |
|Sum Total ||$100,000||145,000||6% avg||47,682||41,250 ||6,432 |
If you want to play with these numbers and input your own income, use the TaxBurden spreadsheet with current taxrates.
The experts get other issues wrong as well. E.g. When giving examples they will almost always presume the reader is in the top marginal tax bracket. Most people face much lower rates. The expert's point may be justified by the top tax bracket, but be completely false for those in the bottom tax bracket.
Another point they often get wrong regards the 'effective tax rate' for capital gains. While dividends and interest are taxed each year, capital gains are only taxed when the security is sold. The time lag between the realization of profit and its taxation allows for reinvestment of the before-tax-profit. The longer the deferral, the lower your effective tax rate. On the same TaxBurden spreadsheet there is a tab at the bottom for a separate sheet calculating the effective tax rates for capital gains after a deferral.
||Taxes Stunt Portfolio Growth ... FALSE
You hear the advice to limit stock turnover because selling a stock triggers capital gains tax leaving you less principal to
reinvest. This smaller investment generates a smaller return and
portfolio growth is stunted. But how true is this? Does this qualify as
"letting the tax tail wag the investment dog"?
There are two situations where it is undoubtedly true. First, when a
stock is sold in order to buy another with the same, or even worse, expected return
(e.g. for rebalancing), nothing (except possible reduction in risk) is gained and tax is needlessly
prepaid. Second, when the payment of tax can be deferred until after
death, you will receive larger dividends from the original investment.
You will not care about the eventual tax after death.
This leaves the majority of situations, where you can see a higher expected return from a replacement stock, and you know the unrealized tax will be paid in some future, regardless. Use your own variables in the example following. Your calculator gives you the Future Value calculation. Chances are that even a 1% incrementally better return will justify switching stocks.
Take a scenario that starts with a portfolio worth $200,000 that has doubled in value (an unrealized capital gain of $100,000). Assume the top 45% tax rate
applied to capital gains at 22.5%. Make the assumption that the
replacement stock will return 1% more than the old stock. Assume that the
maximum deferral of tax will be ten years before you would be 'forced' to
liquidate anyway, even if you don't sell now. How will two portfolios compare when one triggers tax today
in order to buy a new stock, and the other stays invested with a lower
|Invest New Stock at 10%||Keep Old Stock at 9% |
|Pay tax||$22,500||$0.00 |
|Net Invested||$177,500||$200,000 |
|Future Value in 10 Yrs||$460,389||$473,473 |
|Tax Accrued at Yr10||$63,650||$84,031 |
|Portfolio net Tax||$396,739||$389,442 |
Should you make it a strategic policy to hold a stock forever? Investors believe what they want to believe. There are now 30-year-olds who have decided they will buy blue-chip dividend stocks and hold them for their lifetime - planning to not even sell to pay for medical care in their last years of life. They figure they don't need tax shelters like RRSPs because they will never pay tax. They figure their income in retirement will be higher with this strategy because their dividend yields will be greater (on purchase price). There are huge problems with this strategy.
- Blue-chip stocks no longer really exist. They used to have monopoly powers from government, but now even utilities with regulated divisions also manage unregulated divisions.
- Business entities are constantly morphing. Some get bought out, others buy business lines that are not the blue-chip you started with.
- Should you really PLAN on your life being smooth sailing, without ever losing your job or taking a sabbatical and needing cash, without ever finding it necessary to help out a friend or family, without ever needing medical care in your last years, without ever plundering the bank to pay of travel when retired, without your spouse needing home-care while recovering from cancer? Life is just not that predictable.
- Management and competition are always changing. Great companies wither and die. A 30 year timespan is almost unthinkable. Things change.
- Although capital gains accrues without tax, the dividend stream is taxed each year. In the lowest tax brackets this is minimal, but what happens when your wages have risen so that it becomes a material tax? You cannot move the asset into an RRSP or TFSA without triggering all that deferred capital gains.
- Allowing unpaid taxable capital gains to accrue has the result of creating an added burden when bad things happen and cash is needed ... exactly when you don't need more problems. The opposite is also true. In 2008 a lot of people retired people learned what a wonderful thing capital loss carry backs are. The tax recovery in that year of poor returns was enough to fund a year's expenses in many cases. But you had to have paid your taxes in the good times for that to work.
- From a Behavioral Finance view, you should avoid behaviors that you know will trigger bad decisions. Comparing a certain tax bill to an uncertain higher return with another stock is a hard emotional decision. Regardless of the math, you are likely to NOT sell.
- The decision to not ever sell has a cost. It is a conceit to think a static, frozen portfolio will earn benchmark returns. It will underperform. The size of the tax bill locks you into bad decisions. You are setting yourself up.
Before you make it a policy to HOLD FOREVER, play with some number in this spreadsheet. The example shown below shows that it does not take much of an increase in expected rates of return, to make paying your taxes preferable to holding forever. The values of two portfolios with the different assumed tax treatments are tracked. At each year end the HOLD portfolio is valued as if it had been eventually sold and all the accrued tax paid. The difference in value is shown on an annualized rate of return basis.
||The Canadian Banking Ombudsman Protects You ... FALSE
The Ombudsman for Banking Services and
looks good on paper. The Federal
Government supports and recommends it. The brochure says it offers
"resolution services for clients of any firm". It claims it "works
on behalf of clients". In fact:
For a How-To manual written by a consumer advocate on using the OBSI read this OBSI Survival Guide. For a scathing independent evaluation of the process read this 2016 Evaluation of the OBSI Investment Mandate. The Ombudsman is a sham - a sham supported by Government. Complain to
- The Ombudsman is a child of the Banks themselves ... it is not
an independent government entity.
- Although it may work for clients once it STARTS work ... it
will not start work until told to do so by the Bank
- It will not start work at the request of a client.
- It has no power to force a company to respond to the client.
- It cannot force a company to abide by their own dispute
process ... which is a necessary pre-amble to their asking the
Ombudsman to take over.
- It cannot force companies to pay the damages determined by the OBSI.