Wednesday, April 27, 2011

Misconceptions about Investing

I find Larry MacDonald’s Me and My Money columns interesting because they give insight into the reasoning people use for making investments. Two recent columns are about an investor who likes preferred shares and another investor who likes professional money management. In the first case I had a misconception about floating-rate preferred shares and in the second case the investor has mistaken ideas at the core of her reasoning.

Preferred Shares

Matt Byers likes preferred shares and says “Floating preferred shares are also a perfect hedge against inflation.” Typically, preferred shares pay a fixed dividend, such as $1.25 per year, and the issuer can redeem them for $25 any time after a particular date. For this example the nominal dividend rate is 5%. The issuer will redeem the shares if it can get a better deal.  However, with floating-rate preferred shares, the rate changes with prevailing interest rates.

When you buy non-floating rate preferred shares, you are owed a stream of fixed-size payments ending with a large fixed-size payment. An increase in inflation reduces the value of these future payments. This is exactly the opposite of inflation-protection. If you believe that we’re headed for a significant rise in inflation, you would not want to own these preferred shares. But, the floating rate preferred shares do give inflation protection assuming that interest rates rise when inflation rises.

Professional Money Management

Elizabeth Hoyle believes in hiring professional money managers to pick stocks. She advises us to “Invest in companies because they make wealth; governments and the index do not.” She is absolutely correct that companies make wealth, but what does she think the index is? The index is a collection of company stocks. Owning the index is the same as owning shares in every company that makes up the index.

The main reason to hire professional stock pickers rather than buy an index is to try to take advantage of bad traders to make trading profits in addition to the profits of companies whose stock you own. Both approaches are equally good at sharing in the capitalist engine of our economy. The differences are in the fees paid and trading profits or losses.

All evidence says that very few professional stock pickers can generate trading returns over the long term that make up for their fees. Further evidence says that we can’t figure out which stock pickers will be the ones to succeed.

Seeking professional financial advice can be a wise thing to do if you get useful advice on how to manage your finances and retirement planning for a reasonable cost. However, the stock-picking part of the package is usually worthless over the long term. The best chance of generating value from hiring a stock picker is to go for one that charges low fees.

Ms. Hoyle also says that “it’s not about fees – it’s about quality of management.” I’d be interested to know how she defines quality of management. By my definition, most professional money management fails miserably.

4 comments:

  1. I'm not sure I agree with you fully on the first article. IIRC, floating preferred shares means the dividend payments from the preferred shares are set at some proportion of a floating rate such as the Prime rate. I haven't looked at these closely, so I don't know if floating preferreds have tracked inflation closely in the past.

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  2. @CC: Thanks. I've made the update to reflect the fact that the misconception was mine and not Byers'.

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  3. I'm not certain Mr. Byers is right about these securities being "a perfect hedge against inflation". Returns from floating-rate preferred shares will track inflation closely (theoretically, at least) if we look only at dividends and nothing else. But these securities fluctuate in value. Unless we look at past total returns, we won't know whether they've tracked inflation perfectly or not. My suspicion is that correlation with inflation is weak at best. Even if income from these securities tracked inflation perfectly, total returns (which is what investors should care about) might be an entirely different story.

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  4. @CC: I agree that the inflation hedge isn't perfect, but the inflation protection is better than regular preferred shares.

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