What Kind of an Investor Are You?: A guide to the investment solution that is right for you

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WHAT KIND OF AN INVESTOR ARE You?

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WHAT KIND OF AN INVESTOR ARE You? A guide to the investment solution that is right for you

RICHARD DEAVES PHD

INSOMNIAC PRESS

Copyright © 2006 by Richard Deaves All rights reserved. No part of this publication may be reproduced, stored in a retrieval system or transmitted, in any form or by any means, without the prior written permission of the publisher or, in case of photocopying or other reprographic copying, a license from Access Copyright, 1 Yonge Street, Suite 1900, Toronto, Ontario, Canada, M5E 1E5. Library and Archives Canada Cataloguing in Publication Deaves, Richard What kind of an investor are you? : a guide to the investment solution that is right for you / Richard Deaves. Includes index. ISBN 1-897178-15-8 1. Investments. 2. Finance, Personal. I. Title. HG4521.D418 2006

332.6

C2005-907618-6

The publisher gratefully acknowledges the support of the Canada Council, the Ontario Arts Council, and the Department of Canadian Heritage through the Book Publishing Industry Development Program. Printed and bound in Canada Insomniac Press 192 Spadina Avenue, Suite 403 Toronto, Ontario, Canada, M5T 2C2 www.insomniacpress.com

Canada

To George, whose example inspired this book. To Margaret, who might have preferred a novel to a novel book. To Marie, who says I'm an open book. And to Andre, whose own first book lies in the future.


Acknowledgements This endeavor would not have been feasible without the guidance and support of friends and colleagues. In alphabetical order, I am immensely indebted to Lucy Ackert, Howard Atkinson, Paul Bates, Gokul Bhandari, Narat Charupat, Anna Danielova, Bill Horton, Lynn Kennedy, Ken Kivenko, Peter Klein, Itzhak Krinsky, Adrian Lawson, Erik Liiders, Peter Miu, Mahmut Parlar, Sudipto Sarkar, Lyle Stein, Yisong Tian, Chris Veld, and Barry White. A heartfelt thanks to Mike O'Connor, Gillian Rodgerson, and the staff at Insomnic Press who were always extremely helpful. The input of all these people dramatically improved this undertaking. All errors remain those of the author.


Disclaimer All opinions expressed are only those of the author, and do not reflect the views of any companies or individuals for whom the author has consulted or with whom the author has collaborated over the years. Every effort has been made to ensure the accuracy of the information presented. Nothing in these pages should be construed as investment advice. Every individual's investment situation is different, and it may be wise to consult qualified financial professionals.


Table of contents Introduction: What kind of an investor are you?

19

PART I: Some essential background on. . . Chapter 1: Some essential background on investment fundamentals A. Preview B. Interest rates, investment returns, and compounding C. Risk and its rewards D. Diversification E. Valuation and market efficiency R Recap Endnotes

27 27 33 39 45 52 53

Chapter 2: Some essential background on mutual funds A. Preview B. How do mutual funds work and what are their advantages? C. Tangible costs D. Some hidden costs: Games played by mutual fund managers and weak governance of fund companies E. Fund characteristics R Recap Endnotes

67 71 73 74

Chapter 3: Some essential background on the principles of wise investing and how psychology sometimes gets in the way A. Preview B. Saving roadblocks: Limited self-control and procrastination C. Behavioral biases may lead to poor decisions D. Excessive emotion E. Most people don't know as much as they think they know R Recap Endnotes

79 80 81 85 88 90 91

57 58 62

PART II: How well do you do. . . ? Chapter 4; How well do you do buying mutual funds? A. Preview B. Do mutual funds typically outperform? C. Why exactly do mutual fund managers underperform? D. Why the lack of outperformance is not really surprising E. Can we identify star managers? F. Recap Endnotes

93 93 99 102 105 108 109

Chapter 5: How well do you do assembling your own portfolio? A. Preview 111 B. Do people trade because of real or perceived information? 112 C. Overconfidence 114 D. Under-diversification, momentum-chasing, and a love for the familiar 118 E. Self-investment in groups: Investment clubs 122 F. Recap 124 Endnotes 125 Chapter 6: How well do you do with indexation? A. Preview B. What are indexes? C. What is indexation and why does it make sense? D. Index products E. The pros and cons of the various index products F. Recap Endnotes

129 129 134 138 140 142 143

PART III: Going forward. . . Chapter 7: Going forward with an understanding of asset allocation A. Preview 147 B. What is asset allocation? 147 C. Why is asset allocation important? 151 D. Optimizers 158 E. Problems with using optimizers 162 F. Recap 164 Endnotes 165

Chapter 8: Going forward to implement asset allocation A. Preview B. Distributions of final wealth C. Assessing your risk tolerance D. Should the stock-bond mix change over time? E. Extended diversification F. Recap Endnotes

169 169 176 178 181 183 184

Chapter 9: Going forward towards retirement A. Preview B. Sources of retirement income C. How much is needed? D. Sources of uncertainty E. After retirement F. Recap Endnotes

187 187 190 193 196 200 201

Chapter 10: Going forward with self-knowledge and insight A. Preview B. What is your money personality? C. What is your investment temperament? D. Looking for an edge I: Anomalies and style-tilting E. Looking for an edge II: Manager selection F. Recap Endnotes

203 203 206 210 213 217 218

Conclusion: Moving towards the investment solution that is right for you

221

Recommended Readings Web site Guide Index

228 231 233


List of figures and tables Chapter 1 Figure 1: Future value of $1 Figure 2: Bank of Montreal monthly returns (1996-2004) Figure 3: Historical Canadian stock and bond average compounded returns and risk (1957-2004) Table 1: Average return and risk for five Canadian stocks (1996-2004) Figure 4: Risk as a function of the number of securities in the portfolio Table 2: Betas for different industries

31 37 39 41 43 44

Chapter 2 Figure 1: Mutual fund assets in Canada Table 1: Style categories of equity funds Figure 2: Performance deterioration due to MERs

59 62 65

Chapter 4 Figure 1: Number of funds in sample for different years and number of funds surviving till end Figure 2: Canadian equity fund performance Figure 3: Why mutual funds fall short (Wermers study) Figure 4: Repeat performance of winners and losers

96 98 101 107

Chapter 5 Figure 1: Gross and net returns for groups with different trading intensities (Barber and Odean study) Figure 2: Frequency distribution of loser minus winner stock percentage Chapter 6 Table 1: Hypothetical stocks for index calculations Table 2: Non-Canadian stock market indexes Table 3: Market shares of hypothetical stocks Table 4: Canadian-based ETFs Table 5: A few U.S.-based ETFs

113 121 131 134 135 139 140

Chapter 7 Figure 1: Historical annual returns for S&P/TSX Composite Index Figure 2: Historical returns on long-term (LT), medium-term (MT) and short-term (ST) Government of Canada bonds Figure 3: Risk vs. return for Canadian stocks and short-term (ST), medium-term (MT), and long-term (LT) Government of Canada bonds Figure 4: Efficient set combining Canadian stocks and long-term (LT) bonds (using historical data) Figure 5: Efficient set combining Canadian stocks and medium-term (MT) bonds (using historical data) Figure 6: Efficient set combining U.S. stocks, EAFE stocks, Canadian stocks (CAN) and medium-term (MT) Canadian bonds (using historical data) Table 1: Correlation matrix for four asset classes Table 2: Portfolio weights for four asset classes required for 11% expected return under various conditions Chapter 8 Figure 1: Tenth percentile, median, and 90th percentile wealth accumulation paths based on investing in Canadian stocks (using historical parameter values) Figure 2: Tenth percentile, median, and 90th percentile wealth accumulation paths based on investing in Canadian medium-term bonds (using historical parameter values) Figure 3: Percentage of time that stocks outperform bonds over different horizons Figure 4: Tenth percentile, 50th percentile (median), and 90th percentile wealth accumulation paths based on investing half in Canadian stocks and half in Canadian bonds (using historical parameter values) Figure 5: Tenth percentile wealth accumulation paths for all-stock, all-bond and 50/50 portfolios Figure 6: E/P ratio of Canadian stock market over time

152 154 155 157 158 159 160 161

171 172 173

174 175 180

Chapter 9 Figure 1: Income replacement ratio as a function Figure 2: Income replacement ratio as a function Figure 3: Income replacement ratio as a function in retirement Figure 4: Income replacement ratio as a function return Figure 5: Average inflation rate by decade

of savings rate 193 of years of work 194 of years 195 of investment 196 198

Chapter 10 Figure 1: SEI's member types and the money personality continuum 205 Figure 2: Performance of Canadian value and growth portfolios 212 Figure 3: Canadian mutual fund rollover strategy 215


Introduction

What kind of an investor are you? The reason that you bought this book (or, more likely, you are currently skimming this introduction in order to decide whether to do so) is because the title and what it implies attracted your attention. You may have years of experience investing, or you may be fairly new to the process. You may invest in mutual funds, in individual securities, or some combination of both. You may invest on your own, through a broker, or through a financial advisor. You realize the importance of investing, so it is natural to ask what kind of an investor you are, and what kind of an investor you should be. It is human nature to question whether you are doing the right thing, especially when the results are not as good as hoped or expected. (I am guessing that if your results have been stellar you might not be reading this paragraph or be open to new ideas.) Assuming you believe it is possible to do better, you might be wondering if your basic approach is the best one, or should a drastic shift be contemplated? If this question is on your mind, please read on. If you think about it, the first investment decision one needs to make is one of process. Only after you have determined the process that is right for you can you execute your approach. In my view, the process that is right for you really comes down to what sort of an investor you are. The two key process questions are: 1. "Do I need to get some assistance in managing my investments? Or should I be a do-it-yourselfer?" and 2. "Should I invest in mutual funds? Or should I assemble my own portfolio of securities? Or are index products best? " Based on these two process questions, there are six possible, distinct process choices (though, of course, combinations are possible). These choices are illustrated using a flow chart. Allowing myself some linguistic licence, you can be: a self- or assisted-selector; a self- or assisted-rundholder; or a self- or assisted-indexer. Bear with me for now. I will explain what index products and being an indexer mean a few lines down (and in much more detail

20 — Richard Deaves

throughout the book). Also, one term that I have coined needs to be explained: a selector assembles or 'selects7 (with or without assistance) her own portfolio of securities.

What kind of an investor are you now? And what kind of an investor should you be? Years ago, many Canadian investors were assisted-selectors: they bought securities (mostly stocks) with the advice of a broker. Over the last couple of decades, more and more Canadians have become involved in securities markets: according to The 2004 Canadian Shareowners Study of the TSX Group, 49% of Canadians now own shares directly, or indirectly through mutual funds. Many of the new participants are assisted-fundholders: they buy mutual funds with the help of a financial advisor. Then there are the do-it-yourselfers: some people invest entirely on their own, by buying stocks and other securities through a discount broker offering no guidance (the selfselectors). Others buy funds based on their own research, perhaps directly from fund companies (the self-fundholders). The popularity of the do-it-yourself method is evidenced by the fact that the local bookshop is full of books providing guidance to the

What Kind of an Investor Are You? — 21

do-it-yourself investor. Of course, the reader will be aware that the above categorization simplifies reality. For one thing, self-investment vs. full assistance should really be viewed as the end points of a continuum: some people, for example, want a certain amount of help, but, at the same time, they want to play an active role in the decision-making process, so they are between the end points. Additionally, there are people who own both individual securities and mutual funds, and there is nothing wrong with this. It could be that they have decided that individual stocks are best in certain sectors, while funds are best in other sectors. This is a defensible decision. Nevertheless, while the reality is more complicated, it will help to simplify by thinking in terms of the six discrete process choices. What about the two indexation options (self- and assistedindexation)? Though the number appears to be growing, the reality is that very few people are at present in these categories. In fact, some readers (don't be embarrassed!) may not even be sure what indexation is. The idea of indexation is really quite simple. Imagine you are playing bingo with 100 other people. As we all know, bingo is a game of chance, but there can be a small skill component to the game: if you don't pay attention and know all the rules, you definitely won't do well. Say the game goes on for a long while, at least long enough to rank everybody on the basis of performance. The person doing the best receives $100, the person coming second gets $99, the person coming third gets $98, and so on - all the way down to the worst, who sadly receives nothing. The average payout is $50. I have described the normal way to play bingo, but suppose there is another way as well. Instead of competing for a high payout while risking a low one, you are also allowed to lock yourself into the average. In other words, before the play even begins, you have the option to choose as your payoff the average amount made by all people actively participating. Half of the participants will do better, and half will do worse than you. You are assured of getting the average. This is roughly what indexation is. Choosing to index means that the performance of your portfolio is guaranteed to be average, not better, not worse.


Actually, though, indexation is a bit better than this. The reason is that indexation is a low-cost way to invest. Return to our game analogy. Say in order to actively play the game, you have to pay a $45 entrance fee, which means the average net payoff is $5. (Don't worry about who is generous enough to stage such a bingo game!) On the other hand, to passively accept the average payout, you only have to pay $44, for a guaranteed $6 net payoff. This is the reason why indexing is often called passive investing in contradistinction to actively assembling your own portfolio, or paying somebody else to do so via actively-managed mutual funds. This passive approach - albeit a lot less fun - is what true indexation does for you. Indexing means you will usually do a bit better than the average investor. One nice feature about indexation is that it makes it easier to be a do-it-yourselfer. The reason is that no research is required to choose the right stocks or the right funds. Now I am not saying that there are no decisions to be made. There are a few, most of them concerning asset allocation. But this book will carefully deal with asset allocation, thus providing you with the key background. What if you believe yourself to be quite skillful at investing, or you believe you can identify others who are skillful? Then indexation may not be for you. You will do better trying to beat many of your opponents. In the context of investing, if you think you can consistently pick winning stocks, or if you think you can consistently pick mutual funds that will outperform other funds in the future, then stay away from indexing. Nevertheless, the evidence strongly suggests that it is very difficult to do these things consistently. Unfortunately our psychological makeup is such that we often believe that we have what it takes. Ask a group how many people are better than average at some game and invariably more than half will say that they are. But how can this be? Only half can really be better than average. The reason for such excessive optimism is overconfidence. People think they will never have a car accident (which is why some people drive too fast). People think their small businesses will surely succeed (which is why too many people start small businesses despite well-known high failure rates).


What is my personal stance on these decisions of process? Though it will take some pages to make my case, I believe that many of us should primarily locate ourselves in the self-indexer category. That is, we should index! And, provided we are disciplined and do not allow emotion to influence our actions, there is no reason why we cannot do it on our own. Still, my two italicized caveats are important. I said "many." Some of us do need assistance. There is no disgrace in this: I need assistance in many things I do - from servicing my car, to managing my taxes optimally. Reading this book should help you understand whether or not you need some (or a lot of) assistance in the realm of investing. Note as well the word 'primarily.' Even if indexation is appropriate, it may not necessarily be appropriate for all sectors. It is sometimes argued that a return to active management exists in certain sectors (e.g. foreign stocks), but not in others (e.g. Canadian stocks). This suggests an indexing strategy, where appropriate, and pursuing returns from active management, where appropriate. We need to be clear on the attractions of being a self-indexer. You will not be paying mutual fund managers, financial planners, and others sometimes substantial fees to manage your investments since you will be managing them yourself. You will be managing them passively through indexation. Imagine your portfolio set to automatic pilot, aimed at where you need to go for a comfortable retirement. You will not be spending many of your waking hours studying financial statements and stock charts, or fretting about the portfolio composition of fund XYZ, or the upcoming earnings announcement of ABC. You have concluded that the payoff is simply not there. You should remind yourself why you are investing. It is to have a better life for yourself, your family, and your causes, especially in your golden years. You should not be putting that at risk, but the reality is that some of us think it's a lot of fun to pick that next hot stock, just like playing bingo is more fun than watching others play bingo. Human nature is human nature. I know some people will not be able to resist playing a little 'bingo' sometimes, and perhaps you can find an edge. But, at the same time, I argue that the portion of your portfolio that you actively manage should be


small - certainly not the core. Realistically, though, as I have said, being a do-it-yourselfer will not be appropriate for everybody. Those with high net worth, even if they feel themselves eminently capable of managing their own investment affairs, may well want the additional security and peace of mind afforded by a well-qualified financial advisor. Since mistakes become more costly the more money you have, the case for getting at least some assistance strengthens with wealth. Others do not have the necessary investment knowledge, mindset, discipline, or interest to be do-it-yourselfers. For all of these people, while help comes at a cost, the benefit is likely more than commensurate with the cost of a carefully chosen financial advisor. A major goal of my book is to encourage you, the reader, to ask yourself carefully whether you have the appropriate knowledge and disposition to be a do-it-yourselfer. While I have previewed the central themes of this book, there is much more to come. The first three chapters of the book allow us to hit the ground running. First we need to feel comfortable with some investment fundamentals, and this is what the beginning chapter does for us. Still, I promise to stick to what I view as essential. Chapter 2 tells us what we need to know about mutual funds in order to consider them as investment vehicles. Chapter 3 may come as a surprise to a few of you. Its topic is investor psychology. I view this as vitally important since we sometimes make certain investment mistakes because of our psychological constitution. Knowing that we are at times capable of being our own worst enemy should (no guarantee here, though) allow us to avoid some bad decisions. The next section of the book is written primarily from the standpoint of a current or prospective self-investor or do-it-yourselfer. (It will also be useful for those who need assistance.) The three chapters of this section provide information on how well you are likely to do using the three main approaches to populating your portfolios: mutual funds (Chapter 4), actively managing your own portfolio (Chapter 5), and indexation (Chapter 6). In each case, the pros and cons are discussed. Whether or not you opt for indexation, if you truly desire to be a do-it-yourselfer, you will need to know a little more. This is


the main purpose of the final section of the book, which is made up of four chapters. First, you need to know something about asset allocation (Chapter 7). Then you will have to know how to make it work (Chapter 8). Even if you just index, you need to know how much to put into a bond index product, how much into a stock index product, how much into an international equity index product, and so on. Asset allocation deals with this, as well as how much risk you should assume, and whether you should sometimes alter your risk exposure. We will see that this is partly a function of personal preferences. Chapter 9 broaches certain retirement issues, since most of us will be investing primarily for retirement. Finally, Chapter 10 draws some threads together. Among other things, I consider certain intangibles, such as the roles of investment personality and investment temperament. I will argue that these intangibles are important considerations, as you decide whether you want to be a do-it-yourselfer or you require assistance. Finally, in a concluding section, I have some suggestions for you as you go forward. Now that you know what the book is about, a few words on what this book is not about. It is not a book about how to get rich quickly or easily in financial markets. The reason is that the author does not have any magical potions for these things, and I encourage you to be wary of those who claim that they do. It is my belief that patient saving and investing, taking on an appropriate level of risk, and keeping a sharp eye on costs, will eventually win out. This is also not a book about how to analyze stocks or funds and choose the best ones. As I have already said, I believe this is a very difficult undertaking, one that most people should not try. Nevertheless, in Chapter 10,1 do provide a few helpful hints for those who want to try to get an edge. Before you embark on your journey, I am going to ask you to spend a little time answering a questionnaire made up of 50 questions. I believe that you will definitely get more out of this book if you do so. Look on the back cover. There you will see a sticker with an alphanumeric password. Please note it. Then go to the internet and type: http://www.investorgauge.com. Once you get to this Web site, click on the box that says, "Yes, I want to do the Investorgauge Questionnaire." At a certain point you will need


to type in the password that you have just recorded. It allows you to do this questionnaire once at no charge. The questionnaire has two parts. The first part comprises a series of questions designed to test your investment knowledge. While some may be disappointed at not achieving a high score on this part, I would venture to say that by the end of the reading of this book the state of your knowledge will certainly have improved. The second part of the questionnaire is designed to assess such things as your risk tolerance, investment personality, and investment temperament. From all the scores that you obtain, you will be able to learn more about what kind of an investor you are. The ability to see into yourself will also allow you to get closer to understanding what investment process is right for you. After the questionnaire is completed, you will receive a feedback form that you may wish to print out for future reference. Note that several components of the questionnaire will be discussed throughout the book. My goal is that by the end of the book you will have a clear sense of your options, and what is best for you. On this basis, I hope that you will have a good idea of what kind of an investor you are now - as well as what kind of an investor you should be when going forward. In short, I want to help you find the investment solution that is right for you.

Chapter 1

Some essential background on investment fundamentals A. Preview The purpose of the first chapter is to get readers up to speed on what they need to know about the fundamentals of investments. The knowledge gained will be useful as we examine some important issues in future chapters. Some of you may want to skim or skip parts of (or all of) this chapter, while others may want to read it more carefully before moving forward. Be forewarned: this is the longest chapter in the book, and some will find it challenging. If you tackled the Investorgauge Questionnaire as recommended in the introduction, you probably have a good sense of the current state of your investment knowledge. The first 25 questions assessed what you know. How well did you score? Section B of this chapter presents the basics of interest rates, investment returns and compounding. Next (in section C), I introduce risk. Risk needs to be understood since most investments involve some uncertainty. I will illustrate the commonsense notion that investors, if they take on risk, will desire a reward for doing so. One way to mitigate risk is to diversify; that is, to put your eggs in several baskets, not just one. In section D, diversification is explained and illustrated. We will see that, once we understand diversification, our perspective on risk will need to change a bit. Finally, in section E, I move to the basics of how securities with risky cash flows can be valued.

B. Interest rates, investment returns and compounding People invest to preserve and increase, or grow, their wealth. Take a one-year $1000 GIC (guaranteed investment certificate) at a 4% interest rate. After the year has passed, you will have $1000


(your principal or original wealth), plus $40 (your interest, or growth in wealth). Obviously, we all would like our wealth to increase faster. Indeed, other investment choices may be able to accomplish this, but a major theme of this first chapter is that this growth will come at a cost: higher risk. For now, I will postpone defining and discussing risk. First, let's make sure we understand the essentials of interest rates and investment returns. In this book I will be talking a lot about stocks and bonds. So let me start with stocks, or, synonymously, shares or equities.1

i. Stocks The owners of stocks (stockholders or shareholders) are 'residual claimants' to the cash flows generated from the operations of a corporation. By 'residual,' I mean that, before the shareholders receive anything, all employees, suppliers, tax authorities, and creditors must be paid. Why do people own stock? To earn a return, of course. Returns from common stock ownership come in two forms: capital gains and dividends. A capital gain is obtained when a stock's price moves above its purchase price. It is realized if sold at such a price. A dividend is a cash payment declared by the company's Board of Directors and paid out to all shareholders. All major newspapers (including such business-oriented ones as the Globe and Mail and National Post), along with a number of Web sites (such as the Toronto Stock Exchange's www.tsx.com), provide daily stock quotes so investors can see how their stocks are faring.11

ii. Calculating returns To calculate a return on any asset - including a stock—all we have to do is use the following formula: Return = Price change/Initial price + Cash flow/Initial price The first term is the percentage capital gain (or loss, if negative). For a stock, the cash flow is the dividend, and the second term is the dividend yield.


Let's try an example. Bank of Montreal stock was selling at $58.05 at the beginning of September 2005. One year earlier it was selling for $54.38. During this time a total of $1.80 per share was paid out over four quarterly dividends. What was the return on this stock? Using the formula we have a capital gain of: Cap. gain = Price change/Initial price = (58.05-54.38X54.38 = 6.75%

And the dividend yield was: Dividend yield = Dividend/Initial price = 1.80/54.38 = 3.31% The total return is the sum of these two components:111 Total return = 6.75% + 3.31% = 10.06%

iii. Bonds

The other major class of securities to invest in is bonds. Bonds represent debt (unlike stocks, which represent ownership or equity). A standard bond has a fixed maturity (e.g. 10 years). Over this time, fixed periodic (usually semi-annual) interest (or coupon) payments are made. Because the payments are fixed, the term fixed-income securities is used synonymously with bonds.lv On maturity, the last coupon payment is made and the principal value is repaid. Note that the one-year GIC mentioned above is a fixed-income asset. A standard bond is different from the GIC in an important sense. The bond can be traded, so we call it a security (as opposed to an asset). Bonds are issued by both governments and companies. The largest issuers of such securities are actually in the former category, such as Canada and the United States, Ontario, and Quebec. The Canadian government is the largest issuer in this country. Its longer-term instruments, 'Canada Bonds/ are marketable securities backed by the general assets and taxing power of the federal government.v The private sector is also active in the issue of fixed-income securities. When money is required for investment purposes, corporations not only issue new shares but also corporate bonds. Secured bonds are backed by claims on


specific assets, while 'debentures' are not secured by any mortgage or other lien against specific assets. Of course, companies sometimes default, so corporate bonds can carry meaningful risk. Returns on bonds are calculated using exactly the same formula as I used previously to calculate the return on a stock, that is, the price change plus the cash flow (here, an interest payment, not a dividend), both expressed as a percentage of the original price. There is a related measure known as the bond's yield to maturity. It can be thought of as a market-determined interest rate that, unlike the fixed coupon rate, fluctuates with market conditions. It should be noted that the yield is different from a bond return, and normally only approximates it if the bond is held to maturity.vl iv. Time value Now that we understand interest rates and investment returns, let us ask ourselves a fundamental question. Why are they necessary? The answer is quite simple. People would rather have $1,000 now than $1,000 in the future. Because this is so, no one would lend somebody else $1,000 today unless, altruism excluded, she were promised more than $1,000 at a future date. Such a person with excess funds would just keep the money to herself, not lend it out. Since money in the future is worth less than money today, it is said that money has "time value." For example, suppose that we can lend or borrow at the same 5% rate of interest. (Of course, while this equality assumption is made for simplicity, bankers would cringe if lending and borrowing rates were truly equal.) This means that, if you have $1,000 and you put it into a savings account, after one year your account balance will be at $1,050; after two years it will be at $1,102.50, and so on. Or, if you borrow $1,000 from the bank today, you will have to repay $1,050 in one year, or, if it is a two-year loan (with just a lump sum payment required at the end), $1,102.50, and so on. Using these numbers, I can define present value and future value. When we compound money forward, we are converting present amounts of money into future amounts of money, or present values into future values. A simple formula can be used to convert a present value into a future value:


Future value = Present value * (1+interest rate)No-of periods Let us road-test this. Using the numbers above, if we compound $1,000 at 5%, after one period we have: $1,000 *(1+5%) 1 = $1,050

After two periods we have: $1,000 *(1+5%)2 = $1,102.50 And after 20 periods we have: $1000 * (1+5%)20 = $2,653.30

Figure 1 shows how $1 grows over time through compounding. One curve is for a 5% interest rate, and the other for a 7% rate. Despite the only 2% spread, after 30 years you would have 76% more money at the higher interest rate.

Figure 1: Future value of $1


We can also work backwards. For example, what if we want to know the present value of $2,653.30 received 20 years from now? A rearrangement of the previous formula allows us to convert future values into present values: Present value = Future value / (1+interest rate)N°-of Perjods Now let's apply it: $2,653.30 / (1+5%)20 = $1,000 No surprise here. By the way, in the above expression, the interest rate is often called a 'discount rate/ since we use it to deflate or discount future values. The ability to convert future values into present values is more powerful than at first might be apparent. The reason is that all assets can be viewed as claims to a series of future cash flows. For example, say a bank extends a $20,000 five-year car loan at 6% (compounded monthly). A standard loan of this type would require fixed monthly payments over five years. It is possible to work out that the payments are $3#6.66.V11 The bank owns a claim to $386.66 per month for the next five years. If we calculate the present value (using 0.5%, which is 1/12™ of 6% since the payments and compounding are monthly) of each of these 60 payments, and then add them all up, we arrive at exactly $20,000. v. Uncertain cash flows Some of you might be saying that this is all well and good, but many assets have very uncertain cash flows. How can a value be determined for such assets? Take stock for example. The dividends to be received are not simple to forecast. Companies can raise or lower them whenever they see fit. While this problem may at first seem insurmountable, there is a solution to it. One can estimate future dividends. While these guesses are likely to prove wrong, they are the best we can do. Then each of these expected future cash flows can be converted into a present value by the process of discounting. Finally, they can all be added up - just as we did in the case of the bank loan. Logically this should give us the value of the stock.


There is one catch, though, which I begin to deal with in the next section. Since these cash flows are inherently uncertain and hence risky, it is inappropriate to discount them at a rate that does not account for risk. The discount rate that we should use then is not a simple bank interest rate, but rather something else that includes a risk premium. A risk premium is a kind of reward or boost for taking on risk. Any wise investor will insist on this boost.

C. Risk and its rewards Once again, when you put your money into a bank, GIC, or the like, the investment return is certain. You know exactly how much you will have at the end of the year, or whenever the investment matures. But realistically, most investment returns have some degree of uncertainty. If you buy Brascan or Falconbridge stock, their returns are inherently uncertain or risky. Is there a way to measure risk properly? i. Probability distributions Before tackling the quantification of risk, let's think of an experiment. First, a warning: at this point I am giving readers a fairly painless taste of what probability and statistics are all about. 7s this really necessary? Unfortunately, yes: in my view, it is the only way to get a sense of the nature of risk. While some readers will not previously have been exposed to the basic ideas, that doesn't mean it's difficult to understand them (which is all we need to do). Say you are observing the roll of a standard six-sided fair die. Such a die can come up as 1, 2, 3, 4, 5, or 6. To make things concrete, let's say that we are playing a game that allows us to receive $1 for every dot on the die when it is rolled. For example, a '2' would give us $2. Each possible outcome has a l/6m probability of occurring. In other words, if you rolled the die hundreds of times, approximately 1/6™ of the time the die would come up as '!' (giving us $1), approximately 1/6™ of the time it would come up as '2' (giving us $2), and so on. What we have done is describe one particular probability distribution. This is simply a


statement of all possible outcomes that can occur for some experiment (such as die rolling) along with the associated probabilities of their occurrence. (Not so bad so far, I hope!) There are two key numbers that can be calculated if one has knowledge of a probability distribution. The first is a kind of average. In the context of probability distributions we call this an expected value.vm The idea is as follows: if we were to roll a die an extremely large number of times, observe all outcomes, and take an average over all these outcomes, what value would we expect to see? Let's think about this. 116™ of the time we would get 1, 1/6™ of the time we would get '2', and so on. A little thought should suggest that the expected value could be calculated as:

Expected value=1/6 * 1 +1/6 * 2 +1/6 * 3 +1/6 * 4 +1/6 * 5 +1/6 * 6=3.5 So, the expected value is just the sum of the all the products of each possible outcome and its probability. To be a bit more fancy, it is a weighted average (where the weights are the probabilities) of all outcomes.lx To interpret, if you were to receive the payoff from 1,000 rolls, your best guess is that you would receive $3,500. I know what some of you are saying. How can the expected value be a value that we will never witness? After all, we can roll that die till we are blue in the face, but we are never going to see a 3.5 come up. Remember, however, what the expected value means: it is the average that we would expect to see if we were to roll this die an extremely large number of times and observe all outcomes, and we never have to observe this average on a particular roll. The second key number associated with a probability distribution is a number representing variability. A name used for variability in the financial realm is risk. By risk I mean: how will individual die rolls look relative to the expected value? Will they be close or possibly quite distant? We will never see a 3.5, so clearly there is some risk. What would a distribution without risk look like? Well, say we had a six-sided die, but each of the six sides had three dots. Every time that die was rolled we would see a'3'. No risk at all.


ii. Measuring risk Back to the real die, which does involve risk. Over the years, people have suggested various ways to measure risk, and in fact the debate still continues as to which way is best. I will, however, stick to the conventional way: standard deviation* While there is a nice, neat formula for standard deviation, I am not going to burden you with the details (but, if you like, visit the endnotes to this chapter).xl Let's instead try to provide an intuitive idea of what standard deviation tells us. Since this is a measure of risk, the higher its value the more risk there is. So far, so good. If, for example, our die had 2, 4, 6, 8,10, and 12 on its six sides, because the numbers are more spread out compared to a standard die, there would be more risk. And the standard deviation for this die will be greater (double, in fact) than that of the standard die. So what is the standard deviation in the case of the standard die? Well, if you head to the endnotes and use the formula located there, you can calculate it to be (approximately) 1.7. But what on earth does this number really mean? Here goes. Over many die rolls, at least two-thirds of the time when you roll the die you will get a result that is within one standard deviation of the expected value. The expected value is 3.5, so if we add one standard deviation we get 5.2. If we subtract one standard deviation, we get 1.8. So, twothirds of the time our rolls should be between 1.8 and 5.2. Well, this worked out just right since it should be pretty obvious that two-thirds of the time we will get 2, 3,4, or 5 and one-third of the time we will get 1 or 6.xn While dice can be fun, let me turn to the sorts of distributions that we tend to see in the real world. These distributions do not have several possible realizations, but in fact have a very large number. What is an example of such a distribution? Take the temperature at a particular location at a particular time of day at a particular time of year: let's say the noon temperature in Inuvik on January 1st. Exaggerating a little, say the expected value is 50 below and the standard deviation is 25. Now, one can make the statement that at least two-thirds of the time (based on many observations), the temperature on this day will be between minus 75 and minus 25, that is, between the expected value


minus one standard deviation and the expected value plus one standard deviation. So, where are we now? I hope we have a pretty good sense of what a probability distribution is and how you can measure its expected value and standard deviation (risk). Since this isn't a book about playing dice or meteorology, but rather a book about investments, let's talk about a real security. Take Bank of Montreal stock again. Say you own a few shares and you want to use some of the fancy probability theory that you have just acquired. Specifically, you want to calculate the expected return on your stock over the next month and find out the risk (as measured by standard deviation) of diverging from this expected return. At the risk of putting off the reader, I must confess that I do not know the answers. But I don't feel too bad about it because no one knows. So why did I waste your time talking about probabilities and standard deviations? Bear with me. There will still be a payoff. iii. Security probability distributions cannot be observed The reason I can't tell you the expected return and risk for Bank of Montreal stock returns is because I can't observe what its true probability distribution looks like. But I can do something else that is at least second-best. I can observe history. Figure 2 shows a graph of monthly returns of Bank of Montreal stock returns over the last nine years (1996-2004). Let's take a simple average of these 108 observations. The answer is 1.71% per month. There is another kind of average return that investors are usually more interested in, the 'compounded' average. The latter answers the following question: what constant monthly return earned over each of the 108 months making up the 108month (9-year) period under study would make you just as well off as Bank of Montreal stock did? The answer is a lower return number than the simple average: 1.52% (which corresponds to 19.82% per year).xm This number is lower than the simple average because of the fact that there was variability in monthly returns.X1V


Figure 2: Bank of Montreal monthly returns (1996-2004)

Returning to the simple average, 1.71%, we can say that if the past is a very good reflection of the future, then this value should be a pretty good estimate of the true expected return over a given future month. But if this stock's prospects and risk today are different from what has been true over the last nine years, then all bets are off. What about risk? Well, again, I won't bore you with the details (those who like details should head to the endnotes for the formula), but, just as I can calculate a standard deviation from a distribution, I can also use another technique to calculate the standard deviation based on a sample of historical data.xv Using this method I arrive at a value of 6.14%. And, once again, if the future resembles the past, this number should be a pretty good estimate of the true standard deviation of future returns. I could then make the following statement: I could say that there is at least a 67% probability that the return in a given month will be between -4.43% (2.71% - 6.14%) and 7.85% (1.71% + 6.14%).


iv. Rewards for risk-bearing We can perform the same exercise, calculating average returns and risk levels for a good number of stocks, assets, and other investments. If we do so we will find that most of the time higher average returns go hand in hand with higher levels of risk. To examine this pattern more closely, in Figure 3 I look at a history of returns for a broadly diversified portfolio of Canadian stocks vs. a portfolio of long-term Government of Canada bonds. More specifically, the stock returns are based on the S&P/TSX Composite Index, and the bond returns are based on an average of Government of Canada bonds with maturities of 10 or more years. My sample runs from 1957 to 2004. The first date is when reasonably accurate Canadian stock market indexes begin. There were appreciable ups and downs for both asset classes, but during this period of time a broadly diversified portfolio of Canadian stocks earned an average compounded return of 9.37, while a portfolio of Government of Canada bonds with a maturity of 10 years or more earned an average compounded return of 7.69%.xvi As for risk, the standard deviation of stock returns was 16.20% while the standard deviation of bond returns was 10.83%. So, as we see in the figure, higher levels of risk went hand in hand with higher returns. One needs to note, however, that this is something that is not necessarily true over short periods of time. Rather it is something that should be true over long periods of time when the ups and downs have a chance to average out.xv11

What Kind of an Investor Are You? - 39

Figure 3: Historical Canadian stock and bond average compounded returns and risk (1957-2004)

D. Diversification The last section ended with some history: how broadly diversified portfolios of Canadian stocks and Canada Bonds have performed over the last half-century. The purpose of this section is to explain to you the reader what diversification means, and why it is desirable. A by-product of this investigation is that we will see that our perception of what risk means will have to change a little.

i. Combining stocks in portfolios Let's say we have a very simple stock. It either has a very healthy 30% return or a poor return of -10% in a given year. Each of these events occurs with equal probability. It is easy for us to work out that the expected return is 10%. It is also possible to work out that the standard deviation is 20%. Clearly, there is substantial risk here. Take a sister stock. It either has a decent return of 15% or a mediocre one of 5% in a given year. Again, each of these events occurs with equal probability. Once again we have an expected


return of 20%. Naturally, since the return dispersion is lower for the sister stock, the standard deviation is lower as well. If we use the standard deviation formula, we see the answer is 5%. Both stocks are risky. The first is riskier than the second. What if we hold them both together? Further, what if, when the first has a good return, the second always has a bad return, and, conversely, when the first has a bad return, the second always has a good return? Finally, let's say we put 20% of our money into the more risky stock, and 80% of our money into the less risky stock. When the risky stock does well (30% return), the less risky stock does relatively badly (5%), and the overall portfolio return is: .2* 30%+ .8* 5% = 10%

Notice that the way to calculate the return on a portfolio of securities is to take a weighted average of the returns on all the securities in the portfolio, where the weights are the percentages invested. Similarly, when the risky stock does badly (-10% return), the less risky stock does well (15%) and the overall portfolio return is: .2*-10%+ .8* 15% = 10%

This means that whatever happens we are guaranteed a return of 20%. So while each stock viewed in isolation is risky to varying degrees, together in a portfolio (with very specific weights) there is no risk at all. This simple (and rather contrived) example indicates that there is a difference between the risk of a security held in isolation and its risk in the context of a portfolio. Beginning with one of the stocks, the addition of the second reduces risk. The next task that I want accomplish is to convince you that it only makes sense to hold a wellTdiversified portfolio of securities. Recall the recent history of Bank of Montreal (whose ticker is BMO) examined previously. For illustrative purposes, I will also look at four other Canadian stocks: George Weston (WN), Telus (T), Dofasco (DPS) and Petro-Canada (PCA). Over the same nine-year period, the average monthly returns and standard deviations for these stocks are as shown in Table 1.


