Episode 74 - In the news…headlines reviewed
In this episode Greg & Colin review the biggest headlines investors are faced with currently, from oil prices to the US debt ceiling. Enjoy the show!
EP.74 - In the News
Welcome back to the Free Lunch podcast with today's hosts, just today's Greg and Colin, Greg for a change for a change. Yup. Maybe on episode seventy four, it's not quite a change. It's maybe a stable or a staple. That's right. Last week, we continued our discussion about estate planning.
We talked about. I remember we call it something like, I'm dead now. I sure hope I was organized or something like, Exactly. And listen, anybody that wants to know about how to be organized in preparation of their estate planning, go back and listen to that one. But today we're going to talk about things that are back in the headlines. We get a lot of calls and questions from clients, friends, relatives about things that are in the news, and there's a lot. So we're going to tackle some of those today. Greg, you might have noticed there's some things like Chinese property developers and bonds maybe defaulting right? An item. We've heard a lot about inflation worries, both home and abroad, maybe interest rates. Debt ceiling has come up, most notably in the U.S. foreign exchange valuations, global supply chain issues. I mean, we could go on and on. But Greg, where do you want to start this conversation today?
Let's dive in.
Although I just as you were reading all those things that occurred to me, people always talk about, there's this saying that the stock market climbs a wall of worry and all of the things you mentioned. And we're going to be talking about a little bit detail. There are all things to be worried about, and it's one of those things that there's always if you want to worry about things, things that could be detrimental to the stock market, there's tons of things out there. In fact, just about everything out there is bad news. It's not usually good news. Good news doesn't
Make the headlines. Let's talk about
These things because this is what's getting people's attention and causing them to worry.
So you never see a headline that says things are pretty good right now.
No, that's right. No news today.
Nothing bad happened and have a good day.
You mentioned Chinese property developers and let's say, three weeks ago. Who among us had ever heard of Evergrande? I know I hadn't. No, not a chance. No. Probably not. Too many people in this neck of the woods. Well, evergrande, as it turns out, is one of China's largest real estate developers, and it's also one of the world's largest businesses by revenue. They employ about 200000 people, making them a very big company. And it was founded by a Chinese billionaire. I'm probably not pronouncing this right, Suzanne. And he was once actually China's richest man. So the company made its name in residential property, but it also has investments all over the place electric vehicles, food and beverage, sports and theme parks. A very diverse company now, but certainly
Most of its business in residential
Property. And as it grew, it
Financed much of its growth through debt
And reportedly has over something like $300
Billion in debt, which isn't
Unusual for companies to finance their
Growth through debt. Not at
All. The issue stock or debt?
So what happened, though, is a couple of weeks ago, the company disclosed to investors that it might default on some loans that were coming due if it was forced to raise money quickly. And so it sold
Some assets to cover some loan
Payments coming due. But many people are concerned that they won't be able to meet the obligations because of the loan maturities that are coming up fairly rapidly in the next year or so. So what happened? Well, the bond ratings agencies immediately downgraded the company's debt, which has lots of ramifications. Obviously, it inhibits their ability to raise more money through debt and also has a fairly detrimental effect on the stock price. So these companies shares trade on the Hong Kong market, and the shares have fallen about 85 percent this year. Pretty significant, pretty significant. And in stark contrast to, as
You know, there's been a
Real real estate boom over the last couple of years. Covid inspired
In many cases, and a lot of
Real estate companies are doing extremely well, but obviously debt is a big issue. So at this point in the whole evergreen issue, the Chinese government has stepped in to stabilize the housing markets because they need to protect thousands of people who have purchased apartments that are as yet unfinished. And they also have to protect workers in the housing industry, which apparently makes up about 20 percent of the urban workforce in China. So this is a big deal.
This is a big deal in China.
Yes. But remember,
China is also a communist country. True. So it's not a free market. That's right.
Yet it is the second largest economy in the world. And so if Evergrande was to fail, there would certainly be cascading effects on the Chinese economy. What typically happens in situations
Like this is lending
Standards get tougher, making it harder for companies other companies to get access to credit, which leads to a credit crunch, which we're familiar with from 2008 2009.
But wait, we have to emphasize that the issue there is not the same as the issue in 2008 2009, which was a global credit crisis.
Exactly. So this definitely
Would have a big impact on the Chinese economy. Investors would probably start to pull money or want to pull money from the Chinese stock markets as they see that as less attractive. And in the case of Evergrande specifically, Evergrande does borrowed money from something like, I don't know, 170 different. Lenders, which means any kind of default by Evergrande or a bankruptcy would certainly send ripples through the entire financial sector, so absolutely bad news for the Chinese economy if Evergrande were to go under. But obviously there would also be
Ripple effects that were felt
Around the world, as I say, because of China being the second largest economy and significant trade partner to most other countries in the world.
The second largest economy. But if you look at the global market capitalization by stock market, China, I believe, is less than three percent
Of that's right, not a big chunk of the global stock market.
Yeah, absolutely. I'm not trying to say there wouldn't be impact, but yes, it might not be as much as people think it might. Well, let's talk about something else. We've been hearing a lot about inflation and interest rate levels. There's lots of articles that are out there on this. They come out almost every day. I mean, we see them all the time, for sure. Now it's a funny thing, though, because as a stock market investor and I've had this conversation with many people over the last few weeks as a stock market investor, we actually want some inflation. As a consumer, we don't. There's a bit of a paradox there. It's a funny equation because inflation leads to higher corporate earnings and stocks are priced based on the future earnings expectations or cash flows of a company. That's in theory, how a stock is priced based off their future cash flows. Exactly. So during times of inflation, you expect those earnings to go up. So therefore you expect the future cash flows to go up. So therefore you expect the stock price to go up.
That's right. Within reason, and that's why you say a little bit of inflation as opposed to
A lot of inflation. That's right. Well, listen, too much of anything is not good. So as an investor, a little inflation means a higher expected rate of return in stocks. Now, the current inflation rate in Canada is approximated to be around five percent, which is a little more than double what the normal inflation rate is. So some are calling this a period of hyperinflation. But remember in March of 2020, and I know we've talked about this in a few other episodes, we didn't have any inflation due to the global economic lockdown. We actually had three months of deflation.
That's right. So that is
Why a lot of people are calling this a period of transitory inflation where it's just making up for that period of deflation in 2020. And this is just sort of a
Catch up period. They call that the base effect.
So when you're comparing to a year ago period that happened to be very low or either in deflation, then it's going to make prices today seem a lot higher. But they might not be higher than they were two years ago or a lot. They wouldn't be five percent, maybe higher than they were two years ago, but relative to one year ago, they are definitely higher.
That's right, because central banks monitor and adjust money supply to deal with inflation. That's what they do with the money supply. It's one of the tools they use. So the general target is around two percent for a rate of annual inflation. So whenever you hear the U.S. Federal Reserve or the Bank of Canada comment on their inflationary targets, it's usually around two percent. But there are periods of time, as we just mentioned, when inflation is good. So when the economy is not running at capacity, meaning there is an unused labor or resources, inflation theoretically helps increase production. So more dollars translate to more spending, which equates to more aggregated demand. So, Greg, more demand in turn triggers more production to meet that demand. So right earnings kind of get better. And there's times when inflation is bad because inflation, as we talked about erodes purchasing power or how much of something can be purchased with the currency because inflation erodes the value of cash. So if you're on a fixed spending budget, historically you were getting, I don't know, some rate of return on term deposits and you're using that to pay for your groceries. But now interest rates are hovering close to zero. In term, deposits are hovering close to zero. And your groceries have gone up 20 percent. That's what they talk about eroding purchasing power.
Exactly. Yeah, that's right.
So where does this all mean to current interest rates?
Because there is a link
Now, the Bank of England has just told the market to brace for some interest rate hikes. It's thought they may do this because inflation in England is running around four percent, which is a little lower than in Canada, actually. And they believe that an interest rate hike will slow things down a little. So there was a Bloomberg article posted just October 12th, and I quote a combination of higher energy prices. Supply chain disruptions and rising wages in some industries has undercut the Bank of England's original view that much of the jump in prices will prove transitory. The central bank last month said it expects inflation to exceed four percent in the last quarter, more than double its target.
That's big what is
And that's what's happening here, too. So where am I going with this, Greg? Should we expect some interest rate movements from the Bank of Canada, the U.S. Federal Reserve? Things of that? What do you think?
I would think so. The thing everything
One is following right now is step one, which is not necessarily raising interest rates, but cutting back on the quantitative easing, which we've talked about in the past. And so this massive. Round of bond buying by central banks, which tends to keep interest rates down in the longer terms, not just the overnight rate,
But longer term interest
Rates, so they're going to slow that process down and by slowing that process, that's obviously going to reduce demand because they're purchasing a lot of these securities. And that could cause
Interest rates, prices to
Interest rates to start to creep up. And what's going to happen
Is interest rates are creeping up anyway because the central bank can't completely control long term interest rates. And so we've seen in Canada, in the U.S., 10 year bond yields are up to one and a half to one point six percent again, and they were one point two percent just a couple of months ago. And so the market will set those interest rates even if the central banks don't do anything because those rates are set on inflation expectations. And if you expect inflation to be higher than interest, rates will move higher to allow investors to earn a real return.
Yeah, but I mean, do we really care? I know that's
A flippant answer. But in Canada, the overnight lending rate between the Bank of Canada and the big banks is zero point twenty five percent. So if they raise it to zero point five percent, some would say wow, they doubled the interest rate overnight or the interest rate went up 100 percent, but it went from zero point two five two zero point five,
Which is the typical increment
Anyway. So it seems like a lot on a relative
It's not a lot in absolute.
The banks like to see a steeper yield curve, and so all of that would be good for the banks.
So, Alison, this stuff is super important. I'm not trying to say just ignore it, but just know that it's not like we're the only ones talking about inflation and interest rates.
No, absolutely. And the whole
Purpose of this episode is just just be aware of what's being talked about in the news and see what implications that has for all
Of us. But I like that when people say, Oh yeah, but it went up a hundred percent. Yeah, it went from zero point two five to zero point five.
Yeah, exactly. Doubled overnight.
On. Another thing that people have been hearing a lot of in the news
Lately with regards
To the U.S. and it was just resolved. I believe yesterday is this thing about the debt ceiling. So what exactly is this debt ceiling that caused such a commotion in Washington and for anybody that follows the
Politics saw that the Democrats they needed
To increase the debt ceiling and the Republicans were holding back, and there was some brinkmanship going on there that finally got resolved when the Republicans agreed to raise the debt ceiling. So what is the debt ceiling? Well, listen, the U.S. government spends more and money than it collects in taxes, so basically it borrows to make up the shortfall. The government in this happens obviously with all governments, but we're talking about the U.S. here. They borrow money by issuing bonds, and the debt limit is the total amount of money that the U.S. government is authorized to borrow to meet its legal obligations. And those legal obligations are Social Security payments, Medicare benefits, military
Salaries, interest on
The national debt, tax refunds,
Etc. So a lot of obligations
Of the U.S. government, and it's important to look at sort of what the debt limit
Is and what it does
Not do is it doesn't authorize new spending. So the debt limit basically just allows the government to finance existing legal obligations that Congresses have made in the past.
This is not part of
The current government's
Plans to spend on
Infrastructure or anything else. This is just to pay for things that are already approved and being spent and this debt limit. I think it was about one hundred years ago where something that Congress established this limit on how much debt the government could accumulate, and they establish that limit just to prevent governments from spending too much more than they could afford to. But I believe the debt limit has been raised something like, I don't know, 75 or 80 times in the last hundred years
Because that's just the way it is.
So what would happen if Congress failed to increase the debt limit? Well, I think the economic consequences would be pretty massive. So first of all, if they didn't increase the debt limit, then the government wouldn't be able to do any additional borrowing. And it would not be able to meet its legal obligations. Meaning, as I said earlier, so Social Security payments might cease for a time. Military salaries would see some child tax credits wouldn't get paid, et cetera. And that would cause a real problem because all of those people that receive those benefits would have a real cash flow problem
That would cause a real problem in the world because the U.S. Treasury bill rate is known as the risk free rate. So in essence, if they didn't raise the debt ceiling and they defaulted on their payments, all of a sudden, the global risk free rate is no longer a
Risk free rate. Well, that's right.
And what would happen, obviously, is interest rates would skyrocket because investors would demand a higher interest rate, given that there would now be risk seen in holding U.S. government bonds, whereas currently, as you say, they're seen as no risk. So a recession,
Is it a big surprise? Surprise that they actually got the deal done, though, I mean, don't you feel like they were going to get the deal done regardless?
Yes. I mean, listen, this is
Just an opinion.
Everyone has opinions about U.S. politics, I guess, or many people do, and I certainly do. But it would seem unlikely that if pushed to the edge, either side would allow the U.S. government to default on its obligations because the consequences to all Americans and all political parties and everybody involved would be massive.
Certainly, it would trigger a recession.
And that's not me talking. That's Janet Yellen. What does she know, though?
And you know, listen, even back in 2011, there was a standoff in Congress over the debt ceiling, and just that standoff caused U.S. debt to be downgraded
For the first time. I think it was
Recently downgraded to, wasn't it?
Well, I know it was back in 2011.
I don't know if there's
Been any further downgrade since, but obviously it would be very, very bad. And basically, if there was a change in risk profile of the U.S. government bonds, then all other borrowing costs would go higher. Things like credit cards, car loans, mortgage rates, et cetera. So if I was to take a line from Ghostbusters, if they failed to raise the debt limit, it would be bad.
That is a good line.
Yeah, yeah. And for that reason again, is this something that investors should worry about? I mean, I guess it's important to be aware of it. And of course, as we know anything could happen during the last U.S. administration. I mean, they did stop paying federal workers for some time until there was an agreement on, I think, extending the spending or whatever that process was. So it's something that could theoretically happen, but we believe would be relatively unlikely to happen.
Are you talking with that time period of December of 2018 to January of 2019 when the U.S. federal government shut down? Yes, I am. And what happened in the stock market during that roughly 30 days of government shutdown, do you know?
Well, I know that the stock market hit rock bottom on Christmas Eve. Twenty eighteen from Christmas Eve and on it started to improve fairly dramatically.
It was up 10 percent.
The government was shut down. Nobody was getting paid and the stock market was up 10 percent in that 30 day or so period.
All right. Let's move on to foreign exchange
And in particular, this strong Canadian dollar. And Greg, I'm going to make a hypothesis here that the strong Canadian dollar that we're experiencing is all because of the strength of oil.
And I'm going to tell you why. Please do
So. The key dollar right now is trading around 80 cents for every U.S. dollar, and back in March of 2020, it was trading at around sixty seven cents. So it's quite an improvement. Nineteen and a half or so percent improvement in valuation. But if you look at the price of oil now, the Canadian dollar is very linked to the price of oil.
Would you agree? Agreed.
So oil back in March of 2020 was trading at thirty two dollars per barrel roughly, and today it's trading just under $80 a barrel. And just in the last 12 months, it's gone up something like 60 or so percent. So here's the question is the Canadian dollar strengthening versus the U.S. dollar, or is the U.S. dollar simply weakening versus the Canadian dollar? And what does it have to do with the fact that oil is up 60 percent in the last 12 months?
Good question. And actually, it could be some of each.
But I think they don't call the
Canadian dollar petro dollar for no reason.
Yeah, like the Canadian dollar and the Aussie dollar are very similar currencies
In that we have a
Large amount of natural resources. That's our main exports
For our countries.
And so therefore our home country dollar is impacted by the valuation of those commodities that are exported. So some are calling this or would call it a risk on trade, meaning that it is correlated to a rise in equity prices based on a rise in commodity prices. And that makes sense. So if you think of it, when the price of oil was thirty two dollars a barrel, I assume oil company stocks were probably low. And if you look today and oil's at $80 a barrel, you would assume that oil producing company stocks have gone up
Quite a bit, which they have, which they have.
So there was an
Article put out just on October
12th again by a place called Interchange Financial. I'm not promoting them, by the way, but it was an interesting article. I'm going to quote them a little bit. The Canadian dollar is holding its impressive gains and trading near its highest level since July against the U.S. dollar and near its highest level since twenty seventeen against the euro. The loonie strength is primarily due to surging oil prices. So that makes sense from what we just talked about. The price oil's gone up quite a bit. The value of the Kiwi dollar has gone up quite a bit. And so I would say that my own opinion, I'm sure there are those out there with conflicting opinions. Sure that this movement in Canadian dollar pricing should be enjoyed by those that are going to be traveling to the U.S. because I'm not sure if it's actually sustainable at this price level for a long period of time in. Short for your time, who knows, but it's got to be linked to the price of crude. What do you think that summary?
That's pretty heavy stuff.
Heavy oil, heavy oil stuff. There you go. Well, actually, that leads into the last part of our discussion today because there is an issue of supply chains. You can say it's linked to the energy market, but tell us about supply chains in the world.
There's a lot of talk these days about global supply chain issues, and anyone who's tried to rent a car or take delivery of an appliance recently has probably experienced these supply chain issues firsthand. So before we get into it too far? Let's talk about what is a supply chain. You're an MBA type of guy. I'm sure you've been through this. But the supply chain,
Like there is a limited number of people taking their MBA courses, creating a supply chain. Sure.
What are you talking about? Absolutely.
There's very few people like you out there. So a supply chain, it's the entire process of making and selling commercial goods, including every stage from the supply of materials and the manufacture of the goods through to their distribution and sale. So I think most people can sort of get that like if you want to make pencils, you have to get whatever it is the lead for the inside of the pencil and you've got to get the wood and you're going to get rubber to make the
Erasers well and
You need a little bit of metal around the
Rubber. That's that's right, you know. So whenever anything that's manufactured or produced or dug out of the ground, it needs to get to the right place on the right time. So why are these supply chain issues so prevalent now? Well, the answer largely lies in Covet. When you look back to March of 2020, the world essentially shut down in the spring of
2020 and well into the summer. And so what happened is that
Lots of factories that manufacture key components of everything shut down. So for example, I think even back then, you were looking maybe to buy yourself a new bicycle and it was virtually impossible. You cannot buy a bicycle, you cannot buy a skateboard, which I tried to buy from my daughter, and it's because the manufacturing was all shut down. So what happened? So all these
Manufacturing companies shut down?
And if you look at in the rental car industry, when COVID hit, a lot of those rental car companies sold off their fleets because nobody was traveling, the cars were sitting idle anyway. These companies figured they could go buy more cars later when things got back to normal. But what happened is because of the shutdown of many factories and in this case, semiconductors
That are used in vehicles new vehicles. There's now a worldwide shortage of those semiconductors that again resulted from the plant closures in Asia last year, and therefore millions and millions of cars that should have been built were not built because of the shortage of those semiconductor components. And so now you've got a lot of competition for new cars. Rental car companies need to replace their fleets, lots of individuals want to buy
New cars and
There's tons of demand and there's just not the availability of those new cars
Anymore. Let's talk about that
Supply demand curve there, because you just point out, I mean, the demand stayed constant, but the supply shrunk, so the price has to go up.
That's right. We were
Talking about this a number of
Episodes ago when we were talking about inflation and used car prices do not figure into the Canadian inflation numbers, but they do in
The U.S. and used car
Prices are really moving up their skyrocketing because of the lack of availability of new cars. So fewer new cars, then more demand for used cars and the prices go up. So the other thing with COVID, what
Happened and it was
Counterintuitive, but consumer demand for stuff. And when I say stuff, I mean all sorts of things where there's bicycles,
Exercise equipment, motor
Vehicles, people weren't traveling, they were staying home and they were reallocating funds from what they might have spent under normal circumstances to other things like whether it was renovating their homes, buying exercise
Or leisure equipment,
Things like that. So what happened is this demand for lots of things exceeded the ability of manufacturing facilities to keep up with. And so we're seeing these supply chain issues are filtering down through all sorts of products. I have a good friend who's been waiting for a new refrigerator and stove for about the last six months, and if he's lucky, he'll get it in the next two to three months. That's not the way it used to be. There's other issues in the supply chain, so it's
Not just the manufacturing
Of these things, it's the transportation of products and materials. And so what happened is there's now shortages of shipping containers.
Well, because they're all being used to build houses now.
Yeah, right. Yeah, exactly. There's congestion at international
Problems in the trucking industry, there's shortages of drivers, so there's not enough drivers to drive the trucks that you need to get on the
Road to move stuff around.
And this is all contributing
To that supply
Chain crunch. And then on top
Of it all, if you remember back,
I think it was back in May or something here in the spring, there was a massive. Containership named the Ever, Given, not ever Grant, as we were talking about earlier, this ship got stuck in the Suez Canal, which is a major shipping route for products from Asia to the West, and it took six days to free it. So to recover from those six days of no ships moving through the Suez Canal, it took
Months to recover.
So anything can happen, and you look at what supply chain issues have affected mentioned autos, certainly food, if you can believe it, carbonated beverage. There's a shortage of CO2. Iphones, electronics, bicycles, Christmas decorations, sporting shoes
And sportswear due to problems in Vietnam
Were. A lot of these things
Are made, so supply
Chain will affect the availability of goods. As you pointed out, the lack of supply or shortage of supply. Strong demand. Higher prices. And therefore we've got those supply chain issues feeding into the inflation discussion that we just had. And again, are these transitory likely because issues like this usually get resolved, the supply demand imbalance usually finds a way to even out over time. So there's transitory issues around shipping ports, shipping containers, truck drivers, but these will work themselves out over time. Will it have an effect on, say, the markets, possibly in the short term? Will it make a dent in the long term trajectory of the markets like lean on?
Well, I ran
Into this when I was looking at some
Rental cars. You mentioned rental cars. Yes, we are looking to go away after Christmas to a certain place and been there many times. And rental cars for a week usually cost about, I don't know, thirty dollars a day. So what's that? Two hundred and ten dollars for a week or something like that? Get so much there now.
I'm going to guess more than that
Just by a lot. Yeah. So the same seven day period, if you pay now to secure your price, it's eleven hundred dollars for that week right on.
So about three to four times
Or five five x, that's quite quite a change. But OK, look, we've been kind of doom and gloom and that kind of stuff about some of the stuff. But the point of it is what can you do about all of it? And we've talked about this many times. We're going to sound like broken records, but it's because it's what works. I'm going to start us off here, Greg. Number one, focus on your asset allocation. That question should have been answered in your financial planning or financial planning discussions about determining how much risk capacity and risk tolerance you have and you need to achieve your goals. So when you run into a short term situation like a hopefully a short term, a supply chain issue, it's not putting you off your long term retirement plans right on.
What else can we do? We can rebalance
Our portfolios regularly.
So once we've
Got an asset allocation strategy in
Place, the portfolio
Is not going to maintain those exact proportions. And so over time, we have to make sure we don't drift too far from the asset mix
Strategy and rebalance back to it
Exactly and ignore the headlines or instead of ignoring them, treat them as entertainment advice. So the question that we get, like I said about Evergreen, that's interesting to follow. I'm not sure if it's going to have much impact on us here. I hope not, but it's interesting to read about.
Absolutely. And as we've always talked, make sure that you're paying the lowest fees and
Expenses that you can
Those high cost investment options out there, and there's low cost investment options
Sure you're heading towards the appropriate cost for the nature of the investments you're making. That's key.
And that would include tax tax
Rates to monitor your tax rates.
And lastly, I would say, as we're heading into while we're well into the fall, we've been through Thanksgiving. We're on our way to Christmas. I was just reminded the other day that Christmas is less than 70 days away. Just kind of crazy to think about. Well, rest and digest. So don't get caught up in these headlines. Know that if you've done the proper plan and you've laid the proper foundation, just having a longer term perspective will help.
That's right, and I think it
Gets back to the
Discussion we had back in the early days
Of COVID, and that is that it's easy to imagine bad things happening. And that's the wall of worry that we talked about earlier. And there couldn't have been much more bad to worry about than when we got into this global pandemic, and the entire world essentially came to a halt for a period of time. That was pretty bad. And if you look at how it worked out, one of the strongest stock markets we've had in decades ever. And so while you could predict all sorts of bad things happening, in the end, things generally work out because over time, what happens, economies grow, companies become more profitable
And things just in the end.
They generally have taken care of themselves, and you sometimes need to wait it out. But there's really not much you can do other than have the right strategy and, as you say, rest and digest.
Well, I think that does it for today. I think we've run out of time. So thanks for joining us today. Remember to give us a reading on your well, wherever you download our podcast from. And if there's any topics you want us to cover, just let us know we're happy to dove into pretty much anything you reason. All right, till next time
Episode 73 - “I’m dead…I hope I was organized!”
In today’s episode, we discuss the importance of organizing your estate while you can! It's time to get organized and prepare for a what-if moment!
EP.73 - I'm Dead Hope I Was Organized
Welcome back to the Free Lance podcast with Greg Kraminsky and Colin Andrews. Greg, here we are again.
Another week, another podcast episode 73.
I should say nice, which is considered when we started this, we started this at the sort of the beginning of the global pandemic.
That's a lot of content during These many months.
And yeah, May of 2020, I guess was our first podcast.
So yeah, well, Listen, there's lots To talk about, and I expect We'll have a little celebration when we hit number one hundred.
For sure, we will. Now, last week, we talked with Sarah Newcomb. Sarah is the director of behavioral finance at Morningstar. And that was a fun conversation, and I would encourage those to go back and listen to it if you didn't listen to it last week. But two weeks ago, we started this conversation about I'm dead now. What? And today we're going to sort of carry on with that conversation. During the previous episode, when we discussed it, we were talking about the importance of having an
Estate plan, having the will And the Personal directives and enduring power of Attorney things like that. But we have This little book that we give Out to people. It's just a planning book for people to fill out on their own. And it's just a place for them to document, well, anything important in their life that they want to leave information for.
It's really handy, and it's something that we suggest people start to do, maybe even before they have their first meeting with the lawyer. Let's say if you're starting to work on estate planning and you need to meet with a lawyer to have the three documents prepared the will, the power of attorney and the personal directive. And it's just a good way to essentially take inventory of what you have. Not only physical Assets, financial assets, Things like that, but how you want things to be taken care of when you're gone. And so this is really a great place to start. We're going to be talking about a lot of individual items for people to think about. So for anybody listening, don't feel you have to jot these down as we talk because we do have these books available that help you get things organized.
There's a lot of online types Of programs available as well, but this is just a nice, handy little reference book that everybody Can take home and start planning.
Well, I think that's the point is that it's just about getting organized. It's the same thing when we do a financial plan with somebody, you have to organize all of the Data Before we do the financial plan. So this is just organizing your affairs for when you're not able to have a voice.
Well, that's right.
And I think we say I'm dead now. What? This could also Apply to people that become disabled or incapacitated and aren't able to handle their own affairs, and that's where the power of attorney, of course, comes into play. But again, you want the power of attorney to be aware of most of these things as well, because they will be taking over for you when you're not able to write on.
Well, let's kick it off. Where does somebody start, Greg?
When we're talking about estate planning and pulling together information that will be beneficial to somebody who's looking after your affairs after you're gone? We start with personal information. People will need obviously your date of birth, maybe social insurance numbers, things like that. So all of that personal information needs to be identified medical information.
Now, why would somebody need medical information for somebody that's deceased?
Well, it's a good question.
I guess there might be people that need to be notified of your passing and other things like that. So or I was thinking Like for the next generation, if your parents have a pre, what is it called like when you have something an underlying medical issue? Oh yes, that maybe could be passed down.
Sure. Possibly genetically inherited Or what have you? You certainly want to identify a number of key contacts. And so those key Contacts from the standpoint Of actually handling your estate, you would want to Identify the executor Or executors. It's very important Your estate lawyer and your Accountant because all of those people will be absolutely critical in administering Your estate and making sure your Wishes are executed. But as well, There may be family and Friends and other people that you'd like to have Contacted if you were to pass away.
Now, don't you find, though, that in today's day and age of the internet
That the passing
Of somebody, the information that somebody has passed like that flows pretty quickly to most
People, right? It can. And this is just
A way to make
Sure that some very specific
People are notified
People that you would want to know, like who would you want to notify? Not naming them
Specifically, but like what types of people?
Well, I mean, I think it would
Be people that I am
Or was friends
With no longer
In my close circle of where I live. I have friends across the country
And you're just
Well, you know, but one one in each place,
Just people that, you know,
Possibly extended family that maybe you haven't seen in a long time,
Like a strange family, maybe could
Be. So what else? How about insurance policies?
Well, that's probably pretty important information for your beneficiaries to
Have access to. Absolutely. Because insurance
Pays out. Pretty quick upon the death of somebody.
It does. And, of
Policies, in many
Cases, in most
Cases, there is a
Named beneficiary on insurance policies and which means that, as you say, it can be paid out very quickly without waiting for the estate to be probated.
How does that factor in funeral arrangements with insurance
Policies and covering that cost?
Many people will have insurance
Policies, permanent insurance
Policies specifically to cover those what we call last expenses not only to cover the actual cost, but many people actually do make funeral arrangements in advance. And that's just done to make it easier for their family and for the executor to deal with that aspect. If there are funeral arrangements, obviously you'd need to identify the funeral home, what to be done with
Your remains, whether
You want to be buried or cremated, et cetera. So all of that needs to be identified.
And I guess you'd have to identify things like your dependents.
Yeah, that would be important.
And again, keep in
Mind that I think a lot
Of this work can be done in advance of drafting the will because then when you go to see the lawyer, you'll be able to identify. These are the people that I want to have as beneficiaries or these are my minor dependents, possibly people. That guardianship might need to be arranged for. So, yeah, you want to know who they are.
Any relationships, what their relationships
Are, where they're
Located, if they're in town,
If they live independently or
Separately, et cetera.
And any health care history, as we talked earlier, it may affect them.
Your beneficiaries probably want to know where your will is located.
It's kind of important, and I usually would suggest that there will be located in a couple of places. One copy with the lawyer and another copy
Somewhere accessible to your family or
To your executor.
Well, especially if they don't know who
The lawyer is. That's correct. I know we
Have a number of client relationships where people have given us
Just an electronic copy of
Their wills, and it's just an in case situation, just in case somebody can't find it. We have a copy that they can act on.
Exactly. Well, what other kind of documents might you want to have in there?
Well, you probably want to know things like, I mean, this might sound kind of silly because you're dead, but your driver's license, your passport, where is your passport located? That's an important government document. Your birth certificate. Any marriage or divorce certificates. Things like your address book all your contacts. Probably something where if your family is trying to reach out to people that you know, another one that really comes up quite often is what about your computer, your log into your computer that has access to a lot of your information?
