Everyone would like to hear how they can become an instant millionaire. Buy a lottery ticket and hope. Unfortunately, that’s not a very sound financial strategy for dealing with your life savings. What if I told you that you can likely become a millionaire anyway, but the path is slow and boring? If you’re a thrill seeker, you’ve probably already stopped reading. If you think that being a millionaire would be cool even if it takes some time, keep reading. Achieving financial independence through investing can be a lot easier than you might expect.
Rational Investing: Controlling Losses
I recently read the book What I Learned Losing A Million Dollars, by Jim Paul and Brendan Moynihan. The book was originally self published, as publishing companies were reluctant to print a story of a loser rather than the more inspiring success stories that people generally prefer to delude themselves with. This book is worth reading for any investor. A smart man learns from his mistakes; a wise man learns from the mistakes of others.
Jim Paul had made millions and lost it all. When he tried to recover and make money again, he realized that most of his success was luck, not skill. He began studying “the experts” to see what advice wealthy people would have for making money, but he only found contradictory statements and confusion. Finally it dawned on the author that wealthy people haven’t figured out some secret money making strategy. Their secret is that they’ve learned to control their losses by dealing with their emotions and psychological factors that cause people to make bad decisions.
The authors define five psychological activities people perform when risking money. They stress the importance of understanding that any financial activity can fall under any of these categories. The types of investments you buy have nothing to do with the mindset you have when owning them. People may believe they are investing when they are speculating, or believe they are trading when they are actually gambling.
- Investing: devoting money to an activity with intrinsic value that provides adequate returns over a long time period
- Trading: purchasing assets for sale to someone else, at a higher price
- Speculating: similar to trading, except the asset is expected to appreciate in value over time
- Betting: a wager where the primary goal is being right about some claim
- Gambling: similar to betting, where the primary goal is entertainment
People lose money when they have a bettor or gambler’s mindset. Money managers who get emotional about their investments care about excitement or being right, and are very likely to lose a lot of money. To my surprise, I found Stoic advice in this finance book as well. One of the main reasons people lose money is that they personalize the market; they fail to internalize their goals. The authors quote Nathaniel Brandon’s book The Psychology of Self Esteem:
A person’s self image “should not be dependent on particular successes or failures, since these are not necessarily in a man’s direct, volitional control and/or not in his exclusive control. If a person judges himself by criteria that entail factors outside his volitional control, the result, unavoidably, is a precarious self-esteem that is in chronic jeopardy.”
After doing investing research for several months, I’ve decided that as a young person with a long time to invest, I will adopt a buy-and-hold investing strategy based on the Efficient Market Hypothesis (EMH). For people with a math background, I would recommend reading A Random Walk Down Wall Street, and The Four Pillars of Investing to provide the details of the EMH. For people without a math background, you have a few options:
- Study some math and then do your own research as I did
- Find someone you understand and trust to advise you
- Accept the cost of ignorance and settle for simpler lower-payoff investments you understand
When I started doing investing research, I very quickly felt like I was going in circles. There’s a lot of crap about making money, but very little useful information. Even for people familiar with math, it can be confusing to sort out what’s useful, from what is too complicated, or just plain wrong. The rest of this post I will dedicate to describing my understanding of what I’ve read, and the strategy I decided to follow.
An investor is looking to find an activity with intrinsic value that provides adequate returns. You could buy a valuable asset like a house, invest in a business (eg. open a bakery), or buy a prepared financial instrument from a bank. There are always practical concerns other than the monetary payoff of an investment. Buying a house ties you to a specific geographic location. Opening a bakery requires that you actually run the business, hire employees, and so on… You may not be prepared to assume the other responsibilities of your investment. This is where prepared financial instruments can be helpful. They don’t tie you to specific geographic locations, and owning them requires very little work.
A buy-and-hold investment strategy is essentially the boring slow way of becoming wealthy. It isn’t glamorous or spectacular, but it’s easy to understand and apply to your life. To follow a long term buy-and-hold strategy you should understand:
- Bonds and stocks
- Funds and the benefits of diversification
- Index funds and why they are superior to actively managed funds
- Asset allocation and rebalancing your portfolio
Bonds and Stocks
Banks offer two categories of investments: bonds and stocks. You can purchase bonds directly through your bank, and many banks now offer discount brokerage accounts that you can use to invest in stocks. For example, TD Canada Trust can assist you buying bonds or similar fixed income investments like GICs. If you want to buy stocks, you can open a discount brokerage with their affiliate TD Waterhouse. You can convert a TFSA to a discount brokerage account, or you can open a taxable investment account referred to as a “cash account.” This requires that you become familiar with online banking. Given that your financial data is already completely computerized by the banks, and you probably already do online shopping, you may as well learn about online banking and take advantage of the investment opportunities provided to you.
