Imagine that you want to invest in a business. If your objective is to maximize profit, your main question should be: How much money do I get to keep? What’s my profit margin?
The new trend in investing is to just put all your money in broad based ETFs, set and forget it. And I must admit that since I have been reading about personal finance, this is the best deal in the market for the little guy and for many big guys as well.
This new approach is effective because of its simplicity. If we can just manage to find the low cost ETF provider (avoid actively managed funds) then success is the most likely outcome.
However, A few of us would like to squeeze a little bit more profit out of our invested dollars. To do so we have to look a little bit deeper into the numbers.
Let’s imagine your are considering buying two different business.
One is a grocery store: After you finish paying for all the merchandise, rent, salaries and taxes, you are left with a net profit of 3%.
The other business does computer programming. After you pay the rent and all your programmers, you are left with a net profit of 20%
Which one of these two seem to be the better investment? I would say the computer programming business sounds better to me.
How about if we apply the same logic to the stock market. How about if we look for companies with fat profit margins.
The S&P 500 is divided into 10 different industries. As a whole, the profit margin of the S&P 500 is about 9%. But of course, there are some companies that have a fatter profit margins than others. Let’s figure it out.
In short, the profit margins of 20% and the stock return of the technology sector of 35% for the last 12 months can lead us to believe that there is a correlation between fat profit margins and stock returns. But there is no such correlation when we look at the other profit margins and compare it to their stock returns.
Conclusion: Maybe the implied relationship between profit margins and stock returns is not as strong as I believed to be true.
Recently my friend Elijah asked me about ethical investing. His concern is that he doesn’t want any of his hard earned money going towards oil companies.
I sense that Elijah is really interested in socially responsible investing (SRI). The idea goes by other names such as: green investing, ethical investing, sustainable investing, impact investing, or socially conscious investing.
In general, Elijah and millions of others like him want to avoid investing in companies involved with alcohol, tobacco, gambling, pornography, weapons, human rights violations, or poor employee relations.
At this moment Elijah is invested in a the TD Canadian Index e with 20% allocation towards the energy sector. For this index he pays 0.32% management fees. He makes a monthly contribution of whatever he can afford.
I did a bit of searching and I found:
Jantzi Social Index Fund (XEN) This is a Canadian ETF with 16.82% allocation in the energy sector and 0.55% management fees.
iShares MSCI KLD 400 Social ETF (KLD) in the US. with 0% Energy and 0.5% management fees.
iShares MSCI KLD 400 Social ETF (DSI) in the US. with 0% Energy and 0.5% management fees.
In short, ethical investors don’t have much choice.
If you invest in the US and want to avoid oil, one option is to buy all the sectors except the Energy sector if this is the sector that worries him the most, but this option is a bit unrealistic if he’s only investing $100 or $200 per month. And all the other sectors have companies that would not qualify as socially responsible investing.
As opposed to the US, the Canadian market is so small that there are not ETFs or index funds which separate different sectors of the Canadian economy.
Another option is to buy individual stocks and only buy those stocks which meet his criteria. But again, this will expose him to risk of lack of diversification and he doesn’t have that much capital.
One of the problems with ethical investing is that people’s moral values are different.
Some examples are clear cut. If a company makes bombs or machine guns, there is no doubt that those weapons are for killing people and I think that most ethical investors would want to avoid those companies.
But what about companies like Walmart? Some people say that it violates human rights because it prevents workers from forming an union. Other people say that Walmart is a savior for poor people by providing good quality products at low prices.
Another example is a chicken farming company. Some people say that it provides affordable chicken and eggs to the masses. Other people say they represent cruelty against animals.
A winery in California. Millions of people see nothing wrong with drinking a glass of wine after dinner. Others see the sale of alcohol as a complete violation of their moral principles.
And to address Elijah’s distaste for oil. We depend on oil products every second of our modern life. From the plastic keyboard on our computers to the plastic toothbrush we use every morning. We can get our oil from the oil sands in Canada (this is considered dirty oil) or we can get it from the middle east where there are constant human rights violations, but there is no replacement for oil derivatives products in modern day society.