So important, because when you think about how much is done online
Right now, I mean, sort of investing in banking
Is done online. Many insurance policies are paid online. There's just so much of what we do is linked to our phone or our computer, and every one of those sites has a username and
You absolutely want your executor or family members to be able to access that information when you're gone,
Because it's a little awkward going to the funeral home with somebody's smartphone to get a facial recognition of them while they're laying in the casket, right? I mean, it probably be easier to have the passwords that would be easier. Yeah, yeah. So what about financial information?
Yeah, I mean, obviously, financial information is going to be very critical to the executor because the executor has a big job. And basically the job is to identify all assets, identify all liabilities, ensure that a lot of things are taken care of
That would otherwise be left hanging.
And so you obviously need to know where the financial power of attorney is located. And again, that might be more important in the case of somebody who suffers a disability and isn't able to handle their own affairs. But that's valuable information bank account information, credit card
Information, any other charge your credit cards that you might have your investment
Portfolio, where is it located? Who is the
Advisor on the portfolio?
There's other accounts, as we mentioned.
I mean, your wallet is
Full of them,
Either your wallet,
Your digital wallet, frequent flier points, reward
Programs, all sorts of things that probably will want to be canceled
Or redeemed or redeemed if possible.
Where are your tax records? It's important to
Keep tax records for seven years or
More. They've got to be somewhere.
Is there a safe deposit box? And if there is, where's the key?
And then obviously a list of
Things like any debts that you
Might have mortgages,
Loans, lines of credit leases, things like that, all that has to be identified.
I mean, and there's also other things that are owed to you from others that need to also be identified. So I know I've done a few of these in the past where you've done personal loans to family members or friends or things like that.
Your estate probably wants to know if there's money owed to yes or to it. Yes. Any judgments or possessions. So if you've, I don't know, lent something to somebody of significant value? Sure. Probably should be documented.
Somewhere. Exactly so again, that just will help the executor as they
Go through the process of filing probate to understand where all those things are. Now a lot of people are
Involved in or
Of commercial businesses. And obviously there's a lot of unwinding
To be done in that case. And so obviously, you need the formal
Documents, the name, the
Location of the business, the location
Of any other assets that the
Business might own. If the business rent space, then you need to know the landlord information for the business information about the employees.
What else? The accountant, the lawyer
In any kind of buy
Sell agreements that might exist between business partners. And again, the same things
We talked about on a personal basis
Bank information, credit cards, key customers, royalties, licenses, utilities, all sorts of things that businesses would be involved in that you might have the most of the information on. In many cases,
Information is in a desk somewhere,
And it needs to be
Identified where that information can be accessed well
And on the internet to the business website information. I know we ran into this a few years ago. We had to update our payment processing for our domain, for our website, which is markets hyphen works in case anybody's interested, exactly. But the company where the domain was purchased from the had an old credit card and old information, and I remember trying to update the payment on it. And the guy I was speaking with basically gave me three chances to remember the password. And if you don't remember
The password, you're locked out like, I don't mean
Temporarily, I mean permanently.
So it's really critical for those social media
Sites and websites for businesses and personal that people have access to that.
No, exactly. The other thing is
You're pulling together all of this information as
You start thinking about who are your beneficiaries
Going to be and what they can expect or what you're planning to leave to those beneficiaries. So as we talked earlier, there could be life insurance policy payouts. What type of policies? Who to contact for that information? What's the amount? Who's the beneficiary named on that particular insurance policy? And where are the papers or the
Information on those policies?
And there might be some employer
Benefits and social insurance
Payments. Final payments from those beneficiaries want to know what they can expect from a financial standpoint. So we've talked a little bit about
Some financial issues.
And what about
Stuff? People own a lot of stuff
And that's really got to be identified. Personal property,
Real estate houses
Or recreational properties who
Time shares even
Timeshare is sure who are the
Owners or their co-owners or their property owned
Individually, where the legal
Documents relating to
Those where are the keys, et cetera. So real estate is obviously a big thing for many people.
I find people believe that they have very simple estates, but when they start itemizing all of these items, that it becomes clear that it's not so simple.
Well, that's right for, I
Would argue, virtually anybody, possibly with the exception of the commercial and business information
We talked about. Every other
Item on the list we've talked about so far is relevant
For sure. I mean, because even when let's say you have a kid that you helped buy their first home or whatever.
Well, I guess that's
An asset that needs to be declared. But yeah, so even things like vehicles like as you said earlier, do you lease them? Do you own them? Do you have a loan on them? What's the ramifications on a lease leased vehicle for a deceased person? I actually don't know, but I guess you'd need that information. You need to have access to things like, I don't know, keys for sure.
That would be important.
Any insurance information on those vehicles to cancel or renew and somebody else's name, I suppose. But where are they stored? People often have storage units just for random things. And do your beneficiaries know that you have a storage unit?
It's like that show.
What's a storage wall?
Yeah. Yeah, that's right. Yeah. Storage wars.
Not recommending it or not recommending it, but no. Basically, these were people that went in and bought storage units from deceased people
Or people that just abandoned the storage lockers. And obviously,
Death would be one of the main reasons why you might abandon it. Your executor doesn't know that it exists.
Or do you have a safe? I know you talked
About safety deposit boxes, but there's lots of people that have small safes in their home.
Sure. Does somebody have access
To the combination to that safe or even know where it is? And are there any valuables in it? I don't know. Not like Indiana Jones rare jewels, but
Then people have rare items
That are of extreme
Importance to them that they do either hide away in the house or put in a safe or a safe deposit box. And you'd like to know not only is there a safe deposit box, but what's inside it or likewise a safe in your home?
Yeah. Well, I mean, is there a Wayne Gretzky rookie card in there worth $6 million somewhere that you don't know about?
I think I had one of those, but I can't remember where it is now.
Yeah, I don't
Want to talk about that. I had one of those years ago. Well, there you go. Yeah, anyways,
And when we're talking about insurance and in many cases, insurance that needs to be canceled or reassigned, it's not just life
Insurance, but lots of people have some sort of health insurance through Blue
Cross or some other provider like that. They might have dental insurance or benefits through a company plan.
Certainly, we talked about
Motor vehicle insurance. All of those things are important to identify who's the insurer because of course, changes
Need to be made.
This one will hit close to home for you. But what about your pets?
Well, that's right. If you have
Pets, you want to know that they're taken care of and they need to be taken care of right
Away. It can't take. They can't wait
For probate five days, five or five or seven days for somebody to get into the house. Let's say if you live
Alone and take care of your animals, and so you absolutely
Need to identify the pets type of pet their names, I guess good to know
Who the veterinarian is and who's going to
Take care of the pets,
And hopefully you will identify that so that
Somebody's looking after your affairs. As I say, when you're not able to, for whatever reason, we'll take care of them. Very critical.
I guess whoever's left is going to need to know what to pay, what to close and what to cancel. I mean, in today's day and age, there's so many auto subscriptions that were parts of. I'm just thinking and not promoting, but things like Netflix, Amazon Prime and many others that are just automatic subscriptions. But you have other ones like what about just your basic utilities, gas, electric, water, things like that? Do you have a landline? I should ask you, Greg, do you have a landline? Not anymore. Not anymore. So no. Welcome to the 21st century.
We cut the cord and it's been great.
But there are lots of people that have landlines,
And is that a
Bill that needs to just be canceled
And what about charities like people often give sort of automatic amounts to charities? I suppose when you're no longer here, that needs to be adjusted.
That's right. And again, what
About here is getting down
On paper or digitally all of this information.
So when you
Go and meet your lawyer and talk about what you want to be
In the will, you can identify all of these things.
And so it's really not only is this a beneficial exercise to go through for somebody left behind because unfortunately, and we always talk about estate planning, we always talk about getting hit by a bus.
The reality is that somebody out there may not
Make it home tonight, and all of this information has to be documented and identified, regardless of the will or in advance of the will. Even so really critical for sure. And you mentioned email and social media accounts.
In my case, I have an email account that my wife doesn't use.
And so obviously I need to have identified
And password so that she would
Be able to go in and monitor my emails and respond to things that might come in that need to be responded to.
And the social media aspect. I know a couple of these companies are in hot water right now over maybe some business practices,
But if you've got
Like Facebook, LinkedIn, Instagram, Twitter, Snapchat, Tik Tok, I don't know, not promoting any of them as investments, by the way. But just the reality is when I look at the younger generation like my kids, all they know is social media. It's funny. Both of my kids know the passwords to my phone and iPad and laptop, things like that.
Credit cards, pretty
Much, but I don't know the passwords to their phones, and they won't give them to me.
No. And if you ever did find out they would just
Change them anyway. Yeah.
But the point
Is like there was a case
A few years ago where somebody had, well, they had downloaded thousands of dollars of movies
Off of Apple
And they passed away and their spouse didn't know their Apple ID password. And it became a problem in the estate. And I don't know what came of it, but because they won't reset the Apple ID password for a deceased person
Anyway, it's just something to be wary
Of. But other than that, I mean, you also want to write down things like your wishes. What do you want the next generation to either know about
You or wish for
It's really an opportunity to get all that to plan in advance for that time when you actually won't be able to say those things,
Whether it's how you want
In many cases, we find
Most wills deal a lot with financial assets, but a lot of wills don't deal specifically
With property your belongings.
I have a
Couple of rare guitars. What would I want
To happen to those because they likely won't be addressed directly in the will? And so this is a place for lots of those kinds of things to be addressed. And again, what you're doing is you're just planning for the future.
The whole idea
Of estate planning is to be able to have your
Executed essentially from the grave. So things like. Your wishes? Any last words? Very important. As you mentioned at the beginning, we do have a planner that we can make available to
People to try to organize
All of this, essentially exactly in the order that we've talked about. Many people don't like to use paper. They like to store things digitally and you can do the same thing online. There are many different types of
Programs or spreadsheets out there that set up these kinds of lists.
But I think the important thing is just to do it one way or the other.
And now I clearly get this isn't the most exciting thing
To talk about.
This is probably not our most exciting episode, but it's really important.
Well, that's right, and it really is one of the
Critical key first steps when you're doing your estate planning. I mean, how can you plan for your states if you
Don't even have a good, solid
Record of everything you own, everything you owe and how you think you'd like things to be handled when you're gone?
And that really is the starting point.
And listen, get after it, because
I can say humbly that I haven't completed this yet. Myself started it, but I haven't completed it.
What's your problem?
Well, you know, it's one of those things that's easy to put off until you start to panic. If you start feeling some
Chest pains, you might speed up filling out
That book. Yeah, yeah. Well, anybody
That wants, as you say, a
Copy of that plan or let us know we do have many available
In, I shouldn't
Say anybody because there's actually quite a few people that
Listen to the show now right on
More than just our extended families, which is cool, right? Yeah. Very cool. And if there's other topics, I mean, I guess we'll wrap it up there for today's conversation. But if there's other topics that people want us to address, I mean, we're always open to addressing them, for sure.
And listen as we go forward
In the future. On this subject, we will be bringing in experts in the areas of drafting a will thinking about, well, exactly now I know everything
I own and how I want things to work.
Now we need to put it on paper, not to mention the power of attorney and personal directive, which get into all sorts of other areas. But yeah, so stay tuned. We'll have more on that.
Sounds good. All right. Well, I guess that's it.
Yeah. Hey, just before we sign off,
What's going on in your life? Any good books you're reading, shows you're watching?
Yeah, I guess we usually ask those questions.
The only books I'm reading are focused. Your own
Studies? Oh, I'm studying for.
Told you the University
Of Chicago in the CMA program.
So just reading about
Probabilities and portfolio
So it sounds fascinating. I actually quite like it, but it wouldn't be
Reading. And what does seems stand for? Well, you know,
Because you have it right, right? So you tell us
That's the Certified
Yes, it's relatively
Intense going through the
Process, but certainly valuable in the areas
That we work.
I'll tell you, I actually have been watching a few shows,
Though I've been getting caught up
Wow. So name from the past.
Yeah, I noticed that it's got a reboot.
They're coming out with new episodes starting shortly. I don't remember when the last
Dexter was filmed,
But it was quite a few
Years ago. Right on being also
Keeping up with billions. Ok. Comes out every
Sunday, and I show
Sort of about what we do, but not really.
I think I'm about four years behind on that. I think I watched the first season.
Well, you got four more seasons
To go then. Fantastic. Actually, the last episode I watched the season ending episode. It is quite a cliffhanger.
Oh, so you've only
Got to get through about 60 episodes to get
How about you?
I'm actually reading for a change, a really interesting book that is more biographical in nature. So it's called Code Breaker, and it's about Jennifer Doudna,
Who people may not have heard of. She won the Nobel
Prize in Chemistry in
2020 with one other researcher. She's the one
Who really helped develop what they call the CRISPR
Technology, now CRISPR.
Basically, it's a gene editing tool that bacteria use to protect themselves from being attacked by viruses.
But the process, the CRISPR
And the enzyme that's
Attached to it actually allow
For gene editing
In animals. It's now being
Used for treatment of various diseases. It's been used to try to treat people with sickle cell anemia, I think is one that's
Been used for and they're working on HIV as well. This is the new
Age of gene editing, and I think over the next many years it will
Become probably the
Technology that's used to treat lots of
Diseases. So. Fascinating. Book this guy.
His name's Walter Isaacson, and he's written biographies. I think the most recent one was on Steve Jobs. So interesting
Book. But again, not fiction,
But still pretty entertaining.
Oh yeah, super light reading for somebody with a master's degree in genetics like yourself,
That goes back a long way, and I think it's safe to say whatever I learned is out of date and I've forgotten it anyway. Yeah, yeah, that's it. That's all right. Can be busy.
Cool. Well, then I guess we'll catch up with everybody next time.
Thank you for listening to the Free Lunch podcast hosted by the CCM Group at. Would Gandhi to subscribe to this podcast to get more realistic insight on investing or to connect with one of our talented partners? Please head on over to market work. We'll see you next time on the Free Lunch podcast.
Episode 70 – Looking under the hood.
In today’s episode we discuss different account types & explain the difference between traditional transactional, fee based, & discretionary accounts.
EP.70 - Looking under the hood
There are very few things that investors can do that are free. But what about a podcast that delivers educational content on investing, saving strategies, financial planning, topical items of interest and maybe even the odd wacky topic? Welcome to free lunch! Posted by Greg Kraminsky and Colin Andrews of the SAM Group at CIBC Wood, Gundy free lunch will bring listeners the firm's vast knowledge and experience in dealing with uncertainty to help clients achieve their vision through a deep understanding of what is important to them that requires planning money and time. Learn more and subscribe today at market work.
Welcome back to the Free Lunch podcast. Our first episode post, Canadian Election, Greg.
That's right. And what happened in that election, Colin?
Well, I have no idea because we're recording this before the results come out.
But what can't you see the future? Can't you predict the future?
You know, I've tried for many years to predict the future with things like the stock market, and that hasn't gone very well for me. So no, I'm not going to try to predict the future of the election. Well, actually, let me just say this. My prediction is that the party with the most votes will be our government folks.
You heard it here first
Because last week we spent time talking about the impact of elections on stock markets, something we've addressed in the previous U.S. election and now in this most recent Canadian election. As you already pointed out, by the time this episode airs will already know the results of the most current federal election in Canada. But if anybody's is interested in that discussion on what impact elections have on markets and market returns, I would recommend that they go back and listen to that episode. Sure. And also to the one on U.S. elections. I believe it was called. Yeah, but it's different this time. I thought they were pretty well done, but
I'm pretty biased with good reason.
But for today's show, we had a listener ask us to break down the different account structures that are available to investors. So that's what we're going to spend our time on. We're calling this one looking under the hood. And for all those other listeners, if there are any topics that you'd like us to cover, well, then just drop us a line. I mean, we love to hear from people about things they'd like us to talk about, for sure. Because we've covered quite a few topics in the last 18 or so months, having done 70 episodes now, but there's always something to talk about. There's always something that's a headline currently or something that's burning at the back of somebody's mind that they want to discuss or find out about.
So let us know what you'd like to hear about and you'd like us to talk about, and we'll be sure to do it.
We're all ears, but for today we're going to get into the types of advisory accounts, talking about the different structures and see how some of the investments fit into those. So I want to take it away. Sure.
And we actually have covered off some of this on previous podcast episodes. We've talked about the evolution of the investment advisor. And that evolution, of course, includes the evolution of
The type of brokerage
Accounts or advisory accounts that have been popular over the years.
But this one, we're really
Going to focus in on those types of accounts.
And so let's start with the
What I will call the traditional brokerage account. And I say traditional because it's sort of the way the brokerage business has operated
For the last, I don't know,
70 years, and this type of account is a transactional account. And what that means is that the typical interaction between the broker in this case and the client is that the broker would call the client with a recommendation to buy or sell a stock or a bond or a mutual fund. And then there would be commissions charged
On those securities
Purchases or sales.
Now I want to point out you're using the term broker for a reason because in that relationship, they're brokering a trade.
That's right. And even though they do provide advice, the advice would be more related to advice on a particular individual stock, let's
Say, or whether it should be bought
Or sold. And mutual funds also make up
Part of that. And we're going to talk a little
Bit more about how mutual fund fees are constructed a little bit later on, but just for the purposes of discussing traditional brokerage accounts when a
Mutual fund is purchased for
A client under that type of account. In the old days, there could have been an upfront fee charged if you can believe it, up to nine percent nine percent of the fund that went away back in the 90s.
And then there was other ways for the brokers
To earn commissions, either through a deferred sales charge where they would be paid five percent of the value of the fund or some other structure.
But we're going to get into that later.
Suffice it to say that there was a commission earned by the broker and then by the brokers firm on that transaction. And all of these cases, the client or the mutual fund company would be paying the brokerage firm the commissions on that particular transaction.
When I hear of traditional brokerage accounts, it reminds me of the movie Wall Street, where Bud Fox is trying to land Gordon Gekko as a client and he goes to see Gordon Gekko, and I don't want to ruin it for anybody that hasn't seen Wall Street, but it's been around since like nineteen eighty seven and a great movie, actually. But what does he do? He goes in with a trade idea of a couple of stocks that he likes, and he tries to convince Gordon Gekko to give him some money and buy those stocks.
That's right. And listen, when I started in the business over 25 years ago, this was the primary type of account and these accounts are still in use
Today, and there's
Actually nothing wrong with them. It's just that there have been some changes in the way that advisors are brokers, previously brokers, no advisors and their clients interact with each other. And as the broker evolved into the role of an advisor. The transactional account may not be the most appropriate to reflect that role, so
I just want to talk maybe a couple of pros
And cons of the transactional account. Now I've heard this from some clients over the years. Some people actually believe that the transactional type of account keeps the adviser on their toes, meaning that they have to continually be
Coming up with good trade
Ideas. And they feel that if the structure was different than the adviser might not be quite, as, I
Don't know, up to speed on these kinds of
Ideas like they got their finger on the pulse
Of the market.
That's right. Some people do
Want to be actively
Trade recommendations and debate, whether a recommendation is a solid one and what their views are. And so a lot of people do like to get into the nuts and bolts of an individual recommendation, whether it's to buy a stock bond or mutual fund.
Well, I want to get into that a little bit because you and I have talked about this many times. I think in some past episodes to where in this type of relationship, so let's say you've got a client, we'll call them Jane Jane Doe and Jane comes to their broker and says, Mr. Broker, I'd like to or Mrs. Broker. I'd like to buy a stock, and the broker goes and finds a stock for Jane to buy. My question to you is this Greg? What makes that broker more knowledgeable than the rest of the market to which they're trading against?
Well, it's a good question. And of course, we've talked
About that on many
Episodes. And the answer is it's a little bit unclear. We don't believe that any one person will have more information than the market as a whole has and therefore will be able to identify undervalued securities more than anybody else. We believe that the market generally has it right.
But to your point that that Jane Doe might be looking for their broker to be fairly active, to have their finger on the pulse? That's right. So now they're talking about not one trade, but multitude of trades.
Exactly with that idea of being that that
Person must know more than the rest of the marketplace.
Yes, exactly. And that sort of gets into some of the cons of the transactional type account or the traditional account. And one is that's been identified by regulators, not just people in the industry or clients, but the regulators. And that is that there's an inherent conflict of interest when an advisor or a broker calls up a client with a bunch of trades that he's going to earn, he or she will earn a commission on then. Are those trades really in the best interests of the client? Will they really make a big difference to the portfolio or is it a way to generate revenue? And again, I'm not trying to cast aspersions on anybody that's in that role. I was in that role myself and I still am with many clients, but there is an inherent conflict that you need to totally trust the person that you're dealing with to ensure that that conflict isn't
Finding its way into the relationship.
But the other thing, and I think one that's even more important for
Us, who for our
Team who have
Never been involved heavily in
Stock trading or transactions is just that it doesn't really recognize all of the services being offered by the advisors
To the clients.
The focus is on the last
Trade or the next trade.
Exactly. And as we've talked in the past, as everyone that listens to our podcast know, we believe that planning is one of the most important activities that you can do prior to making any investment recommendations or any investment purchases.
I ran into
A guy a few years ago and he was all excited because he was going to start offering his clients financial planning. It's like this new thing or something.
And that is a very
Significant change from when I entered the business because when I entered the business, there were not a lot of advisors doing planning, and that started to change in the late 90s and early 2000s. The focus became a lot more on planning, and that became incorporated into a lot more
Advisors and their clients, which kind of leads us into the next type of account then. So the first one was the traditional transactional account. The next one are the fee based accounts, and we call them fee based.
It's really an asset
Based fee account. And in those types of accounts, the investors would pay
A fee based on a percentage
Of the assets under management for the services, and those services would include all
Transactions and other fees
That might otherwise be charged separately. There's obviously a wide range of fees.
In our case, our fee is
One percent on the first million dollars of investment assets and half a percent on the next nine million.
But again, the fees
Do vary by advisor and by firm.
But that's kind of a one percent fee
Is a pretty typical starting fee for accounts.
And the idea behind that is that if you have an active trading strategy, rather than paying a commission for each trade, you just get a number of trades covered for the year under that fee arrangement.
Absolutely. So the fee would cover any trade costs, whether their stock transactions, bond transactions or mutual funds. And there's also no extra fees, you know, many people are familiar with RSP administration fees, which are charged annually and transactional accounts.
Those fees are all
Covered within that. So and the fee basically includes all services provided by the adviser. And so as we talked, it's not just trading. There's the financial planning. There's the consulting aspect. There's developing plans, meeting with family members, all of the things that we like to do as advisors to ensure we know everything we need to know about our clients and their goals.
I would say that then the fee based arrangement is a step up from the traditional transactional arrangement because you can incorporate things like intergenerational wealth transfer, for example, that has nothing to do with. Should I buy Suncor and sell Cenovus? That's right. And wait. Disclaimer. We're not recommending any of those trades, by the way. No, we're not.
That's right. So and we're not
Saying that buying and selling stocks is not one method of
Building investment strategies for clients. Many of our clients
And many clients in general still like to hold portfolios of stocks, and there's a number of ways to achieve that the transactional account and the fee based account. So let's talk a little bit about pros and cons of the fee based, the asset based fee structure. Well, as we talked about already, there's no costs to do a transaction, so there's no limit on, Oh, do we really want to do this? I don't want to spend the money to do this transaction. It's all covered. I think most importantly, what it does is it aligns the interests in those placing the trade, i.e. the advisors and those whose money is being invested. The client
As the more the
Account grows, the higher the fees will be. And if the account goes down in value, do usually to a bear market or a market correction, then the fees will be lower. And so essentially everyone's on the same side of the table. And the only way the adviser can hope to earn more fees from a client is through the growth of the portfolio.
So as I talked
About the fees, in addition to covering transactions, they cover other costs, such as annual RSP administration fees, any custodial services, all planning is
All included, et cetera. And there's another
Benefit and that is the fees that are charged in non registered investments basically can be tax deductible on the personal tax return. We always, of course, recommend people talk to their tax advisers with regards to that aspect, but certainly talk to your lawyers or accountants about that because those fees are deductible, whereas similar fees in a transactional account or not,
We're harder to make. That's right. So in a fee agreement, you actually get a copy of your fee summary at the end of the year and you just submit it with your tax return as a credit and life is good. Exactly. But what are the cons?
There are some cons, or at least
For some people. And one is that if someone's expectation is to do a lot of trading, if the belief is that the main reason for being in a fee based account is to be able to do tons and tons of transactions without having to pay for each of them, then there may be some disappointment if that doesn't happen. And as we know from research, actively trading an account does not necessarily improve account performance. And in fact, in some cases, active trading is actually detrimental or negative for performance.
So it really
Requires that the client and the advisor really understand and agree that the fee based approach is the right one for them. The other con might be that some of the
In registered accounts are RRSPs riffs locked in retirement accounts. Tax free savings accounts cannot be written off against personal tax returns.
Well, let's talk about discretionary accounts.
You talked about
Transactional accounts and we talked about fee based accounts and those differences. The newest part of the evolution or the continuance of evolution is discretionary accounts. Would you say that I would?
And what exactly is a discretionary account calling?
Well, it's good that you ask. First of all, a discretionary account is a fiduciary relationship,
So I want to talk about that for a minute. Ok, so
Investopedia defines Fiduciary as a person or organization that acts on behalf of another person or persons putting their interests ahead of their own with a duty to preserve good faith and trust. Being a fiduciary that's requires being bound both legally and ethically to act in the other's best interests. So that's the definition of a fiduciary by Investopedia.
And the interesting, you'd think
That in any advisory relationship that that fiduciary responsibility would exist, but it doesn't, but it
Doesn't. That's right. So a discretionary account is one where there's an agreement between the client and the advisor for the advisor to be able to discretionary trade the account on behalf of the client without having to review each trade with them. And in order to do that, it has to. Be a fiduciary relationship. Now I have this ongoing debate with a client about how advisors spelled, so
Whether it's a advisor,
Or advise her and one of them indicates fiduciary and one of them indicates salesperson. And this client would always ask me how I spell advisor trying to point out if we were a fiduciary or not. And my answer to him was always the same. Well, I don't really care how this adviser, because we're portfolio managers, licenses portfolio managers, which actually means we do have a fiduciary duty in that relationship. And in that licensing structure. So the benefit of a discretionary account is that, as I say, the client and the advisor come to an agreement on things like what should the asset allocation be? What strategies should that be? What kinds of securities should be held in the portfolio? And all of those things are documented in what's called an investment policy statement, and they're signed by all parties. And then the monitoring of that portfolio was done
By, I guess, a compliance
Area that makes sure that everything is within the ranges that are prearranged between the advisor and client at the beginning. So to do so, there is a fee that's charged much the same as a fee based arrangement. And in our case, it's actually the same fee. We charge the same fee, whether it's a typical fee based arrangement or it's a discretionary fee based arrangement, it's the same. And what do you get for it? Greg, that's the question that people always ask What do you get for being in a discretionary account? And I always answer, well, you get things like more regular rebalancing of your portfolio where I didn't know when the market is going through volatile swings up or down. We're able to do rebalancing trades, so you're potentially selling something that's gone up in value and buying something that's gone down in value and waiting for things to recover and then maybe doing the opposite trade when it does. So, you're picking up little bits of return each time you do a rebalancing trade. That's right. That's one benefit. The second benefit, I would say, is that it sort of gives people the ability to sleep at night because they know that their portfolio is being managed without them having to spend all the mental energy of managing it. Like, we don't have to call people and say, we want to sell this and buy this, and this is why. And here's the benefit. And here's the pro. Here's the card. They know that if we're doing a trade, it's because it's in their best interest already.
That's right. And that's that fiduciary responsibility that gives them the comfort that's not only an ethical but a legal responsibility. So they have the comfort that, OK, that trade has to be in my best interest and in line
With the parameters of
The investment policy statement.
Yeah. And as we talk about evolution of the
Role in that and we're talking again about
Looking under the hood, I believe is what we call this one and the different account structures. I think this is my own opinion. Discretionary management services are the way to go. If you have a good relationship and that you're a transactional brokerage relationship would be more like Neanderthal, like knuckle dragging behavior, where it's sort of like we've found fire, we're able to make it quite easily. Let's move on
With the world. I may not be quite so far
In that direction as you. I think there's a couple of things. I mean, transactional arrangements can still work as long as they understand, and the relationship and the role of the advisor in the relationship is in line with what we think it should be for all clients. So when you think about it, I mean, for all clients, we believe that the right approach is to understand all of the key
Their financial lives
Their goals for the future and developing a financial plan and then an investment plan to achieve that. And I think once you've done that, then the nature of the arrangement is still important, but it's less important. So for example, if you're comparing somebody in a transactional account to a fee based account, as long as the services offered are the same and everybody understands what the services will be and totally understands what the fees will be, then some people may choose one of those approaches. But if the transactional account is utilized the way they were 20, 30, 40 years ago, then I totally agree with you that it's missing most of the important aspects of financial advice and that is based around having a plan.
And I know I'm being kind of hard when I say things like Neanderthal, like knuckle dragging behavior, but the point is of the accounts we've opened in the last year. One hundred percent of them, I believe, have been opened as discretionary portfolios. And so my only comment to those that are in a transactional relationship and you're right, sometimes it makes sense, like if you have a legacy stock position and you don't want to sell it for some reason. Well, you wouldn't put it into a fee based account number one. Like you wouldn't pay an ongoing fee,
Of course, just to
Custody a stock. It belongs in a transactional account. But if you're divesting that legacy account and now you're talking about the. Next 20 years of investment returns and portfolio management. Perhaps it makes more sense to be in a discretionary portfolio,
And I think one of the important pros and
Cons when we talk
And cons of discretionary
Accounts, the pros are certainly the fiduciary relationship. The ability of somebody to sleep well at night know that things are being taken care of. One of the cons is that I do have a number of clients who do like to be involved in understanding what security is, even though there's no lack of trust. There's just a need for knowledge.
They like to discuss it.
They like to know and they like to have that conversation. And so they might end up in a regular fee based account, but not discretionary. And that's why I think the key thing is that people should understand the types of accounts that are available and then select the one that is most in line with their interests and how they like to have a relationship with their advisor.
Yeah, you don't want to put the cart
Before the horse. You've got to
Figure out no one where the best strategy for you and your family and your goals. And as you mentioned, it's going to start with some planning. I would say if you ever come across an individual who leads that relationship with product, you're going to run into an issue potentially. That's right, that's all I'm saying.
So for sure, and we've talked about
That on other podcasts as well. It's the prescribing medications before doing the exam.
Well, you have a scene you always say, like, what do you say, like if you're a hammer,
How does it go? If your only
Tool is a hammer, everything looks like a nail.