Table 1: Average return and risk for five Canadian stocks (1996-2004) Average return (per month) Risk (standard deviation)

WN

BMO

T

DPS

PCA

2.01%

1.71%

0.93%

1.24%

1.60%

6.91%

6.14%

10.68%

7.60%

8.00%

Let's say the past is a good guide to the future. If we were to put all our money into only one of these five stocks, then our portfolio's expected return over the next month would be 2.01%, 1.71%, 0.93%, 1.24% or 1.60%. The average of these five averages is 1.50%, which is what our expected return would be if we randomly chose one of the five stocks. The average risk of this randomly chosen stock would also be the average of all five standard deviations, namely 7.87%. Now let's diversify. What if we were to invest in two stocks, again choosing the specific ones randomly from these five? There are 10 possible combinations of two stocks. In each case, let's equalize portfolio weights (50% and 50%). The average return (1.50%) does not change. What happens to risk? While the calculation of the risk of a two-security portfolio is somewhat technical, it is important to know the role played by what is called correlation. If two variables tend to move together (e.g. rain and crop yield), they are said to be positively correlated. If two variables tend to move in opposite directions (e.g. hours spent watching television and school grades), they are said to be negatively correlated. Correlations are numbers between -1 and 1. If two variables move together, their correlation is positive; if they move together in perfect synchronization, their correlation is exactly '!'. Conversely, if two variables move in opposite directions, their correlation is negative; if they move apart in perfect synchronization, their correlation is exactly -1. The previous example, where we had two stocks whose returns always moved in opposite directions (their correlation was -1), showed that, when two securities have returns which are weakly positively (or, even better, negatively) correlated, then there is good scope for risk reduc-


tion by combining them into portfolios. In fact, one can say that the lower the correlation, the greater the scope for mitigating risk. In any case, to calculate the risk of a two-security portfolio, we need to know the correlation between the two securities' returns. I calculated all possible correlations between these five stocks. Using these, it can then be shown that the average risk of these ten portfolios is 6.10%. Notice that the risk declines from the onesecurity case (where it was 7.87%). Clearly diversification pays off. But why stop at two securities? Using these five stocks, I also considered the average risk of three-security, four-security, and five-security portfolios (always maintaining equal portfolio weights).xvm Figure 3 tells the story. This figure shows how, as we increase the number of securities, the risk of the portfolio tends to fall. We see diversification in action. Of course, there is no reason to stop at five stocks. It can be shown that, if we continue to put additional stocks into our portfolio, the risk of the portfolio will continue to decline, going below the point reached for five securities. Will it go to zero? Unfortunately, it will not. It can be shown that the decline continues, leveling off at about 30-40 stocks. While 30-40 are getting close to the ideal, ten actually get you much of the way. Naturally, it would be foolish not to get close to this lower bound. In other words, it is desirable to diversify your portfolio, not to put all your eggs in one, or two, or even five baskets.


Figure 4: Risk as a function of the number of securities in the portfolio

ii. Types of risk Notice that we have labeled two territories in Figure 4. Assuming you are willing to invest in risky securities like stocks, the kind of risk that you can (and should) rid yourself of is called diversifiable risk, and the kind of risk that you cannot rid yourself of is called non-diversifiable risk. Why is it that there is some risk that you cannot get rid of? The reason is that most stocks tend to move together to a certain extent (unlike our two hypothetical stocks at the beginning of the chapter, which moved apart) due to economy-wide cyclical activity. The economy has its ups and downs: it goes through periods of buoyant growth, eventually followed by periods of slow or even negative growth (recessions). During the latter, most stocks will fare ill and spending dries up in many sectors. No matter how much we diversify, we cannot get around this. Still we are wise to diversify as much as possible.

iii. A new perspective on security risk Earlier, I promised that our perspective on risk would have to


change a little. Standard deviation as a measure of risk gives us total risk, both that which is diversifiable and that which is nondiversifiable. But since the former can easily be eliminated, the market should not (and normally does not) reward investors for taking it on. So the only kind of risk that you should logically be rewarded for is non-diversifiable risk. How can this be measured? The traditional way of measuring this type of risk is with something called beta. Again, the reader need not be bored with the details.xlx The essential point is that the higher is a security's beta, the greater is the risk of the security in the context of a well-diversified portfolio, and the greater should be its fair or required return as compensation for the risk.

Table 2: Betas for different industries Industry Beta Air transport 1.34 Banks 0.53 Diversified chemicals 0.79 Computer software/services 1.90 Entertainment 1.40 Household products 0.74 Integrated petroleum 0.85 Publishing 0.74

To give the reader a feeling as to what betas look like, they are generally between 0.5 and 2.0, with one being an average beta. A stock with a beta of one has average risk: lower than one means below-average risk, and higher than one means above-average risk. So we can think of beta as non-diversifiable risk relative to its level for an average stock. Table 2 provides several examples of industry-average betas.xx In fact, it would probably not hurt to expose the reader to a fairly simple formula involving beta that was responsible for the awarding of a Nobel Prize in Economics (to William F. Sharpe in 1990). Recall that I said that a security with higher risk should typically earn a higher return. The following formula quantifies this, and beta appears front and center:


Fair return for stock = Risk-free interest rate + Beta * Market risk premium Before test driving this, let's make sure we know what the other inputs are all about. The risk-free interest rate is often estimated by the Government of Canada bond rate. The market risk premium (or equity premium) is defined to be the typical outperformance of the stock market over the risk-free rate. Let's use 4% for the time being. Say we have a beta of 1.2 and the risk-free rate is 5%. Then, plugging in all our inputs, the fair return on the security in question is: 5%+ 1.2* 4% = 9.8%

E. Valuation and market efficiency Investors need to have a sense of what a security is worth. This is especially crucial for selectors. For this reason we now turn to valuation. How can we value an investment such as a stock? i. Holding period approach Let's begin by taking a short-term perspective. Say one year is our holding period, that is, how long we are contemplating holding the stock. Logically, the value of a share today is closely related to what you expect to receive in cash payments over the next year (that is, expected dividends) - plus what you could sell it for one year from now. There are a few points to keep in mind. First, there is no way to know for sure what you will be able to get for the stock in one year. This is another way of saying that there is risk. The approach that must be taken is to estimate this future price. Similarly, while there is less uncertainty about what the dividend is likely to be, there is still some, so once again an estimate is called for. Second, since these two estimates (future price and dividend) are for amounts received one year in the future, time value will come into play. The procedure is to discount back to


the present - using a discount rate that reflects the risk borne the sum of the expected dividend and the expected stock price, in order to arrive at the (present) value of the stock. This is what a rational investor should be prepared to pay for the stock. Let me try an example. Continuing to use Bank of Montreal, recall the price in September 2005 was $58.05. The latest quarterly dividend was 46 cents. Suppose everyone forecasts that the quarterly dividend will remain at its current level for two quarters, after which it will move up to 50 cents. Further, suppose one particular analyst believes the stock will reach $70 in a year. On this basis the return expected by this analyst is: Expected return = (2 * $0.46 + 2 * $0.50 + $70 - $58.05) / $58.05 = 23.9%

Some of you might be saying: all well and good, but how on earth can we come up with an estimate of the stock price in one year? True enough: this is far from easy, but it is helpful at least to have some inkling where this number comes from. Transport yourself one year into the future. The price at that point is logically the present value (as of one year in the future) of the expected dividend and expected price (two years in the future). We still haven't got rid of that pesky (and difficult to estimate!) future price. So now let us transport ourselves two years into the future. The price then should be the present value (as of two years in the future) of the expected dividend and price (three years in the future). This process seems to go on and on - and on.

ii. Dividend discount model

If I keep moving my perspective one period forward, at a certain point the 'stubborn' future price will be for a date so far in the future that I can just forget about it (since its discounted present value will be miniscule). But notice that by employing this process I have collected a bunch of discounted dividends. In fact, in case you haven't noticed it, we now have another formula: Stock value = Present value of 1st dividend + Present value of 2nd dividend + Present value of 3rd dividend + ...


Note that the last three dots mean: and so on, forever. This formula says that the value of a stock is merely the present value of all expected future cash flows (dividends) to be received if you hold the stock indefinitely.xxl This formula is logically called the dividend discount model (DDM). Still, admittedly, this is a rather difficult formula to use, since it involves projecting dividends into the far distant future. Who can do that? / certainly can't!

iii. Constant growth There are ways to simplify things a bit. What if a company's dividends are likely to grow at a constant rate? This is actually quite reasonable for a goodly number of firms. A little math homework (again I won't bore you with the details) allows us to convert our messy DDM into a much more reasonable formula that is really not so hard to use: Stock value = (Dividend expected next year) * (Fair return - Growth rate) There are only three things to estimate, but we have to be careful. To use this formula, we need to feel secure that this is the sort of company where we can truly expect constant growth. Many companies, especially those in rapidly growing industries, will be poor candidates. Often such companies will grow rapidly for a while before reaching a state of maturity and lower constant growth. While there are other techniques that one can use in such cases, suffice it say that, for a fast-growing firm, the price will be higher relative to current dividends than it would be if the firm were growing at a slower constant rate.XX11 The same statement can normally be made about earnings: fast growers will have price-to-earnings ratios (P/Es) that are higher than average. In fact, some analysts use P/Es extensively in valuation. The idea is to compare the firm's actual P/E to what it should be, given its characteristics (such as growth). Let's try out the formula, again using Bank of Montreal. Taking the total anticipated dividend for the coming year ($1.92) and the total realized dividend from the previous year ($1.80), we


calculate an expected growth rate of 6.7%. Let's use a 10% required return on this stock. Using our formula, the value of a share is:xxm $1.92 -r (10% -6.7%) = $58.18 This was very close to the trading price ($58.05) as of the time of writing, suggesting that the value of the stock is consistent with the assumptions made.xxlv iv. Constant growth at the level of the market At one particular level of analysis, constant growth is always quite reasonable, that is, at the level of the entire stock market. Let's think in terms of the S&P/TSX Composite. To use this formula, we first need the growth rate for the market and the market discount rate. Say we feel that a reasonable growth rate think of it as the growth rate for the whole economy - is 5%. By the way, when economic growth rates are reported in the newspaper, they are 'real' (which means inflation-adjusted). The 5% growth rate just assumed is to be viewed as 'nominal,' that is, not inflation-adjusted. This means that it is the sum of the expected real growth rate and the expected inflation rate. The use of a nominal growth rate is necessary if the discount rate used in the formula is also not inflation-adjusted, and normally discount rates are not. For the discount rate, let's use 9%, which is the sum of the risk-free rate (say 5%) and the market risk premium (say 4%) xxv Suppose we observe a S&P/TSX Composite level of 10,000. (The TSX was trading above this at the time of writing.) To make sure you know how to use the formula, you should be able to show that all these values are consistent with an expected aggregate dividend over the next year of 400.XXV1 What if, because of very positive economic news, experts revise their expectations, now forecasting an aggregate dividend of 425? Plugging in this new value, the index should now rise to 10,625.xxvu So one reason the market can go up is because of a belief that earnings (and dividends) will be higher in the future.


v. Market efficiency Now that we understand value, it is important to be able to relate it to price. This leads us to the notion of market efficiency. Say we estimate a stock's value in the manner described above and then compare it to the market price. We find there is a difference. The market price is $10, while we have estimated a value (sometimes called an intrinsic value) of $20. There are only two possibilities: either the market is wrong in setting prices, or we are wrong in estimating value (or perhaps some combination of the two). If we are right and the market is wrong, it's obvious what should be done: buy the stock, since we have found a bargain. But maybe the market is right and our analysis is faulty. What to do? Before deciding, it is well to think about what a market price really means. Quite simply, it is a kind of consensus estimate of the true value of the stock. All investors, via their supplies of and demands for a particular stock, have some impact on the price. And the people with the biggest influence are the market pros, the big institutional money managers (who presumably have studied the stock in question). So let us return to the issue. Who is right? You or the market? Perhaps the answer is not so simple now. The view of the world which says that the market (everybody else collectively) knows more is the so-called market efficiency view. In its strictest version, it is said that markets are efficient if the price of a security is at all times equivalent to the best possible estimate of its intrinsic value. There are some hidden assumptions here, one of which is that all information is freely and publicly available, and all have equal access to it. (Sounds like Utopia, I know.) Why will price and value be identical under these conditions? Return to our previous Bank of Montreal example. Recall that I assumed that dividends would grow at a constant rate of 6.7%, the dividend expected next year was $1.92, and the fair return was 10%. Say that none of these points are in dispute. What is the stock's intrinsic value? Given all these assumptions, we can calculate value, using the constant growth model, arriving at $58.18. Will this be the price? In a world with costless and immediately accessible information, will all individuals agree on this value? Yes! If everybody


has the same information, we can all plug the numbers into the formula, coming up with the same answer. But wait: how did we know which formula to use? We know because one key item of information is simply how to process all the raw data that are available, that is, what formula to use. To recap, since everybody has the same information and processes it in the same way, everybody arrives at the same intrinsic value estimate of $58.18. Clearly, if the price were less, the demand would be large relative to the supply, causing the price to rise. And if the price were greater, the supply would be large relative to the demand, causing the price to fall. Therefore, only a price which just equals everyone's estimate of intrinsic value can persist in the market. The implication is that, under market efficiency, value unequivocally equals price, and all known relevant information is embodied in the price of the security. While I don't believe this view is right, it is a good starting point to build from. In fact, in Chapter 4, I will introduce a more realistic (and somewhat altered) view of market efficiency.

vi. Price changes and efficiency In an efficient market, why are prices observed to change? Prices change because new information causes estimates of values to change.xxvm Note that I have stressed the word 'new/ For information to be considered new it must be unexpected. For example, if the Bank of Canada raises interest rates by 25 basis points (which means 0.25%), and if this was universally expected, the market's reaction will be: ho-hum. Prices would only change if the announcement contained something unexpected (if, say, people expected 50 basis points). Consider the case where the information is truly new, that is, unexpected. To illustrate, we'll return to Bank of Montreal stock. Say conditions within the economy and industry change such that all investors revise their estimate of the company's upcoming annual dividend to $2.20 (from $1.92). Nothing else changes (including the growth rate beyond this first year). Once again, there is no disagreement. How will the intrinsic value change? The answer is that it will immediately jump to $66.67.


vii. Random walk We have seen that, according to the market efficiency view of the world, price changes are unpredictable or random, and will only occur in response to new information. This notion is called the random walk.xxlx The random walk terminology comes from the idea that, if stock price changes are random and unpredictable, they will move ('walk') in an unpredictable ('random') fashion. Think of an inebriated gent who has had way too much and is meandering down the street. You (and he) have no way of knowing whether he will next teeter left or right. His movement is truly a random walk.xxx Some people misinterpret the random walk and think that it means stock prices are meaningless because their changes are unpredictable. In fact, the opposite is true. Stock prices are full of meaning: they are based on a wealth of fundamental information about the economy, industries, and companies. All known information is already embedded in stock prices. New information by definition is unpredictable, which is why stock price changes are unpredictable, but, once the new information is digested, it too will be incorporated into prices.


R Recap 1. Investors hold securities to obtain returns. Returns come from capital gains and cashflows, both expressed in percentage terms. Knowledge of time value allows you to compound present values forward into future values, and to discount future values back into present values. 2. Risk is conventionally measured by standard deviation. Investors want to be compensated for risk, which is why risky securities on average earn higher returns than less risky securities. 3. Diversification allows us to reduce risk, since security returns are not usually perfectly correlated. But diversification only goes so far: market-wide risk cannot be eliminated. Security risk in isolation is different from security risk in the context of a portfolio: only the latter is normally rewarded. 4. Securities are worth the present value of expected future cash flows. Market efficiency in its strictest form means that prices and values are always identical, but later, in Chapter 4, a more realistic version will be introduced.


Endnotes

i When I use the term 'stocks/ I am referring to what are, more technically, called 'common stocks/ Preferred stocks (or shares) are a kind of hybrid between stocks and bonds: dividends are not at the discretion of the Board of Directors, but instead are fixed. ii See an appendix for a listing of some useful Web addresses. Other key exchanges for Canadians are the Montreal Exchange (www.m-x.cd) where derivatives are traded and the New York Stock Exchange (www.nyse.com). iii This return is actually understated a little because the reinvestment of dividends is not accounted for. iv Technically, the term 'bond' is usually reserved for fixedincome securities with an original maturity of a year or more. Fixed-income securities with shorter maturities are usually called money market securities. I will use the term 'bond' to refer to any fixed-income security regardless of maturity. v Canada Bonds have maturities that range up to 30 years. Treasury Bills (or T-Bills) are Canadian government money market instruments, and are issued with maturities of 13, 26, and 52 weeks. The latter, unlike standard bonds, have no interest payments till maturity. Additionally, certain bonds (both government and corporate) have been 'stripped,' which means their coupon payments and principal are bought and sold separately. They are known as strip bonds. vi In fact, if a bond is held for a short period of time, the yield that it was bought at and the realized return can differ substantially. If, after the purchase of the bond, interest rates rise (meaning bond yields rise), then returns will be depressed. And, conversely, if interest rates fall, returns will be elevated. vii For this we use what is called the 'annuity formula:' PV of all payments = Payment * [1 -11(1 + Discount rate)No. of payments ] I Discount rate Note that I have used TV in the above formula. Technically, an annuity is a series of identical cash flows coming at set intervals. viii Another name is population (or distribution) mean. ix A perceptive reader will note that the expected average here is the simple average of all six possible die sides. The 'weighted'


part would come in for a problem such as the sum of two die rolls. There would then be l/36th probability of a '2', a l/18th probability of a '3', and so on. (The expected value is '!'.) x Some argue that, in a financial context, only downside variability constitutes true risk. I will however stick to the standard definition. xi Before giving you the formula for standard deviation, I first need to show you how to calculate a variance. In words, the variance is a probability-weighted average of all possible deviations from the mean squared. For variable x, the procedure is as follows: 1. Take each possible x value and subtract the expected value of x. 2. Square these differences. 3. Multiply each of these squared differences by the corresponding probability. 4. Sum up all of these latter terms to get the variance. 5. Take the positive square root to get the standard deviation. xii By the way, an even stronger statement can be made: at least 95% of the time when you roll the die (again, over many rolls), you will get a result that is within (approximately) two standard deviations of the expected value. A little bit of simple arithmetic will indicate that this worked quite well also. In fact 100% of the time (which, of course, is at least 95% of the time) we would get a die roll between 3.5-2 * 1.7 = .1 and 3.5 + 2 * 1.7 = 6.9. xiii The compounded average return is calculated as follows: 1. Add one to each return to get the corresponding 'gross return/ 2. Multiply all gross returns together. 3. If there are n of these, take the nth root and subtract one. xiv A simple example shows the intuition behind why the compounded average return is lower than the simple average return. Start off with a $100 investment. In the first year, you have a return of -50%. You are now down to $50. In the second year, you have a return of 50%. You are now up to $75. Your simple average return is zero, but your compounded average return


(which tells you what you end up relative to what you started with) is negative. Note that the spread between the compounded average return and the simple average return will be greater the more risk there is. xv Use the following procedure to get the standard deviation from a sample: 1. Subtract each x value from sample mean. 2. Square the differences. 3. Sum up the latter. 4. Divide by the sample size minus one to get sample variance. 5. Take the positive square root to get sample standard deviation. xvi The simple (non-compounded) averages for stocks and bonds were 10.57% and 8.20%. xvii See Siegel, J. J., 2002, Stocks for the Long Run, Third Edition, McGraw Hill, New York. Siegel provides comparable and more complete asset price data for the U.S. One advantage of looking at the U.S. is it has a more extensive set of data of stock and bond returns than does Canada. xviii It gets quite technical moving to the three-security (and so on) case. xix Any standard introductory finance or investments book will explain beta and the theory behind it in detail. A good example is Ross, S. A., R. W. Westerfield, B. D. Jordan and G. S. Roberts, 2005, Fundamentals of Corporate Finance, Fifth Canadian Edition, McGraw-Hill Ryerson, Toronto. xx These are U.S. industry betas using data up to January 2005. The source is:http://pages.stern.nyu.edu/~adamodar/New_ Home_Page/datafile/Betas.html xxi It doesn't matter how long you really plan to hold the stock. The key point is that, when you sell it, the buyer will intend to hold it for while, and, when this buyer eventually sells it, the new buyer will be planning on holding it for a while, and so on. xxii Note that, if high-growth firms did not eventually settle down, in time they would take over the entire economy. One advantage in looking at earnings instead of dividends is that


some firms do not pay dividends. xxiii Note that the previously mentioned analyst would disagree that the stock is fairly priced. Since he found that his personal return expectation (23.9%) was greater than the required return (10%), he would make a buy recommendation. xxiv This example is for the sake of illustration only. I am not claiming that any of the assumptions used (including the use of the constant growth model) are reasonable. xxv The (nominal) risk-free rate could perhaps be 3% real and 2% anticipated inflation. xxvi This is because 400 -s- (9% - 5%) = 10,000. xxvii This is because 425 -*• (9% -5%) = 10,625. xxviii The print media are major suppliers of financial information. Good sources are: Globe and Mail Report on Business (www.theglobeandmail.com), National Post, Financial Post (www. nationalpost.com), Wall Street Journal (www.wallstreetjournal.com), Canadian Business (www.canadianbusiness.com), MoneySense (www. money sense.ca), Business Week (www.businessweek.com), and the Economist (www.economist.com). xxix This term was popularized by Burton G. Malkiel in his 2003 book A Random Walk Down Wall Street, Eighth Edition, W. W. Norton & Company, New York. xxx More precisely, stock prices follow a random walk with (positive) 'drift/ Even if all goes as expected, prices should gradually rise as a reward to investors for putting their capital at risk.

Chapter 2

Some essential background on mutual funds A. Preview In this chapter we will learn some essential facts about one of the most successful financial innovations of this century, the mutual fund. In a nutshell, a mutual fund is a pool of money contributed by individual investors but managed centrally and professionally1 In finance, we usually capture success by dollars. Around the world there are now $11.7 trillion U.S. dollars invested in such funds.11 In section B of this chapter, I describe how funds work and why they are the investment vehicle of choice for many. Like most things, there are pros and cons to mutual funds. The main positive element is clearly professional money management. In the next two sections, I discuss the negative side of mutual fund investment. Most obviously, there are the costs that must be incurred in order to retain this professional management. In section C, I discuss their array Then, in section D, I turn to some of the hidden negative attributes of funds. These come down to "the games that fund managers play" and the weak governance of fund companies. It will be later in the book, in Chapter 4, that we turn to the big question: do the pros (principally professional management) of mutual fund investing outweigh the cons? Finally, I close by providing, in section E, an example of a Canadian mutual fund, while describing some of the key fund characteristics that it is important to understand when investigating such investments.


B. How do mutual funds work and what are their advantages? Mutual funds are investment companies that receive cash from the investing public, buy securities with the money, and issue shares representing indirect ownership of portfolios of these securities to public investors. Ignoring various potential costs for the moment, the investor buys and sells (redeems) units in the fund at net asset value (NAV). An illustration might be helpful. Say a fund has invested in three stocks: 300 shares of A at $10; 200 shares of B at $15; and 400 shares of C at $20. The total value of the shares is: 300 * $10 + 200 * $15 + 400 * $20 = $14,000

If there are 1,000 fund units, the NAV of each would be $14 ($14,000/1,000). If you owned 100 units (10% of the fund total) you would have indirect ownership of 30 shares of A, 20 shares of B, and 40 shares of C. Of course you could go out and buy the shares yourself. Indeed there are investors who steer clear of mutual funds, which means that they have concluded that they can do better without them. But many others have concluded that the clear advantages offered by mutual funds, especially professional money management, more than offset any disadvantages. While some investors have decided to do it themselves, those who have embraced mutual funds are an increasingly large group. Take a look at Figure 1, which documents the growth in Canada of mutual fund assets over the last 15 or so years. One certainly cannot dispute that mutual funds have been extremely useful in opening up the stock market to Canadians from all walks of life. Many people do not have sufficient funds to assemble their own stock portfolios, and, even if they did, would find the task quite daunting. What stocks, after all, should one be buying, and how long should these be held? How many stocks must be purchased for reasonable diversification? Some enjoy the 'thrill of the game/ but the wise investor realizes that she is saving

What Kind of an Investor Are you? — 59

for her and her family's future. She wants to do it right! Without doubt, mutual funds are useful in a number of respects. In particular, an investor can look for a fund whose stated objectives and style conform to his requirements. Then he simply sits tight and lets the manager(s) do all the work. This is not to say that some homework or advice in selecting and monitoring funds will not prove useful. Still, professional managers and fund company personnel control and monitor the portfolio, administer the account, and ensure that the specified objectives continue to be met and that proper record-keeping is done.

Figure 1: Mutual fund assets in Canada

Source: Investment Funds Institute of Canada i. Index mutual funds vs. actively-managed mutual funds There are many flavors of funds, but let me first stress one key distinction, that between index funds and all others. An index fund typically has quite low expenses. The only intention of management is to buy securities in such a way that the return on the fund will almost exactly conform to the return on a particular index. Often the index is a stock market index. A well-known stock market index in Canada is the S&P/TSX Composite Index. So


an index fund designed to replicate the performance of the Composite would (ideally, but not necessarily) buy all the companies making up the index in the right proportions so as to precisely track this index. Not a lot of thinking to be done (just some straightforward technical work), which is why the fees on index funds should be fairly low. Once again, it is said that an index fund is being managed passively. On automatic pilot, as it were! Index funds will be discussed in more detail in Chapter 6, which deals with the process of indexation. In this chapter, when I talk about mutual funds, the reader should think only of those that are actively managed. A manager of such a fund is not in the back seat of the taxi being driven around by the index. Rather, she is in the front seat doing the driving. Obviously, such a driver will demand higher compensation, so actively managed funds have higher expenses. Once again, the big question is this. Can actively managed mutual funds invest well enough to earn gross returns that are sufficiently high to more than offset the costs incurred? Abundant research has been undertaken on this theme. A large majority of studies indicate that mutual funds are not on average able to beat the market! And, while some are able to do well over a given period of time, it is not necessarily easy to say which ones will do well in the future. But I am getting ahead of myself. This is the discussion that Chapter 4 is devoted to.

ii. Asset classes, sectors, and styles While I will have more to say about asset classes later in this book, it is important to understand some distinctions right now. The reason is that virtually all mutual funds specialize in a particular asset class. Sometimes the class in question is quite broad, sometimes quite narrow. We have already discussed the differences between stocks and bonds. Naturally there are bond (or fixed-income) funds and stock (or equity) funds. Another important distinction is between funds investing in Canadian and foreign assets. So, for equities, there are Canadian equity funds and international equity funds. Even in the latter class there is often specialization, with U.S., European, and Japanese funds being quite common. Drilling down further, some funds specialize in


sectors of the economy, such as gold stocks, financials, or energy stocks. If one invests in such funds, it is important to also hold shares in other funds in order to properly diversify over industries. Another increasingly popular way to slice things is by style. To be sure, over the last number of years, style investing has come into vogue. At one time, there were just equity funds. Now there are small cap growth funds, large cap value funds, and so on. Some background on these will be helpful. It is sometimes argued that styles arise when it is noticed that certain groups of stocks, which can be differentiated in some reasonably objective fashion, are outperforming other groups. For example, around 1980 it was noticed that small cap stocks tended to outperform large cap stocks on a risk-adjusted basis. A small/large cap stock is essentially the stock of a small/large company (that is, one with low/high market capitalization).111 Since people want to be in what's hot, small cap funds sprang up to focus on this successful style. It soon became apparent though that things were not so simple, as large cap can outperform small cap at times, as market leadership cycles back and forth. Also, it has been noticed that so-called value stocks tend to outperform growth stocks for extended periods of time, though sometimes growth has outperformed value. Growth stocks are stocks that have high prices relative to earnings, cash flows, and book value, while value stocks have low prices relative to earnings, cash flows, and book value. The reason for this terminology is that when one buys a stock with high expected growth, you are not so much paying for current earnings as future earnings, which means the price relative to current earnings is high. Only growth justifies the price.lv These are the two major style distinctions that have arisen: firm size and value vs. growth. The two-by-two matrix below (Table 1) shows how funds can fall into four categories based on these two styles.v


Table 1: Style categories of equity funds

Size

Value/growth Value Growth Large cap Large cap value fund Large cap growth fund Small cap Small cap value fund Small cap growth fund

One reason for concern over style is that while sometimes one style outperforms its complement, and sometimes the reverse happens, you do not really know in advance which style will win out. Thus it is often argued that you should diversify not only over securities and asset classes, but also over styles. So instead of just holding an equity fund you could hold funds from each box in the above table - thus fully covering yourself.

C. Tangible costs Mutual fund investment entails three tangible categories of costs: loads, management expense ratios (MERs), and trading costs. The first two are clear disadvantages over personal trading, while the third is likely on balance to be an advantage.

i. Loads A load is a sales commission that must be paid to the salesperson who sells an investor a fund. Many funds are distributed in this way, though others are distributed directly by the mutual fund company itself, thus obviating the need for a load. Funds in the latter category are called no-load funds. Not too long ago virtually all Canadian mutual funds charged a front-end load. Think of a 6% load. This meant that an investment of $10,000 would buy you $9,400 worth of mutual fund units. With the growing presence of banks offering no-load funds, a shift to rear-end loads (or deferred sales charges, or DSCs) occurred. What happens in this case is that charges are levied when an investor redeems units.vl Typically such charges decline with the period of time that the investor holds the units. For example, a charge of 5% might be paid if redemption occurs


within the first year, 4% within the second year, and so on.v11 With either front-end or rear-end loads, additional ongoing compensation goes to the salesperson, for monitoring your account and providing advice (whether or not the advice is actually provided), via what's called a trailer fee, which comes out of the MER (which is described next). ii. Management Expense Ratios (MERs) Now that we know how the salespeople are compensated, let us turn to how fund managers and their companies are compensated. This is done through the Management Expense Ratio (MER), defined as a deduction of a set percentage of assets under management as specified in the fund prospectus, primarily in compensation for portfolio management services. There is actually a fair amount of dispersion in MERs with a range of 1.50-3% encompassing most funds. It should be noted that the MER covers a variety of fund expenses other than a direct fee for portfolio management services, namely such items as fund administration expenses, advisor sales commissions, and ongoing trailer fees (see previous discussion), legal and audit fees, custodian and transfer agent fees, marketing and advertising expenses, and GST. In order to give people maximum choice, some funds today are marketed with a choice of load/MER combinations. It is quite typical, for example, to have the choice between a fund with a negotiable front-end load and a higher MER (due to a higher trailer) and an identical fund with a higher rear-end load (or DSC) and lower MER (due to a low trailer). Despite some softening over the last year, it is bad news for the mutual fund investor that MERs have been rising over time. The estimated average MER for all Canadian-based funds rose from 2.02% in 1995 to 2.44% as of April 2003.™ This latter figure excludes so-called segregated funds, which have higher MERs but also contain an insurance component.lx Some have argued that, if anything, MERs should be declining because, as funds and fund companies grow, it should be possible to achieve cost savings through economies of scale.


While 2% (or more) may not seem like much, it needs to be recognized that this constitutes a substantial cost that can significantly eat away accumulated wealth over time. To illustrate, suppose 40 years ago (at the beginning of 1965) we invested $1 in a Canadian equity fund. Let's say each year this fund had a gross return (that is, a return before fees) that exactly equaled the return on the broad Canadian stock market. That is, it did no better nor any worse. Funds are not free, of course, but initially let's suppose that this fund levies no fees, which means that gross returns and net returns are identical. Looking at the path labeled 'No fee' in Figure 2, we see how $1 would have grown to more than $37 by the end of 2004. Clearly, equities have been a good investment! Additionally, this graph shows how much less one's wealth would have grown to given a 2% MER per year, an amount that each year opens up a 2% gap between the net return and the gross return. Now how do we fare? The answer is that we end up with less than $18 (which is less than half of $37). I think the reader will agree that this constitutes a substantial deduction, and loads (where present) have been ignored. This example has been a bit unfair in one sense, though. Suppose the manager in question does have some skill and is able on average to add 1% on a gross basis. This means that on a net basis we should not deduct 2% but rather 1% (2% MER minus 1% gross return boost) from the market's return each year. (By the way this is equivalent to a 1% MER with no skill and we have labeled it in this way on the graph for simplicity.) Now instead of $18 or $37, we end up with almost $26 - still a fair bite. To preview, when we get to Chapter 4, we will see that this intermediate case is a pretty reasonable approximation of reality. In other words, the evidence indicates that there is some skill - but not enough. Not only is the MER high in an absolute sense, it is also high in a relative sense. The U.S. mutual fund market is, in most important respects, very similar to the Canadian market. There is one respect in which it is different though: it is cheaper for investors. Karen Ruckman of Concordia University notes that the average Canadian MER is 50% higher than the average American MER.X She attributes this to a variety of factors. On the justifiable side, there are fewer cheaper index funds in Canada, and Canadian


funds and fund companies are smaller, allowing for fewer costspreading savings in Canada. Still, she concludes that a good part of the story is a less competitive environment in Canada. In other words, fund companies in Canada charge more because they can.

Figure 2: Performance deterioration due to MERs

iii. Trading costs Mutual funds engage in active trading (unless they are index funds), which means that trading (or transaction) costs are incurred. There are three categories: commissions, spreads, and market impact costs. When shares are bought or sold, brokers must be paid commissions, but with the advent of discount brokers, these have declined over time. And for mutual funds, which often buy or sell large blocks of stocks, the per share commission becomes quite low. In this sense, funds are in an advantageous position relative to retail investors. What about spreads? The spread specifies a separate buying price (the ask price) and selling price (the bid price). Spreads are necessary to compensate firms that stand ready to buy and sell securities (that is, 'make markets'). Say a stock has a bid of $49.75


and an ask of $50.25. To buy the stock 'at market" you have to pay the higher price, $50.25. If, immediately afterwards, you decide to sell it back, you only receive $49.75. One can say that the true price is $50 (exactly between the bid and ask), but buying requires paying a little more and selling means receiving a little less. These small differences, which of course matter in percentage terms and add up over time, are spread costs. Bid prices and ask prices are not for unlimited amounts of stock. Depending on market depth they may be for a small number of shares or a large number of shares. Let's say for a particular stock, the bid and ask are both for up to 5,000 shares. Additionally, let's say a fund wants to move 50,000 shares. Specifically, say a sell is desired. How can this be done? While 5,000 could be sold at $49.75, additional shares would have to be sold at lower prices (depending on what the full order book looks like).xl To get around this, a fund can do different things: one possibility is to go through an investment dealer specializing in block trades. Such a dealer will attempt to find a counterparty willing to buy 50,000 shares at what is deemed to be a reasonable price. Or the traders working at the fund can 'ease' the shares into the market: say 5,000 now, wait a while, another 5,000 in a half hour, wait a while, and so on. But, as time passes, the market might move away from the fund, causing it to lose its opportunity. By the way, this last category of costs does not exist for the typical retail investor whose transactions will rarely be big enough to move markets. Where do we see these trading costs? We do not really see them clearly as they come directly out of the fund's assets. Of course, the hope is that the trade in question is sufficiently profitable to more than offset the impact of trading costs. Now it should be recognized that some funds do a significant amount of trading, while others follow a more buy-and-hold strategy. To get a sense of where your fund falls in the scheme of things, you can look at its turnover ratio, the percentage of assets that are bought or sold in a given year. The higher this percentage, the more trading the manager has been doing. It is not that one turnover number is better than another. The key is: has the trading enhanced or detracted from overall performance?


