Building Your Own Index with Individual Stocks

Long-time reader, Gene, asked the following good question.

“Have you considered making a pseudo index fund by buying perhaps 15 large-cap stocks from each of Canada and the USA that would mimic an index? Not ideal for a growing portfolio, but for a relatively-stable account, and low commissions, it could save money on fees. Drawbacks are that it would be harder to increase or decrease holdings, and the savings wouldn't be huge over already inexpensive ETFs.”

Gene is right that a carefully-run stable portfolio of stocks can cost less in fees than index ETFs. However, an important issue is how well such a portfolio would track its index. For an answer here, I turn to Meir Statman’s paper How Many Stocks Make a Diversified Portfolio? Table 1 of this paper shows how the standard deviation of portfolios varies with the number of stocks you own.

At this point, I need to diverge to a topic that few investors understand well: volatility losses. Consider a very simple example. In case 1, if you have a $100,000 portfolio and earn 0% two years running, your portfolio value stays the same. But in case 2, if you gain 10% (to rise to $110,000) and then lose 10% (to drop to $99,000), you’ve lost 1% overall. In both cases your average return is the same (0%), but the volatility of case 2 induced a 1% loss. This is what I mean by volatility loss.

A simple rule of thumb is that the yearly volatility loss due to compounding is about half the square of the standard deviation. So, in Statman’s Table 1, the index has a volatility of 19.158% (or 0.19158). The volatility loss is then 0.0184, or about 1.84% per year.

The table has no entry for 15 stocks, but if we average the lines for 14 and 16 stocks, we get that the standard deviation of a 15-stock portfolio is about 22.465%. This corresponds to a volatility loss of 2.52% per year. This is 0.68% per year more than the index’s volatility loss. However, I pay only 0.21% per year in MERs on my ETFs. So, it’s clear from this analysis that I’m better off with my ETFs.

Of course, Statman based his table on a particular historical period of stock returns. If we repeat the analysis using different data, we’ll get different results. However, the gap between 0.68% and 0.21% is large enough that any analysis that results in the 15-stock portfolio being better is likely contrived.

This is the primary reason why I don’t try to construct my own index. Other reasons are ease of maintaining a portfolio of ETFs and a much reduced likelihood that I’ll get overconfident and tinker with individual stocks.

Short Takes: Unreasonable RRSP Transfer Delays and more

I reviewed two books this week:

How to Make Money in Stocks: Getting Started

Managing Alone

Here are my short takes and some weekend reading:

Tom Bradley at Steadyhand calls out big financial institutions for the maddening way they delay RRSP transfers.

Financial Crooks has some sensible advice about hot water heaters.

Preet Banerjee appeared on The National in a panel on the cost of credit card reward programs.

Big Cajun Man says that credit cards are making us fat, stupid, and lazy. I think credit cards will have to get in line behind television and beer.

Million Dollar Journey explains how to roll a covered call position. Please don’t try covered calls until you can explain why the premiums you collect are not free money.

Managing Alone

Losing a spouse is a devastating event that hurls difficult changes into the surviving spouse’s life, not the least of which are the financial changes. Financial advisors Jennifer Black and Janet Baccarani wrote the book Managing Alone to explore these financial challenges. The book’s style is to illustrate financial planning concepts related to the death of a spouse using detailed real-life stories.

Peeking in on the lives of several couples makes this short book easy to read in a single sitting. Each story illustrates different aspects of coping financially with losing a spouse. The authors take a subject that is ordinarily quite boring and turn it into a page-turner.

A common theme in the stories is the great help people get from working with a financial advisor. This shouldn’t be too surprising because the authors are financial advisors. No doubt working with a good financial advisor would be of great help at a difficult time. But working with a bad advisor would likely be painful and expensive.

Overall, I recommend this book as an easy-to-read introduction to some of the steps people can take to ease the financial difficulties that can come with losing a spouse.

How to Make Money in Stocks: Getting Started

Occasionally I make a point of reading books or articles whose messages are at odds with my own thinking. Every once in a while this leads me to change my thinking, such as when I decided to stop picking stocks and focus on low-cost index investing. It was in this spirit that I read How to Make Money in Stocks: Getting Started.

Author Matthew Galgani, co-host of the How to Make Money in Stocks radio show, seeks to show new investors how to use a particular system of short-term trading. This system, called CAN SLIM, primarily involves chart reading in an attempt to make money riding the momentum of stocks on the rise.

A positive for the system described in this book is that it is quite specific in a number of ways. In many cases is gives precise rules on when to buy or sell stocks. For example, the author says “if a stock drops 7% to 8% below what you paid for it, sell.” The author also gives some precise buy and sell prices based on stock chart patterns.