So we don't want that hammer nail relationship. We want a bigger toolbox.
And that's what these types of accounts do.
The different strategies one may work
Better for a client than another one. There are some advisors that only work on a certain basis. So, for example, there are many advisors who will only operate on a fee asset based fee arrangement and will not do transactional. There are many advisors who choose only to do discretionary management. We currently offer all of those to our clients based on our client's wishes, but it's not inconceivable that over time that could change as well.
Well, and as I said, like a hundred percent of new relationships have gone discretionary, whereas when you and I started working together, which is now 14 years ago, Greg, that's right. That wasn't the case. Most of the relationships were transactional.
It's true. So there's definitely an evolution there, and it's an evolution that is taking place with advisors and with investors.
Oh, by the way, it was 14 years ago this month that you and I started working. Happy anniversary. Yes, happy anniversary. They said it wouldn't last. They did. Yeah, let's get into a brief discussion on the mutual fund structures. What kind of mutual funds are there and where they fit into each of those three buckets of account strategies?
Yeah, because mutual funds are interesting, I think most people fundamentally understand, OK, well, if I'm buying or selling a stock under a transactional account, I'm going to pay a commission. And that commission could be anywhere from one hundred and fifty dollars to five
Hundred dollars, depending
On the advisor and the firm and the value of the stock
Transaction or in the U.S. might
That's right, you can do it for zero if you're doing it yourself, but mutual funds are slightly different. And so let's go back to the transactional type of account. So there's two types of mutual funds that could be purchased in those accounts. One would be the a class and a just stands for advisor class, and those are also called front end load. Mutual funds load is just a word that the industry came up with. It sounds better than commission somehow.
Financially, it sounds better.
I don't, either.
It's a weird word anyway.
A front end load just means that there could be a commission charged up front, and the advisor has the ability to charge anywhere from zero percent up to
Two percent in order to
Purchase that fund. I just want to say, from the standpoint of our team, we have not charged a commission or load on mutual fund purchase in over twenty one years. So that's not something that was ever part of our business. It is something that's available. We typically would charge a zero percent load.
We're not a charity. No, we're getting paid by the mutual fund company, a trailer exactly for that position. We don't feel it's necessary to charge the client anything because of that,
Exactly with these
Types of mutual funds that are purchased in transactional accounts. There will be a
Service fee that's part of
The overall management expense ratio of the fund.
That service fee, which could be
Anywhere from half a percent to one percent, is paid to the advisors firm. That's the A-Class fund. And then even scarier are the what they call low load, which means low commission or deferred sales charge. This is where things get dark.
Yeah, this is where it gets scary.
Yeah, so the deferred sales charge is something that pretty much no longer exists in the industry. But the way it worked was when an investor would buy a mutual fund, they would not have to pay a commission. Up front, if they bought it on the deferred sales charge basis, the advisor's firm would be paid five percent by the fund company,
But in many cases those clients believed they weren't paying
A commission. That's right.
And then how did the fund company, how could they afford to pay a five percent commission? Well, they required the investors to stay invested in their mutual funds for up to about seven years, and that ensured them that they would have that continuing stream of income from
These mutual fund
Investors and they would get their five percent deferred sales charge paid back. Well, that's something that's gone the way of the dodo birds. The deferred sales charge mutual fund is now a thing of the past, and the low load version of that was just deferred sales charge that had a lower two percent commission to the advisor's firm.
I think it was
Certainly at three percent
Or maybe three, and it had a shorter
Time that the investor had to hold those funds before they could sell out and not pay a fee on
The way out. Let's give an example.
So in a deferred sales charge situation, which some people referred to them as discount because they said
Because I said
D-s.c, which is not,
They are not a discount, they're a premium. But in that situation, if you
Purchased a whatever x
Y z mutual fund in year one in year three, you needed to sell it. For some reason, you're buying a house or whatever. You could have a redemption penalty of as much as maybe five percent or something. That's right. So it was, I think in general, it was meant to dissuade people from selling out of their positions. Yes, but I don't believe many people knew the extent of the redemption period when they purchased the
Funds, and that's
Just part of
The issue. One of the key
Things with any type of account, whether it's transactional fee based
Or discretionary, is that
Fees should be 100 percent transparent. Investors need to know and deserve to know exactly what the fees are that they're paying, whether they're paying them to the advisor's firm or whether they're paying to the issuer of the securities. And fee transparency is something that's become much more topical, and the regulatory organizations have actually made some very positive moves in that direction to make sure people understand what fees they're paying.
Let me ask you this, then, if low load and desk funds are sort of the worst of the bunch and front end or a class or better
Because you're not paying a
Commission and there's no redemption penalty, can you tell the listeners, is there a better way of holding them?
Well, and certainly I can. Those two types of funds we talked
About are relevant for
Transactional accounts for fee based and discretionary accounts. There's a class of mutual fund shares called F Class, where F stands for fee based based. And what's happened here is that any service fee that would be payable to the advisor's firm has been removed from the management expense ratio. So if an A-Class fund paid one percent to the firm, then that one percent is gone. And so the total management fee includes only the costs of managing that particular fund by the fund company and trading costs and things like that. And so the overall management expense ratio is much lower in an F class fund. And the reason for that is because the investor is paying the advisors firm directly through
Their fee, as I say,
Whether it's in fee based arrangement or discretionary account,
So it becomes transparent, but it also becomes tax deductible, potentially.
Exactly. So the
Tax benefits on mutual
Funds are particularly strong because that fee, that service fee is being removed from the management expense ratio where it's not tax deductible and it's now being charged in the typical fee based account where it can be deductible. So that's it. There you have it three types of accounts and pros and cons to each. But certainly, as you pointed out, the evolution has been from brokerage style transactional accounts towards fee based and discretionary accounts.
Well, yeah, I mean, you expect evolution and, well, everything these days.
If you think back to
The way things were done 40 years ago in any business line, I'm sure there's been evolution. If there hasn't been, I would be shocked.
The industry is always looking for new and better
Ways to do things. And I think the
Thing we have to acknowledge is that this isn't a cynical, always looking for ways to make more money or anything like that. What it is is it's these are ways to offer better services to investors and clients and have them get more value out of the relationship with their advisors.
Exactly. Well, listen, I think that about wraps it up for today. It does. I'd like to ask anybody listening out there to please go ahead and give us a rating if you're listening to us on any podcast, subscription services or anything like that that allow you to do that. And we'll look forward to our next week's call when we'll be talking about. I'm not sure yet, but I'm sure it'll be fun. Look forward to it. All right. Till then,
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Episode 68 - What is inflation and why is it important?
We discuss Inflation, something that has been coming up a lot these days as we deal with transitory inflation from the global economic lockdown.
Welcome back to the Free Lunch podcast with Greg Kraminsky and Colin Andrews, Greg, Nice to have you back on the show.
It's nice to be back. Had a great vacation, but vacations end and get back
To work like a distant memory.
Exactly. And it was a good vacation. It was
Only a three pounder three pounds
Of what exactly?
Solid muscle, so solid muscle
You were working out the whole time you're away? Absolutely. Yeah. I don't think doing ice cream curls is actually considered working out, Greg.
Well, look at these biceps.
Well, while you were gone, you missed a couple of episodes. So last week, Steve and I talked about what is an expert, and the reason for it is because two weeks ago we had Paul Eidelman join us from Russell Investments, and that was a good show where we talked about something about inflation and it got us thinking about, well,
What is inflation?
Why do people talk about it so much? What's the importance of it right on? So that's what we're going to get into today. On your first day back on the job, we're going to get into something pretty deep here.
It's pretty heavy,
Pretty heavy stuff. Yeah. Ok, well, let's talk about it a little bit.
I mean, because sure, everybody hears and talks about inflation, and it's all in the news today these days. So let's just back up a little bit and do some background here. So what is inflation? Basically, it's a general increase in the cost of goods and services, and the net result of that basically is the decline of purchasing power in a given currency. If prices of everything you buy, everything you consume, go up, your money is not going to go as far. And that's why when in all of our planning, we always include inflation
With regards to all of the lifestyle
Expenses, because of course,
Inflation is a significant
Factor, particularly over long periods of time,
Because whatever it is, you're buying right now, 10 years ago, that item was probably
Cheaper. That's right. Absolutely.
The other side of inflation is deflation, and that occurs when the purchasing power of your money increases and prices decline doesn't happen all that often. But we've absolutely seen great examples of deflation with regards to technology. What did you pay for your most recent television and what would of that cost five or six years ago?
Remember when the first plasma screens came out. Do you remember how much they were selling for? Oh yes, twenty thousand. That's right. Now you can buy one for like, maybe eight hundred bucks at Costco. Exactly.
Yeah, crazy. So it's easy
To measure the price changes of individual products, just as we've been talking about the price of televisions. But most individuals need a big and diversified set of products, as
Well as a bunch of different
Services for living a comfortable life. So those would include commodities like grains or food grains, metal fuel,
Utilities like electricity
And transportation services like health care, entertainment, labor and
Stuff like that. And so when we
Measure inflation, we're trying to measure the overall impact of price changes for a diversified set of products and services and get a single value representation of the increase in price level of goods and services over a period of time. And that's typically what we call the inflation rate, and we'll get into that a little bit how we measure that. So what happens, though, is as the currency loses value, prices
Rise, the currency
Buys fewer goods and services, and that loss of purchasing power impacts the general cost of living
The common public and that ultimately leads to a deceleration in economic growth. So to
Combat that, the country's
Appropriate monetary authority, like in Canada, is the Canadian central bank.
In the U.S., it's the Federal Reserve.
They take measures necessary to manage the supply of money and credit to keep inflation within allowable or permissible or reasonable limits to keep the economy running smoothly.
And typically, they want that inflation number to run somewhere around two percent or less. That's right, and we'll get into a little bit about where it's at right now, but you mentioned something interesting. As a currency loses value, prices rise and it buys fewer goods and services. I would argue that the currency never really loses value. It just loses how much it can buy. Right. That's right. So like a dollar is a dollar.
Yeah, right? It's just purchasing
So there are causes of inflation. An increase, as you've mentioned in the supply of money is the root of inflation. So although this can play out through different mechanisms in the economy, money supply can be increased by that monetary authority. So as you mentioned, the Bank of Canada or the U.S. Federal Reserve. And how do they do that? They do that by printing and giving away more money to individuals or more commonly by loaning new money into existence as a reserve account credit through the banking system, by purchasing government bonds from banks on the secondary market. Now in English, I want to repeat that whole part in English, Greg. Yes, is that that's basically called quantitative easing, which isn't.
Well, I mean, it is English, but
It's a little harder to understand. All it really means. I know you're going to get into it later is that the central bank goes out into the. Marketplace and purchases, bonds that are already trading. Now, why do they do that?
Well, they do that because they're increasing the demand for those particular bonds.
And as the demand
For those bonds increase, the prices increase and therefore the yields on those bonds decreases. They actually control interest rates by doing that.
This is monetary policy or a form of it. And so in all, such cases of money supply increased the money, as you mentioned earlier, loses its purchasing power. In other words, it buys less goods. But there's mechanisms of how this drives inflation, and they're classified into three types. And I'll get into them. There's the demand pull inflation, the cost push inflation and the built in inflation. And there's a few others that
We could get into, like hyperinflation,
Reflation deflation. You mentioned things like that. But in the demand pull effect, demand pull inflation occurs when an increase in the supply of money and credit stimulates overall demand for goods and services in an economy to increase more rapidly than the economy's production capacity. So basically, this increase increases demand. And as we know from our basic economic classes, if you have an increase in demand and a constant supply while the price goes up right on in the cost push effect, cost push inflation is a result of the increase in prices working through the production process inputs. So when additions to the supply of money and credit are channeled into a commodity or other asset markets, and especially when this is accompanied by a negative economic shock to the supply of key commodities similar to maybe a global lockdown. Sure, global pandemic basically the cost for all kinds of intermediate goods rise, so that makes sense in a global economic shutdown. There's nothing being made. And so there's a limited amount of supply the demand may curtail, but not enough. And so it pushes the price up.
Look at what happened this past year with lumber prices when the pandemic started. A lot of the lumber mills shut down because, first of all, they couldn't operate on full staff when we were in a shelter in place or isolating at home. And so the lumber mills shut down, which reduced the demand for lumber. And at the same time, I think a lot of the strategy behind that with lumber mills and other types of businesses like that were that, well, we're in a pandemic. What are the odds that there's going to be a huge demand for lumber? Well, as it turned out, there was a massive demand for lumber. People started buying houses because they thought, Well, we were able to work from home. And now I'd like to change my home location. I'd like to live somewhere else or they
We’re renovating their
Space. They were renovating. And so all of a sudden, you've got this massive demand for lumber and a very limited supply. And as a result, lumber prices skyrocketed. And so again, that not only is a higher price for lumber, which most of us don't buy lumber directly, although some do. If you're doing a renovation, but we buy stuff that lumber is a key element of. So if you're buying a new house, lumber prices, I think, added 20 or $30000 to the
Price of a new house.
So that's definitely the cost push effect right there.
You see it in vehicles
With the semiconductor issues, for
Sure. Ok, the last one I'll talk about is built in inflation, so it's related to adaptive expectations, the idea that people expect current inflation rates to continue in the future. So as the price of goods and services rises, workers and others come to expect that they will continue to rise in the future at a similar rate and demand more costs or wages to maintain their standard of living. So basically, they're saying that it's like expecting a constant growth rate. There's increased wage results that are passed down to consumers. If wages go up on an annual basis, I don't know pick a number two percent per annum. Well, then that gets pushed down the chain. So there's a built in inflation that results in this wage price spiral.
Sure. Yeah, wages are a very important component of the final product, whatever it is that you're buying. And as the cost of wages are just like input costs, as those costs go up, the prices have to go up and that does create that kind of a self-fulfilling spiral.
Though, when I remember studying economics, of course, in school and we talked about the stickiness of wages and how,
Let's say somebody loses their
Job and they're a professional in their field, in their paid, I don't know, pick a number one hundred thousand dollars a year is the going rate for this particular professional. They will not accept a job for fifty thousand a year
Just to be employed. They are looking
To recapture their old wage, and it's only after being unemployed for some long period of time that they will accept a lower paying job. And so therefore economists always talk about how wages are sticky. People will hold on to the idea that they will get what they were getting before. I think I. Took us on a total aside there, by
The way, but no, but I think it worked. You see it on
Very rare occasions that wages are rolled back. Typically, that happens more with government than it does in the private sector. Very difficult in the private sector to actually come to a wage agreement, whether it's through a union or directly with employees that actually has wages going backwards.
Well, here's one you have the Border Patrol people in Canada. Where do they call Canada Border Patrol? You know, they're talking about opening up the border for travel. And then the Border Patrol people go on strike because they want a higher wage. I was going to argue, well, they weren't really doing much for the last 18 months. So maybe I've offended some Border Patrol
People like it could be.
And but that's just everyone really
Is looking out for their own situation. And if inflation looks like it's a problem, then like anyone, well, I need more money. The purchasing power is down and I need more money. So let's talk a little bit about how inflation is tracked. So there's a lot of different types of calculations.
So depending on
The selected set of goods and
Services, you get
Different calculations and different ways of tracking a price index. But the main one that we hear about in Canada in the U.S. is the consumer price index. And basically, that's a measure that examines the weighted average of prices of a basket of goods and services, which are of primary consumer needs, so they would include transportation, food and medical care. Cpi is calculated by taking price changes for each item in the predetermined basket of goods and averaging them based on their relative weight in the whole basket. And the prices in consideration are the retail prices of each item as available for purchase by the individual.
Actually, on that note, you can go to Bank of Canada, okay, and they outline what they consider part of the CPI in Canada. And I look looked just before we recorded here and they said food, shelter, furniture, clothing, transportation and recreation. And interestingly, they have an inflation calculator so you can actually go and look back to nineteen fourteen and put in what the price of something was. Well, you can pick any year, but it starts in nineteen fourteen and you can see what that is in today's dollars. That's a very interesting calculator to go look at.
Well, it is and the reason because
It's a relatively
Standard basket. And so when you're looking at that basket of goods and services from one month to the next and one year to the next, it gives you a pretty good idea of how prices have changed. And so the changes basically in the CPI are used to assess price changes associated with cost of living, I should say. So it is one of the more frequently used statistics for identifying periods of inflation or deflation. Now in the U.S., you mentioned the Canadian situation and again in the U.S., the Bureau of Labor Statistics reports the CPI on a monthly basis as well and goes back to 1913, so very similar on both sides of the border. Interestingly, there are differences in the components of the basket of goods and services. For example, I was just reading in one of the CIBC documents about how the Canadian CPI does not include the cost of used cars. Whereas the U.S. one does
Well, there isn't a lot of argument over what should be included and what shouldn't.
That's right. Certain things will affect certain individuals more than others. But again, as a general guide to know whether inflation is a factor or not, it's sort of the best we have. And I think the key thing to remember is that when we're talking about inflation, we're talking about two things we're talking about what are the actual prices today? And then what is the rate of change? And the rate of change is usually referred usually to the previous month or the previous year. And we'll talk about that in a bit because it can sometimes lead you down the wrong path if you're only looking at rate of change
Well and in our financial planning than we do with
Clients, which again,
Greg, are we promoting that people do a financial?
Plan? Absolutely. We are calling.
Yeah, of course they should. It's like having the foundation before you build a house, you kind of need it. But in that planning exercise, we tend to use an inflation rate of two percent per annum, and that number isn't sort of picked out of the year. It's a historical higher than historical rate, slightly higher than historical rate of inflation.
And it's also the target rate that most central banks will certainly the central banks in Canada and the U.S. used to define as the right level of inflation. So let's talk about that a little bit.
Inflation can be thought of as either a
Good thing or a bad thing,
Depending on which side do you
Take and how rapidly the change is occurring, for example.
So if you have assets,
Let's say that are priced in currency like property
Or commodities, things like
That, it's good to see some inflation because the price of your assets are rising and therefore you can sell those assets at a higher price. However, the buyers of those assets may not be all that happy with. Inflation is because they're going to have to
Pay more for those things, and we're certainly
Seeing it. And speaking of my vacation, every time I go on vacation, I'm deeply offended by how inflation has affected
The price of lakefront property
Because certainly a shrewd investment in lakefront property. 20 or 30 years ago would be one of the best investments
You could have made. Would it have been
A shrewd investment or would it have been that you had some money 20 or 30 years ago when you happen to cross a property that was for sale and you just waited 30 years and it went up in value could be both of those. Yeah. Look, that always gets me about the housing market where people say, you know, you never lose money and houses.
I mean, that's a bunch of bunk.
I've lost money in housing. It's just when you're buying and when you're selling and where you are in the cycle. That's right,
Exactly. Time is definitely on your
Side in that area. On the other hand, so people that are holding
Assets denominated in currency, like if you're holding cash or in some cases some bonds, they may not like inflation all that much because the real value of your holdings get eroded and
Bonds are a unique situation.
We've talked about those before, and I'm sure we'll be talking about bonds again in the future because of course, inflation is tightly correlated with
Interest rates and that
Can have an impact on bond pricing. Now the other thing about inflation is it does promote some speculation, both by businesses in risky projects and by individuals in stocks of companies because they expect better returns than inflation. And you hear this a lot when we're talking about, well, if you want growth, if you want to stay ahead of inflation, you have to invest in the stocks. And that's absolutely true. And again, not to get too deep into the bond discussion, but every bond that's out there also has an inflation expectation built into the yield. And so bondholders also expect to get a real return over above inflation.
Whether we do or not is to be determined. Well, I want
To talk about that for a minute, if you don't mind. Sure. Just when you go to the bank and they want to sell you a five year GIC that's earning less than one percent or something like that, I mean, you have to know that you have a negative return.
That's right, a
Real rate of return, real
Rate because inflation is running more than one percent. That's right. And those geeks are priced that I'm just picking a number at one percent because interest rates are so low. So I was looking at this or I just want to make a comment about this is that when it comes to investing as a stock investor, we actually want some inflation like you just pointed out, because companies make more money during times of inflation. That's right, and a company's stock price is based off of its future expected cash flow. And so if there's inflation, they're expected cash flow is expected to go up. Therefore, their stock price is expected to go up. So it kind of works for us, but as a consumer, it's where we don't want inflation. So buying that house that now is like three hundred thousand dollars more than it was last year. That's a big hit,
And that's why people holding assets are in favor of some inflation. And I think in the end, there's got to be a balance because what happens is if the purchasing power of money is falling over time, there might be a greater incentive to spend now instead of saving and trying to spend later, because you might not be able to keep up, as you point out, with a
One percent saving rate and a
Two or three percent inflation rate. Well, that's so.
Yeah. Wait, wait,
Let's do that math one so positive. One minus three.
Yeah, equals minus two.
So it's below zero. So therefore it's a negative expected return, right?
That's right. And so you do sometimes find that in the early stages of an inflationary period, you may see a boost in economic activities, but then that can obviously decline over time. If as a result of the inflation, then interest rates have to move up. And as interest rates move up and credit becomes harder to get and more expensive to pay for. And that's why, in general, most central banks try to target a balanced approach. And they,
As I say, they've typically set
Two percent as their inflation target because it allows for economic growth without the potential for something to get in the way in the form of higher interest rates, borrowing costs, et cetera. So how do we control inflation?
Well, number one, you and I have no control over inflation, period.
Exactly. We don't we don't control inflation.
But of course, the country's
Financial regulators, like the central banks, that's their job. And we hope they do it properly.
And they do
It by implementing measures through their monetary policy, which basically refers to the action of a central bank to determine the size and rate of growth of the money supply. So in the U.S., for example, the Fed's when I say, fed the Federal Reserve, their monetary policy goals include moderate long term interest rates, price stability that you heard
That a lot.
Maximum employment and each of these goals is intended to promote a stable financial environment. And anybody that follows the business news will know that the Federal Reserve and the central Bank of Canada, they clearly communicate their long term inflation goals in order to keep a steady long term rate of inflation, which, as I said earlier, is thought to be beneficial to the economy. So price stability or a relative constant level of inflation, allows businesses to plan for the future since they know what to expect. And the Federal Reserve believes that this will promote maximum employment, which is determined by sort of non-monetary factors that flow. Weighed over time and are definitely subject to change
Like global pandemics,
Exactly. And so the Federal Reserve doesn't really set a specific goal for maximum employment, and it's largely determined by employers assessments. We've seen maximum employment doesn't mean zero unemployment because at any time there's going to be a certain level of volatility. And I think if you think back to pre-pandemic times, I think the unemployment rate in the U.S. and in
Canada were in that three to four
I was just going to say that actually, I looked at the statistic the other day. For somebody, it was three and a half percent unemployment rate in the U.S. in, let's call it, January of 2020. By March of 2020, it was 15 percent. And today it's running around six percent.
And back when it was three and a half percent, I mean, that was considered full employment. You've reached a point where there's always going to be some people that are not in the workforce for whatever reason or they're looking for jobs or what have you. And so that largely is full employment.
Well, but actually, economists would argue that that number is a bit skewed because it doesn't include people that have given up on looking for jobs. So that's right, it says full employment is three and a half percent. There could be another, I don't know, a few basis points of people that have just given up.
So just to get into
Mentioned earlier, monetary authorities, they sometimes
Will take exceptional measures in extreme conditions of the economy. So we talked about quantitative easing and the normal methods that the central banks may use to increase money supply is they'll have reserves which are drawn on by the major banks. The banks then use those reserves to lend money to individuals or businesses. And that puts money in the hands of those individuals, businesses and spending occurs and the economy trucks along. But after 2008, the Great Financial Crisis, the U.S. Federal Reserve has kept interest rates basically near zero, and they started quantitative easing, which was basically as you talked about a bond buying program.
But they did it by buying government bonds in 2008.
Correct? And that's changed now. It has so
Well. In addition to buying government
Bonds and mortgage
Backed securities, they're now also buying corporate bonds that opened up a whole new area of essentially their ability to control interest rates. Because, of course, interest rates on government bonds are not the same as they are on corporate bonds.
But by buying
Corporate bonds this time around, they were able to help control those high yield or corporate bond yields. Interestingly, back when we were coming out of the global financial crisis, we had lots of people talking, you know, lots of clients
We’re saying, Oh my God, there's going to be
Hyperinflation. The only thing you can do
If you're of sound
Mind is to buy gold and silver, because those are the only things that will hold up in this hyperinflationary environment that were definitely going
To see how silver done. Well, not all that well, and I'm not going to hold you to the
Number, but I think it's a negative
Return. Since then, it's been up and down. It's actually
Showed some signs of life lately, and I think that maybe is more of a meme thing than
It is a silver thing.
But it just goes to show, though, how expectations of hyperinflation based on the quantitative easing that occurred after 2008, they never came true. And interest rates have stayed extremely low since that time and are still there now. So how do you hedge against inflation? We talked about how stocks are considered to be a pretty good hedge against inflation because the rise in stock prices includes the effects of inflation and also when you have additions to the money supply and basically every country in the world
Has and they come through, as I said, bank
Credit injections through the financial system. Although a lot of the immediate effect on prices happens in the financial assets that are priced in currency like stocks. In addition to that, and some people talk, as I said about gold and silver precious metals as ways to
Hedge against inflation
That didn't necessarily pan out over the last
12 years. So for us, we
Usually recommend things that are possibly less speculative, and there are some things that you can
Invest in in the U.S. they
Call them tips, which are basically real return bonds. The tip stands for Treasury inflation protected securities. Basically, it's a bond issued by the government, and it offers a rate of return, which is set by
The coupon, plus whatever
Inflation happens to be for that year. So if the bond carries a one percent coupon and inflation is two percent that year, then the total return on the bond would be three percent over the course of the next year.
Well, I want to get into something that Barry Ritholtz, we're going to give Barry props for this. He came out recently and talked about, So where are we today? Barry finds it helpful to think of inflation coming in different flavors, and I won't go through the whole article that he posted. But I just want to talk about the five things that are important, I guess. So number one, he talked about long term inflation and elevated annual increases in pricing. So this kind of inflation crimps economic growth. I mean, it forces central banks to do things like you just talked about raise rates, which impacts everything purchased with credit. So if you buy a car on credit, but the cost of. Borrowing goes up. Well, then it probably impacts things, wouldn't you agree?
So there's a legitimate concern over long term inflation. That's something that central banks should be on guard against, and that's why they come out with their inflation numbers they're looking at. Where is inflation right now? What do we expect it to be and where can we keep it rangebound? I think is a term that people talk about. Number two, he talks about long term deflation, which is the flip side where prices continually fall. So if we think about that, I mean, if it gets too rapid and prices are just falling and falling and falling, well, that becomes a different issue for central banks. It does. And that happened in Japan, where prices just continued to fall and in the stock market. And I don't have the numbers in front of me, but like I think they had a negative return for like twenty five plus years,
Many, many years,
It started in the late 80s.
I believe there's a reason why central banks have monetary policy that they follow. There's also a reason why our governments have fiscal policy to input what they can into these
Things, too. Number three,
Gradual deflation, where prices can be driven lower in many ways, so economies of scale. So we talked about this where that plasma TV 20 years ago was twenty thousand. And today it's eight hundred bucks and comes with a five year warranty. Yes, it's a huge difference. Exactly. But there's digitization or digitalization. There's automation. There's global workforce that didn't occur decades ago. How many times you get a call from a call center in some place other than Canada?
Where that job used to be in places like New Brunswick, there's transitory inflation, and I would argue that's what we're going through right now,
And I know you're going to spend just a
Minute on it later. But you talked about the price of lumber and it going up in a short period of time. Part of that is in March of twenty twenty. We didn't have inflation in. Paul Eidelman talked about this on our episode two episodes ago, we actually had three months of deflation. And so this period of inflation we're in which some are calling hyperinflation. He's calling transitory inflation because it's just a short period of catch up time and finally price resets. So this is the thing. Supply and demand dictates price and price resets. So it occurs when an entire group of goods or services experience some change in price. At some point, there will be a new price equilibrium that will fall in the supply and demand curve. And anybody that wants to talk about supply and demand curves, I think we're pretty happy to show them how they work.
Well, for sure. And when you think about
Price resets, you can think of it as things like even housing, which we talked about. I mean, you can get like a very rapid increase in prices. I believe in Canada,
Prices have increased
20 percent in the last year. That's pretty rapid now from here. They likely won't go down. You may see a slowing of the rate of growth, and maybe they'll pick up the two or three percent pace. That's more normal. But this that step increase that Barry talks about there.
And the other thing, by the way, and I was
Just thinking about this the other
Day as I was paying my
Netflix or looking at my Netflix bill, is that Netflix? This is a low price item, but it used to be, I think, nine point ninety nine and fourteen point ninety nine now, which is a 50 percent increase. And so it's easy for
Some of these subscription
Providers to get step increases of fairly dramatic size, but it just doesn't affect people or we don't think about it the same way because it's on such a small, absolute
Level. Well, let's
Talk about that in math, just like we talked about before. I don't know how many subscribers Netflix has. I couldn't tell you, let's say, 100 million or just uses that number. So one hundred million and you say it went up $5 a month. So one hundred million subscribers times five
Equals five hundred dollars million
In new revenue
Month, every month.
So that's inflation, too. So let's look at the current situation in Canada just to wrap up here. There's just a report issued by CIBC Economics and that highlighted that while inflation was reported at three point seven percent in July, which seems like a whole lot, that's way bigger than the two percent, which is the target rate. Basically, it's just making up for extremely weak inflation a year ago, which is in the early stages of the pandemic. So in fact, we did go through, as Eidelman mentioned, there was a period of deflation. And so this is what they call the base effect. Three point seven percent seems like a lot, but it's comparing to a very low period. And if you actually look at just the prices, the consumer price index, basically they're running about two percent inflation from before the pandemic. So prices went down, then they went back up. It seems like a big jump. Sometimes you can't rely only on the rate of inflation. You have to look at the actual index to see how things are going. Now this contrasts a little bit with the U.S., where inflation rate was five point four percent in July. But if you look at their annual price increases, they're running about four point two. So they are running hotter inflation than we're seeing in Canada, and there could be a number of reasons.
For that, the Canadian
Dollar had quite a strong period leading up into the summer, and that makes U.S. imports cheaper, basically,
And so that reduces the effect
Of inflation and also the huge stimulus given by the U.S. government, basically in the form of direct payments to individuals was much larger in scope than what was done in Canada.
Well, you mentioned used
Automobiles being part of the CPI in the U.S.. That's right.