Still, it should be mentioned that there is one negative associated with high amounts of trading. Funds with high turnover rates tend to be realizing more capital gains (which must be distributed to unitholders) than funds with low turnover rates. This will not bother you if your fund is held in a tax-deferred account (such as an RRSP), but, if your money is in a taxable account, this will certainly matter, as a gap will be opened up between the pretax returns that funds report and the (unreported) post-tax returns that matter to you.xu

D. Some hidden costs: Games played by mutual fund managers and weak governance of fund companies i. Manager games This section is not about the obvious spinning done by fund managers and companies. For example, it is natural that companies put the best face on their results. If your one-year return does not look good, stress your three-year numbers. Failing that, maybe your five-year numbers are quite showy. And, if none of these numbers are particularly impressive, maybe you have had a great quarter, so why not stress that? Or taking the fund company perspective, advertise your best funds, certainly not your worst ones.xm The games described below however are not at all obvious to average investors. The typical mutual fund unitholder naturally hopes that the fund manager(s) is working hard to deliver the highest possible returns consistent with the fund's stated objectives. The reality is that in some cases goals are pursued that are more in keeping with the narrow self-interest of the manager than that of the unitholder: in effect, 'games' are played. This stems from what economists call the principal-agent problem: the agent, the manager, should be acting on behalf of the principal, the unitholder, but sometimes, if incentives are inappropriately formulated, acts on his own behalf. How are managers rewarded? Compensation is normally a given percentage of assets under management. If the percentage is 1%, and $100 million is under management, then the compensation is $1 million (going to the managing firm),


while, if there is $1 billion under management, then the compensation is $10 million. So obviously there is a strong incentive to attract fund flows. What attracts fund flows? The evidence is that performance (especially recent performance) is the key driver. Studies in both the U.S. and Canada show that the best-performing funds attract the most money.xiv It turns out that there is an asymmetry to this. It is not that the top quartile (best performing 25% of funds) attracts the most money, the second best quartile attracts some money but less, the third quartile (being below average) loses a little, and the fourth quartile loses a lot. In fact what happens is that virtually all new money goes to the leading funds (say the top quartile), while little is lost at the bottom, so there is a powerful incentive to fight your way into this group, to look as good as possible. Three games are sometimes played to achieve this purpose: portfolio pumping, tournamentlike behavior, and closet indexing.xv First, the strategy of portfolio pumping can be used by managers to exaggerate performance. Typically, managers are evaluated over fixed evaluation periods such as one year. Say a manager has a substantial holding in a fairly illiquid small cap stock. If the price of this stock were to rise at the end of the evaluation period, this would serve to boost performance. Some managers have been known to get a quick performance boost on the last day before required portfolio posting by themselves creating demand in such stocks.xvl This buying activity serves to artificially (and temporarily) generate higher returns. Why is this bad? Needless transaction costs are incurred and, since the price should eventually move back to appropriate levels, performance is distorted. Second, funds sometimes participate in tournament-like behavior for strategic reasons. A tournament is a 'winner take all' affair. A golf tournament is a good example. There is only one British Open winner. He gets the glory and the big bucks. To come close is pretty good: the top ten paychecks will certainly be hefty. But does anybody remember who came 20 , or 30 , or 40^? While there will still be a little money (relatively speaking) for such people, the distinctions will not be great. Recall we said that the top funds get almost all the new money. Let's say 'top7 is viewed as


being in the first quartile (top 25%). The solid but not quite top funds get very little new money. Performance is measured on an annual basis, but people can do periodic comparisons in advance of the one-year 'finish line.' Say a manager notices that after a half year she is doing well - but not extremely well. While safely in the second quartile, she is definitely within striking distance of the top quartile. What should she do? Work harder? She already puts in 60-hour weeks, so this can't help. The answer is that she can take on more risk.xv11 By doing so her portfolio is more likely to rise up. Of course, risk being two-sided, she is also more likely to drop down. But look at it from her perspective. Rising up will push her into the first quartile, bring in substantial fund flows and increase her compensation dramatically. Dropping down to the third quartile will not hurt much. So it makes sense to go for it. Why is this bad? You bought this fund because of its attributes and one of these was the risk that the fund manager was typically assuming. Say normally her risk level was moderate. That's what you wanted. But now she has changed her stance to high risk. This is not what you bargained for. Third, closet indexing can be used to lock in gains. Consider another manager in the same race to the finish line. This individual at the halfway point has put up great numbers. As long as he doesn't stumble, he will remain in the first quartile. One way to play it safe is to become a closet indexer. The idea is to re-arrange your portfolio so that your performance will approximate the return on the benchmark index. Essentially you are playing it safe and placing no bets. You are slavishly imitating the index. Why is this bad? This takes no skill. Why would you want to pay a manager big bucks to do what anybody else can easily do?xvm ii. Weak governance at fund companies How are funds operated, managed, and, most importantly, monitored? In other words, what is the state of mutual fund governance in Canada? Critics charge that Canadian governance is weak, often favoring the fund company over the investor.xlx One point of contention centers on the independence of board members. In the U.S., the Securities Exchange Commission (SEC) is currently moving in the direction of greater board member


independence, but a similar movement does not seem to be occurring in Canada.xx One area where a potential conflict of interest exists is in the setting of management fees, with investors preferring low fees and management desiring high fees. Indeed, a study of U.S. mutual fund board composition and compensation found that fees are lower when the percentage of independent members on the board is higher.xxl Governance of mutual funds has attracted a lot of press attention the last few years, in large part because of the revelations of such illegal or inappropriate practices as after-hours trading and market timing. To focus on market timing, this is an activity that is demonstrably deleterious to the well-being of long-term fund investors. What is market timing and who is affected? Investors in international equity mutual funds, investing say in Europe or Asia, are most hurt. Why is this? Recall that mutual fund investors buy shares and redeem shares at the fund's NAV as of the close of trading in Canada. The problem for an international fund is that at the close of trading in Canada, many of its prices are 'stale/ that is, not reflective of current market conditions. A simple example to clarify is probably best. Say there is a Japanese stock fund entirely investing in the Japanese stock market. While Japan sleeps, North American markets have had a great day. When this happens there will usually be a cascade effect leading to good returns later in Asia. If one buys into the Japanese fund at the close of North American trading, the price paid (based on NAV) will be lower than it really should be, since it is predictable that Japanese stock prices will rise. After this happens, a good one-day (largely predictable) return will have been generated. But this return does not come from thin air. It comes out of the pockets of long-term investors. Indeed, one academic study estimates that market timers cost international fund investors 1-2% per year.xxu Compounded over time, this is a hefty number. Moreover the Globe and Mail estimated that market timers in Canada pocketed $550-650 million between 2000 and 2003 xxiii While one cannot fault wily investors who try to take advantage of available opportunities, it is poor governance to allow this to happen. It is argued that some companies have been lax


because they profit from the fund inflows of market timers.xxiv Nevertheless some firms have taken active steps to discourage such activity. For example, TD Asset Management has imposed a 2% penalty on anyone who redeems shares within 90 days of investing in order to discourage market timers. Even better, Fidelity Investments has instituted a system called 'fair value pricing' where NAVs are adjusted to reflect likely offshore market movements.

E. Fund characteristics Let's say you are interested in selecting a mutual fund for your portfolio. How do you go about doing this? The first step must surely be to inform yourself about certain characteristics of the fund. The key items of information to focus on are fund category (asset class), portfolio composition/style, performance, and expenses. There are many freely available financial information sources in Canada, among which are a number of good providers of Canadian mutual fund on-line information. I will employ one of them, Morningstar Canada (www.morningstar.ca), to show how useful information for a fund can be accessed.xxv Going to Morningstar's Web site, we see that funds are separated into categories. Suppose we consider one from the Canadian equity (pure) category.XXV1 Let me illustrate how information can be accessed using a specific Canadian fund.XXV11 I select the PH&N (Phillips, Hager and North) Canadian Equity Series A Fund and go to the Morningstar Quicktake Report.xxvm By selecting the tabs at the top, you can go to the Overview, Performance, Tax Analysis, Investment Styles, and Details pages. The Overview page is, for the most part, sufficient for present purposes, but I will refer to a few other pages. Beginning with portfolio composition/style, we see that the fund is almost entirely invested in equities (98.5%), all of which are Canadian (100%) - just as its category promises. We also have information on its top 10 holdings. A quick glance indicates that many are in the financial sector. Going to the Investment Style page,


we see that this is borne out, since the fund is 40.2% in financials relative to 30.5% for the index. The same page also shows that this fund does not lean dramatically towards growth or value as its Trice/Earnings' and Trice/Book' ratios are very close to those of the index.xxix Now considering performance and returning to the Overview page, the five-year cumulative performance graph is a useful snapshot. We see this fund has outperformed both its index (S&P/TSX Composite) and the average performance of funds in its category (Canadian equity [pure]) over this time. This is reflected by the four-star (out of five) Morningstar Rating, which weighs performance relative to other funds in the same category but also takes into account risk.xxx By the way a good way to get a sense of risk is to look at the one-year Trailing Returns Analysis chart on the Performance page. For example, one can see how often over a full year a return turned negative. Shown just below the Morningstar Rating (on the Overview page) is the MER. A positive is that this fund has a very low MER (1.16%) by Canadian standards. The prime reason for this is that the company only distributes funds directly (not through a broker or independent investment advisor), and is thus able to avoid the trailer fees which serve to push up MERs. Additionally, and for the same reason, it is able to avoid loads (both front-end and rear-end).


F. Recap 1. Mutual funds provide the major advantages of diversification and professional management. 2. Unfortunately this does not come free. Loads, MERs, and trading costs all eat away returns. 3. Less obviously, the games that fund managers play, along with weak fund company governance, are not in the best interests of investors. 4. It is useful to be able to understand the major characteristics of funds. It is natural to focus on asset class, portfolio composition, costs, and past performance.


Endnotes i Though certainly the most popular variety, a mutual fund is only one kind of 'investment fund/ (Other varieties will be briefly discussed in Chapter 8.) Note that, if the mutual fund is organized as a corporation, investors are shareholders, while, if the mutual fund is organized as a trust, investors are 'unitholders/ Since the latter tends to be most popular form, I will tend to generically use the term unitholders. See Macintosh, J. G., and C. C. Nicholls, 2002, Securities Law, Irwin Law, Toronto, for details. ii See Khorana, A., H. Servaes and P. Tufano, 2005, "Explaining the size of the mutual fund industry around the world," Journal of Financial Economics 78:145-85. iii There is mid cap as well. While there is no universally accepted definitions of small, mid, and large cap, many would put large cap at above $5 (or perhaps $10) billion dollars, and small cap at below $500 million (or perhaps $1 billion) dollars. iv Growth/value firms have high/low book-value-to-marketvalue ratios and high/low P/Es. v Some would argue for the intermediate categories 'core' (encompassing growth and value) and mid cap (between small cap and large cap) in this table. vi The salesperson is still happy, as she receives the deferred sales charge as a commission immediately. vii One obvious negative about DSCs is they reduce liquidity: you are going to think twice about dumping a poorly performing fund if you are going to have to surrender 4% of fund value. Not surprisingly, fund companies like this Tock-in.' viii See Warywoda, M., 2003, "What Canadians pay for fund management," on the Morningstar Canada Web site. ix See Milevsky, M. A., 2002, Wealth Logic, Chapter 3, Captus Press, Toronto. x Ruckman, K., 2003, "Expense ratios of North American mutual funds," Canadian Journal of Economics 36: 192-223. xi The order book is a record of all limit orders, that is, bid orders (offers to buy at given prices) and ask orders (offers to sell at given prices). xii An RRSP is a registered retirement savings plan.


xiii It has been shown that advertising effectively attracts fund flows over and above strong returns. Advertised funds do no better than other funds afterwards though. See Jain, P., and J. S. Wu, 2000, "Truth in mutual fund advertising: Evidence on future performance and fund flows," Journal of Finance 55: 937-58. xiv See Deaves, R., 2004, "Data-conditioning biases, performance, persistence, and flows: The case of Canadian equity funds," Journal of Banking and Finance 28: 673-94; and Sirri, E. R., and P. Tufano, 1998, "Costly search and mutual fund flows," Journal of Finance 53:1589-1622. xv Another common game is window dressing, the tendency to eliminate losing stocks just for the sake of appearances. See Musto, D. K., 1999, "Investment decisions depend on portfolio disclosures," Journal of Finance 54: 935-52. For more detail on these and other games played by managers (plus those played by the fund companies themselves), see Deaves, R., 2005, "Let the games begin: The inappropriate behavior of mutual fund managers and companies," Working paper. While much of the evidence of these games is based on U.S. studies, it would be surprising if they were not also quite prevalent in Canada. xvi See Carhart, M. M., R. Kaniel, D. K. Musto and A. V. Reed, 2002, "Leaning for the tape: Evidence of gaming behavior in equity mutual funds," Journal of Finance 57: 661-94. xvii See Brown, K. C, W. V. Harlow, and L. T. Starks, 1996, "Of tournaments and temptations: An analysis of managerial incentives in the mutual fund industry," Journal of Finance 51: 85-110. xviii See Chevreau, J., 2005, "Outing 'closet' index funds," National Post, Financial Post (November 5). xix See Globe and Mail, Report on Business, 2004, "Who's standing up for the investor?" (June 22). Also, see Kivenko, K., J. Cutler, B. Gleberzon, S. Buell, and R. Kyle, 2004, Giving Small Investors a Fair Chance: Reforming the Mutual Fund Industry, Discussion paper, for some suggested reforms of the mutual fund industry. xx The SEC's Web site is www.sec.gov. Major pertinent Canadian government regulators or industry self-regulatory organizations (SROs) are the Ontario Securities Commission (OSC) whose Web site is www.osc.gov.on.ca; the Investment


Dealers Association (IDA) whose Web site is www.ida.ca; and the Mutual Fund Dealers Association (MFDA) whose Web site is www.mfda.ca. The Investment Funds Institute of Canada (IFIC), whose Web site is www.ific.ca, is a mutual fund industry association. In case of malfeasance, investor protection (see the Small Investor Protection Association at www.sipa.ca and Canadian Fund Watch at www.canadianfundwatch.com) and self-education (see the Investor Education Fund at www.investored.ca] can be powerful tools. xxi See Tufano, P., and M. Sevick, 1997, "Board structure and fee-setting in the U.S. mutual fund industry," Journal of Financial Economics 46: 321-55. xxii See Zitzewitz, E., 2003, "Who cares about shareholders? Arbitrage-proofing mutual funds," Journal of Law, Economics, and Organization 19: 245-80. xxiii See Globe and Mail, Report on Business, 2004, "Select few reap unfair gain" (June 21). xxiv The Ontario Securities Commission (OSC) concluded that the behavior of certain funds in this regard constituted a breach of fiduciary responsibility. As a result, in a settlement, five Canadian mutual fund companies agreed to disburse $205.6 million dollars to investors who suffered from market timing, after acknowledging that "they routinely gave preferential treatment to a select few clients at the expense of long-term investors." See Globe and Mail, Report on Business, 2005, "Firms agree to pay clients" (July 1). xxv The use of this Web site is not to be construed as a recommendation. Indeed, two other good providers of mutual fund data and information are: www.globefund.com and www.fundlibrary.com. xxvi The 'pure' epithet is meant to signify that the securities in the portfolio are all Canadian equities. Note that most 'Canadian' equity funds do have some foreign (especially U.S.) securities. xxvii The use of this fund is not to be construed as a recommendation. Indeed one requirement that would make this fund unpalatable to some investors is a minimum investment of $25,000.


xxviii This description is as of August 2005. xxix Recalling our previous definition of style, growth firms would have high levels of these ratios, and value firms low. xxx For funds held in taxable accounts, there can be a substantial difference between pre-tax and post-tax returns. The Tax Analysis tab is useful in this regard. Going there, you will see a fund's tax efficiency, which is calculated by dividing the fund's tax-adjusted return (assuming the highest marginal tax rates in Canada) by its pre-tax return. Obviously, the higher the better.


Chapter 3

Some essential background on the principles of wise investing and how psychology sometimes gets in the way A. Preview It is easy to understand the principles of wise investing. For many people executing them is another matter. The problem is that human psychology sometimes gets in the way. Nevertheless, the hope is that once we understand how we are sometimes our own worst enemy, it should be easier to invest wisely. The importance of psychology in the realm of investing was recognized by the awarding of the Nobel Prize in Economics for 2002 to Daniel Kahneman of Princeton University and Vernon L. Smith of George Mason University. These individuals were instrumental in demonstrating that people do not always make economic and financial decisions in a calm rational fashion, but instead are sometimes influenced by psychology. Their work, along with the work of others, notably Richard H. Thaler of the University of Chicago and Terrance Odean of the University of California, has helped usher in the new field of behavioral finance.1 The psychological considerations that will concern us for the most part fall into four categories: limited self-control and procrastination (section B), behavioral biases (section C), emotion (section D), and faulty self-perception (section E). I explore these issues over the next four sections. The first speaks to the potential divergence between knowing what is best and doing what is best. The second deals with behavioral biases that sometimes color your thinking and push you in the wrong direction. The third, emotion, is the antithesis of rational decision-making. And the fourth, faulty self-perception, is another way of saying "a little knowledge is a dangerous thing."

SO — Richard Deaves

B. Saving roadblocks: Limited self-control and procrastination For most people the major reason for saving and investing is to accumulate sufficient resources for a comfortable retirement. The first step is obviously to institute a saving program. Or, if such a program has already been started, the next consideration should be to make it a regular one, and to save as much as you can. This chapter will be sprinkled with a number of principles of wise investing. Let me begin with the first principle of wise investing: PRINCIPLE of WISE INVESTING #1: Save early, regularly, and as much as you can. I am not suggesting saving so much that you go without today, but rather balancing current and future needs properly. This sounds simple so far. Unfortunately, there is a problem. Quite simply, mankind is subject to limited self-control and procrastination. These are two psychological tendencies that virtually all of us (the author included) are subject to in varying degrees at various times. For example, after the holiday season becomes a memory, many of us decide it would be nice to shed a few pounds. But what is the rush, we ask ourselves? We will start next week: we procrastinate. Assuming we do finally get around to beginning our diet, self-control is not at all easy. Nobody likes to give up what is pleasant to him. People realize that they need self-imposed discipline and rules. They also recognize that controlling their environment can be helpful. Continuing our weight loss analogy, a diet is a set of rules. For example, one diet might specify that one is not supposed to eat more than a certain number of calories per day, or one is not allowed any dessert. Environmental control is important. If you are on a no-dessert diet, it is probably not wise to accompany your friends to a dessert restaurant. Similar environmental control can be useful in the financial


realm. This is why financial advisors sometimes try to get their clients to lock themselves into an automatic savings plan whereby a portion of one's income is automatically invested. One question that you need to ask yourself is: are you capable of doing this on your own, or do you need the gentle prodding of an outside financial advisor?

C. Behavioral biases may lead to poor decisions In this section I introduce a couple of well-known behavioral biases: loss-aversion, which is the tendency to be overly focused on avoiding losses even when it leads to inappropriate financial decision-making; and representativeness, which is the tendency to be too fixated on recent, salient, readily available evidence.11 i. Loss-aversion Sometimes investors forget what they are saving for. Risk should be viewed relative to the time when the money is required. When you are saving for a house down payment required in one year, your approach to risk should be very different from when you are saving for retirement. Consider the following second principle of wise investing: PRINCIPLE of WISE INVESTING #2: Risk should be viewed relative to when you need the money. Say you are saving for retirement due to begin in 30 years. How important is it to worry about day-to-day or quarter-toquarter fluctuations in your portfolio value? Not very important in my view. Yet this is precisely what people often do. Even year-to-year fluctuations are not really of great importance. The problem is that people can get too fixated on short-term volatility and adopt counter-productive strategies because of this. Why is this? In a famous article, Daniel Kahneman and the late Amos Tversky argued that the impact of a loss on people's happiness was much stronger than the impact of a gain of the same magnitude.111 That is, people like to win but hate to lose:


they are loss-averse. Consider, for example, the following choices: suppose you face a choice between (1) a sure gain of $1,000; and (2) a lottery with a 55% chance of gaining $2,000 and a 45% chance of receiving nothing. The latter has an expected gain of $1,100.1V Faced with this problem, most people choose the first choice. This is not surprising: most people are risk-averse, and the $100 ($1,100 - $1,000) premium for bearing uncertainty is insufficient compensation. Actually, this problem can be viewed as a choice between a risk-free investment and a risky investment. Pretend you are starting with $1,000 (the sure thing). Not taking the gamble means you still have $1,000 (for a 0% return), while taking the gamble means you are 'investing' with a 10% expected return. This is because you are starting from $1,000 and your expectation (in the sense of expected value) is that you will have $1,100 after the gamble. The reward for bearing the risk of the gamble vs. being satisfied with the sure thing, which is tantamount to a risk premium, is 10%. For most people this risk premium is not enough, but increase it to 20-30% and they will be tempted. Now consider a second problem. Suppose instead that we have the following choices: (1) a sure loss of $1000; and (2) a lottery with a 55% chance of losing $2,000 and a 45% chance of no loss. (We do not have the option of walking away.) The latter gamble has an expected value of -$1,100. In this case, many will accept the gamble, even though its expected value (-$1,100) is worse than the sure loss of $1,000. The fact is most people are unwilling to face a loss, and will take on a gamble in the hope of avoiding such an eventuality. Think about what is implied here. In effect people have been tricked by the reference point. Imagine the starting point as $2,000 in the red. Then you are given $1,000 to potentially invest. Doing nothing (not taking the gamble) lets you keep the $1,000 (for a 0% return), while gambling provides a -10% expected return. The latter comes from the fact that the gamble is expected to leave you $100 worse off. So surely it is odd to take such a gamble - but many do, because they would do anything to avoid recognizing a loss. If you filled out the Investorguage Questionnaire as recommended, these are questions 30 and 31.


What choice did you make? If you chose A and D, do not feel too bad: you have lots of company. Loss-aversion can cause investors to be too conservative in their investment strategy. The prospect of short-term losses even when the true horizon is much longer - can cloud investors' judgement. Shlomo Benartzi of UCLA and Richard Thaler conducted an experiment in which participants were asked if they would enter into a gamble with, say a 50% chance of winning $200 and a 50% chance of losing $100.v They were then asked if they would enter into a series of 200 repetitions of such a gamble. Next, Benartzi and Thaler showed them a distribution of possible outcomes under repeated gambles, which indicated that the possibility of ending up with a loss after 100 such repetitions was very small.vl They found that the majority (around 75%) of participants who earlier refused to take this series of gambles changed their minds. Benartzi and Thaler's results are consistent with the idea that short-term loss aversion can cause people to overestimate the risk of a long-term gamble. They termed this behavior 'myopic loss aversion/ In an investment context, this behavior can cause people to be too nervous about risky investments in their portfolios, and thus miss out on the higher expected long-run returns that stocks generally bring relative to bonds. ii. Representativeness The next principle of wise investing is: PRINCIPLE of WISE INVESTING #3: Be concerned with future results, not past results. While it is true that the past can tell us something about the future, there is much less to be learned than people think. People think otherwise because of a behavioral bias known as representativeness. Representativeness strikes when people are overly influenced by the 'sample' of data that is available to them, especially the sample that has become available recently. In this context, representativeness is sometimes called recency. Financial decision-makers are confronted with a plethora of information. It is difficult to glean what is relevant from avail-


able sources and reach the right decision. One solution is to reduce decision-making processes down to a set of rules based on experience gained by 'trial and error/ These general rules, or 'heuristics' as they are sometimes called by psychologists, reflect the manner in which individuals incorporate available information into their decisions. Unfortunately such rules can lead to a number of biases. One of these, representativeness, refers to the fact that people tend to form judgements based on stereotypes. What they see occurring around them, especially if it is salient and readily available, is assigned an inordinately high probability of occurring in the future. For example, after a recent spate of violent crimes in the community, people will attach a much higher probability to being a victim of such crimes than is objectively (based on statistics) the case.V11 Consult question 33 of the Investorgauge Questionnaire. Every so often there is a horrific story about someone dying in a shark attack. Such stories are definitely attention-grabbing. Surely, as a cause of death shark attacks must be more common than something bizarre like dying from falling airplane parts? Who hears of such strange cases? Amazingly, though, the latter cause of death is more common. So what kind of mistakes does representativeness lead to? This behavioral bias can explain why a lot of investors pick stocks or mutual funds in a flawed fashion. For example, a lot of people assume that good companies are good investments. This is not a valid inference at all. One can only say that good companies were probably good investments.vm What do we mean by this? Good companies perform well. Their earnings and growth are strong. Such companies and their stocks will attract buyer interest, thus pushing their prices up. Take Wal-Mart: historically, it's a great company with a great record. Clearly, its stock would have been a superlative investment 20 years ago - but what about today? The reality is that sometimes markets push the prices of successful companies too high (and unsuccessful ones too low). Eventually in many cases, the overreaction will reverse itself via a process known as mean reversion. This leads to recent success stories having subpar returns as their prices fall back to earth, and recent 'dogs' having


superior returns as their prices become more realistic.lx The Internet bubble is a recent painful memory for many. Representativeness seems to have played various roles. First, during the price run-up, the press was awash with stories of the Internet revolution and the investment opportunities associated with it. It seemed like every week a new, hot initial public offering was coming out, and prices were immediately on the rise. Notably, Computer Literacy Inc. changed its name tofatbrain.com and its share price immediately rose by 33%. This was no isolated case. In fact, the 'dot-corn effect' has been documented: during this period merely changing a company name to a dot-corn variation led to an average price boost of 74% during the ten days surrounding the announcement of the new name. To some investors, dot-corn represented investment riches. Additionally, in line with recency, investors were mesmerized by past returns. How can people guard against representativeness? My advice here is not to get caught up in fads and allow them to dictate your investment strategy. We have already talked about the internet fiasco, and surely other such fads will appear in the future. Unfortunately we do not know, except with the benefit of hindsight, that a fad is indeed a fad. Still, one can advise that trading on 'new' information may often mean making transactions based on overreactions.

D. Excessive emotion Traditional financial models assume that individuals incorporate information into their decision-making processes using the rules of probability and a cool, calculated, unemotional logic. Emotion plays no role. This 'ideal' leads to the next investing principle: PRINCIPLE of WISE INVESTING #4: Be calm, cool and collected when making investment decisions.

Nevertheless, there is a large body of psychological literature


that shows that one's emotional state can significantly affect decision-making. There are a couple of ways in which emotion can distort financial decision-making. You can let emotional disposition control you, and you can be influenced by regret or the fear of regret. Before providing details, what do we mean when we say emotion? Emotion can be defined loosely as a physiological state of arousal triggered by beliefs about something. While there is no perfect definition of emotion, there is some agreement on the set of emotions that do exist. Most agree that certain states of mind are clearly emotions: these include anger, hatred, guilt, pride, regret, elation, fear, joy, and love. i. Positive emotional disposition, optimism, and attitude toward risk A person's current emotional state may influence her decisions. For example, an individual in a 'good mood' brings this positive outlook to the task at hand. It has been argued that a positive state of mind enhances individual performance on many cognitive tasks. Researchers have found that positive mood facilitates creative problem-solving, and allows individuals to better organize and assimilate information. It seems that, if an individual is in a good mood, she can be more optimistic and even be more open to taking risks than would otherwise be true. While there is nothing wrong with optimism, excessive optimism can be harmful. And, while there is nothing wrong with risk-taking, it should be done in a levelheaded, consistent fashion. The best evidence of this is at the level of the market, not at the level of the individual. If many people are in a good mood at the same time, this may even have an impact on stock prices. What can cause such mass happiness? One obvious thing that can affect a lot of people's emotional disposition is the weather, specifically sunshine. Using data from 26 international stock exchanges, researchers have shown that when there is more sunshine, stock prices tend to rise.x Odd, but true. There are two explanations (both of which are likely to be partly true). Prices may be rising because the good mood induced by sunshine caus-


es people to be more optimistic about the future prospects of stocks. Another interpretation is that it is not perceived future prospects that are changing, but rather people's attitudes about taking on risk. It is possible that a positive disposition induces people to be less risk-averse. Thus risky stocks appear more attractive, pushing up prices. Another reason why people may feel chipper is because the market has performed well in the recent past. Refer back to question 32 of the Investorgauge Questionnaire. Do you too feel more inclined to spend from or put at risk 'found' money, such as lottery or casino winnings, than 'earned' money? Many people seem to act this way. If there is a tendency for high market returns to resemble such 'found' money to some people, then bull markets can be associated with a decline in risk aversion. ii. Regret A negative emotion that can lead to pessimism and fear of risk-taking is regret. Indeed, regret can play a big role in financial decision-making. Sometimes, a particular investment does not work out well. Losses are made, and, as we saw in the previous section, investors abhor losses. One reason for this is that losses lead to regret, a negative emotion. The problem is that fear of future regret may seriously hamper people's decisions. For example, Terrance Odean studied the trading patterns of a sample of U.S. discount broker customers.xl Odean reported that investors realized gains 1.68 times more frequently than they realized losses (fearing the regret associated with them).X11 That is, the stocks that had been performing well were 65% more likely to be sold than the stocks that had been doing poorly. His findings are consistent with the idea that people hate losses and will accept risk (by holding on to bad stocks) to avoid recognizing losses. In addition, Odean reported that although investors did sell some losers, they tended to sell small losers, but kept large losers. He then followed the performance of these losers and found that the stocks that investors sold generally went on to outperform the stocks that they kept. In other words, investors tended to sell the wrong stocks. This bias is sometimes called the disposition effect.


iii. Emotion is not all bad Before leaving emotion, I want to make the perhaps surprising point that in the context of investing, emotion is not all bad. Why is this? Studies have shown that sometimes emotion can have a positive effect by pushing us to be decisive when making decisions is paramount.xm In some situations there are so many options that an individual could devote excessive amounts of time to the decision-making process, simply becoming overwhelmed by the possibilities. Emotion provides a coping mechanism and allows us to focus without being caught up in the details. In other words, it is possible to be too cool, calculating, and emotion-free. Let us finish this section with an illustration from the television series Star Trek. Mr. Spock is presented as a rational thinker who thoroughly considers every piece of information, whereas Captain Kirk is likely to respond emotionally. But Kirk is a leader: he is truly in charge of the Enterprise. Because Spock fully analyzes each situation, he sometimes gets caught up in the details. Emotion allows Kirk to focus and enhances his ability to make critical decisions. The trick, in fact, is to channel one's emotions effectively. Those who are 'emotionally intelligent' (see Chapter 10) are able to do this.

E. Most people don't know as much as they think they know It is important to stay within your abilities and knowledge. This leads us to the next principle of wise investing: PRINCIPLE of WISE INVESTING #5:

Do not assume you know more than the next person and make investment decisions based on this. Overconfidence is defined as the tendency for people to overestimate their knowledge, abilities, and the precision of their information. There is abundant evidence that most of the time most people are overconfident.xiv


While a full discussion of overconfidence and the damage that it can cause will be deferred until Chapter 5, at this point let me preview some of the problems that can be caused by overconfidence. Overconfidence contributes to the 'planning fallacy/ This is the inability to complete tasks on schedule. In writing this book, for example, I was often susceptible to this. Moving to the realm of money, because people are overconfident they tend to think they are more prepared financially than they really are. Recent surveys show that Canadians are not adequately preparing for retirement.xv The problems that overconfidence gives investors in terms of portfolio decision-making are excessive trading and under-diversification. The essential idea is that if you feel you have a very good sense of what stocks are worth, you will transact more often than someone who feels that the market price constitutes fair value. Moreover, if you feel you have identified a group of undervalued stocks, you will be inclined to load up on these while ignoring others, thus foregoing the gains from diversification.


R Recap 1. When it comes to saving, people procrastinate and don't save enough. 2. Behavioral biases get in the way of good financial decision-making. In particular people are too nervous about losses, and too fixated on recent salient events. 3. Emotion also gets in the way: it is best to be cool, calm and collected in your financial decision-making (though perhaps not taking it quite as far as Mr. Spock). 4. People are overconfident. They think they know more than they really know, and are apt to take actions without sufficient information.


Endnotes i A few other key figures are Brad Barber, Werner De Bondt, David Hirshleifer, Hersh Shefrin, Meir Statman and the late Amos Tversky. Hirshleifer wrote an excellent (if technical) review paper on the field of behavioral finance: Hirshleifer, D., 2001, "Investor psychology and asset pricing/' Journal of Finance 56:1533-97. ii Other important biases are described more fully in Charupat, N., and R. Deaves, 2004, "How behavioral finance can assist financial professionals," Journal of Personal Finance 3 (no. 3): 41-52. This section of the chapter leans heavily on this source. iii Kahneman, D., and A. Tversky, 1979, "Prospect theory: An analysis of decision under risk," Econometrica 47: 263-291. iv This is so because: .55 * $2,000 + .45 * $0 = $1,100 v See Benartzi, S., and R. H. Thaler, 1999, "Risk aversion or myopia? Choices in repeated gambles and retirement investments," Management Science 45: 364-381. Notice that the expected payout is $50 but a loss happens half the time. vi The reason for this is that, as repetitions occur, we are likely to move well into positive territory, providing a buffer against potential future bad runs. vii In this context, one hears the terms availability and salience. viii Admittedly, one advantage of 'good' companies is that they sometimes are steady dividend-payers, which can be an important consideration for investors desiring steady cash flow. ix See De Bondt, W. R M., and R. Thaler, 1985. "Does the stock market overreact?" Journal of Finance 40: 793-807. x See Hirshleifer, D., and T. Shumway, 2003, "Good day sunshine: Stock returns and the weather," Journal of Finance 58:100932. xi Odean, T, 1998, "Are investors reluctant to realize their losses?" Journal of Finance 53:1775-98. xii For similar evidence, see Shefrin, H., and M. Statman,, 1985, "The disposition to sell winners too early and ride losers too long: Theory and evidence," Journal of Finance 40: 777-790. xiii See Ackert, L., B. Church and R. Deaves, 2003, "Emotion


and financial markets," Federal Reserve Bank of Atlanta Economic Review 88 (no. 2): 33-41. This section of the chapter leans heavily on this source. xiv See Charupat, N., R. Deaves and E. Liiders, 2005, "Knowledge vs. knowledge perception: Implications for financial planners," Journal of Personal Finance 4 no. 2): 60-71. This section of the chapter leans heavily on this source. xv See, for example, Chevreau, J., 2004, "Boomers lucky to retire by 65," National Post, Financial Post (February 17).

Chapter 4

How well do you do buying mutual funds? A. Preview In the next three chapters, I turn to the three main ways to populate your portfolio. You can buy mutual funds, that is, be a fundholder (Chapter 4), you can buy individual securities, that is, be a selector (Chapter 5), or you can pursue the strategy of indexation, that is, be an indexer (Chapter 6). My working assumption for these three chapters is that you are a do-it-yourselfer, which makes you a self-selector, self-fundholder, or a selfindexer, but the material presented will also be of use even if you conclude that you require some or a lot of assistance. In these chapters, I will consider the pros and cons of the three alternatives. For now, the focus is on mutual funds. In section B, I consider whether professional management is sufficiently skilled to justify the costs associated with it. Once I have concluded that the answer is usually no, in section C, I provide a framework for understanding exactly why funds fall short, and, in section D, a theoretical rationale as to why lack of outperformance should not be surprising. Finally, in section E, I consider if it is possible to unearth the 'diamonds in the rough/ that is, the up-and-coming stars of the mutual fund world.

B. Do mutual funds typically outperform? Here is one way to think about the problem. Let's say you want to paint your living room. You have shopped around and find that someone will do it for $500 (excluding paint). Based on references, you feel she will do an acceptable job. An alternative is to do the job yourself. Unfortunately you don't have much meaningful experience in this area, and you know that a little


research will not get you to the skill level of the experienced painter. True, but what if, with a little effort, you get to the point where the job that you can do is almost as good as what the house painter could do? Of course, there was some time spent on your part (learning and doing), so let's say you pay yourself $200, and say the difference in quality can be quantified at $100 - perhaps this is how much less you might expect to get for your house because of a few imperfections. Notice, however, that you are still ahead of the game. Why? Because the overall cost was $300 (= $200 + $100) vs. $500. This is exactly the way you need to think about professional money management. How good a job can you do? And does the potential improvement based on using the pro justify the far from insignificant extra cost? At first glance this seems like a simple thing to investigate: simply compare the dollar benefits to the incremental costs. It turns out to be rather more complicated though, and, while it is not necessary to understand all the complexities, it is important to understand some of the issues. i. Performance measurement issues Why not just compare a fund's return to its logical benchmark index? For example, say a mutual fund is in the Canadian equity category. We could then compare the average return on this fund over some period of time to the average return on a broadly diversified Canadian stock market index. What could be more simple? Wait a minute. How far back should we go? One year? Five years? Ten years? One could be outperforming over the last five years but not over the last ten. What does this mean? And we do need to differentiate between the outperformance (or underperformance) that has likely occurred by chance and that which has occurred because of managerial skill. How do we do this? Needless to say, all costs should be included in the comparison. What if there is a front-end load? How should that cost be assigned to (or amortized over) different periods? And are we sure that our benchmark is exactly the right one to use? For example, what if we find out that a 'Canadian' equity fund is allowed to invest in non-Canadian securities, such as U.S. stocks? This clearly gives the Canadian fund an advantage. And what


about risk? Maybe the fund is investing in just the riskiest Canadian stocks around, whereas the benchmark index is 'investing' in a smorgasbord. Since risk and return should on average move together, if the fund seems to be outperforming, maybe that's only because it is taking on more risk. I now turn to a discussion of these issues. First, let me discuss something that most readers will not have heard of, even though it is vitally important to understand it in the context of measuring performance: survivorship bias. What is survivorship bias all about? Say I look at all Canadian equity funds with a ten-year record. On average, this group will definitely have good performance! How do I know? The problem is that ten years ago there were some funds around which didn't quite make it to today. Funds that perform badly are often merged into better-performing funds, so, if we just look at the survivors then we are pretty sure to see some success. After all, it's like estimating the average IQ of young students just by sampling all those with grades of B or better. To see the importance of survivorship bias, let's look at Figure 1. These data are from a comprehensive study of Canadian equity fund performance during 1988-98 that I conducted.1 Referring to the Figure, 110 funds were in the sample at the beginning in 1988. Only 70 of these (63.64%) were around at the end for a cumulative mortality rate of 36.36%. On the other hand, of the 241 funds in the sample in 1997, all but seven survived until the end, for a mortality rate of 2.9%. The difference between these two percentages is due to the fact that the 1988 group had longer to fail. Given an annual mortality rate between 2.9 and 4.5%, over time a good number from this group ceased operation. The way to get around survivorship bias is to make sure that you look at the records of both the survivors and the non-survivors, so all careful studies (mine included) now do this. The study also carefully avoided a related bias known as backfilling bias. This bias stems from something called the 'incubator fund' phenomenon, which refers to the tendency of fund companies to start quite a few funds so that several are bound to develop good track records (one game I didn't get to in Chapter 2!), and to the fact that information is voluntarily provided to data-


base vendors. Suppose a company launches two funds at yearend 1995. Call them A and B. Over 1996, A performs better than its risk-adjusted benchmark, B worse. The company decides to let B 'die' by merging it with A. This is all done before either fund's records have been sent to the information vendor. At the end of 1996 the full history of A is sent in. B's history disappears. The problem, of course, with using funds such as A is that we know that they are likely to have outperformed their defunct brethren up to the point when a choice is made to let B die and to send A's (backdated) records in. An obvious potential for upward performance bias therefore exists. The solution that I devised was to discard the 'tainted' portion of A's data, namely the portion coming from the time before the data were first submitted.

Figure 1: Number of funds in sample for different years and number of funds surviving till end


It is also necessary to control for fund risk: funds with higher risk should be earning higher returns. In line with other researchers, my procedure is a little complicated, but I will illustrate by describing a "slimmed down' version.11 Recall from Chapter 1 the formula that I used to estimate what a stock should earn as fair compensation for the risk borne: Fair return = Risk-free interest rate + Beta * Market risk premium The nice thing about this formula is that we can use it for portfolios as well as individual stocks. And, of course, a mutual fund is just another portfolio. So let's rewrite our formula as: Fair return for fund = Risk-free interest rate + Fund beta * Market risk premium This relationship can either be used in a forward-looking or backward-looking sense. In the former case, I am saying that the expected return equals the actual interest rate plus the estimated beta times the expected market risk premium. To use this in a backward-looking sense, I replace the right-hand side values with average realized values. For example, say on average over the last five years a fund earned a return of 17%. The market's average return was 23%. The fund beta is 1.2 (20% riskier than an average-risk investment stock). The risk-free rate averaged 6%, so the average realized risk premium was 7% (13%-6%). Let's do all the required substitutions: Fair return for fund = 6%+1.2 * 7% = 14.4% The fund has surpassed its fair return. Good news. Still a lot of things in life and in markets occur because of chance. We need to do some statistical tests to discover whether this was a chance result. A typical reference point is 95% comfort. This means we are comfortable in concluding that the fund has truly outperformed if the probability that the fund did well purely by luck (no skill involved!) is 5% or less.


ii. Canadian evidence Enough background. Getting back to my study, let's get to the bottom line. How did Canadian equity funds do? Refer to Figure 2 for the answer. Notice that, in seven out of 11 years, the average fund underperformed its risk-adjusted benchmark. In the other four years, outperformance occurred. The average over the full sample was underperformance of 0.115% per month (which compounds to more than 1% per year). To interpret, the average Canadian equity fund fell short of its benchmark by roughly 1% per year.111 And it was determined that one could be 98% comfortable with this conclusion of underperformance.

Figure 2: Canadian equity fund performance

While all fund returns are on a net-of-MER basis, what about on a gross return basis? Gross returns are calculated by adding back MERs. Based on the MERs in effect at this time, one can conclude that while Canadian funds underperformed on a net basis, they were able to add value before fees. In other words, managers did better than throwing darts - but still not well enough!


