Ep.88 - Allison Schrager 

 

Welcome back to the Free Lunch podcast with Greg and Colin and Greg. Last week we started this mini series on how to choose an investment professional to work with. We did, but we're going to continue that discussion next week as we have a special guest joining us today. And this guest works in risk advising on risk anyways and given the volatility we've seen intraday in the stock markets these past few weeks. Kind of like on was it last Monday, the market was down nine hundred points at the open and then closed up positive. Yeah, I would call that a pretty volatile day now. I met this guest at a conference in Scottsdale pre-pandemic, of course, when we used to travel and do things like that and I enjoyed her presentation so much so I thought she'd be a great guest for our show. So today our guest is Alison Schrager. Alison is an Economist, Senior Fellow at the Manhattan Institute, contributing editor at City Journal, a columnist at Bloomberg Opinion, co-founder of Life Cycle Finance Partners, a risk advisory firm. She's done work with the International Monetary Fund. She's worked with Dimensional Fund Advisors, a company that we hold dear to our hearts. And she's the author of An Economist Walks into a Brothel. And we're going to talk about that. Welcome to the show, Alison. I know this is the pinnacle of your career to be on the free lunch podcast.

 

No, every podcast is special. Yeah, there you go. Happy to be here.

 

Especially this one, though, especially this one.

 

Greg, you want to

 

Kick us off? Sure.

 

Well, listen, you seemed like a bit of a multitasker, Alison. So just how did you get here where you are today? Like, Tell us your story.

 

I never really had much of a plan. I'm not a planner and I'm not terribly strategic. After grad school, I just want to not be in academia. That's all I knew. So I started writing for The Economist. That sounds more impressive than it

 

Was in 2006. I think it would

 

Let a monkey write for their website because no one cared about web journalism back then, and they kind of gave me a shot and in exchange said they'd teach me how to write because I was definitely not a very good writer at that time. So I started there. I was there for only a couple of months before I met Bob Merton.

 

I guess your work with

 

Dfa, you would have encountered him some, of course. And he found my dissertation and he was like, I'm really thinking a lot of the same thoughts why don't you come work with me? I will help you. I'll teach you finance and we will build financial products from our research. And obviously, that sounded amazing. And it was also intellectually, as you can imagine, a really special time for me because I was a macro economist at that point, and learning finance from someone like Merton was really life changing, and a lot of lights went on for me and I consider it a great conversion for me into becoming a financial economist instead of a macro economist. Although I think technically some people still call me macro. And so we worked together for seven years and I was always writing on the side. I kept up with the economist and that's how I ended up at DFA when they acquired the product we were working on. And then I got to work there and got to work with all the really brilliant people there learned even more finance. And then I left DFA and didn't really quite know what to do next. But I had learned a lot about finance and I'd kept up my writing. So I felt like the next natural progression was to combine the two, the financial knowledge and my writing

 

Ability, writing skills

 

And writing network that I developed at that point over several years. So I wrote the book, and the original idea was it would be something like Freakonomics for finance, how you can see how the basic principles of finance are at play in industries you never really thought of, like sex work or celebrity photography or whatever.

 

And so I honestly

 

Decided like fun to me that could go around the country and meet cool people and hear what makes them tick. I'm starting a new book now and I'm looking for new stories, and I explain to people that a risk story is always going to be a good story because there's just natural drama in it. You make a decision. The decision has got to be bold. You don't know what's going to happen. So stories about risk are always inherently going to be interesting, and stories without risk are not interesting. It's fascinating talking to people about ideas for new stories, and they always want to tell you a story from their industry, sometimes more interesting than others. But it's amazing how people don't even realize when risk is not present, and that's why it makes it a bad story. I was like, Well, they did this thing, and I was like, Well, what did they have to lose? They're like, Well, nothing politely. I'm like saying, Well, one that's not really a risk story into. That's also a boring story. It was a really fun to write amazing people and heard great stories. And I like to think it came out well because every story as well has that dramatic tension because risk is always has drama to it. And then I think at that point, after you write a book, you're on that what they call public intellectual track,

 

Because that's what you do

 

With the book. After that, I joined the think tank and started writing for Bloomberg and starting the next book.

 

Let's talk a little bit about your book, so it's entitled An Economist Walks into a brothel and Other Unexpected Places to understand risk.

 

That's a catchy

 

Title. I'd argue that you sort of took Freakonomics to a new level there. Because certainly by getting

 

Into things like the sex

 

Trade, that's not something that would logically pop to mind. So how did you come up with these places to look for risk and how did the sex trade and some of the other areas that

 

You talk about big wave surfing

 

And things like that? How did those come to mind?

 

Well, the sex trade sort of fell into my lap. I guess I was starting the book and I had this idea that I'd find like Freakonomics for finance. But Steve Levitt had a bunch of research papers and I did not, and I was like, I am not in the research game anymore. I haven't since

 

Grad school, but I do know how to

 

Report. So I guess I'll find cool stories and meet people in any way it worked. As a journalist, I didn't really actually know how to report because economics journalists don't report. They just sort of sit at their desk and call people actually going out. Meeting people, developing sources was something I really knew how to do or even know how to find cool stories. So it was really struggling to figure out it's like such a good idea in theory what in practice, I was talking to a friend of mine who

 

It turns out I was like, I'm looking for a

 

Cool story, like maybe someone who's doing something illegal. And he was like, Well, my girlfriend actually runs an online brothel

 

And

 

She matches submissives with clients. And her main value

 

Add because it's easy enough to find

 

Clients yourself is that she screams the clients because you're going to be tied up by some random event on the internet. Obviously, that's very dangerous. So she does is she reduces the risk, and for that, she gets one third of the transaction. And I'm like, Oh, that's a good risk story, because risk is always like, how much are you paying to reduce it? So I interviewed her and I wrote this story if we can put a price on risk reduction in the submissive market.

 

And so I did

 

Pretty well, as you can imagine. And then the Bunny Ranch called me the famous brothel in Nevada, and they were like, Well, are you going to write about brothels? You should be worrying about our brothel because I guess they're like the Goldman Sachs brothels. I think the best one, the most prestigious one to be working at. And I was like, Well, I don't really write about brothels. Why don't you tell me more about this?

 

Because I always take

 

That call

 

And it's pretty boring.

 

And then he explained to me that they don't have set prices, that every transaction is individually negotiated. And I was like, Well, that's interesting. You're telling me you have women who are like 19 years old, negotiating for tens of thousands of dollars with men in their sixties. And he is

 

Like, Yeah, no depressed about that

 

Before. It's interesting women come here not really knowing their value. So we have a negotiation training program, so they ask for more like all these feminist buzzwords and it's like, Well, this is interesting. I had a wonderful editor at the time who was like, You need to go. We will put you on a plane and we will go and we'll take a videographer with you. So off we went to the brothel, and while I was there, I was talking to all the women about negotiating. So obviously it came up. What do you charge? And like any interesting market, there's always a good risk element there. So I discovered how people pay premium in the sex market to reduce risk, and then that just became a story. But the other stories like surfing or poker or the other stuff, honestly, any industry has a risk element, so you always know that's going to be there, and that's probably going to be most interesting thing about the industry. So I just picked out things that I thought were cool, and I just wanted to learn about myself. I love celebrity gossip, so that's why I ended up hanging out with the paparazzi for two months because they're just there on the street. They were the hardest group to infiltrate. And so after I got in with them, I just learned all about how that worked. And they said, there's always a risk story and everything interesting.

 

And we'd certainly recommend people take a look at the book because it's just entertaining.

 

Well, are we recommending Alison's book, Greg? Of course we are. Yeah, of course we are.

 

Yeah, thank you.

 

Of course, as we move on here, everything's going to seem mundane by comparison to the stories in your book. But we're involved obviously

 

A lot with our clients in

 

Planning and we do a lot of retirement planning. And you've obviously spent

 

Some time in your

 

Academic and your post academic career thinking about

 

Retirement risks. So what are some of the

 

Biggest risks that people face as they plan for retirement?

 

Actually, I find that more interesting than sex work personally, I think is such an interesting problem and one that's a lot harder to solve. I think we haven't really grappled with people actually retired. I mean, we've gotten pretty good at the saving part, and I think

 

There's good

 

Conventional strategies to how you build up well. I think spending down wealth is a much harder problem. And also there's very few good solutions.

 

It's like I was,

 

You know, my editor recently about annuities.

 

I love annuities like all

 

Economists, but it's sort of like, well, let's put annuities in target date funds. It's like, Well, how do you do a when at what point when you're a balance is what? And our annuity prices are determined by long term bonds, and most target date funds put you in short term bonds. I mean, it's not that easy, and it's amazing to me that we're sort of jumping into this without thinking through all of these things. And there's no margin for error with your spending plan, like if you run out of money and you're 90.

 

What do you do?

 

There's a much bigger margin for error on the savings base and the spending down fees. So I think that's the biggest risk, we don't have a lot of good solutions, except I think good financial advice, which is what you do. But I don't think we've figured out how to deliver that for lower asset people because they also have fewer assets and are more likely to run through them all. They probably need better advice more. So I think that for me is the thing that concerns me most.

 

That's actually a really interesting point. We have a person on our team page, Hilton, who's started a financial literacy program, and she's gearing towards those people that you described because there aren't a lot of channels for them to get good advice because our industry, let's face it, is geared towards people that have money and it's easy to do retirement projections if you have a very big pot of money. It's harder when it's smaller.

 

Totally. I mean, I think the more money you have, you don't even need to spend down principal. You can just live off of interest, premiums and dividends and all these sorts of things. But my mother is on the verge of retiring or somebody retiring because she'll probably always work a little bit because she has a knowledge job. And I keep trying to explain to her she thinks she can't retire until she has enough money that she can live off of interest payments. I'm like, You saved all this money for a reason. You should feel comfortable spending down principal again. There's much less margin for error if you're doing that. So I think in the financial service industry, not just advice, but in general has sort of been built around that more money

 

Means you need better advice.

 

But really, the less money you have, the more you need good advice.

 

Interesting. Earlier, I was talking to call in about this. One of the things we try to do is help people understand risk. And of course, it's only downside risk that people care about. Nobody gets upset if the market is a couple of standard deviations higher

 

Than usual, so it's really the downside

 

Risk that people care about. But it

 

Seems like there's a personal

 

Experience factor.

 

So I think

 

Of my mother, who grew up as a young child during the depression and lived the rest of her life as if she was still in the depression. So even when she had money, she would never spend it because of the scarcity risk. Or at least that was her mindset. And then you look at people like maybe my kids or Collins kids who have grown up thinking that life is all about going to Hawaii or Disneyland twice a year or something, and the concept of not having enough money to actually do those things is totally foreign to them. To what extent do people have to experience a bad event, risky event in order for it to really make sense? How do you teach people about risk when they haven't experienced what could happen themselves?

 

I don't know. I mean, I think even people who have experienced risk tend to forget it. When you hear people who are professionals and financial markets seem to forget that things like value premiums, the key word here is premium, which means you don't get it every year. You might not get it for 20 years. Stock market could go down for 20 years. This is why your premium is it's not a guarantee. And I think there's something in us on

 

Both sides, people who are

 

Way too risk averse, not realizing what they're giving up by not taking risk and people who are just completely oblivious and think upside comes with no cost. And sort of exploring this in the new

 

Book is how

 

Our connections with risk have changed over the years.

 

And it's amazing to me. No risk

 

And reward. It's cliche at this point have, for some reason, it's something no one seems to really understand or internalize at all. I mean, I think education is certainly helpful. I mean, I think it was. Matt Levine of Bloomberg has pointed out that when you teach financial literacy, you'll teach things like

 

Compounding and how wonderful

 

That is. But you don't also say, hey, a higher return also comes with a higher chance of loss, and that is just an ironclad rule.

 

If you remember that, you're going to get into

 

A lot less trouble

 

Because it also

 

Keeps you away from scams. If anyone says, Oh, you're going to get eight percent guaranteed return and never have a loss, that this is not a good investment.

 

And if the stock market's way up, then you made 14 percent.

 

I was just looking. My portfolio is up 14 percent for me, even with all the volatility from last year. But like, I know that that comes with a cost,

 

Which is it's not a guarantee. It's one of the things we took away

 

From all of our time spent with the dimensional gang. And that is that it's not actually risk and return that are related. It's risk and expected return. An actual return is whatever the gods decide to hand out. And that's one of the things that we try to encourage people to understand is that OK, just because you took a higher risk doesn't mean you will get a higher return. It just means you have the possibility. And so that whole concept of probability is one that I think maybe a lot of people don't quite understand.

 

I think they struggle with it or I'm always surprised when you read a lot of media accounts, certainly like the value premium of writing it off because as it existed for 10 years, and it's sort of like, well, the small cap premium like 10 years. I mean, this is why it is a premium

 

Is that it's not a

 

Guarantee. And I can't guarantee that in the five year or even a 20 year

 

Time horizon, it's going to pay off.

 

But on average, over 50 years, it probably will.

 

That's interesting. I'm got to tell you a short story. Greg and I actually were trapped in Austin, Texas, with Bob Merton at an airport.

 

I bet it a lot. Well, it was an

 

Interesting time because you talk about probability of distributions,

 

The airport was

 

Flooded

 

With a massive

 

Storm. In all, the airlines were grounded, so the probability of that was very low when we were going to Austin and it just occurred. So that was the premium. But OK, we think about risk in terms of standard deviation, variance and covariance. But I think at the end of the day, most people just want to know that they're going to be OK. Can you talk a little bit about that?

 

I think people have problems defining risk in finance. I think it's a fine shorthand to say risk, a standard deviation, but really

 

Risk is a very

 

Emotional connection to people and it could be just downside risk could be upside risk could be tail risk. But Bob is a great definition of risk, which I think really explains all of this. And he calls it the only unifying definition of risk, which is risk is what's safe, is it? How do you define safety? And once you define safety, you can define risk and safety

 

Has a real resonance. People want to know

 

They're going to be OK. They want to know they're going to be safe. And safety could be knowing that you have enough money in retirement. It could just be knowing that you're going to get a particular return and that makes it a safe asset and that it's liquid. And you know exactly how much money one year from now it will be because risk is the opposite of safety, then how you define safety also defines risk.

 

Interesting.

 

Now it's interesting to me. I started in this business quite a long time ago. In the 90s

 

Mid-90s, people didn't talk a lot about retirement and accumulation strategies and things like that

 

In those days. And now, of

 

Course, everything you read, Bob Merton is working on it. And so when you have people like him that are making this a major focus

 

Of their academic

 

Study, why is that? Is this the baby boom thing again? Is this the pig and the python? And there's all of us put myself in that category that are now at that point, and it's become a lot more important because there's just so many more of us.

 

Yeah. Well, I mean, think about it, we really started with 401Ks or DC plans in general in the eighties. In the nineties, they were just starting to hit their stride, so no one's actually

 

Retired with them yet. It's sort of amazing to me.

 

They sort of just jumped into this DC world without really thinking about deregulation. And now everyone's approaching retirement with hopefully some money, and no one really knows what to do with them. So I think honestly, considering I think we should be talking about even more than we are. I mean, some people are talking about it. I think in services, I think I've noticed when you write about this column anywhere, it gets a lot of readership, but it should be discussed everywhere and I've seen very few good ways of dealing with it. I think the only country that's ever had a great accumulation plan was Chile. What's happening there with their retirement system, which is quite sad?

 

Well, yeah, because it feels like most people getting back to risk when markets are good. Everybody has a high risk tolerance. And then the minute markets turn bad, their true risk tolerance actually comes to light. Is that a fair statement?

 

Yes, I think absolutely. My mother is someone who looks for balance every day. Anyway, I tell

 

Her not to. She has also to think to

 

Tell her not to when it comes to finance, and she seems like genuinely betrayed when markets fall. Yeah. And it's like very upset.

 

And I'm like, first of all, you should

 

Look every day. And second of all, if you don't want to lose money, you should not be in this portfolio.

 

That's well, we have the same mother.

 

My mom, during

 

The global credit crisis,

 

Would look at

 

Me with tears rolling down her cheeks and say things like, How could you do this to me? Which really hurts? And then when everything got better, she said, Oh, you're doing such a great job. And both times I'm like, I'm not doing anything. It's just the market.

 

This is why I don't get my mother investment advice other than don't look at the balance. She actually has a DFA advisor who I love, and I'm just like, Talk to him. Yeah, he's great. I believe in a strategy, but it's not going to deliver you high returns every time.

 

If that's what

 

You need, you need to talk to them about your strategy.

 

It brings up this point about not only behavioral biases, which of course we can talk about forever, but also the difference between systematic risk and unsystematic or specific risk. And how should everyday people think about those two things?

 

Well, I think if you have idiosyncratic risk, you have the wrong advisor because I think that's where advice is useful. I mean, a systematic risk. There's only so much you can do, but idiosyncratic risk. There's really no reason for it, like if you talk to him, are in. I mean, he once said to me he thinks maybe should not even be allowed to hold individual stock. Holding individual stock is like owning a muffler, a car like it's worthless if it's not part of the larger machine. So therefore you should only be able to buy mutual funds. I sometimes say this to people and they freak out because I don't know why people think investing is buying individual stocks. And it is amazing to me. This is how most people think about investing. In fact, I remember when I was in high school, I took my first finance class and they had us Peter Lynch's book. We're effectively, like, told us to go to the mall and see where their reliance and buy these companies. I look back, I'm like, I can't believe they had us read that like that is terrible, but. So I think people have to break this up and sort of systematic risk is largely unavoidable unless you avoid risk altogether and idiosyncratic risk. If you're exposed to that, then there's something wrong with your strategy.

 

I love that holding an individual stock is like buying a muffler.

 

I'm going to use that one. Yeah, that's that's that's excellent.

 

But it's how people think.

 

So many people I know got into investing this last year, and they very proudly tell me this all my friends who've never invested before and they think I know how to buy individual stocks, which I don't. I don't own any of myself. I don't even know how. And they're like, I bought this, this and that. And they expect this approval from me. And I'm like, You're getting involved in markets, but maybe you balance that out with an index fund.

 

Well, I remember one of my

 

First conferences, Terrence

 

Odin, who's a big name in behavioral finance, was telling stories back in those days. It was the explosion of online trading and discount brokers and things like that. And he was talking

 

About a surgeon

 

Who was coming

 

To him and just a friend

 

Talking about what he thought about the idea of maybe trading options and futures. And his advice was, Well, I hope you lose a

 

Lot of money right away

 

Because if you lose money right away, it'll keep you from thinking you're smarter than

 

Everybody else and losing a whole

 

Lot more money down the road. That's sort of the secret, isn't it? It's like if people take a risk and it happens to pay off,

 

Like gambling, it explodes.

 

Yeah, you see that in a lot of these Tick-Tock investors, these TikTok investors like effectively saying like, it's so easy to make money in the market and they describe like momentum strategy. It's like, Oh God. But I heard Josh Brown say on CNBC about this is when the GameStop stuff was happening,

 

And he's made the same

 

Point you just did. He's like, I think this is a great development because it gets people engaged in markets and also lets them to know like how not to be stupid because they'll probably lose money someday.

 

Yes, exactly. Yeah.

 

Well, listen, I know you're just

 

Fitting us in in between things, so I think we should move on to the lightning round, Greg. Sure.

 

Absolutely.

 

So you've done all the heavy lifting. Thank you for doing that, Alison. Really appreciate that. And we want to just

 

Finish off with a speed round just for fun.

 

So these are no right or wrong to these answers.

 

Greg, you want to make sure? Well, OK. So the first thing is when you're not advising and running your business and writing and

 

Writing books, what do you do for fun?

 

Oh gosh, I play bridge.

 

Oh, OK. Of course, because you're doing a risk analysis in the bridge

 

Game, aren't you? Or No, I'm actually

 

Very mediocre bridge player. My risk analysis and probability abilities get me to the point where I'm mediocre but don't have to work hard. But if you want to be good at Bridge, you actually do have to work hard and

 

I'm too lazy.

 

So any books you're reading right now other than writing,

 

I'm reading Jared Diamond's

 

A People or book research. I was just on a plane to Miami and someone handed me a book about Truman Capote, which I also enjoy.

 

Oh, cool. You probably don't have time for this, but do you stream any shows pandemic streaming?

 

Oh yeah, waste

 

A lot of time. I just finished Yellowjackets. That was wonderful.

 

Yellowjackets, what's that one?

 

Oh, it's about a soccer team in the nineties, and they get trapped in the Canadian wilderness and become cannibals. But it's so much better than myself.

 

Oh, OK.

 

We probably ran into them at some point.

 

Let's move on to some Canadian specific questions because we are Canadian.

 

And just so you know, we have talked

 

To a number

 

Of your fellow New

 

Yorkers as well as other Americans, and so you're getting the same treatment that they all do.

 

Your first question

 

And Colin and I both come from relatively small towns in Saskatchewan, Regina and Saskatoon, Saskatchewan. Your question is how do you spell Saskatchewan?

 

Oh God, don't ask me that. I have no idea. I think there's a W and a Z and there isn't there. Ok.

 

There's a w

 

W for sure. Ok, we'll give you 50 percent on that one.

 

And on those

 

Cold morning strolls in New York, when you're cruising around Manhattan, do you ever wear a tuk?

 

I don't know. I don't know what one is.

 

Oh, I think you do. I think you do wear one. It's that maybe wool

 

Hat with the pom pom at the top.

 

Oh yes, I do have one.

 

Yeah, you might refer to them as beanie a beanie.

 

I think just a pom pom or just a hat hat.

 

Yeah. One more, Greg.

 

Ok, we're Canadians, and there are some

 

Different views about how Canadians are and how maybe they're different than Americans. Have you ever witnessed a Sori fight? I don't know a story. Fight, Colin, would you?

 

Sorry, Greg, I didn't quite follow.

 

I'm sorry. Did I interrupt? I'm sorry.

 

Apologies.

 

We didn't give Alison a chance to reply.

 

Oh, I'm sorry. I'm sorry about that, Alison. Yeah, I do. I just say, I don't know. All right.

 

All right. Ok, we'll wrap it up there, and we'll let you get on to your next activity. Alison, thanks so much for joining us today, sharing your wisdom and knowledge. We really appreciate that time with you.

 

Thank you for having me.

 

Our pleasure. It's a pleasure to have you. Thank you.

 

All right. Well, now listen, next week

 

We continue on the mini series of choosing an investment professional, and the following week we have Kathleen Fitzgerald, adjunct associate professor of Strategic Management at the Booth School of Business at the University of Chicago University, Chicago. Of course, Alison, you know, is the epicenter of DFA. So we're pleased to have her on the show, and please remember to read us on Apple Podcasts, Spotify, wherever you download your podcast content, so until next time, next time.

 

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EP.87 - Choosing A Financial Advisor

 

Welcome back to the Free Lunch podcast. Greg, the free lunch podcast. It is, yes,

 

It's free and you can listen to it over lunch if you

 

Want.

 

That's right. That's right. Last week, we had Jay Schmidt from GMH and company talking about all things tax, and that was a good episode.

 

He's a knowledgeable guy.

 

We'd encourage you to go back and listen to that one if you have any tax questions or even reach out to him. He's always good at answering questions.

 

Right now's a good time to be listening to that as

 

Well, because of course, people are thinking about tax free savings, account contributions, RRSP contributions

 

And withdrawals

 

If withdrawals and

 

Getting everything ready

 

To file their tax returns for this year.

 

So this week on to something different, we are going to start a new mini series. I kind of like doing these miniseries things and we're going to do this one on choosing a financial professional to work with which, hey, that's what we do.

 

Right, exactly. And as it'll

 

Become apparent over the course of

 

This miniseries, of course, people have different needs, different wants, and there's a whole lot of financial professionals out there. So what strategy should people use when they're looking to find someone? I think it's sort of like buying a car. If you think back to the last time you buy a car just

 

Because your

 

Sister or your brother or a good friend owns a particular car, is that the reason why you should be looking at that particular car

 

For yourself? Don't you think that person

 

Is probably biased?

 

They might be. And were you looking at cars like

 

A Honda Fit and a Land

 

Rover at the same time? Obviously, those are pretty dramatically different vehicles. And did you look at everything in between or did you go into the dealership not have the foggiest idea of what type of cars they sold, what prices were? Things like that. The answer is probably no. Most people and I say this because my wife and I are currently looking at

 

Cars for the next

 

Fall. Honda Fit,

 

I don't think so, but

 

Nothing against the Honda Fit.

