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Jun 2, 2014

How And Why I Manage My Own Investments Seven Years Of CMS

by Matt Poyner

Matt PoynerThe investor’s chief problem and even his worst enemy is likely to be himself."  Benjamin Graham

 

am a thirty-seven-year-old professional who doesnot work in the finance industry. I have a wife andfour young children. With a passion for personal finance and investing, I have been reading the Canadian MoneySaver for seven years, along with many other sources of reliable information. This article might be considered my manifesto.

When I started saving ten years ago, I immediately sought quality advice to guide my efforts. I knew about the power of compounding and didn’t want to sabotage my long-term gains by messing up my first few years of investing.

It didn’t take long to become suspicious of the financial services industry. I was particularly uncomfortable with the glaring conflicts of interest arising from the typical advisor-client relationship alluded to frequently in this publication, to the credit of its contributors and publisher.

In short, I became determined not only to do it myself but to do it right. Although I agree with the Ben Graham quote above, I saw no reason, and still don’t, why a reasonably intelligent person could not effectively manage his or her own investments given the proper research and discipline. Of course, this is easier said than done so it was with more than a little self-doubt that after several more months of reading and research, I opened my first online discount brokerage account. Fortunately, around this time I came across a reference to the Canadian Moneysaver online.

Seven years and about 60 issues later I have come to the conclusion that CMS is one of the best resources for Canadian independent investors. Reading each issue cover to cover, along with my small library of finance books, I have become “book smart” as far as retail investors go, while careful evaluation of my successes and mistakes have also garnered a few “street smarts” (try as I might, I have not been completely immune to irrational enthusiasm and discouragement sometimes).

What Are The Most Important Factors In Determining Long-Term Investment Returns?

This, to me, is the most relevant question to which the most superficial, anecdotal, sensational answers are frequently offered. Watch the TV, read the headlines, listen to most advisors and analysts and you will soon be brainwashed into thinking the answer is stock selection, or choosing the “right” mutual fund. The media is saturated with personalities touting what is hot and what is not, pressuring investors to buy this, sell that, thereby generating fees and justifying their own existence.

The truth is that anyone with an Internet connection has access to sound, reliable, evidence-based information about the real determinants of long-term investment returns. You just have to do what most people don’t do: think to ask the right questions. You may be surprised to discover that studies show stock selection and market timing combined account for only about 10% of those returns we are all seeking (Wallick et al., The global case for strategic asset allocation, Vanguard Research Paper, 2012).

In this article I would like to outline what I believe are the real keys to success as an individual retail investor.  Those who are too intoxicated by the allure of finding the next ten-bagger will be disappointed. But you must ask yourself why you are investing at all. If you are looking for casino thrills from the comfort of your own home, there are plenty of “experts” who would like to bend your ear. If, however, you are more concerned with securing your financial future, these are, in my opinion, the four essential ingredients.

1. Create a personal investment policy and adhere to it

Although this is the single greatest factor affecting long-term returns, I will admit that I was late to “discover” this most essential point: It is of vital importance to create your own, written investment policy. Perhaps it is semantics, but you’ll notice I am not using the term “plan.” To me, “plans” merely imply an intention. You might plan to start working out regularly or eat better, but those are more flexible goals than what is appropriate for your investments. We need well thought out, evidence-based rules if we are to resist the fear and greed that lead to so many poor investment decisions. After all, a temporary lapse on your diet may mean the guilt of a piece of chocolate cake, whereas the breach of an investment “plan” can mean financial ruin (recall Nortel, Blackberry, Enron...).

The following is an outline of a purely hypothetical policy.

Sample Policy

• Current Status: $150 000 savings

• Objective: save $2 000 000 for retirement (assuming 2% inflation)

• Time frame: 25-year time horizon

• Savings target: save $2000 per month

• Risk tolerance: high

• Asset allocation: 50% Canadian Equity, 20% US Equity, 15% REITs, 10% bonds, 5% cash

• Strategy: buy at reasonable valuations and hold blue chip, dividend-paying stocks

• Other goals this year: enroll in DRIPs, update investment spreadsheet monthly

Without an investment policy, most investors will fall into the trap of building their portfolios piecemeal with investment products that seem attractive at the time, losing sight of the big picture and losing out on the proven benefits of appropriate asset allocation.

In fact, a seminal study of 82 large pension plans confirmed that “investment policy explained, on average, 91.5 per cent of the variation in quarterly total plan returns.” (Brinson, G., Singer, B., & Beebower, G. (1991, May/June). The Determinants of Portfolio Performance II, an Update. Financial Analysts Journal).

The same study specifically states, “active investment decisions [i.e. timing the market] . . . did little on average to improve performance.” Other research proves that the average retail investor who tries to time the market fares significantly worse. In spite of so much data which should dissuade investors from active management, the following figure from Vanguard illustrates that psychology still drives investors to buy high and sell low.

As the Chinese proverb says, “One dog barks at something, and a hundred bark at the bark.” Cash flows into equities when stocks are expensive and out when they are cheap. Perhaps the greatest benefit of having a policy is in controlling our fear in bear markets and enthusiasm in bull markets.

Matt Poyner Article

2. Minimize taxes and fees

“Investment managers sell for the price of a Picasso (what) routinely turns out to be paint-by-number sofa art” – Patricia C. Dunn, CEO, Barclays Global Advisors.

