Monday, January 11th, 2010
The latest issue of Consumer Reports magazine features an article that looks at why infomercials(and the legend of Billy Mays) are so popular. These ads are carefully scripted to set-off a chemical in your brain called dopamine that typically leads to irrational, compulsive decision-making. This dopamine “high” only lasts for 5-6 minutes, hence the reason so many of infomercials tell viewers to “act now”.
What’s interesting is that dopamine has also been identified by researchers in the field of neuroeconomics (which combines neuroscience, economics, and psychology to study how people make financial decisions) as the cause for imprudent, short-sighted investment decisions.
Not surprisingly, dopamine tends to be released in the brain more frequently when market volatility increases. This is precisely why it’s so important for investors to always make rational, long-term investment decisions based on facts and strategies, not emotion.
Investing Facts
With that in mind, to kick off your week I thought it would be helpful to provide you with a few market facts you might find useful:
- 2009 was the 22nd best year ever for the S&P 500 Index going back 128 years (as far back as data is available). The index however, is still 29% off its 2007 high.
- Despite rising over 30% last year, the S&P/TSX Composite Index is still about 18% below the high water mark it set in July 2007.
- Last year, the MSCI World Index rose 27% in US$ – its biggest annual gain since 2003 and proof that diversifying globally is still an important investment strategy.
- After peaking in November 2008, the VIX index – a closely watched measure of stock market volatility – fell 75% in 2009, a record annual drop.
- After an outstanding 2008, U.S. government bonds ended 2009 with their worst one-year performance in three decades. Despite this, and an improving environment for stocks, flows into mutual funds in the US are still running at five to one in favour of fixed-income assets over equity markets.
Although infomercials and investments are worlds apart, consumers and investors alike, need to make rational decisions based on facts and their long-term needs. For investors, a key success factor is having a well developed investment strategy, complete with rules in place. With a strategy, like investing in dividend growth stocks, you can turn to your stock selection strategy rather than Tony Little or Vince Offer - my personal favourite.
Slap Chop anyone?
Posted in Investor Education | 1 Comment »
Wednesday, November 5th, 2008
A few weeks ago I wrote an article titled Panic or Profit and many folks thought I was just spouting theory. While that may be, the recent evidence of my “theory” has been proven at least half true thus far.
According to the Globe and Mail, panic sticken investors in Canada pulled a record $8.45-billion from the mutual fund market in a stampede for the exits. It was the worst month for net outflows since the Investment Funds Institute of Canada (IFIC) began collecting data in 1990, and nearly doubled the previous record posted in September, which saw net outflows of $4.5-billion.
Panic Selling
Of course many will be inclined to argue that those who pulled thier funds from the market in early October were smart and can now re-invest at lower prices. While this is true, the figures shown are net outflows for the month – so we’re not talking about trading or churning of these funds. This data is a decent representation of those investors who panic-sold.
Further to this point, most seasoned traders, who would be more inclined to recognize the market conditions and sell their holding to re-invest at a later date are likely not invested in mutual funds, but rather individual securities.
One such example of an individual who panic-sold is Norman Bambrick, a 72-year-old retiree in Port Perry, Ont. He bailed out of his bank fund after seeing his $200,000 investment in two accounts take a $12,000 haircut in 10 months.
“The funds didn’t work out for me and I cashed them,” Mr. Bambrick said.
“I had a feeling that they were headed for a disaster,” he said. “I had no confidence in them.”
What is even worse about this example is that the gentleman suffered just a 6% loss to his portfolio. This is an indication that he has received some incorrect advice about his risk tolerance and the investments that he holds.
Understand Your Risk Tolerance
If Mr. Bambick could not tolerate a 6% loss to his portfolio, he should not have been invested in those vehicles. At 72 years old, with such a low risk tolerance and relying on his portfolio for income, Mr. Bambick should likely be invested in Guaranteed Investment Certificates (CD’s in the USA) and Fixed Income securities only. Fortunately, that is exactly what Mr. Bambick did with the proceeds from the sale of his funds.