 

Not at all. The Honda Fit is

 

Perfect for certain people, but generally you start the process by thinking about what your needs are

 

And the budget in general.

 

And then you typically

 

Home in on two or three vehicles

 

That might fit the bill. Do some homework, you read up on

 

Them, you read ratings and

 

Reviews, take test drives and then you make the decision as which one to buy. And what's

 

Surprising is that many times

 

Investors take the opposite approach when they're choosing a financial advisor. Certainly, a lot of investors rely on people they know whether they're friends or family and say, Well, Gee, who do you use? And that's the way they choose.

 

And that's kind of the way you choose many things, whether it's a plumber electrician. That's right.

 

And the interesting thing, though, is that when it comes to financial advice, because of the broad range of different types of advisors out there, it's actually a little bit different than

 

Choosing a plumber or an

 

Electrician

 

Because the needs

 

Are pretty straightforward. In those cases, I need this light installed. I need my plumbing fixed, whereas it's much different in the financial advisory business. And again, as I mentioned, because there's so many different types of advisors, the profession itself is big and confusing. It includes people that are focused primarily on investments,

 

Or there could be those that

 

Really focus primarily on doing comprehensive financial planning. There is commission

 

Based brokers that call

 

Themselves financial advisors, and then there's

 

A fee only or fee based

 

Advisors who don't use commissions at all.

 

And part of the problem is many of these

 

People use exactly the same names. And so the industry hasn't really helped from the standpoint

 

Of almost

 

Anybody can call themselves a financial advisor.

 

There is some reform that's currently occurring to that. They are trying to make it more transparent as to what people actually do

 

Exactly through their titles.

 

There is good news, and the good news is that there's a lot of ways to zero in on who the best advisor is for you. And it requires sort of spending some time, much as you would when you're buying a car. Figuring out on what exactly are the needs that you have, then you can get into whether or not different compensation

 

Structures will work better or

 

Worse for you. But again, you've got to identify your goals in seeking an advisor. Look at what sort of relationship you want and make sense, how much you expect to need, how much contact you want with them, et cetera.

 

And once you have done some preplanning

 

That way, then you can sort of go and look for an advisor who fits your description that you sort of made for yourself.

 

Now we're going to get into five questions to ask yourself, ask others when choosing a financial professional to deal with. So these five questions come to us from Morningstar. We didn't write them. We're just going to talk about them because there's lots of these lists out there that people have published over the years of what questions to ask a financial professional when interviewing

 

Them or thinking about who to

 

Use. So the first question is, are you seeking help with your financial life or your investment portfolio? And this is a good question because those things are related.

 

But they're not the same, so

 

A key issue among financial advisers is focus. In other words, some financial advisers will focus a lot of their time around things like security selection. What stocks should I buy? What bonds should I buy? What is my asset allocation? What new products are out there that will give me a higher expected return? But that's just focusing on investment characteristics. That doesn't necessarily mean that that investment that this person has identified actually falls into what somebody needs if they have done

 

A financial plan, it's just an

 

Investment. So other people will focus on financial planning

 

And really focus

 

On identifying those long term goals, but actually don't necessarily know a lot about the individual investments themselves. Yes. And then you've got people that are in the middle. I would say for us, we're in the middle. We have a good understanding of financial planning and the importance of it. Why you need to do a financial plan. The information that comes

 

Out of it and how it's beneficial

 

To us and to our investors. But we also understand the importance of having how would you say this and academically based scientific approach to investment portfolio management?

 

Absolutely. Because there's no sense developing a financial plan if you can't build an investment strategy that will deliver the goals that you're set for yourself.

 

That's right. So in this Morningstar article, it says if you're seeking holistic planning advice than a financial planner is appropriate if you're seeking broad financial planning guidance on your investment portfolio, but other parts of your plan as well. So yes, we agree with that. If you're just looking for advice, of course, get a plan done. No problem there at all. If you need investment advice, first and foremost. Now I would argue that's putting the cart before the horse.

 

Exactly. Anybody that comes

 

To us and says, I want to invest

 

Money with you and tell me what you're

 

Going to buy. We always deflect to, well, what planning have you done to determine how much risk you need to take? And that's going to determine what investments you need. But if you do, if you're that person out there that just needs investment advice and you think your financial plan is in good shape, then you may be more apt to go with somebody who is just doing investment advisory services.

 

And there are many options in that area and you carry a designation.

 

A Certified Investment Manager,

 

Management Analyst and judgment

 

Analyst. That's right. I should know that because I'm completing that myself for exactly. And I know that that one's not well known in Canada, per say, but in the U.S., it is considered to be one of the gold standards of investment management services.

 

That's right. It's just a way of honing our

 

Skills and really being current on the state of the investment management

 

Industry, the financial

 

Planning industry, it's all encompassed. And again, that is more of a holistic approach to what we do. It's interesting. It strikes me as we're going through these questions, selecting a financial advisor. You go through the same process that we go through when we talk about developing a financial plan or an estate plan, which we've talked about on previous podcasts. In a way, it's like, well, you can't get to the end without doing the work up front and the work up front is, well, what exactly are my needs in an estate plan you think about, well, how do I want my assets to be distributed after I die? And in a financial plan, it's how do I

 

Plan to get to the end, whether it's the

 

Retirement

 

Goal or what have you? And it all

 

Starts by asking

 

Questions and coming up with answers.

 

And so,

 

Well, it's like building a house. You got to lay the foundation first. That's right. What's the question to let's go on to the next one.

 

You should ask yourself like, are you looking for advice on a few specific issues or do you need help with the whole plan so you need a one time or periodic help? Or do you need ongoing assistance? And once you've determined whether you're looking for investment advice or financial planning advice, you do want to consider what specific items you need help with.

 

And the reason we ask is

 

Because there are different types of advisors or planners that can offer either one time assistance or ongoing assistance. If you're seeking advice on just a few issues like you want to just do a quick review of your retirement

 

Assets and the viability

 

Of them doing what you want for just the next five years or so, you might pick what they

 

Call a fee

 

Only financial planner, somebody that for a set fee on an hourly rate, let's say we'll go through your plan

 

And help you work

 

It out, and that'll be the last you have to do with those

 

Planners. I would argue on

 

A basic one. If somebody just has a basic information requirement, you could probably just do that at the bank. You could. There's lots of bankers that have access to simple software that they could easily determine your assets, liabilities and future net worth exactly.

 

However, if you're looking

 

For broad and ongoing financial help, meaning if you expect that. Your advice needs will be ongoing, so then it may be more cost effective

 

To take a more

 

Holistic approach

 

On that and use a

 

Financial adviser who can offer both the planning and the investment management expertize on a fee basis rather than on a one time basis. Wait a minute.

 

Do you know a group in Calgary that offers financial planning services and investment management services together under a flat fee model?

 

I do call

 

Which group is that? That would be our group.

 

Oh, right, right, right, right. Wait, are we recommending our group to listeners?

 

Of course we are. However, we believe that even in terms of recommending

 

Ourselves, we also recommend

 

That people go through this process. Yes, because joking aside, you do require a good fit. And so the needs of an

 

Individual and the kind of assistance

 

They're looking for, whether it's planning or investments or both. It has to fit with the kind of advice and the kind of

 

Services that the advisors

 

Offer, and we'll be talking a little bit about that as we go forward.

 

And then there are some different

 

Models of engagement where there might

 

Even be some sort of retainer

 

Model where an advisor gets paid a monthly or an annual dollar based fee rather than a percentage of assets. That's a little bit more common in the U.S. right now. We don't see that in Canada, but in general, my experience is whatever happens in the U.S. will eventually find its way up here just like inflation. Exactly.

 

Question three How hands off or hands on do you wish to be? Now this goes out to those. Do it yourself or is out there.

 

We did a whole episode on do it

 

Yourselfers last year,

 

And absolutely there are people that

 

When they look at their needs, they say, Well, I'm happy

 

Doing part of this myself,

 

Just like they're happy changing their own oil or framing their basement or all kinds of things. Great. So you got to ask yourself how much of a role you'd want to play in managing your finances just similarly to like, how much of a role do you want to play in maintaining your vehicle? And there's different levels of that. So if you want to be part of the planning process and handle certain parts of it yourself, or do you want to delegate most of the decision making? So if you're willing to handle certain aspects of your plan on your own? Well, obviously the more that you do yourself, the more you'll be able to shave off

 

And advisory fees.

 

I mean, that's pretty straightforward. It's just like if I take my car to, I don't know, minute lube. Am I recommending minute

 

Lube, Greg? I don't know a lot

 

About oil change.

 

All I'm saying. Of course I'm not. I'm not recommending them or not not recommending them. But, you know, if I take my car at a minute lube versus I take my car to the dealership.

 

I'm expecting two different experiences.

 

That's right. So this is just the same in investing that you can pay for hourly services. In many cases, you can pay for on per project basis. So those would be more like financial planners that you mentioned that charge an hourly rate to complete a plan, but they're not going to put that plan into action for you. They're just

 

Identifying goals,

 

Needs whatever, and then they're just handing it back to you. So if you want to be less hands off and you want to delegate, this can be accomplished. And this is accomplished for many busy people that we deal with. They're busy doing things in their own lives, like their own jobs, raising their families, whatever it is that they're doing. And they don't necessarily either have the time to participate in the planning and investment management process or in some cases, they're just not inclined to. They recognize their level of experience and expertize. And it's kind of like, I guess you could pull your own tooth out, but I don't know why you'd want you.

 

You could,

 

You know, instead get

 

A better experience

 

By going to professionals. So in this way, you can pay an advisor. A percentage of your assets usually starts around one percent and they'll do the heavy lifting for you. They'll do the financial planning, the investment management process, the ongoing performance gains all that.

 

You bet you.

 

Another question that sort of ties into that

 

Do it yourself side of

 

Things is the question how comfortable is the investor or the client with technology? Because most

 

Of us in the

 

Kind of advice business

 

That you and I are in still meet

 

Face to face with

 

Clients in offices or wherever.

 

Well, just virtually these days.

 

Well, I was going to say technology is really changing the advisory industry fast and the pandemic has really accelerated that progress

 

Because we've seen

 

A lot over the last couple of years of we're not able to meet face to

 

Face with clients because of

 

The pandemic. And so certainly the technology to allow us to meet virtually has exploded

 

And there's a lot of technology

 

Under the surface as well. So not just meeting with clients, but there's robo advisors that we've talked about before. They use computer algorithms to deliver low cost investment advice

 

And even human advisors.

 

We rely heavily on software program. Rims and things like that for financial

 

Planning and investment

 

Management, et cetera. And again,

 

We use portals on our own companies

 

Websites to allow investors to go in and get information about their not just about their accounts, but information about

 

Their investments.

 

So using that technology, so if you're really comfortable with technology, then there's opportunities for people to do more of the do it yourself or by using technology driven advice like robo advisors. And some people feel that they don't need to pay human financial advisers

 

For services if they

 

Feel that they can get advice by using robo advice.

 

And that's certainly a lower cost

 

Way in some cases of getting that advice. And then with the investment management piece, you can

 

Use a robo

 

Advisor as well. So certainly people that are more comfortable with technology and have that do it yourself

 

Sensibility about managing their

 

Own investments. There's lots of options available and as I say, they can be, although they're not always, but they can be less costly than using a full service advisor.

 

It can be, for sure, but again, you get what you pay for.

 

And certainly if you're a person that likes more face to face interaction with another human, then you want to focus on advisors who not only work using that model, but also are in the same general vicinity. Because, of course, with virtual

 

Meetings and technology,

 

You don't have to live in the same city or even the same country.

 

Well, country, there's a different issue there, but that's separate, but you

 

Don't have to live close to your advisor. But many of us, myself included, still enjoy face to face interaction. And in that case, then you may want

 

To search only for

 

Financial

 

Advisers right in your neighborhood.

 

People are transitory.

 

They move. I mean, we've dealt with

 

Clients in Switzerland, the Dominican

 

Republic, Czechoslovakia. That's right now called

 

The Czech Republic,

 

Right? I always get those. You're right. I'm behind. My geography isn't isn't up to date. I still remember Yugoslavia. Of course, that's no longer that.

 

But we do deal

 

With clients from around the world, and it's fine. You can do it electronically. You can use Zoom or Microsoft Teams or any of those online virtual portals you mentioned. The only issue is maybe a time zone issue. Sometimes like when you live in Switzerland and you're dealing with somebody in Calgary, there's a bit of a time zone issue there, but you can do it. So question five of the five questions on This Morning Star report. Do you have a specific investment philosophy? You'd like to see your advisor employee? Now I would say this is a big one.

 

This is a critical one. Yeah, so this

 

Gets back to do you believe in things like active management versus passive management? Are you aware of the different strategies and products out there? We hear quite often people will be referred to us and they'll say things like, Well, I don't like mutual funds. It's such a broad thing to say, to be quite frank. That's like saying, I don't like water. Yeah, right? Like, well, maybe you don't like carbonated water. Maybe you like only distilled water. I don't know. Like, maybe that's not a good analogy, but there's all kinds of different mutual funds there's. That's right. Just to put them all under the same umbrella doesn't make sense.

 

And as we've talked, I think we've talked about this on previous podcast. Very often when people say I don't like mutual funds, it's because sometime in their past, they invested in a mutual fund and for the time they were invested, they didn't make the kind of returns that they expected to. And as a result, they blame their experience on the mutual fund and not on the underlying holdings of the fund or the strategy that the fund employees.

 

So the bigger question is this question states, is what is your investment philosophy and how do you want to employ it? And if you want to be a market timer, which we don't think people should do, but you could find somebody who believes in market timing, do you want to be more

 

Tactical or less tactical

 

In just having a long range asset allocation that's rebalanced to and you can find somebody that

 

Does that too. I mean, you're going to

 

Find somebody out there that is going to offer you services that align with what your beliefs are. But if you have a specific investment philosophy, you'd like to see the advisor employ, well, then the good news is that if you're listening to this podcast, you're already developing a set of investment beliefs that you like to see embedded in how you want things going forward. And so even if you're delegating the specific decision making to an advisor, you're still giving them the tools to say, Well, I want growth or I want income or I want capital preservation. How are we going to do that? And then you're determining how active or passive your strategy is from that, or if you're open to willing and allowing the investment advisor to ply their own strategy. You could go into more of a discretionary account or discretionary agreement where you have to all be on board as to how much risk is really relevant and should be applied in that situation. But you're giving sort of a bit of freedom to the. Pfizer to select and trade the securities that are in that portfolio

 

Know exactly, and one of the reasons why it's so important to sort of identify if you have your own beliefs about investments is because in order to then when you select an advisor, you may not find the right fit. If your beliefs and the advisers beliefs don't mesh,

 

For instance, we have an

 

Investment philosophy that anyone who listens to this podcast knows

 

Has a pretty good idea of after the last 85

 

Or 86 podcasts. We have a specific investment philosophy, and if somebody comes in and they're talking to us or interviewing us to see if we would become their advisers, and it becomes clear that they would prefer to pick their own individual stocks or focus only on dividend stocks, or take some approach that we don't believe is in their best interest, then it would not make sense for us to be working together for either of us, for us or for the individual. It just again highlights how important it is for in selecting a financial advisor. It's an active

 

Process and we encourage

 

People. Certainly, we will always look to friends and family to get an idea to get names. But from there you then need to do your own research. As you say, just because it works for one person, it doesn't necessarily mean it's going to be the right fit for somebody else. And you can only determine that by knowing yourself and by asking questions,

 

You'll know if that Honda Fit is the right vehicle for you, Greg.

 

Well, I know when we try to get our three dogs inside that Honda Fit, I'm pretty sure in advance that it's not going to be the right one.

 

Yeah. Well, listen, I think we'll wrap it up there for today. Thanks for joining us next week. We have Allison Schrager on the podcast. Allison is an economist with the Manhattan Institute, a think tank in New York, and she's also the author of a book called An Economist Walks into a Brothel. So we're going to have her on and we're going to talk about, I know things that an economist would talk about. And then after that episode, we'll carry on the conversation in mini series on choosing the financial advisory firm. We're going to look at things like fiduciary responsibility, titles, designations, credentials and all those good things right on.

Ok, well then till next time.

 

Until next time.

 

 

 

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. 2022.

EP.85 - Forecasting 2022

 

Welcome back to the Free Lunch podcast and welcome to 2022. Greg, it's 2022.

 

It is, and we're talking 2022 or 2020 as well.

 

We're also also know it's 2022..

 

It's starting to feel kind of like 2020

 

Also, I know it definitely feels like the last two years haven't moved that much, although there have been a number of changes like we're recording, not together today for the first time in quite a while as we have a little bout of, I don't know, COVID in our household. So that's changed from two years ago for us. But true. Anyways, we're just adapting, right?

 

Well, that's right. And if anything, the last two years has taught us that you can adapt and business and life can go on, even with some of these unfortunate restrictions that we've had to live with, for sure.

 

The one upside to this we've got a quarantine situation in our house is they did just change the rules from 14 days to five days as of just a few days ago. So things are adapting all the time. Yep, exactly. But today, Greg, we're not here to talk about COVID and quarantines. We're here to talk about the outlook for the next 12 months as all of the lists have come out or they're coming out the list being from all of the investment banks. And I don't know, market participants, prognosticators, they're seeing what predictions are out there for this year ahead. So this is that time of year when we like to look at that.

 

Well, we do. And I think we want to look at it from a couple of standpoints. But the main standpoint is when you look at these predictions or forecasts for the upcoming year, the question always will be, Well, what do you do about it? There's one thing about making predictions as best anyone can. There's another thing is, well, how does that change? Or should that change what you actually do with that information that comes from all numbers of different sources, some very credible firms or individuals who publish these forecasts, and others from other people not so well educated or informed? And before we get into it, I just want to make one disclaimer. And that is that in if we talk about an outlook for the S&P 500 or for the U.S. market or name any individual stalker, we recommending that people act on that information specifically.

 

Never, never, never. No, we're not. We're just using this as I don't know, evidence from other people of what they're saying.

 

That's right. I do want to make it clear that first of all, as always, if any individual stock is mentioned during this podcast, we're not recommending that people buy it. It's not a recommendation, and that's not the purpose of this podcast. Likewise, if one of the firms that we reference has put out a bullish forecast for stocks for next year, does that mean we're telling people they should take more risk and buy more stocks? No, not at all. No. Those kinds of decisions can only be made with your investment advisor and with the benefit of a financial plan and a very clear identification of what goals are set. So again, strictly for information and entertainment, if you will. And as always, these are not specific recommendations. So having got that out of the way, shall we dove in?

 

They're not specific recommendations from us, but there are analysts that are paid to put out these reports. That's their job. Exactly. And it's not that they're not doing good work to create these lists. They have all kinds of financial modeling tools that they use to come up with where the market will go and what stocks to buy based off of whatever valuations. But so we're not trying to minimize the work that those people are doing either, right?

 

Absolutely not. These are highly educated people in many cases and have a raft of information available to them. And I think what we'll do is let's see what people are saying and see if we can find some sort of consensus. Well, let's start

 

With a baseline. So as we are recording today, we're going to refer to the market as being the S&P five hundred, not because it's the only market. It's just that a lot of the predictions that we're going to be talking about are based off of the S&P five hundred. And today the S&P five hundred is showing a value of four thousand seven hundred and seventy seven. So let's see what the experts think the market that being the S&P five hundred will do over the next 12 months. So, Greg, there was an article put out by seeking Alpha just this last week. It was actually a really good article. In it, they talked about two different opposing views from two different investment firms, one having a very bullish outlook and one having a very bearish outlook on the same market. But the summary of it was that the biggest problem with Wall Street both today and in the past is. The consistent disregard of the unexpected and random events that inevitably occur. Ok, well, yeah, random events always occur. That's why they're called random. Exactly. Like, I didn't plan on doing this podcast from home until my son randomly tested positive for COVID. These are random. The other one was U.S. equities, currently traded at a record valuation premium to global peers. So this is true. U.s. equities are extremely high based on where they've been in the past, and the markets can defy logic, fundamentals and reality in the very short term. And this is also true. You see it when the market moves either upward quickly or downward quickly based on something that's happening or happened. It's not always logical.

 

That's right. Or it doesn't seem logical on the surface, and we've seen that in many periods over the last 25 30 years.

 

It probably seems logical after the fact when you have more facts and you're looking back. So this article, as I mentioned, is very good, but it talks about the accuracy of predictions. So that's how the article starts and it talks about how predictions. There was a study on predictions and how they come from various professions, including psychics and meteorologists, and the study came to two conclusions. The very interesting number one meteorologists are the most accurate predictors of the future. That makes kind of sense.

 

It does, yeah.

 

And number two, the predictive ability was accurate to just three days, so they're the most accurate predictors, but they're only able to have a predictive ability of maybe three days. So I don't know, it doesn't seem that great. It's kind of like flipping a coin. That's right.

 

You mentioned models earlier. I mean, meteorologists sort of base their predictions on models. Models are only good for a certain period of time, and you can't model everything, whether it's weather or anything else.

 

Exactly. And of course, we don't hold meteorologists to their predictions for the weather for tomorrow. We look at it because we want to see. But if it were to be different, it's not like we would say they need to be fired.

 

Well, not only that, the interesting thing is when you think about it, we make decisions based on the short term. So I guess many of us probably know that in general, tomorrow's weather forecast is probably pretty accurate. But we wouldn't make dramatic changes to plans based on a forecast for what the weather's going to be like two weeks from now.

 

Well, in this article, talks about it as stock picking, being like weather forecasting and now I'm quoting the article is essentially an exercise in futility. So that's something that we've talked about in the past, that it's just it's really hard because markets are affected by such a broad spectrum of things, from economics to geopolitics, monetary policy rates, financial events. And so taking any prediction with a very high degree of skepticism is probably the best thing to do. Somebody says, Oh yeah, for sure, the market's going to go up 10 percent in the next 12 months. I would be pretty skeptical of that. So the two opposing views that we want to talk about in this article come from Goldman Sachs and from Morgan Stanley. Greg, maybe tell us, what does Goldman Sachs say the market's going to do over the next 12 months?

 

What's interesting is Goldman Sachs and Morgan Stanley, of course, are just investment firms in the U.S. with long, long histories. So it's interesting when you see something imposing. So Goldman Sachs, they tend to be bullish a lot of the time, pretty consistent. And typically, you don't see them coming out with non bullish forecasts for the upcoming year. Listen, the market is positive in the you and I have talked about this a lot. The market is generally positive more often than it's negative, so it generally pays to be bullish when you're dealing with investors. And not only that, in many cases offering your own products to investors. So being bullish kind of makes sense because you expect the markets to be positive two thirds of the time. And now Goldman Sachs, of course, one thing about being bullish all the time is you can be wrong when it really hurts. So if you look at periods like 2000, when the tech bubble burst and stocks just broad, index stocks were down 50 percent from 2000 to 2002 two and also in 2008, when again, the bear market of the global financial crisis also sent stocks down 50 percent from their highs. So that's a pretty important time. And going into that, they were quite bullish.

 

Well, but Greg, there's no way that in two thousand seven leading into two thousand eight, they had a bearish report out there anywhere to that effect. Nobody said, that's right. The market's going to go down 50 percent over the next 12 months.

 

No, exactly right. There were some warning signs in the real estate market, of course, but nothing that sort of affected the broad market. So this year, Goldman Sachs chief equity strategist guy by the name of David Kostin forecasted the S&P 500 will climb nine percent from that point to 5100 at the year end of twenty twenty two from the. Time that was written, that would be a 10 percent increase on the S&P five hundred for the year.

 

Ok, so plus 10 plus 10.

 

That sounds good. Here's something interesting. The climb will be in the face of decelerating economic growth a tightening fed, which means the Federal Reserve raising interest rates and rising real yields suggest investors should expect modestly below average returns next year. So saying, despite predicting the S&P 500 up 10 percent. Investors should expect modestly below average returns,

 

But that doesn't make sense.

 

It seems like returns over the last several years. Twenty seven percent or twenty six percent this past year and 20 percent the year before. It seems like that has become what people now consider average returns. And we, of course, know that going back 100 years of stock market returns, the average is really more like eight percent.

 

Yeah, I was just going to say, like, if they're predicting a nine or 10 percent increase, that's actually slightly above the long term average of the S&P five hundred. Exactly. But then they're talking about how investors should expect modestly below average returns. So which time period are they talking about?

