Friday, August 28, 2020

Short Takes: Socially Responsible Investing, Future Returns, and more

Here are my posts for the past two weeks:

The Intelligent Investor

Count on Yourself

Here are some short takes and some weekend reading:

Mr. Money Mustache explains an easy way to go about socially responsible investing.  He also describes all he is doing in this area.

Justin Bender estimates future return rates for Vanguard Canada’s asset allocation ETFs (VCIP, VCNS, VBAL, VGRO, VEQT).  They’re not very high because stock and bond prices are very high right now.

Neil Gross
isn’t impressed with proposed changes to the Ontario Securities Commission’s mandate.

Big Cajun Man is getting free online access to his credit report due to a data breach.  It’s crazy that he can’t get them to spell his name right.  My TransUnion credit report swapped my home address with my brother’s home address for a few years, and I can’t get that fixed either.  They even use this address in authentication questions before they’ll send me a free credit report.

Tuesday, August 25, 2020

Count on Yourself

Author and personal finance columnist Alison Griffiths wrote the book Count on Yourself aimed at beginning investors to teach them do-it-yourself index investing.  She takes a gentle approach starting with interesting stories and working in financial material slowly.  This approach works well initially, but the final range of recommendations allows so many possibilities that many readers will remain confused about what to do with their investments.  Published in 2012, much of the detailed information about discount brokerages and index ETFs and mutual funds is now out of date.

A strong part of the book is the explanation of why low-cost index investing is better than the expensive mutual funds most Canadians own.  She makes this case with stories and case studies presented in a way that is accessible to the many Canadians who know little about investing.  Today, you could simplify the recommendations for the novice investor down to just choosing one of Vanguard Canada’s asset allocation ETFs.

Griffiths shows that she gets people’s aversion to figuring out the many financial aspects of their lives: “Have you ever compared extended medical/dental plan rates among the various insurers?  I have.  It takes days and brings on a sudden urge to clean the basement.”  She recommends trimming the list of financial things in our lives, including credit card balance insurance, retail credit cards, and extended warranties.

Much of the first half of the book is aimed at women, including some musing about “if all the world’s financial affairs had been turned over to women.”  In my limited experience, many male leaders are self-centered and ruthless, and when a woman rises to the top, she’s not much different.

One piece of bizarre advice is if you have a high tolerance for risk, “go ahead and be a day trader, dabble in foreign exchange, or play the options market.”  It’s one thing to increase your expected return with higher-risk assets, like more stocks or small-cap value stocks, but it makes no sense to do things that reduce your expected return.

Another piece of advice that makes little sense to me is to avoid owning stocks in a TFSA.  For anyone using a TFSA for short- or medium-term savings, this makes some sense.  However, some investors, like myself, use TFSAs for long-term savings.  There’s nothing wrong with owning stocks in a TFSA in this situation.

To reduce the numbers of ETF choices, Griffiths stated the criteria she used for selection.  I liked the bond ETF criteria: avoid high yield bonds, longer-term bonds, and MERs over 0.5%.  She says that “bonds have a specific job to do in a passive portfolio, and that is to provide income safety.”

One piece of advice you don’t see many places is to allow small monthly contributions to build up for a few months before investing to reduce commission costs.  For investors who pay commissions when buying ETFs, this is sensible.  The same would apply for selling investments after retirement.

Another curious piece of advice “for the math challenged” who “have trouble working out percentages”: “call up your brokerage … and tell them how much you have to invest and what your breakdown (asset allocation) is, and they’ll tell you how many units you should buy.”

In conclusion, parts of this book may be useful for novice investors who need to be eased into understanding personal finance, investing, and the rationale for avoiding expensive mutual funds.  However, the detailed recommendations are too complex and now out of date for this type of reader.

Thursday, August 20, 2020

The Intelligent Investor

Warren Buffett credits Benjamin Graham with writing “by far the best book about investing ever written,” The Intelligent Investor. It holds a mythical status among value investors. Graham produced four editions from 1949 to 1973. I read the revised edition, which is Graham’s 1973 edition with added material from Jason Zweig in 2003 to explain parts of the book and to add more modern examples.

For anyone planning to read this book, I recommend Zweig’s revised edition. Graham’s writing is at times subtle and indirect, and assumes knowledge of historical context that may be unfamiliar to readers so many decades later. Zweig does an excellent job of clarifying Graham’s meaning at critical points.