Sure, green energy is advancing rapidly but I don’t see how green energy could replace all the plastic, rubber, and other chemical byproducts which are derived from oil.
The truth is that a portfolio is not the best way to express one’s moral choices.
Let’s imagine two companies: “Good Company” and “Bad Company”
Both companies have shares in the stock market for $10 and both companies pay $1 dollar in dividends every year. In short, return for investment is 10%.
A campaign against Bad Company and in Favor of Good company moves the share price of each company. Now Good Company shares cost $20 and Bad Company shares cost $5. But regardless of their share price, they still pay $1 in dividends.
As an investor, if I pay $5 in Bad Company for my $1 of dividend, now I make 20% return on my investment. If I pay $20 in Good Company for my $1 of dividend, now I make 5% return on my investment.
In the stock market, the Bad Company shareholders will be rewarded and the Good Company Shareholders will be penalized.
How to create an impact
The best way to create an impact is to vote with your dollars. As a consumer your voice is much louder and corporations eventually listen.
For example. My friend Cheryl has been a vegetarian and then a vegan for many years. When I met her she was the odd person with the different eating habits, but little by little the vegetarian and vegan community has continued to grow. Now there are more and more vegan restaurants all over the city. Cheryl and millions of other vegans have voted with their money and corporations are listening.
Another example is the company Gucci which announced that they will no longer use fur in their designs. Obviously they are responding to demands of the consumer. The consumer has spoken and Gucci is listening.
You can have a much bigger impact as a consumer than as a stock holder
The best way to change a company’s behavior is not by buying or selling its share in the stock market, it’s by buying or not buying its products. If you and millions of others boycott their products, management will realize that they have to change quick.
Other ways to create changes is to lobby government and ask government not to buy products from those companies.
You can also express your SRI with your political vote. For example, in the US, the people voted for Donald Trump, a person who denies climate change and who wants to revive the coal industry at the expense of cleaner sources of energy. Many people who care about the environment didn’t bother to vote, and so, they have to live with the consequences of having Donald Trump as president.
In short, you will have a bigger voice if you express your SRI by the way you consume and by the way you vote than by the way you invest in the stock market.
It’s RRSP season. You see advertisements in all the metro stations, all the TV stations and all the social media. You have until March 1st to make your RRSP contribution and to get that tax break you have been hearing about.
You make an appointment with the financial adviser at the bank. You get one hour. In that one hour, your financial adviser, anyone who happens to be available at the time, gives you a questionnaire. From this questionnaire he’s supposed to assess your risk tolerance and present you 5 or 6 mutual funds which fall into your risk tolerance. Sing here, sign there, initial here and here and we are done, thank you very much. Next…
Asset allocation is one of the most important decision an investor must make and yet, we give it so little time, so little consideration.
There are a few problems with this scenario.
The client and adviser don’t get to know each other. The adviser don’t discover anything about the client’s goals, knowledge nor expectations.
The adviser only show the client the products offered by the bank. Most of the time the adviser will try to nudge the investor into actively managed funds, these are the funds which offer the highest revenue to the bank and thus the lower revenue for the client.
If it is a Financial Advisory firm, not affiliated with a bank, the firm will definitely push actively managed funds. They would never suggest index funds nor low cost ETFs and on top of that, they will charge an additional management fee. They will do what I call “double dipping.”
What’s the solution?
The solution is to look for a fee-only financial adviser. These adviser will charge you for their time. They have no conflict of interests, they won’t try to sell you products.
Have a long conversation with your adviser. Let him know about your plans, your goal, your knowledge, your expectations.
Take a holistic view of your situation. Are you planning to work after retirement? Do you have other investments? Are you planning to leave a money for your heirs?
Build a long term relationship with your adviser, but continue informing yourself. If at any moment you detect conflict of interest, you suspect that he is charging but getting a commission somewhere else, his opinion in no longer unbiased and you should question his decisions.