While this example is of an investor who was not likely in the appropriate asset allocation for his situation, it is still an example of panic selling. When we sell out of fear instead of understanding our fundamental reason for selling we often lock in losses. And, by the time we get up enough “courage” to return to following our original investment plan (when general market sentiment turns positive), we have often missed out on the initial upside gain.
The moral of the story is this:
- If you were lucky/smart enough to cash out before the downturn – don’t be too late to re-invest those proceeds because prices are much more attractive now.
- If you panic-sold during the downturn get prepared and develop a plan that is comfortable for you. Don’t miss out on potential gains when the market turns the corner.
- If you have been holding throughout, stick with your plan because this time is not different and equities will rebound as market uncertainty eases and we return to the fundamental valuations.
I personally fall into category number three and have been buying dividend growing stocks and some index ETF’s over the past 5 weeks.
Which category are you in?
Posted in Investment News | 6 Comments »
Thursday, August 14th, 2008
A recent column by Trent over at The Simple Dollar debated the merits of saving for retirement versus paying down debt. I have also written previously on the subject of paying down debt and how I received a guaranteed 8% Return on my investment, prompting further discussion of this topic.
Why even write this article? Everyone knows they should be paying down debt and saving for retirement simultaneously…or should they?
Let’s take a look.
The Math
When we are investing for retirement we will eventually have to pay tax on the invested funds and the gains made by those investments (unless we invest in a Roth IRA).
The previous point is the key because paying down debt provides us with an absolute guaranteed return equal to the amount of the interest rate we are paying on the loan. Conversely, investing for retirement requires that tax be paid on the money when the investment is cashed in or withdrawn from a sheltered account.
Simply put, this means that we must achieve a pre-tax return on investment (ROI) that exceeds the interest paid on debt by the amount that the investment return will be taxed.
Adjust The Return For Risk
In addition to having to exceed the rate of return offered by paying down debt, the investment must also be adjusted for the additional risk that you are taking on by choosing to invest in stocks etc. versus the “risk free rate” of paying down debt.
The risk free rate is typically defined as the rate that is currently paid on 90-day US Treasury bonds. However, repayment of debt is also risk free at the rate of interest paid on the debt.
A typical measure of Risk vs. Reward is the Sharpe Ratio. Typically speaking the higher the Sharpe Ratio the greater the return for the same amount of risk. Of course, when there is virtually no risk, as in debt repayment or 90-Day treasury bonds, then there is no variability of returns and the Sharpe ratio will not apply.
Calculating the Sharpe Ratio
Suppose the asset has an expected return of 15% in excess of the risk free rate. We typically do not know the asset will have this return; suppose we assess the risk of the asset, defined as standard deviation of the asset’s excess return, as 10%.
The risk-free return is constant.
Then the Sharpe ratio (using a new definition) will be 1.5 (R = 0.15 and ? = 0.10).
As a guide post, one could substitute in the longer term return of the S&P500 as 10%. Assume the risk-free return is 3.5%. And the average standard deviation of the S&P500 is about 16%.
Doing the math, we get that the average, long-term Sharpe ratio of the US market is about 0.40625 ((10%-3.5%)/16%).
But we should note that if one were to calculate the ratio over, for example, three-year rolling periods, then the Sharpe ratio would vary dramatically.
What Does This All Mean?
I strongly urge that when you review your asset allocation that you take a look at the amount of money that you allocate to fixed income investments.
Why just fixed income?
Fixed income investments, such as bonds, are the closest thing that is comparable to one’s debt or more specifically a mortgage.
In light of the risk adjusted return calculations, it is possible to get an acceptable return on investments in equities but highly unlikely that an investment in bonds or other fixed income that could beat the return (especially after tax) from paying down debt.
Because of this, I highly encourage investors with outstanding debt (including a mortgage) to consider allocating the “fixed income” portion of their portfolio to reducing debt. It makes sense mathematically, it helps improve your credit score and it feels good to know that your debt is being reduced more quickly than originally planned.
Posted in Investor Education | 3 Comments »