Bonds are loans you provide to the issuing entity. You loan money to someone now, and you are repaid your principal plus interest at a future date. A government bond loans money to the government at some level. Federal, provincial, and municipal governments issue bonds. Corporations can also issue bonds, but these are considered riskier. The federal government can always print money to pay off its creditors. A company may go bankrupt, liquidate its assets, and still not have enough money to pay you back completely. Businesses cannot print money to repay you. Their ability to repay you comes from the success of their business, which is not guaranteed; hence it is a riskier investment.
Stock represents partial ownership in a company. As a business owner, you are entitled to your share of profits from the business paid as dividends. If the company you own becomes more profitable and valuable, the share price increases reflecting the fact that more people are now interested in owning that company. You can sell your shares at a higher price than you purchased them to collect capital gains, or you can simply hang on to the stock and collect the dividends over time. If the company goes bankrupt, you lose your investment. Bondholders are paid before stockholders during bankruptcy proceedings, so stocks are considered riskier than bonds.
Diversification Using No-Load Funds
The optimal investing strategy would be to guess which small startup company will become the next Google or Wallmart then invest 100% of your money in stock of that company. Of course, no one can predict the future, so this strategy is completely useless. Only a fool would gamble their life savings while trying to predict the future. A more reasonable strategy uses the principle of diversification. Rather than trying to guess which particular companies will be successful, buy a diverse sample of stocks from different companies. Some will do well, others will not. When economic times are good, most of the stock you own will increase in value, and you will make money. When economic times are bad, most of the stocks you own will suffer, and you will lose money.
There is one problem with a diversified stock strategy. Buying individual stocks involves a flat rate transaction fee for each purchase. If you have $100 to invest, buying stock may cost you a $20 fee. That means you need 20% return on your investment just to break even! Since you incur this fee with every stock purchase, buying a diverse portfolio of 60 stocks would cost you $1200 in transaction fees to get started. If you are already wealthy, you can avoid this problem by investing larger sums. Say you have $10,000 to invest in a stock. A $20 transaction fee is now only 0.2% which is a more reasonable fee. Buying 60 stocks for $10k each requires $600k. If you are a small investor with considerably less than $600k to invest, then you should avoid buying stocks directly because you cannot achieve sufficient diversification without incurring excessive transaction costs.
Mutual funds are an extension the stock/bond concept that small investors can use to bypass the issue of transaction fees. A no-load fund has shares that you can purchase just like an ordinary stock, but there is no transaction fee. Consider that 10,000 people each contributing $10,000 would create a portfolio of $100,000,000. That is sufficient capital to buy a diversified portfolio without excessive transaction costs. Funds pool the money from many investors and buy a diversified portfolio according to the fund’s mandate. Some funds invest in bonds, some in stocks, others in some mixture of the two. Sector funds invest only in companies from a certain economic sector (eg. only technology companies) while other funds will target specific areas of the world (eg. only US companies).
Managed Funds vs. Index Funds
Managed mutual funds hire an expert fund manager who is usually highly paid for their stock picking ability. Given the mathematically chaotic nature of the stock market, the notion of expertise in stock picking is ridiculous, akin to hiring Yo Yo Ma to play the stereo. His fantastic chello playing ability has absolutely nothing to do with how good the stereo sounds when he turns it on. Research indicates that actively managed funds tend to trade more often (incurring extra trading fees), and only two fund managers in history have managed to beat the market index consistently. In almost all cases, the highly paid fund managers actually lowered the funds’ returns.
Index funds have a mandate to track a specific index. An index is just a group of companies defined by some criteria such as size, or geographic location. A cap-weighted index sorts companies by their size in an economy measured by market capitalization (market-cap). Large companies like McDonalds or Google have a large market-cap, and smaller companies have a smaller market-cap. An index will often choose an arbitrary number of companies to include in the index. The S&P 500 index chooses the 500 largest companies listed on the NYSE or NASDAQ. As companies rise and fall in the business world, the index will adjust to always contain the 500 largest companies, whoever they may be.
Index funds also have fund managers, but these people should not be highly paid for expertise. The manager of an index fund is responsible for following an algorithm that buys a portfolio of stocks that tracks the fund’s index. Because the fund manager is not a rock-star who makes millions of dollars, index funds can offer a lower Management Expense Ratio (MER) than managed mutual funds. Money that isn’t wasted on excessive trading and useless fund management is returned to investors as extra profits. A managed fund might charge an MER of 3%, while an index fund may charge an MER of 0.5%, six times less!
Ethics and Indexed Investing
There is an ethical question I considered before embarking on my indexed investing strategy. Suppose that I’m an environmentally conscious investor. I disagree with the environmental policy that company XY has been pursuing recently. How can I invest in an index containing XY in good conscience?
Firstly, consider that you are probably already loaning XY money. If you buy a government bond, or pay taxes, and the government of provides a subsidy to company XY, then you are also investing in XY indirectly. Similarly, a deposit or other secure investment like a GIC issued by your bank is like a loan to the bank. If the bank provides loans to company XY, you’re still investing in XY by simply having a savings account with your bank! By investing directly through an index fund, you have the potential to earn a much higher return than the interest rate offered to you by a bond or GIC, even though your money ultimately ends up in the same place – company XY’s bank account.