 

Well, that's right. Just to finish off on Goldman Sachs, though, he estimates that despite a slowing economy, rising yields and tightening monetary supply, that earnings growth which accounted for the entire S&P 500 return in twenty twenty one, will continue to drive gains in 2020, too. And so the basis for Goldman Sachs bullish view on the S&P 500 is rising earnings growth despite all of these negative economic headwinds.

 

Greg, I don't want to get negative here, but how do you have rising earnings growth during periods of negative economic issues? I don't get it.

 

It's a good question. And as we've said before, only time will tell. But let's talk about what's Morgan Stanley say about the outlook.

 

Well, Morgan Stanley takes the bearish view. They're saying that the market is going to fall by about eight percent this next 12 months. So they're saying the S&P is going to close somewhere around four thousand four hundred points. Those are completely opposite predictions. Yes, they are ones up 10 percent ones down almost 10 percent in the same 12 month period. Now, the three main causes for the prediction of a lower market actually go to what you just talked about earnings uncertainty and how they expect earnings growth to be weaker in twenty twenty two because of supply chain issues and some tax and policy uncertainty. So that's interesting. They also talk about premium valuations. So the S&P remains at a premium, with current price earnings multiple of about twenty one times earnings, and they think that that is probably high. They also talk about higher real bond yields, and that's something we've talked about. Like there's a difference between interest rates and the real interest rate when they talk about like the 10 year U.S. Treasury, that's the real rate. That's what the market applies. It's not what the Federal Reserve applies anyways. Those are the three main predictions or main drivers of the prediction. The question is between the two Goldman Sachs and Morgan Stanley. I don't know. We'll either of them be right.

 

Who knows they might be what usually happens when you read these kinds of things, because these are both very highly credible sources of information is, well, who will be correct? What do you do about it? And the answer, in many cases, is all you can do is really look at the risks to both of their views. They agree on certain things. They agree that there's the possibility of higher interest rates and higher real bond yields. They probably both agree that the valuations are currently historically high doesn't mean they're going to change any time soon. But that's just a fact. They only differ on their outlook for earnings. Of course, earnings are very difficult to predict because there's so many things that could affect earnings. And so what do you do? Well, we'll talk about that in the end. What do we do with these kinds of predictions?

 

They do have a quote in there from Robert Rubin, previously U.S. secretary of the Treasury and Goldman Sachs executive, and I want to read this quote. First, the only certainty is that there is no certainty. Second, every decision as a consequence as a matter of weighing probabilities. Third, despite uncertainty, we must decide and we must act. And lastly, we need to judge decisions not only on the results but on how they were made. It's a pretty good quote

 

That is a good quote, and it really highlights some of the things we've talked about in the past around probability. We don't build portfolios based on any kind of certainty about what's going to happen in the future. And that's why we build portfolios the way we do, because there is a level of uncertainty, whether it's about the stock market, about the bond market. And so we make decisions when I like the last comment. We need to judge decisions not only by the results, but by how they were made, if you made a good decision, then whether or not things turned out the way you wanted is not really the point. You're using the best information you have at the time.

 

It's always funny to me when after the fact of a major event, somebody will say something like, Oh, but we saw that coming. It's like, No, you didn't. Otherwise, you would've made a different decision at the time. That's right. So the article, it's a well-written article. I actually really like it, and it talks about just really how hard it is to predict market outcomes. Now, one thing that I will take issue with in the article is it talks about owning, well, selected fundamentally cheap companies and how that makes sense. My question is, well, who is selecting what a well selected, fundamentally cheap company is like? Who establishes this and how? And aren't they just using the price and size premiums from the pharma French factor models when they're discussing this?

 

That's right. And one of the things that in a lot of the articles I've read with regards to the predictions for the markets this coming year is a lot of the analysts or companies are saying this is going to be a stock pickers market. And basically they say that every year and the reason why they say that is because in certain years. Well, in most years, like last year, just by owning the index or stocks that reflect the broad market and not any individual stocks, you can get a really tremendously positive outcome. So last year, just owning the S&P five hundred, you made twenty six percent. And as we've talked last time, a lot of individual companies or stock pickers picked their top ten or their top 20 favorite stocks and ended up with a more highly concentrated, risky portfolio that still didn't do any better than the market. And so what happens is then we'll look back and say, OK, well, that was a good year just to be in the index. But this year is going to be different. It's a stock pickers market. And the interesting thing is that, OK, well, let's say, does that mean that the stock pickers last year who didn't do better than the market are suddenly smarter this year? Why would they do better this year than they did last year? What is it about the market this year that's going to make stock picking more successful than it was in the past? And I think that's one of those types of comments that is certainly out there to justify picking a handful of stocks or a concentrated portfolio of stocks. But it doesn't really make sense when you look at the basis for that.

 

Now our last episode, we did spend a bit of time on hits and misses from the last year in talking about how things did or didn't work out. But let's look at Forbes just to carry on this conversation of outlooks for the next 12 months. Forbes had a twenty twenty two stock market outlook in which they have data from Wells Fargo, FactSet, U.S. Bank, Charles Schwab. Now let's just compare those to what Goldman Sachs and Morgan Stanley already said. Goldman Sachs was very bullish. Morgan Stanley was very bearish. Well, Wells Fargo was actually more bullish. They're saying that the S&P 500 could hit fifty thousand three hundred points. That's a pretty big number. That'd be awesome. Compare that to FactSet, which is just a group of analysts who cover individual stocks with a similarly optimistic outlook, and they see the S&P five hundred hitting fifty two to twenty five. Greg, I would argue that 50 to twenty five is fifty three hundred. Like, that's the same number.

 

That's a very specific number. Exactly.

 

Yeah. Like why not 50 to twenty six? Anyways, then we have U.S. Bank, which also has a bullish outlook and says that the index is going to reach five thousand sixty points. Bullish again. And then we have Charles Schwab, who doesn't give a specific forecast on it or price target for the S&P five hundred. But it just gives a, I don't know, a qualitative forecast, it says. And I quote potential for a good year, the very technical know. Maybe they're trying to hedge their bets.

 

And as you read further potential for a good year, albeit with a decent risk of weakness as market participants account for Fed policy changes so potential for a good year, but with a decent risk of weakness. Talk about being noncommittal on that one.

 

That's that cautiously optimistic outlook that you always hear from people that I know it drives you crazy. It drives me crazy, too. Like what is cautiously optimistic? You're either optimistic or you're not. It's a very noncommittal.

 

Exactly. And the interesting thing is, those kinds of forecasts are really don't make any changes kind of forecasts. It's kind of like, OK, well, we're not saying it's going to be a blowout year for stocks. So we don't want to see people taking on more equity risk, but we're not saying it's going to be terrible. So don't sell what you're holding. So just kind of stay put. Which is fine with me, by the way.

 

And they do talk a lot about inflation as being a key to any change in the outlook, and there's a quote in the article that cracks me up. It's by mid-year we should know what the level of inflation is and that will set the tone for the second half of the year. That's not really. That's a really saying much. It seemed like halfway through the year we'll see what's occurred. And that'll. I don't know. Let us figure out what the next half of the year will look like. That's not really saying a whole lot, Greg.

 

It's kind of the same as saying, Well, let's see what company earnings are like midyear, and that'll help us identify how their year is going to finish out. So kind of like when we have the information, we'll know for sure.

 

I want to do a quick look back and we only only got a few minutes left here. Greg, a quick look back. I know that there's a guy out there named Jim Cramer and I'm not promoting him or slagging him. He's just a person out there that people follow on. Is it CNBC

 

That he's like NBC? That's correct.

 

And again, we're not promoting or not promoting him, but he is well followed and he came out with this list last year. So it's December of twenty twenty and it was a list of stocks to purchase for twenty twenty one. And he suggested that people own five specific companies. There were Facebook, Apple, Amazon, Netflix and Google or Alphabet. Greg Over the last 12 months, those five stocks had an average return of twenty six point eight percent and the S&P five hundred did twenty six point six percent. So I would argue that if you held five hundred stocks, you had less volatility than if you held five. But that's just my own opinion and you ended up with basically the same return now in his comments. I want to quote this because it says I'm so sick of hearing that it's time to rotate into the oils. That was a year ago, December of twenty twenty, December of twenty twenty one. He came out with a similar list and I won't bore you with the names. It's basically just highlighting the best performing companies from the last year. And his comments were the biggest takeaway should be the remarkable resurgence of the oils.

 

So a year before he was sick and tired of hearing about how oils were going to resurge, so to speak. And this year, the biggest takeaway should be the remarkable resurgence of oils.

 

I'm not trying to make fun of it or anything. Well, maybe I am, but it's just another point on these lists are only as good as they are. I think, more importantly, Greg, let's wrap up this episode with our forecast of what people should do in regards to these lists.

 

And I think that for me, any of these forecasts could be right. Goldman Sachs could be rate and earnings growth will continue strongly, as it did in 2021, and we'll see the S&P 500 up by nine percent or Morgan Stanley could be right and earnings uncertainty and maybe trending weaker from 2020. One will actually result in the S&P 500 being lower by eight percent or five percent from today or any of these other forecasts. You mentioned whether it's Wells Fargo, U.S. Bank or Charles Schwab. I think the answer is OK, well, given that we have a number of different forecasts and we have no expectation as to which one of those forecasters is most prescient or most well positioned, then what do we do? And I think in the end, what we do is we say, Well, look, we need to build a portfolio that will capitalize on whatever growth might actually come from the markets. And now we're talking about not just the U.S. market, of course, but global stock markets, and that actually somehow positions the portfolio to deal with the risk that might come from maybe some of these negative if the more bearish outlooks turn out to be the correct ones. So what do we do? I guess the answer is we do what we always do. We start with an analysis of our individuals financial plans, retirement plans, estate plans, what are their goals? What are their financial goals with their current financial position? And what do they need to do to achieve those goals and build a portfolio accordingly?

 

So boring.

 

I know, I know. It's like a broken record.

 

You know what? I'm not going to hold you to it, but just for fun. Why don't we give her own, I don't know, estimate of what the S&P five hundred will do over the next 12 months just for fun. All right. What do you

 

Think? Well, I think if it's not down, then it'll likely be up barring it finishing the year flat as to where it started.

 

I'm going to go out on a limb and say that it's up at the end of the year. Yeah, I'm going to say it's up only from a probability perspective, because as we know, what is it like, 70 percent of the years are up years.

 

So two thirds of the time the market finishes up, yeah, now

 

Up can be very relative. It could be like point zero, one percent or twenty six percent or somewhere in between. I'm not going to go any further than just to say it's up. I'm like Charles Schwab, because that's basically what Charles Schwab said. It's going to be probably a decent year unless it's not.

 

It's good to have that level of commitment.

 

So I will though say with certainty what people should do during the year, regardless of what's happening in the market is rebalance your portfolios so you have no idea, no control over the direction at any time of what the market will do or where it's going. But you can control your exposure to the

 

Market exactly if

 

You've set a tactical asset allocation of some amount in bonds and some amount of stocks. Just make sure you're rebalancing regularly. It'll get rid of all that noise of market timing.

 

Well, that's right. Just to explain it a little bit further, if you have a portfolio that has 50 percent in stocks and 50 percent in bonds, if that's the appropriate portfolio for you and we go through a negative period for stocks, then you will end up owning more bonds on a relative basis. You might end up owning fifty five percent bonds and just forty five percent stocks, and just the rebalancing process helps you to buy low and sell high. You'll be selling your bonds five percent of them, which would have had positive relative performance to stocks because stocks were down and you'll be buying five percent more of stocks which are at lower prices because the market has declined. And so the rebalancing process actually takes a lot of that. As you say, that market timing decision out of the way because you don't need to say, Gee, is this a good time to buy stocks? Maybe they'll go down further. That's not the question. The question is, is my portfolio in balance relative to my strategic asset allocation? And if the answer is no, then your decision is to. Rebalance back to your strategic allocation, not to buy stocks because they're cheap. It just so happens that by doing that, you are buying stocks when they're cheap and that's what everyone tries to do. It takes all of that work out. It takes all of the need for making predictions out of the picture.

 

Excellent advice. Excellent advice. Well, maybe we should wrap it up there, Greg.

 

Sure. This is again our 2022 inaugural episode, and we're looking forward to having lots more things to discuss in our next 50 podcast in 2022.

 

Exactly. All right. Well, next time we'll be talking with something even more interesting, I'm sure.

 

Sounds great.

 

Ok? Till next time,EP.85 - Forecasting 2022 FINAL.mp3

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 and welcome to Twenty Twenty Two. Greg, it's twenty twenty two.

 

It is, and we're talking 2022 or 2020 as well.

 

We're also also know it's twenty twenty two. It's like the No.

 

It's starting to feel kind of like twenty twenty.

 

Also, I know it definitely feels like the last two years haven't moved that much, although there have been a number of changes like we're recording, not together today for the first time in quite a while as we have a little bout of, I don't know, COVID in our household. So that's changed from two years ago for us. But true. Anyways, we're just adapting, right?

 

Well, that's right. And if anything, the last two years has taught us that you can adapt and business and life can go on, even with some of these unfortunate restrictions that we've had to live with, for sure.

 

The one upside to this we've got a quarantine situation in our house is they did just change the rules from 14 days to five days as of just a few days ago. So things are adapting all the time. Yep, exactly. But today, Greg, we're not here to talk about COVID and quarantines. We're here to talk about the outlook for the next 12 months as all of the lists have come out or they're coming out the list being from all of the investment banks. And I don't know, market participants, prognosticators, they're seeing what predictions are out there for this year ahead. So this is that time of year when we like to look at that.

 

Well, we do. And I think we want to look at it from a couple of standpoints. But the main standpoint is when you look at these predictions or forecasts for the upcoming year, the question always will be, Well, what do you do about it? There's one thing about making predictions as best anyone can. There's another thing is, well, how does that change? Or should that change what you actually do with that information that comes from all numbers of different sources, some very credible firms or individuals who publish these forecasts, and others from other people not so well educated or informed? And before we get into it, I just want to make one disclaimer. And that is that in if we talk about an outlook for the S&P 500 or for the U.S. market or name any individual stalker, we recommending that people act on that information specifically.

 

Never, never, never. No, we're not. We're just using this as I don't know, evidence from other people of what they're saying.

 

That's right. I do want to make it clear that first of all, as always, if any individual stock is mentioned during this podcast, we're not recommending that people buy it. It's not a recommendation, and that's not the purpose of this podcast. Likewise, if one of the firms that we reference has put out a bullish forecast for stocks for next year, does that mean we're telling people they should take more risk and buy more stocks? No, not at all. No. Those kinds of decisions can only be made with your investment advisor and with the benefit of a financial plan and a very clear identification of what goals are set. So again, strictly for information and entertainment, if you will. And as always, these are not specific recommendations. So having got that out of the way, shall we dove in?

 

They're not specific recommendations from us, but there are analysts that are paid to put out these reports. That's their job. Exactly. And it's not that they're not doing good work to create these lists. They have all kinds of financial modeling tools that they use to come up with where the market will go and what stocks to buy based off of whatever valuations. But so we're not trying to minimize the work that those people are doing either, right?

 

Absolutely not. These are highly educated people in many cases and have a raft of information available to them. And I think what we'll do is let's see what people are saying and see if we can find some sort of consensus. Well, let's start

 

With a baseline. So as we are recording today, we're going to refer to the market as being the S&P five hundred, not because it's the only market. It's just that a lot of the predictions that we're going to be talking about are based off of the S&P five hundred. And today the S&P five hundred is showing a value of four thousand seven hundred and seventy seven. So let's see what the experts think the market that being the S&P five hundred will do over the next 12 months. So, Greg, there was an article put out by seeking Alpha just this last week. It was actually a really good article. In it, they talked about two different opposing views from two different investment firms, one having a very bullish outlook and one having a very bearish outlook on the same market. But the summary of it was that the biggest problem with Wall Street both today and in the past is. The consistent disregard of the unexpected and random events that inevitably occur. Ok, well, yeah, random events always occur. That's why they're called random. Exactly. Like, I didn't plan on doing this podcast from home until my son randomly tested positive for COVID. These are random. The other one was U.S. equities, currently traded at a record valuation premium to global peers. So this is true. U.s. equities are extremely high based on where they've been in the past, and the markets can defy logic, fundamentals and reality in the very short term. And this is also true. You see it when the market moves either upward quickly or downward quickly based on something that's happening or happened. It's not always logical.

 

That's right. Or it doesn't seem logical on the surface, and we've seen that in many periods over the last 25 30 years.

 

It probably seems logical after the fact when you have more facts and you're looking back. So this article, as I mentioned, is very good, but it talks about the accuracy of predictions. So that's how the article starts and it talks about how predictions. There was a study on predictions and how they come from various professions, including psychics and meteorologists, and the study came to two conclusions. The very interesting number one meteorologists are the most accurate predictors of the future. That makes kind of sense.

 

It does, yeah.

 

And number two, the predictive ability was accurate to just three days, so they're the most accurate predictors, but they're only able to have a predictive ability of maybe three days. So I don't know, it doesn't seem that great. It's kind of like flipping a coin. That's right.

 

You mentioned models earlier. I mean, meteorologists sort of base their predictions on models. Models are only good for a certain period of time, and you can't model everything, whether it's weather or anything else.

 

Exactly. And of course, we don't hold meteorologists to their predictions for the weather for tomorrow. We look at it because we want to see. But if it were to be different, it's not like we would say they need to be fired.

 

Well, not only that, the interesting thing is when you think about it, we make decisions based on the short term. So I guess many of us probably know that in general, tomorrow's weather forecast is probably pretty accurate. But we wouldn't make dramatic changes to plans based on a forecast for what the weather's going to be like two weeks from now.

 

Well, in this article, talks about it as stock picking, being like weather forecasting and now I'm quoting the article is essentially an exercise in futility. So that's something that we've talked about in the past, that it's just it's really hard because markets are affected by such a broad spectrum of things, from economics to geopolitics, monetary policy rates, financial events. And so taking any prediction with a very high degree of skepticism is probably the best thing to do. Somebody says, Oh yeah, for sure, the market's going to go up 10 percent in the next 12 months. I would be pretty skeptical of that. So the two opposing views that we want to talk about in this article come from Goldman Sachs and from Morgan Stanley. Greg, maybe tell us, what does Goldman Sachs say the market's going to do over the next 12 months?

 

What's interesting is Goldman Sachs and Morgan Stanley, of course, are just investment firms in the U.S. with long, long histories. So it's interesting when you see something imposing. So Goldman Sachs, they tend to be bullish a lot of the time, pretty consistent. And typically, you don't see them coming out with non bullish forecasts for the upcoming year. Listen, the market is positive in the you and I have talked about this a lot. The market is generally positive more often than it's negative, so it generally pays to be bullish when you're dealing with investors. And not only that, in many cases offering your own products to investors. So being bullish kind of makes sense because you expect the markets to be positive two thirds of the time. And now Goldman Sachs, of course, one thing about being bullish all the time is you can be wrong when it really hurts. So if you look at periods like 2000, when the tech bubble burst and stocks just broad, index stocks were down 50 percent from 2000 to 2002 two and also in 2008, when again, the bear market of the global financial crisis also sent stocks down 50 percent from their highs. So that's a pretty important time. And going into that, they were quite bullish.

 

Well, but Greg, there's no way that in two thousand seven leading into two thousand eight, they had a bearish report out there anywhere to that effect. Nobody said, that's right. The market's going to go down 50 percent over the next 12 months.

 

No, exactly right. There were some warning signs in the real estate market, of course, but nothing that sort of affected the broad market. So this year, Goldman Sachs chief equity strategist guy by the name of David Kostin forecasted the S&P 500 will climb nine percent from that point to 5100 at the year end of twenty twenty two from the. Time that was written, that would be a 10 percent increase on the S&P five hundred for the year.

 

Ok, so plus 10 plus 10.

 

That sounds good. Here's something interesting. The climb will be in the face of decelerating economic growth a tightening fed, which means the Federal Reserve raising interest rates and rising real yields suggest investors should expect modestly below average returns next year. So saying, despite predicting the S&P 500 up 10 percent. Investors should expect modestly below average returns,

 

But that doesn't make sense.

 

It seems like returns over the last several years. Twenty seven percent or twenty six percent this past year and 20 percent the year before. It seems like that has become what people now consider average returns. And we, of course, know that going back 100 years of stock market returns, the average is really more like eight percent.

 

Yeah, I was just going to say, like, if they're predicting a nine or 10 percent increase, that's actually slightly above the long term average of the S&P five hundred. Exactly. But then they're talking about how investors should expect modestly below average returns. So which time period are they talking about?

 

Well, that's right. Just to finish off on Goldman Sachs, though, he estimates that despite a slowing economy, rising yields and tightening monetary supply, that earnings growth which accounted for the entire S&P 500 return in twenty twenty one, will continue to drive gains in 2020, too. And so the basis for Goldman Sachs bullish view on the S&P 500 is rising earnings growth despite all of these negative economic headwinds.

 

Greg, I don't want to get negative here, but how do you have rising earnings growth during periods of negative economic issues? I don't get it.

 

It's a good question. And as we've said before, only time will tell. But let's talk about what's Morgan Stanley say about the outlook.

 

Well, Morgan Stanley takes the bearish view. They're saying that the market is going to fall by about eight percent this next 12 months. So they're saying the S&P is going to close somewhere around four thousand four hundred points. Those are completely opposite predictions. Yes, they are ones up 10 percent ones down almost 10 percent in the same 12 month period. Now, the three main causes for the prediction of a lower market actually go to what you just talked about earnings uncertainty and how they expect earnings growth to be weaker in twenty twenty two because of supply chain issues and some tax and policy uncertainty. So that's interesting. They also talk about premium valuations. So the S&P remains at a premium, with current price earnings multiple of about twenty one times earnings, and they think that that is probably high. They also talk about higher real bond yields, and that's something we've talked about. Like there's a difference between interest rates and the real interest rate when they talk about like the 10 year U.S. Treasury, that's the real rate. That's what the market applies. It's not what the Federal Reserve applies anyways. Those are the three main predictions or main drivers of the prediction. The question is between the two Goldman Sachs and Morgan Stanley. I don't know. We'll either of them be right.

 

Who knows they might be what usually happens when you read these kinds of things, because these are both very highly credible sources of information is, well, who will be correct? What do you do about it? And the answer, in many cases, is all you can do is really look at the risks to both of their views. They agree on certain things. They agree that there's the possibility of higher interest rates and higher real bond yields. They probably both agree that the valuations are currently historically high doesn't mean they're going to change any time soon. But that's just a fact. They only differ on their outlook for earnings. Of course, earnings are very difficult to predict because there's so many things that could affect earnings. And so what do you do? Well, we'll talk about that in the end. What do we do with these kinds of predictions?

 

They do have a quote in there from Robert Rubin, previously U.S. secretary of the Treasury and Goldman Sachs executive, and I want to read this quote. First, the only certainty is that there is no certainty. Second, every decision as a consequence as a matter of weighing probabilities. Third, despite uncertainty, we must decide and we must act. And lastly, we need to judge decisions not only on the results but on how they were made. It's a pretty good quote

 

That is a good quote, and it really highlights some of the things we've talked about in the past around probability. We don't build portfolios based on any kind of certainty about what's going to happen in the future. And that's why we build portfolios the way we do, because there is a level of uncertainty, whether it's about the stock market, about the bond market. And so we make decisions when I like the last comment. We need to judge decisions not only by the results, but by how they were made, if you made a good decision, then whether or not things turned out the way you wanted is not really the point. You're using the best information you have at the time.

 

It's always funny to me when after the fact of a major event, somebody will say something like, Oh, but we saw that coming. It's like, No, you didn't. Otherwise, you would've made a different decision at the time. That's right. So the article, it's a well-written article. I actually really like it, and it talks about just really how hard it is to predict market outcomes. Now, one thing that I will take issue with in the article is it talks about owning, well, selected fundamentally cheap companies and how that makes sense. My question is, well, who is selecting what a well selected, fundamentally cheap company is like? Who establishes this and how? And aren't they just using the price and size premiums from the pharma French factor models when they're discussing this?