Unfortunately, there are enough competing trading rules in this book that when you try to apply them to real stock charts, you usually end up with ambiguous signals. The author acknowledges this saying “investing, after all, is not an exact science. Few stocks ... are picture perfect in every single respect.”

These ambiguous signals make it difficult to evaluate the trading system. For example, suppose I buy a stock that then tanks. My tendency would then be to focus in on the signals pointing to weakness and decide that I made a mistake. But the reality is that there were positive signals as well. If I always look back at the system’s signals that pointed in the correct direction and ignore the ones that got it wrong, then I will tend to blame myself for poor trades instead of blaming the system.

So, after reading the entire book and attempting to apply all the rules to real stock charts, I’m left with no evidence one way or the other whether CAN SLIM works or not. So, I decided to look at CAN SLIM Select Growth Fund (CANGX) which was launched in 2005.

If the CAN SLIM system has any value for new investors, presumably CAN SLIM experts can make it work. According to Yahoo Finance, CANGX is a mid-cap growth fund. From 2005 Oct. 5 to 2013 July 19, the MCSI mid-cap growth index grew by 84%. During the same period, CANGX grew by only 53%. On average, CANGX trailed its benchmark by 2.3% per year.

If CANGX is run by CAN SLIM experts who can’t beat their index, what hope do new investors have? Galgani says “you do not have to be at the mercy of the market. You can see the right time to get in—and out.” However, the evidence suggests that CAN SLIM can’t help you to do this. The author derides “buy and hold investing,” but CANGX lost to a buy and hold strategy.

Despite giving this book a fair shake, in the end I find it to be mostly an extended ad for Investor’s Business Daily. The book offers advice steering new investors to a strategy filled with uncompensated risk.

Short Takes: Failing to Achieve Market Returns and more

In another hot and lazy summer week a broken computer inspired a post:

Personal Computer Costs and Trade-Offs

Here are my short takes and some weekend reading:

Canadian Couch Potato has some very sensible thoughts on the search for market-beating returns.

My Own Advisor lists the investment and personal finance principles he lives by.

Big Cajun Man says that changes in his tax return from one year to the next trigger requests from CRA for proof.

Financial Crooks digs into how dividends are handled in the Canadian and U.S. dollar sides of a brokerage account (and admits to a misunderstanding about dividend dates).

Personal Computer Costs and Trade-Offs

My family uses computers quite a bit. We have a desktop machine for each of us. We’ve had quite a bit of success with hitting the right combinations of options to keep the costs per year low. When my wife’s computer finally stopped working, we had to go through the process of choosing options once again.

Everyone has different ideas about what work they’re willing to do to keep a computer running. My list is roughly one item long: pay money. If some component in the tower breaks, the whole tower goes. If the machine has too little memory for my needs, then the whole tower goes. If the operating system gets too corrupted to fix without reinstalling it, then the whole tower goes; the several times I’ve tried wiping a hard disk and starting over have not been worth the effort. I’ll work hard to save my data, but then the tower gets replaced.

In the past, I usually chose to upgrade from the minimum RAM, hard disk, and processor to get a machine that would last 5 or 6 years instead of the roughly 2 years that a bare-bones machine can be expected to last. But, things have changed. Processors are more than powerful enough for my wife and me. Hard disks have far more capacity than we need for most things; we use an external drive for backups.

So, that just leaves RAM. Most of the cheap desktop specials we see have had 8 GB of RAM. This is enough for us today, but it seems likely that applications will keep getting fatter and hogging more RAM. My gut feel is that doubling the RAM to 16 GB will extend the computer’s useful life from 2 years to about 4 years. If I’m right, then this is a good upgrade because it certainly doesn’t double the computer’s price.

I’m interested in other ideas for keeping yearly computer costs down without sacrificing usability.

Short Takes: Mortgage Rules Effects, Currency Conversions, and more

During this lazy summer week I managed to write only one post between dips in the pool:

Retailer Strategy of Charging Less than Advertised

Here are my short takes and some weekend reading:

Canadian Mortgage Trends report that the tighter mortgage rules are doing their job to reduce the number of first-time home-buyers.

Canadian Couch Potato explains in detail the steps of using Norbert’s gambit at CIBC to save money converting from Canadian to U.S. dollars. It seems that this process is different at every brokerage.

Retire Happy Blog explains the pitfalls of the insured retirement strategy that many insurance agents pitch to their clients.

Big Cajun Man gets a good rant going about hospital parking fees. They are effectively a form of co-pay; free medical care is a myth.

Young and Thrifty pits RBC against a credit union while negotiating for the best possible mortgage rate.

