Wednesday, June 23, 2010

Chuck it All and Buy GICs?

It's possible to make a reasonable argument that the average investor would be better off investing in GICs than stocks and bonds. Unfortunately, David Trahair fails to make this argument well in his book Enough Bull: How to Retire Well Without the Stock Market, Mutual Funds, or Even an Investment Advisor. So, I'll try to make it for him.

The main argument in favour of investing in stocks is their higher expected returns (called the risk premium) than guaranteed investments like GICs. However, the typical Canadian investor working with a financial advisor is invested in balanced mutual funds (half stocks and half bonds) and pays yearly fees in the 2%-3% range. To these fees we can sometimes add front-end loads and deferred sales charges. On top of that we can add the losses that come from panicking and selling at the wrong times.

Taken together, these costs eat up the risk premium. This type of investor very likely is better off with bank GICs as long as they are held in tax-advantaged accounts and the investor learns to negotiate for the best possible GIC interest rates.

Where this argument falls down is that there is another approach to investing that doesn't involve giving away your risk premium to financial “helpers”. It is called indexing. Just take your retirement savings and buy a mix of low-cost index funds. Returns will be more volatile than GIC returns, but they are very likely to be higher over the long run as long as you don't panic and sell your index funds when they are cheapest.

So, Trahair is right to compare GICs favourably to high-cost mutual fund investing, but wrong to suggest that GICs beat the simple indexing approach. The main failing of his argument is that he ignores the dividends that stocks pay. This is like saying I'm a better basketball player than Kobe Bryant if he doesn’t use his hands.

For the rest of this review, I’ll look at a few specific parts of the book.

It's different this time

Right in the first paragraph, Trahair makes the oft-repeated mistake of thinking that things are different this time: “The old rules regarding personal finance are now history, as in obsolete”, due to the 2008 stock market drop. Long-time investors know that recent history is not a good guide to the future.

Inflation

When it comes to answering criticisms of the 100% GIC approach, Trahair calls discussions of inflation a “red-herring”. It's true that inflation affects all investments, but we should be looking at real returns (returns after taking into account inflation). When Trahair implores you to “sleep at night knowing your investments will NEVER decline”, he is ignoring the fact that GIC investments can decline in terms of real purchasing power if inflation exceeds the GIC return.

To support the idea that today's very low GIC returns may rise in the future, Trahair points to the past: “Do you know what annual interest rate a GIC was paying in 1980? It was 12.36%.” Well, inflation was 10% in 1980. Many investors who had to pay income taxes on GIC interest lost purchasing power. What matters is the difference between GIC returns and inflation.

Dividends

Trahair compares historical GIC returns to historical increases in the S&P TSX Composite Index of Canadian stocks, but the problem is that this index does not include the dividends from the companies making up the index. This error alone casts doubt on the author’s competence to advise people about investing.

Personal Investing Experience

The book contains a detailed account of the author's own experience investing in equities, which was dominated by Labour-Sponsored Investment Funds (LSIFs). LSIFs are known to be very risky. Governments have had to entice investors with tax breaks to generate interest in LSIFs. Investing in low-cost equity index funds is a very different game.

Advice on Stocks

Due to the stock market performance of 2008, Trahair says “Here's my advice: get out of equities altogether if you can.” Since the end of 2008, the S&P TSX Composite Index of Canadian stocks has gone up about 37% (including dividends). Nice call.

Conclusion

Trahair has a point that the typical mutual fund investor could do better. However, better means a low-cost indexing approach rather than hiding from the world with 100% of long-term savings in GICs.

Other reviews of this book:

Canadian Capitalist
Balance Junkie
Canadian Dream: Free at 45

19 comments:

  1. It seems the author makes a number of errors which you counter well. You are exactly right, low cost index funds over the long term are the best choice for most investors as long as they can control their emotions. You are right also that one needs to look at the real return on fixed income (nominal rate minus the rate of inflation).
    For better or worse, most workers today have been put into a situation where we have to take risk because of inflation and longevity if we are going to be able to have a decent retirement. The key is to learn how to manage that risk.
    Nice write-up.

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  2. @DIY Investor: Thanks. Pressure to take on risk comes from the risk premium. Ironically, the risk premium rises as more people seek safety.

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  3. You mention that the TSX index does not include dividends. Is that really correct? And does an ETF that tracks the index not include underlying dividens as well? This is very different than my understanding.

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  4. I like the idea of index investing, but I do think there are times when you want to have less of your capital at risk in the stock market. This is one of those times.