Semiconductor issues, I know that there are used vehicles that are leaving Canada and being sold in the U.S. for much higher cost than what they even were originally
Sold for. Absolutely. So again, you have to really look into the
Details and make sure we understand
What we're looking at, but that's inflation for you. So what do we do about it? What can we do about it? Or how should we think about it from an investment standpoint? Well, the first thing, as always, is you want to make sure that your asset allocation properly reflects not only your risk tolerance, but also your risk capacity. And looking at risk capacity, we have to say, well, OK, what are some of the factors that could affect the markets that we're investing in, the bond markets, in the stock markets and real estate?
Probably, and never mind what might
Happen if we assume certain things could happen? Are you prepared? Are you able to withstand the potential downside risks of something negative? Secondly, I think you have to believe this. You have to believe that market timing based on an expectation of any particular event occurring is a very difficult thing to do. And we've talked about market timing a lot in these podcasts. Should we get out before the presidential election? Are our stocks priced too high? Should we get out now? And is inflation a factor in our interest rates going up as just another type of prediction
That people might be tempted
To do? Market timing around. And I think we've learned that it's probably impossible to do effectively.
Well, we did
A whole episode on how market timing is really
The question that's asked all
The time, just in different ways. Exactly.
And lastly, have discussions
With us with your advisors and make sure you understand issues such as inflation, interest rates and other factors that could impact your investment returns. And that's all part of making sure that you're in the right portfolio mix and have the right diversification.
Well, I find it interesting that there are people I run into all the time that want to ask questions.
I was on the golf course a few weeks ago
And I was paired up with my younger guy
And on about the 14th hole, he said. I've been meaning to ask you this the whole round, but I just
I didn't want to bug you. You're not working right now,
Your golfing, but I just need to ask you a couple of questions and I said, Yeah, go for it happens all the time, right? You go to family functions or whatever. People always want to know about things like the stock market or bitcoin or whatever. So this guy shared a story with me about how I don't know when early days he bought half of a bitcoin for fifty dollars. Well, bitcoin, I look today is sixty one thousand Canadian dollars, so it has fifty dollars has gone to thirty thousand or more dollars
Since he bought it. He should become
A hedge fund manager.
Well, there's question, he said. I'm completely stressed because here's my situation. I'm a student. I have lots of debt. Every year I worry about carrying this debt, how I'm going to fund it, but I'm scared. If I sell this half of bitcoin and pay off my debt, will I miss out on the next growth rate? What would you do? And I said, Look, I can't tell you what to do. I can only tell you what I would do if I was in your situation for myself. If I had purchased something for fifty dollars and it was now worth thirty thousand dollars and I had done nothing to earn that extra twenty nine thousand nine hundred and fifty dollars and I had debt that I could pay off that would make my life easier.
I would sell it and pay off the debt. That's a win.
Take it as a win. The reason I'm even bringing that up, Greg in this episode is that if there are people out there and we run into them and you want to ask questions about things like this, this is all complicated stuff. So we talk about monetary policy like everybody knows what it is. It's not simple. Quantitative easing is not simple. Fiscal policy is not simple. I mean, but what is simple is what you pointed out those three things make sure you've got the proper asset allocation, the one time markets and look for advice in planning right on. So sorry, that was a little bit wrap up. Long wrap up. But anyways, anything else before we kill it for today,
I think we've done all we can.
Ok, well then I guess till next time we'll look forward to it.
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Episode 67 - How to become an expert
Steve and Colin look at what it is to become an expert. Where does this idea of being an expert come from and how can you set yourself up to be one?
Welcome back to the Free Lunch podcast with Steve Molina and Colin Andrews. Steve, this is two weeks in a row for you.
Yeah, it's a record.
Well, you know what, Colin? You might be seeing a lot more of me.
Well, I hope so. Because last week we had a good discussion. We talked with Paul Eidelman, director of Global Strategy with Russell Investments in Paul, shared with us his thoughts on inflation. Interest rates. General market movements. So I'd encourage those who missed that episode to go back and listen to it. And we had Paul on the show because Steve Paul is an expert in his field. Yeah, I'd say so. So that brings us to our topic for this week, which is what makes someone an expert. How do you become an expert? And should we listen to all these so-called experts? And Steve, one of my favorite things is when somebody comes to me and tells me how the stock market works, even though they might work in a different field. I mean, they might have a good understanding, but there's no way
Or there's a I guess
A small likelihood that they're an expert in the stock market if they work in a different field. Would you agree with that?
Yeah. Yeah, I'd
Agree. An example of this is when we have clients whose accountants and I'm not knocking accountants by any means, but they're advising them on how they should invest and say, listen, there's no way that we are going to complete somebody's tax return. We would tell people to go and use their accountants. Right?
Yeah, makes sense.
So I always have a hard time understanding why it is that
People in other fields feel like they should
Poses experts in ours. I mean, it's kind of like when you have a health issue, what's the first thing people do when they have a health issue, Steve?
Well, I think there's something on the Web called WebMD.
Yeah, they Google it. They Google their symptoms. And I've been guilty of this in the past. Have you ever done it?
I actually have
A great story
For you. Ok.
My life at midnight told me, honey, I'm starting to have problems with my vision. And I started to Google it. And what came up was some pretty severe detrimental stuff to her health. And so what did I do? Yeah, I panicked. Next thing you know, I'm texting my friend who's
A doctor and in
That field, and he's telling me to take it easy.
Yeah, well, that's the thing is when you Google it,
It always seems to lead to
Two things when it comes to health.
One, you're having a heart attack
Or two, you have some
Major form of cancer.
Of course. I mean, that's just
What happens in yikes.
You could follow that what you've read online or you could do what you did.
Just go to a doctor and an expert in their field and maybe get a proper diagnosis
Like that optometrist that I texted. That's the word I was looking for.
So, Steve, tell us what is an expert?
Yeah. So, Colin, what is an expert? Well, let's go to this worldwide web. And an expert is someone who has a broad and deep competence in terms of knowledge, skill and experience through practice and education in a particular field. Informally, an expert is someone widely recognized as a reliable source of technique or skill, whose faculty for judging or deciding rightly, justly or wisely, is accorded to authority and says by peers or the public in a specific, well, distinguished domain
Sounds pretty specific.
An expert more generally is a person with extensive knowledge or ability based on research, experience or occupation in a particular area. Study experts are called in advice for the respective subjects, but they do not always agree on the particulars of field of study. An expert can be believed by virtue of credentials, training and education, profession, publication, experience, have special knowledge of a subject beyond that of the average person, sufficient that others may officially and legally rely upon the individual's opinion on that topic.
So this is kind of back to my comments about not knocking accountants by any means. But when an accountant is giving somebody investment advice, it's not in their field of expertise. Correct. So perhaps they should just focus on their field of expertise.
And historically, if we go back, an expert was referred to as a sage, a sage.
That sounds pretty cool. Yeah.
Someone who was usually a profound thinker, distinguished for wisdom and sound judgment.
So what? You're sage.
I'm a sage in your field. In my field. Yeah, I would say so. Now, it's interesting to note, the definition of expert isn't always necessary for individuals to have a professional or academic qualification.
So maybe like just through experience.
Yeah. So, for example, a shepherd. Shepherd tends to his flock has maybe 50 years of experiencing working with his flock. He would be considered an expert in his field.
We don't have any shepherds as clients.
No, I don't we don't have any shepherds. But, you know, I think the closest relationship would be. Well, we have farmers, actually.
That's a good point. So my family farmed. For two generations anyways, and they just kind of became experts from doing it for a long time. That's exactly to that point. So anyway, well, let's talk about what expertise is expertise, characteristics, skills and knowledge of a person that is the expert or of a system which distinguished experts from novices and less experienced people. So, this would be back to you, the the Sheppard example that I suppose after 50 years of leading that flock, they probably know what they're doing in many domains. There are objective measures of performance capable of distinguishing
Experts from novices.
So, one of those fields would be like chess players where expert chess players will almost always win against recreational chess players. I mean, like if you and I sat down at a chess board with a I don't
Know, expert chess player, Grandmaster. Yeah.
It'd be over quick, like three or four or five moves. You're done. Could be expert medical specialists are more likely to diagnose the disease correctly. So back to your point of when we lay
There in bed and all of a sudden
And you know, your hand goes numb, it's like, oh, crap, what's that? And then your self-diagnosis and you go, you're the interweb. And all of a sudden you realize, oh, my God, I'm having a heart attack or have cancer or something. When really, I don't know, maybe you're just laying on a nerve or something. Right. So. So the word expertise is used to refer also to expert determination where an expert is invited to decide a disputed issue. So, the decision from that expert may be binding or it may be advisory according to the agreement between the parties in dispute. So, I guess that would be more like a court of law type of thing. But there are academic and there are historical views on experts and expertise. So, in academia, there are two academic approaches to the understanding and study of expertise. The first understands expertise as an emergent property of communities of practice. So, what does that mean in English? In this view, expertise is socially constructed. So, there are tools for thinking in scripts for action and are jointly constructed within these social groups, enabling that group jointly to define and acquire expertise in some domain. In the second view, expertise is a characteristic of individuals and as a consequence of the human capacity for extensive adaptation to physical and social environments. Because over time, Steve, we've had to adapt to various challenges.
I agree. After what?
How many years we've been in this industry? Over 20
Years. Yeah, a lot enough years to go through a few major market cycles. So even in this last example of March of 2020, when we went through the global economic shutdown and due to the coronavirus, I mean, we knew what to do because we went through a very similar market in 2008, 2009 with the global financial crisis. And it's just through that experience
That we knew what to do. We didn't know what was
Going to happen specifically, but we knew what to do. So many accounts of the development of expertise emphasize that it comes about through long periods of deliberate practice. So that's just what we're talking about. So, when you're working at a job for 20 plus years, putting in a lot of hours, it just kind of comes to you. There is, however, recent research on expertise, which emphasizes the nurture side of the nature and nurture argument. So, some factors not fitting that nature, nurture dichotomy are biological, but not genetic. Such as starting age handedness in season of birth. But we will get into that today. We know well this say that listen, if you're working in your field for 10 years or more, you probably have a bit more of an expert angle than somebody who's just starting. Correct. So, what about the historical view, Steve?
Keeping in line with the socially constructed view of expertise expertise can also be understood as a form of power. So, experts have the ability to influence others as a result of their defined social status. By similar token, the fear of experts can arise from a fear of an intellectual's elite power. So, if we go back in history, a good example is simply being able to read, believe it or not, made someone part of that intellectual elite
That is going back quite a ways.
Yeah. Yeah, it's going back quite a ways.
But we saw
The introduction of the printing press in Europe back in the 15th century that allowed and contributed to higher literacy rates. It allowed the subsequent spread of education and learning, changed society
Probably for the better. Yep.
So, Plato's Noble Lie came up in.
Oh, that was at the early 400.
Well, before you and I started before. Yes.
So, Plato was an Athenian philosopher, considered the founder of Western philosophy, and he came up with this noble. That concerns a lot of experts. He believes that most people weren't clever enough to look at their own and society's best interests, so the few clever people the world needed to lead essentially the rest of the flock. Therefore, the idea was born that only the elite should know the truth in its complete form. And the rulers must tell the people, the city, the noble lie, to keep them essentially passive and content
The risk of upheaval and unrest.
So, in today's day and
Age, not going back to 400
A.d., I guess, would be we're talking about leaders.
So, these would be maybe political
Leaders or business leaders in how
They have a responsibility
To lead in their area of expertise.
And that's really interesting, because there was a former president
Who loved to
Downplay certain things, such as?
Well, he was an expert in everything. Oh, yeah. Actually, this goes back to your point earlier you made about Krimmer, where it was. But basically, if you just pound the table hard enough and long enough and you stick to a theme, at some point you may be seen as an expert, even though you might not know what you're talking about.
Yeah. And there's some real danger in that.
So, in today's
Society. So, if we keep moving along this point, so in contemporary society, doctors and scientists
Considered experts in that body of knowledge that they own. And inaccessibility and even the mystery that surrounds that field does not cause the layman to disregard the opinion of experts on account of the unknown. Instead, the complete opposite occurs whereby members of the public believe in in highly value the opinion of medical professionals or scientific discoveries, despite not understanding it.
Well, an example is might be vaccinations.
Yeah, I mean, I don't understand vaccinations, but I'm not supposed to.
I just believe in the science and I follow it and therefore I'm vaccinated. Right. Same here. Call me. Well, let's talk about something called Germaine's scale. So, there is this woman, Maryline Germaine, and she developed a psychometric measure of perception of employee expertise called the generalized expertise measure, where she defined a behavioral dimension in experts. So, it's a 16 item scale which contains objective expertise items and subjective expertise items. So, the objective items would be things like evidence-based items. So, in our field, when we talk about investing, we often use the term evidence-based investee. Sure do. And that just means that we have evidence, historical evidence, academic evidence to support what we believe works. So various factors of return. Well, in Germaine's skill, she talks about how it's relative to a specific field. An expert has things like specific education, training and knowledge. They have required qualifications. They have the ability to assess importance in work related situations. They have the capability to improve themselves. They have intuition and they have self-assurance and confidence in their knowledge. That's called Germaine's scale. Now, there are other subjective items that she also mentions that
They have some knowledge
Specific to a field of work. They have been, let's see, ambitious about their work in the company that they are. They can assess things like how they're capable of improving themselves. They're charismatic. They're able to judge what things are important in their job. And a few others don't go through all of them because it'd be kind of boring just to list out all 11 items. But the point is that it's been called out. This area of how to become an expert is you kind of need those specific items.
Well, and why would you want to become an expert?
I don't know, Steve. Why would you
Have some key benefits for sure? And let's see. Experts are more likely to be listened to and regarded for their skill. They know their skill set in their business better than most people. Instead of working to create a peer network, they're usually drawn into one. Experts can predict upcoming changes to the marketplace as they follow trends.
Kind of like when we had Paul Eidelman on our show. I mean, we had him on there because he's an expert in economics. And if we're going to talk about predicting future
Market movements, we've got to talk with
Somebody who that's all they study.
And I think it also leads into that peer network. We are all part of this peer network to get insight from other people, which helps draw our research and our own ideas from.
Well, it actually I think you have to be humble about that. Like you've got to be humble and understanding what it is that you understand and what it is that you don't. And you're never going to try to fake what you don't understand. Just go to the people that do
Some of the other reasons why you want to become an expert is people trust. Its people come to us because people see us as experts, and they believe our opinion. People want to know or want to work with experts. They're motivated to learn from them. Most media rely on input or commentary from experts.
We see that
In our field all the time. I mean, that's why people are on things like Bienen and other investing shows is because they're giving their insight. Correct.
And I have to be honest with a lot of that stuff. A lot of that stuff is opinion.
Well, that's actually back to that point in our field. You'll hear things like the bond bubble is about to burst and somebody will say that for 10 or 12 or 14 straight years and they'll be wrong for 10 or 12 or 14 years. But then in one year, it happens. Now, they're seen as an expert because they've been calling for it for 14 years, but it means they're wrong for 13 years. Exactly. But they pounded the table long enough.
The other one is
Like a bear,
Like there's these perennial bear market people that always talk about the stock market's going to correct and they're wrong until they're right. And then somebody else say, look, he called that or she called that bear market like you have. So what? They were wrong for 90 percent of the time, and they got it right, 10 percent on time. But somebody will see them as an expert. Yeah, exactly.
No, that's fine. Experts seem to find each other and trade information. They have a greater likelihood to make more money in their career. So that's a good motivator. Career opportunities seem to find experts as they're in demand for their knowledge or skill.
Their intellectual property or intellectual capital can't be downplayed. If you are an expert in your field, then you're probably going to be rewarded more than if you were a novice in your field.
Oh, absolutely. So obviously some amazing benefits that come with being an expert. Here are six specific things you can do to build your expertise, Colin,
Or give him the game plan. Oh, yeah.
Ok. So for those of you want it, here it is. Practice, practice, practice. Malcolm Gladwell, author of Outliers, suggests that it takes 10000 hours of practice to become an expert at one task. So if we break that down, if you work a 40 hour week and you spend every moment at work practicing that specific task at which you want to gain expertise and you work a 50 week per year, it only takes about five years to hit that 10000 hour mark. If you think you're going to remain healthy and love what you do professionally, then five years really isn't that long is a calling.
Well, it's not. It goes by quickly. And actually with that calculation. I was just doing some mental math. I mean, these were 10, 20, 30, 40. I mean, I've got about 50000 hours then. I hope I know what I'm talking about when it comes to the stock market and investing after 50000 hours
On, you know what? I think your clients, they'd agree with you.
I hope so. It's better than going
To the interweb
And saying, how should I invest today?
So becoming an expert requires and sincere, genuine desire to do the work. If you aren't passionate about something, you won't become an expert at it.
That was number one. Number two is redefine your network is the second, I guess, step. So there's a guy named Jim Rawn. I don't know if I'm saying his
Rahni, but he's a personal development guru. And he says that you are the average of the five people you spend the most time with, which is kind of a scary thought. So if you think about who those five people are
For you, if you want
To up your professional game, I guess you'd need to surround yourself with people who elevate you because expertise is contagious by spending time with people who are themselves experts in your field. You'll naturally catch some of their wisdom. So he says, listen, talk to them, ask them questions. Listeners, they
Share their insights,
Find ways to spend more time in their presence. And this is actually one of the areas where every year we go to various conferences, and there's a reason for that.
We don't have
To do that. But it sure elevates your game when you're in a room of academics and you get to listen to their insights on things like the capital asset pricing model or whatever. It just I want to be around those five people. Number three is become a thought leader. So experts are never content with the status quo. They're always looking for the next evolution of their profession. So they're constantly trying new techniques, improving on existing concepts, exploring new ideas and adding value. And they're always looking to push the boundaries and expand the limits of their field. Expert Steve are at the forefront, leading the way for the future of their profession. Where I see this in our industry is we've actually been asked to speak at many conferences because of some of the work that we do.
And I've had people come up to me and say, this is great.
So once you build it this way, then you can just sort of sit back and relax. And it all just works. Right. In my comments, I've always been well know you have this completely wrong. You build it, but then you have to keep building it. You have to keep. I don't know. It's like a renovation. It's like a constant renovations, like renovating your house for your whole career.
That's just our industry is constantly evolving. Staying at the forefront, understanding what our client's needs are and what the future looks like for them.
Exactly. Because it is changing all the time. I mean, things like even with this upcoming election, they're talking about will the capital gains inclusion rate change? Will certain tax benefits be changed? I mean, it's a constant. The only thing constant is change. That's a quote. I can't remember from who, but it's a very old good one. No. Four, share your knowledge. So experts become more valuable by sharing their skills and knowledge. They always want to be a service to their professional community. And if you want to be seen as an expert, put your expertise out there for all to benefit from. Do not be afraid of being judged. Put your thoughts and ideas based on your expertise out there. A few ways you can share your knowledge is to train others, try and speak at a small event or a conference in your local city. But remember, it's not about you. You have to be seen as someone who confidently shares information and expects nothing in return. So this is a big one to me. I've always talked about how we need to work to elevate the experience in our community, whether it be for advisors or the end clients, that we need to work as a community to improve
People invests in how they're investing.
I agree with you,
Because the reality
Is we can't look after everyone. There are far too many people, far too many needs out there. And the more we can mentor other advisors or other people in this industry to do the right thing for their clients, the better we'll all be.
Yeah, let's raise the bar collectively. All right. What's the next one, Steve? Number five.
Number five so rigorously follow trends. So every field undergoes change some more rapidly than others. Experts always stay at the forefront. So that's what we talked about. They explore new trends to understand where their industry is headed. This provides the expert with foresight, while others are unaware of the shifting waves of progress. Experts can connect the dots more easily to take advantage of change. The easiest way to stay abreast of trends is to set up a specific Google alert.
Wait, we are we recommending Google?
No, we're not recommending Google. But wait,
Wait. Well, we are we're recommending Google for a search engine. Yeah, just we're just not recommending the stock, just not recommending stocks.
But you can also use there's trend blogs out there. Commit to reading more. Read industry analyst reports. We get these on a regular basis.
And like you
Mentioned, Courland, we attend conferences regularly. Number six never stop learning.
Never. I want to repeat that.
Never stop learning. Lifelong learning.
And in our industry, we have continuing education requirements that are required every couple of years. So we have
So many credits. And that makes sure that we are constantly learning in our industry. So you would think at some point experts have learned everything they could learn. Wrong experts never stop learning. As a matter of fact, most people, once they become
An expert, commit
To learning more. You see, once we're an expert, we begin to enjoy the benefits of
Being an expert.
You stay as an expert. So experts read more, continue to educate themselves through courses and workshops. Gather knowledge from other experts and so on.
Well, I want to talk about that for a minute. So I haven't shared this with you, but I'll share it with you right now. I just
Signed up to do the CEMA
Designation, the certified investment management analyst designation. Wonderful. Yeah, it's a program being offered through the University of Chicago Booth School of Business. And it's one of those things that when I was talking to my wife about it, like, I don't need to do this, but I want to. I think it would be really cool to study at the University of Chicago for a short period of time.
There's some great
Knowledge influencers there. I think there's like eight Nobel laureates have come over the University of Chicago, things like that.
So I'm really looking forward to it. That's awesome.
Thank you. Yeah.
So I guess if you're going to do something professionally, lifelike be a great programmer, marketer or accountant, lawyer might as well try and become an expert because the benefits are amazing and it's just good for your overall being.
And it's a great way to give back. As we talked about, raising that collective bar
Of knowledge within the
Community can't be downplayed. Well, it's kind of a fun conversation. Hopefully not to. I don't know what word I'm looking for, but I've lost my extra words. So anyways, it was a fun conversation. Steve, thanks for coming on the show again.
Appreciate it. Yeah, thanks for having me.
My pleasure. And listen, for all the listeners out there, please. Do us a favor, give us a rating on whatever podcast
Downloads you're using.
I know Apple Podcasts, you're able to easily send a rating. Send us some feedback on how these shows are going. If you enjoy them, if you don't, that's OK to stop listening if you don't enjoy them. But if you do enjoy them, send us some feedback. And in that feedback, maybe include some topics that you'd be interested in having us address in some future episodes.
Sound good? Sounds great. Thanks again. All right.
Till next time.
Episode 66 - Talking Inflation, Interest Rates and Market Cycles with Paul Eitelman
We interviewed Paul Eitelman, Director of Global Investment Strategy with Russell Investments. Paul shared his views on transitory inflation and more!
Welcome back to the free lunch podcast with today, Steve Molina taking Greg’s spot and myself Colin Andrews. Steve, good to have you back on the show.
Yeah, thanks for having me.
Last week's episode, we wrapped up our Back to Basics Mini. Greg and I were focusing on market timing, stock picking and market cycles. And it seems like we're always in a market cycle just by the definition of a cycle. And today we're going to spend some time digging into some of that today. Joining us is Paul Eitelman. Paul is the director, chief investment strategist for Russell Investments, and he's joining us from beautiful Seattle, Washington. So welcome to the show, Paul.
Yeah, thanks so much for having me on.
Well, it's great to have you on. It's been a few years since we saw your face in Calgary, but hope to see you back here sometime in the near future
When they're definitely looking forward to it.
Yeah, this global pandemic is behind us at some point. So, Steve, why don't you kick us off?
Thanks, Paul, for joining us. Let's just jump in. Tell us your story. How do you end up where you got to today?
My career has had a bit of an arc to it. I actually started out as an aspiring economist, so I started my professional career at the Federal Reserve in Washington, D.C. in the summer of 2007. And it was a unusual time to join the US central bank. It was right on the cusp of the biggest financial crisis in decades. And I think that was a really fascinating experience for me to be around really smart people like Chairman Ben Bernanke and a lot of the professional economists at the Federal Reserve trying to do our best to kind of save the US economy from what looked to be a really, really bad financial disaster and a lot of strains on the banking system. So I think that was a fascinating experience for me.
A lot of sort of strong foundations around macroeconomics, economic theory, central banking. And then from there, I've transitioned into the private sector as an economist and investment strategist. So I spent three or four years in Manhattan working for JP Morgan. I was a senior economist in the private bank there, helping their ultra-high net worth clients. Think about the economic outlook that could inform sort of prudent asset allocation. And then over the last sort of six years or so, I've seen that Russell Investments. And there I've increasingly transitioned from just doing economics to now also being responsible for our investment strategy in North America. So not only thinking about the economic outlook, but what is our views on the US equity market interest rate strategy and a whole range of things. So that's my arc. It's been a progression of things, but gradually from economics, a bit more into the private sector and markets.
Ok, Steve, I’m going to jump in here for a second. Did something happen between 2007 and 2009 while you were at the US Federal Reserve?
Yeah, I think so. There's only just a couple of months after I joined, the US housing market blew up and we had one of the biggest financial crises in the history of the United States at least.
All right, now its ringing a bell, ringing a bell that you had to go back to those dark days.
Yeah, sorry. Go ahead, Steve.
Well, I’m curious to hear what the difference is from the Federal Reserve days of two thousand seven two thousand eight to where it is today with the current crisis or current pandemic that everyone's trying to deal with. What are your thoughts about that?
Well, I think there are some similarities and there are some differences in terms of the similarities. The Fed is been faced by some really big challenges. Both the global financial crisis and the of the crisis were so severe that the Fed's normal toolkit was not enough to support the economy. So in both cases, they cut interest rates, at least the overnight interest rate all the way down to zero. But that wasn't enough. And so in the GFC, in twenty two thousand nine, for the first time, Ben Bernanke started sort of this novel new experimental monetary policy framework where they started buying assets and specifically Treasury securities on a really large scale as well, with the hope of not just keeping short term interest rates at zero to support the economy, but also influencing longer term interest rates lower as well to help boost consumer activity and business borrowing, et cetera. So that was really experimental and unique and a bit scary for a lot of people a decade ago. But because covid was so dramatic in terms of shutting down entire industries in the US global economy, in the span of just a couple of months, the Fed had to kind of rely on a lot of those same experimental tools again this time around. So. If anything, I think their response was stronger this time for good reason, so not only did they cut interest rates to zero and not only did they launch a quantitative easing program again, but the scale of it was unlimited in scope. So Powell said, I will buy as many Treasury securities as it takes to make sure markets are functioning here. That was a really historic and important backstop for financial markets that were really struggling in the spring of 2020. And they even went a little bit further.
And I think the innovation this time around was extending the support beyond sort of safe fixed income securities and actually buying corporate bonds. And that was an extra really, I think, historic and unusual effort to make sure that the borrowing costs for businesses were manageable during a time that a lot of companies had their revenues dropped to near zero. And so I think at the highest level, what the Fed has had to do is everything they possibly could to make sure that households and businesses could survive to the other side of the pandemic when we had vaccines become available and the economy could start to return to normal again. And I think they've been pretty successful with that. Frankly, in the United States, for example, with the economy, if you're measuring it by real GDP, is back slightly above pre covid levels again. So an almost complete recovery in the United States. There's still a lot of people that I think Chairman Powell would like to get reengaged in the labor market again. So they're going to stay accommodative for a while here. But it was an awful recession and it's been an impressive and an awesome recovery in terms of the speed of growth subsequent to those lockdowns. And so I think that's the difference is unlike the in 2008/ 2009, we had a pretty slow recovery because households had to manage down their balance sheets. They had a lot of debt that they had to work through and economic performance was pretty poor. Today, we're seeing some of the strongest economic growth rates in 30 or 40 years. And so the Fed's accommodative now. But the big question is, when are we going to have to start to change tack because we don't want to generate too much strength and overheating and inflation. And so that transition is happening a little bit faster this time.
Well, listen, I probably jumped ahead in my questions, but if I was a question of just you mentioning you being part of the Federal Reserve back then.
But if I back up for a second, let me ask you this as director and chief investment strategist for Russell, what does that day look like for you?
It's a very sad day, but my primary responsibility is to make sure that we know what is happening in the United States and global economy and what those potential risks and opportunities might mean for our professional portfolio managers. So it's staying on top of incoming data. The new news, what that might mean in terms of risks. So keeping tabs on what's happening with the coronavirus, keeping tabs on what's happening with corporate earnings
Growth, what Federal Reserve officials might be saying and looking for where there might be opportunities or areas that the market could be getting things wrong. And that's a really hard thing to do. We're actually pretty humble about those kinds of activities. And some of the kind of signals and modeling that we look at the most is around other people's behavior. If we're seeing everyone else panicked, that tends to be a pretty interesting signal for us to want to step
In and buy and be investors, whereas in contrast, forcing everyone euphoric and very optimistic about the outlook. Sometimes we might want to lean in the other direction. So it's very much a mix of sort of market psychology, economic data, market data and looking for things that might be at an extreme that we can take advantage of knowing that that's a
Very hard thing to get right, because markets are pretty efficient, even if they're not perfectly efficient.
Actually. Have a comment on that. So this morning when I was leaving the house, my wife asked me, hey, what do you do in your podcast on this week? Because she will often ask me that. And I said, oh, we're interviewing this fellow named Paul Eitelman from Russell Investments. And she said, well, what does he do? Well, he's the director, chief investment strategist for Russell Investments. And she said, well, what does that mean? And I said, well, I guess he sort of follows inflation rates, interest rates, economic headlines and does forecasting based around that. And she said to me that a quarter is that a full time job? I said, yeah, I think it's actually a pretty important one, you know, and I'm not knocking her. She's a social worker. And her day is way different than what your day would be. So can you maybe expand a little bit on that? How the. Headlines that you are tracking these days, because inflation is one that has come up a lot recently. Can you talk a little bit about that?
Inflation is a really big issue right now. It's been incredibly strong and I think surprisingly strong in the last four months or so in the United States and in a couple of the developed markets in the US, for example, we're seeing core inflation rates up around four and a half percent, which I mean, it's a big number. It might not sound like a lot, but central banks want to see two percent inflation.
We're getting almost double their objectives.
And that can be a challenge for a lot of investors is really important for retirees, because if you have a lot of inflation and you hold fixed income investments, that inflation can erode your purchasing power over time is a big issue. And it's been something I've been quite focused on as sort of an economist and a strategist. But we've seen sort of under the surface of the data is a lot of that inflationary strength has been driven by just a couple of categories.
So part of my job is what is this inflation?
Is it noise or is it a signal that we need to take seriously? And because the inflation is so concentrated in just a couple of categories, we think it's more likely than not to be a short term
phenomenon and something that is likely to be stick. So the kinds of inflation that we're seeing just to try to bring that to life a little bit is really in things like automobiles. So because of all these stimulus efforts from the government's stimulus checks, et cetera, people have been going out and buying new cars. That's sort of the cool thing to do. And they've been doing that at the same time that global supply chains are disrupted.