Make sure that the products he offers you don’t have trailer fees, or other kind of compensations. You want to make sure there is not even the perception of conflict of interest.
Finding a financial adviser without conflict of interests is very difficult but not impossible. If you find him, don’t be afraid to pay him his hourly fee, in the long run you will save a ton of money.
Many people think that having money in cash is the safest investments of all, but in reality, it is the worst investments of all. Having cash money is the only investment where you are guaranteed 100% to lose money.
How do you lose it?
You lose it to inflation, the silent killer of capital.
Why does inflation occurs.
In order to create economic stimulus, governments try to have a stable rate of inflation, both Canada and the US favor an inflation rate of about 2%.
The reason the governments wants inflation is because the government wants to discourage people from holding money. If your money lose value day by day, then you are better off spending in goods and services. If people buy goods and services then businesses make money and this economic activity creates jobs.
Who is the big loser in the inflation game?
The poor and the financial ignorant are the big losers.
The poor are losers because every time prices increases the poor have to pay more for goods and services, but many times salaries don’t increase at the same rate as inflation, therefore the purchasing power is less and less.
The financial ignorant loses out because they don’t know how to invest their money in a way which will produce a rate of return higher than inflation.
Imagine this scenario:
Inflation is 2% and your bank offers you 1% interest for your money, at this rate your money is losing 1% power every year.
Here is the Canada’s rate of inflation for the past 10 years.
Elijah is a friend I met at the McGill toastmasters club. His speeches have always been thought provoking and inspirational.
Elijah is a true hustler. He has several side gigs and job. Due to his many activities he hasn’t much time to think about his financial goals. He only started saving after having a conversation with me about the possibility of retirement or having some money for emergencies.
This interview was held May 2017
Age: 33 Work life: Different jobs at different places and side hustles. Education: Bachelor’s in communication and music.
Alain: What are your professional ambitions? Elijah: After graduation, I never wanted to work a 9-5 job. So far, I have succeeded at that.
Alain: How do you earn your living? Elijah:
I have been a musician for years, I do gigs at different bars and events.
I teach guitar and drums to a few private students
Alain: Can you tell me a bit about your financial planning? Elijah: In the past I have accumulated some savings, but I always ended up spending it.
I haven’t been disciplined about saving because:
I didn’t have the motivation,
I didn’t have the knowledge
It wasn’t that important
I never had a steady income
Only recently I have had the capacity to set aside a certain amount of money to save regularly.
Alain: Have you ever thought about retirement? Elijah: I don’t think that far into the future. I can’t imagine what life would be like at age 65.
I am trying to set up my life so that even at 65 there will be demand for my services. I hope that people will want to have videos made, they will want to listen to my music and will want to learn to play musical instruments.
Alain: Do you have any goal which could affect your financial life? Do you want a house? Kids? Get married? Elijah: Yeah, probably, but at the moment I am more focus on living on the present.
Alain: So what are your financial goals? Elijah: I would like to have a bit of money set aside for emergencies. I would like to continue working until old age without the pressure of having to produce every month. I would like to work because I want to, not because I have to.
The whole idea of financial planning is new to Elijah. He lives a frugal lifestyle and he is happy with it. His priority is to have lots of freedom, not to have a 9 to 5 but not to lack anything either. He doesn’t mind living a spartan life but if he feels like having a beer with friends, or taking a trip to Costa Rica, he would like to have the money to do it without worrying too much about how to pay for it.
We started by opening a brokerage at his main bank
I asked Elijah not to listen to the advice of the financial adviser at the bank. The bank offers actively managed mutual funds with high fees. The more a fund cost, the less money it makes for its investors.
We spoke about choosing and Index fund, a broad based investment products which represent the whole economy of a county.
Elijah opened an account and deposited some money he had in his bank account.
We chose the Canadian Index Fund with management fees of less than 0.33% per year.
He’s making contributions every month.
This is just the beginning, his present savings are not enough to fund a retirement. After a few months he will have enough money to face any short term emergency.