This book is filled with Graham’s widely-quoted ideas, including the distinction between investors and speculators, the Mr. Market parable, and margin of safety. I won’t explain these ideas here.

The most remarkable part of the book is in Graham’s 1973 Introduction:

“The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor. We have some doubt whether a really substantial extra recompense is promised to the active investor under today’s conditions. But next year or the years after may well be different. We shall accordingly continue to devote attention to the possibilities for enterprising investment, as they existed in former periods and may return.”

What intellectual honesty! He is saying that while his methods worked in the past, they may not work any more because markets have changed. A few years later (1976), Graham was more certain about the demise of his value investing ideas:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

One may ask what value this book has if its author no longer believes in its ideas. One answer is that some parts of the book are relevant to investors who have no intention of picking individual stocks, particularly Zweig’s added material. Another answer is that readers who decide to pursue value investing despite Graham’s warnings will benefit. They may not beat the market, but Graham’s ideas will help them limit downside risk.

In an appendix, Buffett convincingly defends the existence of superior investors (who were Graham’s students) against claims that efficient markets eliminate this possibility. This material comes from a speech Buffett made in 1984, well after Graham gave up on his stock-picking methods. One way to reconcile this seeming contradiction is that Graham’s best students found ways to grow beyond his teachings to outperform through stock picking in later, more difficult markets.

This fact may give the modern aspiring value investor hope. However, each new decade has seen a big increase in competitiveness of markets. Even the great Buffett seems unable to outperform any more. It may be that he is working with too much money or that he’s too old now. But it might be that markets keep getting harder and harder to beat. Even if Buffett is still a superior investor in today’s competitive markets, other value investors have to question whether they are elite enough to beat the market. And if they can’t, they are getting zero compensation (or even negative compensation) for their extra effort compared to just buying index funds.

Anyone can “equal the performance of the market averages” by “owning a representative list” (index investing). But Graham warned: “If you merely try to bring just a little extra knowledge and cleverness to bear upon your investment program, instead of realizing a little better than normal results, you may well find that you have done worse.” Unfortunately, the definition of “just a little extra knowledge” has grown substantially as markets have become more competitive.

One area that Graham warned investors to avoid was Initial Public Offerings (IPOs). He said they come out in force in bull markets and investors get burned. The tech bubble in the late 1990s showed that not much has changed.

Some of Graham’s teachings are relevant to all stock investors whether they pick individual stocks or not. “It is absurd to think that the general public can ever make money out of market forecasts.” Investors shouldn’t allow themselves “to be stampeded or unduly worried by unjustified market declines.”

Some of the best quotes in the book come from material added by Zweig:

On Jim Cramer’s stock picks: “By year-end 2002, one in 10 had already gone bankrupt.” “Perhaps Cramer meant that his stocks would be ‘winners’ not ‘in the new world,’ but in the world to come.”

On the Motley Fool: “The Foolish Four … was one of the most cockamamie stock-picking formulas ever concocted.”

On asset allocation percentages: “Once you set these target percentages, change them only as your life circumstances change. Do not buy more stocks because the stock market has gone up; do not sell them because it has gone down.”

When a company is “paying a fat dividend on its preferred stock,” “you should approach its preferred shares as you would approach an unrefrigerated dead fish.”

On Peter Lynch’s “buy what you know”: “To his credit, Lynch insists that no one should ever invest in a company, no matter how great its products or how crowded its parking lot, without studying its financial statements and estimating its business value.”

“You and no one but you, must investigate (before you hand over your money) whether an advisor is trustworthy and charges reasonable fees.”

On index investing: “By enabling you to say ‘I don’t know and I don’t care,’ a permanent autopilot liberates you from the feeling that you need to forecast what the financial markets are about to do–and the illusion that anyone else can.”

“Day trading–holding stocks for a few hours at a time–is one of the best weapons ever invented for committing financial suicide.”

“The single best choice for this lifelong holding is a total stock-market index fund. Sell only when you need the cash.”

“Late in his life, Graham praised index funds as the best choice for individual investors, as does Warren Buffett.”

On what it takes to pick stocks: “begin by downloading at least five years’ worth of annual reports.” “Then comb through the financial statements.” This should be enough for most individual investors to realize that they’re not really stock-pickers. “If the steps in this chapter sound like too much work to you, then you are not temperamentally well suited to picking your own stocks.”

