Monthly Archives: August 2017

Investing in commodities is worse that dead money

Smoking shisha with friends

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:

  • Stocks: X%
  • Bonds: X%
  • Real estate: X%
  • Commodities: 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.

When you invest in stocks, you get dividends or the price of your stock goes up as the company retains earnings. See article on what kind of return to expect from the stock market.

When you invest in bonds, you get paid interest.

When you invest in real estate you get rent.

When you invest in commodities you get nothing.

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.

See article on why investing in gold is a bad idea.

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.

Summary

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. 🙂

 

How to chose a mutual fund

With my friend at the military academy

Mutual funds is one of the most flexible and available financial products for new investors. They are within the reach of practically any one. With as little a $25/month, anyone can get started.

See my previous article about what are mutual funds.

Let’s say that you decide to get started investing in mutual funds. Open your browser, type “mutual funds” and you will be presented with myriad of options. There are more mutual funds than stocks in the stock market.

The first step is to ignore all the mutual funds which are advertised. The reason is  that these funds take money from the pocket of investors to buy advertisement. Not only the fund pays for advertising, but they also pay handsome yearly commissions to the financial advisers (financial product pushers) who sells it to you. These commission are often called trailer fees and they about 1% per year.

How much are you paying in management fees

Most mutual funds in Canada have management fees of between 2% to 3%. You should avoid those at all cost. Canadian mutual fund companies should be ashamed to charge such ridiculous high prices.Those generous commission are coming out of the pocket of the investor year after year.

Unfortunately, those are the mutual funds which most financial advisers (financial product pushers) will recommend to the public, the reason is that those are the products which will pay the highest commission.

Here is a rule of thumb. If the management fee is more that 0.5%, run away. Don’t even consider it.

Actively managed funds under perform index funds by a lot

By this time I have read hundreds of reports claiming that most actively managed funds do not beat the index. Some reports say that 75% of actively managed funds under perform, other reports say that 90% of actively managers under perform. It doesn’t matter… The conclusion is that the investor is better off investing in index funds than on actively managed funds.

Steps to invest in Index funds

All major Canadian banks are catching up with the index fund reality. Most of the time they will not promote their index funds, they rather promote their actively managed funds. But all of them have their own version of index funds, you just have to ask for it. Look or ask for funds with this keywords: “Canadian Index,” “US index,” and so on.

Some banks offer index funds with expense ratio of more than 0.5%, simply ignore those funds and go with the bank who is offering index funds that cost 0.5% or less. Remember, the more you pay the bank, the less that it’s left over for you.

What are Mutual Funds

Giving a speech at local Toastmaster club

One of the best financial instruments to get started as an investor are mutual funds.

How a mutual fund operates

An investment company solicits investments from many investors. Those investments can be  as small as $25 per month. This is what makes mutual fund so appealing, that it is within the reach of practically anyone who can put together a small amount of money.

The money collected is is used to make investments, generally of stocks, but also bonds and other securities. A professional mutual fund manager is the person in charge of making daily investments decisions.

Having a large pool of money allows the money manager to diversify into many investments. Small investors generally don’t have the capital to invest in hundreds of different companies. Also, small investors don’t have the time nor expertise to research hundreds of companies.

Different focus of mutual funds

Many mutual funds companies have different focus of interest. For example, some funds may invest in technology companies, other funds may invest in dividend paying stocks, other may invest is small stock. It is up to the investor to decide which of those investments philosophies he/she prefers and then buy the mutual fund which reflects that philosophy.

Advantages of mutual funds

One of the big advantages of mutual funds is the elimination or reduction of single stock risk. Those who once owned Nortel, Enron, or Blackberry are well aware of the single stock risk. Single stock risk exist when an investor can lose a significant amount of money because the single stock they own, has a big decline in price. By having hundreds of stocks, the single stock risk is greatly diminished.

Disadvantages of Mutual funds

However, mutual funds are risky and many of them could do so bad that they could be closed down. It is quite possible to lose 50% or more of your money when investing in mutual funds.

Another big disadvantage of owning mutual funds is their high fees. Canada has one of the highest mutual funds fees in the world. While you, the investor, are putting your money at risk, the mutual fund company could easily eat away more than 50% of your profit. It’s very important to make sure your fees are low. Most Canadian mutual fund charge between 2% to 3% in fees. This is outrageous, they should be ashamed of themselves, but is it also, the generally public faults.

Side note: I have a friend, who continues investing in expensive mutual funds because the mutual fund salesperson invited him to a nice steak dinner.

Look for low fee index funds

If you are interested in mutual funds, make sure you don’t pay more than 1% in management fees. There are many alternatives out there.

It has been proven over time that most active managers don’t beat the benchmark to which their funds are compared. For example, a Canadian mutual fund may be compared to the Canadian stock market index. Most mutual fund don’t beat their benchmark because of their high fees or because of many other mutual funds inefficiencies.

The solution to diversify your investment and pay a low fee is to invest in a mutual fund which follow the national index. For example, in Canada, I would invest in a mutual fund which follows the the Toronto Stock Exchange 300. In the US, I would invest in a mutual funds which follows the S&P 500. The fee for this kind of funds is generally 0.10% or less.

Historically the US market and Canadian market have grown at the rate of over 8% per year. If you subtract the index fund expense of 0.10% then you will be left over with a profit of 7.9% or more. This is a more interesting scenario than paying 2 to 3% in fees to a mutual fund a mutual fund manager.

Large-Caps, Mid-Caps or Small-Caps?

Teaching tango at University of Montreal

What the academics say

Ever since I have been reading finance books, I have been reading that Small-Cap stocks are more risky but they perform better. I see graphs and charts backing up these studies, so I decided to double-check. Is it true that Small-Cap perform better than Big-Caps?

I went to my favorite ETF provider and I looked for Big-Caps (VOO), Mid-Caps (VO), and Small-Cap (VB).

What my findings say

My findings did not corroborate the results of the academics. In fact, my findings contradict the research of the academics. Maybe the academics had different set of data, but I have to work with the data that is available to little investors like myself.

Here is a 5 year graph which showcases Large-Caps, Mid-Caps and Small-Caps.

I was not able to find a longer term comparison.

In the graph we can see:

  • Big-Caps going up 19.95,
  • Medium-Caps 15.81
  • Small-Caps 9.51

You might say that 5 years is not a long enough time frame to make a decision, and I agree with you, but the time frame in which an investor gets in and gets out is often random, dictated by his life circumstances, most of the time outside of his control. In any other 5 year period, the results could have been different. What the next 5 years will do, no one knows.

My conclusion

Maybe the academics are right, but I am not an academic, I am real person with real money. I have to go with the information and the tools which are available to me at the moment.

We don’t know which sector is going to do better or worse, we don’t know whether small or large caps will perform better. If we assume that in the long run, stocks are going to go up, then let’s buy a little bit of all of them. Let’s buy Large, Mid, and Small caps. When we retire, when we begin to withdraw money to sustain our lifestyle, then we can take a look and determine which on performed better.