 

That's right. And one of the things that in a lot of the articles I've read with regards to the predictions for the markets this coming year is a lot of the analysts or companies are saying this is going to be a stock pickers market. And basically they say that every year and the reason why they say that is because in certain years. Well, in most years, like last year, just by owning the index or stocks that reflect the broad market and not any individual stocks, you can get a really tremendously positive outcome. So last year, just owning the S&P five hundred, you made twenty six percent. And as we've talked last time, a lot of individual companies or stock pickers picked their top ten or their top 20 favorite stocks and ended up with a more highly concentrated, risky portfolio that still didn't do any better than the market. And so what happens is then we'll look back and say, OK, well, that was a good year just to be in the index. But this year is going to be different. It's a stock pickers market. And the interesting thing is that, OK, well, let's say, does that mean that the stock pickers last year who didn't do better than the market are suddenly smarter this year? Why would they do better this year than they did last year? What is it about the market this year that's going to make stock picking more successful than it was in the past? And I think that's one of those types of comments that is certainly out there to justify picking a handful of stocks or a concentrated portfolio of stocks. But it doesn't really make sense when you look at the basis for that.

 

Now our last episode, we did spend a bit of time on hits and misses from the last year in talking about how things did or didn't work out. But let's look at Forbes just to carry on this conversation of outlooks for the next 12 months. Forbes had a twenty twenty two stock market outlook in which they have data from Wells Fargo, FactSet, U.S. Bank, Charles Schwab. Now let's just compare those to what Goldman Sachs and Morgan Stanley already said. Goldman Sachs was very bullish. Morgan Stanley was very bearish. Well, Wells Fargo was actually more bullish. They're saying that the S&P 500 could hit fifty thousand three hundred points. That's a pretty big number. That'd be awesome. Compare that to FactSet, which is just a group of analysts who cover individual stocks with a similarly optimistic outlook, and they see the S&P five hundred hitting fifty two to twenty five. Greg, I would argue that 50 to twenty five is fifty three hundred. Like, that's the same number.

 

That's a very specific number. Exactly.

 

Yeah. Like why not 50 to twenty six? Anyways, then we have U.S. Bank, which also has a bullish outlook and says that the index is going to reach five thousand sixty points. Bullish again. And then we have Charles Schwab, who doesn't give a specific forecast on it or price target for the S&P five hundred. But it just gives a, I don't know, a qualitative forecast, it says. And I quote potential for a good year, the very technical know. Maybe they're trying to hedge their bets.

 

And as you read further potential for a good year, albeit with a decent risk of weakness as market participants account for Fed policy changes so potential for a good year, but with a decent risk of weakness. Talk about being noncommittal on that one.

 

That's that cautiously optimistic outlook that you always hear from people that I know it drives you crazy. It drives me crazy, too. Like what is cautiously optimistic? You're either optimistic or you're not. It's a very noncommittal.

 

Exactly. And the interesting thing is, those kinds of forecasts are really don't make any changes kind of forecasts. It's kind of like, OK, well, we're not saying it's going to be a blowout year for stocks. So we don't want to see people taking on more equity risk, but we're not saying it's going to be terrible. So don't sell what you're holding. So just kind of stay put. Which is fine with me, by the way.

 

And they do talk a lot about inflation as being a key to any change in the outlook, and there's a quote in the article that cracks me up. It's by mid-year we should know what the level of inflation is and that will set the tone for the second half of the year. That's not really. That's a really saying much. It seemed like halfway through the year we'll see what's occurred. And that'll. I don't know. Let us figure out what the next half of the year will look like. That's not really saying a whole lot, Greg.

 

It's kind of the same as saying, Well, let's see what company earnings are like midyear, and that'll help us identify how their year is going to finish out. So kind of like when we have the information, we'll know for sure.

 

I want to do a quick look back and we only only got a few minutes left here. Greg, a quick look back. I know that there's a guy out there named Jim Cramer and I'm not promoting him or slagging him. He's just a person out there that people follow on. Is it CNBC

 

That he's like NBC? That's correct.

 

And again, we're not promoting or not promoting him, but he is well followed and he came out with this list last year. So it's December of twenty twenty and it was a list of stocks to purchase for twenty twenty one. And he suggested that people own five specific companies. There were Facebook, Apple, Amazon, Netflix and Google or Alphabet. Greg Over the last 12 months, those five stocks had an average return of twenty six point eight percent and the S&P five hundred did twenty six point six percent. So I would argue that if you held five hundred stocks, you had less volatility than if you held five. But that's just my own opinion and you ended up with basically the same return now in his comments. I want to quote this because it says I'm so sick of hearing that it's time to rotate into the oils. That was a year ago, December of twenty twenty, December of twenty twenty one. He came out with a similar list and I won't bore you with the names. It's basically just highlighting the best performing companies from the last year. And his comments were the biggest takeaway should be the remarkable resurgence of the oils.

 

So a year before he was sick and tired of hearing about how oils were going to resurge, so to speak. And this year, the biggest takeaway should be the remarkable resurgence of oils.

 

I'm not trying to make fun of it or anything. Well, maybe I am, but it's just another point on these lists are only as good as they are. I think, more importantly, Greg, let's wrap up this episode with our forecast of what people should do in regards to these lists.

 

And I think that for me, any of these forecasts could be right. Goldman Sachs could be rate and earnings growth will continue strongly, as it did in 2021, and we'll see the S&P 500 up by nine percent or Morgan Stanley could be right and earnings uncertainty and maybe trending weaker from 2020. One will actually result in the S&P 500 being lower by eight percent or five percent from today or any of these other forecasts. You mentioned whether it's Wells Fargo, U.S. Bank or Charles Schwab. I think the answer is OK, well, given that we have a number of different forecasts and we have no expectation as to which one of those forecasters is most prescient or most well positioned, then what do we do? And I think in the end, what we do is we say, Well, look, we need to build a portfolio that will capitalize on whatever growth might actually come from the markets. And now we're talking about not just the U.S. market, of course, but global stock markets, and that actually somehow positions the portfolio to deal with the risk that might come from maybe some of these negative if the more bearish outlooks turn out to be the correct ones. So what do we do? I guess the answer is we do what we always do. We start with an analysis of our individuals financial plans, retirement plans, estate plans, what are their goals? What are their financial goals with their current financial position? And what do they need to do to achieve those goals and build a portfolio accordingly?

 

So boring.

 

I know, I know. It's like a broken record.

 

You know what? I'm not going to hold you to it, but just for fun. Why don't we give her own, I don't know, estimate of what the S&P five hundred will do over the next 12 months just for fun. All right. What do you

 

Think? Well, I think if it's not down, then it'll likely be up barring it finishing the year flat as to where it started.

 

I'm going to go out on a limb and say that it's up at the end of the year. Yeah, I'm going to say it's up only from a probability perspective, because as we know, what is it like, 70 percent of the years are up years.

 

So two thirds of the time the market finishes up, yeah, now

 

Up can be very relative. It could be like point zero, one percent or twenty six percent or somewhere in between. I'm not going to go any further than just to say it's up. I'm like Charles Schwab, because that's basically what Charles Schwab said. It's going to be probably a decent year unless it's not.

 

It's good to have that level of commitment.

 

So I will though say with certainty what people should do during the year, regardless of what's happening in the market is rebalance your portfolios so you have no idea, no control over the direction at any time of what the market will do or where it's going. But you can control your exposure to the

 

Market exactly if

 

You've set a tactical asset allocation of some amount in bonds and some amount of stocks. Just make sure you're rebalancing regularly. It'll get rid of all that noise of market timing.

 

Well, that's right. Just to explain it a little bit further, if you have a portfolio that has 50 percent in stocks and 50 percent in bonds, if that's the appropriate portfolio for you and we go through a negative period for stocks, then you will end up owning more bonds on a relative basis. You might end up owning fifty five percent bonds and just forty five percent stocks, and just the rebalancing process helps you to buy low and sell high. You'll be selling your bonds five percent of them, which would have had positive relative performance to stocks because stocks were down and you'll be buying five percent more of stocks which are at lower prices because the market has declined. And so the rebalancing process actually takes a lot of that. As you say, that market timing decision out of the way because you don't need to say, Gee, is this a good time to buy stocks? Maybe they'll go down further. That's not the question. The question is, is my portfolio in balance relative to my strategic asset allocation? And if the answer is no, then your decision is to. Rebalance back to your strategic allocation, not to buy stocks because they're cheap. It just so happens that by doing that, you are buying stocks when they're cheap and that's what everyone tries to do. It takes all of that work out. It takes all of the need for making predictions out of the picture.

 

Excellent advice. Excellent advice. Well, maybe we should wrap it up there, Greg.

 

Sure. This is again our 2022 inaugural episode, and we're looking forward to having lots more things to discuss in our next 50 podcast in 2022.

 

Exactly. All right. Well, next time we'll be talking with something even more interesting, I'm sure.

 

Sounds great.

 

Ok? Till next time,

 

 

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EP.84 - Hits and Misses from 2021 

 

Welcome back to the Free Lunch podcast with Greg and Colin and Greg, this is our last episode of Twenty Twenty One.

 

It is hard to

 

Believe, very hard to believe, and we're going to take our annual, I say, annual because this is the second year that we're going to do it in a row. It's our annual one week break from our podcast and we'll pick it up again mid-January.

 

Sounds good.

 

And it's hard to believe that here we are in twenty twenty one, the end of twenty twenty one going into twenty twenty two. And based on current events, Greg, it kind of feels a lot like twenty twenty all over again.

 

It does. As we're recording here, Omicron is now become the most prevalent strain of the COVID. And yeah, it's deja vu all over again.

 

Yeah. So is it twenty twenty two or is it twenty twenty two as in kind of like twenty twenty?

 

I guess so. Yeah, it could be.

 

I don't know. I'm feeling some COVID fatigue these days. I don't know. How about you?

 

Definitely, definitely. And part of the problem, too, is you get these false starts. Well, it felt like things were starting to open up again and then they get slammed shut, you know, particularly for things like travel, which we're all eager to do.

 

Yeah, it's just been taken off the table. Well, listen, for the second year in a row, we're going to go over various themes from the past year. So we're not going to spend a lot of time talking about COVID per say. But we want to talk about things that are in the news, like there's lots of publications this time of year where people come out with their lists of things to buy for the next year. Right? Different investment themes to focus on. All of the prognosticators come out and give their predictions. And it's kind of like when Punxsutawney Phil pops his head out in Punxsutawney Philadelphia to give his update on whether or not there will be, what is it, six or eight more weeks of winter? Exactly. Yeah, it's kind of kind of that, right? So we're going to look back at twenty twenties predictions for twenty twenty one and see how they made out.

 

Yeah, and there's definitely some hits and some misses. So let's get into it.

 

Ok. The first one I want to look at is based on themes, and there was an article put out at the end of 2020 by Forbes, and it was the top 10 investment themes for twenty twenty one. Which, you know, I guess lots of people would have focused on, right? Yeah. I won't go through all 10, but there was one item there, it said, and I'm going to quote it as effective vaccines and therapeutics are now becoming available. I believe that the overriding macro theme of twenty twenty one will be the reopening of the global economy. Mm hmm. That was right for a while. Absolutely. It was absolutely right. And now it's not. So was it right or was it just right in the moment and now it's wrong or wrong in?

 

Well, you know, when you look at when these these articles came out, probably, I would guess December or so the vaccines had already been developed like so they weren't in broad use yet, but everybody knew that the vaccines were coming. And of course, the assumption was, well, the vaccines are coming. People are going to line up one hundred percent to get their shot and to move on with life. And again, that's one of those things that would have been easy to predict. But the thing that would have been more difficult to predict is what actually happened. Yeah, yeah. You know, so it was very rational expectation.

 

Yep. Ok. So just a couple of points from that article. Point three, I notice I've skipped the first two point three transformational technologies for a transforming society. And I'm going to quote this again. Society will likely continue to communicate, work, shop and educate more remotely than they have ever before. That's true. Yep, right on. Right? Like, that's absolutely happened even in the day and age where if you happen to get quarantined for some reason, most people, I shouldn't say most. A lot of people, if they're working or in school, can still do that stuff online. Now, that's

 

Right.

 

Yeah. So I would say that that that was right. Yeah. Point four was more exponential growth for e-commerce. I would say that's true as well. Right? I mean, look at all of the well, it's almost the downfall of brick and mortar stores these days, right? I mean, most shopping again, I shouldn't use the word most. A lot of shopping is being done through e-commerce.

 

That's right. Right. And I think what we've seen is that, you know, there's certainly pent up demand for people to get out. You know, and I happen to be in one of the large shopping malls in in Calgary a couple of weeks ago, and it was pretty busy in there. So I think there's still probably is room for brick and mortar, you know, and will be for the foreseeable future. But there's no question that e-commerce has grown exponentially and likely will continue to grow. Yeah, yeah, I think they got that one right.

 

Number five was smaller caps positioned to outperform larger caps.

 

Now, when you say a smaller cap, so what are we talking about there?

 

Well, you know what we're talking about? I do, but you want me to explain it? Yes, I do. Smaller companies are poised to outperform larger companies in stock price or stock returns. And this was right until it was wrong. Right. So they were absolutely right that from September of twenty twenty to March of twenty twenty one, the small cap index in the U.S. was up about sixty nine percent. Yeah, but that is a good number. So three times the return of large companies. But since March, they've actually leveled off and aren't returning at the same levels, which actually makes sense if you think about economic cycles or stock market cycles. Right. We are coming out of a bear market in twenty twenty. And it's usually small companies that lead the charge out of those bear markets, right?

 

And particularly after a long period of underperformance, which they had. You know, if you look back prior to, you know, the few years prior to coming out of the COVID recession, if you will, you know, they had underperformed in the larger mega-cap companies had really outperformed, you know, particularly in the technology area, but other large companies as well.

 

Well, you're going to get into some of those in a bit here. Indeed. Okay. Just one more point I want to talk about it was point six international equities return to prominence. So what they were talking about is that, well, international stock markets are going to outperform domestic stock markets, domestic in this case, be in the U.S. because it's a U.S. article, right? Mm hmm. Well, how did they do? Well, the AEFI index, which is Europe, Australasia and the Far East, did grow over the past 12 months, around seven percent give or take. Yeah, right?

 

Which, by the way, over one hundred years of stock market returns, that's probably about average.

 

Yeah, that's right. That's right. The S&P five hundred, the domestic market in this case grew by about twenty four or twenty five percent. So they were right in a way like international equities did return what we would expect them to return. Right.

 

But no more. So let me ask you a question, does that mean we should not be buying international stocks?

 

Are you asking me to give you some specific advice?

 

Greg Moore general advice.

 

Well, are we going to give specific advice? Listen, you need to have international stocks in your portfolio just for diversification purposes. So, Greg, are we recommending international stocks? Yes, we are. Yeah, of course we are. It's kind of like, say, are we recommending bonds? Are we recommending domestic stocks? Of course we

 

Are. And I think it highlights what we've talked about in the last couple of podcasts about risk and expected return. And there's no reason to expect that international markets would do significantly less than U.S. markets or Canadian markets at any point. Our expectation over time is that they will all do well, and but we know that having exposure to those kinds of stocks or geographic locations can be beneficial and can add diversification to a portfolio. And actually, there will be years I would expect where international stocks outperform, for sure. We want to be exposed to those areas rather than being concentrated in one in one area. So just because it underperformed the S&P 500 doesn't mean we shouldn't own that investment because who knows what it'll do next year?

 

Well, and the S&P 500 isn't the whole market exactly right? So that's right. I mean, there is there's some work that's been done that shows that if you have an asset allocation that includes Canadian U.S. international equities along with bonds, you lower your volatility than if you just have all U.S. or all Canada or all international, right?

 

Yeah, exactly.

 

Ok, let's move on.

 

Well, listen, I want to talk a little bit about and you know, and again, this can seem too easy. And what I'm talking about is is looking at the top picks for the upcoming year, top stock picks. But I wanted to make a point here, and the point is that looking at articles about the top picks for 2021 or 2022, whatever, those kind of articles attract a lot of attention. People want to know where should I put my money? And these are smart guys writing these lists, and so we should do what they say. And this one is kind of an interesting one, and this one is published last December 21st of 2021, exactly a year ago

 

Today of 2020

 

Of 2020. That's right. So exactly a year ago as of this recording, and it was by a very popular online publication, you know, catalog publications, I won't give the exact name, but the synonym would be something like raggedy or diverse idiot. Ok, that's the name of the company. But anyway, so before we dove into the article and the author starts by saying this, which is, you know, the disclaimers two caveats. One was choosing the best stocks to buy today depends heavily on your personal financial situation. We couldn't agree more. You can't recommend a stock unless you actually know the individual's personal financial situation. And and that in fact becomes the the very basis for any stock recommendations that were in fact allowed to make. And so you need to read their guide on how to invest in stocks, you know, which outlines some of their ways to manage risk. And then the second point they make leading up to these 21 stock picks for 2021 was to say the list isn't meant to be fully diversified. Instead, they're my highest conviction stocks to outperform in 2021 and beyond. But they acknowledge the best one step way to diversify your holdings is to build the core of your portfolio around something like the Vanguard Total World Stock Index Fund, basically, which is just an exchange traded fund that invests in thousands and thousands of stocks from around the world. Now, where we recommending that particular Vanguard Total World Stock Index Fund, not specifically. In fact, we couldn't recommend anything on this podcast without being able to talk to an individual and know exactly what their situation is.

 

But we would recommend that people have diversified holdings.

 

Exactly, exactly. So, so the interesting thing is the author identifies that if you could only buy one thing, one thing at all, it would be this globally diversified stock index fund. However, let's go to the list of the best 21 stocks to buy for 2021. And so these are some of the stocks they name, and I'm going to mention a bunch.

 

Well, no. Wait, we have to give our own disclaimer here. Are we recommending any of these stocks, Greg?

 

Absolutely not. No, and we don't. As you know, we don't recommend stocks on this podcast. We recommend broad investment strategies, but not individual stocks. And we could never recommend anything without understanding exactly what our clients or what an investor's personal financial situation looks like. Ok, give a risk tolerance their risk capacity. Anyway, let's look at some of the names on this list. Irobot, Upwork Fiber, Redfin, Beyond Meat, Etsy, Teladoc Health. Zillow Group. Pinterest, Roku. Altria Group. Mercadolibre. Intuitive Surgical Square C Ltd., Philip Morris, Salesforce. Walt Disney, Berkshire Hathaway, Bitcoin and Amazon. So first of all, there is kind of a common theme there. Technology figures quite prominently in that list. There's also some surprises. Altria Group, which is the old Philip Morris, you know, the tobacco company. Yeah, funny how that would make it on the list, but it certainly is there. So those are the top twenty one. To perform well in 2021 and beyond. So how did they do well on average, when you look at the returns of all of those on average over the 21 stocks? Negative eight point three percent doesn't seem too good. Doesn't seem too good. The S&P 500, as you mentioned, was about 24 percent over the last year, and even the single one stock to buy if you could buy only one a total world market index up 13 and a half percent.

 

Well, that seems better than down minus eight point three percent.

 

It does seem better. You know,

 

Interesting on that list, though. Two is one item you mentioned. You mentioned bitcoin. Yes. Well, bitcoin is not a stock.

 

Bitcoin is not a stock.

 

So how did it make a top stocks to own list?

 

Well, you know, I guess that's just you don't buy it as a stock. I guess it would be like having gold on the list instead of a gold stock. You might just have gold bullion or something. But the goal here is not to laugh heartily at how some of these picks worked out. The goal is to really understand what's going on here. So the author had it right. You know, this is not a diverse portfolio. It's quite concentrated in U.S. stocks and in technology. And the other common element. Let's pick out a couple of names Pinterest. Ok, so Pinterest did negative. Forty four percent in twenty twenty one. Not too good, but the year before in 2020, it was up three hundred and fifty percent.

 

Well, amazing that it's on the list, then.

 

Exactly, you know, and here's Redfin, which I don't actually know what Redfin does. But they were down forty one percent this past year, but they were up three hundred and twenty five percent the prior year. So another one of the themes in these the seem to be, well, these are stocks that have done really well last year, and the argument will always be and they're poised to continue that excellent performance next year. And I think that's where a lot of these predictions for the next year go wrong. That is just relying heavily on last year's performance. And as you know, with mutual funds are always marketed with a disclaimer that past performance is no guarantee of future results. And the same is true whether you're you're picking stocks or where, whether you're buying a mutual fund,

 

It sounds a lot like a momentum factor they've built in. They're like the stocks that did well in 2020. They just sort of assumed would continue on that momentum.

 

That's right, you know, and some of these names actually had, you know, had a good result.

 

What's what's the top performing one?

 

The top performing. One is Etsy at twenty seven percent,

 

So the top performing pick out of twenty one picks. Yeah, was up.

 

How much? Twenty seven percent, only slightly more than the index as a whole. Yeah, yeah. There's another top performer. Intuitive Surgical was up 28 percent. And here's an interesting one. Berkshire Hathaway up twenty six percent. Now what's Berkshire Hathaway? I would argue it's a diversified portfolio of individual companies, because that's what Berkshire Hathaway owns. So again, I think when you look at this, the authors suggested that the single best thing to do would be to buy a broadly diversified index ETF Global Index ETF with thousands of stocks, and it performed 13 and a half percent. So maybe it would have been better to stop there as opposed to presenting these what I would call shiny objects that look like, Oh man, these things could really, you know, could really fly. You know, we missed out on three hundred and fifty percent last year, but we're not going to miss out this year, and that just highlights the risk of that kind of stock picking.

 

Now listen, anybody that wants to own any of those individual names, you could still do it. You could do it through a core and satellite strategy, right? Yeah. So even to the author's point, you could own that broad based ETF as your core for sure, and still have a few of those names as satellite positions, smaller positions and and

 

You know, and that's something that we often tell our clients is like, there's nothing wrong with having some thematic investments that you just like. You know, lots of people personally like certain themes or have a strong belief in certain themes. And there's nothing wrong with that. Just control the amount of risk that you're exposing your to with those individual stock selections.

 

Yeah, yeah. Right on. Well, let's talk about Warren Buffett for a minute, because you mentioned Berkshire Hathaway, I did. Warren Buffett gives us timeless advice all the time these days about the S&P five hundred. Specifically, he's a staunch supporter of index funds, which actually many people don't know. You know, so what does he say to people that are new to investing, you know, that want to sort of replicate what he's been able to accomplish, as he says, look consistently buy an S&P 500 low cost index fund, keep buying it through thick and thin, and especially through the thin. Well, that doesn't sound like the Warren Buffett of old.

 

Well, that's right, and people hold out. Warren Buffett is one of the great value investors of all time. Following in the footsteps of his teacher, Benjamin Graham, who was the father of value investing and basically. He acknowledges, as Benjamin Graham acknowledged, that you know what, for most people, it's just not realistic to think that they can do that.

 

Yeah, yeah. So a couple of other money managers that are in the news these days. There's a guy named Bill Miller. Remember Bill Miller? I do. He ran the website called the Legg Mason Value Trust Fund in the U.S. Pre Global Credit Crisis. And for 15 years, he beat his performance, beat the S&P 500 for 15 straight years.

 

There was a book about him, the man who beat the S&P.

 

Yeah, yeah. And then in year 16, he was really wrong. And all of the return was given back. And subsequently, a few years after that, he was let go. But he's back in the news again because his his current fund, the Miller Opportunity Trust, is outperforming the S&P five hundred and it's getting lots of recognition for doing that. But what is this, Greg? Is this a resurgence of Bill Miller? Is it just another part of a cycle?

 

Well, you wonder if it's, you know, people don't go from being smart to being stupid to being smart again. They're usually, I would think their intelligence is pretty consistent from year to year. But what does change are market cycles. Sure. And that actually leads into another money manager. You were going to bring up her name is Cathie Wood.

 

Yeah, she's getting a lot of press this last year running the Ark Innovation ETF. A number of these Ark ETFs, Ark and Ark is the flagship ETF. It gets a lot of attention because in 2020 it had stellar returns, right? Like, it was up a lot. It was,

 

You know, like a hundred percent or more.

 

Yeah. And I think it attracted something like nine and a half billion dollars in 2020 flowed into that ETF because of that performance. But this year, not so good. The last 12 months, it's got a negative return of about twenty five percent.