There's a shortage of semiconductors globally.
So automobile manufacturers haven't been able to produce new cars and everyone wants to buy them at the same time. And so you have too much demand for the available supply of cars on the market. Inflation sort of conceptually is equilibrating mechanism to make sure that demand supply imbalance. So when there's too much demand for the available supply, you get inflation. And that's what's happening in the automobile market. It's because of this really strong recovery and because of these supply chain bottlenecks. But it's probably not the kind of inflation that is likely to be long lasting. We're seeing globally a lot of interest for companies to invest in new semiconductor plants, because if you can, you're going to make a lot of money selling semiconductors, car manufacturers and that sort of profit maximizing carrot, if you will, is the sort of factor behind why these things should come back into balance over time. The other areas of inflation are more around the pandemic and the crisis and recovery out of it. And so it's things like airfare prices and hotel prices. And if you think back to the spring of 2020, no one was traveling. Demand for air travel totally collapsed and the airliners had absolutely no pricing power at all. They basically couldn't give away a free flight if they tried. And because the vaccines have been quite effective, we're seeing today now air travel will get that close to pre covid levels again. And with that recovery in demand, they've had a recovery in their pricing power again. And that's inflation. It's prices recovering from something that was near zero to something a little bit more normal again. But as we get back closer and closer to normal again, that really big recovery demand is unlikely to be something that should persist year after year after year. So I guess that's a really long way of saying we really try to go into the hood of what's happening with the data releases, understand what it means for the outlook. And in this specific case, we think it's more likely than not that inflation, which is really strong right now, should moderate back down to something more normal over the next one to two years. And that has important implications for how we might think about investing.
There's this buzzword that keeps floating around every time I pull up a headline or news article and it always references inflation and things being transitory, would you say that's what's going on right now in the world?
Our outlook is that inflation is transitory. And basically what that means is these call it four or five percent inflation numbers are unlikely to be the new normal or outlook, which is it's an uncertain one. I mean, this is I've been through a couple of recessions, but this is my first pandemic.
It's all of our first pandemics.
We never know exactly what the future holds, but our sort of models are telling us that it's more likely than not that inflation will move back down to two percent or slightly less than that in the case of the United States, because. A lot of it's in these concentrated categories that are unlikely to be persistent, and so that's what sort of transitory means to me. It has important implications, if that's right. It could mean that central banks could keep rates very low for maybe a little bit longer.
Well, actually, I've had a lot of people ask me about inflation these days, of course, because they see those same headlines. And I kind of point out that, look, inflation in March of 2020, wasn't it like zero or I mean, there was no inflation. So if it's four and a half percent today or four percent or whatever the number is, but it was zero 18 months ago that what's the true level of inflation? Is that a fair question?
I mean, it's a really important point. So in 2020, we actually had three months in a row of deflation, so slightly negative or declines in prices on a sequential basis. And that was because the economy was collapsing and there was no demand for anything. And that set sort of a low level for the index.
And so you fast forward a year from end
And we're seeing one of the strongest recoveries ever. And similar to what I was talking about with airfares and hotels, demand bouncing back to something a little bit more normal again. So a lot of that inflation is sort of a simple recovery phenomenon. And it doesn't tell me that much about sort of the medium to longer term outlook. It's sort of more cyclical in nature.
Steve, what do you got for us?
Well, it's just going to ask you've touched a little bit on it. What's the lay of the land going forward for the economy and the global stock market? You've talked a little about this great recovery. What should investors look like for the next short term, long term, I guess, next within the next five years?
Yeah, I think there is still some runway here for the economy and financial markets. And some of that is just where we are in the business cycle, where just over a year removed from a recession. And even though the recovery has been impressive, there is still not really any signs of the kinds of macroeconomic imbalances that would let you think about a recession be more likely than normal.
And these things are really hard to forecast. But those kinds of big risks for markets tend to happen when the labor market is fully recovered, when businesses are investing and over investing and getting sort of greedy about the outlook and when debt levels in the economy are really high. And so today we've certainly recovered a long way. But in the United States, for example, there's still six million fewer people employed than there were before. The coronaviruses seems like the labor market still has a decent ways to go here before those kinds of risks start. Emerging business investment, we think, can be quite strong here. Businesses are really confident about the outlook. There was actually a survey recently from the Conference Board that showed CEOs are more confident than they've ever been in the outlook because of how strong the profits recovery has been. And so that should allow some pretty good investment going forward. But we're nowhere near where the US or global economy was in the late 1990s when there's just way too much investment and overinvestment in technology and capital goods.
Again, I think a little bit of room to go there.
And I think what all of that means to me is if recession risks are a little bit lower than normal, that makes it more likely that I can earn a positive equity risk premium. So one of the big things that hurts you as an equity investor is when the business cycle ends, when you have a recession, you have a drawdown of 20, 30, 40 or 50 percent.
And so I wouldn't say those risks are zero for gas in the future is really, really hard. But relative to maybe a normal recession risk of being between 15 and 20 percent in any given year, we think those risks are closer to 10 percent. That's a marginal view. But investing is all about decision making under uncertainty. And if we think those big downside risks are maybe a little bit smaller than normal, having some equity allocations can make sense to them.
I like that quote. Investing is all about decision making during things of uncertainty. So he said something like that. Yeah. Let me ask you this thing of uncertainty. The 10 year US bond yields have been getting a lot of press recently, maybe in the last 60 days or so. And I know they moved from something like one point three to one point four up to one point six. And now they're at about one point to four or something like that. So in that period, it's gone basically from one point three to one point to four. It doesn't sound like a lot yet. It has definitely moved that market and this forecasted interest rate movements. Can you talk about that a little bit?
There's been sort of two waves in the Treasury market. Recently, Treasury yields rose pretty significantly through the early part of twenty twenty one because people transition from being worried about the pandemic, to excited about the recovery, and particularly excited about the prospect of aggressive stimulus from the US government after Biden won the presidency and Democrats won the House and Senate. So that unlocked the possibility of aggressive spending legislation boosting the US economic growth profile. And so under that idea of stronger growth, Treasury yields rose, which is sort of normal market reaction. But subsequent to that, there have been a couple of risks. And it's been hard to totally unpack what has happened over the last couple of months. But we've had, I think, a reassessment of what's happening with the coronavirus where the Delta variant has really spread aggressively around the world and infections. And unfortunately, more severe outcomes have started to rise again, even in countries that are highly vaccinated. And so I think that's created some concern that really exceptional growth that people were thinking about might have some sort of downside risk associated with it. That was, I think, one of the factors behind me stepping back down. The other one, somewhat perversely, was with the Fed starting to talk about the possibility of taking away some of its accommodation. I think investors have gotten a little bit worried that they might not allow as much inflation or overheating or economic strength as they previously thought. And that sort of reassessment around central bank policy maybe was sort of the second big catalyst. But I think it's easier to tell stories after the fact and to know some of these things in advance. So I think those are the two big waves of excitement about economic strength and then
Maybe a little bit of dose of humility and uncertainty as the outlook has gotten a little bit of cloudier here in the last couple of months.
So if you are a retail investor or I guess institutional investor, what do you do during times like this?
Because there's a lot of concern that, well, as the economy recovers, does the party stop and they start raising interest rates? How does a retail investor, I guess, just an investor in general, what are your thoughts? How do you prepare for this going forward?
I think the most important principle is to always have a plan. So forecasting the future is hard and having a strategic asset allocation, potentially with the help of a professional advisor that is well suited to help you meet your desired outcomes under a range of possible economic and market outcomes and forecasts is probably the most important starting point. From my personal perspective with where we are today, I think staying invested is maybe the second most important principle, because if you're just sitting in cash, central banks are forcing you to have a zero nominal return on that cash right now. And we've just talked about inflation being an issue and a risk. And if you're getting a zero return on cash and inflation's four or five percent, your spending power on that cash balance at the bank is gradually eroding over time in that kind of environment. I think it's really important to be invested, whether it's in the equity market or I think even better, a diversified multi-asset portfolio that can weather a range of outcomes. But getting that extra return to help you overcome sort of the inflation hurdle is probably more important than ever right now. With interest rates near zero.
I think we'll all agree with that, that it's better to be invested, stay invested, because one of the things we run into, Paul, is people will say things like when times are bad,
Say, well, I need to get out because I'm scared. And we say, well, OK, so you're going to sell out. And then what?
They said, well, wait for things to get better and then I'll buy back in saying. So let me understand this. You're going to sell at a lower price. Now with the plan of buying back in at a higher price later, does that make sense? And maybe I can let you answer that question.
It's not a good way to be successful over the long term.
There it is. I knew we were talking the truth.
Selling low and buying high is a good way to lower your return outcome. We think if anything, the opposite is better.
If you can, if you have the liquidity and ability when everyone else is panicked and when prices are cratering, that's the best time to step in and buy and take advantage of other people's behavioral mistakes and constraints and challenges during those circumstances. It's usually when sort of things are the darkest that the return opportunities. The greatest,
But on that behavioral side, do you think people are actually capable in general of investing during bad times?
It is really, really hard to do, particularly by yourself and even for us as professional investors. We've built sort of processes around us to help us avoid making those same mistakes. And one of the ones that's I think most important for our philosophy is we have an index that tracks market psychology for us. It's a range of different measures from how investors are positioned, surveys of investor psychology, how bullish and bearish people are. And no single indicator
Is very good. But the sort of composite that we get from all of that information is actually quite helpful for us. So I can be sitting there in March of 2020 not having a clue about what the pandemic means for the economic outlook. But if I know that investors by and large are more panicked than we've ever seen in the history of our index, that's an important ballast for me to say, hey, hang on, if things start going right here, the return potential could actually be pretty significant. And those kinds of insights are important for us not only to avoid the mistakes, but also to try to take advantage of some of those rare opportunity to do present. So I think it is a really huge challenge, particularly for individuals that maybe don't have as many resources as we do in the profession.
That's good. I think we have time for a speed round. Steve? I think so. Paul, you've done all the heavy lifting. Appreciate that. And appreciate your insight on all those things, inflation, interest rates, et cetera. But Steve's going to start you with the really important part of the podcast, and that's the speed round. Yeah. So we've got the speed round that we ask. We go through this every podcast, Paul, and there's no right or wrong answers to us.
But judgment aside.
Well, we will judge you, just not now. Well, we're on the call right now. Exactly.
Judge, later, let's go through this.
What do you do for fun when you're not working?
I like to go hiking. It's a beautiful place in the Pacific Northwest. And I've also taken up during covid side hobby of woodworking, and I'm not very good at it. But I'd gotten some furniture from my house and I don't know, I wouldn't call it high quality furniture, but it hasn't fallen apart when I sat on the edge. So I'd say it's a moderate success.
That's when any books you're reading right now, I'm a little bit of a sci fi guy. So there's a new book called Project Hail Mary from the Sky. And we I don't know how to say his last name, but he wrote The Martian, so I'm pretty into his stuff and other books and I've just started that. So I can't really talk about the story, but I'm pretty pumped about it.
Any shows you're currently watching,
You binge anything, you binge anything.
We've been watching some Bosz on Amazon Prime, which is a detective fiction story. Pretty good. I've been enjoying it. My wife really likes it and I'll usually fall asleep halfway through an episode and she keeps plowing ahead. So she probably has a better read on it than I do. But that's part of the top of the list for us right now.
Well, now I'm going to get into a couple of Canadian specific questions because our audience is primarily Canadian. Although the podcast does get simply around the rest of the world. I'm not sure why some places there are people that listen to it, but how do you spell Saskatchewan?
And by the way, nobody's ever gotten it right, so there's no pressure.
Saskatchewan. Oh, now take your plow ahead and try to plow ahead. S A, c, h. Oh, no, no, no.
Yeah, the first three. Right. That was close, though. Spelling bee for you. Now, seeing that you live in the Pacific Northwest, it must get kind of
Chilly there during the winter months.
Do you ever wear a toque?
Yes, you do. Yes, you do. I guarantee you. I bet you've worn one in the last 12 months that it's a wooly hat with it.
Yeah, that's right.
A wooly hat or beanie, as it's called, in places like Santa Monica. Nice. So what we call it, it's OK.
I've always wanted to go ice fishing, which is a much bigger thing in Canada, but I haven't been able to do it yet.
I'm Canadian and I've never been ice fishing, so I know that it is a thing that people do, but I'm sure I don't know, ice fishing.
I've never been ice fishing. So, Paul, if you end up going, you're going to have to come back and tell us about it.
Yeah, maybe that's just an image of what people.
Well, you're not that far from Canada, right?
Like your short drive, your neighbors. Yeah.
So when you do go to Canada, do you ever wear a bunny hug when you're traveling through Western Canada?
Bunny hug. Probably not.
I guarantee you've worn one at some point. Paul, it's a do you have a hooded sweatshirt that you wherever.
Yeah, of course. Yeah.
So honestly, nobody ever gets those questions. I'll stop it there. But the bunny hug in Saskatchewan is a hooded sweatshirt. That's what it's called. I don't know why. I don't know where it came from, but that's what it is. So listen, you did pretty well. You did pretty well. Thank you for joining us. We really appreciate it. I hope to see you again in Calgary sometime soon, like we talked about at the beginning. And any last words before we let you go?
No, thanks so much for having me. And hopefully I'll do better on the Rapid Fire next time.
Well, in all fairness, like I said, those are very Canadian specific questions that if you asked me a few things about Manhattan, I would probably do not very well myself.
So I have those ready for you next time. Yeah.
All right. And thanks, everybody, for joining us. Steve, thanks for being on the show.
Yeah, thanks, Collin. Thanks again, Paul.
And just a reminder to the listeners, please leave us a review on Apple podcast or wherever you listen to this podcast and we'll see you next time or not. See you, but you'll hear us next time when we get into something probably not as exciting as this one, but hopefully pretty good nonetheless.
CIBC Private Wealth Management consists of services provided by CIBC and certain of its subsidiaries, including CIBC Wood Gundy, a division of CIBC World Markets Inc. “CIBC Private Wealth Management” is a registered trademark of CIBC, used under license. “Wood Gundy” is a registered trademark of CIBC World Markets Inc. This information, including any opinion, is based on various sources believed to be reliable, but its accuracy cannot be guaranteed and is subject to change. CIBC and CIBC World Markets Inc., their affiliates, directors, officers and employees may buy, sell, or hold a position in securities of a company mentioned herein, its affiliates or subsidiaries, and may also perform financial advisory services, investment banking or other services for, or have lending or other credit relationships with the same. CIBC World Markets Inc. and its representatives will receive sales commissions and/or a spread between bid and ask prices if you purchase, sell or hold the securities referred to above. © CIBC World Markets Inc. 2021.
Episode 64 - The Silent Killers…Fees, Expenses & Taxes
We continue the Back to Basics Mini-Series discussing the costs involved in investing. Looking at what fees are charged, expenses incurred, and taxes.
EP.64 - The Silent Killers…Fees, Expenses & Taxes
Welcome back to the free lunch podcast, notice my new inflection.
Are you enthusiastic today, Greg?
Last week we talked about factors of return, a fun discussion. I always like talking about factors of return, actually, especially when people are asked which stocks to buy.
That's right. Yeah. A little bit of a different discussion today.
We're on the fourth of five episodes and our miniseries on Back to Basics. As I said at the first one, it's sort of a lead up to back to school in September. We're going back to basics with investing. And today we're going to talk about the silent killer that is the silent killer of returns. Greg, fees, expenses and taxes, the less you pay, the more you keep, as they say. And that's important to understand, right?
But the capital markets are not charities. There are fees to invest. There are taxes that have to be paid when you make money. But of course, I never quite get that concept of people being upset, of having to pay taxes when they've made money versus not making money. Isn't one side better than the other?
Certainly, but I think it's important to pay the taxes that you need to, but not pay taxes that are avoidable,
Of course, because there's always going to be fees. You just need to know and understand which ones are expected and reasonable and which ones are just dragging you down and to start that off. Greg, I got a little song for us. Maybe I'll play it. Well, we have a little banter here.
You might get this. The cash register sounds familiar. Somebody's paying the fees, Greg.
Sounds like something from the 1970s.
You know this song. I know you know it.
I do know this song. It's kind of like a little digging about my age again.
No, never. I would never bug you about being bald or older. Oh, here we go. Baldor Older.
It's always about the hair, isn't it?
All right. Anyways, let's get into it, OK?
As you mentioned, there are costs to everything that's to be expected. But as our clients and anybody who's listened to this podcast, no, we believe that there are really three things you can control. You can control your asset allocation, you can control your diversification and you can control your costs. Beyond that, your returns and your investment experience overall is going to be determined how the market behaves.
So in the last couple of episodes, we've talked about asset allocation, we've talked about diversification, and today we're going to talk about costs. And you identified three types of costs that are incurred in investment management. And I'm going to break them down. You could characterize these a little bit differently, but I'm going to break them down into three main areas. The first is Fees. And here what I'm talking about is fees for advice. So whether you work with a full service advisory firm like ours, when we're owned by a bank, as many are, whether you work with an independent firm or even a robo advisor, there's going to be fees for advice. And those fees can vary fairly broadly from firm to firm and even within firms from advisor to advisor. So we'll delve into those in just a minute.
There's some marketing out there these days that tries to, I don't know, paint the wrong picture so people don't actually know what fees they're actually paying in some of these places.
Exactly. And so it's really important that people understand the fees. Fees have to be transparent. People need to know what they pay. Any of us would expect that for whatever we're buying. And so that's really critical The second area of costs would be expenses. And what I'm talking about here, those would be the costs of like implementing a specific investment approach. For example, if you buy individual securities, first of all, there's going to be some transaction costs involved. Commissions, if you buy ETFs or mutual funds, there's going to be within those management fees which are earned by the managers of the funds, plus any other costs that are associated with trading custody of securities administration and in some cases, even marketing. So in many cases, people are paying costs for the fund provider to market their own products.
Now, there's been a ton of compression on those expenses over the years, though, in your time in this industry, you've seen them go down dramatically,
Massive compression, which is a good thing. It's good for everybody. It's good for the industry. It's good for investors for sure.
But some of it's been shifted in the U.S. You can trade stocks for free essentially at some of these platforms.
But it's not really free because there's something called order flow that comes into play like the company still makes money somewhere.
The company makes money. And the question is who pays for it? And the answer is probably all of us to some extent, because it's reflected either in costs of the transactions themselves or even impact on trading prices. Those are expenses. And then the third thing, which is not talked about quite as much, but is critically important are taxes. And here, if you're not careful, the government is your partner. They're sharing your returns. So taxes, as you mentioned, can silently eat away at your return. And it's important to know the different investment strategies and approaches can either help to minimize tax or can actually work against you and increase your taxes and therefore reducing your after tax returns.
But at the end of the day, there's going to be taxes collected. You can't do tax evasion. No,
But you can definitely do tax avoidance in the legal areas
And you can do tax deferral. And tax deferral in many cases is basically tax saved. And we'll talk about that a little bit.
I got a question for you. On taxes. We pay a fair amount of taxes, you and I.
Sadly, that's true.
I think I've paid way more taxes in this last year than the last president of the United States paid in the last many years is what I've been reading anyways.
That's right. I don't believe he paid tax at all.
That might be called tax evasion. I'm just throwing it out there.
Well, it's because he's smart and he's using the tax system to his advantage. Yes, of course. But anyway, we won't get too far into that. Let's go back into those three areas of costs that I talked about and go into a little bit more detail. So the first one was advisory fees. Now, when I talk about advisory fees, what I'm really talking about here is a certain type of approach whereby people pay a fee for advice and it's usually a fee based on the. A number of assets being managed, things like that, or in some of our discretionary accounts where clients or investors give us the authority to manage their accounts and make investment decisions for them, and so those would be advisory fees. And we've talked about these a little bit in the past. When you're investing, you've got two basic choices. You can either engage an adviser or you can go it alone. We talked about do it yourselfers as regards to investing as well as other things in life. And that's totally a personal decision and depends on the individual investors’ confidence, ability and time and hopefully ability and time are the most important of those, because we know everybody is confident and in some cases overconfident. And that can actually detract from investment decisions
And people can do it by themselves.
There's a lot of information out on the interweb these days that will actually teach people how to trade and how to invest. But there's a difference there and we'll get into that a little bit.
And again, we're not saying people shouldn't sort of manage their own investments. What we're saying, though, is that it's not maybe as simple as it sometimes seems and that there can be pitfalls that you have to be aware of. And it's not that people can't learn those days just need to have the ability and spend the time to do it wisely.
Just go to YouTube. I'm sure there's a video.
That's true. Yeah, exactly. So the decision to use an advisor would have to be based on a belief that the advisor has credentials, experience and knowledge that's going to assist investors in developing the most appropriate investment strategy and investment plan that an investor can live with. I think it's critical to understand what services exactly are provided for the advisory fee. And so let's talk about some of those services, which include but are certainly not limited to the following. One is understanding everything about an investor's personal situation, which allows the advisor to develop a financial plan that clearly identifies their goals and values, financial position and outlook, tolerance and capacity for risk, which actually are two different things and any other factors that will ultimately help or in fact be critical in developing an appropriate investment strategy and plan. There's a lot in there.
There's a lot
And we've talked a lot over the last year and a half or however long we've been doing these podcasts about developing a plan. And the planning piece is really I can tell you, twenty five years ago, it was really not a big issue because when people came to us, they didn't want to talk about financial planning. They wanted to talk about what was the best stock to buy what's going to go up this year, where should we be. And so there's really been a significant shift in terms of focusing on planning, because it's the old thing. How do you develop an investment strategy if you don't know what the goal is?
The ones that stick out there for me or and we've talked about on a specific episode about planning is risk tolerance versus risk capacity. Those are just two majorly different things.
Just because you have the ability to tolerate lots of volatility, does it mean you have the capacity to withstand it financially?
Exactly. And only the financial plan can identify that if you know that you're not able to withstand a 20 percent downturn in the stock market because that'll derail your retirement plans or whatever other plans you have in mind, then you cannot have an investment strategy that might expose you to that kind of downside risk. OK, also, what else do advisors provide? They understand the full range of investment options available in order to help investors achieve their goals over an appropriate period of time. And so there's literally tens of thousands probably of investment choices. There's three or four thousand mutual funds that you could select, thousands of ETFs, ten thousand individual securities. So really, it's important that the advice includes an understanding and some due diligence on those investment options that are available.
Well, you can drown in the number of investment options out there. I mean, I was reading that there are more mutual funds trading in the U.S. than individual stocks.
In each of those funds owns a variation of stocks.
And I believe the same is true for ETFs as well. So it's crazy. So what else do you get? You get an investment strategy and appropriate products for the portfolio. And one of the things we're going to talk about a little bit later when it comes to taxes is also advising on asset location. So here we're not talking about what's the right asset allocation, what we're talking about, where should the appropriate products go? Do they go inside an unregistered account or inside a registered or tax deferred account? Because that's part of tax minimization rebalancing portfolio on a regular basis, providing coaching, particularly during times of extreme market volatility, because it's important to be able to help investors through those emotionally challenging periods. And of course, as we know, those are the periods when the headlines are screaming. And so. Not only do you have, like, the actual reality of what's going on with the markets and therefore your investment portfolio and therefore your being on track to achieve your goals, you've also got every newspaper if anybody reads those anymore headlines, Any news, just screaming about how terrible things are. So the coaching is really critical. And there's obviously a host of other services that are provided for that advisory fee.
I want to go back to that mention on asset location. Just talk about that for a minute. This one is an important one to me, I know you're going to get in to taxation a little bit later. But I think this fits in well here is that where you hold certain assets, attracts different tax rates, and some of that is beneficial and some of it is not. Typically, when we're working with clients and we figure out their asset allocation because we've done a plan and determine how much risk capacity they have when we're actually investing the money, we want to be very aware of what type of accounts different assets are going into. So, for example, in registered accounts or RRSP or registered retirement income fund accounts, whatever those might be, what would you want to hold there primarily, Greg,
I would want to hold types of securities that attract a high level of tax like fixed income bonds, which attract interest income, and those are taxed at the highest rate.
So then in your tax free savings account, you'd want to hold things that attract the highest expected rate of return because of the long term nature short. And so that would be great.
Well, I would say equities. Yeah, you're two for two, by the way. And I would also say you could also include fixed income in there as well, just because of the fact that you will never pay tax on it And depending on your asset allocation and the available assets, it may force you to look at things outside of the registered accounts. The RSP and the RIF for those as well.
And then everything else is held in your non registered accounts. Equities would attract dividend tax credits and things like that and capital gains taxation. But it's very common when we're going through this asset allocation strategy with clients that in some cases their RSP might be 100 percent invested in bonds and their TFSAs, 100 percent invested in equities. And then everything else is in between. And that's by design.
Yeah. Sorry, I went off on a tangent at all,
But not at all. So what's a reasonable and typical fee for advisory services? Well, you can find fees. And again, as I mentioned earlier, it can differ quite broadly, not only between different types of firms, but even within firms. Different advisors might have different fees and typically the range could be anywhere from half a percent for large accounts anywhere to up to one and a half or even one point seventy five percent for smaller accounts. So that's the range. We believe in our group that a fee of one percent or less is reasonable. And even looking at robo advisors which don't provide a dedicated advisor to understand you or your family situation, those type of advisors will typically charge an overall asset fee of zero point for the zero point five percent, depending on the size of the account. So, again, we're not talking about right or wrong. I'm just saying these are typically what the fees are. And again, the decision you have to make is what do you get for the fees?
Well, and even before we get into that, I got something in the mail a few months ago. It was from one of these robo advisor firms. I won't mention them by name, but it rhymes with health wimple.
And the fee that they quoted when you read through the fine print actually was the same fee that we charge,
For a lot less service. So I found that to be quite interesting to read. Anyways, Russell Investments puts out something every year. It's called The Cost of Advice Report or the value of an advisor study. What they look at are five things. They call them A, B, C, P and T and E stands for active rebalancing of investment portfolios. B is behavioral coaching. C is customized client experience and planning. P is product alignment, and T is tax smart planning and investing. And they actually assign values to each of these areas, these five areas to try to determine, well, what is the value of receiving investment advice Greg.
So they quantify it in terms of potential return.
Now they do it in Canada and they do it in the US. I won't go into the U.S. numbers too much, but the Canadian numbers for the year 2020, do you remember something happening in year twenty twenty that was quite significant in our lives?
Oh, I'm thinking of I just can't put my finger on it. Maybe a global pandemic of biblical proportions.
Yeah. Global pandemic, global economic shut down things that hopefully we won't have to experience again any time soon or to that magnitude anyways. The fee that the assigned to that or the value of advice was two point eighty eight percent per year.
How does that break out?
Well, it breaks out by active rebalancing, added zero point one percent. Behavioral coaching added one percent customized client expense. And some planning added zero point four percent product alignment was zero point seven two percent and tax smart planning and investing was zero point six six percent. The one there that really sticks out is the behavioral one. A full one percent difference is what they've attributed to working with an advisor versus going it alone. That's important because that's one percent per year. So that's a compounding one percent.
Well, it is. And we've talked a lot about behavioral biases and how being human leads us to make either impulsive decisions or decisions based on fear or greed, either of those two. And so just with some coaching and having somebody to talk to about some of these things before making a decision can help in real terms.
Well, it's very easy to say. Yeah, but I knew that that was going to happen. So I did this or I knew this was coming up, so I did that. That's all a bunch of nonsense. I had a meeting a few weeks ago with somebody and they were talking about what happened last year and how well they knew it would come back. So they just knew it was going to be that way. So if they were managing it on their own, they would have invested more.
Sure. And you know what? We all do it. And I do it myself. Despite having been in the business for over twenty five years. I still look back and shake my head how did we not know when we heard that there was a pandemic in China and they were actually like shutting down whole cities? One of our own team members was in China at the time and basically was quarantined for the full four weeks that she was there. And yet how is it that we didn't know that that was going to cause a big problem? Like, of course, we knew that was going to be a problem. We just didn't do anything about it. And that line of thinking is exactly wrong. We didn't know, just like when the market was down. Thirty five percent. Gee, I should have backed up the truck and mortgaged the house to buy stocks because everybody knew that stocks were going to come back up. Well we didn't know that we've been through two Bear markets where the markets were down 50 percent. So when we were only down thirty five percent, there was still another fifteen to go. Of course, we didn't know that at the time. It's just so easy to believe that we knew it at the time because of what we now know.
So the data for the study comes from that historical evidence of what people did and didn't do during different market cycles. It's not data we've come up with. It's data that has been quantified by a bunch of intelligent people that are tracking it. So I got to believe that is real. Probably you could argue, maybe some people might say, well, it's not two point eighty eight percent per year maybe, but it's some percent.
But hopefully it's something. And hopefully that's why investors choose to work with advisors like us.
Well, especially if you just said on average, we believe a fee of one percent or less is reasonable. Let's just talk about the value of that. You're paying one percent or less and getting somewhere around two point eighty eight percent per year in just value of advice.
That's really the hope. You bet. The second type of cost that we talked about were expenses. And these are pretty straightforward to understand transaction fees or commissions. In a transactional account and certainly the way the industry was Twenty five thirty five years ago, basically, the advisor called you up to make a trade. They did the trade and you paid whatever the transaction fee was. And you didn't have a lot of choice when the early days that could have been two percent of the value of the transaction. You do a twenty thousand dollar transaction four hundred dollars, and that's one way. And so when the advisor would call up to sell that stock sometime later, there would be another two percent of the other way. So you're giving up four percent in those days.
So if you're up 10 percent, you paid four percent in transaction costs. You're really only up six percent.
And then you got taxes on top of that.
Right on. So commissions are a part of a certain types of businesses. But again, the good news is those commissions have come down a long way over the years. There's operating costs in mutual funds or ETFs, just the cost of doing business, of doing transactions within the fund of safe custody of assets. There's management fees. So whether you buy an ETF or a mutual fund, there's a management fee which the manager gets paid for selecting the securities that are going in there and as well in the what we'll call advisor class mutual funds. So in the case of transactional accounts where investors are not paying a fee for service, so to speak, or a fee for advice, there are service fees built into those funds, which typically would be anywhere from half a percent to one percent.
And these could be the same for mutual funds that are sold at the bank level. There's this misconception that people don't pay any fees in certain mutual fund structures. That's just not true. I mean, that's right.
There's fees built in even when you buy a GIC.
And people think, well, I don't pay anything to buy a GIC. That's nonsense.