Our first goal was accomplished, to get into a habit of saving and planning for the future.
In future meetings we will speak about the saving a bigger amount and about how to start diversifying his savings.
Next meeting will be May 2018.
Pitch. I am a money coach. If you would like to talk about your financial situation, please get in touch with me.
If you have been reading my blog for awhile, you will know that my favorite asset allocation for Canadians is ⅓ Canadian stock, ⅓ US stocks, and ⅓ International stocks.
Let’s say that you met me 10 years ago (October 2007) and you asked me how to invest your money. And let’s say that I gave you the same advice that I give out today. Would you have been a happy investor? Let’s find out.
If you invested on October 2007, you were in for a wild ride. The national and international markets where about to tumble due to the financial crisis of 2008. You would have been looking at your portfolio and calling me a complete idiot, cursing yourself for ever talking to me.
I often say that if you are going to invest in the stock market, you have to have a 10 years outlook and that at the end, if you are well diversified, you should come out fine. That prediction turned out to correct.
The financial products which I use to do my investing are as follows:
Canada: The XIU. This represents the 60 biggest Canadian Companies
International: XIN. This represents big size companies from all over the world.
As you can see in the graphs, on 2008 everything dropped. The Toronto and US market lost about 50% of their value while the international index lost about 40% of its value. At this time, many retail investors without a financial adviser would have bailed out.
Let’s say you endured the pain. Where would you be today?
Your International exposure would still be negative by 14.7%
Your Canadian exposure would be positive by a mere 5.04%
But your US exposure would be positive by 67%
Your average of these three investments would be 19.15%.
Divided by 10 years, this will give you about 1.9% per year.
These are not great returns, considering the amount of risk involved. The amount of pain related to seeing your investment dropping by over 50%.
There is a problem with my calculations. I don’t know how to add the dividends earned during these past 10 years. Let’s say that on average you earned 1.5% in dividends. Now your total return per year is 2.4%. This is less bad, but It’s still very poor return. Consider the psychological stress, I would have preferred to lose out to inflation and have my money in cash.
What are the alternatives?
During the same period, bonds have gone down the the less that 1% territory. You might as well keep your money under the mattress.
And real estate, also had a big drop in the States. Since then it has recuperated as well, but let’s be honest, real estate is not a real passive investment. I invest in real estate and believe me, it gives me plenty of headaches.
In conclusion, in spite of a 50% in the stock market. Stocks are still the best place to put your passive money. However, the faith that I once had on the stock market, it has been badly bruised. I feel that 2.4% is not enough compensation for putting my money in harm’s way. I am still investing in the stock market, but I feel a lot less enthusiastic and optimistic than when I first started writing this article.
Here is a 10 year graph of the same investment, the S&P 500, being held in Canadian dollars and being held in US dollars.
Because of the cost of hedging, the investments in Canadian dollars under performs the investment in US dollar by a whooping 15.60%, that’s a lot of moolah.
Long ago I suggested that the ideal portfolio for a Canadian would be composed of ⅓ Canadian index stocks, ⅓ US index stocks, and ⅓ international Index stocks.
Now the question is: In which currency should you hold those investments which are not in Canadian dollars?
The way I have decided to do it is by investing my ⅓ of US index in US dollars.
I would have considered investing the ⅓ of international in foreign currency but it is just too complicated. I would have to deal with Euros, Yens, Yuans, and all the other currencies of the emerging market. My portfolio in not big enough to burden myself with all those details.
On the other hand, my US investment is ⅓ of my portfolio, that is quite substantial. So the question is valid. Should I invest my US portion in Canadian dollars or in US dollars.
Many of you may be unaware that there is such an option.
When we buy the most popular US index, the S&P 500, we have the option to buy it with US dollars or in Canadian dollars. The S&P in Canadian dollars is protected against the currency fluctuation of the Canadian dollar vs. the US dollar. But that protection comes at a price. It is like paying for home insurance, it’s not for free. This hedging cost is about 0.15% of your US assets. Not a lot, but it’s just another erosion of your capital.