 

Yeah. And here's the problem. And listen, Cathie Wood might be a fantastic investor and portfolio manager, but probably up until 2020, nobody had heard of her. She's been around for years, but nobody had really heard of her in 2020. So what is it that caught people's attention? Well, of course it stellar returns. Yeah, and that's that's usually what happens is you is people notice. Well, wait a second. You know, there's lots of ended. They notice it by doing their own research. No, they usually look, you know, see in the financial press, there's an article or multiple articles about Cathie Wood in her Ark Innovation Fund or her genomics fund or her digital currency fund, or whatever it might be, digital finance. And so as people notice it and then they think, wait, a second is I've missed out on 130 percent return or whatever it was, I'm not going to miss out on that again. That was, you know, I'm getting on board. And sure enough, it did not do as well. And that's not because Cathie Wood became stupid after having been smart in 2020. It's that probably the massive run up in in a lot of the stocks in the portfolio maybe got ahead of themselves. Maybe the prices got ahead of themselves. Maybe people started to take a look at reallocating from from technology names or biotech names into more of the value names that had been sort of overlooked for all those those years. And I think that's the problem is, you know, it's like any mutual fund that you can't buy last year's returns. Yeah, it's just too bad because if you could, I'd be buying this one.

 

Well, I mean, remember in back to the future, too, I think it is. Oh yeah. Biff Tanner, yes. Steals the sports results, magazines. Yeah, and goes back in time and places all the bets and becomes a very wealthy person. Exactly. Be great to be able to do that. Yeah.

 

As soon as somebody builds a time machine, I'm going to be the first one on board.

 

The problem is, I don't think they make Delawareans anymore. Oh, that's right, right? Or if they do, they're not that. I don't know. Well, driven. Exactly. Ok, one more. And last person who's been in the news recently, Harry Dent Harry Dent wrote a book in the early 2000's, like in nineteen ninety nine, I think, or two thousand itself saying the roaring 20s, how the Dow Jones was going to go to was at forty thousand points during the the two thousands. And he was so wrong.

 

Well, and what was the return of think? The S&P 500 from 2000 to 2009 returned negative zero point nine percent a year. Yeah, over 10 years. That's not that's not roaring.

 

Yeah. So he followed that up when he was completely wrong with the Great Depression ahead or something like that, a book, something like that about how things were going to be just awful after 2009 going forward. And again, he was so wrong, Greg.

 

Yes. And the only thing I can tell you is I read an article recently where he is expecting that 2022 will will usher in one of the worst, you know, financial periods of our lifetimes.

 

Well, then I'm a buyer.

 

Well, he is. He's known as the contrarians contrarian, so I don't know if that makes him a non contrarian or

 

If you're a contrarians contrarian. That's two double. That's two negatives exactly the negative times negative as a positive,

 

So he must be an optimist.

 

I think he's an optimist. That's right. Well, there we go.

 

Listen, I want to bring up one thing. There was an interesting theme that occurred last year, and it picks up on the technology theme a little bit. But of course, everybody's heard of Tesla. Tesla, far and away is the most visible electric vehicle company in the world, and based on its market capitalization right now, it's worth somewhere in the neighborhood of a trillion dollars, a trillion big number. That's a big number. Now, there was a new IPO that came out back in November, and a company called Rivian. Rivian is another electric vehicle company. It's been in development for four years and and they're starting to manufacture vehicles. And in fact, in twenty twenty one, by the end of this year, they're expected to have sold 1200 wait vehicles,

 

One thousand two hundred vehicles.

 

That's correct. Ok. Yeah. And I'm assuming that the expectation is 2022 will be dramatically better than that, but certainly in the hundreds of thousands, not more so when Rivian was launched. And Rivian, by the way, had both Ford and Amazon had held positions in Rivian when Rivian went public. The shares surged 29 percent after the IPO, and in fact, it resulted in at the peak Rivian shares being worth $100 billion. Now $100 million starting to not sound like a lot when you're talking about companies like Tesla with a trillion dollar market cap. But $100 billion makes Rivian more valuable than General Motors, which tracks in and about, I don't know, seventy eight or $80 billion of market cap and Ford, which is something in the same in the same general vicinity, $78 billion. So GM, just for comparison, so Rivian is selling 200 vehicles in 2021. Gm sold six point eight million vehicles in 2020. Ford sold four point two million vehicles in 2020. And if just for fun, Volkswagen and Toyota each sold over nine million vehicles. In 2020, Rivian sold zero. So are we seeing that Rivian is not going to be a company the size of GM or Ford? One day, I have no idea. But based on current sales and sales expectations and the fact that all of the large carmakers GM, Ford, Volkswagen and Toyota are all investing heavily in electric vehicles. Where would you predict the majority of cars to be made? I don't know, and I'm not making a prediction, but you do have to ask yourself. The question is, could this company be worth as much as established carmakers like GM, Ford, Volkswagen and Toyota?

 

Well, a hundred billion divided by twelve hundred is something like $83 million per vehicle. All right. Are they selling the vehicles for $83 million each?

 

Well, and listen, lots of money has been made over the decades by investing in new companies and startups. And by the way, it's one of the reasons why small companies over time tend to have outperformed is because all of the large companies of today were small companies once other than Rivian, which became a mega company the day it started trading. But so sure, it's not, you know, there might be great opportunities down the road, but it's hard to argue that that number makes sense, and we'll only know in the future whether it makes sense or not. So are we saying that's a ridiculous number for the value of Rivian? It seems like it today, but it might not be. But only time will tell. But are we recommending people go out and buy Rivian shares calling? No. Could you be more precise?

 

I don't know. Eighty three million dollars per vehicle in sales? No. And we're not, I don't know, being hard on Rivian as its own. It's just, I don't know. It's as we started this episode off by saying like, this is the time of year where you have all of the themes that come out for the next year. Right? And themes tend to repeat themselves, right? Or, you know, they may not exactly repeat themselves, but they certainly rhyme, right. The point is that nobody knows what the top stock will be for twenty twenty two, I don't care which list you, you read about it. Nobody really knows, right? Right. Nobody knows which sector will be the top performing sector. Exactly. People have their ideas, but nobody really knows, right? So what do people do? Go? Let's give our outlook for twenty twenty two. Greg, what should investors do in twenty twenty two?

 

Well, and before we do that, let me just take one minute to say. Despite, you know, kind of our our joking around and it's easy pickings, you know, to look back and say how predictions were wrong. And again, the point is not to pick on anyone in particular, but to pick on the process itself. The whole concept of making predictions about the future because if you look at last year and we want to end this on a positive note before we get into our predictions for 2022, I'd say it was a pretty good year like look at all the good stuff that happened. They did come up with a vaccine or multiple vaccines, which are very effective against COVID. They're developing treatments for COVID that look like they're very promising, which means that as we go forward, even if people do get COVID, the symptoms can be managed and hopefully avoid really negative outcomes. The markets did fantastically well. The Canadian stock market, it looks like it's going to close the year up. I don't know something in the 20 percent ish range, the U.S. market up 25, even international markets, which you know, did not outperform but still pulled in a almost a seven percent return. That's not bad. Diversified portfolios that held both stocks and bonds did pretty well. You know, certainly more than you would expect from just pure diversified portfolios. So it was actually a pretty good year. From an investment standpoint, it was. But what's going to

 

Happen next year? Yeah, what's going to happen? That's all good. But what are we going to do for this next year?

 

Well, if I had to be a betting man, I would say that we expect stocks to outperform bonds. We expect diversified portfolios to to balance risk against expected return and to help investors go through what may turn out to be tough times. We expect that financial planning will be the cornerstone of most people's investment strategies because how can you even pick an investment strategy if you don't know what the goal is? Mm hmm. I don't know. What do you got?

 

I think that's about it. Like, you heard it here first. Our expectations for this next year are that it will probably be good unless it's not right.

 

Well, and listen, anything can happen. You know, we it's impossible to say we expect a bear market to occur, but we have to remain open to the possibility because bear markets come around quite regularly.

 

Right. But the one thing we can be certain of, Greg, is that as long as somebody is doing the proper planning and has that in place, they've positioned themselves for whatever the market might be going forward.

 

For instance, do we believe that anyone can control the return from their portfolios? I don't think so. Can anyone control the risk in their portfolios? Definitely. You control risk in the ways that we've talked about endlessly on this. You can control the amount of diversification you have. You can control your exposure to stocks, bonds, cash, real estate, you know, the major asset classes. And by doing that, you can manage the volatility. You can't eliminate volatility in any way, but you can decide whether you want your portfolio to be more volatile or less volatile, and you can control the costs in your portfolio. Beyond that, it's up to the markets.

 

Well, maybe we should sign off there on that note for the year. Say, happy new year to everyone.

 

Absolutely.

 

 

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EP.83 - Credit Market Quandry or Opportunity FINAL.mp3

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Welcome back to the Free Lunch podcast with Greg and Colin Gregg, here we are for another episode, episode what?

 

Eighty three,

 

Eighty three right on? Last week we started this discussion on investment risk looking at the capital asset pricing model and how risk is priced into a portfolio. I know that's sort of a technical discussion, but it's basically just a combination of what they call the risk free rate and the market premium. And when you sort of put those together in a calculation, it gives you your expected return for a given level of risk. Is that an easy way to describe it? It is.

 

I think everybody fundamentally understands that risk free is what the bank pays you in our terms. Anything over and above that requires taking on more risk. That's right. And risk and return are connected,

 

Connected, related, the rhyme, all that good stuff. And today we're going to talk about risk in a different context. We're going to talk about other forms of it. Because Greg, I got to tell you about an experience I had just the other day. Can I tell you OK? I went to a large Canadian box store. I was purchasing some new winter boots, something I haven't done for quite a while,

 

Actually, given the weather, it's a good plan.

 

Yeah, I was at the store and I found these boots that I wanted, and as I went to pay for them, the salesperson said, Well, if I applied for a new credit card, I would receive an immediate 30 percent discount. Sounds pretty good, right? Sure, I told him, Well, I don't really want a new credit card. After much convincing by the salesperson and their manager, I decided to go ahead with the credit card application to save the 30 percent on these boots with the idea that I would just cancel the credit card as soon as I got home. Of course, now that's not the problem. I decided to go ahead with this application. The problem was that the person that was entering the information for me was actually supplying the information.

 

That's a problem. So we didn't even ask

 

You didn't ask me any questions they put in there that I had worked at my job for five years, that I owned my own home with no mortgage and that I was a manager making ninety thousand dollars a year.

 

Ok, so at least they got the you've worked at your job for five years, part right for at least five years.

 

That's the only thing everything else was made up. They're not answers I gave so that manager or person that was entering the information knew exactly what answers to give to the questions to ensure that my credit card application would be approved. Now this just seems wrong on so many levels, don't you think?

 

Well, yeah, it seems. I don't want to cast aspersions, but because you didn't mention the store, it sounds a little fraudulent.

 

Yeah, I'm not going to mention the store because I don't want to do that, but it does remind me of the great financial crisis or the global credit crisis in that back then you could do these ninja mortgages to remember those.

 

Let's see. No income, no job or assets.

 

That's right. You could get a mortgage on a home without qualifying. And I feel like this is kind of what happened at the store is that there must have been. Now listen, during the days of ninja mortgages and the subprime crisis in the U.S., there was an incentive to the salespeople to ensure that there was mortgages sold. It feels like this was the same experience I had at this store. These incentives have us looking back at what caused the global financial crisis in 2008 to 2010. It actually started more like in 2007, but it's got to get you thinking, are we poised for a similar event in credit markets? Like is credit to easy to obtain? Is the velocity of money too fast based on how easily available credit is? These are questions we have to ask right on. So how do we approach this, Greg?

 

Let's talk about a little bit. First of all, let's just do a refresher on the great. What is it? Is it the great financial crisis? The global financial crisis? We call it the GFC.

 

Well, I think yeah, because it can mean the great, the global, and it can also be the global credit crisis.

 

And I think we called it the Great Recession as well. Whatever we call it, it happened. And as you say, it happened and really affected us in the period of 2007 to 2009. And just as a refresher, that crisis was about home mortgages. If you recall, in the lead up to 2006, home prices were escalating in the U.S. at an incredible rate. And of course, everybody was buying a home or multiple homes or multiple homes. And so there was lots of people financing those homes with mortgages and hundreds of billions of dollars of mortgages were repackaged into securities, which were called collateralized debt obligations, or CDOs. So what's a CDO? Well, when mortgages or mortgage backed securities are pooled together, they create a new security, which is called the CDO, and this collateralized debt obligation was just a way to repackage individual mortgages. And so this new security could then be sold off to other investors. Now, so the CDO now contains possibly hundreds of mortgages. It's divided up into what are called tranches or different levels of risk. And then each tranche is sold to investors, and each of those tranches each carries a different level of risk or a different yield and a different yield or return.

 

So, for example, the risk in mortgages generally is that the borrower will not be able to make the interest and or principal payments, and therefore the borrower will default on that mortgage. In a case of a single mortgage, if the mortgagee defaults, then the provider of the mortgage has to try to get compensated so they sell the property and hopefully the amount that was borrowed is recovered. So there's an expected default rate on mortgages and the way that CDOs are structured. The first defaults will primarily affect the lowest tranche, so like the riskiest layer of this particular CDO. And so there are people at the bottom. They get the highest yield, but also they take the brunt of the first defaults on the group of mortgages. And as you move up the ranks to the top tranche of the CDO, that group would only be affected if a very large and unexpected number or percentage of mortgages in the CDO defaulted,

 

Which would have been lower risk mortgages,

 

Which would have been much well, it would have just been. No, not necessarily. It would have been the way it was structured so that you've got 200 mortgages in a pool now. And so the first five percent of mortgages defaulting would only affect the lowest tranche. Now what happened in the period leading up to the global financial crisis was that most of the mortgages in these CDOs were what were called subprime mortgages. And what that meant was the borrowers did not meet the basic requirements of a typical mortgage lending guidelines. And as you talked about ninjas.

 

So I meant to say, like in Canada, when you go to get a mortgage, there's a qualifying total debt servicing ratio, correct where they look at how much income you have and how much debt and has to be under a certain percentage in order to qualify for the mortgage. So sorry, go on with your ninja mortgage.

 

Exactly. And so as the housing bubble was growing and growing in the U.S., many people that were buying houses not only did they not have appropriate level of debt service, they didn't have income at all or assets as security or jobs for that matter.

 

No income, no asset, no job or asset.

 

Exactly. And so these subprime mortgages are offered to homebuyers who don't and wouldn't normally qualify. And what was happening at the time, if you recall, is just that house prices were going up so quickly that most of these buyers didn't think they'd have to worry about it because they could just wait for a year or two and then sell the property for thousands of dollars more than they paid for it. And then they would come up with equity where they started without equity. Anyway, bottom line is so these are bad, bad mortgages, the high risk of default and those mortgages, particularly given that people would have to come up with money to pay for these mortgages eventually, even if they were subprime mortgages. But what happened is so we're now bundling up subprime mortgages into these CDOs. So what they did, though, is through that miracle of financial engineering. They took these subprime mortgages, which are highly risky, bundled them up into CDOs and actually created the top tranches of those. Cdos got a or AAA credit ratings, so the ratings agencies would go through and say, well, OK, because most of the defaults or the initial defaults are going to affect the lowest tranches of these CDOs, then the highest tranches would actually get high credit ratings, despite the fact that the entire pool of mortgages backing those CDOs were subprime and highly risky.

 

So we know what happened in 20 08 and 2009. The housing bubble that created this massive demand for mortgages burst. Millions of homeowners were upside down on their mortgages, and all that means that they owed more on the mortgages than their houses were actually worth. And so massive defaults, a huge number of mortgages went bad, and investors in the mortgage backed CDOs were wiped out at essentially all levels, not just the lowest tranches, but even at the highest tranches. So important learning. So let's fast forward to today. The CDO market is still alive and kicking, but what's backing those CDOs is a little bit different, and today it's a little bit more of boats close, which are collateralized loan obligations. So the structures are much the same as CDOs, except the securities in the close are actually leveraged loans as opposed to mortgages and leveraged loans are typically loans that are issued to less than creditworthy companies. So instead of pools of risky mortgages, close hold pools of risky debt issued by companies that would be rated well below investment grade. So from a credit worthiness standpoint, and it's not a small thing. In fact, right now, it's estimated that the current size of the CLO market is in excess of a trillion dollars, making it larger than the market for CDOs was leading up to the global financial crisis.

 

Now, is that a red flag?

 

To me, that's a red flag. No, I'm not too intimately connected to the CLO market, but you have. You believe that in times of relatively cheap money that we're in now, there's been a massive issuance of debt to corporations or by corporations, and if things went bad, it's the kind of thing that if everything goes well and interest rates stay relatively low and companies remain profitable or become profitable, that could be a good thing. But what you always have to worry about is what could go wrong. And I think that's where the risk lies.

 

So these CDOs and close you're talking about are asset backed securities, right? Collateralized, meaning there's collateral behind them. But any asset backed security is a type of financial investment that is collateralized by all kinds of different pools. Usually, they're generating cash flow from debt, which you just talked about, such as loans, leases, credit card balances or even receivables. Like there have been some asset backed securities issued on royalties, for example, of a company. They take the form of a bond or note paying income out of fixed rate for a set amount of time until maturity. So that's all well and good like that sounds very much like a normal bond gets issued with a term to maturity, and it has a specific interest rate that it's issued with. So income oriented investors, I mean, they like asset backed securities as an alternative to other debt instruments like you mentioned corporate bonds or bond funds. But the problem, Greg, is that the underlying assets of an asset backed security are quite often illiquid and they're hard to sell on their own. Exactly. So pooling these assets together and creating this financial instrument is what they call securitization, which simply allows the issuer to make these illiquid assets marketable to investors you take. It's very similar to what you talked about with collateralized debt obligations and mortgages. I mean, to sell a mortgage is that's a fairly illiquid instrument on its own. But to sell a pool of mortgages just makes it easier for somebody to want to own. So it gets these shakier assets off the books and possibly alleviates credit risk to the issuer, actually. So the underlying assets of these pools, as I mentioned, can be all kinds of things. They can be home equity loans, automobile loans, credit card receivables, even student loans. There's even been things like cash flow from movie revenues, royalty payments, aircraft landing slots. Wow. Toll roads, I mean, anything that's cash producing can actually be securitized into an asset backed security.

 

It's interesting and back in the day, and I say that because I'm talking about the early 2000s in those days when interest rates were actually reasonable, we would often have available for our clients what they call commercial paper. Commercial paper is just short term notes issued by companies, and typically they would mature within a year, and we had all sorts of commercial paper that were essentially asset backed securities of collateralized credit card receivables, and those were very popular because they paid a better rate than Canadian Treasury bills.

 

Well, look at my experience at the store. I got talked into a 20 percent interest credit card and I didn't have to qualify for it.

 

Exactly. And of course, what the credit card issuers love are not people like you and I who try to pay off our credit card bills every month. But the people that don't pay the bills every month and are subject to those 20 percent interest charges

 

And then somebody baskets up all of those credit card receivables and sells them off as a bond. Exactly taking that illiquid security and making it liquid. So exactly these investment vehicles came under tremendous scrutiny during that global credit crisis, global financial crisis, Great Recession, whatever you want to call it. And a lot of them were issued backed by things like, as you mentioned, U.S. mortgages, with the idea being that when people are in times of dire straits, the last thing they stop paying is their mortgage. And I think that's why they got such high credit ratings individually. But remember, these are illiquid in nature. I don't know. You have to ask our asset backed securities still around? Can I ask you that you can? Do you know the answer?

 

The answer is a big yes.

 

Yeah, of course. There's been like three hundred billion dollars in asset backed securities sold to the marketplace in the last less than 12 months. So in a world with very low yields and I would argue constant greed, there's many people that are looking at other types of investments to try to get higher yield. And as you mentioned earlier, I mean, higher yield equals higher risk, but investors are limited to what they can do to achieve these higher yields. I mean, you can adjust your asset allocation, maybe hold more equities with higher dividends than bond rates. You could look at alternatives to traditional low risk bonds, such like these asset backed securities or collateralized. I have a hard time saying collateralized, by the way, it's doesn't really roll off the tongue. No, but they do offer higher yields, but we have to remind ourselves that they come with higher risk. So I know some of the largest fixed income money managers in the world have been focusing some efforts on something that kind of maybe rhymes with subprime mortgages, and they're called re performing loans. You heard of these?

 

No. I haven't heard of Re performing live in Scotland, so well, what the heck are they?

 

Well, interesting that you asked that, Greg. Let me answer that question. A re performing loan is a mortgage that has basically become delinquent because the borrower stopped making their payments and they hadn't paid for 90 days. So they've missed three months of mortgage payments, but it's called performing again or re performing because at some point the borrower resumed making those mortgage payments. Ok, so these re performing loans are just like any other asset backed security. They just get sold off as a basket of sort of bond like investments. So Fannie Mae, which is the Federal National Mortgage Association in the U.S., this is an organization that helps make mortgages and rental housing affordable to millions of Americans. They've been carrying billions of dollars worth of delinquent mortgages since the housing crisis of 2007 to 2009. So what they're able to do is they can get these mortgages off their books by packaging up these re performing loans again, mortgages that people just have started paying again and they sell them now. Is this another red flag? I got to ask,

 

And it certainly could be, and so much of it is dependent on what's going on in the economy at the time. Right now, the economy seems to be doing well, but that may not last forever.

 

Yeah, I mean, this sounds really familiar. Maybe the big difference between what is happening with packaging mortgages or securitizing them today versus back in 2006 is what you talked about is maybe there's only one tranche and I'm just guessing. But in the lead up to the global credit crisis, we saw these mortgages packaged up, which was probably fine. But what ended up happening is synthetic pools of the same mortgages were created over and over again, so people were buying things that actually weren't the basket of mortgages. They were just like a financial derivative or something that just mimicked exactly kind of mortgages. Right?

 

Yeah, exactly. And so you had how many securities out there based on essentially one pool of mortgages, it was more than one.

 

You know, it reminds me of today is I know we're not supposed to really talk about cryptocurrencies and things like that, but NFTs, I don't know anything about NFT. Is Greg. Are you familiar with this term?

 

Well, I just know there are non-fungible tokens and essentially it's a digital asset, kind of like a piece of art is an asset. Well, you can get a piece of digital art, which would be exactly the same thing. Only you own it and you pay for it, and it becomes marketable that if there's a buyer for it somewhere down the road, you could sell it at more than you paid for it, theoretically.

 

But how do you really know that you're the only one that owns an intangible asset that is only digitally created?

 

Exactly. And what is the true value of something like that? It's only the true value is only what somebody is willing to pay for it.

 

I liken that to maybe those synthetic pools of these mortgages. Now, Greg, I got to ask you, are we recommending NFTs to anybody?

 

I'm not recommending it, to be honest. I don't know enough about it. For all I know, it could be worth a way more in the future or way less in the future. I would consider that a highly speculative investment, and we typically don't recommend those kinds of investments.

 

I actually think buying a bond issued by the government of Venezuela is highly speculative. I think NFTs are like highly speculative on steroids.

 

There you go. Yeah, exactly.

 

So what about the US housing market? How is it doing right now, Greg?

 

It becomes the question again and that the housing market has been on fire in the U.S. and is the housing market overheated? That's a fair question that lots of people are asking Are we in a housing bubble? If we are? Will that bubble burst and what are the consequences of that going to be? We're seeing housing data hitting levels that we haven't seen since back in 2006, which was the peak of the last housing bubble. And we're seeing it at least three different ways. So begging the question Is this another bubble like 2006? And a lot of experts say that it isn't that it's just economics. So if you look in the U.S., I mean, nationwide, home prices grew about 12 percent year over year, which is their fastest pace since 2006. That's based on the S&P CoreLogic Case-Shiller index, which again has been around tracking housing prices for years. So gains were broad based, and in all 20 cities tracked by the index, they experienced price growth above their respective median levels. So whatever the average has been, they're certainly far exceeded that. And also for the first time since 2005, the median sale price for previously owned single family homes is higher than that for new construction. Now, that's interesting. The premium Americans typically pay to be the first to live in a new house has been completely erased as home buyers have rushed to buy any home on the market.

 

I never get that why there's this premium to buy a brand new home, like I get it like you're the first person that gets to live in it. But new homes come with all kinds of things like you need to build a fence and plant grass and all that stuff. Oh, sure.

 

The expectation is, however, that a new home would be or could be more. More expensive because of course, it's being built today at current prices. Certainly, what happened with lumber prices post-pandemic increased the costs of a new host dramatically.

 

What are we post-pandemic?

 

Well, both post post initial pandemic.