    Your criticism of David's call on equities in 2008 is an easy one to make over such a short time period, but index investors haven't exactly ripped the cover off the ball over the past 10 years either. There's no guarantee the next 10 years won't be the same or even worse. Don't forget that the market had a similar recovery during the Depression just before it went on to make lower lows. David's call may yet turn out to be a good one.

    If we mimic the Japanese experience of the past few decades, we could be facing many more years of flat to negative returns. I don't know whether that will happen or not, but it's a definite possibility.

    I realize that you disagree heartily with me on this, but I think a wise investor is open to all possibilities.

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  5. @Anonymous: The major indexes that we see on a regular basis, like the S&P TSX, S&P 500, and DOW do not include dividends. Similarly, most index ETFs do not include dividends, but rather pay them out to shareholders (less fees). There are some specialized indexes that do track dividends, but these are rarely reported on.

    @Balance Junkie: I don't think you understand my position on these matters. You say that stocks may have a bad upcoming decade. I can't disagree because this is possible. Another possibility is that stocks will have the best decade in recorded history. All outcomes are available with some probability. I believe that on the balance taking into account all possibilities and their probabilities, stocks are a good bet to outperform other investments.

    I don't beleive that commentators have unusually good insight into the probabilities of different outcomes. So, when someone talks about the possibility of a bad decade for stocks, the implication is that this outcome has high probability. I don't believe the commentator has any useful insight into this probability. I can list possible outcomes as well as anyone, but make no claims about the likelihood of each one because I don't know. I look to the long-term history of different investments to say that I believe that stocks have a risk premium. I don't count on any particular outcome. In this sense I am open to every possible outcome.

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  6. Funny you should write this post because I've been looking at how ill-timed DT's "get out of stocks now" call has been in retrospect. I don't buy the argument that this is a cheap shot because it is DT's argument that stocks are bad because look at time period X. Well, if you look at time period Y, you get a completely different story and the argument is exactly the same that DT has employed. What's good for the goose is also good for the gander.

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  7. Nice post Michael. You counter his book and principles very well!

    For the life of me, if this is such a great strategy, why doesn't Buffett or Soros hold a bunch of GICs?

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  8. I agree that it is possible that stocks could outperform other asset classes over the next decade. It's just that I don't think that will happen and I'm not exposed very much to stocks as a result. You have the opposite view and I can respect that. I just take the other side of the trade.

    I agree with CC on the goose/gander thing. I just wanted to present the other possibility: that David could end up being correct and that it's too soon to tell. (I do realize that he could be wrong too.)

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  9. @CC: I don't really consider the observation about stock performance since 2008 to be a criticism of the GIC strategy in general. I mostly just consider it to be a funny outcome.

    @Financial Cents: Perhaps Buffett and Soros are at an age where more GICs (or the American equivalent) would make some sense. Of course, they have so much money that even a 99% drop in net worth wouldn't affect their lifestyles much.

    @Balance Junkie: I think you and I see these matters fundamentally differently. I'm not on the other side of the trade because I'm not trading. If someone guesses that a roulette wheel will come up 17 and it does, I don't consider him to have been right; I consider him to have been lucky. Similarly, if it doesn't come up 17, he's not wrong, but is unlucky. People who analyze the entire game of roulette and conclude that they should or shouldn't play can be right or wrong. I've made an attempt to analyze the entire game of investing and have come to a conclusion that may or may not be right. But, I don't spend time trying to guess outcomes that appear random to me. For the most part, I find macroeconomic matters to be random. I can believe that someone like Buffett can make better than random guesses about the long-term performance of individual stocks, but I don't believe he can make useful short-term predictions about the entire stock market.

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  10. Great post.
    I can make a reasonable arguement that one could replace there bond holdings with a 5 year GIC ladder and do better over the next 10-20 years. A portfolio of rolling 5 year GICs outperformed the DAX long bond index from 1950 though to 1990 a period with overall rising interest rates. From 1990 until know bonds have outperformed, a period of overall dropping interest rates. I know that know ones knows with any certainty what the future holds, but given the interest rate environment we are in today I think we can all agree that there is a much higher probability of interest rising over the next ten years then falling, an environment in which GICs have historicaly outperformed bonds.
    That being said I feel pretty much everyone should hold some equities. Even if it is just 20% to protect against inflation.

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  11. @Ryan: On one level it makes sense that GICs would outperform government bonds because investors need to be paid for the lower liquidity.

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  12. Nice review.