C. Why exactly do mutual fund managers underperform? My research (and virtually all studies looking at funds in other countries) indicates that mutual fund managers on average underperform their risk-adjusted benchmarks.lv It is important to understand why this is so. To begin, it helps to differentiate between the stocks held in a fund and the fund itself. Let's focus on the former for now. There are a number of reasons why the stocks held in a mutual fund may do better or worse than the relevant benchmark. Let us first ignore all costs associated with mutual funds. This means we are looking at gross returns, not net returns, since net returns deduct management costs. One obvious potential reason why the stocks in the fund perform well is the stock-picking skill of managers: the hope, of course, is that managers will use their stock-picking ability to add sufficient value to more than compensate for their salaries and overhead. The next reason is rather subtle. It relates to my earlier discussion of style. As discussed earlier, some managers specialize in certain styles. For example, one manager invests in large cap stocks, another in small cap stocks. While the former may outperform the latter over a certain period, this can easily reverse later on. The market index includes both small cap and large cap, so if small cap does better than large cap, the market index will fall short of small cap but will surpass large cap. But how should we evaluate managers who favor the small cap style or the large cap style? Should we say they outperformed their benchmark because their style did better than its opposite style? The appropriate thing to do is partition the total value-added of managers into that part which is due to stockpicking skill and that part which is due to selecting or sticking to the right style. And so, if a manager did well because her style did well, this provides a style boost for return; conversely, if a manager did badly because her style did badly, this leads to a style drag on return. Aside from the small cap vs. large cap source of style boost or drag, there are two other style distinctions that are often made. The reader will recall the earlier distinction between value and


growth. Some managers focus on value stocks and others focus on growth stocks. A second additional distinction is between those who chase momentum and those who do not. Some managers choose stocks largely on the basis of past good performance. Such a 'the trend is my friend' strategy stems from the observation that it is sometimes profitable to purchase stocks that have done well over the previous three months to one year. But one must be careful here since such momentum-chasing is very far from bankable.v Again, the point is to separate style boost or drag and stock-picking. Let's say the stocks of a particular manager outperform on a gross return basis because of stock selection skill and style boost. Since investors own funds and receive net returns - and not the gross returns on the stocks in these funds — it is necessary to bring in the cost side. First, of course there are MERs. Mutual fund management must be compensated. This opens up a gap between gross and net returns. Second, active management involves trading, and trading incurs transaction costs. This increases the gap between gross and net returns. There is a third force potentially pulling down fund returns. It has recently been shown that some of the underperformance of managers is the result of their need to provide liquidity services to investors. What does this mean? A small reserve in cash equivalents (T-Bills, for example) must be kept because investors often withdraw money from or inject money into funds, and funds must be ready for such contingencies. Additionally, to keep a fund close to being fully invested, a manager is sometimes forced to make purchases and sales at times and prices not of choosing. That is to say, not only does a manager execute informed trades, but he also, because of unpredictable fund flows, must engage in a significant volume of uninformed liquidityinduced trading.vl This can be thought of as a drag coming from non-stock holdings/ A comprehensive study of U.S. mutual fund performance by Russ Wermers of the University of Maryland is very useful in allowing us to put all these pieces together.V11 One reason for moving south of the border at this juncture is that the database used in this particular study had substantial advantages over


anything that was available in Canada. In addition to standard return data, which subtract out transaction costs and MERs, Wermers also had data on the exact portfolio composition of each mutual fund. Because of this, it was possible for him to see whether or not the stocks in the fund outperformed other stocks (even if the fund itself did not outperform its benchmark), and so he was able to decompose returns into the performance and cost components that I have described. Now that we understand all the issues, let me turn to how well the average fund (and the stocks in an average fund) fared. The stocks in an average fund beat the benchmark index by 130 basis points (1.30%) per year. Some of this came from style boost, and some came from stock-picking skill. Not bad: this obviously reflects some skill on the part of managers. But the average mutual fund net return was 100 basis points lower than the benchmark. Not so good. To understand the difference, refer to Figure 3 below. MERs and transaction costs take up about 80 basis points each more than enough to eliminate the value from management. The return is further lowered by 70 basis points because of the drag coming from non-stock holdings. So, on balance, it does not seem that an average mutual fund is a winning proposition.

Figure 3: Why mutual funds fall short (Wermers study)


D. Why the lack of outperformance is not really surprising In Chapter 1,1 spoke of an important concept known as market efficiency. To review, this says that the value of a stock is always equal to its price. The underlying assumption driving this was that all market participants had the same information and analyzed stocks using the same techniques. If market efficiency exists in this form, there is little for professional money managers to do: after all, there are no special bargains out there for one to take advantage of. Of course the reader probably recognized that this concept was simplistic (if not rather simpleminded). There are lots of reasons why different people with different ideas, modes of analysis, and sources of information will come up with different estimates of value. And, logically, some will be better at it than others, and some members of this more skilled group will become money managers. Nevertheless, one might puzzle over why this group cannot collectively outperform. This will make rather more sense after I alter the concept of market efficiency to something that is much more reasonable. I begin by considering the following paradox. If value and price are always the same, then it does not make sense to undertake analysis. It would be unwise for anybody to spend their time (and resources) to carefully analyze stocks in the hope of unearthing bargains. And, if everyone believes this, then no analysis will be done. Yet, if no analysis is done, how can stock prices move to their correct values (that is, always reflect all relevant known information)? Herein lies the paradox. Nevertheless, there is a way to get around this paradox. I will do so with a kind of 'story/ Suppose there are two types of investors: those who analyze stocks (the A group) and those who do not analyze stocks (the N group). From period to period, people, if they so choose, can costlessly switch strategies (go from an A strategy to an N strategy, or vice-versa). What are the costs and benefits of belonging to the two groups? There is an obvious cost to being a member of the A group. Analysis is costly, at the very least in terms of one's time.


If one has neither the time nor the inclination, it is always possible to hire someone (like a mutual fund manager) who does the analysis, but this service must be paid for. Unless there is a countervailing benefit to analysis, it would not make sense for anyone to join (or be a member of) the A group, so I will assume there is a benefit. A reasonable benefit is that those who analyze are able to generate higher average gross returns than are investors in the N group. Intuitively, this comes from trading sometimes with Ngroup traders who lack the expertise to distinguish bargains from overpriced securities. The greater the number of these 'ignorant' traders, logically the higher would be the typical gross return going to the A-group traders. Thus, to analyze confers both an additional cost and an additional benefit. Which strategy should one employ? In other words, should one analyze stocks to earn higher gross returns while incurring the costs of analysis, or should one choose stocks randomly? Clearly, one should pursue the strategy that gives the higher expected net return. Suppose one of the strategies initially provides a higher expected net return. Traders will switch to this higher-yielding strategy. For example, suppose the superior strategy is to analyze. As people shift to the analysis strategy, it is more and more likely that, when you trade, your counterpart will be performing analysis as well. This can only imply a reduced advantage to analyzing: the gross returns of analyzers will fall. This is, after all, the nature of competition. This further implies that the expected net return to analyzing will also decrease. In fact, the process must continue until neither strategy yields a higher expected return than the other. What are the ramifications of all this? Since investors will switch to the more favorable strategy, the only logical outcome is that both strategies on average will have identical net returns. Further, some people will choose to analyze and others will choose not to, but there is no advantage in changing to the alternative approach (nor any disadvantage in doing so). The additional gross return from analyzing relative to not doing so is exactly counterbalanced by the additional cost of analyzing. The existence of analyzing traders pushes prices towards intrinsic values, but there is no reason for prices to be exactly identical to


intrinsic values at all times. Sometimes it should be possible to identify mispriced securities. Analysis does pay off in the sense that it can enhance gross returns, but, because of low barriers to entry into the securities industry, those additional returns should be just counterbalanced by the additional costs involved. Now I can properly characterize a new improved version of market efficiency. It is said that financial markets are efficient if no investor can consistently earn excess returns, where excess is meant to be after allowance has been made for risk and after all costs have been factored in. The world I have described is efficient in this sense. What was the point of this 'story?7 It is my view that this lesson can be extended to the real world in the following way. You invest in a mutual fund because you believe that analysis will pay off in the form of higher gross returns. While you realize there will be costs, your hope is that benefits exceed costs. But now this story has told us that the benefits should exactly equal the costs. In other words, you should have no preference between randomly putting together your own portfolio and buying into an actively managed mutual fund. Doing it yourself generates lower gross returns, but the costs are lower as well. On the other hand, mutual fund investment leads to higher average gross returns, but the costs are higher as well. In fact, the moral of the story is that there is no advantage one way or the other. There are several points that now need to be made. We saw that on average mutual funds have net returns that are lower than their benchmarks: the costs exceed the benefits. This is not consistent with the analyzer/non-analyzer story that I have just described. To move to a state consistent with the story, there would need to be less money invested actively, and more money invested passively. It is interesting to note that, if enough people move to an indexation strategy (as I will be encouraging people to do in this book), then eventually such a state will be reached. But why is this change slow to occur? It has been suggested that the reason may be related to what psychologists call 'cognitive dissonance/ which is the tendency to suppress that which is unpleasant.vm Apparently, many investors think that their funds are performing better than they are actually are.lx Readers


of this book know that the average mutual fund underperforms. But many other people have not heard this, and, even if they had, would not believe that their fund belonged in the underperformance category. All well and good, some of you are saying, but, once again, why are we talking about the average fund? Shouldn't we be talking about superior funds? These, of course, are where smart people will invest. So let's shift the question over to this: is it possible to identify funds that will likely do well in the future? Obviously, we know which funds did well in the past. I begin to turn to this very important issue in the next section.

E. Can we identify star managers? The popular belief certainly is that it is possible to identify star managers, but does objective research support this? I suspect many of you are saying: why not just locate a true star and stick with her through thick and thin (hoping there is not too much of the second)? Of course, there will be a few bumps in the road but star power will ultimately win out. This turns out to be far from easy. Who, after all, are these reliable stars? In the U.S., two names that almost everybody has heard of are Warren Buffett and Peter Lynch. Indeed, these two individuals (and a handful of others) have put together stellar records. The problem is that it took a number of years of consistent good performance before people realized these individuals had the 'right stuff.' No one could have been certain of their skill early on. In fact, it can be shown that, if someone has moderate skill it will take a very long time before this fact is clear in a statistical sense - and by that point they are likely to be 'hanging up their hat.' Consider the following mental experiment. You have 1,000 individuals in a room, each holding a quarter. You ask them all to flip their coins and honestly record the outcome. With such a large group you are likely to have about 500 heads and 500 tails. Let's say that a head stands for coming out ahead (that is, beating the average) and a tail means falling short. After the first flip those getting tails must sit down, but those getting heads re-flip.


Now roughly 250 will get another head, meaning 25% of the original group has outperformed the 'market' twice running. After three years, there are about 125 consistent winners; after four: 6263; and so on. After nine years the best guess is that there will be two people standing; one after ten years. What geniuses! Beating the market nine or ten years running. Of course, I have designed this experiment so we can all see that it was just plain luck. The point is that with a large group of managers some will outperform just because of luck. Say, after nine years, there are four who have beaten the market year after year. It is likely that two of these were just lucky while (maybe) the other two possessed skill. But which ones? That is another reason why performance chasing is such a tenuous exercise. And yet, there is a belief that past good performance will lead to future good performance. This is known because, as I said in Chapter 2, those funds with the best performance have historically attracted the lion's share of new cash inflows. Does this make any sense? To a certain extent the answer seems to be yes - but there are some crucial reservations. Figure 4 provides evidence from my study on the ability of successful and unsuccessful funds to continue to perform well or badly. (Not that we would chase the second group!) I show the percentages of funds in the winner category that continue to be winners one year in the future, two years in the future, and so on - up to five years in the future. I do the same for loser funds. There is evidence of some very short-term (one-year) 'persistence' (winning after winning, or losing after losing) for both successful managers and unsuccessful ones. Looking ahead one year, 59% (of winners) and 62% (of losers) repeat. There is a less than 5% chance that this finding is due to chance.


Figure 4: Repeat performance of winners and losers

What about beyond one year? Now the evidence essentially says that there is no predictability. Persistence seems to last only a year. Beyond one year in the future, the percentages are only slightly above 50%, and this could very easily be due to randomness. A few final points to consider. First, on the surface, it looks like this persistence reflects some short-term skill (or, in the case of losers, shortcomings). But why does it go away after one year? Some have concluded that the answer is partly in the nature of the skill. Remember gross returns can beat benchmarks because of stock-picking skill or a style boost. Careful U.S. research on this point indicates that most of the reason for short-term persistence is style boost, much of it due to momentum-chasing.x Some funds have chosen stocks that are doing well (which is why these funds are in the winner category). Recall that stocks that do well sometimes continue to do well for roughly another year. So just holding on to these can make you a winner again - no stockpicking skill involved! In Chapter 10, 1 will return to these issues.

108 - Richard Deaves

R Recap 1. On average, mutual funds do not outperform the market. More precisely, one should say that they do not outperform their riskadjusted benchmarks net of fees. 2. Managers make a contribution, but it is not enough to offset all costs. These costs are MERs, transaction costs, and non-stockholding drag. And don't forget loads where relevant! 3. But this inability to outperform is entirely consistent with a reasonable version of market efficiency. What is a little surprising is that mutual funds are not even able to tie passive approaches. Perhaps cognitive dissonance explains this. 4. There is a little short-term persistence in returns. At the least it makes sense to consider this when selecting funds for the first time.


Endnotes i Deaves, R., 2004, "Data-conditioning biases, performance, persistence and flows: The case of Canadian equity funds," Journal of Banking and Finance 28: 673-94. ii The reasons I had to use a procedure that was more complicated than the slimmed-down one are: first, it is now recognized that beta does not fully capture risk; and, second, 'Canadian7 equity funds also invest to a certain extent in offshore securities (like U.S. and European stocks). iii Note that all returns are on a pre-tax basis. Any analysis using tax-adjusted returns is problematic because people face different tax rates. iv Given my audience, I naturally focus on Canadian evidence, but numerous U.S. studies find broadly similar results. See Malkiel, B. G., 1995, "Returns from investing in equity mutual funds 1971 to 1991," Journal of Finance 50: 549-72, and Gruber, M. J., 1996, "Another puzzle: The growth in actively managed mutual funds," Journal of Finance 51: 783-810. v I will talk more about momentum investing in Chapter 10. vi See Edelen, R. M., 1999, "Investor flows and the assessed performance of open-end mutual funds," Journal of Financial Economics 53: 439-66. vii Wermers, R., 2000, "Mutual fund performance: An empirical decomposition into stock-picking talent, style, transaction costs, and expenses," Journal of Finance 55:1655-95. viii See Goetzmann, W. N., and N. Peles, 1997, "Cognitive dissonance and mutual fund investors," Journal of Financial Research 20:145-58. ix This could be related to lack of clarity and rate of return information on statements. x See Carhart, M. M., 1997, "On persistence in mutual fund performance," Journal of Finance 52: 57-82.


Chapter 5

How well do you do assembling your own portfolio? A. Preview People assembling their own portfolios -1 call them self-selectors - have certain advantages and disadvantages over professional money managers such as mutual fund managers. On the positive side, you don't have to pay yourself any fees. While this may sound like an obvious point, there is a subtlety to consider. If you are investing on your own, actively putting together a portfolio that you feel to be appropriate, assuming that you are taking the task seriously, you are spending some of your precious time on this. Now, if you consider stock-picking a purely enjoyable leisure activity, then this point is a moot one. But, if you consider it 'work' in some sense, then the value of your time must be included in any calculation of cost. In essence, you need to think in terms of paying yourself for your own time. Also on the plus side is the ability to exert greater control over cash flows. Recall that one problem that a mutual fund manager has to face is unexpected redemptions and inflows. On the negative side is the fact that most selectors are amateurs. No slight intended: you are not doing it for a living. One would then expect the gross performance of individual investors to be below the gross performance of professional money managers. With this in mind, I investigate how well self-investors do. I begin, in section B, by asking the following question. Do trades usually make sense? Specifically, do trades improve portfolios at least enough to justify transaction costs? Perhaps, shockingly to some, the answer is no. This suggests that sometimes people are not trading on true information, but on perceived information. Overconfidence is the likely culprit. A full discussion of this behavioral tendency is reserved for section C. Some other portfolio mistakes commonly made by individual investors that


serve to degrade portfolio performance are discussed in section D. These are under-diversification, momentum-chasing, and a preference for local or own-country investments. In section E, I consider whether two or more cooks are better than one. In other words, does investing performance improve when amateurs team up and invest through investment clubs? Unfortunately there is no Holy Grail here.

B. Do people trade because of real or perceived information? Brad Barber of the University of California and Terrance Odean set out to investigate the performance of individual investors.1 In their comprehensive study, they investigated the trading histories of more than 60,000 U.S. discount brokerage investors between 1991 and 1996. The major goal was to see if the trades of these investors were justified in the sense that they led to improvements in portfolio composition. Think about why a market transaction might make sense. If you sell one stock and use the proceeds to buy another, and in so doing incur $200 in transaction costs, this is only logical if it is done in the expectation that you will generate a higher portfolio return - high enough to at least offset this transaction cost. To be sure, individual investors do a lot of trading. Barber and Odean in their study found that, on average, investors turn over 75% of their portfolios annually. This means that, if a typical investor holds a $100,000 portfolio, in a given year she trades $75,000 worth of stock. What did these researchers find? Figure 1 tells the story. The sample of individual investors is divided into five equal groups (quintiles - since there are five), where the groups are formed on the basis of portfolio turnover magnitude. Specifically, the 20% of investors who traded the least were assigned to the lowest turnover quintile (no. 1), the 20% of investors who traded the next least were assigned to quintile 2, and so on - all the way to quintile 5, which was reserved for those investors trading the most. To put all this into perspective, those trading the least only


turned over 0.19% of their portfolio per month - less than 3% per year. Those trading the most turned over 21.49% of their portfolio per month - more than 300% per year. For each quintile, the bar chart displays the gross average monthly return and the net (after transaction costs) average monthly return. So was all this trading worthwhile? Was it based on superior information, or was it based on the perception of superior information? An inspection of the figure reveals that, while the additional trading did lead to a very slight improvement in gross performance, at the same time it led to a substantial deterioration in net performance. In other words, most of the trading was not helpful: the evidence suggests that it was not done because of superior information. Rather it was done because of the perception of superior information.

Figure 1: Gross and net returns for groups with different trading intensities (Barber and Odean study)


A few further points should be noted. First, returns for all quintiles (both gross and net) were fairly high during this period (even for those trading excessively). This is because the overall stock market did well. Second, just as was discussed in Chapter 4, it is important to risk-adjust returns. The reason is that if an investor earns high average returns only because high risk has been borne, this does not imply any sort of stock-picking. Barber and Odean in their research did risk-adjust their returns - the returns in the figure are 'raw' - and found that the results were quite similar to those displayed in the figure. In fact, for all investors, the net risk-adjusted annual return (after taking into account transaction costs, bid-ask spreads and differential risk) was below the market return by well over 3.00%. The 20% of investors who traded the most underperformed the market (again on a net risk-adjusted basis) by about 10% per year.

C. Overconfidence Why is it that investors trade too much? Some finance researchers think it is because of overconfidence. Recall the definition of overconfidence provided in Chapter 3. Overconfidence is the tendency for people to overestimate their knowledge, abilities, and the precision of their information. That most people are overconfident is well-documented by researchers in both the psychology and financial economics literatures.11 i. Measuring overconfidence There are a number of ways to detect and measure overconfidence. Some studies have asked people to rate themselves relative to average on certain positive personal attributes. Often people rate themselves above average on those attributes. In one study, a sample of U.S. students was surveyed, and 82% of them rated themselves in the top 30% of their group on driving safety.111 This strain of overconfidence is sometimes called the betterthan-average effect. The idea is that, while most people think that they are better than the average individual, the reality is that only


half can truly be (while the other half must be worse than average). Refer back to question 27 of the Investorgauge Questionnaire. Did you think that you were better than average? Now you may well be, but, if you think you are and in reality are not, this is overconfidence shining through. Another strain of overconfidence is called illusion of control. The point here is to investigate whether people think they have more control over events than objectively can be true. For example, people have been asked how likely it is that certain events (good or bad) will occur to them - such as winning the lottery or dying of cancer. The evidence indicates that most people overestimate the likelihood of good outcomes, while underestimating the likelihood of bad outcomes. Again refer back to the Investorgauge Questionnaire - this time to question 26. This question was designed to "calibrate7 you. After you answered a series of investment knowledge questions, I asked you how many of these questions you thought you got right. Say you got seven out of the 25 questions right, but you thought that you answered 12 questions right. If so, then this is symptomatic of overconfidence. You are said to be overconfident (in your investment knowledge) because the self-perception of your knowledge exceeded the reality. If, on the other hand, you thought you got less than seven right, you are actually underconfident. Now I am not sure how you did, but I can tell you this. Generally, studies using calibration tests find most people, most of the time, are overconfident.lv Moreover, it is not just amateurs who are overconfident, but also people in their fields of expertise. Studies have documented overconfidence in investment bankers, market forecasters, business managers, lawyers, and medical professionals^ While overconfidence is pandemic, there is evidence that the degree of overconfidence may be a function of demographics. Gokul Bhandari of McMaster University and I found that educated people are not only more confident than those with lower levels of education (which is natural enough), but they are also more overconfident. That is to say, the gap between their knowledge perception and actual knowledge is greater.V1 It was also found that there is a difference in the degree of overconfidence between men


and women, with men tending to be more overconfident than women.vu Interestingly, the magnitude of the difference depends to a great extent on the tasks that people are asked to perform. The difference is greater for tasks that are perceived to be 'masculine/vm It is argued (why, I don't know!) that financial matters fall under this rubric, with men tending to feel more competent than women in this regard.lx In 15 surveys (each with approximately 2,000 respondents) conducted between 1998 and 2000 by the Gallup Organization for UBS PaineWebber, respondents were asked what they expected the rates of return on the stock market and on their portfolios to be in the following 12 months.x On average, both men and women expected their portfolios to outperform the market. Nevertheless, men expected their portfolios to outperform by a higher margin than did women.

ii. Why don't people learn? Researchers have tried to explain why people fail to learn from past mistakes. It is believed that certain behavioral biases contribute to the longevity of overconfidence. One such bias is self-attribution bias. People tend to attribute successes or good outcomes to their own abilities, while blaming failures on circumstances beyond their control, or plain bad luck.xl In a sense, people learn to be overconfident. For example, a lot of people think highly of their investing ability. They believe they can time the market or pick the next hot stock. When the market is rising, most stocks will do well, including those that they pick, and most people will take that as a confirmation of their acumen. On the other hand, when their stocks drop in price, they will generally blame it on circumstances over which they had no control - such as the general condition of the market or the economy. Closely related to self-attribution bias is hindsight bias. This is what makes people think that they "knew it all along."X11 Such hindsight bias leads people to believe in illusory predictive power and to be too confident in predicting the future.xm Consider a study where students were asked to say how probable certain political events were over the next few months.xlv Six months later, at which point it was clear which events had or had not occurred, the same group of students was called back and


asked to recall their earlier probability estimates. The tendency was to come up with higher probabilities (than before) for events that had happened, and lower probabilities for events that had not happened. In other words, "I knew it all along/' At the beginning of this section, it was stated that overconfidence causes excessive trading. Why is this? While there is rigorous theory connecting overconfidence and excessive trading, the intuition behind the theory goes like this. Two people are studying a stock. One is very overconfident in his stock-analysis ability. The other is neither overconfident nor underconfident: rather she is correctly 'calibrated/ Both of these people know that the market price is a kind of market consensus view on what the stock is worth. Say the price is $10. Some people think it should trade for more, while some think it should trade for less than $10. The market price averages all these views out. These two individuals independently analyze this particularly stock. Their different models tell them the value of the stock should be $15. How can this be? Stock analysis is far from a science. There are many different ways to model value, and a number of strong assumptions have to be made, all of which can easily be wrong. So, when they compare their estimate of value to the market price (which is the market's estimate of value), what will be their reaction? The person who is overconfident is likely to think: I am right, the market has missed something. On the other hand, the person who is properly calibrated is likely to think: I probably missed something, I'd better rethink this. The former person will trade, the latter will hold off. Is this theoretical connection borne out in reality? The answer appears to be yes. In an experiment that I conducted with Erik Liiders and Rosemary Luo (she of McMaster University), it was shown that those students who in an earlier calibration test showed the highest levels of overconfidence, traded the most and had the worst portfolio performance.xv


D. Under-diversification, momentum-chasing, and a love for the familiar i. Under-diversification Another investor error likely related to overconfidence is the tendency of investors to be under-diversified. How are overconfidence and under-diversification connected? Suppose you study a number of stocks and you believe, because of overconfidence, that you possess the skills that allow you to choose with a high degree of accuracy which stocks are likely to outperform in the future and which stocks are likely to underperform. Of course you will load up on the former, and avoid the latter. Since most amateur investors really do not have the time to study more than a few stocks, it is likely that you will have identified just a few 'winners/ But, since you are so sure that these ones are good buys, why dilute your portfolio with stocks that you have not studied? Why diversify? If this is your approach, you will tend to under-diversify. Morgan Kelly of Cornell University studied the portfolio composition of more than 3,000 U.S. individuals.xvl Most held no stock at all. Of those households that did hold stock (more than 600), he found that the median number of stocks in their portfolios was one.xvu Yes, you read that right: one. And only about 5% of stock-holding households held ten or more stocks. Most evidence says that to achieve a reasonable level of diversification, you have to hold more than ten different stocks (preferably in different sectors of the economy). Clearly, many individual investors are very under-diversified. William Goetzmann of Yale and Alok Kumar of Notre Dame undertook a careful study in order to ascertain who is most prone to being under-diversified.xvm Not surprisingly, they found that under-diversification was less severe among people who were financially sophisticated. Diversification increased with income, wealth, and age. Those who traded the most also tended to be the least diversified. This is likely because overconfidence is the driving force behind both excessive trading and under-diversification. Also less diversified were those people who were sensi-


tive to price trends (stay tuned) and those who were influenced by home bias (again, stay tuned). ii. Momentum-chasing Another mistake made by investors is that they often choose securities (and investments in general) based on past performance. Recall in my description of representativeness in Chapter 3. Again, the idea of representativeness is that investors who are subject to this bias believe that past success implies future success. I have already discussed how representativeness can lead investors to choose stocks and funds just based on past performance. A few more examples might be helpful. Werner De Bondt of De Paul University conducted a survey of a group of members from the American Association of Individual Investors.X1X He found that more people become bullish if the market has recently turned up. And Shlomo Benartzi studied why people tend to load up on company stock in their retirement accounts.xx He concluded that momentum-chasing might be a factor in this. When he divided plans into quintiles (remember: these are five groups of equal size) based on company stock performance over the previous ten years, he found that employees of the top-performing companies contributed 40% of their discretionary money into company stock vs. 20% for the bottom-performing quintile. Does momentum-chasing make sense? The answer seems to be no as, in the same paper, Benartzi found that in the year after portfolio formation employees who allocated the most to company stock earned 6.77% less than those who allocated the least. In a recent study of the investment decisions undertaken by Canadian defined contribution pension plan members, I analyzed the tendency of investors to be momentum-chasers.xxl Survey participants were asked to allocate $100,000 between two stocks, stock A with an "average return over the last five years of 5%," and stock B with an "average return over the last five years of 15%." Further, they were told that "[ajnalysts forecast that both stocks should earn about 20% per year over the next five years." Those who are neutral on future direction would go 50/50 in order to maximize diversification. Momentum-chasers would put more than 50% in A, while contrarians would put more than


50% of their money in B. Let me digress for a moment. Does momentum-chasing ever make sense? As I mentioned earlier, the best evidence suggests that it is one factor (among many) that a manager may want to look at. Indeed, on average, positive risk-adjusted returns appear to lead to future positive riskadjusted returns slightly more than one would expect based on pure randomness. This statement is true for medium-term return intervals (say 3-12 months). On the other hand, for longer-term return intervals (say 3-5 years), the evidence weakly favors reversals, that is positive returns being followed by negative returns.XX11 In short, if a stock did well over the last year and you had to guess how it was going to perform over the next 12 months, you would lean slightly in favor of continuation. On the other hand, if a stock had performed well over the past five years and, again, you had to make a bet, you would be best to lean slightly towards reversal. So, arguably, the 'best7 answer is probably to put very slightly more than 50% of your money in B (since the return interval is five years) - not too much more though, since the key consideration, especially given the weak momentum and reversal evidence, is not to lose diversification. Still a 50% 150% portfolio is just fine. How did people respond in practice? The frequency distribution of the 'loser' (B) percentage minus the 'winner7 (A) percentage is shown in Figure 2. The mode (the most popular answer) is at zero: these individuals maximize diversification benefits, splitting their money equally. They have answered this question appropriately. Unfortunately they are in the minority. A high percentage of respondents (63.8%) are momentum-chasers, 11.6% are contrarians (in banking on reversals). Both groups surrender some diversification. Notably, the second most popular answer is a bad choice: namely, to put all one's money into A, totally giving up all risk-spreading. By the way, how well did you do? (This was question 34 from the Investorgauge Questionnaire.)


Figure 2: Frequency distribution of loser minus winner stock percentage

iii. Home bias This section looks at another mistake made by investors, the tendency to over-invest in the familiar. Proper diversification suggests that you should neither over-invest nor under-invest in individual securities or asset classes. A number of studies, however, indicate that people feel comfortable with the familiar. This is one reason why people load up on company stock (see previous section). Investors tend to favor companies in their own area (municipality, province, or even country). Gur Huberman of Columbia University reports on a fascinating case of such 'home bias/xxm In 1984, AT&T was forced by the court into a divestiture whereby seven 'Baby Bells' were created. These companies were created along regional lines. An example is BellSouth, serving the southeastern United States. If people like familiarity, then we would expect that a disproportionate number of a Baby Bell's customers to hold a disproportionate number of shares in the same Baby Bell. Indeed that is exactly what happened after the divestiture. The reader might be wondering: what is the harm in


supporting local companies? From a diversification standpoint, if anything you are wise to underweight (not overweight) local companies. If the economy of your region fares poorly, this will be bad both for the stock market performance of local companies and the employment prospects of local workers. If you work and invest locally, technically speaking, your two income sources are highly correlated. Diversification theory says you should look for income streams that are weakly correlated. For this reason it would have been better for investors to buy stock in Baby Bells outside their region. To see if you may be subject to home bias, refer to question 35 from the Investorgauge Questionnaire.

E. Self-investment in groups: Investment clubs So we have seen that investors do not do very well on their own. Perhaps in groups they fare better. Why might we expect this? In a group environment people can bounce ideas off fellow group members. You might believe, for example, that a particular investment will be a great one based on certain assumptions that you are making. But, when forced to defend these assumptions to the group, you might soften your view. In effect, all moves have to be vetted by committee. A good example of investors teaming up is the investment club. In an investment club, individuals (perhaps family members, friends, or co-workers) pool their savings and, by collective decision-making, invest in the stock market. John Nofsinger of Washington State University notes that the press has reported that 60% of clubs beat the market.xxlv He writes that one famous 'successful' club was known as the Beardstown (after their home town) Ladies, a group of women with an average age of 70. They achieved some fame when it was reported that their average return was more than 23% - this at a time when the market was earning about 15%. They were featured in dozens in publications and even appeared on television. Everyone wanted to know their secret. Unfortunately, after an audit by Price Waterhouse, it came to light that their portfolio had not outperformed the market after all. In fact, the opposite was true. It turned out that the problem


was that the well-meaning septuagenarians misunderstood the operation of the portfolio tracking software that they were using, and were thus reporting incorrect numbers. This anecdotal evidence aside, one has to be careful of reported statistics in this context because of what is known as 'selfselection bias/ Statistics usually come from associations of investment clubs whose members voluntarily report performance. There is a not-surprising tendency for a high percentage of successful investment clubs to report performance, compared to the much smaller percentage of unsuccessful clubs reporting performance. Brad Barber and Terrance Odean corroborate this bias in reporting on the investment performance of 166 investment clubs during 1991-97.xxv Using data on investment clubs that were not self-reported, they documented that the performance of the average club lagged not only the market but also the performance of the average investor. And, instead of 60% of clubs beating the market, the fact is that 60% of clubs were outperformed by the market.


F. Recap 1. The evidence indicates that individual investors fare no better than professional investors. Most trades only incur costs: they do not improve performance. 2. Overconfidence is the culprit. People think they know more about the securities that they are trading than is actually the case. 3. Other common mistakes are under-diversification, momentumchasing, and over-investing in the familiar. 4. It does not help to team up with other amateurs. Investment club investment performance is unimpressive.


Endnotes

i Barber, B. and T. Odean, 2000, "Trading is hazardous to your wealth: The common stock investment performance of individual investors," Journal of Finance 55: 773-806. ii This section leans heavily on Charupat, N., R. Deaves and E. Liiders, 2005, "Knowledge vs. knowledge perception: Implications for financial planners," Journal of Personal Finance 4 no. 2): 60-71. iii See Svenson, O., 1981, "Are we all less risky and more skillful than our fellow drivers?" Ada Psychologica 47:143-148. iv See Lichtenstein, S., B. Fischhoff and L. D. Phillips, 1982, "Calibration of probabilities: The state of the art to 1980," in Kahneman, D., A. Slovic and A. Tversky (editors), Judgment under uncertainty: Heuristics and biases, Cambridge University Press, Cambridge, Massachusetts. Calibration tests are also often done via confidence intervals. Participants are asked to provide a series of (say 90%) confidence intervals. If they are well-calibrated, 90% of the true answers should fall within these intervals, but almost invariably well less than 90% of the true answers are contained within these intervals. v Overconfidence has been observed in people of various backgrounds and occupations. See Deaves, R., E. Liiders and M. Schroder, 2005, "The dynamics of overconfidence: Evidence from stock market forecasters," Working paper, for evidence on stock market forecasters. And see Barber, B. and T. Odean, 1999, "The courage of misguided convictions/' Financial Analysts Journal Special Issue on Behavioral Finance: 41-55, for references on the overconfidence of investment bankers, business managers, lawyers and health care professionals. vi Bhandari, G., and R. Deaves, 2005, "The demographics of overconfidence," Forthcoming in Journal of Behavioral Finance. vii Also, see Lundeberg, M. A., P. W. Fox, and J. Punccochar, 1994, "Highly confident but wrong, gender differences and similarities in confidence judgments," Journal of Educational Psychology 86:114-21. viii See, for example, Beyer, S., and E. M. Bowden, 1997, "Gender difference in self perception: Convergence evidence


from three measures of accuracy and bias/' Personality & Social Psychology Bulletin 23:157-172. ix See Prince, M., 1993, "Women, men, and money styles," Journal of Economic Psychology 14:175-182. x This story is recounted in Barber, B., and T. Odean, 2001, "Boys will be boys: Gender, overconfidence, and common stock investment," Quarterly Journal of Economics 116: 261-92. xi See, for example, Langer, E. J., and }. Roth, 1975, "Heads I win, tails it's chance: The illusion of control as a function of the sequence of outcomes in a purely chance task," Journal of Personality and Social Psychology 32: 951-55. xii See Hawkins, S. A., and R. Hastie, 1990, "Hindsight: Biased judgements of past events after the outcomes are known," Psychological Bulletin 107: 311-327. xiii See Shiller, R. J., 2005, Irrational Exuberance, Second Edition, Princeton University Press, Princeton, New Jersey. xiv See Pious, S., 1993, The Psychology of Judgment and Decision Making, McGraw-Hill, New York. xv See Deaves, R., E. Liiders and R. Luo, 2005, "An experimental test of the impact of overconfidence and gender on trading activity," Working paper. xvi Kelly, M., 1995, "All their eggs in one basket: Portfolio diversification of U.S. households," Journal of Economic Behavior and Organization 27: 87-96. xvii A median is the midpoint of an ordered series of numbers. For example, if we start with (5,1, 22,18, 7), and we order them to get (1, 5, 7,18, 22), the median is 7. xviii Goetzmann, W. N., and A. Kumar, 2005, "Why do individual investors hold under-diversified portfolios?" Working paper. xix De Bondt, W., 1998, "A portrait of the individual investor," European Economic Review 42: 831-44. xx See Benartzi, S., 2001, "Excessive extrapolation and the allocation ot401(k) accounts to company stock," Journal of Finance 56: 1747-64. xxi The highlights of this survey are provided in Deaves, R., 2004, "Flawed self-directed retirement account decision-making and its implications," Canadian Investment Review (Spring): 6-15.


Chapter 7 presents another slice of the survey results along with some background on the survey itself. xxii See Jegadeesh, N. and S. Titman, 1993, "Returns to buying winners and selling losers: Implications for stock market efficiency," Journal of Finance 48: 65-91; and De Bondt, W. R M., and R. Thaler, 1985. "Does the stock market overreact?" Journal of Finance 40: 793-807. xxiii Huberman, G., 2001, "Familiarity breeds investment," Review of Financial Studies 14: 659-80. xxiv Nofsinger, J. R., 2001, Investment Madness, Prentice Hall, Upper Saddle River, New Jersey. xxv Barber, B., and T. Odean, 2000, "Too many cooks spoil the profits: Investment club performance" Financial Analysts Journal 56 (Jan-Feb): 17-25.


Chapter 6

How well do you do with indexation? A. Preview Quite simply, indexation entails assembling a portfolio to replicate the performance of a market index. Two steps are involved. First, as will be discussed in section B, the right index must be chosen. The right index should be one that closely tracks the market in question. The strengths and weaknesses of some famous indexes are touched on. In the next section, I explain how indexation operates, and why it is a wise strategy for most of us. Then, in section D, the main index products are discussed. I will argue that an important consideration in indexing is choosing an indexation vehicle that closely tracks the index. And finally, in section E, the pros and cons of the various index products are weighed off against each other. To succinctly answer the question posed by the title of this chapter before moving forward, by indexing you do almost as well as the overall market does - provided your index is designed to replicate the market. "Almost," because there are some fees - albeit low - attached to the best index products. Still, since we saw that the typical (actively managed) mutual fund underperforms its risk-adjusted benchmark by roughly 1 % (definitely more than these low-cost indexation fees), suggesting the wisdom of indexation for most investors.