 

I thought we were into pandemic

 

Exactly intra intra pandemic anyway. But it is interesting that people will pay more for resale homes than they will for new homes. And just as an aside, we're actually seeing that in the used car market right now. In many cases, the price of used cars, if you can believe it is exceeding the price of new cars, it's crazy the models. And that is crazy. But that's what happens when demand goes the way it has been going. So you look at the differences, though, to the mid 2000s. Back in 2006, dubious lending and market euphoria kind of powered that surge. Today's boom is almost entirely due to just a nationwide supply shortage. So if you look at the monthly supply of homes sitting near record lows of about three months, which isn't a lot if you're a buyer and you're out there shopping. And so that leads sellers to demand increasingly large sums for their properties. If you look back to 2009 post the bursting of the housing bubble, there was more than 12 months of supply available. And so you've got that issue going on. You've also got today's market, which is backed by more strong underwriting processes that we talked about a little bit early and is not engulfed in kind of like the subprime mortgage business that we went through. So you look at the price growth that we're going through, and that's pretty solidly rooted in basic economics. So you've got record low mortgage rates and heightened focus on space coming out of the pandemic. So that sent buyer demand through the roof. And you've got a pullback from prospective sellers and a lack of new builds and the increased cost of new builds, as we talked about. So you've got a decline in the homes available for sale. So that's just Econ 101 supply and demand curves. There's less supply and constant demand. Or I'd argue, even rising demand prices have to go up. That's basically what's happening globally in all kinds of goods. It's not housing only, it's just called inflation.

 

It's right. I mean, if the supply shrinks and the demand at a minimum stays constant, the price goes up periodically. So let's finish this episode off with what can you do about it? We've talked about these sort of red flags of the credit market, collateralized debt or collateralized loans, the size of the mortgage market in the U.S., specifically a potential housing bubble. Don't really know, but prices have gone up quite a bit. What can people do? But well, I guess our listeners are going to get kind of sick of hearing these punch lines, but they remain constant. What are they

 

Regardless of what's happening in the collateralized loan obligation market? It really doesn't affect us on a day to day basis. What affects us on a day to day basis is our own future. So we start with a financial plan. Figure out what you want to accomplish financially in your life and use that plan as a guidepost for whatever we do going forward from that. Yeah, I think we want to build an asset allocation based on the plan that tells you essentially how much risk you need to take on to achieve your goals. And we always acknowledge, as we've talked in the past, there is risk, there's risk in investing and risk is two sided. There's risk, good risk, which is that OK, that our expected returns will deviate positively from what we expect and we'll actually get better returns. And there's downside risk that OK, and we could go through periods where returns are not what we expect. They're lower than what we expect. And so we know that we have to take on some risk. We just need to take on the risk that we need and not more than that in order to achieve those goals.

 

And you need to diversify your holdings to reduce that risk. Because as we all know, having a lot of one thing brings more risk than having a little in many things.

 

That's right. If someone said to me, Well, how concerned should I be and what changes should I make to my portfolio? Because I'm worried that U.S. banks are going to have a lot of defaults on their hands or they're holding too many close in their portfolio? Well, the answer is we can't really do much about that. And if there's something simmering under the surface that's about to blow up, it's hard to predict and it's hard to know. However, by diversifying our holdings, we can make sure that, well, we all protect it against something unexpected on the downside and that will come out of it on the other side, as we have in the past. I think the other thing, too, is just avoiding complex structured investments where you don't actually understand how those things are structured. And you and I both know a lot of the collateralized debt obligations that we experienced during the Great Financial Crisis were based around things called credit default swaps.

 

Oh, let's not talk about those. I don't even

 

Want to go into that. But suffice it to say that credit default swaps. In a collateralized debt obligation became very complex, engineered investment products, and for most investors and probably half the advisors out there or more. They couldn't really understand how they were structured. And if you can't explain it to a person in your own words, then you probably shouldn't own it. So stick with things that you understand. Most people understand stocks, bonds, real estate, cash. And if you have good diversification among those asset classes, you probably have everything you need.

 

Yeah, whether it's in an exchange traded fund or mutual fund or individual holdings, those all can be easy to understand. But yeah, when you start talking about credit default swaps, which is just a form of insurance against default in a collateralized debt obligations securitized by a basket of synthetic loans that don't actually

 

Exist and divide it up into tranches, which which you don't even know what a tranche is.

 

Yeah, yeah. So we're getting off topic. So we said, sir, with a financial plan. Yes, build your asset allocation, diversify your holdings, keep your fees and expenses reasonable. Understanding that there will always be some fees and expenses, but keep them reasonable

 

And your tax bill because certainly taxes are just less money in your pocket and more in the government's pocket.

 

And lastly, Greg, what is it?

 

Rest and digest. Just enjoy life, and don't worry too much about things that you have no control over. We always tell people control what you can and the stuff you can't control. Let it happen and be positioned to enjoy the ride.

 

Yeah. Like, I have no control over when my daughter will talk to me anymore.

 

Well, exactly,

 

But that's the joy of being a parent. I should write an asset backed security based off of royalty payments from when my daughter will speak to me. That's right. Securitize it and sell it. Exactly. I think I'm on to something here. Ok. I guess that does it for today. Hey, Greg.

 

It does. Yeah, no. I think we've covered that topic and look forward to moving on to the next topic next week.

 

Excellent. All right. Till next time. Until next

 

 

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EP.82 - Basic Revisited - Risk and Volatiity 

 

Welcome back to the Free Lunch podcast with Greg Kraminsky and Colin Andrews, Greg, here we are for episode 82. Nice. Yes. And in episode 81 last week's episode, we had Michelle Houston join us to talk about having a money mindset. It's an interesting discussion. It was, but it got us talking about risk as in her talk. She talked about the risk that business owners face and, I don't know, growing revenues or growing their business, things like that. But in our world, we view risk as investment risk, right?

 

That's right.

 

Yeah. And it's something that we talk about all the time with people like, what's a question that we get all the time from people? Greg, how risky is it? Yeah. What's the market going to do? Yeah, right. Like, what's the market going to do in the next six to 12 months? Yeah. And the answer, unfortunately, is like, who the heck knows, right?

 

That's right.

 

Right. So when we talk about risk, Investopedia defines risk is and I'm just going to read it. Risk is defined in financial terms as the chance that an outcome or investment's actual gains will differ from an expected outcome or return, and it includes the possibility of losing some or all of an original investment.

 

That sort of goes to a couple of different points, you know, because sometimes, as they say, initially, the risk that you don't get the outcome that you were expecting. So when you think about that, you know, a lot of times people will say, OK, well, what is the stock market done over the last hundred years? And let's say the average return over the last hundred years has been eight percent a year. So that sort of becomes the expected return. Well, we expect things to be roughly in line with what they historically have been over long, long periods of time. And so some people will say, OK, well, what if you get four percent? Well, that's a risk because you're expecting eight, you got four. It's also if you get 12 percent, that's actually the other side of risk. That's a positive risk, which is one that we all delight in, but it's just the opposite side of not getting the expected rate of return. So that's one thing. But then the other thing which they point out is, well, what about the risk of losing everything, like losing all of your investment? And we've talked about that on previous episodes, and we'll talk about that again today because that's the kind of thing that you can actually control. You can control the risk of losing everything, and we'll talk about that. But you can't really control the risk of getting a zero percent rate of return on the market or a negative 10 on the market, that kind of thing.

 

Well, and they talk about that is systematic versus unsystematic or idiosyncratic risk.

 

That's right.

 

So systematic risk being the risk of just being invested in the market where your expected return might be something like eight percent, but your real return is going to be whatever the market returns.

 

That's right.

 

But the idiosyncratic risk, or I think it's called idiosyncratic right,

 

Is it's called a number of things specific risk, company risk, idiosyncratic risk. And I think it just means the same thing. It's not systematic risk, right? It's risk that's outside of that, you know, market risk as a whole.

 

But for our listeners, so like you can think of like systematic risk is just being invested right in the market, right and idiosyncratic risk is, I don't know, stock picking, right?

 

That's right. Yeah. Or being in one sector which is doing poorly while the rest of the market is doing extremely well. Yeah, or vice versa.

 

Right. So it's an interesting discussion because, you know, you talk about expected return. We expect the expected return to be this based on past historical data. But the reality is the real return will be whatever it is, right? That's right. So how does it relate to investors risk its perceived risk? It's this perception versus real risk, and what you talked about is the perceptible risk. And is that a word perceptible? Sure. Go for it. It is today is that it's something that we're forecasting and there's a number of academic models out there. One very famous one, the capital asset pricing model, which we've talked about in the past, and I know you're very familiar with, right? Somewhat so just that it takes what we just talked about. If you want to figure out the return of a portfolio or the expected return of a portfolio, the capital asset pricing model says that the expected return of a portfolio equals the risk free rate, plus the beta times the market risk premium.

 

Say what

 

I know. Let's talk about that in English for a second. So it means whatever return I'm expecting from my portfolio is made up of a couple of of two functions how much I've got invested in the risk free rate, which is like U.S. Treasury bills, right? Known as the risk free rate, plus the sensitivity, the price sensitivity of my expected return of the market. So what you pointed out that eight percent rate minus the risk free rate times some form of sensitivity. So. When I say sensitivity, the market's beta, the market sensitivity is calculated as one, right? So think of it this way. If we expect the market to return eight percent and you just, I don't know, multiply that by one, it's eight percent, right?

 

That's right. So beta essentially is the market, the overall volatility of the market that we all experience every day, as measured by an index of some kind or a benchmark of some kind.

 

That's right. But the beta of our portfolio isn't going to be one. It's going to be different than one. It's going to be based on how much we have in, I don't know, stocks and bonds and whatever, right? Like our location kind of thing will determine that. So. So I call this the brake and gas pedal portfolio that you know you've got basically only two pedals, you've got the brake, which is the risk free rate, right? And the gas pedal, which is just the what you expect to return from the market. And in that scenario, if you talk about it as risk, well, what's your risk? You're either all on the gas pedal, all on the brake pedal or some combination thereof, right? Yeah. So I don't know where I'm going with this.

 

Well, it's kind of a simple way to think about asset allocation and how that affects your performance and the volatility of your portfolio. Right. Because if you think about it, beta of the market includes the whole market. And so the market is made up of all of the stocks and individual stocks and sectors that comprise it. So in Canada, for example, we have a relatively heavy weighting towards financials and commodities, let's say. But the beta of the Canadian stock market reflects all of those put together. Now, certain portfolios may overweight certain types of securities within their portfolios. So, for example, energy stocks, for example, are typically more volatile than the market as a whole. And so if your portfolio is overweight it towards energy stocks, you're going to expect some extra volatility.

 

We want to be rewarded for that exactly extra risk.

 

That's right. Right. And so it may have a higher expected return.

 

And what has it done in the last few years?

 

Well, it's certainly done well this year, but not so much last year, right? And that's the volatility we're talking about.

 

But that goes back to that expected return versus real return, right? Like people that invested in energy stocks predominantly wanted to be rewarded for that exposure, right? Yep. And they just weren't.

 

Not last year, for example. Yeah, for sure. Absolutely, for sure. And so that's the thing. So but again, you know, when you're talking market volatility or beta or alpha, which we haven't talked about yet, but these are all things that probably don't really matter to the individual investor. They matter, but they matter, you know, sort of under the hood. And to the average investor, it's like, Well, yeah, but what does that mean? What's the risk? I'm going to lose my money because I think in investor terms, they probably don't worry so much about, well, what's my deviation from the expected return this year? They care more about what is my expected return, and let's hope that it's positive and not negative, you know? And so there's a lot of different kind of risks that we experience in investing, and there's some risk that we experience by not investing when we dove in and talk about some of the different types of risks that we all experience. You know, this kind of reminds me, do you ever do you ever go on the World Wide Web? Yes. Yes, you do. Yeah, you know the internet? Yeah, the

 

Interweb. Yeah.

 

And there's always a lot of these lists, you know, so they'll be like a headline, say, you know, 10 ways to improve your heart health and then they'll go through 10 different things that you should do. And I feel like we're into one of those modes right now because we're talking about different types of risks. So let's dove in slide one and slide one, I think you've already talked about, but it's a little bit more than that. So we're going to talk about market risk. So we've already talked about, well, what's market risk? We talk about systematic risk. That's just the risk of being in the market. But there's also a couple of other market risks that don't specifically relate to how stocks as a group perform. And one of those is interest rate risk. So interest rates are something that affect all markets, stock markets, bond markets, that kind of thing. And it's just the rate. Well, if interest rates change, that can have an effect on the market as a whole or on some individual stocks or sectors within the market, right? So interest rates going up can be beneficial for some types of companies. Banks, possibly they'll earn more on their loan portfolios because of higher interest rates that they're charging their borrowers. But it might not be that good for certain sectors like real estate, for example, or utilities, where they're not as able to quickly react to changes in interest rates to improve their profitability. Because, of course, real estate companies are heavily indebted, and as as mortgages are being renewed, they're being renewed at higher, higher rates.

 

But that interest rate movement, that's part of the monetary. Policy of the central bank rate. So if they're raising interest rates, well, actually there's two different types of interest rates we should talk about. There's the nominal rate and the real rate rate. So the nominal rate is that that rate that the Bank of Canada lends to the banks and they lend out that money to consumers or whatever. But the real rate is actually set by the market, right?

 

Yeah, I mean, sure. And I guess the way to think about it is nominal rates are whatever the posted rates are. So it may also include, you know, what's the nominal rate on a gig today? Well, it might be anywhere from one and a quarter percent to two percent, you know, depending on whether you're buying a one year or five year gig. So that's just the posted rate on the gig. But the real rate is, well, what's the nominal rate? But what's inflation, you know? So the real rate is, well, gee, if I'm getting, you know, one in a quarter percent on a gig and inflation is running at four percent, five, five percent, five percent, you know, I'm down three point seventy five percent,

 

But you haven't lost any money.

 

That's right. That's absolutely right. And that's where we, you know, maybe we should talk about inflation because inflation risk is one of those risks. That's a risk of not being invested. And so if your money is sitting in under the mattress buried in the backyard or or in an account that doesn't pay any interest, then you're actually getting a zero percent return on your money. But what about inflation? You know, so. And inflation is one of those things. It's it's kind of subtle. You maybe don't notice it day after day. But if you think about just, you know, for the last number of years or maybe even decades, inflation has been quite low, maybe two percent, let's call it. So if you think about it, two percent inflation doesn't seem like a lot. But if your expenses today are $100000 a year, two percent inflation for 10 years means that in 10 years, to get the same goods and services that cost $100000 today, you would need one hundred and twenty two thousand dollars. Ten years from now,

 

You just figure that out on top of your head. You calculate that in advance.

 

I did calculate that in advance and looking out 20 years, it's going to cost one hundred and forty nine thousand dollars to get the same thing that you're getting today for $100000. And so it is kind of insidious the way it sneaks up on you. Now here's the thing. Lately, inflation has been running a lot hotter four to five percent, let's say. So remember I said at two percent inflation 10 years from now, $100000 of services and goods would cost one hundred and twenty two thousand at four percent, it'll cost one hundred and forty eight thousand. So the difference in ten years, it's now costing you forty eight percent more to get what you can get today. And in twenty years, that actually is two hundred and nineteen thousand. So inflation has a very big impact on your purchasing power of your dollars. And so so the risk of inflation means that money that's sitting and not earning anything is actually declining in value by whatever the rate of inflation is two or four percent a year.

 

So Greg, are we recommending that people maybe invest that money instead of just, I don't know, earning a negative real return?

 

We absolutely, I would say, recommend that people have some money invested in the markets. The big question is going to be how much? And so that's, you know, a discussion for advisors and their clients. But certainly having all of your money sitting, not earning anything is it's losing.

 

Well, Ali spends a lot of time talking about inflation in the last few months because it's been so present in the headlines. But what are some other risks that we should be talking about today?

 

Well, let's talk about liquidity risk and what liquidity risk is. What's the risk? It's the risk of being unable to sell your investments at a fair price, you know. And so for instance, when we're talking about broad market investments, if you're buying an index or a mutual fund or something, those investments are very liquid. You can get in and get out quite easily. But there are certain investments that aren't quite so easy to sell, and those would include things like certain what we call exempt market investments. So those are investments that you have to buy outside of the market, whether by private placement or offering memorandum, things like that, something that most people will have more exposure to would be things like real estate. You know, real estate itself is it's a marketable investment. There is certainly a demand for real estate. You know, if you want to sell your house, there's probably a buyer out there, but not particularly liquid, meaning that if you needed to sell your house today and you felt your house was worth $600000, there may not be a buyer today at that price.

 

But even if you had a buyer at that price, even just the transaction turnaround time because like, like you said, if you sell a stock, the transaction time is two days,

 

Two days settlement.

 

That's a good settlement. If you sell your house today, you're not getting your money in two days. No, right, there's going to be barriers.

 

That's right. And there's lots of other types of. Investments that are just not as liquid and so the risk of being in something illiquid increases your chance of a loss if you needed to sell something very quickly. So what's another one? Well, this is something we've talked about over and over again in these podcasts, and that's concentration risk. So that's the risk of having too much of your money invested in something, whether it's an individual stock or a particular sector of the markets, and that exposes you to what you talked about earlier, idiosyncratic or or non systematic risk. So the market could be moving along just fine, as it did back in 2020. But if you were overly concentrated, let's say, in energy stocks or if you're overly concentrated in transportation or leisure and hospitality stocks, you would not have been doing as well as the market as a whole.

 

But the flip side of that is if you are overly concentrated in tech stocks in 20 20, you probably had a pretty rockin return.

 

That's right. And again, that gets to the two sides of of risk is there's upside risk and there's downside risk and and tech stocks in 2020 certainly outperformed the expected return, while energy and travel and hospitality stocks underperformed. And so that's that just the risk of being not well enough diversified.

 

Well, we've used this example many times. They get rich versus lose everything portfolio that comes from concentration risk. Exactly like you can actually get rich if you have a concentrated portfolio of just a few names and they do well, right? That's right, you absolutely can. The problem is the odds aren't in your favor.

 

You have to get lucky, and that's the hard part to predict.

 

Well, on the flip side of that is you can lose everything. That's why it's called a get rich versus lose everything portfolio. Right, exactly. So if you invested in some names that aren't around anymore and you put all of your wealth into them, it's gone.

 

That's right. And that's why for most of us, humans. Diversified portfolio that eliminates some of those risks. It limits your upside, but it limits your downside. And most of us react more negatively to to losing money than we do react positively to earning or gaining money. So. Wait a minute.

 

Are you recommending that people diversify their risks?

 

Yes, I am, Colin.

 

Yeah, OK. I just want to keep track of this, for sure.

 

All right. So what else? You know, the markets aren't only stock markets, of course. As everyone knows, we also invest in bonds. Most balanced portfolios have exposure to bonds, and bonds have some unique risk relative to stocks. And and the key one is credit risk. And the credit risk is strictly the risk that the issuer of a particular bond either won't be able to pay the interest on that bond when it's due or won't be able to repay the principal when the bond matures.

 

You're talking about Evergrande in China right now.

 

That's right. Yeah, well, I'm not talking about them specifically, but they're a good example.

 

Are we recommending evergreen bonds? No, we're not. Of course not.

 

But credit risk is obviously in and bond portfolio managers, of course, spend a great deal of their time evaluating credit risk. And so when they include bonds in a portfolio, they're including bonds where they believe that the issuer has a very strong likelihood of paying the interest in the principal.

 

Now, if the issuer may be is suspect on their ability to repay the interest and principal, then the interest that they'll pay you must be a lot higher than the interest on something less risky.

 

That's right. Yeah, and that gets into cost of capital, an issue where that has higher risk profile. Lower credit rating is going to have to offer a higher interest in order to attract a buyer for their particular bonds. You know, and the interesting thing is, well, how do you mitigate credit risk? Well, you made a great credit risk by holding lots of bonds if you have a portfolio of a thousand bonds. The risk of default of the overall portfolio was a whole lot less than the risk of default of a single issuer.

 

We already recommended diversification. Now we're talking about diversifying your bonds, too. Exactly right. Yeah. Ok. Just keep a track. Ok.

 

Well, and while we're talking about bonds, although this relates to stocks as well, another risk that people maybe don't think about every day is reinvestment risk. So what is reinvestment risk? Well, the reinvestment risk is the risk of a loss from reinvesting principal or interest at a lower rate than the original. So let's work this through. Let's say you buy a bond that in the good old days would have a five percent coupon rate, meaning that you would get five percent interest on your bond. Well, you know, here we are 10 years later, and a 10 year bond today is yielding only one point six percent, let's say. So now you've got a bond that you've, you know, you've been earning five percent for the last 10 years, and now the next 10 years is going to be one point six percent. So that's a loss relative to the original investment. So that is something that happens in a period of declining interest rates where all the cash flows from your bond, the interest payments you get every year or the maturity. Principle is going to get reinvested at a lower rate. Now the other side of that, of course, and we've talked about risk, you know, there's negative and positive risk reinvestment risk at times like we're in today is actually positive. It's a benefit to your portfolio because with interest rates rising, all of the cash flows that we get from bonds, whether it's from their interest payments or the maturities can now be reinvested at a higher rate than we're currently earning.

 

So and it's within reason rate, like the U.S. 10 year Treasury has moved up from one point one percent six months ago to, I think it's just under one point five percent.

 

That's right.

 

That's right. But to your point, one point five is higher than one point one.

 

It is. And so that benefits the portfolio. So that's that's a positive risk in today's environment. Right on what else? How about horizon risk? You know, you don't hear about that a lot, but what is horizon risk? Well, you know, everybody has an investment horizon. So when we sit down and we talk to people and and do our financial planning, it's like, Well, when are you going to need this money? You know, if we're doing retirement planning, for example, and it's like, Well, I plan to retire in 10 years. Well, things can happen that can shorten that investment horizon because of unforeseen events. So, you know, for example, there could be health issues. You might, you know, lose a job and all of a sudden a divorce, for sure. All of a sudden, that 10 year time horizon is gone and the time horizon is now tomorrow. So there's certainly a risk because if you're in a balanced or stock weighted portfolio and you've just come through a volatile time and the markets are down 20 percent, which can certainly happen, the timing may not be great for liquidating assets.

 

No, that's a good point, actually. Maybe we should talk about sequential risk as an offshoot of that, for sure. Right. So tell us what sequential risk is Greg?

 

Well, sequential risk is just the risk of the timing of returns when you're withdrawing funds from a portfolio. So what do we mean by that? Well, listen, you could have a whole range of returns in a portfolio where you're not pulling any money out. So this is just investments that are there for 10 years. You could get 20 percent, you know, return in year one and negative 20 in year two and 15 in year three and minus eight and your four doesn't matter. And if you got exactly the same returns in another portfolio, but in a different order where you got negative returns in the first year and positive returns in the second year and so on doesn't matter. The end value of the portfolio is the same in either scenario.

 

So the order, if you don't take

 

Money out, if you don't take money out, so the order of returns has no impact on the final value of a portfolio. Assuming you get the same returns every year, but not in the same order. Order doesn't matter when you're taking money from a portfolio, so let's say you've built a portfolio and now you've retired and you're pulling out five percent of your portfolio every year for cash flow to live on, then the order of returns makes a big difference.

 

So this is like somebody who retired in two thousand eight. Yes, right at the beginning of the global credit crisis, as we know, the stock market went down 50 or so percent between two thousand eight and two thousand nine, correct? If you were forced to withdraw from your portfolio and you had one hundred percent stock portfolio and it was down 50 percent, then you've lost years of future income.

 

That's right. That's right. You can never make it back. And so once you start withdrawing funds, the hope, of course, is that your positive returns will be early in the in the period and the negative returns will happen later. Because if the opposite happens, if the negative returns, as you point out back in 2008 or let's say, early 2020, then that can have a devastating impact on how quickly the portfolio declines with the five percent withdrawals. And so sequential risk very important when you're withdrawing funds and it speaks to, you know, a lot of people over the years have said, Oh, well, of course you want your portfolio to be less volatile, you know, as you get older once you retire. And people sort of, I think intuitively think that, but not exactly understanding why that is. And one of the reasons why that is is just because of the sequential risk and the risk of getting, you know, returns in the wrong order.

 

And what tool can investors use to offset sequential risk?

 

Well, I would think proper asset allocation and proper planning with your advisor.

 

Yeah. So again, Greg, I hate to say it, but are we recommending that people review their asset allocation?