    The other problem I notice is that we try to apply cookie-cutter approaches to a variety of different situations despite differences in risk tolerances and personal needs. GICs are not risk free and neither is anything else. But telling someone who really has no risk tolerance to invest in XIU is not necessarily a good idea. A 'risk premium' implies that you are trading security for money. What if more money has little or no value to you, but not losing money has a lot of value to you? Then the risk equation is different. For instance an index fund of bonds is potentially just as 'valuable' as an index fund of stocks. Also, the bond index IS paying you for the inflation risk. This 'inflation risk' premium can be measured by the difference between the return on a bond index fund and a real-return bond index fund. I think for older investors this kind of thinking is important because I see a lot of soon-to-be retired folk invested heavily in stocks.

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  13. @Anonymous: I agree that people have different risk tolerances. These can arise due to differences in real needs and differences in temperament. For people with low risk tolerance, bonds can be risky as well. If you buy long bonds, unexpected increases in inflation or interest rates can cost you money.

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  14. When I lived in Australia in the late 90s, one of the leading investment magazines published an article "proving" that real estate was always a better investment than equities. They did so by using a 10 year time frame and then publishing a host of accurate data and sure enough real estate came out on top of equities by a decent margin.

    I forget the exact date of the magazine's edition but it was roughly August 1997. So what was going on 10 years before August 1997? August 1987? Anybody remember what happened a couple of months later? The biggest crash since the great depression. Obviously if you were to buy at the very top of the market and were forced to sell 10 years later, equities wouldn't have looked like a particularly smart idea. Ditto in this day and age perhaps.

    (Incidentally, a bit of research showed that the article's author was heavily involved with the Real Estate Industry.)

    My point, obviously, is that you can always 'prove' that such-and-such an investment is better than another investment by carefully choosing the time period for comparison. What counts is how investments do over the long run (i.e. decades) and over the long run, equities rule hands down.

    If you are a market timer with some expertise, then by all means time the market. Otherwise, if you are like the rest of us, then stick to index funds and invest for the long term and avoid GICs other than when constructing a balanced portfolio perhaps.

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  15. @Mark: Unfortunately, investing hot tips are always easiest to sell to people when they are bad advice. It's easy to convince people that investing in an asset class is a good idea just as that asset class is peaking.

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  16. My mutual funds, with equities, add up to nearly the same dollar amount now as they were in 2006, two years before the crash. My GIC account keeps rising - it never goes down - even though the return is only keeping up with inflation. So what. At least I'm saving money. The stock market is for the insider trader only. It relies on us suckers, the little guy, to help plump it up, but it's gambling for the rich.

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  17. @Bob: If your mutual funds are typical of the equity funds available in Canada, you've been paying a high price to own them through a period where stocks did not perform well.

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  18. I came across your article today and found it and the comments very interesting. Disclaimer: I am in the financial services industry as a deposit broker that provides the highest gic rates from over 40 financial institutions across Canada for over 6000 clients. I don't say this to promote my business, since I won't include my business name or any links. It is important that you also know I was a financial advisor for over 18 years and I have always advocated a balanced approach to investing.

    My primary reason for commmenting here is to say that when it comes to investing, there is no magic bullet. All forms of asset classes carry risk, and the performance of these assets can be made to look good or bad depending on the time frame one chooses to look at.

    That being said, I do believe that GIC's get a very bad rap by financial advisors, stock brokers and the "investment community" in general. And, in my opinion, most of that stems from only looking at the GIC rates offered at the retail level of the banks, trust companies and credit unions. Yet with a little research, a person could find GIC rates that are, on average 1% to 1.5% HIGHER than the rates at the retail branches at many of these same institutions. As noted in comments above these GIC rates will beat Gov't of Canada Bond yields, but they will also beat T-bill rates, bankers acceptance rates and other forms of fixed income investments.

    With these higher GIC rates, the after inflation return arguement in today's environment doesn't hold up well either, since the most recent inflation rate is hovering around 1.3% according to Stats Canada, and GIC rates available through a broker are 2.15% and higher. Furthermore, if held in a registered plan, the after tax issue is not applicable either. GIC's can and should form part of a balanced portfolio, since no one asset class always outperforms the other asset classes.

    At the end of the day, investing in any asset class comes down to individual preference, knowledge, suitability and risk tolerance.

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  19. @Voyager1971: You make a number of good points. In particular, the point about not taking the posted GIC rate from big banks is very important. GICs are definitely a reasonable choice for the fixed-income part of a portfolio. However, a 100% GIC portfolio as Trahair advocates makes little sense for people with decades of life left.

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