B. What are indexes? A market index is a construct that is designed to convey market movements to investors. There are indexes other than stock market indexes (for example, bond market indexes), but, for concreteness, most of my discussion will focus on stock market indexes. Normally, a good stock market index is based on a large enough number of stocks so that it will provide a true reflection


of how the overall stock market is performing. Why should we pay attention to market indexes and changes in their levels? Typically, a single stock has a portion of its day-to-day return variability 'explained' by market movements caused by events with a broad impact (such as the Bank of Canada lowering interest rates, or a rise in political uncertainty), and another portion of its return variability accounted for by firm-specific events (such as a company missing earnings, or announcing a promising new investment project). In a broadly diversified portfolio, most of the return variability explained by firm-specific events is averaged out (since some firms will be announcing good news, while others will be announcing bad news), leaving the return variability explained by big-picture events and broad market movements. Since, as we have seen, wise investors hold well-diversified portfolios, market movements (as reflected by index movements) provide some notion of how well wise investors are doing. For this reason they are important. How are market indexes calculated, and what desirable qualities should they embody? Let me begin with the most famous index in the world, the Dow (Jones Industrial Average). The Dow was created in 1896 as an average of 12 U.S. stock prices. Over time stocks were added until, by 1928, there were 30 stocks in the Dow. Though stocks are added or deleted from the average every so often, the number has been held fixed at 30 since that time. Today such famous names as Boeing, DuPont, Exxon, General Electric, General Motors, Home Depot, Intel, IBM, McDonald's, Merck, Microsoft, Proctor and Gamble, Wal-Mart, and Walt Disney are in the Dow. Of the original 12 stocks, only General Electric has retained its membership and original name, although several others have survived in much the same form.1 The original computation method of the Dow was simplicity personified: it was simply the average price for all stocks in the index.11 So, for example, by the time there were 30 stocks in the Dow, the average would have been calculated as the sum of the 30 stock prices divided by 30. Naturally, increases in the Dow meant that the market was moving in an upward direction. In the next pages, I will be calculating some hypothetical index values. Let's say the four stocks in Table 1 are the con-


stituent stocks of an index. I begin by calculating the average share price of these stocks in the manner of the Dow, arriving at: [80 + 40 + 160 + 50] 74 = 82.5

If stock B doubles in price, the index goes up by 12.1%, while, if stock C doubles, the index will go up by four times this amount.111 C, of course, is initially priced at four times D. So we see that the impact on the index is a function of the original price of the stock in question. It is for this reason that we call the Dow a price-weighted index. Such an index is really illustrating what transpires for a special portfolio based on holding the same number of shares of each stock (e.g., one of each, or 200 of each, etc.). This may not be a good reflection of the market though, if one particular stock has a total market value 20 times that of another.

Table 1: Hypothetical stocks for index calculations Stock Shares Current Price in Dividend (millions) price one year in one year A B C D

1 3 2 4

$ 80.00 $ 40.00 $160.00 $ 50.00

$100.00 $ 50.00 $140.00 $ 55.00

$3.00 $1.00 $5.00 $0.00

For this and other reasons, it is now well-known that, despite its fame, the Dow is a weak index.lv Virtually all important stock market indexes today are market value-weighted indexes. An example is another U.S. stock market index which, while less famous to people outside of the financial industry, is actually much more commonly used inside the financial industry. It is called the Standard and Poor's 500 (S&P 500). The name suggests that one obvious improvement is increased breadth: while the Dow restricts itself to 30 quite large corporations, the S&P 500 uses a more representative sample of 500 fairly large corporations. Just as in the case of the Dow, stocks are added to or subtracted from the index periodically according to certain criteria. The number of stocks in the index however is held constant at 500.


Value-weighted indexes like the S&P 500 are preferable to price-weighted ones like the Dow. A value-weighted index is calculated as the ratio of the current aggregate market value of the stocks in the index to the base-period market value.v This attribute makes it more representative of market movements because of the fact that the impact of a company in the index is in line with its size (or market capitalization). To see how this works, refer to the second last column of Table I, which shows prices as of the end of the year for the four stocks. I will calculate an overall index-level capital gain using this index. Assuming that the beginning of the year is the base period date, by the end of the year the index level is at: 1.042 = [100*1 + 50*3 + 140*2 + 55*4] / [80*1 + 40*3 +160*2 + 50*4]

The denominator is the initial market value of all the stocks in the index (720), and the numerator is their current value (750). Since the initial index level is 1 (= 720/720), the index capital gain is 4.2% (= (1.042-D/l). This is not quite an index return though, since dividend payments are not included. Later I will calculate a true index return by incorporating such payments. Before doing this let me turn to Canadian indexes. The bestknown stock market index in Canada is the S&P/TSX Composite Index. It comprises more than 200 publicly listed companies based in Canada meeting various inclusion criteria.vl While these are the largest companies in Canada, some of them are rather small by international standards. As for calculation methodology, it is, like the S&P 500, a value-weighted index, and the calculation procedure is essentially identical. As its name suggests, this index is now managed by Standard and Poor's. Formerly it was managed by the Toronto Stock Exchange (TSX, previously branded as the TSE). At that time it was called the Toronto Stock Exchange 300 Composite Index (TSE 300), and there were always exactly 300 stocks in the index. Over time, the Canadian investment community felt that the index was losing relevance. One problem was that the bottom 100 companies only represented about 2% of the value of the index. In May 2002, the TSE 300 became the S&P/TSX Composite Index, and, over a half-


year transitional period, companies not meeting certain criteria were dropped from the index. While today there are 30% fewer companies in the Composite compared to before its transition, there is no fixed number: rather, stocks must meet various size and liquidity conditions.V11 The TSX is further subdivided in a number of ways. Industry groups such as Energy, Financials, Gold, Industrials, and Information Technology have their own sub-indexes. Division is also done by size. The 60 companies with the highest market capitalization are put in the S&P/TSX 60; those 60 with the next highest market cap are in the S&P/TSX Mid Cap Index; and, finally, the residual Composite members are put in the S&P/TSX Small Cap Index. Additionally, there is an index of very small (micro cap) companies called the S&P/TSX Venture Composite Index.vm All indexes viewed up to now share a particular problem: they provide only a view of capital gains. Conveniently, most indexes have associated 'total return' indexes. To see how these work, refer back to Table 1 again, and notice that three of the four stocks paid a dividend at the end of the year in question. If I add each company's dividend to the share price before calculating the total market value at the end of the year, I arrive at an index level at the end of the year of:

1.064 = [(100+3)*1+(50+1)*3+(140+5)*2+(55+0)*4] + [80*1+40*3+160*2+50*4] This implies a correct market return including dividends of 6.4%. Around the world there are thousands of different indexes representing different markets (or composites or segments thereof). See Table 2 for a listing of some of the most important nonCanadian indexes (where I have left out the two U.S. indexes previously mentioned). As mentioned above, most are similar to the S&P 500 in that they are value-weighted. To mention a few, in the U.S. there are the NYSE Composite Index (made up of all stocks on the New York Stock Exchange) and the Russell 2000, which is a U.S. small cap index. Major stock markets (with associated indexes) exist in Japan, the U.K., Germany, and France. A notable 'world'


index is the MSCI EAFE Index. This is a composite non-North American world stock market index made up of all of Western Europe, Australia, and selected Far East markets (Japan, Singapore, and Hong Kong). In other words, most of the developed world economies outside of North America are part of EAFE.

Table 2: Non-Canadian stock market indexes Country or region U.S.

Index NYSE Composite

U.S. U.S. U.S. U.K.

NASDAQ 100 Wilshire 5000 Russell 2000 FTSE100

Germany France Japan Hong Kong World exc. North America

DAX CAC

Nikkei 225 Hang Seng MSCI EAFE

Details

All stocks on New York Stock Exchange Largest 100 on NASDAQ Comprehensive U.S. index Small cap U.S. index London market Frankfurt market Paris market Tokyo market Hong Kong (China) Europe, Australia and the Far East composite market index

I close this section by noting that it is not just equities that have indexes: thousands of customized bond and commodity market indexes exist as well, and these can be very useful for assembling a portfolio. For example, a well-known Canadian bond index is the Scotia Capital Universe Bond Index. It is comprised of a large number of bonds issued by the Government of Canada, various provinces, and some corporations.

C. What is indexation and why does it make sense? i. What exactly is indexation? Indexation is quite simply the process of constructing a portfolio whose return replicates as closely as possible the return on a market index. It goes without saying that first you must choose the right index. At a minimum it should be value-weighted and


quite representative of the market in question (which lets out the Dow on two counts for those investing in the U.S. market). While indexation can be done for commodities, fixed-income securities, and other asset classes, I continue to focus on equities. Still, most of what I present is transferable to other sectors. The replicating portfolio is most simply (but necessarily most efficiently) assembled by purchasing in correct proportions all the individual securities in the index. One can also index by purchasing various index products (principally, index mutual funds and exchange traded funds (ETFs). The latter are in many respects like mutual funds, except that they trade on an exchange.lx Indexation is successful to the extent that the replicating portfolio's return tracks the return on the underlying index. Superior performance, while on the surface appealing, is not what is being sought by indexation. ii. Using indexation The simplest way to index is to assemble a portfolio of securities in the exact proportions that these are found in the index. To make sense of this, refer to Table 3. This table, expanded from Table 1, shows, in the last column, the percentages in the index accounted for by the four securities making up this index, that is, the value weights.

Table 3: Market shares of hypothetical stocks Stock Shares Current Market value Value weights (millions) price (millions) A B C D

1 3 2 4

$ 80.00 $ 40.00 $160.00 $ 50.00

$ 80.00 $120.00 $ 320.00 $ 200.00

11.1% 16.7% 44.4% 27.8%

An indexer should use these exact same percentages in putting together her indexed portfolio. If the index is fairly small, an individual investor could manage the job of indexation on her own. Once an index is large though - and the best indexes will be quite broad - it will be much more efficient for individual investors to use low-cost index products (such as ETFs), where


the job of indexation is done by the vendor of these products. By the way, even if a financial institution does the job, it will not always be appropriate to exactly replicate an index. Consider the case where the underlying index contains a quite large number of securities. Many U.S. indexers, for example, are instructed to try to replicate the S&P 500, which is constructed from 500 stocks. To replicate this index exactly requires a very large number of transactions, both at the outset, and over time when rebalancing becomes necessary. Indeed, it may be better to economize on transaction costs by buying only a subset of the 500 securities, but a subset (both in terms of the number of securities, and also in terms of the identity of the securities) that is optimally chosen, so as to appropriately balance off transaction costs and straying from the index. The latter 'straying' problem comes under the rubric tracking error. To see what is involved, say I am trying to replicate the previous hypothetical index, but I do so by only holding stocks B, C and D (which have the largest weights). That is, I do not hold stock A, the one with the lowest market weight. The percentages of the other three stocks are 'grossed up' to maintain proportionality^ We earlier saw that the true index return over the year in question was 6.4%. The (imperfect) tracking portfolio only generates a return of 3.6% though.11 This is because the strong performer (A) is absent from the tracking portfolio. It is important, when comparing the attractiveness of various index strategies or products, to examine tracking error. iii. Why does indexation make sense? Assuming that we have identified the appropriate index, the motivation behind indexation (or passive management, as it is sometimes called) is not to attempt to generate superior returns by actively managing your own portfolio or by purchasing actively managed mutual funds. If done through an indexation vehicle, this is a one-stop shopping trip to achieve portfolio diversification. Chapter 4 made the case that most mutual funds do not typically outperform the market after fees. Moreover it is extremely difficult to identify in advance the ones that are likely to succeed with any kind of consistency. Chapter 5 made clear


that individual investors do not do a very good job in investing their own money. This is partly because of a lack of knowledge, and partly because people are subject to behavioral biases that get in the way of optimal decision-making. The bottom line is that it is extremely difficult for anyone - money managers as well as individuals - to outperform the market on a risk-adjusted basis. With so many clever money managers seeking to find mispriced securities and exploit market anomalies, it is no wonder that it is very difficult to find an edge. And yet, history tells us that the market is a good place to be. Equities on average outperform fixed-income securities. Quite simply, a good way to achieve market returns without excessive fee or mistake erosion is to index. Many have come around to this way of thinking since indexation was first used as a strategy in 1971 by Wells Fargo, which put together a portfolio for the Samsonite Pension Fund based on the New York Stock Exchange Index.

iv. Is indexation perfect? No, indexation is not perfect. One critique that I sometimes hear, which I personally do not find compelling, is that if you index you buy them all, the 'stars' and the 'dogs.' This is true in the sense that you will have both past stars and past dogs in your portfolio. As for the future, nobody knows, and we are back to the difficulty of active management, which is the art of separating future dogs from future stars. A much better critique has very recently been espoused by Jeremy Siegel of the University of Pennsylvania in his book The Future for Investors.*11 To put things into perspective, Siegel is a well-known proponent of indexing. Still, he decided to compare the historical performance of the U.S. benchmark S&P 500 (which is the main benchmark for U.S. indexers) to the performance of a portfolio made up of the original members of this index. To remind the reader, firms enter and leave indexes on a periodic basis. Successful, growing firms enter the 500, and laggards are turfed out. How can this be bad? I have already talked about style investing and the long-term outperformance of value investing. Value investing is all about focusing on the laggards, which sometimes get beaten up too much and are ready for a


turnaround. What Siegel found is that the original index members safely outperformed the index itself. What is behind this? The explanation is that the 500 has a growth bias. In fact, this will be true of any index which does not include every stock in the market, and which brings in successful firms and drops unsuccessful ones. Is this a fatal flaw for indexing? Not at all, but it does suggest that there might be some gains from style tilting and this can be done by style indexation. I will have more to say about this in the last chapter of the book.

v. Why you might not fully index

Indexation and active management are not necessarily mutually exclusive. The term 'enhanced indexation' is sometimes used for the strategy of mixing indexation and active management. The core of the portfolio is indexed, and then a manager or individual can try to locate a few underpriced securities to enhance returns. Of course the onus is on the investor to really make sure that he (or the manager he chooses) really has the skills to deliver 'pumped up' returns. There is evidence that in certain sectors there are exploitable gains to active management. The case seems to be strongest for small cap and non-North American markets.xm Additionally, in situations when active management can be 'purchased' more cheaply, the case for indexation weakens. Defined benefit (DB) pension plans, for example, because of their purchasing clout, are able to negotiate fees well below 'retail.'xlv So active management makes more sense in this context. Additionally, to the extent that defined contribution (DC) pension plan (or group-RRSP) sponsors are able to negotiate lower fees for their members, the case for indexation in this context is also weaker.xv

D. Index products Because of the transaction costs involved, individual investors are not going to find it wise to index on their own. Realistically, the two choices are index mutual funds and ETFs. A simple pur-


chase of one of these is all that is required for effective indexation. It is the mutual fund or the ETF managers themselves who assemble the portfolios of underlying securities. Specifically, as I have described, they purchase portfolios of securities in proportions that are designed to replicate the relevant index as closely as possible. I next examine these two choices in more detail.

Table 4: Canadian-based ETFs ETF iUnits S&P/TSX 60 Index Fund iUnits S&P/TSX 60 Capped Index Fund iUnits S&P/TSX MidCap Index Fund iUnits S&P/TSX Capped Energy Index Fund iUnits S&P/TSX Capped Financials Index Fund iUnits S&P/TSX Capped Gold Index Fund iUnits S&P/TSX Capped IT Index Fund iUnits S&P/TSX Capped REIT Index Fund iUnits Government of Canada 5-year Bond Fund iUnits Canadian Bond Broad Market Index Fund iUnits S&P 500 Index RSP Fund iUnits MSCI International Equity RSP Fund TD S&P/TSX Composite Index Fund TD S&P/TSX Capped Composite Index Fund TD S&P/TSX Canadian Growth Index Fund TD S&P/TSX Canadian Value Index Fund

Sector Canadian equity Canadian equity Canadian equity Canadian equity Canadian equity Canadian equity Canadian equity Real estate Fixed-income Fixed-income U.S. equity International equity Canadian equity Canadian equity Canadian equity Canadian equity

Since index mutual funds operate exactly like actively managed mutual funds except for the fact that the strategy is to emulate the index, there is little to say about them. Investors can buy and redeem units at net asset value (NAV), subject to any loads or redemption charges. The ETF is an efficient investment product for passive investors.xvl Unlike a mutual fund, ETF units are, as their name implies, traded on an exchange. In fact they trade on an exchange (in Canada on the TSX) just like a stock, and are priced on a similar bid/ask basis. Table 4 provides a full current listing of Canadian-based ETFs.XV11 Liquidity is greater than in the case of mutual funds, in the sense that ETFs can be bought and sold at


any point in time during the trading day, whereas mutual fund unitholders must wait till the end of the trading day.xvm It may be useful to supplement Canadian-based ETFs with U.S.-based ones. South of the border there is a vibrant ETF market, with $265 billion of value spread over 290 ETFs as of August 2005.X1X Table 5 provides a selection of U.S.-based ETFs.**

Table 5: A few U.S.-based ETFs ETF NASDAQ 100 Tracking Stock S&P Mid-cap 400 Depository Receipts (Mid-cap SPDRs) iShares Russell 2000 iShares MSCI Emerging Markets iShares MSCI France iShares MSCI Germany iShares MSCI Japan iShares MSCI United Kingdom iShares Lehman Aggregate

Sector U.S. equity U.S. equity U.S. equity Non-N.A. equity Non-N.A. equity Non-N.A. equity Non-N.A. equity Non-N.A. equity U.S. bonds

E. The pros and cons of the various index products The principal difference between ETFs and index mutual funds is cost. Quite simply, MERs are lower for ETFs.xxl Focusing on broad Canadian equity index funds, the illnits S&P/TSX 60 Index Fund (both in its capped and uncapped versions) has an MER of 17 basis points (0.27%) and the TD S&P/TSX Composite Index Fund (again both in its capped and uncapped versions) has an MER of 25 basis points.xxu Compare these numbers to the 80-100 basis point MERs generally witnessed (with some exceptions) by index mutual funds.xxm In my earlier discussion of the importance of MERs, I illustrated how over time even a small difference can open up a large wedge between final cash balances. For this reason, ETFs are superior indexing vehicles for most investors. There are some positives for index mutual funds, however, that need to be taken into account, and that potentially might


push some investors to prefer certain low-cost index mutual funds. One advantage is that they can be bought and sold in small units, either as one-off transactions or as part of small regular monthly purchases. ETFs, on the other hand, like stocks, are best bought in substantial quantities in order to minimize brokerage commissions. For many this means accumulating a sufficient amount of money over several months in order to make an ETF transaction of sufficient size. There are two drawbacks here. One is a period when only minimal interest, instead of market returns is earned on savings. Second, given the tendency that I have previously discussed for many to procrastinate, some people will not get around to making these purchases, and others might even spend some of their 'savings/ Another disadvantage of ETFs concerns the handling of dividends. ETFs accumulate dividends outside the fund and pay them to shareholders every quarter. Thus, there is a period of time during which the investor is not able to reinvest dividends. Mutual funds, on the other hand, reinvest dividends as they are received.XX1V All of these pros and cons have an impact on how well the indexing vehicle tracks the underlying index, that is, on the tracking error. Paul Halpern and Eric Kirzner of the University of Toronto have investigated the relative abilities of ETFs and index mutual funds to track their underlying indexes, and they conclude that ETFs tend to perform better in this regard.xxv The main factor is simply that the higher MERs of mutual funds lead to a higher persistent gap between index return and indexing vehicle return.


F. Recap 1. When indexing, choose an index that closely tracks the market whose returns you seek to imitate. 2. Indexation is wise for most investors because there is abundant evidence that mutual fund managers do not, on average, justify their fees, and individual investors do not manage their money any better. 3. Index mutual funds are like other mutual funds, except that their managers make no attempt to outperform the index. The same holds for ETFs, except they trade like stocks. 4. Both ETFs and mutual funds have advantages. ETFs are usually preferable though because of their lower MERs.


Endnotes

i See Siegel, }. J., 2002, Stocks for the Long Run, Third Edition, McGraw Hill, New York, for details. ii Purists will say that this is more an 'average' than an 'index/ iii In the first case, the index goes to: [80 + 80 + 160 + 501/4 = 370/4 = 92.5 This is 12.1% higher than its original level. In the second case, the index goes to: [80 + 40 + 320 + 501/4 = 490/4 = 122.5 This is 48.5% higher than its original level. iv So, if the Dow is so awful, why is it so famous? The answers are history and inertia! One weakness of the Dow is the way it treats stock splits. Normally a (say) two-for-one split results in there being twice as many shares at about half the price per share. Since nothing fundamental has really occurred, the denominator is adjusted downwards every time a split occurs in order to immunize the Dow from split-induced changes. The adjusted divisor was 0.135 as of mid-2004. One problem with this procedure is that rapidly growing firms (which often split) receive a lower weighting in the index merely because of the act of the split, thus leading to a downward bias in the index. Valueweighted indexes (as will be discussed), where stocks are represented as the product of the number of shares outstanding and the price per share, are immune to this problem. This is because going from one million shares at $200 to two million shares at $50 has no effect on the product. v Often this ratio is multiplied by an arbitrary factor, which is then the initial level of the index. This factor is of no real consequence though, since people should only be concerned with percentage changes in the index, and these are unaffected by this factor. vi As of November 4, 2005, there were 209 companies in the index. In December, 72 income trusts (to be explained in Chapter 8) began to be phased into the index. vii Note that market value is viewed in terms of a 'float market capitalization basis/ Specifically, the issued and outstanding shares are adjusted by removing control blocks, where the latter are defined to be groups of shares held by individuals or companies owning or controlling 20% of the company's shares.


viii This index has 518 members (as of November 11, 2005). ix Additionally, indexing can be done using derivatives such as index futures. In brief, the idea is to invest cash in risk-free securities, while using the latter as collateral in setting up long futures positions in index futures. It can be shown that, if this is done properly, index returns can be emulated. See Deaves, R., 1994, "Speculative versus arbitrage opportunities from index futures mispricing/' International Review of Economics and Finance 3: 319-25. x For example, to gross up stock B's percentage you would use 18.8%, which equals 16.7% / (1 - 11.1%). Similarly, the grossedup weights for C and D are 50.0% and 31.3%, respectively. xi To see this, calculate a weighted average (using the grossedup weights from the previous footnote) of the returns of the three securities in question: .188 * 1(50-40+1)140] + .5 * [(140-160+5)/160] + .313 * [(5550+0)/50] = 3.6% xii Siegel, J. J., 2005, The Future for Investors, Crown Business, New York. xiii See Haslem, J. A., 2003, Mutual Funds, Blackwell Publishing, Maiden, Massachusetts. xiv In a defined benefit pension plan, the employer promises to set aside funds (normally supplemented by employee contributions) and invest them for the purpose of making benefit payments to retirees according to a formula. More details will follow in Chapter 9. xv Note that a defined contribution pension plan is a structure whereby employers (and sometimes employees) making regular contributions into a pension account, which is then invested (normally) at the discretion of the employee. What will be available at retirement is determined by how well the investments in the account perform. Again, more information on defined contribution pension plans and group-RRSPs will come in Chapter 9. xvi For a comprehensive treatment of ETFs in the Canadian environment, see Atkinson, H. J., and D. Green, 2005, The New Investment Frontier III: A Guide to Exchange Traded Funds for Canadians, Insomniac Press, Toronto. xvii As of the time of writing, Barclays Global Investors


Canada (which issues the illnits Canadian ETFs) was to hold a vote to convert the ^tatus of four of its funds. If approved, the iUnits S&P/TSX 60 Capped Index Fund would be converted into a product that would track a version of the S&P/TSX Composite Index. Barclays also wants to convert its iUnits Government of Canada 5-year Bond Fund into a diversified fund based off the Scotia Capital Short-term Bond Index. And the iUnits funds based off the S&P 500 and EAFE would become 'currency-hedged/ See Carrick, }., 2005, "Barclays muscles in to zap TD's last advantage with ETFs," Globe and Mail, Report on Business (October 13). xviii It needs to be noted that the four TD Canadian-based ETFs have low levels of liquidity and wide spreads. See Carrick, J., 2005, "Barclays muscles in to zap TD's last advantage with ETFs," Globe and Mail Report on Business (October 13). xix These figures come from a Morgan Stanley Equity Research report on ETFs written on August 9, 2005. xx Some useful Web sites for Canadian-based and U.S.-based ETFs are: www.iunits.com, www.tdam.com, www.ishares.com, www.amex.com and www.nasdaq.com. xxi This is easily established by a visit to www.morningstar.ca (or another Canadian mutual fund information and data Web site). It will be apparent that there exist index mutual funds with MERs well in excess of 100 basis points. Frankly, it is difficult to see how such fees can be justified. xxii A capped index sets an upper bound on the weighting of any one stock (e.g., 25%). This became an issue in Canada in 2000 when once high-flying Nortel came to make up a large percentage of the TSX. xxiii One exception is TD's eFunds (www.tdefunds.com) which must be accessed entirely via the Web. There is an MER as low as 30 basis points for a Canadian broad market index. xxiv Several brokers offer automatic reinvestment programs for ETF distributions (dividends, capital gains, and interest income). See Atkinson, H. J., and D. Green, 2005, The New Investment Frontier III: A Guide to Exchange Traded Funds for Canadians, Insomniac Press, Toronto, for details. xxv See Halpern, P., and E. Kirzner, 2001, "Quality standards for index products," Working paper. There are subtle reasons


why ETF and mutual fund prices may differ even when the same index is being tracked. In the case of an index mutual fund, some shares might not have traded recently, so some stale prices might be entering the index. On the other hand, with an ETF, prices are set by supply and demand, and sometimes the ETF price may be higher or lower than what is represented by the stocks in the ETF. There is a mechanism that minimizes this problem: large traders have the right to convert a large number of ETF units into the underlying stock, and vice-versa.

Chapter 7

Going forward with an understanding of asset allocation A. Preview The asset allocation decision is all about the right amount of risk-taking. Inevitably there is a personal psychological dimension to this, since ultimately the individual investor must come to a decision based on her own comfort level. This chapter can serve as useful background. Since asset allocation entails deciding how much money to allocate among asset classes with different risk and return dimensions, I begin, in section B, with a discussion of the nature of the major asset classes (and sub-classes). In section C, I establish the case that asset allocation is important. First, it explains most return variability. Second, it allows you to increase return without taking on any more risk. One could say that the latter constitutes a kind of 'free lunch' that should not be left on the table. Optimization is discussed in sections D and E. In theory, optimizers allow for the selection of just the right set of asset classes, and in the right proportions. I illustrate their use (in section D) and discuss their limitations (in section E). A warning to the reader. The material in sections D and E is somewhat challenging, so you may want to skim (or temporarily skip) these sections.

B. What is asset allocation? As we have already discussed, it is well known that investors should not put all their eggs in one basket. Say you have assembled a portfolio of three or four stocks. Such a portfolio might suffer major declines if you have the misfortune of seeing two or three of these witness negative news. When you have more stocks in your portfolio - ten or more - you would indeed be unfortunate to see most of your stocks decline. This will tend to happen only if the market as a whole declines. After all, no mat-


ter how well-diversified your portfolio is, you cannot rid yourself of market risk. So it is important to follow the principle of diversification. Aside from diversification across securities, there is another level of diversification to be conscious of: this is diversification over asset classes and styles. i. Broadest asset classes: Stocks and bonds Indeed it is less well understood that diversification can operate not only at the level of individual securities but also at the level of asset classes. What asset classes are relevant for our purposes? For now, I will stick with the two broadest asset classes, namely stocks and bonds (or, synonymously, equities and fixedincome securities). Within the bond class, one can make finer distinctions. One key distinction is between government bonds and corporate bonds. The former are exposed to interest rate risk, while the latter are exposed to both interest rate risk and default risk.1 Another distinction is between bonds that mature in the near future (money market instruments) and those that mature in the distant future.11 On the equity side, there are two key style-based distinctions. We have already discussed that these are based on market capitalization and growth vs. value. Recall that, historically, the large cap and small cap sectors have differed in terms of performance, with small cap dominating large cap more often than not. And growth stocks and value stocks have also differed in terms of performance, with value stocks usually dominating. Another key distinction is between domestic and foreign securities. This is particularly important on the equity side. It should not surprise the reader that Canadian stock markets are dwarfed by those of the rest of the world combined. Based on a recent ranking, Canadian stocks constituted only 2.5% of the world portfolio by market value.111 So to ignore foreign securities is to give up a lot of opportunities and diversification potential. Most commentators would split up the rest of the world into the U.S., the EAFE countries, and the emerging market countries.lv Finally, emerging markets include such developing countries as India, China, Korea, Malaysia, Indonesia, Thailand, Brazil,


Argentina, Chile, Poland, Hungary, the Czech Republic, Turkey, and so on. If one returns to Tables 4 and 5 of the previous chapter, it is apparent that ETFs can cover virtually all these asset classes (and styles). Where there are gaps (small cap Canadian equity for instance), low-cost, actively managed mutual funds can be used as supplements. While, in my view, the stock-bond (domestic and international) universe is sufficient for most investors, in the next chapter I will touch on some other less important asset classes (e.g., real estate, income trusts, hedge funds, commodity futures, and so on.) ii. Do people really understand asset allocation? A choice that we all have to make - whether we buy individual securities, mutual funds, or ETFs - is how much risk to bear. This can be viewed as the stock-bond mix (or equity exposure) decision.v If you have a $100,000 portfolio made up of $40,000 in common stock and $60,000 in bonds, your equity share (exposure) is 40%. Because stocks are riskier than bonds, the higher your equity share, the greater is your readiness to bear risk. Before moving forward, one question we might want to ask ourselves is whether most investors even understand what asset allocation is. As evidence I will refer to some analysis that I recently undertook of a survey conducted for SEI Investments of Canadian defined contribution pension plan members.vl The surveyed individuals have some say in how their pension money is invested, so it is quite important that they understand the basics of investments, in general, and asset allocation, in particular. This survey was a comprehensive one as more than 2,000 plan members participated. One goal of the survey was to obtain information on the level of investment knowledge of this group of individuals. Two questions were designed to ascertain whether investors understood asset allocation and the stockbond mix. The first question asked respondents to imagine that they had $100,000 in their pensions, and had to allocate all this money among three alternatives: a 'government bond fund/ a 'corporate bond fund/ and a 'stock fund/ Your answer to a question like this should reveal your pre-


ferred stock-bond mix. For example, if a respondent favors a 60/40 stock bond mix, she should assign $60,000 to the stock fund, and $40,000 should be allocated between the two bond funds. It is important to stress that there is no right answer to a question like this. It all comes down to a person's risk attitude, and these can differ markedly for valid reasons. (I will discuss this issue in the next chapter.) While individual concentrations ranged from 0% to 100%,it turned out that the mean share over the entire sample allocated to stocks was 43%. A second question on the survey was almost identical, except that the three choices were a 'bond fund/ a 'growth stock fund/ and a Value stock fund/ Once again, logically, answers could differ depending on risk preferences. Importantly though, investors should understand asset allocation and the stock-bond mix. One way to investigate someone's understanding is to check to see if their answers to the two questions are consistent. Their risk attitude should determine the stock-bond mix, and there is no reason why this should change from question to question, regardless of the menu of alternatives. If respondents provide markedly inconsistent answers to these questions, serious doubt is cast on their understanding of asset allocation. As it tufhed out, the mean equity share based on the second question - that is, the dollars allocated to both stock funds relative to the pool of money available - was 69%.vu The clear implication of this is that many pension plan members had difficulty understanding an issue as vital to their financial well-being as asset allocation. (Questions 28 and 29 of the Investorgauge Questionnaire repeated these two asset allocation questions. Were you consistent?) It is natural to wonder why the answers came out the way that they did. As discussed earlier, behavioral finance has taught us that when individuals are unsure of their decisions they sometimes rely on rules of thumb - remember these were called heuristics - that allow them to make what to them seems a reasonable choice. When the problem involves choices over alternatives, and it is possible to spread one's selection over more than one option, researchers have documented a 'diversification heuristic.' People who are unsure automatically choose "a bit of


everything on offer/' In the present context, a diversification heuristic can lead to evenly spreading one's money across all three alternatives. This would suggest an equity share for the first question of 33% and an equity share for the second question of 67%. Recalling that the shares implied by the two sets of responses were 43% and 69%, we see that the diversification heuristic was instrumental in the choices of many people.

C. Why is asset allocation important? i. It explains most return variability While many investors do not understand asset allocation, I now show that it is quite important that they make the effort to do so (especially if they wish to manage their own money). It is often observed that the asset allocation decision is the most important one for an investor's portfolio performance. In what sense is this meant? An investor faces three layers of choices. First, the normal stock-bond mix, or, synonymously, the strategic asset allocation (SAA), must be chosen. Say it is 50% stocks and 50% bonds. Second, the individual securities within these two asset classes must be chosen. That is, specific stocks and bonds must be chosen. (If one buys mutual funds, the choice is still being made, but one has abrogated this choice to someone else. Indexation involves letting the index decide.) Third, in response to changing market conditions, one can adjust one's equity share. This is known as market timing or tactical asset allocation (TAA). If one feels that equity exposure should be raised in anticipation of a market upturn, it might be appropriate to increase the portfolio equity share from 50% to 60%.viii Gary Brinson and various co-authors examined a sample of close to 200 U.S. pension funds in order to ascertain the impact of the above three key decisions (strategic asset allocation, selection, and tactical asset allocation) in explaining differences in return variability.1X What they found was that asset allocation was far and away the most important factor. In their paper they famously assigned it a percentage of 93.6%. While some have criticized their methodology, arguing that they overstated the impact, most


still concur that asset allocation is a vital decision in controlling risk in your portfolio and matching it to your needs.x ii. Asset allocation can increase return and decrease risk at the same time I now want to turn to some data on Canadian stock and government bond returns. More specifically, the stock returns are based on the S&P/TSX Composite Index. The Government of Canada bond returns come in three flavors: short-term (threemonth Treasury Bills), medium-term (with maturities of 3-5 years), and long-term (with maturities of ten or more years).

Figure 1: Historical annual returns for S&P/TSX Composite Index

During this period of time, a broadly diversified portfolio of Canadian stocks earned an average return of 10.57%; short-term Government of Canada bonds earned 6.73%; medium-term Government of Canada bonds earned 7.63%; and long-term Government of Canada bonds earned 8.20%. Note that these are all simple (or 'arithmetic') averages. Compounded averages give us a better sense of the actual growth of money over time. Now the numbers are 9.37%, 6.67%, 7.48%, and 7.69% for the four asset classes respectively. As was discussed in Chapter 1, the gap between stock and bond average returns narrows. This is because compounded averages are always less than arithmetic


averages, the gap widens with volatility, and stocks are more volatile than bonds. Referring to Figures 1 and 2, we see that there were ups and downs for both stocks and bonds. In Figure 1, the most risky asset class of the ones under consideration, Canadian stocks, is shown. Note that 31% of the time (on 15 occasions) the stock market had a negative return. On the upside, 15% of the time (on seven occasions) the stock market had an annual return of 30% or more. Bond market returns are shown in Figure 2. We can see that longterm bonds are more risky than medium-term bonds, and mediumterm bonds are more risky than short-term bonds. Still, on only one occasion was the return as low as -10% for long-term bonds. One might wonder how bond returns can ever be negative. Bonds pay coupon interest on a regular basis, but the interest paid is fixed over the life of the bond. When market interest rates go up, this means that newly issued bonds will have coupon interest payments (as a percentage of the market value) that exceed those of older lower-interest bonds. Why would anyone want to buy these older bonds? Indeed, without a market adjustment, no one would. What must happen is that these older bonds have their prices pushed down by the market, so that the coupon interest payments as a percentage of the bond price - this percentage is known as the 'current yield' - become more comparable. When the percentage capital loss created by this market adjustment is greater than the current yield, a negative return results.


Figure 2: Historical returns on long-term (LT), medium-term (MT), and short-term (ST) Government of Canada bonds

Comparing Figures 1 and 2, it is clear that the volatility (or risk) of stock returns has historically been greater than the volatility of bond returns. This is highlighted in Figure 3.X1 As discussed earlier, the measure that is conventionally used to measure risk is standard deviation. The standard deviation of stock returns was 16.20%, while the standard deviations of shortterm, medium-term, and long-term bond returns were 3.68%, 5.90%, and 10.83%, respectively. Recall the interpretation of standard deviation that was presented earlier. At least two-thirds of the time a random variable (such as a stock or bond return) should fall within plus or minus one standard deviation of its mean. In other words, we would expect stock returns to be between -5.63% and 26.77%, 67% of the time. And T-bill returns should be between 3.05% and 10.41%, 67% of the time.*11 Say we had to put all our money into either just stocks or just bonds (whatever the maturity), and we thought that the future was likely to resemble the past. The choice would come down to a balancing of return expectations and risk. The decision would not be obvious. Indeed, it would depend on our willingness to bear additional risk in exchange for higher anticipated (but not guaranteed) return.


Figure 3: Risk vs. return for Canadian stocks and short-term (ST), medium-term (MT), and long-term (LT) Government of Canada bonds

I now want to illustrate that combining asset classes can lead to beneficial risk reduction. The implication is that, for almost everybody, both equity and bond exposure will be desirable. First consider portfolios made up partly of Canadian stocks and partly of long-term Canadian bonds.xm Figure 4 shows these combination portfolios in terms of anticipated return and risk. We see a curve with two end points. One end point, the higher one, represents a portfolio 100% invested in stocks. The other end point, the lower one, represents a portfolio 100% invested in long-term bonds. Just comparing these end points, again we see high return and high risk for stocks relative to bonds. Combination portfolios, where some money is invested in stocks and some money is invested in bonds, fall on the curve joining these points. Some people wonder why combination portfolios do not fall on a straight line joining these end points. In fact, this would be true if stock and bond returns moved together in a perfectly predictable fashion, that is, if they were perfectly positively correlated.Xlv This would mean that, when stock returns are


higher, bond returns would always be higher, and, when stock returns are lower, bond returns would always be lower too. In fact there is only a weak (positive) correlation between stock and long-term bond returns. In other words, knowing the direction of the stock market only helps a little in guessing the direction of the bond market. It is because of this low correlation that the curve of combination portfolios is a curve - and not a line. And the greater is the curvature, the greater is the scope for risk reduction through combining asset classes. A little thought should indicate that, based on this graph, it is never really a good idea to put all your money into bonds. Why? Start off with the portfolio fully invested in bonds. Then decrease your bond exposure and increase your stock exposure a little. This involves a movement along the curve starting at the 100% bond portfolio. Notice what happens. Anticipated return increases and risk decreases! This is a win-win situation. Risk decreases because of the diversification achieved by combining the two asset classes, and return increases because more money is invested in typically higher-returning stocks. The stock-bond mix that minimizes risk is roughly 30% in stocks and 70% invested in bonds.xv Let me define what is known as the efficient set. The efficient set is a curve which maps out the highest expected return for a given risk level on a graph where the y-axis is expected return and the x-axis is risk. Thus it is the locus of all portfolios that might logically be considered by an investor. Clearly the efficient set then is all points on the curve above and including the minimum-risk portfolio (which is the farthest left point on the curve). All points on the efficient set are potentially reasonable. One need only choose the point on this graph that best matches one's risk preference.


Figure 4: Efficient set combining Canadian stocks and longterm (LT) bonds (using historical data)

In Figure 5 (which has the same scale as Figure 4), we perform a comparable exercise - this time using medium-term bonds instead of long-term bonds. One thing to notice is that there is greater risk reduction achievable in using medium-term bonds vs. long-term bonds. This is due to the fact that the correlation between medium-term bonds and stocks is actually slightly negative. Also, the risk-minimizing portfolio now has a bond percentage above 80%.