On mutual fund studies: “mutual funds, on average, underperform the market by a margin roughly equal to their operating expenses and trading costs.” This “has been reconfirmed so many times that anyone who doubts them should found a financial chapter of The Flat Earth Society.”

On covered call strategies: “For individual investors, covering your downside is never worth surrendering most of your upside.”

“For most investors, diversification is the simplest and cheapest way to widen your margin of safety.”

Despite being revered by value investors, it’s doubtful that this book will help anyone beat today’s markets. However, anyone who intends to try to beat the markets should consider this book to be mandatory reading, if for no other reason than to limit losses. Graham gave up on his stock-picking methods, and so should almost all individual investors.

Friday, August 14, 2020

Short Takes: Seeing the Past with Rose-Coloured Glasses, Hardest Decision in Investing, and more

I wrote one post in the past two weeks:

What the Experts Get Wrong about Inflation

Here are some short takes and some weekend reading:

Rob Carrick and Roma Luciw discuss housing costs for young people today. I had to laugh at remarks in the second half by Bridget Casey. It’s true that certain aspects of modern life are more challenging for young people than they were a generation ago. Even adjusting for inflation, rents are higher, university costs are higher, and finding full-time work is harder. However, her characterization of what life was like back in the 1980s was way off. If I could be young again, I’d rather do it in 2020 than go back to the 1980s.

Steadyhand offers help to investors who sold out of stocks during the recent crash and are now faced with the hardest decision in investing: how to get back in.

Big Cajun Man has a set of heuristics for what to do with savings. There are exceptions to his rules, but you could do a lot worse than his plan.

Tuesday, August 4, 2020

What the Experts Get Wrong about Inflation

“In the following analysis, we assume future inflation of 2% per year.”  How often have you seen something like this in investment projections or other financial analyses?  This kind of assumption leads to biases that can invalidate a financial analysis.

Even the great Benjamin Graham wasn’t immune.  In the early 1970s, he wrote the following in his book The Intelligent Investor:

“Official government policy has been strongly against large-scale inflation, and there are some reasons to believe that Federal policies will be more effective in the future than in recent years.  We think it would be reasonable for an investor at this point to base his thinking and decisions on a probable (far from certain) rate of future inflation of, say, 3% per annum.”

The following footnote was added by Jason Zweig in a revised edition of Graham’s work:

“This is one of Graham’s rare misjudgments.  In 1973, just two years after President Richard Nixon imposed wage and price controls, inflation hit 8.7%, its highest level since the end of World War II.  The decade from 1973 through 1982 was the most inflationary in modern American history, as the cost of living more than doubled.”

Readers may think I’m calling out Graham for his wrong guess about inflation.  This isn’t my point.  Graham’s mistake was that he guessed at all.  Future inflation is unknown.  Just as we treat future stock returns as a range of possibilities, we should be doing the same thing with inflation. 

We might guess that annual inflation over the next decade is likely between 1% and 3%.  But we can’t say for sure that it won’t shoot up above 5%.  You may judge this to be unlikely, but do you really want your financial security to depend on inflation definitely remaining below 3%?

The biggest effect of assuming future inflation to be at some known level is to make long-term bonds seem safer than they really are.  Once we consider the possibility of rising inflation, 30-year government bonds look a lot riskier.

Because inflation affects how much we can get for our money in annual spending, it’s better to focus on investment returns after subtracting inflation (called “real returns”).  Stock markets look volatile no matter how we view them.  Their nominal returns are volatile.  So are their real returns.  Even if we just treat inflation as a known constant, stock returns are volatile.

However, a 30-year government bond looks very different depending on how you think about inflation.  The bond’s nominal return over the full 30 years looks completely safe.  If we assume inflation stays at some fixed level, the bond still looks completely safe.  But if we correctly assume that future inflation is unknown, the bond suddenly looks a lot riskier.

I have no reason to think Graham would make the mistake of investing everything in 30-year government bonds; he understood the risk of high inflation.  But many people who use spreadsheets and Monte Carlo simulation tools don’t understand the implications of fixed inflation assumptions on their simulation results.  Personally, I avoid all long-term bonds.

When we run financial projections assuming fixed inflation, we make bonds (particularly long-term bonds) look safer than they really are.  We need to get out of the mindset of trying to guess a single value for future inflation and treat it as uncertain.