Secondly, consider that it is difficult to research and know everything about every company such that you can even make an informed decision to support only companies you believe to be ethical. How would you accomplish this by only accessing public information? There is a lot of data that companies keep secret, especially data that might contain something ethically questionable. Even an honest attempt to ethically categorize every company would be imperfect. Indexing is a method of diversification that supports all economic activity indiscriminately. This is a simplification that places the ethical responsibility on the business leaders capable of affecting change, not the small investors with limited resources and information.
Asset Allocation and Rebalancing
Asset allocation and rebalancing is the strategy that buy-and-hold investors use to eliminate emotional decision making that causes losses. People make money by buying low and selling high. However, emotional investors often do the exact opposite, buying hot-stocks at a high price, and selling underperforming ones at a bargain. Rather than investing in whatever feels good at the time, rational investors should decide on an algorithm ahead of time, and follow the algorithm when investing, even if it feels wrong. Rebalancing to a target allocation is an algorithm designed to buy low and sell high. The general strategy for a buy-and-hold investor is:
- Select an asset allocation between bonds and stocks
- Select a few no-load index funds for their low fees and diversification benefits
- Use your initial contributions to establish a portfolio at your target allocation
- Rebalance whenever new contributions or investment gains/losses move your actual asset allocation too far from your target allocation
Assets are distributed between stocks and bonds. Bonds are more predictable than stocks because they have a known principal, interest rate, and maturity date. You can calculate exactly what you will receive in the future, although future interest rates, inflation, and the solvency of the issuing entity are unknowns (risks) with bonds. Stocks have historically had higher returns over the last 200 years, but companies succeed and fail unpredictably. You cannot simply calculate what your return will be on any stock investment. Share prices jump up and down dramatically and often. In financial lingo, this is called volatility, and stocks are highly volatile compared to bonds.
Every reasonable long term investing portfolio should contain both stocks and bonds. Financial markets are mathematically chaotic. They cannot be predicted or calculated with accuracy. The general wisdom suggests that stock/bond allocations between 70/30 and 30/70 are reasonable. Historically, there have been decades where both bonds and stocks have done well, where both have done poorly, where bonds have outperformed stocks, and where stocks have outperformed bonds. For this reason, I have selected a conservative 50/50 split for my own portfolio.
Using an indexing strategy requires selecting a few different index funds that give you sufficient diversification. I like to keep things simple, so I decided to only invest in four index funds: Canadian/US/International index funds for stocks, and a Canadian Bond Index. I am a little biased toward Canadian bonds and stocks because I am a Canadian citizen. A spreadsheet program like Excel can help you track your asset allocation and generate some pretty pie charts to compare your actual and target allocations.
In 2011 the United Nations ranked countries by Gross Domestic Product (GDP), which is a measure of the size of a country’s economy. Currently, Western investors do not have a safe accessible means of investing in the Chinese stock market. Looking at the top 20 countries by GDP, removing China from the dataset, and grouping the European countries together produces an interesting chart. The US and Canada represent 40.2% of the top 20 investable economies, European countries represent 32.4%, and other countries represent the remaining 27.4%. A stock allocation diversifying across geographical regions should choose something close to a 40/60 split between US & Canadian versus International stocks. This is how I chose a allocation of 20/30/50 for Canadian/US/International stock. It seems reasonable after accepting my Canadian bias.
Rebalancing: Buying Low and Selling High
Your asset allocation will change as a result of investment gains or losses, additional contributions, or withdrawals. You should check on your investments occasionally, and recalculate your asset allocation. I configured a spreadsheet to do this for me in a slick looking pie chart, so all I have to do is punch in my current account balances. When the actual allocation strays too far from the target you should consider rebalancing. This means selling funds in areas where you are above your target, and buying funds in areas where you are below your target.
Suppose the Canadian economy has a good year. The value of the Canadian index rises relative to the others. My actual allocation is now above its target in Canadian stocks, and under target in the bond category. To rebalance, I should sell some of my Canadian index, and buy more of the bond index. This may seem counter-intuitive. Bonds have lousy interest rates at the moment, and Canadian stocks are going up! Why would I sell Canadian stocks? I’m following my algorithm, not my emotions. If Canadian stocks do poorly next year, I’ll be glad I sold high and bought some bonds with my winnings this year. If Canadian stocks continue to rise instead, I’ll still reap some rewards from my remaining Canadian stocks. Don’t be greedy, don’t be emotional, be rational.
When you are just starting to invest, your portfolio is small. You can probably rebalance effectively using only new contributions. As you get wealthier, your portfolio will start to vary by larger amounts, and you may need to buy and sell within your accounts to rebalance properly. Remember that this is best done in a tax-free account like an RSP or TFSA, to avoid incurring unnecessary taxes. You need to research the tax laws in your region to avoid making investment mistakes.
That’s it! Executing a buy-and-hold strategy is straightforward. There are other investing/trading strategies that can make money, but the boring slow way is an understandable, logic based approach you can use to work towards financial independence!