Figure 5: Efficient set combining Canadian stocks and medium-term (MT) bonds (using historical data)

D. Optimizers In the previous section, we performed a few simple examples of portfolio optimization. This is the process of methodically searching for the highest-returning portfolios for given risk levels using a set of asset class building blocks. When there are only two asset classes the exercise is fairly straightforward - but what if there are more? The use of 'optimizers' allows you to solve this problem when there are three or more assets. There is abundant evidence that international diversification allows one to reduce risk without surrendering return. Let me illustrate this proposition by bringing U.S. and other developedcountry equity markets in as asset classes. Because of data limitations, the data used in this exercise only begin in 1971. First, as a reference point, consider portfolios made up of just medium-term Canadian bonds and Canadian stocks. This set of portfolios is represented by the broken curve in Figure 6.xvl Now let us bring in foreign stocks. For the U.S. we use returns on the S&P 500 Index, which, as was previously mentioned, is the index most widely used to assess managerial performance in the U.S. The best known index for the rest of the developed world is Morgan Stanley's EAFE Index (which was described earlier). In Figure 6 all four asset classes, viewed as individual entities, are shown as points. Focusing on these points, between 1971 and 2004, the U.S.


broad market averaged an annual return of 12.92%, with a standard deviation of 17.42%. EAFE's numbers were 13.95% and 22.39%. Are these numbers relevant for a Canadian investor? Not exactly. A Canadian investor purchasing U.S. stocks exposes herself to foreign exchange risk. Assuming that she bought $Cdn 10,000 worth of U.S. stocks at the beginning of the year, and that the return on her stocks is 10% over the year in U.S dollars, if the exchange rate between the Canadian dollar and the U.S dollar does not change over the year, then her return, denominated in Canadian dollars, will also be 20%. If, however, the U.S. dollar appreciates, then she will do better than 10%, while, if the U.S. dollar depreciates, she will do worse than 10%. From the standpoint of that Canadian investor, what is important is what she ends up with in Canadian dollars, so all foreign returns must be converted into Canadian-dollar-denominated returns. But this means that foreign investments will be risky for two reasons: first, the foreign market return, denominated in local currency, is unpredictable, and, second, exchange rate movements are unpredictable.

Figure 6: Efficient set combining U.S. stocks, EAFE stocks, Canadian stocks (CAN), and medium-term (MT) Canadian bonds (using historical data)


If we convert U.S. equity returns into Canadian dollar-denominated returns, the average annual return during this period was 13.58%, and the standard deviation was 17.99%. EAFE's comparable numbers are 14.51% and 22.44%. Notice that, in the case of both the U.S. and EAFE, the mean returns and risk levels are higher. The returns are higher because the Canadian dollar on average worsened against foreign currencies during this period. And risk levels are higher because foreign exchange risk is tacked onto market risk. To calculate the efficient set using these four asset classes, aside from the information that we have already presented, we also need to have correlations between all pairs of asset classes. Using the historical data, I have worked out these correlations, and they are shown in Table 1. Again, recall that a correlation is always between -1 and 1. To review, if a correlation is positive, the two asset class returns tend to move in the same direction. The higher its value, the more this tendency holds. On the other hand, if a correlation is negative, the two asset class returns tend to move in opposite directions. Again, the higher is its negative value, the more this tendency holds. To interpret Table 1, the diagonal elements are by definition one, since something is always perfectly correlated with itself. Looking above the diagonal at the CDN/US correlation, the value is 0.59. Notice that this mirrors the US/CDN correlation below the diagonal, since the order is immaterial for correlation. Since correlations must be between -1 and 1, we could say that the correlations between all equity sectors are moderately positive - but still far enough away from one to achieve real gains from diversification. This suggests that bringing foreign equities into the mix will pay off to a certain extent. Additionally, all equity sectors are weakly correlated with Canadian bonds.

Table 1: Correlation matrix for four asset classes CDN US EAFE

MT

CDN

US

EAFE

MT

1.00 0.59 0.58 -0.06

0.59 1.00 0.58 0.29

0.58 0.58 1.00 -0.02

-0.06 0.29 -0.02 1.00


When we consider all possible combinations of these four classes that provide the lowest risk for a given level of return, we end up with the solid curve shown in Figure 6. Notice that the earlier (broken-line) curve, where we restricted ourselves to Canadian securities, is everywhere interior to the curve where foreign securities can be brought into the mix. In other words, foreign diversification pays off! Risk can be reduced without surrendering return. The reader might be wondering about the technical procedure required to generate the efficient set when there are more than two assets. Suffice it to say that it is complicated, which is likely why the 1990 Nobel Prize winner Harry M. Markowitz is famous for the development of optimizers.xvn The output of an optimizer tells you, first/the highest return associated with a given level of risk and, second, the portfolio weights required to obtain these risk-return combinations. While many other sets of weights would allow you to earn the same return, your risk level would be higher.

Table 2: Portfolio weights for four asset classes required for 11% expected return under various conditions Weights-1 Weights-2 Weights-3 CDN US EAFE

MT

5.58% 19.80% 20.68% 53.95%

51.52% 28.09% 4.18% 16.21%

51.48% 21.37% 10.94% 16.21%

As an example, what portfolio weights are required to achieve an 11% return, while keeping risk as low as possible? The numbers in the first column of Table 1 ("Weights-1") answer this question. For example, 20.68% of our money is put into the EAFE portfolio. Intuitively, Canadian stocks have the lowest weighting, because they earned the lowest average return of the three equity choices. (The other two sets of weights are explained presently.)


E. Problems with using optimizers There are some problems with using optimizers for making strategic asset allocation decisions. The first centers on how we arrive at the required parameters. In order to construct the previous four-asset-class efficient set, we required values for the expected per period return for each asset class, the standard deviation for each asset class, and the correlations between all possible pairs of asset class returns. To do so, we simply used history: that is, past average returns, past standard deviations, and past correlations. Unfortunately there is no reason to believe that the future will resemble the past. And there is evidence that parameters based on historical data are unreliable as forward-looking measures.xvm Still, the past does provide some guidance for the future. And the consensus seems to be that past risk levels and correlations are reasonably informative about future risk levels and correlations. There is less confidence in the relationship between past and future returns. With this in mind, one way to use optimization is to use past risk levels and correlations, but to alter expected returns based on judgment. Take the previous four-asset-class portfolio weights needed for an 11% return as shown in Table 2. Because Canadian returns were lower during the estimation period, very little of our money was invested in Canadian stocks. In fact, most of our equity exposure was foreign. The reader may recall that this period witnessed many difficulties for Canada: slow productivity growth, declining commodity prices, and political separation worries, to name just three. In my view, there is no reason to think that the next 30 years will be as challenging for Canada relative to the rest of the developed world as the previous 30. So one logical adjustment is to set all equity returns at the same level - say at the Canadian level. If we do so, we get the second column of numbers in the table (Weights-2). Now the Canadian equity share is much more reasonable.xlx In fact, I would argue for a further adjustment. The correlation between Canadian stocks and EAFE stocks is only slightly lower than the correlation between Canadian stocks and U.S.


stocks. Yet there is reason to believe that the correlation between U.S. stocks and Canadian stocks is normally markedly higher than other correlations. The main reason is the close linkage of the U.S. and Canadian economies. Suppose, for example, that we allow the U.S./Canada correlation to be bumped up to 0.65, and we bump the EAFE/ Canada correlation down to 0.50. The new resultant weights coming from the optimizer (Weights-3) now suggest more EAFE stocks and less U.S. exposure (than before).xx A second problem with standard optimization is horizon. The theory behind optimizers is in terms of single-period returns. Most of us think in terms of years, so the graph can be thought of as anticipated return vs. risk over a one-year horizon. If this is your true horizon, there is no problem at all. But, for many, the natural horizon is quite a bit longer. Take a 40-year old secondary school teacher planning to retire in 20 years: 20 years might be the natural horizon for her retirement portfolio. We could, in fact, convert our efficient set into one that was in terms of anticipated returns over 20 years and risk over 20 years. In reality there is a problem with this approach. Think about the one-year diagram again. The idea is that we make our asset allocation choice and then do nothing and wait for the year to pass to see what has transpired. Over one year this approach may not be too unreasonable. Over 20 years, though, this is problematic. For one thing, there are likely to be a series of cash flows into (and sometimes even out of) the portfolio. The problem with this is that the timing of these cash flows will have a substantial impact on the portfolio's performance. Moreover, as time passes, one might want to change asset allocation because opinions change on the future performance of asset classes. Plus, as will be discussed below, there is the quite natural tendency for investors to reduce their equity exposure as they age.xxl All of the above implies that the efficient set approach should be viewed as a useful mechanism for concentrating thought. But its validity as a precise tool for asset allocation is rather limited.


R Recap 1. Asset classes differ in terms of historical returns, risk levels, and correlations with each other. The major distinction is between more risky but typically higher-returning stocks and less risky but typically lower-returning bonds. Unfortunately many do not even understand what asset allocation is. 2. Asset allocation is important because it explains most return variability, and it allows for risk reduction without surrendering return. 3. In theory, optimizers allow for the selection of just the right set of asset classes, and in the right proportions. 4. Unfortunately, optimizers have severe limitations. In particular, using historical estimates for parameter values can lead to inaccurate results, but it is not obvious how to do much better.


Endnotes i Interest rate risk comes in two forms: changes in interest rates will cause bond prices to rise or fall; and coupon interest payments must be reinvested, and so, if rates fall, they will be reinvested at lower rates of interest. ii Long-term bond prices are more affected by interest rate movements than short-term bond prices. That is, they suffer from more interest rate risk. iii See Bodie, Z., A. Kane, A. J. Marcus, S. Perrakis and P. J. Ryan, 2003, Investments, Fourth Canadian Edition, McGraw Hill Ryerson, Toronto. iv As described earlier, EAFE refers to Morgan Stanley's EAFE (Europe, Australia and the Far East) Index. In other words, markets of the developed economies are represented. v Some speak about the stock/bond/cash decision. 'Cash' is meant in the sense of highly liquid, short-term, safe securities such as Treasury Bills (normally held in a money market account or fund). For simplicity, I am lumping 'cash' into the bond category. vi To remind the reader, in a defined contribution pension, the account is (normally) invested at the discretion of the employee. What will be available at retirement is a function of how well the investments in the account perform. vii Given the sample size, the difference between percentages (69% vs. 43%) was well beyond the realm of sampling error. viii Even within asset classes, the composition of the securities in terms of risk or other characteristics might be altered. If, for example, you believe that the market will fall, you might want to move to more defensive stocks within the equity portion of your portfolio, since these are less likely to be adversely affected by market movements than other categories of stocks. ix See Brinson, G. P., L. R. Hood and G. L. Beebower, 1986, "Determinants of portfolio performance," Financial Analysts Journal 42 (no. 4): 39-44; and Brinson, G. P., L. R. Hood and G. L. Beebower, 1991, "Determinants of portfolio performance II: An update," Financial Analysts Journal 47 (no. 3): 40-48. x See, for example, Hensel, C. R., D. D. Ezra and J. H. Ilkiw,


1991, "The importance of the asset allocation decision/' Financial Analysts Journal 47 (no. 4): 65-72. xi Compounded average returns are used in this figure. xii For technical reasons, it is more proper to use arithmetic averages for confidence intervals. xiii The following formulas can be used to work out the expected return and risk levels associated with any set of portfolio weights. If we put x% of our money in the first asset class and the rest (l-x)% in the second asset class, the expected return and risk are: Expected return of portfolio = x * Exp. return of 1st + (1-x) * Exp. return of 2nd Risk of portfolio = Square root of{x2 * Variance of 1st asset class + (l-x)2 * Variance of 2nd asset class + 2*x* (1-x) * SD of 1st * SD of 2nd * Correlation} By varying the weights, one can 'trace' a curve of risk-return combinations. xiv This means that the correlation is exactly positive one. xv The precise answer can be found using a technical formula. xvi This broken curve is a little different from what was shown in Figure 5, because the sample periods used for estimation of parameters are different. xvii William Sharpe, Harry Markowitz, and Merton Miller shared the 1990 Nobel Prize in Economics. xviii See, for example, Farrell, J. L., Jr., 1989, "A fundamental forecast approach to superior asset allocation," Financial Analysts Journal 45 (no. 3): 32-37. xix One reason that we should be nervous about a result with low Canadian exposure is, on the assumption that you plan to retire in Canada (or at least partly in Canada), you will have to face Canadian prices, so, if the Canadian dollar were to strengthen dramatically, your offshore investments would yield poor returns (denominated in Canadian dollars). In other words, though international diversification is wise, Canadians should have significant domestic exposure. This is one reason why the federal government was not overly worried about removing the 30% foreign investment limit for RRSPs recently.


xx See Auger, R., and D. Parisien, 1989, 'The risk and rewards of global investing/' Canadian Investment Review 2 (no. 1): 25. The authors demonstrated the diversification gains for Canadian investors of incorporating the U.S. and other international markets (EAFE) into their portfolios. During their sample period (1973-87), the correlation between the Canadian equity market and the U.S. was 0.7, and the correlation between the Canadian equity market and the rest of the world was 0.4. The much lower latter correlation suggests that there were (and are today) significantly greater gains from diversification which extends outside of North America. xxi Even at the end of the horizon there is an issue. Will the individual liquidate her portfolio when she retires? This is not to suggest that anybody would immediately consume all capital. But some retirees do purchase a life annuity with the money, which guarantees them a fixed periodic cash flow for the rest of their lives. This is tantamount to liquidation.


Chapter 8

Going forward to implement asset allocation A. Preview In the last chapter I discussed asset allocation and why it is important to understand it. This chapter has a more pragmatic purpose, to actually put asset allocation into practice. I begin, in section B, by illustrating what different asset allocations really mean to you, the investor, in terms of different distributions of final (end-of-horizon) wealth. In order to choose the strategic asset allocation that is right for you, it is important to consider your own personal risk capacity and attitude, which I do in section C. In section D, I consider whether tactical asset allocation, adjusting risk-taking in light of market conditions, ever makes sense. Finally, in section E, I explore extended diversification by considering asset classes beyond stocks and bonds.

B. Distributions of final wealth Thinking just in terms of stocks and bonds, how can we decide what is the right mix? In other words, what is the right strategic asset allocation? Nobody really knows the exact answer. Optimization teaches us that the greater the risk that we take on, the greater the return that we expect our portfolio to have. Still, precisely where on the efficient set should we locate ourselves? One reason this question is hard to answer is because the answer is different for each individual. Why? We all have different degrees of risk tolerance. I will discuss the individual-specific component of the choice in the next section. For now, I concentrate on how to allow people to think intelligently about the choices. One good way is to look at simulated distributions of final portfolio values as of the


end of a relevant horizon. For example, if you are going to retire in ten years, a natural horizon to focus on would be ten years. Let me present the results of some simulations that I carried out based on Canadian data. I used the historical average returns and standard deviations on stocks and medium-term government bonds during 1957-2004, as well as the observed correlation between these two asset classes. This was done to consider final wealth distributions for different horizons and different stockbond mixes. Figures 1, 2, and 24 show, for horizons up to 20 years out, the median (50™ percentile) level of wealth accumulation for various investments, as well as the 10™ (lower curve) and 90™ (higher curve) percentiles. To understand these graphs, in both cases imagine beginning with $1 in an account. The exact level of wealth accumulation achieved by the investment in question is unknown because future returns are uncertain. In a simulation run, we set things up so that the expected return in a given year is the same as the historical average return, but the actual return varies because of randomness, and the degree of randomness comes from the historical standard deviation of the asset class. Every year wealth accumulation occurs in this random fashion just as it does in real-world markets. Over time wealth randomly accumulates. While one run is of interest, it is more interesting to perform a large number of runs to see how well things are likely to go, and how bad are the worst scenarios. Once many runs are done, percentiles are calculated and examined. Say we do 100 runs and rank them (from highest to lowest) in terms of the level of wealth accumulation after ten years. The 90™ highest wealth accumulation level is the 90™ percentile, the 80™ highest is the 80™ percentile, and so on. Refer to Figure 1. The median wealth accumulation path over 20 years turns our original $1 into between $7 and $8. While this sounds quite nice, it does not come without risk. The tenth percentile is far lower: 10% of the time we will not even end up with $3 after 20 years.


Figure 1: Tenth percentile, median, and 90th percentile wealth accumulation paths based on investing in Canadian stocks (using historical parameter values)

Now consider Figure 2, which is based on investing entirely in medium-term bonds. The graph appears to be similar to the previous graph, but there are salient differences. For one thing, focusing on the median wealth accumulation path, wealth does not accumulate as fast for bonds as it does for stocks. No surprise here: bonds do not typically earn returns as high as the ones earned by stocks. On the other side of the ledger, bond risk is lower: the tenth percentile for bonds is safely above the tenth percentile for stocks.


Figure 2: Tenth percentile, median, and 90th percentile wealth accumulation paths based on investing in Canadian medium-term bonds (using historical parameter values)

Another way to make the comparison between stocks and bonds is to ask the following question: what percentage of the time do stocks outperform bonds over various horizons? Figure 3 tells the story. One thing that is clear is that the probability that stocks will outperform bonds increases as horizon lengthens. In other words, equity risk, relative to fixed-income risk, falls with horizon. By 20 years out, stocks have been able to outperform bonds close to 70% of the time in our simulation runs. A point in favor of stocks, but far from a sure thing! Some readers will have seen comparable U.S. data by reading Jeremy Siegel's best-selling book Stocks for the Long Run.1 He documents that, between 1802 and 1996, stocks outperformed bonds over 20-year holding periods 91.5% of the time. This U.S. percentage is more favorable than the comparable Canadian one. Why is this? Several factors are likely at work. First, while I have performed a simulation with hundreds of independent runs, naturally occurring data do not allow for this.11 How many independent 20-year periods are there in Siegel's data?111 Only nine.


Hardly a convincing number. Second, the equity premium, which is the average spread between the return on stocks and the return on fixed-income securities, has historically been higher in the U.S. than in Canada.lv And it is its high level south of the border that strongly argues for high equity exposure.

Figure 3: Percentage of time that stocks outperform bonds over different horizons

How impressed should we be by a high historical equity premium? If one is investing now, in a certain sense one does not care about the past equity premium. One cares only about the future equity premium. There is, in fact, substantial debate, nicely summarized in The Equity Risk Premium by Bradford Cornell who teaches at UCLA, whether or not an equity premium, as high as has been witnessed over the last 50 or so years in the U.S., is likely to be seen in the future.v There are a number of reasons to think that the answer may be no.


Figure 4: Tenth percentile, 50th percentile (median), and 90th percentile wealth accumulation paths based on investing half in Canadian stocks and half in Canadian bonds (using historical parameter values)

One argument comes from the concept known as survivorship bias, which I discussed earlier in the context of mutual funds. I made the point that, if you look just at surviving mutual funds at the end of some period (say 20 years), then the group under consideration will, by construction, look quite successful. The reason is that many unsuccessful funds will have dropped out because of bankruptcy, merger, or consolidation. Thus, the sample provides a biased snapshot of performance. It has been argued that the same applies at the level of national stock markets. The U.S. market has historically been the most successful over the last century. Other markets have not done as well. In some cases, markets have effectively ceased to exist causing massive wealth losses. A case study here is the Russian stock market at the time of the Bolshevik Revolution. By focusing on the most successful market, one gets a distorted picture of what is likely to happen in the future. Indeed, if we lower the equity premium in the U.S., and then do the same sort of simulation that I have just done using Canadian data, the results fall into line with what I have found.vl All of this suggests that the choice between stocks and bonds is not clear-cut. But the reality is that one does not want to see


this as an either/or proposition. In my view, virtually everyone should be holding some stocks and some bonds. A lesson coming from the optimizer analysis of the previous section was that it never makes sense to hold only bonds, because, by adding some stocks, both return rises and risk falls. Effectively, then, the extreme points are the all-stock portfolio and the risk-minimizing mix of stocks and bonds. All points between could conceivably be wise choices (depending on risk attitude). Consider for example a 50/50 stock-bond mix. The tenth, 50^", and SO"1 percentiles of wealth accumulation are shown for this equally weighted portfolio in Figure 4. Not surprisingly, the median wealth accumulation is between the stock and bond wealth accumulations.

Figure 5: Tenth percentile wealth accumulation paths for allstock, all-bond and 50/50 portfolios

Of course, one reason why people shy away from too much equity exposure is that they are afraid of things going wrong. The tenth percentile paths are useful because they give us boundaries such that 90% of the observations are above them. In Figure 5 we show the tenth percentile paths for all-stock, all-bond, and 50/50 portfolios. It is interesting to compare the latter two. Despite the fact that the 50/50 portfolio is riskier, its tenth percentile is (after a few years) above that of the all-bond portfolio.


This is because the extra return provided by equities more than offsets the extra risk borne.

C. Assessing your risk tolerance How much of a capacity do you have for assuming risk? Are you young enough to bounce back from adverse markets? Also, how much of a stomach do you have for risk? Will you sleep nights if in a given year the value of your portfolio declines by 10% or more? If not, then you might want to moderate your equity exposure. Financial planners often try to get a handle on an investor's risk tolerance by asking clients to fill out an investor profile questionnaire. Usually, many of the questions are designed to garner insights on an individual's risk tolerance. A series of questions from the Investorgauge Questionnaire were designed as a brief risk tolerance assessment instrument. You will recall that, depending on how you answered these questions, a stock-bond mix range was recommended. For example, if your recommended range was 60-80%, this means that you should have roughly 70% equity (and 30% bond) exposure. One question is repeated from the Investorgauge Questionnaire to indicate why your score came out the way it did: Characterize your investing style: a. I am an aggressive investor who is willing to assume substantial risk to earn higher returns. b. I am a mildly aggressive investor who is willing to assume moderate risk to earn higher returns. c. I am a moderately conservative investor who is willing to assume only low levels of risk to earn higher returns. d. I am a conservative investor who is willing to assume only very low levels of risk to earn higher returns. Of course, one can sense that high (where 'a' is interpreted as high, and 'd' is interpreted as low) scores on such questions would lead to a recommendation that the client lean heavily


towards equities, while low scores would lead to a recommendation that the client lean more towards fixed-income securities. The above question gets at people's overall comfort level with risk-taking. Age and proximity to retirement also matter significantly. In fact, the first question in the risk tolerance section of the questionnaire directly asked this: How many years from now do you plan to retire? Based on your response, a base-case amount of risk-taking was generated. Subsequent questions were more of an attitudinal nature and your responses led to a bumping up or bumping down of your base-case equity exposure.vn Why is it that age should have a major impact on equity exposure? To make sense of this, consider the following. An individual's total wealth is made up of two components: first, tangible wealth, such as real estate, financial securities (stocks and bonds), and privately held businesses; and, second, a kind of intangible wealth known as human capital, which is defined to be the income-generating capacity of an individual coming from his skills, education, and experience. Both components generate streams of uncertain (risky) cash flows (income) over time. It is usually argued that human capital generates a less risky, more stable stream of cash flows than do equity securities. Suppose an individual wants to maintain a fairly stable level of risk-taking over her life. As she ages and approaches retirement, her stock of relatively safe human capital declines (because she has fewer working years remaining). To counterbalance this and maintain a fairly stable risk stance, a lower equity exposure in her investment portfolio is needed.vm Indeed, it is typical for financial planners to recommend an equity share that not only conforms to an investor's risk attitude, but also declines one for one (that is, 1% per year) as people approach retirement. Aside from risk attitude and age, researchers have recently argued for the importance of two other determinants of equity exposure: these are income and education. Why they should matter is related to the previous discussion. Quite simply, both are likely to be positively correlated with one's stock of human


capital. High education implies a high stock of human capital implying an enhanced ability to generate future income. Similarly, current income is a useful proxy for human capital.lx All in all, we would expect younger people with more income and higher education to hold more stock. The evidence indicates that at least some individuals decide on risk exposure according to what asset allocation theory suggests is appropriated Specifically, age, income, and education matter as suggested above. Nevertheless, the age effect is rather more complicated than theory would suggest: equity share and age may be related with a hump-shaped pattern, with the equity share at first increasing with age before declining. The most logical explanation for this is that young people, with scarce experience investing, are still unsure of themselves when it comes to risk-taking. Interestingly, gender and marital status appear to have an impact on risk-taking. There is abundant evidence that men hold more equities. This is consistent with the finding in the psychology literature that men are less risk-averse than women. Married individuals also tilt towards stocks. One possible reason for this is that two-income families can afford to take on more risk because of their greater ability to withstand a single job-loss event.

D. Should the stock-bond mix change over time? Should the stock-bond mix be adjusted over time? It should be stressed that portfolio rebalancing will definitely be required periodically for two reasons that have nothing to do with changing views about market conditions. First, along the lines of what we have just discussed, as an individual ages and approaches retirement, it is advisable to reduce risk exposure. Second, let's say that you are 50% invested in stocks, and 50% invested in bonds. After one year, the stock market return is 20% and the bond return is 5%. If $100,000 had been invested initially, the equity holding would be worth $60,000, and the bond holding $52,500. The total portfolio would be worth $112,500 (for a 12.5% return). The equity share has now risen to 53.3%


($60,000/$112,500), while the fixed-income share has dropped to 46.7%. Let's say that because of the passage of time (one year) the equity share should have fallen to 49%. This implies an equity mismatch of 4.3% (53.3% -49%). I would not claim that this mismatch is severe, but after two or three years of strong markets, it can easily go well beyond 10%, in which case the portfolio cries out for rebalancing. A rather different issue is this: at any given age, should an investor's target asset allocation change? Should she adjust equity exposure depending on her view on market direction? That is to say, should one try to employ tactical asset allocation (TAA) by adjusting the stock-bond mix based on personal judgment? There are differences of opinion on how effective this strategy is. And one must begin by saying that the bulk of the evidence indicates that money managers are not very good at it.xl Intuitively, the idea of TAA is to overweight equities when you think they are undervalued, and, conversely, to underweight them when you think they are overvalued. What sort of indicator can one use to decide whether the stock market is under- or overvalued? Many commentators rely on market multiples, which are ratios of stock index levels to (arguably) more anchored variables such as earnings, cash flows, book value, or dividends (where all of the latter are expressed in aggregate terms). As an example, consider Figure 6, which shows the Canadian market E/P (earnings-to-price) ratio from December 1956 to December 2000.xii While I could comment on some of the ups and downs of this ratio, and how useful (or not so useful) they turned out to be for predictive purposes, focus on the declining trend in the ratio from the mid-90s to the end of 2000.xm This decline meant that prices were getting quite high relative to earnings. If one had decided to move away from stocks as a result of this signal, it would in retrospect have turned out to be a good move, as 2001 and 2002 were both double-digit negative return years for Canadian stocks.


Figure 6: E/P ratio of Canadian stock market over time

More comprehensively, Barry White and I recently investigated Canadian stock market returns following very high and very low levels of E / RX1V We also performed a similar exercise using the dividend-to-price ratio or dividend yield (DIP). Specifically, we ranked years by beginning-of-year E/P (or D/P), and then calculated average subsequent returns for the lowest third, the middle third, and the highest third groups. For E/P, the results were somewhat as expected, with the lowest- to highest-thirds generating average returns of 6.5%, 13.3%, and 12.3% respectively. Our results were stronger for D/P, with the lowest- to highestthirds generating average returns of 5.4%, 9.7%, and 17.0%, respectively. The difference in average return between the highest- and lowest-third was statistically significant at conventional levels.xv So where does all this leave the average investor? My advice is: either totally avoid tactical asset allocation or proceed with very great caution. Only an overconfident investor will believe he can time the market with any consistency at all. Those who have studied the issue carefully, and who have the ability to buttress themselves against inevitable regret, may, under certain circumstances, want to adjust market exposure a little. But, if your


target strategic asset allocation calls for 60% in stocks, I personally would be chary of about adjusting it by more than 5% in either direction.xvl

E. Extended diversification I would be remiss if I left this topic without a very brief mention of alternative asset classes beyond stocks and bonds. Should stocks and bonds constitute one's entire wealth portfolio? For most investors they certainly do not. A few pages back I talked about human capital. This is also part of one's portfolio of assets. The way to invest in this asset class is to increase one's knowledge and skills by obtaining higher education and job market experience. Would it make sense to take a year off work to get a graduate degree (say in business)? To address this, one uses the same kind of financial tools that we discussed in chapter 1. One needs to compare the present value of lost earnings (from taking a year off work) to the present value of increased income during the rest of your career. If the latter exceeds the former, then the educational hiatus is defensible from a financial standpoint. Real estate is another asset class that many of us unconsciously invest in. We do this by purchasing a home. For many of us this is a highly leveraged investment since much of the house purchase is financed by mortgage debt. If one wants additional real estate exposure, a good way to obtain it is through an ETF that is available in Canada, the iUnits S&P/TSX Capped REIT Index Fund. An asset class that has attracted a lot of press the last several years is income trusts, as more and more companies have converted all or part of their business into trusts to pass income through to unitholders without incurring corporate taxation.XV11 The rapid growth of income trusts over the last few years can be attributed to such factors as: the desire for certain investor classes for securities with dependable cash flows and moderate risk; the recognition that excess cash might not be invested wisely; and the tax advantages of the structure that allow income to flow directly to investors without first being exposed to corporate tax.xvul As of the time of writing though, the federal govern-


ment was taking a hard look at the tax status of this asset class, leading to future uncertainty.xix I have devoted a lot of ink to mutual funds in this book. The fact is that there are other kinds of managed funds that one may want to contemplate. One example is managed futures, whose managers often try to take advantage of predictable commodity price movements.xx Another example is hedge funds, which have experienced strong growth the last few years.-0-1 While many perceive them to be quite risky, some commentators argue that they are a lot less risky than is commonly thought, and for this reason they should have representation in many portfolios.XX11 Still the lack of regulation in this sector can be a source of worry.xxm One advantage of both managed futures and hedge funds is that they are well known to have low correlations with the stock market. For completeness, two other examples of investment funds are labor-sponsored investment funds and closedend funds.XX1V While most average investors are well advised to stay within the asset classes discussed prior to this section, these alternative classes can be useful in providing additional diversification opportunities for sophisticated investors. If one chooses to stray somewhat into this territory of extended diversification, my personal recommendation would be to certainly keep overall exposure to less than 10%.


R Recap 1. A useful tool to see what different asset allocations will deliver is to examine what they imply for distributions of final wealth. 2. The most important factors governing strategic asset allocation are risk attitude and age. 3. Tactical asset allocation, though potentially efficacious, should be avoided by most investors. 4. Additional asset classes beyond domestic and foreign equities and bonds can provide additional diversification, but are probably not necessary for most average investors.


Endnotes

i See Siegel, J. J v 2002, Stocks for the Long Run, Third edition, McGraw Hill, New York. ii All graphs in this section are based on a 2,000-run simulation. iii For this we need non-overlapping return horizons. Consider two overlapping two-year returns: 2001-2002 and 20022003. 2002 (a weak year) appears twice. So obviously the pair of two-year returns are not independent of each other. iv Note that there are different ways to calculate the historical equity premium. For example, one can use either T-bills or bonds as the fixed-income reference point. Plus one can work in terms of arithmetic or geometric average returns. v Cornell, B., 1999, The Equity Risk Premium, John Wiley & Sons, New York. vi What if we assume that the equity premium will be lower in the future than its historical average level? See Leibowitz, M. L., and W. S. Krasker, 1988, "The persistence of stocks: Stocks vs. bonds over the long term," Financial Analysts Journal 44 (no. 6): 40-47. They performed a U.S. simulation based on a more modest equity premium. Specifically, they assumed a 4% premium and a correlation between stock and bond returns of 0.4. Based on these assumptions, they found that there was a 21% chance that stocks, even after 30 years, would fall short of bonds. (Of course, this implies there is a 79% chance that you will do better with stocks.) vii While one's stomach for volatility should be factored into the risk-taking decision, it is also important to take into consideration the risk of not meeting retirement goals because of excessive nervousness about short-term market movements. See Kitchen, A., 2005, "Asset allocation for DC plans: Shooting for your goal," Defined Contribution Monitor (August). viii See Bodie, Z., and R. C. Merton and W. F. Samuelson, 1992, "Labor supply flexibility and portfolio choice in a life-cycle model," Journal of Economic Dynamics and Control 16: 427-49. ix Jagannathan, R., and N. R. Kocherlakota, 1996, "Why should older people invest less in stocks than younger people?"


Federal Reserve Bank of Minneapolis Quarterly Review 20 (Summer): 11-23; and Viceira, L. M.f 2001, "Optimal portfolio choice for long-horizon investors with nontradable labor income," Journal of Finance 56: 433-70. x See Bhandari, G., and R. Deaves, 2005, "Misinformed and informed asset allocation decisions of self-directed retirement plan members," Working paper. xi For numerous references on the timing performance of money managers, see Haslem, J. A., 2003, Mutual Funds, Blackwell Publishing, Maiden, Massachusetts. xii People normally think in terms of P/E ratios, not E/P ratios. E/P is sometimes preferred when earnings become very low or negative. xiii One reason for not showing this ratio after 2000 is that in 2001, because of major losses suffered by Nortel, this ratio went negative for a year. xiv Deaves, R., and B. White, 2005, "The sustainability and predictability of Canadian stock prices," Working paper. xv The result was significant at about 5%. There is also evidence of predictability in stock prices based on P/Es in the U.S. See Bleiberg, S., 1989, "How little we know," Journal of Portfolio Management 15 (Spring): 26-31. He sorts historical market P/Es into quintiles and examines subsequent returns of these quintiles, finding that the lower is the P/E quintile, the higher is the subsequent market return over the next one or two years. xvi TAA should not just be viewed in terms of the stock-bond mix. For example, Peter Miu and I suggest that sometimes it might make sense to shift among maturity segments in the fixedincome part of a portfolio. See Deaves, R., and P. Miu, 2004, "A duration-constrained return enhancement strategy for Canadian default-free fixed-income portfolios," Canadian Investment Review Summer: 10-15. xvii See Carrick, R., 2005/Tut stock in trust, or trust in stocks," Globe and Mail, Report on Business (May 21), for a discussion of some of the basic differences between stocks and income trusts. xviii See Halpern, P., 2004, Is the Trust in Trusts Misplaced: A Study of Business Income Trusts in Canadian Capital Markets, Research sponsored by Investment Dealers Association. Also, for a


discussion of the valuation of income trusts, see Roberts, G., 2005, "How to evaluate income trusts: Institutions evaluating trusts more carefully than you might think/' National Post, Financial Post (October 11). xix See Globe and Mail, Report on Business, 2005, "Ottawa's move on income trusts throws sector into disarray," (September 28). xx See Borzellino, R., 1998, "Where do futures market profits come from?" International Derivatives. xxi See Globe and Mail, Report on Business, 2005, "Hedge funds tighten their grip," (October 27). xxii See Brulhart, T., and P. Klein, 2005, "Faulty hypotheses and hedge funds," Canadian Investment Review (Summer): 6-13. xxiii See Globe and Mail, Report on Business, 2005, "Hedge fund rules lack teeth; Sector rife for potential conflict: Report," (May 28). xxiv It has been shown that you have to be particularly careful about the excessive fees associated with labor-sponsored investment funds. See Anderson, S., and Y. Tian, 2003, "Incentive fees, valuation and performance of labour sponsored investment funds," Canadian Investment Review (Fall): 20-27. Closed-end funds are in some respects comparable to managed ETFs. Like ETFs, they trade on exchanges, but, unlike standard ETFs, the portfolios of securities are actively managed. One negative with closed-end funds is that they sometimes trade at discounts to NAV, and this discount can have an unpredictable component. See Deaves, R., and I. Krinsky, 1994, "A possible reconciliation of some of the conflicting findings on closed-end fund discounts," Journal of Business Finance and Accounting 21:1047-57.

Chapter 9

Going forward towards retirement A. Preview For most of us the main reason for saving and investing is to fund a comfortable retirement. I begin, in section B, by discussing the various sources of retirement income. In the next section, I ask the following central question: how much is needed for retirement? It is possible to come up with a savings rate that will put us on a trajectory to reach our goals. The reality is that such a calculation is based on a number of assumptions, all of which may turn out to be untrue. Thus it is important to consider risk and uncertainty, which is the topic of section D. While most of this book is aimed at preparing you for your retirement, in section E, the perspective is changed to what should be done with one's money after retirement.