Retailer Strategy of Charging Less than Advertised

I recently came to the sad realization that I needed a new pair of shorts and maybe a dress shirt too. I would have to (gasp!) go to a clothing store. For some reason these stores group everything by meaningless brand names instead of just having all the shorts or shirts of the same size located together. Even more puzzling is having my purchases ring up at the cash register for less than the marked price.

I’m pretty good at looking around for signs that say something like “25% off marked price.” So, I usually know what price to expect when I get to the cash register. But many stores (Sears and The Bay come to mind) seem to routinely charge me less than I expect.

I remember buying some socks a year or so ago and the lady at the cash actually apologized for the fact that I’d have to pay the marked price; she then suggested that I might want to go back and choose different socks! Fortunately, I declined; they turned out to be good socks.

What advantage does this give the retailer? Superficially, it would seem they are leaving money on the table. Maybe people start to count on these price reductions? But if this were true, then these retailers are making customers unhappy when there is no secret price reduction.

Another possibility is that these retailers are trying to get their customers to focus less on price. After all, what’s the point of looking at the price if you know it’s likely wrong? I’m doubtful about this possible explanation, though. I certainly pay attention to the marked price even if I suspect the real price is lower.

My best guess is that this pricing strategy makes customers feel as though they got a good deal. The most prized customers, compulsive shoppers, have an extra justification for making their purchases and are likely to come back sooner.

Short Takes: Mandatory RRIF Withdrawals, New Mortgage Qualification Rules, and more

I had only one post during this holiday-shortened week:

Dividends More Stable Than Capital Gains

Here are my short takes and some weekend reading:

Dan Bortolotti has a very sensible take on mandatory RRIF withdrawals.

Canadian Mortgage Trends reports the details of new debt-ratio rules to qualify for insured mortgages. What amazes me about these rules is how deep a debt hole you can dig for yourself even if you stay within the new bounds.

The Blunt Bean Counter announced that he is taking the summer off from blogging, but couldn’t resist helping us with his take on the new CRA Revised T1135 Foreign Income Verification Form.

Where Does All My Money Go? interviews Jonathan Chevreau in a podcast about financial independence and retirement. You can’t retire comfortably without financial independence, but you can achieve financial independence without having to retire.

Retire Happy Blog explains the difference between withholding taxes and income taxes. Focusing just on withholding taxes can be short-sighted.

Big Cajun Man isn’t too impressed with a funeral home that tried to charge $500 to dig a small hole to bury ashes.

Million Dollar Journey explains the Capital Gains Refund Mechanism (CGRM) that shifts capital gains in a mutual fund to investors who sell their mutual fund units and helps defer capital gains taxes for investors who remain in the fund. The guest writer begins this article expressing amazement at how much DIY investors pay in capital gains taxes compared to mutual fund investors. Perhaps another reason for this difference is that so much of what would have been capital gains in mutual funds gets siphoned off in fund fees.

Dividends More Stable Than Capital Gains

One of the justifications that dividend investors use to justify their belief that they will beat market indexes is the fact that dividend income is more stable than capital gains. Dividend Growth Investor recently explained this line of argument. Dividends do tend to be more stable than capital gains, but this doesn’t mean that dividend investors will beat the market over the long run.

Dividend Growth Investor says that “Investors who sell stocks to fund their retirement face the risk of selling off stocks at low prices during bear markets, which could result in asset depletion.” The implication here is that this is not a problem if you own dividend-paying companies.

However, the reason why dividends are more stable is that companies do what they can to avoid cutting dividends. Even when it is painful to pay dividends, companies tend to pay them anyway. Even if the money is better reinvested in the business, or better used for an acquisition, or the company is forced to increase debt, it often pays dividends anyway.

The paying of dividends can be as damaging to businesses during bear markets as the selling of stock is damaging to portfolios. Dividend Growth Investor offers a common answer to this: “I try to select companies that regularly pay and increase dividends, and also have the potential to increase profits over time.” Choosing better dividend stocks avoids those businesses that would be hurt the most by having to pay dividends during bear markets.

Now we’re getting to what is really behind dividend investors’ hopes of beating market indexes: stock selection. They hope to pick superior stocks just like any other active stock picker. However, there is no guarantee that great dividend-paying businesses of the past will continue to be great businesses in the future.

The best justification for dividend investing that I’ve heard is that it helps some investors stay invested when they get nervous during bear markets. The steady stream of dividends helps them stay calm and stay invested. As long as they’re adequately diversified, this makes some sense. However, I’m very doubtful of the typical investor’s ability to outperform the market over the long run with dividend stocks. A more realistic goal is to roughly match the market’s total return over time while using the comfort of steady dividends as a way to stay invested.