 

Yes, I believe we are. Yeah, like

 

All the

 

Time, the strongest possible

 

Terms. Yeah. And I think where people kind of lose it, not lose it, but lose track of it as well is that I think in general, people understand, you know, you need to be diversified. You need to focus on an asset allocation based on a plan, that sort of stuff. But there's a critical part missing there, and that's the rebalancing piece. Mm hmm. So when you go through a period like two thousand eight, where the market's down 50 percent, whether your bonds weren't. Down 50 percent,

 

Right, they were positive, yeah,

 

So if your bonds went up, I don't know, just give it a No. 10 percent in value, although I think it was more like 20 percent then during that period, if you sold that amount of bonds that were up 10 percent and bought equities that were down 50 percent, you have sequential risk working for you.

 

And it's also the power of rebalancing is in the rebalancing process, forcing you to sell high and buy low, which everybody wants to do. Everybody's goal is to buy low and sell high, and rebalancing does that for you without you having to make predictions about whether now's a good time or a bad time to buy

 

An emotionally is hard to do on your own. I would argue, right? So you have to have a pretty structured. Now we did a little example here. We said the order of returns example, so we took a million dollars. We just put it into a four year period. The first series of payments, not payments, but returns was plus 20 minus 20 plus 20 minus 20, right? And then we just did the inverse. So a million dollars in the first year was minus 20, then plus 20 minus 20 plus 20, right? So in year two, how do you think the portfolios were as far as dollar amounts? Similar different year to plus 20 minus 20.

 

Obviously, the minus 20 is going to be a little bit worse.

 

Oh no, no, you're too, though you're too. So they've both gone minus 20 or plus 20, minus 20 or plus 20.

 

This should be the same.

 

Yeah, that's right. It's equal, right? But year three, there's a massive gap. Sure, there is. Right. So the first portfolio in your three was worth one point one five two million. That's the one that went plus 20 minus 20 plus. Sure. Right. The second portfolio that went minus 20 plus 20 minus 20 was seven hundred and sixty eight thousand. It's a pretty significant difference.

 

It's a big difference. And I think if what you want to do is look at that in either scenario and imagine, OK, well, let's say on top of that, you were pulling money out of the portfolio at the rate of five percent. That's just going to have an even stronger impact on the overall value of the portfolio at that time.

 

Now let's hope that this person was lucky and didn't have to pull any money out in year three from the down portfolio. That's right. In your for what happened. What happened to the numbers?

 

The portfolios will be exactly the same.

 

The same again, right? So yeah, so that's the point of it is, like you said, it's not the order of returns like that will just equal over time, but it's well, do you have to start taking money out?

 

Exactly. You know, and so it gets back to, you know, really the importance of planning in the whole piece. And when you talk about, well, the need to revisit your asset allocation. Absolutely. There's a need to revisit that. The you know, the change from working to retiring is an incredibly significant change that obviously will have been preplanned. You know, from the standpoint of financial planning and retirement planning. But then at that moment, and probably somewhat in advance, there's a need to revisit the investment plan as well and make sure that the investment plan accounts for the higher risk to the portfolio because of things like sequential risk and and inflation.

 

So are you recommending people do planning? Yes, I am. Yeah, that's a strong recommendation.

 

Yeah, exactly. So yeah, so I think that's when we look at some of these risks and and listen, you know, we could sit here and we haven't listed every risk. And I kind of think about it, you know, when you see ads for pharmaceutical products on the television and let's say they're the products are, you know, the drugs are designed to treat a skin condition, for example, and then they go through the list of possible side effects.

 

Yeah, they scare the crap out of me,

 

You know, and there are way more side effects than there are, you know, the initial disease issue that the drug is trying to solve. You sort of feel that way when you go through all of these risks, you know, you identify what could go wrong. But I think the thing we have to keep in mind is that not all risks are unmanageable. There are risks that we can control. And so the idea is not to scare people away from investing in stocks and bonds because as we talked about, you can't leave your money sitting in cash because then inflation risk, it's going to slowly eat away the value of your investments or the value of your money, as opposed to some of these other market risks, which may be a little bit more dramatic, but over the long run have been shown to be mitigated. Sure, by time, you know. And so I think the key idea here is not to be scared off by the risks, but to understand them to control the risks that we can control and then to accept the risks that we can't like market risk and make sure that the portfolios that we build, you know, reflect those risks and account for them all. So I guess we're talking about asset allocation again.

 

Well, maybe we should wrap it up there. What do you

 

Think? Absolutely.

 

You know, just to summarize, because we've given a number of specific recommendations during this episode, Greg. Very specific. Absolutely. Let me summarize them, please, do we recommend that you be invested? Correct, yes. We recommend that you be diversified. Absolutely. We recommend that you focus on your asset allocation, right? And we recommend that you do financial planning. I think you've nailed it. Those are bold recommendations, they are. They are. All right. Well, I guess that's it.

 

Yeah, I think it's worthwhile, particularly at times like this when there's lots of news in the markets and lots of volatility, you know, every time the market goes up six or eight hundred points, everyone asks, OK, should we have bought, you know, why didn't we buy yesterday and what's going to happen tomorrow? And if it goes down 600 points, the same discussion on the other side. So as more volatility comes into the markets, we have to revisit discussions of risk and make sure that we understand what's happening. And do we need to make changes based on that volatility right on?

 

Well said.

 

Well, in that case, let's leave it at that and we'll be back next week. Yep.

 

Until next time.

 

 

 

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.

EP.81 - Melissa Houston 

 

Welcome back to the Free Lunch podcast with Greg Kraminsky and Colin Andrews and Greg, here we are. Episode eighty one.

 

Oh, and it's hard to believe, but awesome.

 

And last week we sort of wrapped up our estate planning mini series where we had Jonathan Ing from Underwood Gill home. Join us to talk about all things estate planning. But we are committed to having him back to discuss things like trusts, and I think you mentioned something in the last episode trusts, blended families, things like that. That's right. And that'll happen probably in the new year. So for today, we're going to go in a different direction with our discussion and we're pleased to have join us. A financial strategist for CEOs, a columnist at Forbes.com and the host of another podcast, Greg, called the Business Society podcast. I'm sure that's a good one, too, but free lunch is probably better. But who did it? But Melissa Houston is joining us. Melissa is a chartered professional accountant who helps successful business owners increase their profit margins without having to increase revenue. That's an interesting concept. We'll get into that. But she has over 20 years of business experience with all kinds of corporations, government, not for profit businesses. Melissa, we're very pleased to welcome you to the Free Lunch podcast today.

 

Thank you so much for having me. I'm very excited to be here today.

 

Well, that's great. And first of all, just can you tell our listeners where you're joining us from today, Melissa?

 

Absolutely. Fellow Canadian, I'm joining you from Ottawa, Canada, capital of Canada.

 

Well, the capital out east. I'm just joking. It's good to have a Canadian on the show. We've had a number of Americans recently and it's nice we can speak the same language.

 

That's right. And no, I'm kidding. No, I was really excited when I saw that this was a Canadian podcast because I too deal mostly with Americans. And it's so fun to talk with fellow Canadians because we're doing so many fantastic things up in Canada as well.

 

Well, that's great. And so why don't we kick off Melissa with just how did you get where you are today? So tell us your story.

 

Absolutely. So it's a little bit of a convoluted story. My first career was in social work. I had been working in social work for about five to six years, but I felt it was a very high burnout career path. And talking with my dad, it was like I didn't know what to do. I remember my Grade 10 business teacher telling me, Oh, I think you're good at business. And my dad was like, Well, accounting is a very respectable profession. So I ended up registering for business, and I eventually ended up majoring in accounting and got designated. I'm very analytical, but in my career path, I really noticed what I was doing was it felt very much like introverted work. And even though I'm an introvert, I have an extrovert, a part of me, which is part of the social work side of me where I really wanted to help people. And I noticed when I was working in public accounting, when we were helping small and medium sized business owners understand their books like they would come in, they would get their books assessed and their tax returns completed. And we would sit down and we would give them really good, valuable feedback on what was going on in their business. And I could see the disconnect right there where it was like, they don't understand what we're telling them. So I really wanted to go out on my own and start exploring that and really helping business owners and filling that gap of that lack of education where we hear so much in the personal finance space about managing our personal finances. But I also wanted to talk to them about managing their business finances and how they can create so much more profit in their business when they understand their business numbers

 

With a background in social work and just to share a little bit. My wife is a social worker. My parents are both social workers. Oh wow. Sister in law is a social worker. Ok, that's familiar with that space. And what I've found, and it sounds like you found, is that in our role as portfolio managers, investment advisors, we actually tend to do a lot of counseling. So you're just talking about how in the accounting world you end up using maybe some of your social work skills in counseling business owners, is that right?

 

Absolutely. And actually, that is something that I really put at the forefront because money is such an emotional topic for so many people. We all have money stories, and I really tried to talk about the emotion behind it and how their mindsets are affected by the emotion that they're feeling and how they could inadvertently be holding themselves back in business because there's such a negative relationship with that money. So that's definitely one of the first things that I talk about with my clients is developing that healthy relationship to money.

 

What is that? So what do you mean by a healthy relationship with money and how do you help people do that?

 

Everybody has their own money stories. I've never met two people with the same story. And quite often just for example, I was working with a business owner not too long ago who felt like it was really a negative thing to want to. More money in their business, then what they needed to live because they had been told that rich people or wealthy people were not nice people, so this is the conditioning that they had in their childhood, but they didn't realize they were carrying it so strongly until we started talking about it. And they were like, That's right. I totally to deserve to have a piece of the pie and getting over those mindsets that are holding them back in business. Or there's other people who I've worked with who have a real fear of selling, not themselves, but their products, their offers. And it becomes a very personal thing and it becomes very guilt ridden, asking people for money for their services and reframing those kind of thoughts to ensure that they're not holding themselves back in their business. And a positive money mindset is definitely somebody who can see money for what it is, and money is really a tool that we use for exchange of goods and services. And when you have a positive relationship with money, you can get into that growth cycle and understand that having a lot of money is not necessarily a bad thing. There's a lot of good things you can do when you're creating wealth for yourself, so you can either choose to share it with your family, friends or keep it for yourself. Build a not for profit like whatever it is that motivates you.

 

Interesting. I want to ask you a little bit about something that it might sound personal, but because you put it on your website, I figure it's fair game to talk about and

 

I have a feeling I know what's coming.

 

You talk

 

About your own personal experience where somehow you accidentally found yourself deeper in debt than you would have liked and

 

Huge debt.

 

Talk about how does that happen? Because I'm sure it happens to many, many people. And probably that gives you a lot of personal experience to assist you with your money coaching. So tell us a little bit about that.

 

I love that you ask this because I love sharing the story, and the reason I share it is for people to understand that your mistakes don't define you. Me, being a CPA in the industry for over 20 years, I managed to accumulate over a hundred thousand worth of debt and this was consumer debt and I had hid a lot of it from my husband. He's more debt averse than I am, and I knew what I was doing was wrong at the time. But I kept doing it and it was like this habit that was feeding my ego and making me feel better because I was accumulating these material things and I just kept going and going knowing that I was running out of credit. I was eventually going to get caught with this, and I was lying to my husband, and no matter what I was buying, I still wasn't feeling better. It may have given me a little bit of a boost for 24 hours or even 30 seconds, like whatever it was. But I realized whatever it was that I was chasing just wasn't coming from this material stuff. So when everything hit the fan, so to speak, I got caught in my lies and I had to come clean. First of all, facing the disappointment of my husband was very, very jarring to me. But I also was like, How did this happen to me? Like, I knew better and I still allowed myself to do it. And I went on this journey of self-reflection and what I really realized, and it didn't come to me overnight.

 

It was peeling back the layers, peeling back the layers because I knew on the surface I was very happy. But as the layers were peeled back, I also realized that I wasn't being true to who I really wanted to be. So I was at the stage where my kids were older. They didn't need me as much. It was more time for myself and it was really time for me to go out on my own and leave my job that I wasn't happy with and really try something that I always wanted to try like I really, always wanted to be an entrepreneur. And that just helped me realize that when we aren't being true to ourselves, how much trouble we can get ourselves into, like even the best of us by the best of us. When I say that, I mean, because I'm so money oriented and specialize in money management and stuff, I still was brought down the path of mistakes and errors. And like I said, I share this story so that people know that our mistakes don't define us. And I've had a lot of finance professionals come out to me and say, You know what? I really appreciate you sharing that story because the same thing happened to me and I felt like such a failure. But it's not who we are. It's just a blip in time as far as I'm concerned.

 

So you're talking about being a finance professional running into trouble personally in your finances? Isn't that kind of like the plumber with the leaky pipes or the chef who doesn't cook? Or you know what I mean? Like, it's the

 

Electrician who won't change a light bulb? Yeah, yeah.

 

I find it easier in our seat to tell people what to do, what to do with their money, how to invest it, how to save it, et cetera. It's probably harder for me to look at myself and to follow those same principles because I'm not objective

 

And it can be hard, especially when you're pulling out a. Motions, we're all human and we all see what our neighbors have, what our siblings have, friends, whatever. And I don't know about you, but yeah, I want the finer things in life, but I also know that I need to be able to afford them. So it's that constant struggle, like it's a personal struggle within yourself in the day of being in debt and the access to credit. It's so easy you're constantly fighting your inner wants versus choosing the right thing to do.

 

Yeah, like that purchase. Is it really going to bring happiness? In other words,

 

Exactly like, you know, it's going to put a dent in your savings or what have you? I mean, depending on the level of the purchase. But sometimes common sense has to come in there, and those can be hard decisions to make sometimes.

 

Sorry, Greg, I don't want to cut you off, but I do have one thing I just want to share. So, Melissa, I bought a sports car a year or two ago. I thought this would bring me happiness because it was a car that I've wanted my whole life. Guess what? I sold it because it didn't bring me any form of happiness. It was just another thing to look after. I hated it.

 

That was exactly what I was going to bring up. Oh, so you think a lot of know it's excellent. I think a lot of studies of happiness and what makes people happy have identified that people kind of have their normalized level of happiness and that things like buying a new sports car can temporarily bring you some joy. And then you basically, after a while, revert back to your normal level of happiness. And some people, maybe generally speaking, are happier than others. But that's kind of you when things like that, for the most part, don't change.

 

That purchase brought me about 30 minutes of joy.

 

I can relate. I have a swimming pool that brought me about the same amount of joy. I can't return it.

 

What else should we ask Melissa here?

 

Greg, there's one thing you talk about something you call resetting your debt mindset. Why wealth is possible for anyone. Maybe you can explain that a little.

 

Absolutely. I mean, it's so common when we go back to talking about money stories. So for people who have grown up in an environment where debt was always around and they're taught to feel that it's normal, that they'll always be in debt, and then they continued that pattern into their own adult years. It's never too late to change that, even if you weren't raised like that, but you ended up in a pattern of debt. It's not too late to change what's going on, and resetting your mindset is really doing that self-reflective work that looking deep inside you and trying to figure out what the triggers are to be getting yourself into debt like that. And once you understand what the triggers are and how you can change that and understand, create a debt repayment plan for yourself and get out of debt, then you can start building your wealth. And being on the other side of debt is just so much more freeing than constantly living with the stress and the weight of carrying that debt.

 

I guess for entrepreneurs and business owners who you deal with a lot where attitudes toward debt must be a little bit different on the entrepreneurial side because obviously debt could play an important role in financing or capitalizing a business.

 

Yeah, absolutely not. All debt is created equal, but debt is debt, no matter how you look at it. And what I talk about with my clients is, yes, there are investments that you can make now where you're financing these investments. And if there's going to be a return on that investment, then it would absolutely be worth it. But so often entrepreneurs, especially online entrepreneurs, I'm noticing they get into this cycle of having to put themselves into debt for the next shiny object that's going to pull them out of maybe slump sales or not making enough money with their offers, and they're putting themselves into debt by grabbing on to things that really aren't working. So what I really tried to talk about with debt is that good debt versus bad debt. It's such a confusing topic for so many people because so many people think, OK, well, it's for business, so it's OK to be in debt. But that's not the case because when you're overleveraged, you're still putting your business at risk.

 

As we talk about business owners in our line of work, we see so much wealth created by business owners. So many individuals think, Oh, playing the stock market, for example, in quotations is the way to achieve wealth. And we all know that for the most part, the stock market is absolutely a great way to invest and to grow wealth, hopefully slowly but positively over time, whereas the ability of business owners to create wealth is seemingly unlimited. And so can you maybe just talk about that? Like, why do business owners have that unique ability to build wealth in a way that the rest of us mortals can't?

 

I love this question because I love talking to business owners specifically about this. You definitely are in a unique position to build your own wealth, especially when you own your business a hundred. That you have the ability to structure your business in the way that either you are making millions of dollars or if you're comfortable at just one hundred thousand dollars, whatever makes you comfortable. You have the ability to create that because it's your business and understanding what your financial goals are and mapping those financial goals out within your business so that you are increasing your net worth through your business is absolutely magical. And I love to show business owners how they can do this. And a lot of clients that I work with, like I've mentioned earlier, they're facing those money mindset restrictions because they're limiting themselves with their beliefs of the ability to make money within their business. So I love it when business owners own the fact that they can create as much wealth as they want through their business.

 

I'm sure you've run into this. There are many entrepreneurs out there who were fantastic at generating great business ideas and starting and creating businesses, but managing the businesses. Maybe not so much. How do entrepreneurs bridge that gap between sort of the creative side of starting a business and a successful business? And then the I won't call it mundane, but the more sort of detail oriented side of managing the business, both from a personal and a financial standpoint?

 

Absolutely. And this is the struggle that I see with so many entrepreneurs. They're so good at what they're offering. They're really good at bringing in money. They could be making millions of dollars. And in fact, I interviewed a gentleman not too long ago who had been making millions of dollars, and he lost it all because he was not managing his money well within his business. And that's the thing a lot of business owners feel overwhelmed by, like you said, the less shiny, mundane tasks of running your business. And I really tried to bring it the excitement of that because who doesn't get excited when they start realizing how much money they're making for themselves? So quite often, business owners are associating their success with their revenue numbers. Do explain to them that it's not the revenue numbers that are going to generate a really good business. It's your profit line. Not enough people talk about the profit that they're keeping. The profit is all your revenue coming in less, all your expenses going out. And if you're positive, you're making a profit if you're negative. That's a red flag. Your business is in trouble. You need to keep your business profitable, and profit is when you own 100 percent of your business. That is what you get to keep after you've paid your taxes. So as your profit increases in your business, so does your net worth. And the sad thing is, eighty two percent of businesses fail due to financial mismanagement. So you can be making all the money that you want. But if you're not managing your finances within your business, you're still putting yourself at risk for losing that business. So understanding how your financials work really help drive the business. More than anything,

 

You're in Ottawa, you mentioned. Have you shared these findings with our current government?

 

No, no. Would they listen?

 

I'm just joking, but I do have some of these here. So what we run into is we do deal with a number of business owners or we have over the years. And I find sometimes the expectations are out of line of meet with somebody and they'll say, Well, I'm not looking for much. I just want twenty or twenty five percent rate of return per year. And we start talking about how well the S&P five hundred has an eight percent per year for 80 years. So to get 20 percent per year. You're talking about taking on a lot of risk. And the comments are often about, well, that's what I'm getting out of my business. So maybe I should just invest back in my business rather than divest my investments. So this is what you're talking about. Yeah, you could put it back into your business and hopefully grow it by twenty or twenty five percent. But what if it doesn't? What if something happens to the business and all of your money is tied up in that business?

 

And as you're speaking in, the first thing that comes to mind is diversification. It's always the safer bet to diversify where your money is invested. And I mean, you know, as well as I do have diversification works,

 

I hope so. We've got a lot of credentials behind the names to say that we do. But we do talk about how there is no free lunch in investing, except for three things there are three free lunches. Number one, asset allocation. Number two, diversification. And Number three of this podcast.

 

So it's awesome

 

Just to build on Collins point. We have heard a lot of times from business owners. I want my money to work as hard for me as I did when I was building my business, and it is kind of a mindset change because of course, entrepreneurs, they sort of put it all on the line at many times. They bet the farm on their idea, and hopefully it turns out to be a good one, and they realized that they could lose it all. And yet when they move from that point to taking the profits, their hard earned profits and investing them, they're not quite as eager to withstand that kind of volatility that they were willing to take in their own businesses. And so I think part of our challenge is to convince people that the risk they took paid off and now they get to benefit by now, reducing the risk overall and searching for a lower but more stable, passive, so boring. I know, I know. I hope there's no entrepreneurs listening to this.

 

But no, you're absolutely right. You're probably saying things that people don't want to hear, but you're absolutely right.

 

I think the key thing for us with our clients is to understand the risks and the expected returns and to invest accordingly.

 

Well, it's like if you're dealing with business owners, maybe you dealt with the last business owner to open up a blockbuster franchise. That's I mean, that probably didn't work out very well.

 

So that's right. Well, I just want to get back for a second. You were talking about the importance of focusing on profit and not revenue. And for me, that's always been kind of the exciting thing is to imagine that well, without having to necessarily bring in more revenue, you can actually find ways to increase your profits. We always talk about with people, it's the money you take to the bank that matters. Profit margins. Yeah, they're important, but they don't matter. It's the dollars that matter, and it's a tricky thing to get across. But how do you help businesses improve profits without necessarily improving revenues?

 

So often I get business owners coming to me, and they haven't even looked at their financial statements when, years or ever. So the first and most basic place you can go is just looking at those expense items and seeing how many expenses are going into creating that revenue and where you can cut. So often I see business owners carrying things like subscriptions or spending too much on advertising that's not giving them a really good return or just so many things that can happen in a business. And if you just look at your expenses and you plug up your money leaks right there, you don't even have to increase your revenue or your sales levels because you're tightening up your expenses and keeping more money for yourself.

 

And that applies on a personal level as well. I'm sure for all of our listeners speaking for myself, so I won't cast aspersions on anyone other than me. But when I sit down and look at my monthly bills, the automatic charges to the credit cards for subscriptions like Netflix, Disney, Prime Video, BritBox

 

Was BritBox,

 

Britbox. Basically, it's a streaming service of mainly British television shows.

 

We wouldn't have that one in

 

Our house, which are excellent, by the way, but I just discovered I'll admit this live on the podcast. I actually accidentally have two Amazon Prime subscriptions. So, oops. So that it just shows it's not till you sit down and you add it up. You see what an impact that has on your monthly expenses. You have

 

A great scene about creeping incrementalism,

 

Creeping incrementalism. That's right. Every little edition of eight, ninety nine or ten point ninety nine a month doesn't seem like a lot. Yes, in itself, but you have a couple dozen of those and starts to add up.

 

Exactly. It's so true.

 

So, Melissa, what's the best advice you could give to our listeners in regards to what you do and what you think people should do

 

For business owners? It's always know your numbers and create that financial plan. If you're a business owner, twenty twenty two is coming up. If you don't have a 12 month strategy plan, you need to create one. I always say to business owners, a goal without a plan is just a wish. So if you have these goals of increasing your revenue, growing your business, whatever it is for 2022, you need to map that out month by month for the next 12 months. And that gives you a roadmap to creating those profit levels that you're looking for in your business as well and monitoring those month over month over month. Honestly, my key advice to business owners is create that plan because it gives direction for your business and it gives you actionable steps to take.

 

Excellent. And it certainly mirrors what we recommend to our individual clients for their personal financial future.

 

Even the quote you shared with the same quote I know Blair on our team has used quite often in financial planning discussions about a goal, so the plan is just a wish. So I've heard that before, but that's very good advice, very good advice. Craig, what else do we got

 

That sort of covers off what we wanted to talk about today? We appreciate your experience and your insights, and we never let anybody off the hook without a little speed round at the end here. So these are softballs, so you don't have to worry too much about catching them. So I guess the first question is what do you do for fun when you're not working,

 

Being Canadian and well, being specifically in Ontario too? Because I'm not sure if you guys don't think in Calgary, you guys really have cottage as much a

 

Nothing like Ontario. No. Yeah.

 

Yeah, so. We're definitely up in Cottage Country, go there by the lake. Have fun if it's the winter, well, right now it's kind of cold. Go up there or light a fire, relax, go for a walk. Stuff like that. In the summer, we're on the boat. Water skiing tubing. All that fun stuff with the kids and just enjoying the outdoors.