B. Sources of retirement income I begin by identifying the normal sources of retirement income. Retirement income is built on three pillars: governmentadministered programs, various kinds of company pensions, and personal saving (whether tax-sheltered through an RRSP or otherwise). i. Government-administered retirement income Old Age Security (OAS) ensures that all Canadians regardless of means and work history receive a minimal monthly income. Canadian citizens or those with long-term residency qualify. As of mid-2005, the maximum monthly benefit was $477 per month or $5,724 per year. At a certain net income level ($60,806), a portion of this benefit is 'clawed back/ This portion becomes 100% at a net income level of $98,793. Note that all these dollar figures are adjusted for inflation. For very low income Canadian residents, there are also the Guaranteed Income Supplement (GIS) and the 'Allowance/ 1


The Canada Pension Plan (CPP - QPP in Quebec) is a public pension scheme that allows workers to receive benefits based on past work and CPP contributions. CPP is compulsory and contributory (by you and your employer in equal amounts). Contributions begin at a very low income threshold ($3,500 in 2005) and stop at the maximum pensionable earnings level ($41,100 in 2005). Advantages are virtually immediate vestibility (eligibility) and ease of portability among employers. The maximum annual CPP payout is $9,945. Funding nominally has been from employer and employee contributions, but the reality has historically been that CPP is a 'pay as you go' scheme coming out of general revenues. Because of fears that demographic shifts would eventually make the CPP unsustainable (arising from the fact that there would be fewer workers supporting more pensioners in the future), funding reform occurred in 1997 with the creation of the Canada Pension Plan Investment Board (CPPIB). The CPPIB now invests worker/firm contributions in dedicated accounts and with proper attention to maximizing returns. As of 2005, those who receive both the maximum OAS and CPP will receive annual payments of a little more than $15,000. If that is enough for you, you probably do not need to be reading this book. Most of us, however, do aspire to greater comfort in our retirement, which leads to the next source of retirement income, company pensions.

ii. Company pensions Not all companies offer pensions. When offered, they come in two flavors: defined benefit (DB) and defined contribution (DC). To review, in a DB pension, benefit payments are made to retirees according to a formula. For example, you might receive 1.5% of the final average of your salary over the last five years times the number of years of service up to maximum of 35 years. So, if you earn $60,000 per year on average over the last five years of your employment, and you were with the firm for 20 years, then your pension would be $18,000 per year as long as you live. How does a firm manage this? Companies have a fiduciary responsibility to set aside in a dedicated pension fund an amount sufficient to pay future retirees what they have been promised. The managers of these pension funds in turn invest the money in stocks, bonds, and other


appropriate assets, so that the required growth can be achieved. From the standpoint of the worker, such a scheme has some salient benefits. First, like in the case of OAS and CPP, there appears to be certainty as to what will be received on retirement. Second, on retirement you are certain that you will receive your pension payment until your eventual death. Unfortunately, such 'certainty' is not necessarily ironclad. During the last couple of years, the press has been awash with reports that numerous private pension plans are seriously underfunded.11 And companies such as Stelco and Air Canada have pushed workers for pension adjustments as they have tried to dig themselves out of financial distress (partly caused by generous DBs). What brought the matter to a head were the pension contribution holidays and increasingly generous pension promises of the late 1990s as market returns were consistently high - coupled with the devastating bear market beginning in 2000. The result is that many firms are beginning to seriously consider whether they wish to continue to offer DBs to new hires. m What appears to be emerging is a gradual shift to DC pensions. In the U.S. and the U.K., DCs are much more entrenched and are well on the way to supplanting DBs. Companies like DCs because they involve a wholesale transfer of risk to employees. Even if the dollars contributed are identical, in a DC the monies (normally) must be invested by the workers themselves. Hopefully the reading of this (and other) books will facilitate the process of wise investment for those with DCs, but earlier in the book I reviewed the existing evidence, which sadly indicates that a lot of mistakes are being made. The problem with this is that the retiree in the future may have insufficient funds for retirement purposes. Moreover, on retirement, unless the worker opts for a life annuity (see later in the chapter), there will always be the possibility of running out of money (which means relying solely on government benefits). iii. Personal savings The third pillar of retirement income is personal savings. Much retirement-based saving in Canada is done through the Registered Retirement Savings Plan (RRSP) program. An RRSP is a tax shelter in that contributions, up to a maximum of 18% of


income (capped at $16,500 for 2005), can be subtracted from taxable income. When, on retirement, cash is withdrawn (usually through a Registered Retirement InvestmentFund or RRIF), at that point the money is taxable, but, since one's tax rate is normally lower in retirement, and investment returns within the RRSP can compound tax-free, RRSPs constitute a significant tax-deferral and reduction strategy. For many, a significant retirement nest egg is their house. There are several ways to convert this asset into an income-generating device during the retirement years. One way is to sell it (and rent something smaller), invest the proceeds, and make periodic withdrawals to support your standard of living. Downsizing for empty nesters can also make good sense as the price difference can be pocketed and invested. Another possibility is a reverse mortgage, whereby a financial institution will, for a portion of your house equity, give you a lump-sum payment or a regular income stream.lv Additionally, there are people who have been far-sighted enough to accumulate non-tax-sheltered financial or real assets such as stocks, bonds, and non-principalresidence real estate investments.

C. How much is needed? How much income will you need during your retirement years? Normally, experts do not answer this question by providing a dollar amount. Rather they answer it on a percentage-ofworking-income basis. The reason is that if your working income is $25,000, you have become accustomed to a certain standard of living. And, if your working income is $100,000, you have become accustomed to another, much higher, standard of living. For most people, a reasonable goal is to roughly maintain what they are used to. A common rule of thumb is about 70%. Why can you get by with less than during your working years? Your children will be grown up and no longer dependent on you (you hope!). You won't face work travel, work dining, and work clothing expenses. Your house is likely to be paid off. Only you know whether or not these things apply to you. Based on your cir-


cumstances, maybe 70% is just fine. Maybe it is too low. But allow me to assume that you are average and 70% is reasonable. Consider this number a midpoint of a range. Your goal is likely higher - say 80% or more. On the other hand, you may feel you can (barely) get by on 60%. What steps can you take to give yourself a good chance of reaching your goal? It really comes down to two things. First, saving enough. And, second, saving right. Consider the following example. Jane Doe is 35 years of age. Her income is $50,000. She already has $50,000 in retirement savings. Her financial advisor tells her that she can expect $10,000 per year from external sources. By this I mean government payments (OAS and C/QPP) and any company defined benefit (DB) pension payments to which she is entitled.v (Given this low percentage relative to income, it is safe to assume that, like many Canadians, Jane does not have a DB pension.) So, as of right now, she can replace 20% of her income with these external sources. And the $50,000 of retirement savings when invested over time will help as well. But she will need to set aside additional funds on a regular basis to reach her goals. Suppose she feels that she can afford to set aside a certain percentage of her income on a regular basis - say 10% per year. Note that, if she has a group-RRSP or a DC pension through her employer, some of this 10% may be coming from her employer. When she retires, her plan is to buy an annuity that will make equal periodic payments until the end of its term. To calculate her income replacement ratio, I need to make a certain number of heroic assumptions (all of which can be altered later). The starting values for the relevant variables are given below: Savings rate (10%) Working years (25 years) Years of annuity (25 years) Investment return on retirement savings (5%) Annuity interest rate (2%) Based on all these assumptions, it is possible to calculate that she will end up with a 62% income replacement ratio.vl This is


just in excess of her minimal needs. Let me next comment on the assumptions made. In particular, it is important to consider whether these assumptions are reasonable, and what happens if time proves them wrong. First, the savings rate. This is something that is most under her control. If she finds that her saving rate is not sufficient to move her towards her goals, then she can try to get by on less now to improve her retirement outlook. To digress, some of you might be saying that inflation has been ignored: for example, her $50,000 salary is likely to rise over time. Actually, inflation has not been ignored. For simplicity, I have decided to do all my calculations in today's dollars. So, for example, if we expect 2% inflation for the 25 years of her working life, by the end she will be earning about $82,000, but this is still $50,000 in today's dollars. For this to be a valid exercise, all interest rates and investment rates also must be inflation-adjusted - and I have done this (see following discussion). Another point. Depending on her career path, it is possible that Jane will see her salary rise even more than inflation (that is, it will rise in real terms) as she progresses through her career. Implicitly I am assuming that she has reached her likely maximum pay in today's dollars.v11 The 25 years of working life is reasonable: many Canadians do retire in their early 60s. If her health remains good, she may want to work longer. Plus she may want to supplement her retirement income by working in retirement. So she may have some flexibility in this regard. But the 25-year annuity is taking a chance. A woman of 35 today has a life expectancy of about 86 years.vm So, on the surface, it looks like she will have to increase her annuity term by a little. Actually, the problem is worse. A life expectancy is an average. Some will live beyond this average. What if she lives to the ripe old age of 95? Then, based on current planning, she will run out of money. I will discuss what approach she should take to insure against this later in the chapter. What about the investment rate of 5% ? You may be saying to yourself that this sounds low. But remember that everything is inflation-adjusted, and this includes returns. The average return on the Canadian stock market during 1957-2004 was 10.57%, but


inflation averaged in at 4.25%. So the real (inflation-adjusted) average return on stocks was 6.32%. As the previous chapter made clear it is wise to have some fixed-income exposure. Given that the average inflation-adjusted return on Government of Canada medium-term bonds during this time was 3.38%, the return on a reasonable 60% equity/40% debt portfolio was 5.15%. So 5% is quite reasonable. As for the annuity interest rate, the inflation-adjusted yield on Canadian real return bonds in mid-2005 was a little less than 2%.

D. Sources of uncertainty Now let me be realistic. Uncertainty and risk lurk all over the place in the above example. Start with the element that we control most closely: how much we save. Figure 1 shows how the income replacement ratio varies as one increases or decreases their savings rate. It is not hard to see that if you increase your savings rate, it is possible to get closer to your goals.

Figure 1: Income replacement ratio as a function of savings rate


While an increase in the savings rate will move Jane closer to her goals, given her family responsibilities it may not be realistic for her to save up to 15%. Of course she could work longer. Figure 2 tells us to what extent this can help. If she retires at 65, she is now very close to her replacement income goal of 80%. Note that in this latter set of calculations I have maintained a 25year annuity term which actually is advantageous since it means that she has a cushion up to the age of 90.

Figure 2: Income replacement ratio as a function of years of work

Figure 3 allows years in retirement to vary. Clearly the longer the term of the annuity the lower is the replacement ratio. If she goes to a 30-year annuity, for example, the ratio will now dip below 60%.


Figure 3: Income replacement ratio as a function of years in retirement

Perhaps it is possible to do better by taking on more investment risk or by being lucky. If the equity share in the portfolio is increased, then one can certainly expect to have more at retirement. After all, a common theme in the book up to now is that investment returns tend to be higher if you take on more risk. And indeed Figure 4 indicates that this is so, as higher returns associated with more risk-taking can be helpful. Clearly, the investment return assumption plays an important role. If you take on substantial market risk, and/or you assume the same risk but the market performs much better over a long period than it has historically, then it is possible to have a quite comfortable retirement. But, in the first case, it may be unwise to take on risk that is inconsistent with your capacity and tolerance for it. And, in the second case, there is really no reason to expect (or plan for) this. In fact, it is important to be aware of the left side of the bar chart. If Jane purposely shies away from equities, or, if she embraces them but their returns turn sour, then it would be possible for Jane to move below a 50% income replacement ratio.


Figure 4: Income replacement ratio as a function of investment return

There is another important issue that is pertinent in this context. All calculations have assumed a 5% investment return every year. The reality is that in some years the return will be well above this level and in other years well below. Over the long run, things should average out, but this does not always happen over shorter periods. The problem is that the exact sequence of good and bad years matters dramatically. What if most of her good years are at the beginning, when she has little to invest, and, conversely, what if most of her bad years are at the end, when her portfolio can least afford a reversal in fortune? It is not difficult to show using simulations that she could easily end up with substantially less (or more) at retirement than what the calculator generates. Of course, this is another reason to aim high. If you are unlucky with the sequencing of years, then you will create some insurance against the possibility of falling below your needs.


E. After retirement You have just retired. What's next? Specifically, how should you invest your savings? To be sure, you are more vulnerable than during your working years. When working, if your investments encounter difficulties, you can always prolong your working life. On the other hand, if your investments soar, you may decide to retire sooner. Freedom 50, anyone? One school of thought says that you can't afford much risk when you reach retirement, and that you should concentrate your money in fixed-income securities, buy an annuity, or both. That is, you should avoid all market risk-taking. Let's consider the annuitization route. Life annuities, which are marketed by insurance companies, guarantee a fixed income stream until death in return for an up front payment.1X Some people don't like them because, if you die shortly after the annuity purchase, your estate receives nothing. The other major type of annuity is a term-to-maturity annuity, which is fixed for a term (for example, 15 years), after which time payments stop. If you should die before the term reaches its end, payments can continue, or a lump sum payment to your estate can be made. On the surface, annuities sound like a good risk-avoidance vehicle, but there are problems. One problem centers on the fact that standard annuities are not inflation-protected. Inflation, which should be viewed as an ongoing rise in average prices, is something we are all used to. And yet people younger than 30 will not remember inflation as any kind of serious menace. Baby Boomers, however, will remember the very high interest rates and inflation of the late 1970s and early 1980s. Indeed it took a concerted effort by the U.S. Federal Reserve and (locally) the Bank of Canada to tame inflation. A serious recession in the early 1980s was the result of this inflation-fighting exercise. Figure 5 shows average inflation rates by decade since 1960. It is natural to hope that inflation will stay tamed, and, if policy-makers have learned their lessons, there is every expectation that this will be the case. While inflation is harmful to most of us, it can be downright terrifying for retirees if their income is not 'indexed,' or adjusted


for inflation.x To see why this matters, say at 65 you purchase a life annuity that pays you $1,000 per month. Given the sort of inflation experience that we have had in the 1990s and 2000s (say 2%), after 20 years you would need $1,490 to purchase the same basket of goods. This is obviously a serious worry. But what if inflation is worse? If inflation averages in at 5% over the 20-year period, then you would need $2,650 to purchase the same basket of goods. Such an occurrence could be catastrophic. And yet inflation experienced on average during the 1970s and 1980s was worse than this!

Figure 5: Average inflation rate by decade

In my view, inflation protection is particularly important during the retirement years. During the working years, salaries roughly move up in line with inflation, but this is not necessarily the case with the income flows that you receive during retirement. Fortunately OAS and CPP are indexed, and some but not all DB plans are partly or fully indexed. What about other retirement income? Standard life annuities are not indexed. While


indexation can be purchased - and my recommendation is that it is usually preferable to purchase it - it can increase the cost of the annuity by 15-20%. Then the problem is the resultant income stream may be too low for many people. Another possibility is to hold on to your money, invest it, and take withdrawals on a regular basis. A common way to do so is through a RRIF. How much risk should be taken on in such an account? The amount of equity risk to assume is a tricky proposition. In fact, there are two serious risks to weigh off: market risk and the risk of running out of money. To avoid equities reduces the first risk while increasing the second. Moshe Milevsky of York University has shown that a portfolio with an intermediate stock weighting (say up to 50%) reduces the probability of shortfall.*1 On the annuity versus investment account issue, there is a middle ground. One can annuitize part of one's wealth, purchase annuities later in the retirement years, or both. Elsewhere Milevsky argues that life annuities make sense as an insurance vehicle, but the probability of dying in the first years of retirement is actually not high at all. This means that life annuities start to make sense as you continue to age. One possible strategy could be to gradually shift your portfolio from standard risktaking investments to indexed life annuities starting sometime after 75.xii


R Recap 1. Retirement income comes from three main sources: governmentadministered programs, company pensions, and personal saving. 2. It is possible to determine how much you need to save in order to meet your retirement goals if you make a series of strong assumptions. The main ones are the investment return that you obtain during your working years, how long you will work, the return during your retirement years, and how long you will live. 3. All of these assumptions may turn out to be false, which is why it is important to save extra as a buffer. 4. After retirement it is best to maintain some equity exposure so as to minimize the probability of outliving your money. A life annuity may also be wise, especially after you have been retired for some time.


Endnotes i Full up-to-date details are available from various government sources. One Web site is www.sdc.gc.ca/en/isp/pub/factsheets/ rates.shtml. ii Pension legislation dictates that shortfalls be gradually eliminated over time. iii This is strongly supported in a recent (2005) Watson Wyatt survey of CFOs, which in discussion paper form is called "The pension crisis continues - Its grip is stronger." iv Reverse mortgages have certain negatives. One problem arises if you want to leave your home, free and clear, to your children or others who will inherit it from you. Your estate will not receive your home unless it first pays off the loan after your death. v The advantage of this $10,000 base is that it is relatively safe. It is not perfectly safe because legislative changes and the inability of a company to make good on its pension promise are always possibilities. vi The calculator that will allow you to derive this figure, and to see how the replacement rate varies with the assumed input values, is available at www.investorgauge.com. vii To the extent that her pay will go up even after accounting for inflation, she is better off than this analysis suggests. viii This number is based on the Canadian Institute of Actuaries 1986-1992 mortality tables. It is assumed that the woman in question has a healthy lifestyle and no adverse family health history. ix Married couples often buy joint-and-last-survivor annuities. Payments continue until both parties die. x Indexation is all about linkage. In most of this book, indexation has meant linking a portfolio to an index, which is itself designed to emulate the market (or sector) under consideration. In the present context, indexation implies linking income to purchasing power. xi See Chapter 8 in Milevsky, M. A., 1999, "Asset allocation at retirement: The risk is not enough," Money Logic, Stoddard, Toronto.


xii See Chapter 23 in Milevsky, M. A., 2002, "Longevity insurance: A product whose time has come?" Wealth Logic, Captus Press, Toronto.

Chapter 10

Going forward with self-knowledge and insight A. Preview What kind of an investor are you? To really answer this question, additional self-assessment is called for. I begin in section B with the following question: what is your money (or investment) personality? Knowing something about this will be helpful as you try to answer that key question: "Can I do it myself, or should I rely on somebody else such as a financial advisor for help?" Something else that is important to know about yourself is whether you have the right disposition to handle your own investments. This I discuss, in section C, in the context of investment temperament. Once you have a good sense of whether or not you should be a do-it-yourselfer, I turn to considering how it might be possible to give your portfolio a bit of a boost. Even though I have previously argued, and I continue to argue, that the core of your portfolio should be indexed, sometimes there are possible ways to do a little better. One way is through anomaly capture and style-tilting (section D). Another way is through judicious manager selection (section E).

B. What is your money personality? There is a new body of research that facilitates the slotting of people into money personality groups.1 It is known as psychographic profiling or attitudinal segmentation. Using a statistical technique known as cluster analysis, attitudinal segmentation attempts to assign individuals to distinct groups based on measurable attributes. For example, people differ in terms of their investment knowledge, confidence in their ability to handle money and plan for their retirement, and openness towards


financial education. Research conducted by Vanguard in the U.S. and SEI Investments in Canada analyzes the money personalities of retirement account members.11 While it is true that, like snowflakes or fingerprints, we are all unique individuals, when it comes to money personality we tend to cluster around certain profiles. While Vanguard identified five groups, their key distinction was between 'planners' and 'avoiders.'111 Planners are motivated and comfortable with retirement and pension concepts. Avoiders are not comfortable at all: they may not have the time, they may not have the inclination, or they may not have the capacity to become planners. SEI also identified five distinct attitudinal segments. Their names and associated characteristics are as follows: 1. Smart guys:lv While they are the most knowledgeable and exhibit the highest comfort level with their pensions, often they are also the most overconfident. 2. Participators: The main way in which this group is different from the previous group is in their desire for financial education. 3. Seekers: These individuals are worried and desire support. They are least comfortable that they will have sufficient resources on retirement, and have an insatiable appetite for education and advice. 4. The needy: They are uncomfortable and struggling. Currently inactive, they express a desire for advice. 5. The disengaged: Partly because they lack time, and partly because they lack interest, this group is even more inactive than the previous one. They are not taking advantage of the educational support currently being offered.

If one compares the Vanguard and SEI groups, it is apparent (and not surprising) that money personalities in Canada are quite similar to those south of the border. This is evidenced by the fact that an examination of the above groups also suggests a continuum along a planning-avoidance dimension. Referring to Figure 1, the smart guys are the ultimate planners, followed by the partic-


ipators. The disengaged are the ultimate avoiders, followed by the needy. The seekers fall somewhere in the middle.

Figure 1: SEI's member types and the money personality continuum

Work on attitudinal segmentation can be of great use to pension plan providers and sponsors because it tells them what sort of assistance is required for different members. For example, it can be argued that the smart guys only require communication. They want to be informed of the nature of the investment choices available to them, but require little else. They believe themselves to be already equipped with the requisite skill set. Nevertheless, given their high levels of overconfidence, some education would likely be useful to many of them. On the other hand, participators desire education. Seminars and retirement planning tools are ideal. Once armed with this knowledge, they feel themselves quite capable of moving forward. These two groups are various shades of planners. Moving to the right along this continuum, the insecurity and/or disengagement readings start to rise. The needy and disengaged are avoiders. As I have said, the seekers fall somewhere between: many of them are 'wannabe' planners. As a result, seekers, the needy, and the disengaged definitely need various forms of education and advice. How can you, the reader of this book, use this money personality analysis? Again, recall the Investorgauge Questionnaire that you were asked to do in the introduction to this book. One of the outputs from this survey was your investment personality score.


I call this your Investment Personality Quotient (PQ). Note that, given the context, I am using the term 'investment' rather than 'money.' The highest possible score is '10'; the lowest possible score is '0'. The questions used to generate this score were designed to situate people on the continuum shown in Figure 1. A '0' makes you an ultra-avoider; and a '10' makes you an ultraplanner. Many people, likely yourself included, will be somewhere between these two extremes. The main point though is, the higher your score, the more likely you are in the planner camp. And, the lower your score, the more likely you are in the avoider camp. Let's say planners are people who score between '5' and '10,' and avoiders are people who score between '0' and '5.' I suspect many of my readers will be some shade of planner. How do I know this? Well, you were interested enough in acquiring financial knowledge to buy and read this book (assuming you have not skipped to the last chapter), which to me is a pretty good signal that you are a planner. But if you are not, please don't take it personally: you just have other, equally valid, interests.

C. What is your investment temperament? When considering whether or not you should be a do-it-yourselfer managing your own investments, how does the planneravoider continuum described in the previous section fit in? Without doubt, planners in most cases want to be do-it-yourselfers, and indeed they are good candidates. Nevertheless being a planner, though necessary, is in my view not sufficient. What other attributes are desirable? It should not be surprising to hear that you must also have a reasonable level of investment knowledge. The survey also generated a KQ (Investment Knowledge Quotient} ranging from '0' to '10.' Once again, the higher the better. I would say that anybody scoring '5' or higher is a reasonable candidate to be a do-it-yourselfer. Should people with lower scores feel they must forever get help? If you feel yourself a bit deficient in terms of KQ at the present time, but you intend to do some remedial work, then you will eventually be


able to get your investment knowledge level up to scratch. I would expect that reading the book up to where you currently are can only have helped. It is not only important to have a reasonable level of knowledge. It is also crucial to have a realistic sense of your knowledge. I have spent some ink talking about the tendency for most individuals (authors included) to be overconfident of their skills, knowledge, and abilities. And I have described the sort of trouble overconfidence can get the average investor into. Most dangerous was the "I have all the answers'" attitude that impels some people to trade excessively. Be honest with yourself. Are you one of these investors? If so, you may not be the best candidate to be a do-it-yourselfer. Unless, that is, you have learned enough about yourself to recognize your problem, and are willing to take steps to deal with it. Something else needs to be kept in mind as you consider the do-it-yourself decision. There has been a lot of interest recently in the concept of emotional intelligence (or EI).V It is likely that we all know someone who is apparently very intelligent, but who drifts through life with little success. And we probably also know somebody else who, despite fairly modest cerebral RAM, seems to accomplish many things and achieve most of his goals. Why is it that the former person, who likely has a higher IQ than the latter person, is less successful? The answer is probably that the latter person has higher EL (Please excuse the alphabet soup.) Since I have mentioned IQ, let me discuss whether this matters. We all know that your IQ is a number that says how intelligent you are relative to the general population. IQ is ascertained through testing, though admittedly these tests are controversial. Obviously, the higher the better. People with higher IQs tend to succeed in more areas. Do you have to have a certain IQ level to be a do-it-yourselfer? Do you need strong math skills? In my view, once a reasonable threshold is reached, IQ does not matter at all! And math skills do not matter either. If you have bought and read this book, you have reached whatever threshold needs to be reached (and I am only half joking). More does not matter one iota. In fact, it may hurt a little, as there seems to be some evidence that, if we use education as a signal of intelligence, higher


levels of intelligence are associated with higher levels of dangerous overconfidence. Does your KQ have anything to do with your IQ? Not at all. Anybody who makes an effort to improve their investment knowledge will eventually convert this into a high KQ (regardless of IQ). Back to EL Let me begin by describing some fascinating research.vl A group of four-year-olds was tested in the following fashion. Picture a child being brought into a room and being told that the rnarshmallow on the table is his or hers for the taking once the experimenter leaves the room. The experimenter, however, has to go on a short errand, and, if the child can wait and not eat the rnarshmallow until the experimenter gets back, he/she will receive a second rnarshmallow as a reward. One of the key components of El is emotional self-control. Some children could not control their emotional impulse: they wanted that rnarshmallow and they wanted it now! Others were able to control themselves: maybe they agonized, but they resisted temptation, since they realized that two would be better than one. They were able to defer gratification. You might be thinking that this small piece of research was just an innocuous piece of psychological research without much applicability. Nothing could be further from the truth. The children involved in this test were tracked down 12-14 years later, and their performance on a multitude of levels was assessed. Not only were the gratification-deferring individuals much more socially and emotionally competent (measured in different ways), but they were also much more academically competent. Amazingly, they had much higher scores on SAT tests. And, believe it or not, the result of this simple rnarshmallow test was a much better predictor of SAT performance than IQ (measured at four years of age). El actually has a number of dimensions beyond emotional self-control. While some people might be strong on several dimensions but not others, there tends to be a relationship between strength on one level and strength on another. The dimensions are as follows:V11


1. Knowing one's emotions: Are you aware of your emotions? Can you sense when the urge to trade (or not trade) has an emotional component? 2. Managing one's emotions: People who score poorly are often battling feelings of stress, while those who score well can bounce back quickly from investment setbacks. 3. Motivating oneself: Would you have passed the marshmallow test at four? (I'm glad I didn't take it.) 4. Recognizing emotion in others: Do you have empathy? Do you have the sort of people skills that allow you to smooth over difficult situations? 5. Handling relationships: Relationship-building is all about managing the emotions of others.

While all of these are useful attributes, in my view, from the standpoint of being a good do-it-yourselfer, the first three matter the most. These are said to fall into the category 'personal competence/ while the latter two fall into the category 'social competence/ Two powerful emotions are fear and greed. Can you recognize when these are beginning to influence your investment decision-making? For example, that stock of yours has been shooting up, and it doesn't seem to be backed up by any fundamentals. Yet, like the famous bunny, it just keeps going and going. Your rational side might be saying that this is the time to cash in, but your greed is talking back. What do you do? Can you recognize the conflict? Now let's say the market has dropped by 25% over the past year, and a good part of your portfolio has been invested in stocks. No one likes to see those lower account balances. You are kicking yourself and regretting your mistake. Wait! Who says you made a mistake? Provided that the risk that you took was consistent with your capacity to bear it, and you were properly diversified, a bad event, after the fact, is not the same as a bad decision, before the fact. You had no way of knowing that the market was about to turn down. And you are savvy enough to know that the price of higher average long-run returns from equities is occasional gut-wrenching episodes where you start to question your decisions.


Several questions on the survey were designed to ascertain your emotional intelligence as it pertains to your investment decision-making. The questions were chosen to stress the personal competence attributes. Given the context, I call the resultant score your Investment Temperament Quotient (TQ). A score of 'W is the highest, and a score of '0' is the lowest. The higher your TQ score, the greater your ability to sense and control your emotions in the investment realm. I am not saying you need to expunge all emotion. This would, after all, take away what makes you human.vm The point is simply to understand your emotions and channel them appropriately. Some recent research by Andrew Lo (and colleagues) at MIT backs up the importance of emotion. Among other things, they found that those traders whose emotional reaction to market outcomes - whether positive or negative - was most intense, exhibited the worst trading performance.^

D. Looking for an edge I: Anomalies and style-tilting Say you have performed appropriate self-analysis and have decided to do it on your own. My arguments have convinced you that, like most average investors, you should index all or most of your portfolio. You realize that this will achieve the diversification that will allow you to eliminate as much risk as possible. You also understand the importance of asset classes and diversifying over them. You have a good sense of your capacity to take on risk, and you understand that it should be related to your age, proximity to retirement, and unique circumstances. Is this enough or should you look for an edge? Should you try to enhance your returns over and above what indexation will achieve? I would suggest that most investors should be happy enough with indexed returns and not look for an edge. At the same time I am aware that some will be tempted to do so. The purpose of this section is to suggest where occasional opportunities may arise. You can pursue them yourself or look for low-cost managers who can pursue them on your behalf. This section is


not about the art of uncovering undervalued securities through careful analysis of companies. For this topic, which is known as fundamental analysis, there are numerous sources elsewhere.x Rather, I will summarize some of the strategies that have been shown to be on average effective in generating 'excess' returns (that is, returns, net of all costs, that are greater than required by the risk of the investment). These strategies are based on looking for stocks or portfolios with certain attributes. These strategies are as follows: 1. Low price/book stocks (value stocks) outperform high price/book stocks (growth stocks). 2. There is momentum over 3-12 month horizons. 3. Reversals occur over longer horizons. Financial economists put all these tendencies under the rubric 'anomalies/ Anomalies are return patterns that do not seem to be capable of explanation by considering risk. Still, it is important to note that, while we are able to say what strategies have worked well in the past, there is absolutely no way of knowing which strategies will work well in the future. It is always possible that a particular strategy worked well in the past mefely because of chance. After all, there are hundreds of ways to categorize stocks. The best sort of anomaly to try to 'capture' is one that appears to have 'legs' because there is a compelling story behind its existence. I begin by presenting evidence of the recent effectiveness of these strategies in the Canadian context. In Figure 2,1 show how portfolios of Canadian value stocks have performed over about the last 25 years. The portfolios are the Barra Canadian growth and Canadian value stock portfolios.xl Over the period 19812004, value stocks averaged 12.62% per year vs. 6.96% for growth stocks.X11


Figure 2: Performance of Canadian value and growth portfolios

As for momentum, Sean Cleary of St. Mary's University and Michael Inglis of Ryerson University found that during 19791990 high momentum stocks outperformed the TSX by 2.56% per quarter before transactions costs.xm While they were dubious that those facing high transaction costs could capitalize on this, they argued that institutional traders would certainly have been able to achieve excess returns.xiv And, as for reversal, I investigated whether past Canadian stock market returns over medium-term horizons (two years) had any ability to explain future Canadian stock market returns.xv In other words, does reversal occur at the level of the entire stock market? I was able to conclude with a reasonable degree of comfort that indeed low past markets returns are more likely than not to lead to high future market returns.xvl Let me suggest a possible 'story' that ties together these three anomalies. One well-documented behavioral bias is conservatism-induced anchoring. It seems to be the case that, when companies announce excellent earnings numbers for a run of several quarters, the market continues to be surprised for some time. This could be because analysts are overly conservative in revising upwards their estimates of future earnings, and thus they


continue to be surprised, which could explain the medium-term momentum as good news follows good news for a while. (The same is true on the downside, as bad news follows bad news for a while.) As time passes though, another behavioral bias likely kicks in, namely recency (which was previously discussed). After seeing companies perform extremely well for a year or so, it may be the case that analysts extrapolate recent strong performance too far into the future. What they currently see happening is what they believe will continue to happen for a long period of time. In reality there is much evidence that earnings (and companies) mean-revert. This is a technical way of saying that the high-flyers come back down to earth (sometimes, like Nortel, with a thud). If analysts (and investors) underestimate mean-reversion and overestimate growth persistence, it is likely that the price of the hot stock will go too high and the price of the cold stock will go too low. Eventually reality must set in. This is why we witness reversals in stock returns in the longer run, and why "beaten down' value stocks outperform 'pumped up' growth stocks on a risk-adjusted basis. How might an investor, who for the most part wants to be an indexer, try to take advantage of some these findings? One possibility is to use ETFs to 'style-tilt.' Specifically, we could tilt away from growth and towards value. Recall my earlier discussion of style, where I said one of the main style dichotomies is value vs. growth. A broad index will include both value stocks and growth stocks. Still, it was also stated in Chapter 6 that most stock indexes have a natural growth-tilt since rising stars enter the index and fallen angels leave the index. Conveniently, in Canada there are value stock and growth stock ETFs. Instead of indexing one's Canadian equity exposure with a broad market ETF, one could instead invest in both the growth stock and the value stock ETFs, but with a tilt towards value.xvn

E. Looking for an edge II: Manager selection In Chapter 4,1 presented evidence that the typical investment manager is not generating returns sufficient to account for the


risk that he is bearing and the costs that he is incurring. And yet, in any given year, some managers are performing well. It is trivial to point to those who have excellent past performance. It is quite another thing to identify in advance which managers are likely to have good/wtare performance. Is past performance predictive of future performance? This is the performance persistence issue. Some weak evidence of performance persistence was presented in Chapter 4. Let me provide some additional evidence from my study of Canadian equity fund performance. Specifically, what if we put together a portfolio of winning funds, hold it for a year, then sell it off and replace it with another portfolio of winning funds? And we repeat this year after year. This can be termed a 'rollover' strategy. This does seem to work quite well, as can be seen in Figure 3 below. To interpret, you would have added more than 200% to your cumulative return during the period of the study. But there are some important things to keep in mind. First, no attempt in this study was made to style-adjust. Recall that much performance persistence can be attributed to style. For one thing, many winning funds continue to be winners because of the momentum of the stocks in their portfolios. Take this away, and little performance persistence remains. Unfortunately, because of data limitations, I was unable to style-adjust returns in my analysis of Canadian mutual funds. So a good percentage of the return boost displayed in the figure was indeed probably due to style.


Figure 3: Canadian mutual fund rollover strategy

Second, profitable return enhancement opportunities are probably, for the average (as opposed to the institutional) investor, an illusion. Today many funds have either a front-end load charge or a deferred sales charge. This annual portfolio rebalancing strategy would be quite costly because of these charges.xvm Further, this strategy is based on buying a large portfolio of funds. Most people, because of financial limitations, are simply not in a position to do this. So does this mean we should give up searching for any edge from active management? While to most investors I would recommend adhering to straight indexation, for those wishing to pursue excess returns or 'alpha/ there is some hope. First, as I mentioned back in Chapter 6, certain sectors seem to have greater scope for 'alpha mining' (for example, small cap and international). Second, even for sectors where alpha is more scarce, there is research, much of it very recent, suggesting that it may be a little more possible to identify skill than we had previously thought. Some of this research alleges that the previous pessimistic research was statistically and methodologically flawed.xlx Some of it also investigates what portfolio factors or manager attributes are likely to be associated with good future performance. Daniel Indro and others at Perm State document that fund size matters: it is best to be neither too small nor too big.xx Keith Brown of the University of Texas and W. V. Harlow find that style-consistency is particularly useful.xxl Judith Chevalier of Yale University and Glenn Ellison


of MIT investigate what sort of demographic characteristics of fund managers are associated with good performance.XX11 What would I recommend to that minority of investors who do want to have an actively managed component in their portfolio, over and above the indexed component (which should certainly comprise the bulk of their portfolio)? In selecting managers, always be very sensitive to loads and fees. Research indicates that higher loads and fees do not translate into higher returns.xxm While even the most favorable evidence shows that past performance is a very murky indicator of future performance, nevertheless a fund with better past performance should be preferred to one with inferior past performance. Would I recommend the regular fund switching that my study simulates? In my view, such a strategy would not be beneficial to most investors because of all the fees incurred. Still, one should monitor performance periodically, and every so often you may want to move out of poorly performing into better-performing (low-cost) funds. There is a new approach to active investing that some investors may want to consider: some management companies do not manage investors' money on their own, but rather they hire a 'portfolio of managers/ These companies are 'managers of managers' or 'funds of funds/ The advantage here is that expert in-house personnel can sift through the universe of managers available, examine performance along with other pertinent factors, and then seamlessly fire and hire as circumstances warrant. Plus, because of their institutional clout, they should be able to keep the direct money management fees down. As long as their cut is reasonable, this can turn out to be an automatic pilot way of continuously searching for managerial ability.


R Recap 1. Your investment personality tells you whether you have the interest and mindset to manage your own investments judiciously. 2. While basic investment knowledge is important, it can always be learned. Perhaps more important is investment temperament: those who score well here are more likely to react appropriately to adverse market events. 3. Those employing anomaly capture are trying to boost portfolio return by using strategies that have worked in the past. But no one can guarantee what the future will bring. Still, the evidence seems to call for a slight tilt towards value and away from growth. 4. Past performance is not predictive of future performance. Still, the evidence says that successful managers have a slightly greater likelihood of being successful in the future than unsuccessful ones. And other portfolio and manager attributes also seem to have a modicum of predictive power.


Endnotes

i This section leans heavily on Deaves, R., 2005, "Attitudinal segmentation of CAP members/' Benefits and Pensions Monitor (May). Also, see Deaves, R., 2005, "DC risks 101," Benefits Canada (April). ii See MacFarland, D. M, C. D. Marconi and S. R Utkus, 2004, " 'Money attitudes' and retirement plan design: One size does not fit all," in Pension Design and Structure: New Lessons from Behavioral Finance, edited by Mitchell, O. S., and S. P. Utkus, Oxford University Press, New York; Marconi, C. M., and S. P. Utkus, 2002, "Using 'money attitudes' to enhance retirement communications," Vanguard Center for Retirement Research Working paper; and SEI Investments, 2004, DC Pension Plan Members: Psychographic Profiles. iii The Vanguard groups (going from the planning side of the continuum to the avoider side of the continuum) are: 1. successful planners; 2. up-and-coming planners; 3. secure doers; 4. stressed avoiders; and 5. live-for-today avoiders. iv Let me reassure female readers of this book that 'smart guys' is meant ironically: this group, which does have a higher percentage of males than do the other groups, may think they have all the answers, but in reality they do not. v See, for example, Goleman, D., 1995, Emotional Intelligence: Why It Can Matter More than IQ, Bantam Books: New York. vi Ibid. vii Ibid. viii As I mentioned in Chapter 3, there is evidence that a total lack of emotion is deleterious to decision-making. See Ackert, L., B. Church and R. Deaves, 2003, "Emotion and financial markets," Federal Reserve Bank of Atlanta Economic Review 88 (no. 2): 33-41. ix See Lo, A. W., D. V. Repin, and B. N. Steenbarger, 2004, "Fear and greed in financial markets: A clinical study of daytraders," Working paper. x One good book on fundamental analysis is Damodaran, A., 2002, Investment Valuation, Second Edition, John Wiley & Sons, New York. xi Barra is a firm that, among other things, maintains style stock indexes.


xii There is abundant evidence of a value effect in U.S. and international markets. For example, see Chan, L. K. C, and J. Lakonishok, 2004, "Value and growth investing: A review and update," Financial Analysts Journal 60 (Jan/Feb): 71 (16 pages), and Brouwer, L, J. Van der Put and C. Veld, 1997, "Contrarian investment strategies in a European context," Journal of Business Finance and Accounting 24:1353-66. xiii Cleary, S., and M. Inglis, 1998, "Momentum in Canadian stock returns," Canadian Journal of Administrative Sciences 15: 27991. xiv Again, there is abundant U.S. and international evidence of momentum. For example, see Jegadeesh, N. and S. Titman, 1993, "Returns to buying winners and selling losers: Implications for stock market efficiency," Journal of Finance 48: 65-91; Chan, L. K. C., N. Jegadeesh and J. Lakonishok, 1999, "The profitability of momentum strategies," Financial Analysts Journal Special Issue on Behavioral Finance: 80-90; and Rouwenhorst, K. G., 1998, "International momentum strategies," Journal of Finance 53:267-84. xv For some U.S. evidence on reversals, see Fama, E. R, and K. R. French, 1988, "Permanent and temporary components of stock prices," Journal of Political Economy 96:246-73, and Poterba, J., and L. H. Summers, 1988, "Mean reversion in stock prices: Evidence and implications," Journal of Financial Economics 22: 27-59. xvi For those technically inclined, the regression's r-squared was 16%, and the p-value of the coefficient of past market returns was 6%. xvii Or one could invest most equity money into a broad market ETF, and then top it up a little with a value-based ETF. (As mentioned in Chapter 6, one problem in Canada is that the fund, which specializes in value, has low liquidity.) It must be stressed that only a slight tilt is recommended, as value can have lengthy periods of underperforming relative to growth. 'Style rotation/ which is beyond the scope of the book, is the strategy of tilting back and forth between styles in anticipation of changing markets. xviii Most fund companies with multiple funds allow virtually costless switching between different funds in the same family, weakening this latter point somewhat. xix See Kosowski, R., A. Timmerman, H. White and R.