If you are investing for a short term period, you should not be investing in the stock market.
If you are investing for a long term goal, then you are further diversifying your portfolio not only by investing in the US market but also investing in the US dollar.
As Canadians, we have to be aware that our currency fluctuates a lot with the price of oil. We think that Canada is an advanced economy, but we are nothing more than a big gas station for the rest of the world. If oil prices go up, our currency goes up, If oil prices go down our currency goes down. Our currency is in fact too volatile and the US dollar is the more stable currency; their economy is more diverse.
Looking it from that point of view it makes sense to have some of our money in US.
In regards to cost, how does it compare.
When I keep my US investment in Canadian dollar I have to pay the hedging cost every year, this hedging erodes my returns over time.
When I keep my US investment in US Dollar, since I earn in Canadian dollar, I have to pay the conversion cost from Canadian to US and then when I retire, from US to Canadian.
In the long run, I feel that keeping my US investments in US dollars is less expensive and I feel more diversified.
I advocate not to have bonds in a portfolio, but the conventional wisdom is to have a portfolio of stocks and bonds.
Let’s clarify a few points:
Stock are not more risky than bond in any 10-20 years time period, they are just more volatile.
Stocks produce a higher return than bonds.
If stocks are not more risky than bonds and if they give higher return than bonds, why should anyone own bonds? Because they reduce volatility, because with smaller ups and downs an investor is better able to withstand the changes of the market.
Let’s assume a portfolio of 50-50 stocks and bonds. Let’s assume that the expected return of stocks is 8% and the the expected return of bonds is 2%. The expected return of your portfolio is 5%.
What I suggest is to put 100% of your portfolio in stocks. then draw a line that goes up at the rate of 5% per year. This means that if you start your portfolio with $100,000, by the end of the year you should have $105,000.
Here is an example the Toronto Stock Exchange vs. a 6% growth line.
In this example, I overlap the real returns with the 6% growth line. If the returns are in excess of the 6% line, they are not to be considered are part of your assets, they are meant to be considered as insurance money, or protection against a downturn. Just like you don’t consider the money that you pay in insurance as part of your assets.
If the returns are less than the 6% line, then you just have to be patient and have faith that eventually the returns will catch up.
All that being said, you think you should own some bonds. At what stage should you add bonds to your portfolio?
Most financial advisers suggest adding bonds as percentage of your assets as you grow older. They will say that if you are 60 years old, you should have (for example sake) 60% of your portfolio in bonds, and the older you get, the biggest the percentage of bonds you should have.
But let’s be realistic. If you only have $100,000 at age 60, you don’t have much money to protect and therefore, you should be more concerned with growing your portfolio than protecting it. On the other hand, if you have $5,000,000. You don’t care about making more money, you care about protecting your assets and you could easily be 100% in bonds.
Actual amount of money matter more than percentages.
So here is the question again: At what stage should you add bonds to your portfolio?
Answer: When you have reached your capital objective.
Let’s say that you believe that to retire you want to have $500,000 in your bank account. After years of hard work you have reached the amount of $500,000. Then, the next step should be to start protecting your asset.
Let’s say that your portfolio of $500,000 grew 8% in one year. That would be $40,000. You would sell about $40,000 worth of stocks and buy some bonds. And do that for every year thereafter until you reach a level of dampen volatility which will make you feel good at night.
Disclaimer: Of course, this is my way of thinking which fits my risk profile. I am not saying you should do the same or that you should follow my example. You may have different risk tolerance or time frame.
The way that I think about it is that first you want to make your money and then you want to protect it. As you grow your assets you should keep in mind that there is an strategy to make your money, and there is another strategy to conserve your money. You don’t want to be too conservative if you have very little to protect and you don’t want to take risks if you don’t have to.
Social inequality is nothing new, it has existed since the beginning of civilization. Some people like to focus on building wealth and some people focus in other activities other than building wealth.