 

It sounds idyllic. We do have cottage country. We just have to drive about nine hours. Well, three hours in Colin's case. Nine hours, yeah. In my case, to get to it. So this cottage country, it's just not close. It's called British Columbia. Exactly. Yeah.

 

And we don't call them cottages. We call them cabins.

 

I know my cousin there is always calling it the cabin.

 

Yeah, I actually like to call them cabbages. So it's just the combination of the cabin cottage. Yeah. So tell me, Melissa, are you a reader? What do you read in these days?

 

Wow, what am I reading these days? I am reading like everything, and I just actually picked up a book. It's called She Talks. I ordered it from this woman out in P.E.I., who's speaking about how women need to claim their spots in the business world and create that wealth. So I just started that book, and so far it's been really, really great. I wish I could remember the author's name right now, but it's called she talks excellent.

 

Well, that obviously ties in very closely with your main objective of helping women entrepreneurs more specifically.

 

And because she's Canadian too, I took a special interest. I'm not going to lie.

 

There you go now because I brought up the thorny subject of subscription fees. Are you a binge watcher? And if so, what are you watching these days?

 

I'm really on this Canadian theme. I'm binge watching over and over again. Schitt's Creek. Oh, I just love that show. It makes me feel like I'm home. Like, it's just so comfortable and it's funny. And I love that character, David, and I just listen to it over and over again.

 

That's good. I got something for you. You mentioned that you are an introvert by nature, but you saw this desire to be extroverted in some part of your life. I've recently come across a definition of this. Did you know that? No, I didn't know that. It's called an ambivalent Oh, and I came across it because I actually think I'm the same thing. You're always defined as either being an introvert or an extrovert and nothing in between, which is just not the case. Like, there's lots of introverts that are extroverted socially and there's lots of extroverts that need some downtime. So there you go.

 

Ok, that's good to know. Lesson learned. Yes, I will always credit you for that, too. It's time I repeat it.

 

And Beaver and beaver. You'll never say that to anyone without having to explain what you're talking about.

 

I love it. Do we let her off the hook, Greg?

 

I think so. That was great, Melissa. We really appreciate you joining the podcast today, and I think that's valuable information for individuals and business owners. So thank you for that.

 

So much for having me.

 

Where can people find you if they're looking for more advice or want to pursue what you do a little further?

 

You can find me at Melissa Houston and the fractional CFO agency.

 

The fractional CFO agency. Yeah. Got it.

 

Perfect. Thank you so much.

 

Thank you, Melissa. It's been a pleasure and good luck with business. Thank you. Sounds like you might make it.

 

Thank you.

 

Thanks again. All right.

 

Till next time. Bye now.

 

 

 

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.

EP.80 - Will and Estate Plannin Next Steps FINAL.mp3

 

Welcome back to the Free Lunch podcast with Greg Kraminsky and Colin Andrews and Greg, we made a mistake last week. We did. Yep, we said last week was episode 80. It was an episode 80. It was episode 79. Oh, today is episode 80 perfect? That's a big mistake. We're numbers people. We should make no mistakes like that,

 

But it happens.

 

I guess it happened. That's right. So last week we had Jonathan Ng join us to talk about estate planning. What are we talking about today, Greg?

 

Well, we're going to continue on that discussion. So why don't we pick it up, Jonathan? Thanks again for being with us and where we left off last time as we were talking about selection of an executor for the estate. And you had mentioned two critical things of importance in the qualities of a good executor. The one was, you said, be humble and the idea there was be willing to ask for advice if needed, take advice and assume that maybe you don't know everything. And there are some experts that could maybe help you out with the process. And the second thing you mentioned was it's helpful if the executor is well organized because there's a lot of organization required and pulling together everything that's needed to fulfill the role of the executor. So let's pick up from there. What are some of the other considerations in selecting an executor?

 

Sure thing. Thanks again, Greg. Thanks again, Cole, for having me back.

 

Oh, actually, before you get going, I should mention, and this week we have Jonathan Ng joining us again from Underwood Gill home. Jonathan, over to you.

 

Thank you. So on qualities on being a good executor, another one I would put in. I like to call this the diplomat. This quality is applied often in the context of people who are writing a will and they have adult children. And the common question is which of my children do I choose? Do I choose all of them? And that's a whole rabbit hole we can talk about a little bit later? Or if the thought process is along the lines of which one do I choose? I think a lot of clients will kind of get caught up in this idea of what is that child's day job? What do they do? Are they a lawyer or are they a banker? Or are they an accountant? Do they work in finance? Do they have traits that would lend themselves to be an executor? Maybe a real estate agent even? And yes, yes, yes, yes. And yes, those are great traits. But here's a trait that you may not have expected or a title rather. And it is the diplomat who among these adult children is the diplomat among them. This adult child as executor is accountable to his or her siblings, who would presumably be the beneficiaries of the estate there in the hot seat.

 

They are accountable to them. They have to provide a reporting of what they're doing and act in a relatively expedient period of time. So a person who is the diplomat among the family has the trust of their siblings is huge. And again, it doesn't always have to be an adult child. It could be a friend of the family. But again, have you seen them in a role of diplomacy? Convince yourself that they would be in a good position there, maybe digging in a little bit deeper and more practically speaking with respect to qualities of a good executor? Ask ourselves, does this person have the bandwidth in their life to do a good job? What is their career look like? What is their family life look like? Where do they live geographically? Are they close to where this estate is going to be all going down and ask ourselves? And I encourage clients to engage that person directly and talk a little bit about what it would mean for them to take a pause on certain things in their life or squeeze this burden of being an executor into their life and see if it works.

 

And you mentioned geographically, Jonathan, so what are some of the issues? A lot of people might name their sibling a brother or a sister who lives in a different part of the country to be their executor? What complications does that create?

 

Well, first and foremost is logistics. We live in a digital age here. We're sitting in three different places recording this podcast. A lot of work can be done remotely, but there's a lot of work that is very local in nature and is very boots on the ground in nature. So we have to ask ourselves, is this person in a position to, for example, make their way to Calgary on a periodic basis to deal with the sale of real estate to engage a realtor? I'll take it further while the house is on sale. Why the house might be vacant if the deceased left a home? Are they in a position to personally see to or hire the services of someone to inspect that house every couple of days because vacant property needs to be properly insured until the sale? So an executor who lives in Sudbury, Ontario, could do all those things with respect to a house here in Calgary. But we have to ask ourselves, what is the convenience factor there? I like to put it this way. Are we setting them up for success by giving them this estate? That's sort of the soft side, if they can call it that.

 

The hard side about having an out of province executor in particular, is the idea that or the notion that an executor needs to post an insurance bond if they need to apply for a grant of probate. We might be talking more about probate later, but if they have to go through this probate process and out of province, executors commonly asked to post a bond that is an expensive B estate, not a whole huge inconvenience, but certainly a cost to the deceased's assets and one step that the executive has to go through. I will let listeners know that bonds in my experience. Are very rare because it is possible for that requirement of a bond to be waived if the beneficiaries agree. That's what we see quite commonly. But again, even going through that process, canvasing all the beneficiaries. Getting their consent to waive the bond is again a couple of week dance that we have to go through if we have an out-of-province executor that adds delay.

 

One of the other things I've run across Jonathan, and maybe it speaks to a little bit about the need to revisit the will on a regular basis. But in many cases, I've run into situations where somebody has named their best friend as executor and then they pass away at age 80 and their best friend is also age 80 and not exactly in a position at that point to perform the duties of executor. So talk a little bit about how important it is to revisit that executor decision on a regular basis

 

When you hit the nail on the head right there. Greg, that's probably the classic scenario. We're looking at a will where our executor is aging might be sick, even passed away. So when it comes to making decisions today, try to avoid those scenarios. The first one is to name an alternate executor. I know that seems like simple advice, but it's not forgotten. I'll give everyone an example of sharing here. My primary executor named is my wife failing my wife. It's my father in law who's rounding around 70. But he's the right guy for the job for us. Knock on wood. He's in good health. Retired engineer love spreadsheets. He's got all those traits and a diplomat, I'll say about him as well. But we might not be lucky enough, blessed enough to have his health at all times. So we have an alternate executor named. So if at the time of our passing, he has passed as well and the alternatives kicked in, or listeners should know that an executor is not obligated to act if this falls on Jim's lap through a series of catastrophes and he's not in a position to act. He can renounce. He can give up the job before he even starts, thereby opening the door to our alternate executor to act. And in our case, we would consider naming, for example, someone that may be in our generation or a trust company, the corporate executor that's always there. The corporate executor will not die. They will see to the administration of this estate, and I'll do it professionally.

 

I have to tell you a quick family story. Then Jonathan, my mom came to me one day and said, I've named you my executor because you're the oldest in the family, the oldest child in the family. And she looked at it like it was this great honor that she had bestowed upon me. And I've been around enough families that have unfortunately been impacted negatively by who was the executor and what beneficiary is expected from them that I said, that's great. Just so, you know, when the time comes, I'm going to just take it to a corporate executor and hand it off. I'm not taking on that liability. So that's what you're saying is that you just have some flexibility to name somebody that potentially isn't, I don't know, emotionally involved in that estate. That benefit? Absolutely.

 

It's a huge benefit. We talk about naming family first or trust company and making it seem discreet in that sense. Absolutely not. There are other people in our lives, friends, extended family members who might fill this role, and that kind of touches back on the other factors of personal traits. Diplomacy, like maybe a family friend, is the right person who can bring everyone together after your passing, and they might have the bandwidth. They might have the relationship with the adult children and the skill set. One other piece and this is if you want to get real fancy with your will, is possible to give your executor the authority to nominate an executor, you can effectively pass the buck. You can say, OK, this is who I'm going to choose. I'm going to choose SoFi. But if she's not interested in acting, she has the authority to choose an executor to act in her place, whether it be, for example, a trust company that she fully gives the job to. She steps away. She abdicates the crown, so to speak. Maybe she gives it to another individual. It's not common, but that's an option that we do explore from time to time.

 

You brought it up, Jonathan, so let's explore a little bit. You talked about one of the roles of the executor is to apply for probate. So I'm wondering if you can just describe what exactly is probate? What's the process? What does it cost and what does it accomplish?

 

I'll mention first to your listeners across Canada. The terms are different from province, the province and state to state. But probate is a common terminology, a different province of different names. The idea here is a will, and this is a story that I've told to you guys before, I think, and I amplify it with a lot of hand motions and I use props, but unfortunately I can't do that, so I'll do my best to this. But so if you can imagine everyone listening, if I'm holding an original will and original will, this is the real deal it signed to witnesses the whole thing that is a valid document. Make no mistake, that document gives that executor the authority to administer that estate. And that document, coupled with a death certificate in theory, is what an executor needs to prove that someone a has died and b that that executor is now in charge. Again, make no mistake, those are two powerful legal documents. Easier said than done. Those two documents won't win the day. All the time, in particular, will identify two scenarios or many others. Two scenarios why an executor needs to take it further and obtain, so to speak. A third document called a grant of Probate Letters Probate Certificate of Appointment of an estate trustee with a will. That's what they call it in Ontario. My gosh, they should really talk to their marketing department.

 

The idea here is that Will and Death Certificate just ain't enough for two institutions number one, the Land Titles Office. So here in Alberta, if a deceased passed away with real estate in his or her name alone, that executor does not have the authority to sell that property. Not yet the land titles office. And because of provincial land law that executor needs a probate will. I'll define what that is in a second, but I want to just broadly introduce a probate. Well, here's another scenario, and this is bringing it back to you, gentlemen. Banks and financial institutions may not accept the will as enough authority. They would ask for a probate will again. Here it is. Again, they're going to ask for a probate will. What is the bank effectively doing? They're saying to the executor, Hey, we recognize that you're the executor named in this will. But frankly, our client now deceased, has just too much money. Or maybe there are personal circumstances in her or his life where if we gave you seven hundred thousand dollars to administer, that might leave the bank in some type of position of liability. We want you therefore to get this grant of probate from the court. So there's that word again. So what is this executor doing? This executor is bringing that will to court.

 

They're submitting it in a court application. It's, in my view, very simple. They don't have to appear personally. They file it. Heck, you can mail this thing into the courthouse. So again, the original will is submitted along with about a half inch thick worth of application documents that are publicly available in those documents. Summarize assets of the deceased marital history family history, essentially giving the court a snapshot of who this deceased was. And it varies where you are in the province and in Canada. But I'll say currently in Calgary, they're looking at three upwards to four months of processing time after that period has lapsed. The executor now receives this magical document called a grant of probate. Physically, it's essentially a photocopy of the original will, with a certificate in the front saying this executor is officially appointed as what's called the personal representative, and this will has been. Here's the big one. This will has been validated by the court. So with this document that executor can sell that land with this document, that executor can go back to that bank or financial institution and say, I have the blessing of a judge to now take charge of this money, and then the bank is now in a comfortable position to hand over custody of those assets. So that's what probate essentially is all about.

 

We were talking about the role of the executor pulling together all those documents and filing the court documents and making sure everything is done properly. The executor could choose to do it themselves, but they could also, rather than handing off the entire responsibilities of being an executor, they could engage a firm like yourself or an attorney like yourself to. Assisted with that process without actually handing over the full executor ship, if you will, is that right?

 

It's a common service for estate lawyers to prepare that court application and see it through. I do want to remind everyone that in the interests of access to justice, that these forms are available and many people successfully apply for probate on their own. But there are some pitfalls there in that they have to be filled out in a very particular way because I fill out one of these things a week where lawyers are comfortable with the forms, comfortable with what the clerks want to see, and the clerks have a very particular preference.

 

Now you're talking about probate specifically, but there's obviously ways to bypass probate with certain assets. Can you talk a little bit about that? But some of the strategies involved?

 

So when we talk about probate, we're referring to the assets of the deceased. I mentioned in the probate application have to present a list of assets. I'll be more specific. Estate assets. When I was talking about the house that an executor can't sell until probate or maybe bank assets that are, so to speak, frozen until probate is granted. These are classically defined as assets of the estate. These are assets property bank accounts that are owned by the deceased in his or her name alone. And again, just to reiterate, these are assets that are kind of frozen until probate is granted. Well, there are whole classification of assets that we'll call non estate assets or assets outside of the estate that we people can control outside of our will. Think of it like this. Imagine an asset where you can create a destiny for that asset outside of the will. I always like to say, imagine you put an address label on it and you put a stamp on it, but it's not sent yet. So upon your death, that asset is shipped directly to that place. There's two categories here of assets where you can do this. The first one is beneficiary designated assets and the second one is jointly owned assets. So again, we're talking about assets where you can bypass the estate, bypass probate and so to speak, ship these assets over to chosen people on death.

 

So the first one beneficiary designation assets were commonly looking at life insurance, RRSP and thrifts, the registered retirement funds. And just to keep it simple, tax free savings accounts. There are others that the listeners, you gentlemen are definitely aware of, but generally speaking, these are assets where you can name a beneficiary and it is pretty slick if you were to pass away the named beneficiary saying will use myself as an example. If I named my wife as the beneficiary of my life insurance policy. As soon as she has a death certificate, she can file a claim with the life insurance company to collect those proceeds. And in my experience, I've seen a check issued in a matter of weeks as early as weeks. It's that fast. No will is needed because by definition, by definition, this is a non estate asset. This, in theory, is not the business of the will. This is between my wife as beneficiary and the life insurance company that's like and one can name multiple people. They can say, I want that life insurance split among three people in a certain percentage. And again, there it is. Those three will make the claim upon the death of the life insurance owner.

 

And then there we go. So that's beneficiary. Designated assets, the other type of asset that can be used to bypass the estate and bypass probate are jointly owned assets. So following on the example of myself and my wife, we own our house in joint names. It's registered in joint names, her and I, and we have some bank accounts registered in joint names. If I was to pass, the law dictates that the ownership of our house and the ownership of those jointly owned accounts pass directly to her again without a will. Practically speaking, she is going to the Land Titles Office with the death certificate, and she is leaving, so to speak, with a title of the house in her name alone. It's that fast. Same thing when she meets with our financial advisor or banking advisor, they'll move relatively quickly to remove the name of the deceased from the account, and then the asset is hers. There are some pitfalls here that I hope we can talk about one day. I'll leave this grenade there and then backs away. It's the scenario where maybe an aging parent holds an asset in joint names with their adult child. Now we have questions of who owns that account on the death of that parent. I'll just leave that one there, guys.

 

That is a big one that does come up pretty regularly. Well, Greg, we've had experiences with this where people will want to name a child on their trading account. Yes, which is a beneficial change of ownership, which actually in theory triggers, I don't know, capital gains, taxation and other issues as one, I don't know for sure. Keep going on with this.

 

I know you could probably spend another half hour just talking about that, Jonathan, but I do want to just dig into that a little bit and by describing a situation I was involved in and this is many, many years ago. But Client was diagnosed with cancer and panicked because he didn't know how much time he had left and immediately named his wife as joint holder of his investment account when he passed away. It was discovered, first of all, this was a second marriage, not a first marriage. And in the will, the proceeds of that account had been in. Tended to go to his children of his first marriage. And so here there was a discrepancy between what was named in the will and the actual fact that the account had been made joint with his second wife and the second wife essentially claimed the proceeds of that account when the will allowed for those proceeds to go elsewhere. I guess that is a pitfall. But what happens in a situation like that, where there's a discrepancy between the will and the structure, let's say, of the account?

 

Yeah, it's a great question. So I'll drop a fancy legal phrase on everyone here. And it's this idea that a will speaks on death. We use this term. So when we're trying to harmonize what is said in a will versus the ownership on an account, the whale tries to say something on the death of that person. So even though a whale was written in nineteen ninety six, it's interpreted as if it spoke the moment before the deceased died in two thousand twenty one. So let's take it further. You suggested maybe the deceased had a joint account? Well, that joint account originated. It was by nature. It was held with that other person. And the way we reconcile these facts is on the death of the person. The whale tries to whale that account to somebody. Yes, but on the other hand, the account it is originated, it was created to be owned by somebody else. What wins the joint account ownership is going to win. In that scenario, I would wager. I mean, people take this to judges all the time and judges might have a different view. But based on these straight facts and the way you put it, Greg, I would say that the spouse is absolutely going to keep that account despite what the will says. And I may not have been too clear with my legal fact dropping, but here's the simple way I like to put it the deceased didn't have that account to a will. Let's put it that way I mourn his death or her death. It passed directly to the other owner. That will clause was effectively sterile. It had no effect because he couldn't, will it? It's like me writing a will, saying I give my 911 to my nephew, Isaac. Here's the thing I do have a nephew named Isaac. Problem is, I don't have a porch to will write the same concept, right?

 

And I guess what you've highlighted then, is that obviously a lot of people use joint accounts as a way to bypass probate. And I guess what you're saying is that it's not always the answer, depending on what else is going on in your life and what your long term plans are. And one of the reasons why people feel it's important to avoid probate is because they believe there are high costs involved in getting a grant of probate from the courts. So can you just talk a little bit about costs and how important they really are in deciding whether or not to allow something to be part of the estate as opposed to trying to keep it outside of the estate costs?

 

There are two factors two ways that the estate will be levied here. The first one is court costs. This is where our listeners have to be very cognizant of where they live or where the deceased lived, when she or he died, because these court costs are going to vary from province and province, state to state. So here in Alberta, the court fees are we call a probate fee as opposed to a probate tax. More on that in a second. So here in Alberta, the fee tops out at five hundred and twenty five dollars. So simply put, if a deceased had an estate valued at two hundred and fifty thousand. The fee will be five hundred and twenty five bucks. That's the court cost five twenty five. If a deceased had an estate worth two hundred and fifty billion, the court costs will be five hundred and twenty five bucks. That's it. That's how it's done over here in other provinces. Very different. The estate value tax will be applied to that estate value. And in provinces like BCR Ontario, we're looking at an aggregate of maybe one point four one point five percent of the estate subjected to tax. So that's like fifteen thousand on every million and that can add up. That's quite a lot. So that's the first cost that in the state would be exposed to if probate is needed. The other cost comes back to my desk are legal fees. Greg, you mentioned that sometimes people will hire lawyers and it's a privilege to be asked to help out with estates.

 

What are these lawyers getting paid? Let's get right into it here. It varies. So a nice, lawyerly answer for you. It depends. But some quick facts in Alberta, it's not uncommon for a lawyer to charge a percentage levy a fee based on a percentage of the estate. There's a guideline that suggests that the probate lawyer or the estate solicitor for her or his services will charge two thousand two hundred and fifty dollars a 20 to 50 plus one percent of the gross value of the estate. That's not small. What I want listeners to know is that that's optional any lawyer saying that this is the rule and this is what I'm entitled to and I shall charge this. And sorry, this is what I have to charge you, the court says. So that is, in my view, a bit of a twisting of our guidelines. They are not obligated to follow that. Many lawyers, myself included, will tailor a fee case to case family to family based on the circumstances based on the complexity. One other takeaway I want to put out there and this is certainly turning into a public service announcement about lawyers, is again, if a lawyer is going to levy a fee, especially one in that range, the one. The executive is not hiring that lawyer, only to prepare that grant of probate application put together the court application, apply to court.

 

It's a lot of work, don't get me wrong. And then, of course, ultimately deliver that grant of probate to the executor. That lawyer doesn't say, go forth and administer the state is now yours. Here is my bill for one percent of the estate. If you have any questions, call me later and it's going to cost you. I see that from time to time, it saddens me. This is a reminder to clients out there and humbly speaking to some of my colleagues out there that being the estate solicitor continues on. After that, the services include advising the executor in certain circumstances regarding the administration of the estate, advising on the final distribution, obtaining something called releases from the beneficiaries before the final distribution is made. Remember you're hiring a lawyer to work with you as an executor for this year and a half two year journey, and the fee structure should reflect back or, on the other hand, should reflect only getting the grant of probate. And that's something that I commonly like to do. I like to unbundle the fee to borrow a term from the cell phone provider. I like to charge a single fee to get that grant of probate because that's a discrete amount of work that's asked of me. And then I often charge hourly after that. Use me if you need me. Otherwise, my feelings won't be hurt if you don't call me and I'm not charging you for it.

 

Craig seems fair. Brings up a good point, something we've talked about in the past. Like, Are we actually recommending Jonathan to people out there? Of course. Of course we are. Of course we are. We wouldn't have them on the show. We trust him. We've had a long working relationship with Jonathan and the firm that he represents. So, hey, we're going to run out of time for today. I can't believe it, but we are.

 

Well, obviously this is a big topic. And of course, Jonathan has devoted his professional career to this topic, so not surprising that we can't get through it at all in an hour. But listen, I think we've covered a tremendous amount of ground. And Jonathan, first of all, I want to thank you for both the last couple of weeks of being on our podcast, and I'd like to actually extend an invitation. We'll give you some time off. But I think there's some ground that we haven't covered, which is probably useful for a lot of people to be aware of, and that's the use of trusts. And so maybe we could seek your assistance in a future episode to talk about the importance of trusts in the use of trusts in estate planning and things like that. So we'd certainly appreciate that if you can save some time for us in the future.

 

Looking forward to it. Thanks, guys.

 

I like how you put them on the spot there.

 

I know there's just no way out of that.

 

If you could just sure save a few minutes in the future, like maybe half hour to talk about trusts and the importance of planning for blended families, maybe just those topics. I do have one thing for you. I noticed in the last few weeks I always said, Will an estate lawyer and I am incorrect. I have become corrected that it's wills and estate lawyer. Is that right?

 

Oh man, this is a tough one. I don't know. I see it more tangibly. I mean, OK, well, I write wills, but I guess I write one whale at a time. Gosh, this is a tough one.

 

Yeah, yeah. Yeah. Finally, got one that stumped you.

 

Let me get back to you on. I see both. I think I use them interchangeably generically. The term is wills and estates, so plural on both.

 

Oh, and I was wrong again. Okay.

 

No, no. You're going to have to leave that one with me. That perplexes me. I'm not too sure.

 

Well, in our world, it's advisor versus advisor one. If it's spelt with an O indicates fiduciary duty and one if it's spelt with an E indicates sales person. So that's why I was just curious

 

And for clarity, you are

 

Advisors. We're neither. We're portfolio managers, licensed portfolio managers, so we are fiduciaries. So that's how we talk anyways. But listen, thanks again, Jonathan, for joining us today, and we are going to hold you to coming back and talking about trusts and things of that nature. So we do appreciate your expertise. Thanks again. All right. Okay. Till next time,

 

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