Wermers, 2004, "Can mutual fund 'stars' really pick stocks? New evidence from a bootstrap analysis," Working paper; Teo, M., and S.-J. Woo, 2001, "Persistence in style-adjusted mutual fund returns," Working paper; and Baks, K. P., A. Metrick and J. Wachter, 2001 "Should investors avoid all actively managed mutual funds? A study in Bayesian performance evaluation," Journal of Finance 54: 45-85. xx Indro, D. C, C. X. Jiang, M. Y. Hu and W. Y. Lee, 1999, "Mutual fund performance: Does fund size matter?" Financial Analysts Journal May/June: 74-87. xxi Brown, K. C., and W. V. Harlow, 2004, "Staying the course: Mutual fund style consistency and performance persistence," Working Paper. xxii Chevalier, J., and G. Ellison, 1999 "Are some mutual fund managers better than others? Cross-sectional patterns in behavior and performance," Journal of Finance 54: 875-99. They find that younger managers with MB As from high-SAT colleges tend to be good performers. All these factors may be signals for effort expended. xxiii See, for example, Deaves, R., 2004, "The comparative performance of load and no-load funds in Canada," Canadian Journal of Administrative Sciences 21: 326-33.

Conclusion

Moving towards the investment solution that is right for you Let's spend some time reviewing the major lessons learned up to now. I began by providing some essential background on investment fundamentals and investor psychology. A lot of attention was accorded to understanding risk. Risky securities and asset classes over the long-term generally earn higher returns in compensation for the risk borne. The proper measure of a security's risk in a portfolio context (beta) differs from the conventional measure of risk (standard deviation), because the former embodies only non-diversifiable risk. Securities are worth the present value of expected future cash flows. This sounds simple, but market pros have a great deal of trouble estimating value. It is almost as important to know your psychological makeup as it is to be up on investment fundamentals. When it comes to saving, people procrastinate and don't save enough. Behavioral biases get in the way of good financial decision-making, as does emotion. Perhaps worst of all, people are overconfident, and are apt to take actions without sufficient information. I also reviewed the three portfolio choices available to investors: mutual funds, assembling a portfolio of securities, and indexation. Mutual funds provide diversification and professional management as major advantages. Unfortunately, this does not come free. Loads, MERs, and trading costs all eat away returns, and at times managerial 'games' and weak governance can worsen the situation. While managers do add some value before fees, on average they don't earn enough to offset fees. This inability to outperform is entirely consistent with a reasonable version of market efficiency. Still, there is a little short-term persistence in returns, which means that it at least makes sense to consider past performance when selecting funds for the first time. The evidence indicates that amateur investors fare no better


than professional investors when assembling their own portfolios. Most trades only incur costs: they do not improve performance. Overconfidence seems to be the main culprit. Underdiversification also results from overconfidence. Additionally, people are prone to be too fixated on chasing past winners, and they over-invest in the familiar. It does not help to team up with other amateurs, since the performance of investment clubs is unimpressive. The strategy of indexation is designed to allow you to track the market (actually slightly underperform it because of low fees). This strategy is wise for most investors because of the inability of the typical mutual fund manager to justify his fee and of individual investors to do any better. Index mutual funds are like other mutual funds, except that their managers make no attempt to outperform the index. The same holds for ETFs, except they trade like stocks. ETFs are usually preferable because of their lower MERs. I also covered two topics that all do-it-yourselfers or assistedinvestors wanting to play some role in managing their own investments should have knowledge of: asset allocation and investing for retirement. Asset classes differ in terms of historical returns, risk levels, and correlations with each other. Asset allocation is important because it explains most return variability, and it allows for risk reduction without surrendering return. While optimizers allow for the selection of just the right set of asset classes and in the right proportions, because of the impossibility of arriving at the right set of inputs their use should be viewed as illustrative. The most important factors governing strategic asset allocation are risk attitude and age. Tactical asset allocation, though potentially effective, should be avoided by most investors. Most people are saving for retirement. Careful financial planning requires that you save enough to maintain your desired lifestyle in your golden years. Calculators, which require assumptions on investment returns, work duration, and longevity, can be helpful in this regard. Of course, all assumptions can turn out to be wrong, and life circumstances can change, so a savings buffer is wise. After retirement, it is best to maintain some


equity exposure so as to minimize the probability of outliving your money. A life annuity may also be wise, especially after you have been retired for some time. The main purpose of the last chapter was to move us closer to a big decision: is the do-it-yourself route right for you, or do you need partial or full assistance? If you tackled the Investorgauge Questionnaire, you should have a good sense of your investment knowledge (via your KQ), investment personality (via your PQ) and investment temperament (via your TQ). Even if you have not got around to it yet, you probably still have a good sense of how you would measure up (but beware of overconfidence!). So should you be a do-it-yourselfer? Only you can say for sure. Clearly, those with higher levels of KQ, PQ, and TQ are better candidates. Luckily, you can increase your KQ by reading books like this one, by attending retirement planning seminars provided by your employer, and so on. Moreover, despite the fact that there is likely a genetic component, there is evidence that you can improve your TQ. And a higher PQ may ultimately follow, as over time you develop an interest in investments and planning for your retirement. All of which is to say that, even if your current scores are a bit on the low side, suggesting that you should acquire outside help at present, persistent attention to self-improvement may lead eventually to the ability to be a true do-it-yourselfer. And yet, there is no doubt that a good financial advisor (or a group of them) can at times add value. Many issues, such as tax minimization, estate planning, and income and asset protection are likely to require outside expertise. Let me stress that when I say that you may want to be a do-it-yourselfer, I am focusing on the investment management side of your financial affairs. Even here, value can be added by obtaining outside help. Advisors can sit down with you and help you formulate an investment policy statement, so that you will have a blueprint to fall back on when markets are not where you want them to be. Even in an indexed environment, they can ensure that you remain properly diversified over asset classes. They can also see to it that your investments are tax-efficient. And so on. Moreover, because those with high net worth have more dollars at stake than others,


the logic for getting help becomes stronger for this group. If you decide you need help, my recommendation is to go feebased, and to make sure that the fee is commensurate with the benefits provided. Fee-based financial advisors charge on a percentage of assets under management basis (rather like the MERs of mutual fund managers). Commission-based financial advisors, on the other hand, receive compensation that is dependent on the nature of the transactions that are done in the account. John De Goey in his book The Professional Financial Advisor argues that a commission-based approach creates perverse incentives and potential conflicts of interest. Say your advisor is considering which of two actively managed mutual funds to recommend. Should he recommend the one that compensates him more, or the one that compensates him less? Wait a minute, you are saying, he should recommend the best one. While most advisors will recommend the one that they feel is best, one always has to wonder. Plus, if I have convinced you that the core of your portfolio should be indexed, I must warn you that quite a few advisors will disagree with my view. As De Goey says (on page 161), "ask about ETFs and watch the typical 'independent' [financial service provider] squirm." There is simply less money to be made for a commission-based advisor here. This is why the fee-based approach makes the most sense. You pay x% of your portfolio to the advisor regardless of which transactions occur in your portfolio. Be prepared to ask potential financial advisors some questions. Ask what education, credentials, designations, and experience they have. Ask how they make investment recommendations, and what they think about indexation (if they are very negative on the latter you can recommend this book). Most importantly, ask how they are compensated. Once again, it is best to go for someone who is not compensated in any way as a result of transactions. Changing gears, let's suppose that you have decided to be a do-it-yourselfer in managing your investments. The two major decisions that you will need to make are: 1. how much you should save on a regular basis; and 2. in what asset classes should you invest. There are lots of financial calculators that will help


with the first question. I provide one such simple calculator at investorgauge.com. As for the second question, let me finish the book with a simple portfolio recipe which, in my view, provides a reasonable model portfolio (and portfolio construction methodology) for many do-it-yourselfers. While refinements are clearly possible, one of its virtues is its simplicity. I will assume that all saving is designed for retirement purposes and is held in taxdeferred accounts (say in RRSPs), and that you have a cash buffer for contingencies (that is, not included in any of the dollar amounts used here). The steps are as follows: 1. Subtract your age from 100. The resultant value is your target equity exposure. Say you are 40. Then your target equity exposure is 60%. 2. It will not surprise the reader that I recommend ETFs. Invest 30% of your money in the iUnits S&P/TSX 60 Index Fund for Canadian equity exposure. The other 30% I would allocate to foreign equities. Because non-North American markets have a lower correlation to Canadian markets than do U.S. markets, I would put 10% of my money into the iUnits S&P 500 Index RSP Fund and 20% of my money into the iUnits MSCI International Equity RSP Fund. 3. The rest of your money should go to bonds. I would suggest that you put the last 40% of your money into the iUnits Canadian Bond Broad Market Index Fund. Assuming that you now have $100,000 in your RRSPs and you want to reallocate this entire amount to my model portfolio, you would have (ignoring commissions) the following portfolio: Fund IUnits Canadian Bond Broad Market Index Fund iUnits S&P/TSX 60 Index Fund iUnits S&P 500 Index RSP Fund iUnits MSCI International Equity RSP Fund

Dollars $40,000 $30,000 $10,000 $20,000


Anything so simple, of course, will require periodic adjustment. And some caveats and special cases need to be noted: 1. The numbers would be different for someone younger or older. For a 50-year old, for example, the dollar amounts (with rounding to the nearest thousand) would be $50,000, $25,000, $8,000, and $17,000 in the four funds in the above table, respectively. 2. One problem with immediately converting your current RRSPs into the model portfolio is that transaction costs may be incurred. For example, if you are selling off stock, you will face commissions. If you are moving money out of mutual funds, you may face deferred sales charges. In the latter case, it may be better to wait until these charges have gone near zero. The ideal approach might be to gradually move your funds over to the model portfolio. Because everyone's situation is a bit different, it is difficult to be more specific. 3. You should be setting aside a certain percentage of your income every month, based on what you have calculated is necessary to fund a good retirement. Ideally, it can flow into a money market low-fee mutual fund until you are ready to deploy it. New purchases of these ETFs can be made with these cash inflows. The problem with ETFs is that you incur commissions when you make a purchase (or sale). For this reason, it is better to accumulate enough savings so that any given ETF transaction has no more than a 1% commission hit. It may well be best to buy ETFs only once every quarter-year, half-year, or full-year. 4. Rebalancing is periodically required. Rebalancing entails selling units in one fund and, with the proceeds, buying units in another. I would suggest no more than once per year for rebalancing. It is not necessary to worry excessively if you have strayed a little from your target asset allocation. Indeed there is a trade-off between the transac-


tion costs incurred to get you back on target and the mismatch you face if you don't rebalance. 5. Individual circumstances can lead to deviations from the model portfolio. If some of your savings are not for retirement but for nearer-term needs (such as to buy a house), then you should take on less risk since your effective horizon is shorter. On the other hand, those with high levels of human capital (high income and education) can afford to take on more equity risk. And those who are quite riskaverse might feel more comfortable with less equity exposure. A warning to the latter group: be careful about fixating too much on short-term market volatility. If doing so causes you to shy away from equities excessively, you run the greater risk of having an insufficient retirement income. 6. Some would argue for the inclusion of additional asset classes. What about real estate, income trusts, and emerging markets, for example? What about style diversification? One could have both value and growth positions, as well as mid and small cap funds. Additionally, one could slightly style-tilt. What about active management if you find the right fund in the right sector? All good points, but now we are getting away from a simple recipe. I hope you now have a clear sense of your options, and what is best for you. A sense of what kind of an investor you are, and what kind of an investor you should be. And you are moving closer to finding the investment solution that is right for you. Happy investing!

Recommended Readings Chapter 1 Ross, S. A., R. W. Westerfield, B. D. Jordan and G. S. Roberts, 2005, Fundamentals of Corporate Finance, Fifth Canadian Edition, McGraw-Hill Ryerson, Toronto. Siegel, J. J., 2002, Stocks for the Long Run, Third Edition, McGrawHill, New York. Chapter 2 Benz, C, P. Di Teresa and R. Kinnel, 2003, Morningstar Guide to Mutual Funds, John Wiley & Sons, Hoboken, New Jersey. Bell, A., 2002, Mutual Funds for Canadians for Dummies, Second Edition, John Wiley & Sons, Toronto. Chapter 3 Ackert, L v B. Church and R. Deaves, 2003, "Emotion and financial markets," Federal Reserve Bank of Atlanta Economic Review, 88 (no. 2): 33-41. Charupat, N., and R. Deaves, 2004, "How behavioral finance can assist financial professionals," Journal of Personal Finance 3 (no. 3): 41-52. Charupat, N., R. Deaves and E. Liiders, 2005, "Knowledge vs. knowledge perception: Implications for financial planners," Journal of Personal Finance 4 (no. 2): 60-71. Chapter 4 Malkiel, B. G., 2003, A Random Walk Down Wall Street, Eighth Edition, W. W. Norton & Company, New York. Kivenko, K., J. Cutler, B. Gleberzon and S. Buell, and R. Kyle, 2004, Giving Small Investors a Chance: Reforming the Mutual Fund Industry, Canadian Association for Retired Persons report. Chapter 5 Barber, B. and T. Odean, 1999, "The courage of misguided convictions," Financial Analysts Journal Special Issue on Behavioral Finance: 41-55.


Deaves, R., 2004, "Flawed self-directed retirement account decision-making and its implications," Canadian Investment Review (Spring): 6-15. Nofsinger, J. R., 2001, Investment Madness, Prentice Hall, Upper Saddle River, New Jersey.

Chapter 6 Atkinson, H. J., and D. Green, 2005, The New Investment Frontier III: A Guide to Exchange Traded Funds for Canadians, Insomniac Press, Toronto. Cadsby, T., 1999, The Power of Index Funds, Stoddart, Toronto.

Chapter 7 Bernstein, W., 2001, The Intelligent Asset Allocator, McGraw-Hill, New York. Deaves, R., 2004, "Investment planning or random guessing?" Human Resources Reporter (May).

Chapter 8 Gibson, R. C., 1996, Asset Allocation: Balancing Financial Risk, McGraw-Hill, New York. Milevsky, M. A., 1999, Money Logic, Chapter 4, Stoddard, Toronto.

Chapter 9 Chand, R., and S. Carmichael, 2002, 7s Your Retirement at Risk? Winning Strategies for a Financially Secure Future, Stoddart, Toronto. Cohen, B., and B. Fitzgerald, 2002, The Pension Puzzle: Your Complete Guide to Government Benefits, RRSPs and Employer Plans, John Wiley & Sons, Toronto.

Chapter 10 Chan, L. K. C., N. Jegadeesh and J. Lakonishok, 1999, "The profitability of momentum strategies." Financial Analysts Journal Special Issue on Behavioral Finance: 80-90. Chan, L. K. C., and J. Lakonishok, 2004, "Value and growth investing: A review and update," Financial Analysts Journal 60 (Jan/Feb): 71 (16 pages).


De Goey, J. J., 2003, The Professional Financial Advisor, Insomniac Press, Toronto. Deaves, R., 2005, "Attitudinal segmentation of CAP members" Benefits and Pensions Monitor (May).

Websites Guide Investorgauge Questionnaire and other tools www.investorgauge.com

Regulators/industry associations/investor education and protection Ontario Securities Commission (OSC) Investment Dealers Association (IDA) Mutual Fund Dealers Association (MFDA) Securities and Exchange Commission (SEC) Investment Funds Institute of Canada (IFIC) Investor Education Fund Small Investor Protection Association Canadian Fund Watch

www.osc.gov.on.ca www.ida.ca www.mfda.ca www.sec.org www.ific.ca www.investored.ca www.sipa.ca www. canadianfund watch .com

Print media Globe and Mail National Post Canadian Business MoneySense Wall Street Journal Business Week Economist

www.theglobeandmail.com www.nationalpost.com www.canadianbusiness.com www.moneysense.ca www.wallstreetjournal.com w w w.business week, com www.economist.com

Exchanges Toronto Stock Exchange (TSX) Montreal Exchange New York Stock Exchange

www.tsx.com www.m-x.ca www.nyse.com


ETFs Barclays iUnits (Canadian-based)www.iunits.com TD ETFs www.tdam.com Barclays iShares (U.S.-based) www.ishares.com AMEX-listed ETFs www.amex.com NASDAQ-listed ETFS www.nasdaq.com

Mutual funds Morningstar Fundlibrary Globefund TD eFunds

www.morningstar.ca www.fundlibrary.com www.globefund.com www.tdefunds.com

Index Ackert, L., 91, 218, 228 Active management, 23,100, 137-138, 215, 227 Advisor, 19-20, 24, 63, 72, 81, 191, 203, 223-224 commission-based financial advisors, 224 fee-based approach, 224n sales commissions, 63 Air Canada, 189 Alpha, 215 American Association of Individual Investors, 119 Anchoring, 212 Anderson, S.,186 Annuity, 53, 167,189, 191-194, 197-200, 223 formula, 53 purchase, 197 term, 192, 194 Anomalies, 137, 210-212 Arbitrage opportunities, 144 Argentina, 149 Asia, 70 Ask price, 65, 66 Asset allocation, 22, 25,147,149152,162-164,166,169,178181,183-185, 201, 222, 226 choice, 163 class, 38, 60, 62, 71, 73,121, 135,147-149,151-152,153, 155-156,158,160-161,162, 163-165,166n, 169-170, 178-183,184n, 185n, 201n, 222-226

allocation decision, 147, 151,166 allocation theory, 178 Assisted-fundholder, 19-20 Assisted-indexer, 19-20 Assisted-investors, 222 Assisted-selector, 19-20 Atkinson, H. J., 144n, 145n, 229n AT&T, 121 Attirudinal segmentation, 203, 204, 205, 218n Auger, R., 167n Australia, 134, 165 Availability, 91n Avoiders, 204-206, 218n Baby Bells, 121,122 Backfilling bias, 95 Bank of Canada, 50, 130, 197 Bank of Montreal (BMO), 29, 36-37, 40, 46-47, 49-50 Barber, Brad, 91n, 112,113, 114,123,125n, 126n, 127n Barclays Global Investors, 144n, 145 Barra, 211, 218n Basis points, 50,101,140,145 Beebower, G. L., 165n Behavioral finance, 79, 91n, 125n, 150, 219 Bell, 121 Benartzi, Schlomo, 83, 91n, 119,126 Benchmark index, 69, 94-95, 101

234 — Richard Deuves

Benz, C, 228n Bernstein, W., 229n Beta, 221 Better-than-average effect, 114 Beyer, S., 125n Bhandari, Gokul, 115,125n, 185n Bid price, 65-66, 74n Bleiberg, S., 185n Bodie, Z., 165n, 184n Boeing, 130 Bond fund, 139,145,149-150 Bonds, 25, 28-30, 38-39, 45, 53n, 55n, 60,129,134,139, 140,145,148-150,151-160, 164,165,169-178,181,183, 184n, 185n, 188,190,193, 225 long-term bonds, 153,155, 157 medium-term bonds, 153, 157,171-172,193 short-term bonds, 153 strip bonds, 53 Borzellino, R., 186n Bowden, E. M., 125n Brinson, Gary, 151,165n Brokerage commissions, 141 Brouwer, I., 219n Brown, K. C., 215, 220n Brulhart, T., 186n Buell, S. 75n Buffett, Warren 105 Bull markets, 87 Business Week, 56n

Canada Pension Plan (CPP), 188-189,198 Canada Pension Plan Investment Board (CPPIB), 188 Canadian Business, 56n Canadian dollar, 159-160,166 equity fund, 60, 64, 75n, 76, 94-95, 98,109n, 214 indexes, 132-133 Canadian Investment Review, 126n, 167n, 185n, 186n Canadian Journal of Economics, 74n Capital gain, 28-29, 52, 67,132133,145n Carhart, M. M., 75n, 109n Carmichael, S., 229 Carrick, J., 145n, 185n Chan, L. K. C., 229n Chand, R., 229n Charupat, N., 228n Chevalier, Judith, 215, 220n Chevreau, J., 75n, 92n Church, B., 91n, 218n Cleary, Sean, 212, 219n Closed-end funds, 182,186n Closet indexing, 68-69, 75n Cognitive dissonance, 104, 108, 109n Cohen, B., 229n Commissions, 63, 65,141, 225226 Company pensions, 187-188,

CAC, 134 Canada bonds, 29, 38-39, 53n, 152,154-155

Computer Literacy Inc., 85 Contrarians, 119,120 Cornell, Bradford, 173,184n

200


Correlation, 41-42,156,157, 160,162-163,164,166n, 167n, 170,182,184n, 222, 225n Coupon payments, 53n Current yield, 153 Cutler, J., 75n, 228n Czech Republic, 149 Damodaran, A., 218n DAX, 134 De Bondt, Werner, 91n, 119, 126n, 127n De Goey, John, 224 Deferred sales charge (DSC), 62, 63, 74n, 215, 226 Defined benefit (DB) pension plans, 138,144n, 188-189, 191,198 Defined contribution (DC) pension plans, 119,138, 144,149,165,184n, 188189,191, 218 Defined Contribution Monitor, 184n Discount broker, 20, 65, 87,112 Disposition effect, 87 Distributions of final wealth, 169,183 Di Teresa, P., 229 Diversifiable risk, 43 Diversification, 27, 39, 42, 52, 58, 73, 89,118-122,136, 148,150-151,156,158,160161,166-167,169,181-183, 210, 221, 227

benefits, 120 heuristic, 150-151 theory, 122

under-diversification, 89, 112,118,124, 222 Diversified portfolio, 38-40, 44,130,152 Dividend Discount Model (DDM), 46-47 Dividend yield, 28-29,180, see also, Divendend-to-price ratio (DIP) Dividend-to-price ratio (D/P), 180 Dividends, 28-30, 32, 45-50, 53n, 55n, 56n, 91n, 131-133, 141,145n, 179,180 Dofasco (DPS), 40-41 Do-it-yourselfers, 20, 24, 206, 222, 225

Dot-corn effect, 85 Dow Jones Industrial Average (DOW), 130-135,143n DuPont, 130 EAFE, 133-134, 145,148,158163, 165n, 167n stocks, 159,162-163 earning-to-price ratio (E/P), 179-180,185 Econometrica, 91n Edelen, R. M, 109n Efficient set, 156-163,169 eFunds, 145n Ellison, Glenn, 215, 220n Emotional intelligence (El), 207-208, 210 Equity exposure, 149,151,162163,173,175-177,179, 200, 213, 223, 225, 227

premium, 45,173-174,


184n risk, 172,199, 227 European Economic Review, 126n Exchange Traded Funds (ETFs), 135,138-142,144146,149,181,186n, 213, 219n, 222, 224-226 distributions, 145n iUnits, 139,140,145n, 181, 225 TD S&P/TSX, 139-140 units, 139,146 Expected value, 34-36, 54n, 82 Extended diversification, 169, 181-182 Exxon, 130 Ezra, D. D., 165n Falconbridge, 33 Fama, E. R, 219n Farrell, J. L. Jr., 166n Fatbrain.com, 85 Federal Reserve, 92,185,197, 218 Fee-based, 224 Fiduciary responsibility, 76n, 188 Financial Analysts Journal, 125n, 127n, 165n, 166n, 184n, 219n, 220n Financial Post, 56n, 75n, 92n, 186n Fischhoff, B., 125n Fitzgerald. B., 229n Fixed-income, 29, 53n, 60,135, 137,139,148,172-173,177, 179,184n, 185n, 193,197 risk, 172

securities, 29, 53n, 135, 137,148,173,177,197 Foreign diversification, 161 equities, 160,183, 225 exchange risk, 159-160 securities, 148,161 stocks, 158 Fox, P.W. 125 France, 133-134,140 French, K. R., 219n Front-end loads, 62-63, 72, 94, 215 FTSE 100,134 Funds of funds, 216 Future value, 30-32, 52, see also present value Gallup Organization, 116 General Electric, 130 General Motors, 130 George Weston, 40 Germany, 133-134,140 Gibson, R. C, 229n Gleberzon, B., 75n Globe and Mail, 28, 56n, 70, 75n, 76n, 145n, 185n, 186n Goetzmann, William, 109n, 118,126n Goleman, D., 218n Government of Canada, 38, 45,134,139,145,152,154155,193 bonds, 38, 45,152,154-155 Green, D., 144n, 145n Growth stocks, 61,100,148, 211, 213 Gruber, M.J., 109n GST, 63


Guaranteed Income Supplement (CIS), 187 Guaranteed Investment Certificate (GIC), 27, 29, 33 Halpern, Paul, 141,145n, 185n Hang Seng, 134 Harlow, W.V. 75n, 215n, 220n Haslem, J. A., 144n, 185n Hastie, R. 126n Hawkins, S. A., 126n Hedge funds, 149,182,186n Hensel, C. R., 165n Hindsight bias, 116 Hirshleifer, David, 91n Home Depot, 130 Hong Kong, 134 Hood, L.R. 165n Horizon, 83,163,167,170,172, 227 Hu, M.Y., 220n Huberman, Gur, 121,127n Human capital, 177-178,181, 227

IBM, 130 Ilkiw, J.H., 165n Illusion of control, 115,126n Inflation-adjusted Investment Dealers Association (IDA), 76n, 185n Investment Funds Institute of Canada (IFIC), 59, 76n Income replacement ratio, 17, 191,193-196 Income trusts, 143,149,181, 185n, 186n, 227 Index fund, 59-60, 64-65, 75n,

39-140,145,181, 225 Index mutual funds, 59,135, 138-142,145, 222 Indexation, 21-24, 60, 93,104, 129,134-138,142,151,198, 201n, 210, 215, 221-222, 224 enhanced indexation, 138 strategy, 23,104 Indexes, 38,129-135,137,141, 143n, 213, 219n price-weighted index, 131 total return indexes, 133 value-weighted indexes, 131132,135n, 143n Indexing, 22-23, 68-69,129, 137-138,140-142,144n, 213 India, 148 Indonesia, 148 Indro, Daniel, 215, 220n Inflation, 48, 56n, 187,192, 197-198, 201n adjusted, 192,193 protection, 198 Inglis, Michael 212, 219n Insurance companies, 197 Intel, 130 Internet bubble, 85 Intrinsic value, 49-50,103-104 Investment bankers, 115,125n Knowledge Quotient (KQ), 206, 208, 223 personality, 25-26, 203, 205-206, 217, 223 Personality Quotient (PQ), 206, 223 temperament, 13, 25-26, 203, 206, 210, 217, 223 Temperament Quotient


(TQ), 210, 223 Investment clubs, 112,122-123, 222 Investor Do-it-yourselfer, 19, 20-22, 24-25, 93, 203, 206-207, 209, 222-224, 225 protection, 76, 231 psychology, 24, 221 Investorgauge Questionnaire, 25, 27, 84, 87,115,120,122, 150,176, 205, 223 iShares, 232 iUnits, 225, 232

Jain, P., 75n Japan, 133-134,140 Jagannathan, R., 184n Jegadeesh, N., 127n, 219n Jiang, C. X., 220n Joint-and-last-survivor annuities, 201n Jordan, B. D., 55n Journal of Behavioral Finance, 125n Journal of Financial Economics, 74n, 76n, 109n, 219n Journal of Financial Research, 109n Kahneman, Daniel, 79, 81, 91n, 125n Kane, A., 165n Kaniel, R., 75n Kelly, Morgan, 118,126n Khorana, A., 74n Kinnel, R., 229n Kivenko, Ken, 75n Kirzner, Eric, 141,145n

Kitchen, Av 184n Klein, Peter, 186n Kocherlakota, N.R., 184n Korea, 148 Krasker, W.S., 184n Krinsky, I., 186n Kumar, Alok, 118,126n Kyle, R.,229n Labor-sponsored investment funds, 182,186n Lakonishok, J., 219 Langer, E. J., 126n Large cap, 61-62, 74n, 99,148 stocks, 61, 99 Lee, W.Y. 220n Leibowitz, M.L., 184n Lichtenstein, S., 125n Life annuity, 167n, 189, 197199, 200, 223 Limit order, 74n Liquidity, 74n, 100,133,139n, 145n, 219n Lo, Andrew, 210, 218n Load, 62-64, 72, 73,108,139, 216, 220n, 221 front-end load, 62-63, 72, 94, 215 no-load funds, 62, 220n rear-end loads, 62-63 Loss-aversion, 81-83 Liiders, Erik, 92n, 117,125n, 126n Luo, Rosemary, 117,126n Lundeberg, M.A., 125n Lynch, Peter 105 MacFarland, D. M., 218n


Macintosh, J. G., 74n Malaysia, 148 Malkiel, Burton G., 56n, 109n Managed futures, 182 Management Expense Ratio (MER), 62-64, 65, 72, 73, 98,100-101,108,140-141, 142,145n, 221-222, 224 Marconi, C. D., 218n Marcus, A. J., 165n Market efficiency, 45, 49-52,102, 104, 108, 127n, 219n, 221 impact costs, 65 risk premium, 45, 48, 97 timing, 70-71, 76n, 151 Markowitz, Harry, 161,166n Marshmallow test, 208-209 McDonald's, 130 Mean reversion, 84 Merck, 130 Merton, R.C., 184n Metrick, A., 220n Micro cap, 133 Microsoft, 130 Mid cap, 74,133 SPDRs, 140 Milevsky, M.A., 74n, 199, 201n, 202n Miller, Merton, 166n Mitchell, O.S., 218n Miu, Peter, 185n Momentum-chasing, 100,107, 112,118-120,124 Money market securities, 53n Money personality, 202-205 MoneySense, 56n Montreal Exchange, 53n

Morgan Stanley, 145n, 158, 165n Equity Research, 145n EAFE, 158,165n Morningstar Canada, 71, 74n Quicktake Report, 71 Rating, 72 Mortgage debt, 181 MSCI EAFE, 133,134,139, 140, 225 Musto, D. K., 75n Mutual funds, 19, 20, 21, 22, 23, 24, 57-60, 62-65, 67, 6971, 73, 74n, 75n, 76n, 84, 93-94, 97, 99-101,103-105, 108,109n assets, 58-59 governance, 69 industry, 74-76 management, 100 manager, 103, 111, 222 Mutual Fund Dealers Association (MFDA), 76 NASDAQ 100,134,140 National Post, 28, 56n, 75n, 92n, 186n Net Asset Value (NAV), 58, 70, 71,139,186n New York Stock Exchange (NYSE), 53n, 133,134,137 Composite Index, 133 Nicholls, C. C., 74n Nikkei 225,134 Nofsinger, John, 229n Nortel, 145n, 185n, 213


Odean, Terrance, 79, 87, 91n, 112-114,123,125n, 126n, 127 Offshore investments, 166 market movements, 71 securities, 109n Old Age Security (OAS), 187189,191,198 Ontario Securities Commission (OSC), 75n, 76n Optimization, 147,158,161164,169, 222 Order book, 66, 74n Overconfidence, 22, 88-89, 111, 114-118,124,125n, 126n, 205, 207-208, 222-223 Parisien, D., 167n Passive management, see indexation Peles, N, 109n Pension funds, 151,188 payment, 189 plan, 119,138,144,149150,188, 205, 218 Performance chasing, 106 measurement, 94 Perrakis, S., 165n Persistence, 106-107, 213-214, 221 Personal competence, 209-210 Petro-Canada (PCA), 40 Phillips, Hager & North (PH&N), 71 Phillips, L.D., 125n

Planners, 23,176-177, 204-206, 218n Planning fallacy, 89 Pious, S., 126n Poland, 149 Portfolio, 19-24, 38, 40-44, 52, 59, 63, 68-69, 71, 73, 75n, 76n, 81, 89, 93, 97,101,104, 111-113,117-120,122-123, 126n, 129-131,134-138, 147-149,151-152,155-158, 161-163,165n, 167n, 169, 171-179,181,184n, 185, 193,195-196,199, 201, 203, 209-210, 214-217, 221, 224227 composition, 23, 71, 73, 101, 112,118 diversification, 136 formation, 119,171-175 minimum-risk portfolio, 156 of securities, 19-20, 40,135, 181, 221 pumping, 68 rebalancing, 178-179, 215 return, 40,112, 217 weights, 41-42,161-162, 166n Poterba, J., 219n Preferred stocks, 53n Present value, 30-32, 46-47, 52, 181, 221, see also future value Price/book, 72 Price Waterhouse, 122 Price-to-earnings ratios (P/E), 47, 74n, 185n Principal-agent problem, 67


Probability distribution Procrastination, 79-80 Psychographic profiles, 203, 218 Psychological Bulletin 107,126 Psychological makeup, 22, 221 Psychology of Judgment and Decision Making, 126n Punccochar, J., 125n Quarterly Journal of Economics, 126n Quebec Pension Plan (QPP), 188,191, see also Canada Pension Plan Random walk, 51, 56n Real estate, 139,149,177,181, 190, 227 Rebalancing, 136,178-179, 215, 226 Recency, 83, 85, 213 Reed, A.V., 75n Registered Retirement Investment Fund (RRIF), 190,199 Registered Retirement Savings Plan (RRSP), 67, 74n, 187, 189-190,191 group-RRSPs, 138,144n, 191 Regret, 86-87,180 Repin, D. V., 218n Representativeness, 81, 83-85, 119 Retirement goals, 184, 200 income, 13,187-189,192,

198, 200, 227 planning, 205, 223 Returns, 23, 27-28, 30, 33, 3642, 52n, 55n, 60, 64, 67-68, 70, 72-73, 75n, 77n, 83-85, 87, 91n, 97-101,103-104, 107-108,109n, 113-114,120, 127n, 136-138,141-142, 144n, 149,152-156,158160,162-164,166n, 170171,176,180,184n, 185n, 188-190,192,195, 209-216, 219n compounded average, 36, 38, 39, 54-55,152,166n Reverse mortgage, 190 Risk attitude toward, 150,175, 177,183, 222 aversion, 82, 87, 91,178, 227 non-diversifiable risk, 4344, 221 preference, 150,156 premium, 33, 45, 48, 82, 97, 173,184 reduction, 155-157,164, 175, 222 tolerance, 26,169,176-177 Risk-adjusted basis, 61,114,137, 213 returns, 120 Risk-free investment, 82 securities, 144 Risk-taking, 86-87,147,169, 177-178,184,195,197,199 Roberts, G. S., 55n 'Rollover' strategy, 214-215


Ross, S. A., 55n Roth, J., 126n Rouwenhorst, K. G., 219n Rubric anomalies, 211 tracking error, 136,141 Ruckman, Karen, 64, 74n Russell 2000,133-134,140 Ryan, P.J., 165n S&P 500 Index, 131-133,136137,139,145,158, 225 S&P/TSX 60,133,139-140,145, 225 Composite, 16, 38, 48, 59, 72,132,139-140,145,152 Mid Cap Index, 133 Small Cap Index, 133 Venture Composite Index, 133 Salience, 91n Samsonite Pension Fund, 137 Samuelson, W.F., 184n Schroder, M., 125 Scotia Capital Universe Bond Index, 134 Securities Exchange Commission (SEC), 69, 75n Segregated funds, 63 SEI Investments, 149, 204, 205, 218 Self-attribution bias, 116 Self-control, 79-80, 208 Self-fundholder, 93 Self-indexer, 20, 23, 93 Self-investor, 24, 111 Self-Regulatory Organizations (SRO), 75n

Self-selection bias, 123 Self-selector, 20, 93 Servaes, H., 74n Sevick, M., 76n Sharpe, William R, 44, 166n Shefrin, Hersh 91n Shiller, R. J., 126n Shumway, T., 91n Siegel, Jeremy, 55n, 137,143n, 144n, 172,184n Sirri, E. R., 75n Servaes, H., 74n Singapore, 134 Small cap, 61-62, 68, 74, 99, 133-134,138,148-149, 215, 227 Canadian equity, 149 funds, 61, 227 growth funds, 61 sectors, 148 stocks, 61, 99 style, 99 Smith, Vernon L., 79 Social competence, 209 SPDRs, 140 Standard deviation, 35-41, 4344, 52, 54n, 55n, 154,159160,162,170, 221 Star managers, 105 Starks, L.T., 75n Statman, Meir, 91n Steenbarger, B. N., 218n Stelco, 189 Stock fund, 70,149-150 Stock-bond mix, 149-151,156, 175-176,178-179, 185 Stock portfolios, 58, 211 Stock-picking, 99-101,107,


109, 111, 114 Strategic asset allocation (SAA), 151,162,169,181, 183, 222 Style, 59, 61-62, 71, 77n, 99101,107,109,137-138,176, 202, 210, 213-214, 218-220, 227

boost, 99-101,107 distinctions, 61, 99 diversification, 227 drag, 99 indexation, 138 investing, 61,137 tilting, 138, 202, 210, 213 Summers, L.H., 219n Survivorship bias, 95,174 Svenson, O., 125n T-Bills, 53,100,152,165,184n returns, 154 Tactical asset allocation (TAA), 151,169,179-180,183, 185n, 222 Tax

efficiency, 77, 223 shelter, 189 Tax-adjusted returns, 109 Tax-deferred account, 67, 225 Tax-free, 190 Tax-sheltered, 187 Telus, 40 Teo, M., 220n Thailand, 148 Thaler, Richard H., 79, 83, 91n, 127n Tian, Y, 186n Time value, 30, 45, 52

Timmerman, A., 220n Titman, S., 127n, 219n Toronto Stock Exchange (TSX), (TSE), 20, 28, 38, 48, 59, 72,132-133,139-140,145, 152,181, 212, 225 Total return indexes, 133 Tournament-like behavior, 68 Tracking error, 136,141 Trading costs, 62, 65-66, 73, 221

Trailer fee, 63, 72 Tufano, P., 74n, 75n Turkey, 149 Turnover ratio, 66 Tversky, Amos, 81, 91n, 125n U.K., 133-134,189 UBS PaineWebber, 116 United States, 29, 55, 57, 60, 64, 68-70, 75-76, 87, 94, 100,105,107,109,112,114, 118, 121,126,130-131,133137,139-140,145,148,151, 158-160,162-163,167,172174,184-185,189,197, 204, 219, 225 dollar, 57,159 equity, 139-140, 160 Federal Reserve, 197 U.S./Canada correlation, 160, 163 Utkus, S.P., 218n Value stocks, 61,100,148, 211, 213 Van der Put, J., 219n Vanguard, 204, 218


Variance, 54n, 55n, 166n Veld, Chris, 219n Viceira, L. M., 185n Volatility, 81,153-154,184, 227 Wachter, J., 220n Wal-Mart, 84,130 Wall Street Journal, 56n Walt Disney, 130 Watson Wyatt, 201n Wealth accumulation, 170-172, 174-175 Wells Fargo, 137 Wermers, Russ, 100-101,109n, 220n Westerfield, R.W., 55n White, Barry, 180,185n White, H., 220n Wilshire 5000,134 Window dressing, 75n Woo, S.-J., 220n Wu, J.S., 75n Yield to maturity, 30 Zitzewitz, E.

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