Here is a short excerpt for Plutarch in the year 594: “the disparity of fortune between the rich and the poor had reached its height, so that the city seemed to be in a dangerous condition, and no other means for freeing it from disturbances… seemed possible but despotic power.”
No only has income inequality existed for thousands of years, but it has existed in all the geographical areas of the globe. In short, income inequality is just one more trait of humankind.
And why wouldn’t it exist? Business people who like to accumulate capital practice their craft with the same tenacity that a pianist practice his scales, or a painter practice his techniques. If a musician gets better with each practice session, shouldn’t a capital accumulator get better with each business deal? Imagine that we tell a guitarist who practice 8 hours per day, that he has to give half of his skills to someone who only practice 30 minutes per week. It doesn’t make sense, but we don’t think twice to tax a business person more that 50% of his income to re-distribute his wealth.
We live in North America, a land full of opportunities and choices.
You present two college students with two career options. One career pays $80K per year and the other pays $35K per year. One student picks the career which is better paid and the other picks the career which is less well paid. These are choices these students took out of their own free will. One student is going to earn more than the other one. Why should we penalize him/her by taking some of his earnings away?
Two consumers are presented with two smart phones, an iPhone and an Android. One cost almost $1,000 and the other one cost about $100. Both of the phone do phone calls, text, Facebook and YouTube just the same. One buys the iPhone and the other buys the Android and invest the savings. For sure, after 10 years, the one who invested the money will be better off. Why should that person be penalized.
There are two apartment renters, each one renting a two-bedroom apartment. One uses the extra bedroom as an office/storage room. The other one uses the extra room to rent it to a friend. One is going to accumulate more money that the other one every month. Why should we penalize his money making decision?
Income inequality will never go away. We should not penalize a person for making a decision which will benefit him/her financially. Instead, we should educate people to become more savvy consumer, better informed investors. We should teach people about the magic of compound interest, about investments, about how to become better consumers and don’t waste money on brands.
Once we do a better job educating people about the investments opportunity presented at their feet every day, then we will have a better chance of reducing income inequality.
Most financial advisers recommend capital diversification between two asset classes: stocks and bonds. But every now and then I see some financial advisers recommending two additional asset classes: real estate and commodities.
A common portfolio including those additional would look like this:
Real estate: X%
In previous articles I have explained why I don’t like investing in bonds. I think the opportunity cost is too high. In the long run stocks outperform bonds and stocks are NOT more risky than bonds, they are just a more volatile.
In previous articles I have also mentioned that I invest in real estate. In particular, I own a condo in the coolest neighborhood of Montreal. Obviously, I like real state as an investment. As long as the tenants pay the rent on time and don’t destroy your property, it’s a sweet business.
One asset class which I dislike worse that bonds is commodities.
what are commodities?
Commodities are standardized raw materials or products such as wheat, sugar, corn, coffee, cocoa, oil, gold, copper, etc.
How do people make money with commodities?
Investors speculate on whether the prices of any one of those commodities will go up or down. If they think the price of of corn will go up they buy corn. If they think they price of corn will go down they sell corn. If their speculation works out, they make a ton of money. If their speculation doesn’t work out, they lose a ton of money.
Why I don’t like commodities as a long term part of your portfolio?
Commodities is a zero sum game. For every trade there is a winner and a loser. If we add commissions into the equation, on the long run, investing in commodities is a losing game.
Let’s say you buy a bar or gold. You hide it under your bed. 10 years later, you look under the bed and you see the same bar of god. You don’t see a bar and a half, you don’t see two bars, none of that… Your bar of gold has remained the same. You check the price of gold and most likely your bar of gold has increased in value at the same rate as inflation. Nothing more, nothing less. If your investment is going to grow at the rate of inflation, you might as well buy government bonds.
There are similar scenarios for all kind of commodities. They have violent swings up or down, but if you look at any long term chart, on a 20 year period or longer, the value doesn’t go up higher than inflation.
My ultimate recommendation is to continue piling up your money in real estate and stocks. You will continue getting dividends checks or rent checks. Let the money continue working for you. 🙂