No, exactly. And that's part of life. And again, the key thing here is not that they're bad, it's just that you need to understand what they are. And if you have the ability to minimize them as much as possible, then you want to take advantage of that.
Well, and I think our industry regulator, as much as I like to be hard on them, actually some of the reforms they've put forward are to make those fees transparent.
So that's right.
Client focused reforms coming forward this year.
In a couple of years ago, they introduced. The more transparency in fees and rates of return, which are now reported every December on the year end statement trading expenses we've talked about in previous episodes, the trading expense ratio or TER. Those are the actual costs of trading that are always incurred in mutual funds and ETFs, but not reported as part of the management expense ratio. So it's important to know those.
It seems crazy that the mark is always reported in the T or is not. I don't really understand, but
It's a bit unusual, but it's a fee. And then there, of course, custody fees or RSP administration fees, things like that, which again, typically are more common in transactional accounts than they are in fee based accounts.
So what are the typical expenses that we want to go through?
Well, listen, I mean, there are some incredibly inexpensive investment options. And so some ETFs like the broad index ETFs, whether it's the TSX Composite Index or the S&P 500 index, those can be as little as five or seven basis points. So what?
I mean zero, five percent.
That's right. And as you get into more diversified. So let's say you don't just want the index. Let's say you want to have international funds in the portfolio. Or as we've talked about in the last episode, when we talk about sector funds to get exposure to those, I shouldn't say sector factor funds where you want to get exposure to those factors that give you higher expected returns, those kinds of things that could increase fees to point four or five or even point six percent or higher for an ETF. Now, mutual funds, there's a lot of people who still think mutual funds. Oh, I don't like mutual funds. Their fees are too high and there's no question. Twenty five years ago, mutual fund fees were easily in the range of two and a half to three percent. And there was one well-known fund company in Canada that I won't mention which fees greatly exceeded three percent. And they also had fees to acquire the funds in the first place. So those were the bad old days and those days are largely gone again, thanks to a lot of those client focused reforms that you've been talking about to a point where there's many, many mutual funds and mutual fund providers that provide fantastic market exposure, well diversified strategies and diversification and extremely low costs. And what I'm talking about, there are management fees of about zero point to five percent or twenty five basis points. So extremely low cost for the kind of diversification that you can get now. And the last thing we'll talk about were taxes. And we've talked a little bit about that already. So we talked about asset allocation. So highly taxed types of securities such as bonds you'd want to have and registered accounts, whether there are RSPs or RIFs and more tax efficient securities like stocks can be a non registered accounts and tax free savings accounts. The other thing, though, that affects tax is trading activity. And so when you look at a lot of investors might have non registered accounts where they hold their stocks, but they're doing lots of trading. So they might have turnover over 50 percent of the portfolio, meaning that every year you're replacing half of the securities you own that ends up triggering tax. If you've been lucky enough to be in periods like we have largely for the last 12 years, stocks have largely gone up. And so every time you sell it, triggering tax, you're paying tax. And then the money that's left to invest afterwards is you're after tax dollars.
Now, if you had a very similar strategy, but you were in a different fund structure, you might not be triggering as much or any.
Well, that's right. And so here we're talking about whether it's you as an individual investor who is buying and selling the stocks actively, whether it's your fund manager who's buying and selling the stocks actively, the more turnover, the more tax is going to be payable in the current year when that can be a very significant amount. And even with the preferential tax rates on capital gains, your money that's available after tax to invest is less. And there's other portfolios are mutual funds or funds that have very low turnover by design. And those funds tend to capitalize on all the growth that's available in the markets. But they don't trigger the tax each year, which means that you don't have to pay tax each year and the investment can continue to grow and grow until at some point there will be taxed to pay down the road But as my accountant tells me, tax deferred is tax saved because when you do finally have to pay the tax, it could be 20 years down the road.
And in the meantime, you're avoiding that silent killer.
You're avoiding the Silent killer, while you're deferring it. And when you pay for it, you're paying it with deflated dollars. Inflation does affect all of us. And maybe year to year it's relatively low at two percent. But over a long period of time, it could be 20, 30 percent. When you're paying your tax down the road with those deflated dollars, essentially it's saving you money. So that's it. Those are the silent partners in investing. We've got fees, expenses and taxes and anything we can do to manage those to control them. And most importantly, to make sure that everyone's aware of what they're actually paying, the better it'll be to the bottom line.
Exactly, because there's no point in paying excessive fees or taxes if you don't have to. That's just the point we're trying to make. I know that listen, talking about fees and taxes isn't the most exciting thing out there.
But it is the discussion that many advisers don't like to have because they find it uncomfortable or feel like they're being challenged to defend their fees. And I think for us, it's more a function of, hey, it's your money. You deserve to know exactly how it's being spent and what value you're getting for it.
And if you're working with somebody that doesn't want to talk about it, well, maybe give us a call. We'll talk to you about it.
All right. Well, listen, that was I want to say that was fun, but I mean, it was taxes.
Yeah, really? How fun is that?
But next time we're going to talk about dividends, market cycles and something else and the headlines, headlines, right, and I'm looking forward to that one.
Me too. All right.
See you next week.
Episode 63 - Back to Basics…Factors of Return
In this episode of Back to Basics, we discussed factors of return; where you can reduce your risk level, but still have higher expected returns.
Welcome back to the free lunch podcast with Greg and Colin and notice how I changed my inflection there Greg?
That's different. I think people are going to notice that
I noticed it. So we're on episode three of her Back to Basics miniseries. And last week we talked about stock picking and market timing. And Greg, recent market movements actually show how difficult this is. Remember back on July 19th when the Dow Jones sold off two percent or roughly a thousand points at one point? Yeah, I'm sure it created some panic out there. But the next day, the market rallied something around two percent back, which I guess is just highlights how difficult it would be to time those events.
It's pretty volatile. Now, the other thing, too, of course, is everyone gets all in a knot. Oh, my God, it's eight hundred or a thousand points. But that's when the Dow Jones is trading at, what, thirty five thousand ish? Just think back in the old days when the Dow was trading at 10000, it didn't seem like that big a no. The market didn't have to go down too many points for it to be two percent. These large numbers make you feel worse than they need to.
Well, I remember that day it was the House of Representatives voted down the bailout package of the global financial crisis 2008. And the Dow was around, I don't know, 11000 points or something. And it went down twelve hundred points at the open. That's a way different number than a thousand points on thirty five thousand. Exactly.
Yes. I remember that day. That was not fun.
No, I think we turned the channel that day. We didn't actually watch some of the strange soaps.
We watched soaps.
Yeah, but this week we're going to talk about factors of return. And we spent a lot of time in previous episodes going through the stuff. But as this is a back to basics miniseries, we wanted to use this as a refresher. And we did a webinar back in June discussing health and wealth. And lots of the material that we're going to cover today was in that recorded webinar. So if anyone wants to watch it, please send us a note and we'll forward up the link right on. So to get us started, Greg, we've got a song by.
I've heard of this band, they’re an up and comer, an up and comer. I wonder if it makes you feel all right when the Dow goes down a thousand points.
Yeah, well, let's get into that. We're talking about the Dow and the S&P 500, things like that. So, Greg, let's get into what is the stock market?
I think that's probably a good place to kick off from. Listen, everyone listening, I'm sure, has some point watched CNN or CNBC or something like that. And they've seen the closing numbers, the Dow Jones Industrial Average, the S&P 500, the TSX,
Those kind of things. And as we've talked, I mean previously, these are all just representations or benchmarks of the markets. And in most cases, they're a small part of the markets themselves, but they're meant to be representative. So the one that gets the most attention is the Dow Jones. Despite the fact the Dow Jones has only 30 components. It's the third largest companies, industrial companies. Originally it was the Dow Jones Industrial Average, but 30 of the largest companies that trade in the U.S. stock markets. So 30 names.
So it's really not that representative of the whole market. And certainly it's a market of large companies. If you move down into the S&P 500, those would be the 500 largest companies that trade in the U.S. market, which also seems like a lot certainly more diversified than the Dow Jones 30.
But every day there's actually about 1600 publicly listed companies that trade on the different exchanges in the U.S. alone.
It seems that, again, 36 100, that's three thousand six hundred companies.
Yet everybody always quotes the Dow 30.
Or the S&P 500 for that matter. So it's really a very small proportion. And of course, that doesn't actually include private companies, companies that trade over the counter or that aren't listed on an exchange. So just as review, I mean, the stock market itself is an auction market where buyers and sellers, they meet and agree on a price. And so for a trade to happen, you actually have to
Accomplish a buyer and seller agreeing on a price. Sometimes you'll hear a day like the 19th when the markets were down
800 or so points. People will say something like, oh, there was more sellers than buyers. And obviously that's not true.
Can you explain why?
Well, there's got to be a buyer for every seller. So if somebody is out there selling their stock in order for a transaction to occur, there has to be somebody willing to buy that stock from them. What probably is true is that there are more people eager to sell than there are people eager to buy. And I think that maybe is more descriptive of how things happen, because the more people that are eager to sell, they might be willing to sell at any price, whereas the buyers might be very specific about the price they're willing to pay.
So one side just more motivated than the other side. But as you say, it's just math. You have to have one for one. You have to have a buyer for every seller or there's no trade.
So one of the things we should cover off to is just looking at the size of the stock markets as a whole, because when we look at some of the details on geography of the global stock markets, it's a big world.
And in fact, when you look at the representation of each country as a part of the global stock market. So if you consider all the stocks that possibly trade on exchanges around the world, then we can look at each country and see what they represent. And in the case of Canada, turns out Canada represents only three percent of the global stock market, whereas the US represents over 50 percent. I think it's close to 54 right now, given how strong the returns have been in the U.S. stock market. So when something catastrophic happens in the U.S. like what we went through with the global credit crisis, starting with the horrible mortgages that were
Being issued in the U.S. and then, of course, leading to a much broader crisis, you can see how that has a pretty big impact given the size of the U.S. market.
So when people talk about the market, wouldn't it be better to actually be talking about the global stock market versus the TSX or the Dow Jones or whatever?
I think it probably would be.
And I think part of the issue there is just its people probably can't relate to it, like the benchmark MSCI, which is the Morgan Stanley Capital International Index of the World stocks. It's not something that people are familiar with. And so they don't know whether the current level is high or low or how to compare that. So unfortunately, people
Just sort of gravitate towards the indexes that they're more familiar with. So you're if you're investing in Canada, the TSX Composite
Or the TSX 60 Index, and if you're investing in the U.S., it'll either be the Dow Jones 30 or the S&P 500
years ago, I had somebody come in and they were quite upset. They said the market is just down so much. And when they were describing this, global stock markets were actually rallying in I said, well, which market?
And they said, well, oil oil's down. I didn't realize oil was the market Greg.
So to your point, which market are we talking about here? That's right, not only is it important to understand what exactly we're referring to or what people are referring to when they talk about how the market is doing, but to really understand that there's a lot going on outside of those particular indexes that we're going to be talking about. I just wanted to mention, too, when we're talking about the importance of different countries as part of the overall market, one of the ones we hear a lot about is China. Some of the emerging markets, China, Brazil, Russia, that kind of thing. China right now only makes up three percent of the world stock market. A lot of people are still interested in investing in China. And I'm not sure if that's going to change a little bit over the next little while, given what's going on politically and the fact that, as we keep pointing out on our Podcast, is China still is a communist country. They're trying to behave or act like capitalists. But there's a lot of reasons
Why shares of Chinese companies you may want to be careful with and certainly anyone that wants to capitalize on growth in China or India or any other places is best to look at some sort of funds or broader way to invest in those types of companies.
It's kind of a paradox, isn't it, to have like a capitalist slant on a communist economy?
Exactly. And I'm not sure in the end
That it can work when a lot of it comes down to governance, because part of the thing that makes investing in the us and Canada a little bit less risky is just the fact that there are certain requirements for listing the companies.
Financials have to be audited carefully and by using a respected or respectable audit firm. And some of those things don't apply necessarily in Chinese companies. Anyway, off the topic a little bit. Yeah. Let's talk a little bit about how big the markets are. So we talked about the fact that the US represents 54 percent of the global stock market. So what does that billion. Well, in dollars it's about 70 trillion dollars.
See that again? That's 70 Trillion dollars. 70 trillion U.S. dollars.
That's right. That's crazy.
So Canada, again, representing only three percent of that.
But I guess still a fairly big number when you're talking about 70 trillion dollars of market capitalization.
Now they're talking about how some of the large cap companies like Apple may be the first one trillion dollar market cap company.
Hard to believe
Now, Greg, are we suggesting people invest in Apple?
Not specifically, no. They could. Yes, of course. I mean, you have Apple products. Don't.
I've invested in many Apple iPhones, computers, laptops.
I love that's investing or spend.
Let's spend the night. Yeah, there's no return expected on those. Anyway, as we talked about a little bit, the size of the global stock markets, that Canada itself is a relatively small part, as are certain other countries, like some of the emerging markets, countries like India and China,
But even like Australia is three percent or something like that. So, again, just and we've been banging people over the head with this point. But just make sure that you're diversified outside of some of these small countries so that stocks. But what about the bond markets?
What about the bond market, the market that nobody talks about? Because there's two main ways for companies or countries for that matter, to raise capital, and that is through issuing stock or by issuing bonds.
Bonds essentially are loans.
We don't have time to get into the intricate details of the bond market today. But let's just say that not all bonds are created equal. So when we have somebody that says, well, I can get a government of Venezuela bond that is going to pay me 10 or 12 percent versus the government of Canada bond, that's going to pay me, I don't know, one point five percent. There's a difference in those bonds. Exactly. So the power of the bond market, though, is massive. So if the stock market was worth over 70 billion U.S. dollars, the bond market is worth approximately 130 trillion U.S. dollars.
So that again, that's a bigger number, Greg. That's almost double.
So 130 trillion dollars. Yet nobody talks about the bond market. And you got to ask, why is that? So I'm asking you, Greg, why don't people talk about the bond market like all they ever talk about when you turn on the news? Is the Dow Jones, is this the TSX? Is that the price of oil is here? The Canadian dollars’ worth this, but nobody really talks about the bond market.
Yeah, it's not exciting and it's harder to relate to because the bond market is so much less volatile than the stock market. People talk about the bond market around the edges, so they'll talk about inflation and they'll talk about interest rates and they'll make general comments. Interest rates could be going up. That could be bad for bonds, but nobody knows
What that means. It sounds smart, though. Yeah. When you say, gee, something could be bad for stocks, you envision stocks going down 20 percent of something is bad for bonds. Maybe they'll go down a couple of percent, maybe three, maybe four. But there's just so much less volatile. That's just doesn't make for interesting commentary on the business news. Well, a few weeks ago, the U.S. 10 year Treasury moved from one point four or five to one point six, and that caused a big uproar. And it's like 15 basis points and may even be a big number in bond world. But in stock world, it's barely a blip. It's less than what happened on the stock market last week, but that power of the bond market can't be discounted. I mean, it's literally led to the end of wars. It's just a huge market. And the difference is that it's not an auction market. So buyers and sellers aren't meeting on a centralized exchange to trade bonds. Bonds are primarily traded between institutional bond desks.
So finding out the true price of a bond would be very difficult for a retail investor to get to because it's as we said, it's never reported. Actually, that's not true. Recently it has been because that U.S. 10 year Treasury, it got up to like close to two, I think, a week ago, and then it fell to one point one eight or something like that within a few days.
The bond market has been puzzling people because everyone's been so concerned about inflation. And yet interest rates, as measured by the U.S. 10 year government bond or the Canadian 10 year government bond. The interest rates on those are the yields have actually been going down,
But it's not sexy.
Nobody's talking about how they picked up 40 basis points over the US 10 year Treasury on a trade. So, Greg, instead, what do we hear about these days? We hear about things like and we've talked about these in the past, Bitcoin, Ethereum, Dogecoin. Last year it was weed stocks. This year, this last 12 months, it's been short squeezes on companies like AMC Theaters, GameStop,
One of them you and I looked at the other day, Dillard's. I didn't realize Dillard's stock was up like I can't remember hundreds of percent in the last year and you've got these people bragging about how they have diamond hands on this Redit Wall Street bets forum and diamond hands for those that don't know means they hold the stock and they're not going to sell it no matter what. That's diamond hands. This is really sound like investing, but it sounds like collecting. That's right.
if you give it and sell the stock now. So let's be clear. There's investing and they're speculating or gambling. And when you're participating in a short squeeze with your diamond hands, this isn't necessarily investing. It is probably speculation at its best. So being part of something like Dogecoin isn't investing great digital dogecoin was created as a hoax.
I heard that. Yeah. And then a bunch
Of celebrities got on board and now it's worth money somehow, but there's no intrinsic value to it.
Anything can be worth money if people are willing to pay for it.
The problem is linked to the consequences of investing in something that you don't really understand and not understanding what the potential outcomes could be. So that's an issue.
Well, now let's get into so we know what the
Size of the markets is. We know the markets are huge, 70 trillion dollars minimum, possibly more by now. And so since stock markets were first created, basically investors have been looking to crack the code. And what I mean by crack the code is like find that magic formula that allows them to predict what's going to happen in
The future with stock
Prices based on what's happened in the past. That means looking for patterns in stock returns. Last time we talked about using fundamental analysis techniques like Benjamin Graham developed in the 1930s to try to figure out what stocks are trading below their intrinsic value. That's what Benjamin Graham was all about. And by doing that and finding stocks that were trading below their intrinsic value, we was able to do well by investing in those stocks and waiting for everyone else to realize that the stocks were undervalued. But we also talked about how the speed of information flows and the sheer numbers of people using fundamental analysis has made it harder, if not impossible, to actually gain an advantage. I mean, the whole idea of fundamental analysis was to gain an advantage against the other guy. And so when you go into the market as a buyer or a seller that, you know something that the other guy doesn't know.
Was 90 years
Ago, 90 years ago. And these days
There's probably not a lot that's not known by everybody who will take the time to actually get that
Information. Well, actually, I would
Even say because of high frequency trading and things like that, even if you don't know the information that's causing the change to price, whatever it is, it's being traded automatically because of high frequency trading and other AAII like trading
Let's approach it this way. First of all, let's talk about the growth of a dollar.
Conversation will lead us into the discussion of factor investing, which is
One of the things we wanted to cover today. Well, we're 18
Minutes in and now we're finally getting to factors
Of return. Well, that was a long
Is good, though.
So let's talk about the growth of a dollar. So let's say if you didn't want to take any risk and you had invested fifty five years ago, which puts us back to what, about nineteen seventy or so or sixty five, fifty five years ago, you would have invested in US Treasury bills and U.S. Treasury bills are known as the risk free rate. So the rate that the US government pays on its short term Treasury bills is risk free. You know, you're going to get your money back. The US government will always pay you
Back unless they fail, unless they fail, which is highly unlikely
At this point. So how would that have worked out? So your one dollar would have grown to twelve dollars over that time period?
That's not bad, 12 times your return. That's right,
And that's with taking zero risk.
But let's say you were willing to
Take the risk of the stock markets. And in this case, we'll talk about the S&P 500 just because that's a well tracked index.
Well, your one dollar fifty five
Years ago would have grown to two hundred and eight dollars
Today. That's better.
So 208 is better than 12. OK, that's why you're the kind of advisor you are.
I can do math.
This is what we call the equity premium. OK, so there's a risk premium. There's a risk to investing in stocks compared to Treasury bills.
And that risk
Has in the past, in the last 55 years, allowed your one dollar to grow to two hundred and eight dollars. So what if we told you that not all companies are created equal?
And when I say equal doesn't mean better or
Worse, it just means different. So when you look at the market as a whole and let's talk about the whole U.S. market. Thirty six hundred stocks or so, there's large companies, most of which are represented by the major indexes. We've talked about the Dow Jones 30 or the S&P 500, but you can break the rest of them down to midsize companies and eventually small
Companies and micro even.
That's right. So what if you took that one dollar fifty five years ago and invested it in small companies over the same 55 year time period?
And we said that just in the S&P,
Five hundred the large stocks that one dollar grew to two hundred and eight. Well, in small companies that one dollar grew to seven hundred and ninety dollars.
That's a better number, calling you up
Looking for your math, your math smarts on that one.
So that seven hundred
Ninety dollars, that difference, that massive outperformance of small companies over the large companies is basically what's called the size premium.
I want to talk about that just for real quick. Second, it's really easy to understand if you look at two companies, it doesn't matter where they are, ones like a smaller company and ones a large market cap company. Well, a smaller company just has more room to grow as room to capture more market share and grow. And that's basically what that size premium is showing you.
Exactly. That's the size premium. And the work on the size
Premium began back and
I believe in the early 1980s.
And since that time, the
Size premium has been confirmed not just by other
Authors who maybe did research on the size
Premium, but just it's been proven to be the case around the world.
Size premium has been
Seen in all the global
Stock markets, not just the US market, the Canadian market, the international markets, even emerging markets. You see that size premium
And you might ask, well, why is the
Size premium exist? And I think there could be many reasons. But one of them you can't ignore is just the whole basis of capitalism, and that is that small companies probably are inherently more risky than investing in large companies. And so for investors to allocate money to a small company that's a riskier company, they expect a higher return.
And we're not telling people to allocate money to individual small companies
Because of absolutely right that
It also comes down to something called cost of capital, which is just what does a company have to give up if they're issuing stock or if they're issuing bonds, for that matter, what do they have to give up to attract capital? And a smaller company is going to have to offer more. And so the cost of capital to that small company becomes the investors return.
So it makes sense if you just think about it intuitively, that
Small companies should have higher expected returns. And as we saw in that result, that basically has worked out that way.
What's the last premium we're in talk about today?
Well, let's talk about price. What we're talking about price is not the dollars per share of a company, but we're talking about is the
To something. So let's say how was the stock priced relative to its book value? So if you look at what is the company worth, when you add up all of the assets and subtract all the liabilities, that's kind of its book value. That's what it's worth. And if you could look at price relative to that, then you're going to get a number. So price to book value might be, let's say it's 20 times. So the stock is trading at 20 times its book value. Well, if you divide up the market as a whole and looked at each individual company and their price to book value that they're all trading at, again, just
Like size, you're going to get a whole
Range of companies trading at very high prices relative to their book value, maybe 30 times or more for like high growth technology companies maybe, or things like that. And you could get companies trading down at eight to 10 times their book value.
So in market terms,
We call those either value companies, which are companies that are trading at low prices on a relative basis relative to their book values or high prices, which would be called the growth companies.
And I think people would be more I don't know, they're more used to hearing things like price to earnings ratios that show that value versus growth company. So a company that's a big growth company might be like Tesla. It's trading at six or seven hundred times earnings.
Yes, that's right.
A company like CIBC is trading at, I think, around.
Times are eight to 10, I think.
One is considered
A growth company and you would invest in it because you expect it to continue on that growth trajectory, whereas the other one might be considered to be just a better value.
Exactly. So the value factor was identified and referenced,
I believe is in the late
80s, early 90s, and in a paper
By Fama and French
That talked about the cross section of stock returns, and that's where they identified the value premium in addition to the size
Premium and certainly the
Premium of investing in stocks relative to bonds. So when we talked about the growth of a dollar, just to recap, a dollar grew to twelve dollars over fifty five years and Treasury bills, that's
The market premium.
No, that's the risk of Treasury bills, yet grew to two hundred and eight
Dollars just by being in
The market as a whole.
That's the market preview. That is
Seven hundred ninety dollars by being in small companies,
Small company size premium.
What about small companies that had a value tilt? So how did that dollar do? Well, two thousand seventy seven dollars, one dollar grew to two thousand seventy seven.
And so that's the price
Premium or the value premium even relative to just small company stocks as a group. So I just want to mention. So these are probably the three most researched and investable factors or they certainly were. Now there's been hundreds and hundreds of factors identified over six hundred. But what they find is that when they look at certain factors, they're all just some sort of combination or variation based
On the main factors that
Have already been identified. So I think one of the things we can talk about and maybe in future episodes we'll talk about other factors, like there's a momentum factor, which is very real. The stocks that are doing well currently tend to continue that performance for some period of time into the future.
But certain academics discount the momentum factor. They say that there's not statistical evidence to support it in the long term.
Well, and it may well be that it's more of a behavioral factor than an actual underlying causal factor, such as
The risk of buying small
Companies or something like that.
So, again, lots of things to talk about, but a lot of people will say, well, I need to pick
Stocks because I don't want to just get index returns. I want to beat the index. And what the factor research has done is shown that while there are factors of expected returns, that when you invest and have exposure to those factors, you end up with a higher expected return than the market as a whole.
It's not guaranteed. It's a higher expected return. That's right.
And so what it does
Say, though, is that
If you had a choice
Of investing only in large companies, let's call them like the S&P. Five hundred companies and you're one dollar guru to two hundred and eight dollars. And there was a chance to expose your portfolio to a group of stocks that grew to two thousand and seventy seven, almost 10 times the amount. Would you not want exposure to that?
Well, I would.
Well, I think so. And I think most people would
Sum up there are factors of return.
They're not generally based on specific stock analysis or maybe even technical trading.
They're really based on
Evidence based research that shows that certain types of stocks can perform better.
And many products in many
Funds are now offering ways to get exposure to those factors.
They're marketing and like it's new, like I see all these ETFs coming out that are factor based
Or something like that
Factor smart beta, smart beta.
It all boils down to the work that was done by Eugene Fama and Ken French as the pioneers in that area, really with the former French factor models.
That's right. And unfortunately, a lot of those six hundred factors or more that have been identified.
In fact, there's an ex
University of Chicago professor
John Cochrane, who has written numerous papers about what he calls the factor Tsou. Just that there are so many factors that you have to
Spend a lot of time and research to
Weed through them. But unfortunately, a lot of companies will use those as ways to market and sell products. Exactly. And I think that's where we need to make sure that we're investing in a way that gives us exposure to what we know to be factors that
Have been proven to be
Pervasive and persistent and as well just kind of make sense.
I want to sum up here just the last three
Episodes we talked
About in the first episode, asset allocation being your most important decision, really. Secondly, diversification. So spread the risk of stock picking is fairly futile.
It can be
Done, but it's pretty hard to do. Market timing, same thing is very difficult. Yep. But that if you have a portfolio where you've already identified the proper allocation
You've diversified your positions and you've included these factors of return, you probably have given yourself a better opportunity of doing well.
You're just playing the odds. You're just putting yourself in the best possible position to benefit from these things.
Well, that was good.
Maybe we'll end it there. But next.
So we're going to get into know your costs so that fees, expenses, taxes, things of that nature, that should be a riveting conversation.
Well, it should be. But I mean, those are your silent partners in investing. So they're sharing your returns. And so I think we're going to talk about that and things are going to cost. There will be costs associated with investing, but making sure the costs are reasonable and right. And so we'll cover that off.
Sounds good. All right. Well, next time.
Episode 62 - Back to School…Stock Picking & Market Timing
Greg and Colin continue on their back to basics mini-series. Discussing the futility of stock picking and market timing, focus your efforts elsewhere!
EP.62 - Back to School…Stock Picking & Market Timing
Welcome back to the Free Lunch podcast with Greg Kraminsky and myself, Colin Andrews, notice how I changed it up there Greg?
You did? Yeah, that was I think a lot of people are going to pick up on that.
So we're on episode two in our miniseries on the basics of investing. And last week we reviewed the importance of asset allocation and diversification and how those two elements need to be done correctly to give yourself an opportunity to have a successful outcome. I think that's pretty straightforward. You bet. So today we're going to talk about stock picking and market timing. Now, in our last episode, we talked about how asset allocation makes up something like as much as 93 percent of a variation of portfolio returns. Yes, right. And how everything else accounts for less than seven percent. So we're going to spend 100 percent of today's episode talking about something that accounts for less than seven percent on the variation of return.
Sure. And we're going to talk about that, of course, or we're going to start with stock picking. And listen, stock picking is something that many people did for a very long time. And the purpose of it really is to identify companies, to invest in that have the possibility of going up in value by more than the market as a whole, because that's the only reason why you would do that. Do you think you could beat the market?
And there's lots to think they can. True?
Yeah, and probably many have, but maybe not consistently. So there's a couple of different approaches that are used to identify individual stocks. But we're going to focus primarily on what's known as fundamental analysis, and the fundamental analysis, the objective is to determine a company's intrinsic value. Compare that to the current trading price of that company's shares. And if the intrinsic value is higher than the current trading price, then the company would be believed to be mispriced and undervalued and therefore should be bought. And conversely, if the intrinsic value is lower than the trading price of the shares, then they should be sold. So we talked about this in our one of our very early podcast's. Benjamin Graham is known as the father of value investing, and he literally wrote the book on fundamental analysis back in 1934, which was called Security Analysis. And he wrote a follow up book, The Intelligent Investor in 1948. And a lot of Graham students went on to a very illustrious careers in the investment world, and those included people like Sir John Templeton, who founded Templeton Mutual Funds and Warren Buffett.
Now, if he's the father of value investing, does that mean that he named his first child value investing?
That's right. Yes, value investing's Father.
So, again, we're talking about going back to the 1930s, 1940s of a fundamental analysis of stock. And his first book now has been available for almost 90 years. And tens of thousands of well-trained analysts and computer programs have utilized the techniques that he described, a fundamental analysis to research essentially every significant stock or major stock that's traded on any of the world's exchanges. So the success of fundamental analysis historically was based on the fact that not many people were doing it, and therefore Graham and his disciples had information that was not broadly available to the public. So today, any potential advantage from doing this kind of analysis has largely been eliminated by virtue of just the dissemination of information, the Internet, the World Wide Web. And there are now so many people using fundamental analysis as a way to identify stocks that essentially stock prices are now fully reflecting that. And in fact, there was a speech that Benjamin Graham made in 1963. So that's going back a few years. Yeah.
And I'm going to give you a quote. And the way he talks is a little bit different, but hopefully we'll get the message. He says, similarly, take the case where an individual stock is favored by one of my own fraternity of security analysis is because he is optimistic about its future earnings and general prospects. To the extent that investors generally agree this company has good future prospects to that extent, its prospects are also likely to be fully reflected in perhaps over reflected in the market price. So what he's basically saying there is that if everybody thinks that the company is undervalued, then the price will already reflect that because people will have already been buying it. And therefore there's no further opportunity, which sounds a lot like something that we talked about previously. And we'll talk about more in the future. The Efficient Market Hypothesis published by Eugene Fama back in 1965,
The father of modern finance.
Exactly. And we've met modern finance. He's a nice guy.
Yeah, he is.