My heart breaks a little every time I hear of a friend who has all of his or her investments in mutual funds.  Mutual funds in Canada, with average management expense ratios of 2.2%, are the most expensive in the world (mean 0.95%). The effects of these fees cannot be overstated. Even two percent per year sounds innocuous, but the real effect of these fees over time is staggering.

If I invested $100 000 now for 25 years earning 8% per year, I would have $685 000 in the end. Add a 2.2% fee on that and my total after 25 years becomes $396 000.  Forget 2% due to compounding, that is a 50% reduction in profits!

But aren’t you getting the benefits of professional active management, i.e. great returns that make up for the fees?  Unfortunately, the evidence is abundant and the answer is a resounding no. In fact, what is crystal clear is that the average actively managed fund will underperform the market. And the reason is simple. In any stock market, for every buyer there must be a seller, and vice versa.  Therefore the average of all trades is, by definition, the average return of the market as a whole.

As Nobel laureate William F Sharpe writes: “Properly measured, the average actively managed dollar must underperform the average passively managed dollar, net of costs. The laws of arithmetic have been suspended for the convenience of those who pursue their careers as active fund managers.”

That is not to say that some funds will not, on occasion, outperform the market. But they are the minority only about 10%, according to SPIVA Canada. And, again, there is ample proof that it is impossible to determine who those outperformers might be, based on past performance or any other factor.

MERs may be the most pernicious drain on investor returns, but let’s not forget two other important sources of investor costs: trading fees and taxes.

Trading fees, whether inside a mutual fund or executed directly by an investor can add up fast. I have found it advantageous to use an online discount brokerage and trade only when rebalancing annually, or every few months when I have accumulated enough dividends to make a meaningful purchase of more shares.

Taxes are another topic altogether. Suffice it to say that it is important to understand that the CRA treats interest, capital gains, and dividend income differently and that these differences should affect what investments are held where in your portfolio. For example, I hold my US dividend-paying stocks (Dogs of the Dow) in my RRSP to avoid the 15% dividend withholding tax that would otherwise be applied to this income.

3. Balance risk and return through asset allocation and diversification

To state the obvious, all investments involve risk but some are riskier than others. In general, risk and reward are correlated, so it is up to the investor to balance these two concerns. This is most effectively done through asset allocation, traditionally considered the proportion of investments allocated to equities vs. fixed income (usually bonds).

Depending on your financial situation, stage of life and ability to tolerate market fluctuations, the “rule of thumb” of having your bond allocation match your age may or may not be appropriate. With bond yields at all time lows, and taxed at much higher rates than other income like dividends, for example, I would suspect many investors (myself included) may be better served by a lower proportion of bonds. This is especially true if the equity portion of your asset allocation tends to be more conservative (more on blue chip dividend stocks shortly).

In any case, asset allocation is extremely important, and is yet another factor proven to have a greater effect upon returns than market timing or stock picking. To give an idea of how asset allocation has affected volatility and return historically, have a look at this figure from Vanguard which includes data from 1926-2012:

Matt Poyner Graph

The figure above is useful, not only to illustrate volatility and return, but to help us align our expectations and assumptions when choosing a particular asset allocation strategy. For example, if you are seeking an annual return of 10%, but don’t have the time or disposition to tolerate a 40% market correction, you need to reevaluate.

Diversification might be considered the next layer of asset allocation. Just as equity returns and bond yields are not highly correlated, among equities, there are Canadian, US, International, and all the different sectors contained therein.  Because these different markets will frequently behave differently, diversification is a proven strategy to lower overall volatility and mitigate risk.

4. Invest for dividends

So after all this education and planning, what should an individual investor actually buy? Of course, there are going to be many differing opinions here, but the conclusion I have come to for myself is that it makes the most sense to primarily buy and hold blue chip dividend paying stocks. This is not because I am particularly conservative or risk averse. It is simply because over the long-term dividends have been the main contributors to total return in equity markets.  

Matt Poyner

They may not be sexy or exciting, but the evidence is clear: stable, dividend-paying stocks are the driving force of superior equity returns. In fact, one hundred dollars invested in the S&P 500 in 1940 would be worth $12,000 now if dividends were not included. That same $100 would be worth more than $175,000 now with dividends reinvested (Source: Bloomberg, Guinness, Atkinson Asset Management).

Of course, the relative contribution of dividends to equity returns has been variable. The following figure illustrates S&P 500 returns by decade:

Matt Poyner

It is interesting to note that in decades of low economic growth (1940s, and 1970s), dividends accounted for over 75% of total returns. This is in stark contrast to the 1990s where they “only” contributed to 25% of returns. The tech-euphoria of that decade seems to have fueled an appetite for capital gains over dividends, which subsequently lowered the overall dividend yield of the S&P 500. It is worth noting that, historically, this is the exception rather than the rule as investors of previous decades placed much greater importance upon dividends. There are promising signs this trend may be reversing.

My Portfolio

So, after seven years of reading CMS and most other recommended reading materials I could get my hands on, what does my portfolio look like? I believe recommendations are more compelling if they are coming from someone with skin the game, so to speak. So, although my choices will not be right for everyone, here is what works for me:

Matt Poyner

The journey of this DIY investor has been engaging, enlightening, and sometimes unnerving. I don’t have a product to sell, a service to offer, or a book to promote. I simply hope that by sharing my hard-won lessons, one of you may find something here to help you achieve your financial goals.

Matt Poyner is a DIY investor and participant in the

Oshawa Shareclub. matt.poyner@gmail.com

Figure 1: Historical total return of stocks within the S&P500 between

1972 and 2010. Source: Ned Davis Research, December 31, 2011