So in the same speech that Graham made, that previous comment, he also identified something that a lot of people don't think about. But it's impossible for investors as a whole and therefore the average investor to do better than the general market. And that's just based on the fact that basically the market is the sum of all investors’ portfolios and therefore the market itself is the average.
Well, and if you think back to the when did Benjamin Graham first read that 1934.
Yes. Fundamental analysis.
So great in the dirty 30s, right? Yeah, and information flowed a little slower in the 30s, did in the 20s. So how would people have gotten the price of their stocks they owned? I guess they'd get it from the newspaper.
That's right. And it could take a long time to get that information. It would be even harder to get information that companies would publish their earnings reports and things like that. And yeah, news would move very slowly.
Whereas today we get it at the one click.
One click. So I did some clicking around on the interweb and I looked at the top returning stocks for twenty one over the last trailing 12 months. The number one performing stock isn't going to be a surprise Greg,
We've talked about it a few times on this podcast.
We probably need to stop talking about it.
I think so this will be the last time we won't mention it again.
Gamestop is up over 4000 percent in the trailing 12 months
Pretty decent return.
Now, these are U.S. stocks. The stock that came in second for return in the trailing 12 months actually surprised me a great deal. It's Dillard's Dillard's, the U.S. retailer. And I just can't understand why Dillard's stock would be up six hundred and fifty two percent over the last 12 months other than, I guess, going into the pandemic and economic shutdown, their stock would have gone down dramatically.
But I can't understand why it's gone up over 600 percent since
Maybe we'll look into that.
Yeah, and there's a whole list of them. I won't get into all of them, but there's a number of brick and mortar stores. Abercrombie and Fitch is another one. Pitney Bowes, Nabors Industries, Bed, Bath and Beyond is up over 200 percent in the last 12 months. So it seems that if somebody was trying to stock pick, they would be trying to find those names.
That's right. And it's one thing even for professionals who are scanning the entire list of companies that comprise the S&P 500 or the Russell 3000 for the average investor sitting at home who has heard of all brands. And I can tell you that nobody has called me inquiring about it. Stock's up three hundred and twenty one percent. Yeah, a very active corporation, up two hundred and eighty five percent. Techno glass up to one hundred and eighty percent. So these kind of names that a lot of individual investors, particularly picking their own stocks, whether they're Canadian or us, are likely going to miss these. Whereas of course an index investor likely owns most of these names, at least to some extent.
Yeah, maybe a small amount. But in any event, they're there. But picking stocks is a hard thing. It's a hard thing to do. It is. I mean, to pick it is easy, but to pick the one that goes up is hard. Yes. Yes. So just for fun, when my son was eight years old, he's now turning 18. I had him I printed out the Dow Jones Industrial Average and the TSX 60, and I gave him a highlighter. You remember the story? I do. I like telling it. I gave him a highlighter said pick ten names from each list. Didn't tell them why. He just said pick the names. And he picked names like Coca-Cola, McDonald's, Nike, Disney, Wal-Mart, Agrium, Agnico-Eagle Mines, Anapolis, Suncor Energy and the Home Depot. So there's some of the names that he picked up. So just for fun, I benchmarked his picks against our former firm's North American core equity portfolio to which they've picked us and Canadian stocks as well. Now, these are the people that picked that list. They have CFA's and MBAs and all kinds of designations, and their job is to pick stocks. My son, who was eight, obviously, his job was not to pick stocks. No. Now, the analysts that made those picks for that former firm, they're paid lots of money to do that job right Greg.
I would think so.
You know, my son Kailen was paid to do his job.
Not really, no.
Thirty dollars a month. That's what his allowance was.
It's pretty good.
So I've benchmarked his performance versus this North American Core portfolio. Now, in the last one year period, I should mention, there have been no changes to this list at all. They were just picked and left alone, buy and hold, buy and hold. In the last one year period, the North American core guided portfolio, it returned fifty three percent. That's pretty good. And Kaitlyn's picks only returned forty one percent. So they outperformed him in the last twelve months. However, in the last three, five and ten year periods, his picks have far surpassed the picks of the analysts.
As we've talked about last time, one year is not really a reasonable time frame to judge performance.
Right. And so now as he's turning eighteen, this is ten years’ worth of data. The portfolio that he picked has returned seventeen point six one percent per year for ten years.
Have you increased his allowance by seventeen point six percent a year?
We've increased his allowance by one hundred and twenty five percent over ten years. So he's gone from thirty dollars to maybe. I don't know. It is that 80 dollars or something, but nowhere near what was there, so I'm bringing this up and I've brought this up in past presentations just because picking stocks is hard. Now, this kid knew nothing about what he was picking. You just picked names he is familiar with and picked some. He wasn't. Yeah, there was no strategy involved at all.
And I think the point here is not to make fun of people who pick stocks for a living or anything like that. What we're trying to do is point out how difficult it can be and how random it can be. And so there's lots of great companies out there. And any research department, even a well-stocked, well rounded out research department, can only cover so many stocks. And so they're going to typically use their typical basket of names with the TSX 60. Probably most of the names in there are well researched. Of the two hundred and sixty that make up the TSX Composite Index, probably a lot less coverage of those names.
And that's just Canada and that's just Canada. So if you talk about three thousand five hundred stocks that trade in the U.S., there's probably tons of research analysis on the biggies, the apples, Amazon's General Motors, Et cetera.
Dillards, of course, but there probably isn't the coverage on those smaller ones because you just can't get to them. So, again, the point is it's very difficult and there's lots of professionals trying to do it and not a huge percentage of them are successful So let's just talk about a couple of other ways of picking stocks. So we talked about fundamental analysis. Another very significant method that we won't talk about too much right now is technical analysis. And what technical analysts do is they chart the performance of stocks or markets and they look at trend lines based on how a stock has traded. They look at moving averages are relative strength in trading, and they look at different patterns, which they'll call things like candlestick patterns and formations and things. And what they're really looking for is to compare the trading patterns that stock or a market are currently undergoing to previous times. The markets have shown similar patterns and then they make predictions based on if a stock moves through a moving average, then it's likely to keep going to another level, that kind of thing. So it's just another method of attempting to identify stocks that are going to go up or that are mispriced or have some likelihood of a particular direction. And so, again, as we talked about, now availability of information is massive. The gut feelings of stock picking of the past days are gone because there are lots of tools available and do it yourself. Investors at home have access to all the fundamental research, all the technical analysis that professionals have now. And the question is, does that help? And I think the answer continues to be not. Typically, it's a bit of a gamble. So we talked about this a little bit last time. What's the alternative to picking individual stocks? Alternative is to become more diversified, either buy through some sort of investment fund or just holding a massive number of shares that you diversify away that specific risk. And it's interesting, I think we talked about this the last time, but back in when was that 2008, Warren Buffett of Berkshire Hathaway. Most people know the name and Ted Sidey's who's a hedge fund manager, made this a million dollar bet where Buffett was going to select the performance of the S&P 500 and Sidey's was selecting five hedge funds. And at the end of ten years, whoever won basically would win a million dollars from the other party and donated to charity in the end. And before the ten years had even passed in mid-2017, Sideys conceded defeat. The hedge funds returned twenty two percent and the S&P 500 index returned eighty five and a half percent. And arguably, hedge fund managers are among the best because they have full ability to invest in a variety of different strategies and they charge fees of up to 20 percent on performance and things like that.
Well, they're the best. The charging fees
So that's just basically what happened in that particular case and just highlight some of the risks. And again, some of the other risks of stock picking is you can get overly concentrated in one stock or sector. As we talked about last episode, it's the whole get rich versus lose everything risk. And again, the time cost. And this is something that I want to just spend a minute on. There's a time cost of being wrong in a portfolio. So let's say we use the stock market average, whether the composite index or the S&P 500 as our benchmark.
So if you have a small stock portfolio and if you happen to have what the author of this particular paper called a Torpedo stock, the impact of those torpedo stocks, which is the name, would suggest the stocks blow up. The impact on a concentrated portfolio can be fairly strong, apparently heavy. If you only have ten stocks and one of them blows up, that affects. Ten percent of your portfolio, and that could happen in a year when the stock market is doing just fine. Well, that underperformance, it's not just a dollar value in your portfolio. Actually, it could take you years to catch back up to where you would have been had you just been in a diversified portfolio reflecting the stock index. You have to do better than the stock market index for several years in a row just to catch up to where you would have been. So that concept of a torpedo stock or making a big mistake can have a real time impact on your portfolio.
And when we think about portfolios as being basically just a tool for investors to achieve their financial goals, such as retirement or something else that can put a real delay into achieving those goals by just having one blow up.
So what do people do about it?
Well, I guess the only thing you can do about it is try to avoid that by having a well-diversified stock portfolio and focusing on some of the things that you can control. You can control the asset mix. As we talked about last time, you control the diversification, avoid overconcentration and look at all the possible ways to diversify that might actually allow you to have access to some of those factors of higher future returns. So for all of those people that say, well, I don't want to just do as well as the market, I'd like to beat the market, there are a couple of ways that I've have been identified that might help you do that. And they just don't involve picking individual stocks.
So those are the factors of return that we're going to get into in another episode. So won't spend any time on that today. So basically, what are we seeing that picking stocks is hard? Like it's hard to be right over and over and over again. You can be right once. And it could be lucky or you could be right because you actually were right. But then to do it over and over again is pretty difficult.
Yeah. And we're not here to tell people they shouldn't try to pick stocks. And in all fairness, probably most advisors, even if they don't recommend picking stocks, most advisors and most people have one or two individual stocks in their portfolio because.
It's fun, and they appeal to some aspects. So if somebody has a real strong feeling about environmental issues, then they might choose to invest in a clean energy ETF or stock or something like that. Yeah, and that's something that it feels right. But as long as it's not too huge a part of the portfolio, that it could derail your plans if it doesn't work out. I think that's the secret. We talk about this as a zero sum game. And really, when it comes right down to it,
If you believe a stock is undervalued and you're going to buy it, the stock market is an auction market. And in order for you to buy the stock, somebody else has to be willing to sell it. And what that means is that person obviously would have a view that the stock perhaps is overvalued and should be sold. And so here you've got two people with exactly opposing views, executing a trade.
And one of them might be right. But yeah, they can't both be right.
Now, you talk about a zero sum game and we've talked before. It's actually a negative sum game because that doesn't include the fees. Exactly. Those transactions. So whether you're the buyer, the seller read on. All right. Well, it's not stock picking. We're not here to slag it. We're just saying it's difficult. The next part is market timing. Market timing is just as difficult as stock picking, I would say, Greg. Yep. So before we get into it, I wanted to talk about an article in Forbes now back in March of twenty twenty.
So just at the beginning of the pandemic, they identified six reasons market timing is for suckers. These are their words, not ours.
Number one, we always think we can do this successfully make sense. Everybody thinks that they know when to get in and when to get out. Number two, you don't have an edge against the pros. So this has been removed by things like program trading, flash trading, algorithmic trading, things of that nature. Yep. Number three, you need to be right a lot. They're not one time trades like you actually have to continually be right. So if you're market timing to get into a market or get out of a market, well, actually, it's kind of the same thing. Right? You got to be right. When to get in, right? When to get out. Yeah. If you're right, what to sell or great what to buy. Like, there's multiple reasons to be right or multiple times to be right. Number four is you need to be a full time investor. In other words, are you employed in another field? Do you actually have the time to do your due diligence on any trade in that? Due diligence is not. The newspaper from the nineteen thirty four is no number five. Market timing is stressful. It is super stressful. I know this from experience.
Yeah. It's like a roller coaster ride. You know, every time you think it's going to go up and it goes down or vice versa, it creates stress. And lastly, number six, the future is unpredictable. A common argument investors have is that they want to wait for things to get better. So what we've seen is, let's say somebody sold out of the market march of twenty twenty because they were scared. And we said, well, when are you going to get back in? They said, well, when things get better, what doesn't make any sense is sold things low and you're going to buy them when they're higher. Yeah. That's actually contrary to what you want to do, right?
That's right. Yeah, and that's a very it's an understandable, but an emotional response to volatility.
Yeah. And makes it very difficult. So market timing, the way I kind of look at market timing is it's kind of like stock picking, but on a more of a macro level. So rather than is now the right time to buy or sell a particular stock and market timing talks more about is now the right time to be in or out of a particular asset class? And typically IT stocks. We've heard a lot about bonds lately, but typically it would be stocks. So market timing theory is trying to interpret or detect, buy and sell signals in trading patterns and in history. And again, with regards to asset classes, when some of the decisions you make with the help of market timing can bring profits, others can cost money.
When you coming up with acting, let's say, on a series of guesses or estimates or probability assessments to use in your buying decisions and selling decisions is really what it's all about. So the aim in twenty twenty one is the same as the aim was in 1997 when the strategy really gained a lot of prominence. And it's everyone's goal to buy near Willow and to sell near a high end. So a lot of people think that that's going to make a massive difference in the end. And ultimately, a lot of people become disillusioned trying to do market timing because they figure out it's costing the money either real value by having stuff that they own go down or missed opportunities by not being in the market when it's going up.
Well even just recently in the last year, I mean, you think about the Dow Jones, it's what's it, around thirty five thousand points right now? Yes, somewhere around there. Yeah. When it was at 25000 points or was like, oh, jeez, the market's expensive if I want to get in now. Yeah, that's right. Well, if they didn't, they missed out on what does that thirty three percent rate of return.
That's right. And you and I talked a little bit about probability in one of our previous podcast and the markets over the last twenty years. I would say, in fact, the whole time I've been in the business over twenty five years, they've sort of defied probability a lot during those periods. they defied probability with the run up of the bull market in tech stocks, which ended abruptly. But it went on for quite a long time. We talked about in last week's episode how the U.S. market basically had a negative return every year for the first ten years of the millennium. And so there's a lot of things that happen that you don't expect. And it's not because they can't happen is just because you don't expect them, because they're unlikely but still happen. It's like the 100 year flood. So what happens is market timing can pay off sporadically and the results are largely random and successes and failures sometimes come in spurts. So the worst thing that can happen near the start of investing career is you make a bunch of successful timing decisions and that leads you to believe that you've broken the code and that you've got a talent for market timing or whatever and what happens that can get you back into the future timing decisions. And in fact, when you look at it in the last twenty five years, you probably only needed to time the market right. Three times and would have been awesome if you were able to time the peak of the tech market in two thousand. Time, the peak of the real estate inspired stock market run up that ended in 2007 in the US and spotted the pre pandemic peak. Yeah, those are the only three timing decisions that you ever needed to make. It would have rocked it.
So basically, I don't. but let's just go back there for a minute. But that's all hindsight bias,
Because of course, everybody says, oh yeah, I knew that the markets were going to come back or whatever. No, you didn't. Otherwise you would have invested more money in them.
Exactly. And at the bottom of those, obviously, it would have been a great it would have been great to get out at the top. But as you pointed out earlier, you need to make two rate decisions. You also needed to get back in at the bottom. And so what are the odds that you saw the peak of the tech bubble coming in exactly March of 2000 and you knew to get back in and exactly November of 2002, the odds are very low. And so you're never going to be exactly right with those kinds of things.
And in fact, you can often be quite wrong. And if you miss getting back in, then you've missed out on a whole lot of gains.
Well, and we'll spare the listeners that breakdown of if you missed the best one day, five days. Ten days. Thirty days. Yeah. Have a period to see that it creates a significant different outcome.
So what's the goal of market timing? The goal of market timing is to buy low and to sell high. And there is a way to do that. And in our opinion, the way to do that is not by absolutely timing the markets, but by using your asset allocation that we talked about last time as an opportunity to sell high and buy low. And so what do we mean by that? Well, if you go through a really bad market dislocation, like we did in March of twenty twenty or during the global credit crisis, if you had a 60 40 standard 60 percent stock, 40 percent. Bond allocation and stocks went down 50 percent, as they did back in 2009. Well, you would have been offside. Your 60-40 would look more like a 50 50, let's say, or even worse. And so you would have just rebalanced and bought 10 percent more stocks buying at the low and selling your bonds to buy those stocks, selling at a high price. And you would have accomplished the same thing, not with 100 percent of your portfolio, but with part of your portfolio. So unfortunately, a lot of people sit back and wait and they'll say, OK, well, when the market sells off 10 percent, then I'm going to start buying. And you might be waiting a long time for one of those. And so it's just a very difficult thing to do. And if you reach the point of being kind of a long term investor who's investing using a long term process, you can see those market setbacks is something that you just have to live with. And again, the best way to protect yourself against them is to put money into the stock market. Only if you can afford to leave it there for many years.
Not one year.
Not one year.
Yeah. Is one year is not many years. One years, not long term. I don't care who you are.
Let's talk a little bit about the historical results of some of the professional money managers that are in the news these days, Greg.
Sure. There's a guy out there. His name's Bill Miller, currently in the news because a fund that he manages has done quite well in the last few years. Absolutely. Mr. Miller used to run the Legg Mason Value Trust Fund in the U.S. and for 15 straight years, that fund outperformed the S&P 500. There were books written about him, strategies mimicked, trying to mimic. His results were created. But what happened, Greg? We know what happened.
What happened with the global credit crisis? Yeah. The global credit crisis in 2009, the global credit crisis was at its worst. It was March 9th of 2009 was the absolute low. And in that year or during that period, Bill Miller's fund gave back all 15 years of returns. So what happened to Mr. Miller, you remember?
He was fired up like he sucked at his job, right? I was joking, of course, but he was let go. he was rehired by another fund company to run another fund. And what happened to him that year? You remember?
He had the worst performing record in the whole universe and just part.
Well, he was let go of that fund, but now he's back in the spotlight, saying, look, I can do this. I'm a good picker and a good market timer, and he's having some success with it. So I don't mean to be so hard on Bill Miller and his past results, but is just evidence of the fact that here's somebody that that is their full time job. They've been heralded as a genius at one point and then heralded as, I don't know, villain at another point. And it's just really hard. It's really hard to stock pick and market time.
That's right. Yeah, exactly. And because it's such a competitive industry and fund managers live and die by their performance relative to a benchmark.
Yeah. And what have you done for me lately?
Well, listen, should we wrap up this episode of stock picking and market timing?
Let's do that. And I think as a means of wrap up, just the way we talked last time about asset allocation and diversification, what we're talking about here is just it's kind of an evolution of investing because investing started with stock picking and without asset allocation. It was just stock picking and bonds were something that were largely left to institutional investors and things like that. So the market started there, started with Benjamin Graham and fundamental analysis. And as time went on and information became more broadly available, even as long ago as 1963, Ben Graham was seeing that the kind of stuff that he did and wrote about wasn't working anymore.
And that was fifty eight years ago or
Was fifty eight years ago. So that's just it just shows the evolution. And so now as we're moving towards sort of a very different way of investing, we have to start looking at investing as a process, not as a transaction. It's not just a buy or sell, whether it's a stock or the entire asset class. It's a process. And if you can think about investing as a process, then we can avoid some of the pitfalls and risks that we've talked about and hopefully have a better investing experience. And once again, importantly, linking that back to the investors financial goals from their plan.
All back to the plan. We keep saying it over and over again.
Oh, man, it must get old. Let's get tiring. You're listening to us talk about the planning.
All right. Listen, thanks for joining us today on the free lunch. And we'll be back next week with the third episode of our Back to Basics miniseries.
Sounds great. All right.
Episode 61 - Back to School…Asset Allocation & Diversification
Greg and Colin launch a mini-series focused on back to basics for investing. They talk about the importance of Asset Allocation and Diversification.
EP.61 - Asset Allocation and Diversification FINAL.mp3
Welcome back to the free lunch podcast with Greg and Colin. Last week, we discussed how a mutual fund works, the difference between it and an exchange traded fund or ETF. And that's a question we get all the time, isn't it?
Well, more and more these days, because certainly the growth in the ETF side of the investment fund business has really been tremendous.
Yep. And you had a good analogy. You describe the difference between a mutual fund and an exchange traded fund is the difference between what a hardcover book and a paperback.
Right. So the same words inside just the packaging is slightly different.
But it got us thinking, why not do a miniseries on investing basics, revisiting some of the key themes around investing? Because, Greg, we've been hosting this podcast for well over a year now. We've covered a lot of topics,
That's for sure. Yeah, its time has gone by quickly, actually.
Yeah. And as we're in the summer here, and I hate to say it, but we're looking forward to September and back to school and things like that. Already we plan on running five to six episodes of this Back to Basics miniseries, which should align with kids going back to school in September. And Greg, people just getting more learned.
Is learned a word.
Of course it is. Yeah.
Yeah, I like it. So to kick it off, we're going to tackle arguably the most important item when it comes to investing, and that is the importance of asset allocation.
Yeah, right on. And I think as most of our clients know, that when we when we sit down and talk to them, we identify the fact that there are very few things in investing that we can control. And you can't control the how the stock markets or the bond markets perform. You can't control what countries are going to do. You can't control certainly whether or not a global pandemic is going to occur out of the blue.
You mean like the year before we were seen with the upcoming global pandemic?
Exactly. Yeah. But there are a few things we can control. And it all has to do with controlling risk so we can all control the risk in our own portfolios and so we can choose to take on more risk or less risk. That's entirely within our abilities. And so that's really what we suggest people focus on, focus on the things that we can control, and then the rest will just happen. And so the first thing we can control and the most important decision that investors make would be regarding their asset allocation. And so when you think about it being invested in a market, whether it's a stock market or a bond market or whatever, there's certain risks that are just inherent in being invested in those markets. And that's what we call systematic risk and the systematic risk that affects stocks and bonds and so on. But that just exists. And so what we want to do is want to say, well, look, different asset classes carry different systematic risks. For example, stocks may have higher risk or volatility. When we talk about risk, we're talking about volatility then with bonds. And so asset allocation, it really allows us to determine how much overall risk we want to take with our portfolio. And so that's where we get to decide about how much of our portfolio we want to have invested in each asset class, whether it's stocks, bonds, cash or cash equivalents or other alternative investments. So let's move on from there.
Ok, well, let's talk about the basics of asset allocation. The specific claims vary, Greg, but financial professionals in general sort of have this claim that more than 90 percent of the variance of a portfolio is return is directly attributed to the asset allocation rate. So just that mix of how much is in stocks, how much is in bonds and other asset classes. This assertion stems from studies by somebody named Brinson who study this back in 1986. And he states, and I quote, "Investment policy dominates investment strategy, explaining on average ninety three point six percent of the variation in total plan return." So this conclusion, Greg, has caused a great deal of confusion and debate in academic and financial communities. And we hear it all the time.
But what the Princeton study explains is that more than 90 percent of the variability of a portfolio is performance over time is simply due to how it's constructed its asset allocation and in measuring the relationship between the movement of the portfolio and the movement of the overall market. And that's gets back to what you were talking about, systematic risk versus nonsystematic risk. Right. So systematic risk, just the risk of being invested because things happen when you're invested like global pandemics happen.
You're exactly right.
But he finds that more than 90 percent of the movement of one's portfolio from quarter to quarter is due to market movement of the asset classes in which the portfolio was invested. So just what I said. Right.
And if you think about it, then so if 90 percent or more, in fact, a study ninety three point six is due to the asset allocation decision, then what does that mean for the other? The remaining six or seven percent of the variability, where does that come from, that comes from market timing or stock selection, things that are outside of that that big asset allocation decision. So when you think about it, you know, you could spend a whole lot of time on stock selection or market timing to affect six percent of the portfolio. Or you could spend a lot of time on asset allocation and take care of that 93, 94.
One of those numbers is bigger than the other one is a lot bigger. So there are criticisms to the Princeton study. So there are some other academics that said, look, its results are based on bull and bear markets, which explain most of the variation in returns. In other words, a rising tide raises all boats. I've heard that saying before they used up. Sure. Yeah, right. And they assert that perhaps maybe the study doesn't ask the right question, that a more appropriate question would be one that probes the difference in return between funds. So there's academics that argued that Brinson is asking the wrong question and they feel the most relevant question pertains to the relationship between asset allocation and returns, not volatility. That's kind of a head shaker head scratcher, I should say. But what are the implications for an individual investor in the study? And what I'm quoting here is actually some work by a guy named Ibbetson who looked at the impact of asset allocation policy on balanced mutual funds and pension funds. And we can extrapolate from the study that for the long term in individual investor who maintains a consistent asset allocation and leans towards just being invested in the market, whether it be in index funds or just broadly based funds, asset allocation, what Ibbetson says determines guess how much performance, Greg?
You tell me
About 100 percent of performance. So whether it's ninety three point six percent or 100 percent, whatever, that's those are big numbers, right? Right. So regardless of whether one is measured return variability across time or return variation between funds or return amount. So in summary, from these studies, the impact of asset allocation on returns depends on an individual's investing style. So just what you talked about. So if you're a long term passive investor, well, asset allocation is by far your most important decision, right? If you're a short term investor who trades more frequently, investing in individual securities and trying to practice market timing, then asset allocation has less of an impact on returns because, well, there's just lots that can happen in the short term. Right. And you can get it right.
In the short term, you could get it right till you got it wrong, actually.
Yeah, exactly. Well, that's right. You know, and there you're talking about, you know, if people are choosing to invest or like if they're high frequency traders or day traders and they're for the most part, they're not making an asset allocation decision. They're deciding to be 100 percent invested in stocks. So they've actually abandoned the first, you know, sort of key tool that we have to control risk, which is asset allocation. And so they've decided in a sense that we're going to go 100 percent risky or at the risk of using the riskiest asset class, which would be stocks. But then they're looking for market timing and stock selection to try to increase their returns.
Sounds like gambling.
Well, it's a little bit harder because you take a little bit of the of the systematic risk, which is a positive right. Systematic risk is both positive and negative, but it can be positive. But you might actually take some of that out of the equation if you're not being consistently invested.
Some might say, well, yeah, but why do we even want things that are volatile in our portfolios? But you need volatility in order to have return.
So you need that systematic risk of being invested in things that have higher expected returns because they have higher volatility.
Yeah, that's right. I mean, the only thing without volatility typically would be cash investments. And of course, today's cash rate's zero point two percent or something. It doesn't help people, for the most part, achieve their financial goals.
So let's talk about what it means in English, in English. What I like to equate asset allocation or that asset allocation decision to is like a recipe, like baking a cake. I've used this analogy before. You know, in order to bake a cake, you've got to have the right amount of ingredients in order for it to be successful. Right. In order for the I don't know, the cake to bake, of course, and to take it in as asset allocation is kind of the same thing. You have to have the right amount of stocks, the right amount of bonds or whatever the other asset classes are in there to get your desired outcome. But each of those asset classes on their own in the asset allocation decision are different. Just what we talked about, some have more volatility than others. So the less volatility in the portfolio, the less expected return is over long periods of time. Right. The more volatility, the more expected return is over long periods of time. I think that's a pretty fair statement to make. Right. And it's because of the different expected. Rates of return between those asset classes, so I hope that those who have been listening to our podcasts over the last year and a bit kind of get that relationship of risk and reward that you can't have things like no risk and high reward. It just doesn't work that way.
Yeah, and that's not what capitalism is all about. I mean, capitalism rewards investors who provide capital and the riskier the venture, the higher expected return those investors are seeking.
Exactly. But on the other hand, taking on more risk doesn't always align with any form of guaranteed higher returns. You might just be taking on more risk.
Yeah, especially in your time horizon. So what you pointed out or what we talked about is if you're day trading, you're taking on a lot of risk. Greg, are we recommending people day trade?
No, we're not Colin. But I did want to mention one thing, though, and that is that, you know, when we talk about asset allocation, there is no right asset allocation, like some investors may choose to be 100 percent invested in stocks. And so their asset allocation mix is one hundred percent stocks, zero cash, zero bonds. And that may be totally appropriate. For example, if somebody has a large pension and essentially they're receiving guaranteed income for the rest of their lives and possibly the rest of their spouses lives, then they may not need to have fixed income in their portfolio and they may be able to withstand the volatility that you'd get with a 100 percent stock portfolio. So, again, we're not saying that there is one right asset mix for everybody. In fact, the asset allocation has got to be appropriate for each individual investor, not only to, you know, sort of align with their goals of their plan, you know, as we've talked about in the past, but also with their ability to withstand the volatility, just the emotional stress of being in a highly volatile investment portfolio. So, again, the key thing is asset allocation is a determinant of variability of returns and of the actual returns. And then the exact asset mix. That's right for you is right for you based on a number of other factors.
Well, and based on the planning that you've done to figure out what is the right asset allocation for you, because, for example, say, Greg, let's assume that we've got somebody that doesn't have a pension that funds all of their expenses. And let's just talk about general rules of thumb. So general rule of thumb for allocation mix might be your fixed income should be somewhere close to your age is one that is commonly that's common. So in other words, the older you get, the more fixed income you should have because your time horizon changes dramatically. So expected rates of return for fixed income are obviously lower than stocks, but they protect you during sell offs. Can you think of any recent sell offs that we've lived through?
Well, let's see. Maybe back in March of 2020 when stocks went down thirty five percent and government bonds skyrocketed in value.
Yes, that was a risk return trade. So people were selling stocks because they were scared to be quite frank and buying bonds for safety. But anybody that had those bonds going into that sell off, well, they did better than if you had all stocks. Right. So this same trade as occurred in all major crises since I've been working professionally and you've been working professionally. Right. Like it's just always worked out that way.
So the expected rates of return for stocks is higher, but bonds will actually protect you in a sell off. Now, there are various factors of return within the stock market. We've spent some time in those in past episodes and we're going to talk about them specifically in one of the episodes for this miniseries. So I'm not going to spend any time on them today. But for today, we're only going to talk about stocks as represented by our model portfolio. So, Greg, you know that we run model portfolios that range in asset allocation from 80 percent in bonds and 20 percent in stocks all the way to 20 percent in bonds and 80 percent in stocks and everything in between. Right. And if you had to describe why the difference or the different levels of those models, what would you say?
Well, just whatever's appropriate for the client based on their on their plans and their goals and the amount of volatility they want to take.
Right. Because that decision of allocation is based on the as we talked with the planning that goes into determine, well, how much risk they actually need to take on to achieve their goals and each person's goals specific to them. So the so Greg, the planning has to be done first rate, but the decision is not static, as I mentioned, because as we get older or things change in our lives, we might have to adjust our asset allocation, meaning that, you know, when we're younger, we can, in theory, recover from major market corrections, more so than when we're older. And it's just because of a different time horizon. Right.
So I always described it when my grandpa was still alive is my portfolio is actually the same holdings as my mom's portfolio and the same holdings as my grandpa's portfolio. Just our weightings were different.
So let's just talk about what those basic asset classes are now, Investopedia has listed seven different asset classes or basic asset classes that I would think these are pretty well known, but equities are stocks, fixed income or otherwise known as bonds, cash and cash equivalents, which you talked about earlier, real estate, commodities futures and other financial derivatives. Those are all examples of asset classes out there, right?
So for our discussion today, we're only going to focus on three. We're going to focus on cash, bonds and stocks. And again, let's talk about them like a recipe to bake a cake. So we have to have the right amount of each ingredient in order to have that successful outcome. So I did. I looked at our model portfolios and the as I said, they range from 80, 20 to 20, 80 and everything in between. And they looked at how they did over the last one, three, five and 10 years. So, Greg, over the last one year return period, which one year numbers what's the significance of when your numbers? Is there any.
Well, I wouldn't think so. You know, one year is not a long time, and particularly in years that are so volatile as 2020 was with the big downturn in March, it does tend to distort the one year numbers. Right. So if you're measuring, for instance, against a time period just after the big correction, well, then, of course, the numbers today are going to look fantastic. But they're nowhere near repeatable, you know, on an ongoing basis. So certainly the longer time horizon you can look at, the more realistic those kind of numbers are. Right.
But just for argument's sake, let's look at the one year numbers on our models, because anybody that was invested in what we would call a conservative portfolio, which was 80 percent invested in bonds and 20 percent invested in stocks, actually had a pretty good one year number. Greg, you know what that number is?
I do, because I'm looking at it.
What is it?
9.66 Percent. And that's without taking on a whole bunch of market risk, right?
But if you look at that number over a five year period, that model portfolio did four point two seven percent per year. Right. So it just highlights the difference in one year and five year or more. Now, if we look at somewhere in the middle our balanced portfolio, which is 50 percent stocks, 50 percent bonds, what's that rate of return over a one year period,
Nineteen point three five percent.
Now, if somebody came in and complained that they got nineteen point three five percent over the last year, I might have a problem with that. But as you say, that one year is a skewed number. Over the five years, it's done over five percent per year. So it is a pickup in return from four point to seven to five point one seven. But it's not as obvious as the one year number, right?
And if we look at the our most aggressive model portfolio, which is 20 percent invested in bonds and 80 percent invested in stocks, that one year number, it looks pretty healthy.
It does almost twenty nine point seven percent, almost 30 percent. We can
Call that 30, can't
We? OK, we'll call it 30, 30
Percent one year. That's a pretty darn good year. But again, over the last five years, it's done six percent a year.
Yeah, right. And I think that's the thing. So when you when you look at one year, numbers can be very skewed because of the volatility in any particular year. But the longer the time horizon, the more those things get smoothed out. And so then if you compare the 80 percent bond portfolio to the 80 percent stock portfolio over five years, 80 percent bonds did four point to seven, as we talked about, and 80 percent stocks did five point ninety nine. So that's a pick of about one point seven percent or so per
Year per year. That's the important part, is that that's a compounding difference. Exactly. So it's not that our conservative portfolio or in general or 80 percent bond portfolio did four point two seven percent over the last five years. It did four point two seven percent per year for five years. Exactly right. And compounding is a pretty important thing in investing, isn't it?
It's one of the most important things. Right.
So obviously lots of variation on portfolio returns based on the asset allocation model that's selected. And remember, these models own the same positions. They're just in different weightings. But I have to caution everybody, don't put the cart before the horse, because if you just looked at those things, if somebody just came in and said, how did your models do last year? And we showed them the returns, which one are they going to gravitate towards?
Typically the one with the highest return.
Of course, we're all human. We've got a greed factor built in that says, well, why would I take one with less return rate? I mean, why not take the one with the higher return? But these models have to align with your goals. And if they don't, you're in the wrong model. Right. Or you've got just your goals.
So we don't want to put the cart before the horse. You shouldn't really pick your asked allocation before understanding how much risk you need to take to meet your goals. And it can only be done. For some financial planning, so if you don't need to take on more risk than don't, and how many times have we had in the years done planning for people? And it showed that they actually had enough money to fund their life just as is, and they actually didn't need to take on any market risk whatsoever. Most people don't accept that either, right?
No. And I think for a lot of people, it's like, well, I need either I need to stay ahead of inflation. And so you need to make two percent or whatever the number is just to keep ahead of inflation. And so you're not you're not falling behind and just a desire to actually earn money on your savings, you know? And so I think it's very difficult for people to accept zero return. But I think what you find is in people that are, you know, that are lucky enough to be to own securities or wealth of half a billion dollars. For the most part, they don't take a whole lot of risk unless they happen to be tech entrepreneurs
Trying to get into space.
Exactly. Yeah. And it becomes more a matter of protecting it rather than growing it.
Yeah. And I want to just highlight that part just for a second, because the flip side to that is we've had people that have been referred to us over the years, like I had a dentist years ago who was referred to as he came in his portfolio was four hundred thousand dollars, which actually didn't quite meet our minimum. But whatever we want to do some planning with them. I said, well, how much are you expecting to earn every year on this? Four hundred thousand dollars? Do you know what he told me? One hundred thousand dollars a year. So he said, what do you think? And I said, well, what are you going to do after year for? Is it what do you mean? I said, well, if you're spending a hundred thousand dollars a year and you're starting with four hundred thousand, you're going to be out of money in four years. So what are your what are your plans after you're for? It wasn't the answer he was looking for and he decided to go elsewhere. But, you know, so the point I'm trying to make if you need to take on lots and lots of risk to meet your goals, like more risk than you think is reasonable, you might want to adjust your goals. Right. So, Greg, let's just wrap up this section here with one final statement. Am I recommending our model portfolios if they match your potential clients asset allocation based on the goals identified in their financial plan? Of course you are. Of course. Why wouldn't we? We're biased. We think we do a good job.
Exactly right. Well, let's spend a few minutes now talking about diversification, which is a little bit it's sort of like the asset allocation discussion, but just a little bit more detailed. So I talked about asset allocation being, you know, kind of like the first tool, you know, in our toolbox as a way to control risk in the portfolios. And I now want to talk about sort of the second key element of risk control or risk management that we use, and that's diversification. And so in the case of asset allocation, we talk about reducing risk by including a number of different asset classes in the portfolio. And so what that does, obviously, by adding any other asset class to a stock portfolio, it reduces risk by diversifying those asset classes from each other. So now when we talk about diversification, we're talking about diversifying within each asset class. OK, so within stocks,
Because we've already addressed the asset allocation piece rate, how much stocks and bonds, et cetera, et cetera. But what you're seeing within
Stocks, within stocks, how do you diversify and reduce risk? Yeah, and or I should say, how do you reduce risk? The answer is diversification. So let's talk about that. So what is it? You know, and we all grew up with the old adage, you know, don't put all your eggs in one basket, which is, you know, it's an it's a pretty brilliant concept when you think of it. You know, the concept being if you drop the basket, you break all the eggs. But if you have a number of baskets, then even though you may drop one, you're not going to you're not going to break all the eggs. So diversification, what we're trying to do is smooth out what we call unsystematic risk events in a portfolio. OK, so the positive performance and some of the investments may neutralize negative performance in others. OK, so we talked about systematic risk. That's just the risk of being invested in an asset class like stocks. Unsystematic risk is risk that comes from being in a type of stock that experiences a bad result, even though it's still a stock. So the stock market may be doing well, but a particular company may fall on hard times, or you might find out that the particular company is actually a fraud or some other such thing.
Well, let's spend a minute on that unsystematic risk today. Could explain GameStop. Sure it could, right?
Yeah. And it just so happens that most of the risk in GameStop has been positive for many people who bought GameStop when it was trading at four or five dollars a share and it's now worth one hundred and whatever, ninety dollars a share, whatever it might be. However, there are people that paid as much as four hundred and sixty dollars for GameStop shares and they're now down, you know, two thirds or three quarters. And so that's unsystematic risk because during the time that GameStop both went up and went down, the overall market was doing relatively well. So that kind of highlights the difference between unsystematic risk and systematic risk. So why would you want to diversify? Again, it's to not only smooth out those risks, to ideally totally eliminate unsystematic risk, because in a sense, what you can do, like unsystematic risk, is the risk. We just talked about the sometimes called specific risks, other specific risk of being invested in a company or a sector of the economy that experiences a bad time when other the rest of the market is doing fine or the rest of the economy is doing just fine. So we want to we want to do that by including many, many, many securities. Right. So if you own one security, one single stock, you obviously have a massive amount of specific risk. If you own 50 stocks, you have significantly less specific risk. Right now, if you look at the markets, though, the market might include anywhere from six hundred stocks or it might include three thousand or four thousand stocks like the U.S. And so while a 50 stock portfolio is better from a diversification standpoint than a one stock portfolio, a thousand stock portfolio is even better because you're virtually eliminating all of that specific risk now within stocks, though.
So just thinking about stocks is a lot of ways to diversify and so you can diversify just by owning more stocks. But the thing is, you also want to include more different stocks. So, for example, one of the earliest ways of. Diversifying stocks was by doing it geographically, so, you know, as Canadians, we tend to own a lot of Canadian stocks, whether owning them directly or in a in a fund of some kind. But it's a big world out there. Canada represents only three percent of the world's stock market capitalization. And so if you only invested in Canada, you'd be limiting yourself to three percent of the world's opportunities in stocks. No. And so you've got the rest of the world out there. The U.S. is probably fifty four fifty five percent of the world. And then the balance is made up of international stocks and emerging markets. You know, and there's a lot of reasons for owning all of those. For example, I just took a quick look at returns for two different decades for the Toronto market. So the Canadian stock market, the US stock market, as measured by the S&P 500 and the international stock markets, measured by what they call the EFFI Index, which is just everything outside of North America. And it's interesting, you look at the period from 2000 to 2009, very good year for Toronto or for Canada, five point six percent annually during that period compared to the US market, which is actually down to zero point nine percent during that time per year, per year.
I was going to say per year
For 10 years. Yeah. And the international markets, in fact, were down one point seven percent per year for that entire time. She's now, if you looked at that, you might say, well, you know what? Why would he ever own anything other than Canadian stocks? They did so well in the subsequent ten years, from 2010 to 2019, the Canadian market did six point nine percent per year, still pretty good. The US market, thirteen point six percent, double what the Canadian market did and the international markets, eight point three percent, again, compared to Canada at six point nine. So going into each of those decades, nobody had any idea of how things were going to perform. You know, you just had to make your bet and so you could make a bet. And if you bet on Canada for the first 10 years, you would have been right. But you would have had to then make a switch in 2010 to bet on the US or else you would have been wrong. And so our approach is really to say, look, I'm not going to be exactly right, but I'm going to cover all these bases. I'm going to be well diversified across geographies. And that way I don't really care which geographic area does the best because I'm invested in all of them and I'm going to benefit from all of that.
I'm spreading my risk, that's all. Exactly.
Yeah, exactly. So one other discussion that I'd like to revisit and one we've had before is this concept of the get rich versus lose everything portfolio. You know, we've talked about that before and it's just the concept of holding concentrated positions. So if you own any individual stock, there's really two extreme outcome possibilities for that. The stock could actually go to infinity. It could be the best stock in the world and you could obviously get very rich or it could go to zero. And we're not saying that stocks go to zero very often, but in many cases they can lose 80, 90 percent of their value. And we watch that happen with energy stocks during the pandemic
Was going to see. When you talk about diversification in owning more than one thing, unfortunately, some people feel they're diversified if they own multiple stocks in the same sector, exact. And that is the energy market in Alberta and Canada there. Sure.
Yeah, yeah. And so in a sense, a sector, because it is kind of a defined part of the economy. Many stocks within the sector all tend to behave the same way. And so if you only own stocks in one sector and it doesn't matter whether it's energy or financials or anything else, if you only own those kinds of stocks, then it's almost like owning a one stock portfolio. It's just a one sector portfolio. But again, the extreme possible outcomes are lose everything or get rich. And when we diversify, what we're basically doing is we're limiting the outcomes, limiting the potential outcomes. So there's certainly upside potential. And we know that just the stock markets in general, regardless of any other kind of stock picking, but just being invested in the markets has provided very nice returns over 100 hundred years now. But they also have never gone to zero. And so by having a more diverse portfolio, yes, you may not get rich, you may not hit the ten bagger that that people want, but you also won't lose everything. And so it's just a much a much more controlled set of outcomes.
You had a scene that you had written down here from Carl Richards.
Yes, yeah, Carl Richards, he says, you know, you're diversified when there's always something in the portfolio to complain about and you know, and that's and that's the thing about diversification. You're never going to get every element completely right. And that's the point of it. So that's the good thing. In another renowned financial historian and economist, Peter Bernstein, in an interview said diversification is an explicit recognition of ignorance. And again, that's not an insult. It just says that nobody is knowledgeable and can accurately predict the future. And so you diversify and you can diversified in a number of ways. So we talked about geography. We talked about sector. You can also diversify by market capitalization and all. What that means is certain stocks have a massive market capitalization, meaning the market value of all their shares outstanding are huge. You know, they could be tens of billions of dollars or more like Apple.
Tesla might. That's right. Those types of things
And companies, I think, are getting towards that one trillion dollar mark, some of the big ones, whereas there's lots of companies that have a very small market capitalization. And you'll sometimes hear those talked about as large cap, which is just large capitalization or small cap. But by having both types of companies in the portfolio allows you to participate in different market cycles.
And we're going to talk about those factors of return in another episode in this miniseries. Absolutely.
And other ways are just relative price. You know, is the price high relative to certain fundamental ratios like price to earnings or price to cash flows or whatever, or is it low? And so there's a number of different ways to diversify stock portfolios, bond portfolios, the same thing. You could buy bonds issued by governments or you could buy bonds issued by corporations or credit quality. So how creditworthy is the issuer of that bond? Is it a high quality company that's been around for 150 years, or is it a relatively new company or a company that's run into trouble? So, again, the key thing is there are many ways to diversify a portfolio and the more we can diversify, the more we can control the risk rate on. Exactly.
Do you want to get into how a diversification impact portfolio returns real quick?
Well, sure. You know, and as we talked about the Carl Bernstein quote, you know, there's always something to complain about. Basically, diversification averages out returns. So some of the holdings are going to be the best performing, you know, assets or best performing stocks or sectors. But they're also going to be some poor performing sectors. And so there will be an averaging and you're going to do better than the worst and you're going to do less well than the best. But so it averages out the returns, but it also averages out the volatility of returns. And so you end up with kind of a smoother ride, just the way we talked about asset allocation by including bonds and a stock portfolio, you smooth out the volatility. The other thing is, you know, if you have a relatively smooth ride, you're more likely to maintain a long term strategy if you have lower volatility, because it's easier on the nerves and it's something that people can understand and be prepared for. And again, so less diversified portfolios have the potential for more volatility and therefore the potential for people to lose, lose faith in their investment strategy over time. So that's it.
That's it. That's it. In a nutshell.
Everything you need to know about diversification, do it.
Yeah, well, and we had a note here from the first time we did this, it was about and I'm reading it right here, pizza chains. Why do pizza chains or pizza restaurants offer more than just cheese pizza? Yeah, well, why do it?
Well, people might not want just cheese pizza.
So I like pepperoni
Kind of shooting themselves in the foot if all that they offer is one thing. Right. So why should you know, I guess to summarize, your portfolio shouldn't just have one thing in it or one theme. It's got to be diversified and you need to really focus back on your past allocation.
Right, exactly. And the good news is for investors out there is that there, while diversification can seem complex, there are very simple ways to execute and implement a well-diversified portfolio. Right on.
Well, listen, next time we are going to get into market timing and stock picking, I believe, right on. So that was early on with that.
Yeah, those are fun conversations because they're among the they are far and away the most frequent conversations we have with clients.
The most frequent conversation to which we just pointed out only attributes to less than seven percent of your portfolio is variation in return. Exactly right. Interesting. All right. Well, till next time. Right on.
Episode 60 - What is a mutual fund?
Greg and Colin discuss how a mutual fund is constructed. The different classes of mutual funds, expenses, expense ratios, and liquidity factors.
EP.60 - What is a mutual fund
There are very few things that investors can do that are free, but what about a podcast that delivers educational content on investing, saving strategies, financial planning, topical items of interest, and maybe even the odd wacky topic? Welcome to Free Lunch. Posted by Greg Kraminsky and Colin Andrews of the CME Group at CIBC Wood Gundy, free lunch will bring listeners the firm's vast knowledge and experience in dealing with uncertainty. Top clients achieve their vision through a deep understanding of what is important to them. It requires planning money and time. Learn more and subscribe today at Market Stasch Work Dotcom.
Welcome back to the free lunch podcast with Greg and Colin and Greg. Last week we had Pat Woodcock on the show. That was a fun one.
That was good. Yeah, he's an interesting guy.
Yep. Pat talked with us about getting healthy, losing weight, gaining muscle and doing it all with a plan. So it's interesting, I'm sure, for people out there wondering why we're having all this emphasis on health when we're supposed to be talking about wealth. But it's all linked to planning.
That's right. Of course, we talk about it ad nauseum on these podcast, the importance of planning and making planning an ongoing process, not just something you do once.
So whether it be in your investment world or your health world, it's so important to come back to. So the conversation was fun. I'd encourage anybody interested in getting healthy to go back and listen to that one and also to listen to the health and wealth miniseries that we wrapped up a couple of weeks ago. But today, Greg, we're getting back to our roots a bit, something more investment related. We're going to talk about something that's important. And it's important because we get a lot of questions about it. And that is, Greg, what is a mutual fund?
We're going to get into it, but there's a lot of misunderstandings about mutual funds and what they're all about.
While the question that I've had many times over the years or the statement is almost like mutual funds, I don't like mutual funds, I like stocks. I don't want to pay those mutual fund fees or something like that. So I've had this discussion many, many times, and I'm sure you have as well. I have.
And it's interesting because when you get into that, I don't like Mutual funds and you dive into, well, why don't you like mutual funds? What's typically the answer? Well, I bought one and it did terribly. And so I got out. And which one did you buy? Well, I did the one that did really well the year before. And so there's a lot of reasons why people don't like mutual funds. But typically that's a biggie.
Exactly, because let's face it, not all mutual funds are created equal, just like how all individual stock portfolios are not created equal to so. But too often we're talking to clients about when we're talking about investing in equities. And we mentioned that those equities are mutual fund based. It becomes clear that there might be a disconnect because you can have mutual funds that are specific to bonds or specific to stocks or a combination that holds bonds and stocks or even a mutual fund of other mutual funds for sure. So there's definitely pros and cons to investing in mutual funds or even exchange traded funds. And this might blow some of the listeners minds. But, Greg, mutual funds and exchange traded funds are basically the same thing,
Extremely similar. That's right.
But they're marketed differently. So the main difference is that mutual funds well, actually, I won't get into all the differences. But one of the main differences that they're priced at the end of the trading day where exchange traded. Funds are priced throughout the day, but the structure is essentially the same thing. There's actually many fund companies that have a mutual fund version and an ETF version of the same portfolio. Exactly. So before we get into it. Greg, I wanted to play a little song because people are going to ask about freedom, the freedom to choose things like stocks, bonds, mutual funds, ETFs, whatever. So let's listen to a little Fleetwood Mac here just for fun, maybe as a time filler,
Maybe showing my age. But this album used to be one of my favorite albums of all time when it came out. That was a very, very long time ago.
Stopped dating and stop dating it.
Well I was a very young man
Anyway as a child actually. Exactly. Let's do it. Greg. What's a mutual fund.
All right. Well a mutual fund is a type of investment fund. Sounds a little bit redundant. What's an investment fund? An investment fund is a collection of investments. So as you mentioned, it could be stocks, bonds, other funds, whatever. It's a collection of investments in a mutual fund is just a type of that. But unlike some of the other types of investment funds, mutual funds are open ended. Which means that as more people invest, put more money into the fund, the fund issues new units or shares. And so the mutual fund, so it's open ended mutual funds that'll become important when we talk later about ETFs, a mutual fund typically focuses on some specific types of investments. So if it's a bond fund, it may invest mainly in government bonds or it might invest in stocks. But stocks from large companies only, or it might invest in stocks from certain countries. And then you have other funds that might be, say, balanced funds which invest in a mix of stocks or bonds or other mutual funds.
Well, this goes back to your point about if somebody invested in a mutual fund years back and it didn't work out and they say, I hate mutual funds, but you just point out there's so many variations of what a mutual fund can be.
Exactly right. And so why would somebody invest in mutual funds? Well, when you buy a mutual fund, what you're doing is you're pooling your money with many other investors. So this allows you to invest in a variety of investments for a relatively low cost, because when you think about it, if you were to build a diversified. Portfolio of stocks, well, and we can argue about what diversified means, but let's say somebody considers 50 stocks as being properly diversified. Well, if you've got one hundred thousand dollars to invest, you would end up having to buy two thousand dollars worth of 50 individual stocks. You would rack up some serious trading charges and you would have relatively small investments in each one.
Even if one of those two thousand dollar positions doubled in size, it's not really going to impact the overall economy.
So by pooling your money with other investors who are looking for a similar type of investment, let's call it, for example, U.S. stocks, you're able to have a very diversified portfolio without having to spend all of the money, time and effort to individually buy 50 or more stocks. And by the way, most mutual funds hold probably closer to 100. So that's a problem. The other advantage, obviously, is that what you're doing is you're hiring a professional manager to make decisions about the specific investments. So by doing that, you're getting the benefit of a professional manager or at least somebody who does nothing else for a living, but select stocks by whatever basis they choose to do that, as opposed to trying to do it yourself.
Kind of like building a road, like you'd want somebody that that's all they do is build roads to build that road.
Exactly right. The thing about mutual funds, obviously, they're broadly available through investment dealers like ourselves or banks and credit unions. Things like that, so broadly available. And you can buy or sell your funds at any time. Like all investments, mutual funds have risk. And it's one of the things that people have to realize, just like if you're buying stocks individually or you're buying them through mutual funds, you could lose your money on the investment. And that typically happens when the markets go through some of their more normal corrections or even bear markets which come around from time to time. So the value of the funds change as the value of the investments inside the funds go up or down. And depending on the nature of the fund, the value could change frequently and by a lot. So the other thing is there are fees that will affect the return on your investment. Some of the fees that are embedded in Mutual funds are paid by you and others are paid by the fund directly. So one of the things that's really critical is understanding the costs of investing. And we've talked about that many times. In fact, I think it's one of the three things when we talk about controlling what you can control, it's one of the three we talk about asset allocation, diversification and cost
Fees and expenses super important.
So we really have to understand the costs of investing in mutual funds. And so let's take a look at what are the costs of owning mutual funds. So the bulk of the cost of a mutual fund, it's what's called the MER, which stands for management expense ratio. And so the management expense ratio will vary from fund to fund. But the management expense ratio includes a couple of key things. So let's look at a couple of different types of mutual funds. So you'll hear us talk about series F or F class funds. And those are the kind of funds that we buy in fee based accounts.
So as many of our listeners know, that one way that accounts can be managed by us is on a fee basis where there's no charges for transactions. When we buy or sell a mutual fund or a stock or a bond, there's no charges because that's all included in the overall fee that's charged based on the assets in the account. So those are called Series F and the others are called Series A, those are the adviser series, and that's where a client account, the transactions are being paid for each time there's a transaction made. And so even though we never charge a fee to buy or sell a mutual fund, whether it's a series A or series F, the series A fees have some extra costs included. And we'll talk about those. So let's talk about the series F first. So the fee based type of mutual funds, the costs only reflect the costs of the fund itself. So we use it in fee based accounts, as I mentioned, and any fee for advice or services charge separately. So the MER or the management expense ratio for the series F Funds includes the fee paid to a mutual fund company for investment management to pay the fund's operating expenses and taxes. So let's start with a mutual fund that has a management fee of point six percent or what we call 60 basis points. That means point six percent. And that's kind of a typical fee, but not the best fee, but a typical fee charged on Canadian equity mutual funds. And what you'll find is that a fixed income fund typically has slightly lower fees than that. So you're paying the management fee of point six percent. What does that cover? Well it pays for the professional investment management and research, the risk management oversight, the service and support for our firm, in this case, the firm we work for and the day to day management of the mutual fund company. So that's the first component, the management expense,
BEcause those mutual fund companies earn. Charities, because they have employees,
They do pay people too. That's what you're paying for, is the professional management. And then the second component of the management expense ratio are operating expenses. And so these might be somewhere in the neighborhood of 10 basis points or zero point one percent. And that'll vary again from fund to fund. And the operating expenses will include things like record keeping for unitholders other day to day expenses, such as accounting and fund valuation, custody audit, legal services, regulatory filings, costs of preparing and distributing annual and semiannual reports, that kind of thing. So those are the operating expenses. So the management fee and the operating expenses add up to make the MER. And on top of that, they are subject to tax at a rate that's determined in the provinces where the funds unitholders live. So let's say, for example, we'll us Toronto because a lot of mutual funds are based there. Eight basis points would be around the right amount for taxes for those funds in Ontario.
which would be different than Alberta, of course.
Different from Alberta. That's right. So if you add up everything, it looks like you've got 60 basis points, management fee, 10 basis points for operating expenses, eight for taxes, and so point seven, eight percent a year. So that's the management or the mark that was series. Now let's look at series A. So Series A as I mentioned, those are four accounts that are not in a fee based structure. And so the series reflects the cost of the fund that we just talked about and includes a fee payable to the adviser or I should say, to the advisors firm for their advice and service.
So when you say advisory firm, that could be a bank. So if you bought a series, a mutual fund from a chartered bank, there would be a fee embedded in there.
That's right. So that fee is called a trailing or a service fee. And those fees, because in those cases, the investor is not paying fees directly to the adviser firm. And so they're collected basically as part of the overall management expense ratio of the fund and then paid to the advisers firm. So typically for a A class fund or A serious fund, the typical service or trailing fee would be about one percent for stock based mutual funds or equity funds and usually point five to point seventy five percent for fixed income funds. When you talk about the trailer fee, well, what exactly does that cover? And it can be broken down into three components. So the first thing is advice. So financial advisers provide advice. They do due diligence on the fund. They make sure that it meets the investors objectives. They do tax planning and things like that. So that component is the advice component. The second component would be, I guess, access, and that's the infrastructure required by the adviser and the firm to support the distribution and sale and servicing of those mutual funds and things like a trade confirmations, opening and closing accounts, et cetera. So lots of those types of things. So in general, as I mentioned, you're looking at fee from zero point five percent to one percent. So that covers off the management expense ratio or MER.
Wait, though you said there's three things that three components advice, access and
So we talked about the MER and again, for an F Class fund, we said, let's say that might be point seven, eight percent for a typical fund, a Canadian fund. And so if you add the one percent service fee for a class fund for somebody who's not in a fee based account, then that would be one point seventy eight percent.
At a minimum.
That's right. That's an average. Now, we don't think that's the best we can do. And obviously, we're going to talk a little bit about how can you do better than that? And the answer is, well, lots of ways. There are many funds that have lower fees. And of course, that's what we would want to focus on ourselves. But in addition to the MER, there's something that's not quite as well documented, and that's the TER, which stands for trading expense ratio. And what that measures is the fund's trading costs. And so you'll find if a fund is highly active and the managers are doing tons of trading, then the trading expense ratio is going to be higher and in fact, it can be a lot higher. And so when we're talking about certain funds, I was looking at one fund in particular, and this is a Canadian equity fund.
To remain nameless,
To remain nameless. It does invest in US securities, but the turnover in that fund is two hundred and sixty three percent.
Let's just explain that for a second. So in a typical mutual fund that's replicating a market, the turnover would be just whatever the market turnover would be. So if it's the S&P 500 as an example, the turnover would be just to trade positions to replicate the index.
That's right. I don't have the exact number on it, but I think it's something like four or five percent a year. So two hundred and sixty three percent is pretty active.
That's a lot higher than five percent,
That is, and as a result, so the trading expense ratio on that is 18 basis points or zero point one eight percent. Now, that may not seem like a lot, but there are funds that you can buy where the trading expense ratio is close to zero. And those would be funds that tend to hold positions longer and not trade as often and therefore not trigger not only capital gains, possibly, but also trading expenses. So when you add up the MER and the TER, for example, that's what the total costs are. And so you have to be very mindful because with trading costs of point one eight percent on top of an MER, which could be anywhere from point seven eight to this particular fund, I mentioned the actual MER on an F class version of the fund, which means the investor is also paying a fee to the advisor. Separately, a total MER was two point nine nine percent, point one eight percent for trading costs, so three point one seven percent overall.
Ok, so let's break that down for listeners here just for a sec. So if you invested in that fund that's charging three point one seven percent plus a service fee of let's call it one percent, so four point one seven percent. So that fund has to do four point one seven percent higher than the market return just to break even to the market every year, every year.
And the likelihood of that every year is probably pretty low, Greg.
Exactly. And certain funds may outperform in certain years and underperform in other years. And that's why you need to really look at, well, what exactly is the fund investing in? What is the volatility of the fund as maybe some of that related to this incredibly high turnover?
Well, and so let me ask you this. Are we recommending that clients focus on their fees as a way to improve their performance?
Yes, we are.
Of course we are. You need to understand those fees. You need to understand what's embedded and what's transparent. Because one of the thing you didn't mention is that the service fee on an F class fund would be transparent and it could be written off as somebody's personal tax return, as a professional expense in some cases.
Whereas in an A class fund, the same fee is there, but it's embedded and not really talked about or able to be written off.
That's right. And again, our point here in talking about fees is not to say, gee, mutual funds are bad because they have fees, because, of course, there's fees to everything, whether you're buying and selling individual stocks on a transaction basis, there's costs to buying ETFs, cost to buying bonds or GICs. So there's always fees, but you have to know the fees, understand them and make sure that you're building that into your overall plan so that you know the fees and know what the hurdle is basically.
I know we don't have any problem, when people ask is what the fees are and break it down. And if you're working with somebody that was avoiding that question, well, maybe you might want to question whether you should be working with them.
There's nothing to be defensive about. And all investors are entitled to transparent fees and to know what they're paying for.
Let's get to some of the pros and cons of mutual funds. And there's a few out there. So some of them you kind of touched on. So advantages of mutual funds. No. One, you mentioned advanced portfolio management. Now, whether you believe in modern portfolio theory and active versus passive or whatever it is, you have to believe that somebody who does this for a living all day long probably has access to more information than somebody who looks at the newspaper on the weekend to see what stocks to buy. And so there's a cost to hiring those professional managers that have fancy designations like CFA at the end of their name, chartered financial analyst. And they have hordes of employees that all they do is analyze stocks and bonds. And there's a cost to that. There's an a