Monthly Archives: November 2017

Stages of Asset accumulation and asset decumulation

How we get into investments
Going out to a concert with friends. 🙂

Most people have little interest in personal finance and investments. It’s hard to believe that one day your money could earn more money than you earn yourself, so the idea of living out of your investments is in the same area of your brain as winning the lottery.

Then, as we get a job, we start seeing advertisement about investments about Retirement Savings Plans promoted by many banks and employers. Canadians see these savings plans as a way to reduce their tax bill.

Little by little we start getting bank statement and we discover that in fact our investments are making money. Our investments go up and down in value but on the long run, we should see the balance of our account steadily increasing.

How we optimize our investments

It is at this period that many of us become interested on how to optimize our investments. Maybe we make the following discoveries:

  1. We discover that most actively managed funds under perform Index funds.
  2. We discover that most fund companies have high management fees 2.5% to 3%, these high management fees rob us of a big chunk of our investments.
  3. We discover that it is better to own Index Funds and ETFs than individual stocks. The average return is the same but the risk is much lower.
  4. We also discover that Canada is only a small part of the global economy and that we will be missing out by staying invested in Canada and ignoring the rest of the world.
  5. We discover that bonds under perform stock and unless we have hit our wealth number, we should continue preferring stocks over bonds
  6. We discover that investing in gold, does not produce higher return nor more security. Instead it adds a lot of risk to our portfolio.
  7. We discover that commission based advisers have a conflict of interest. Would they recommend the best investment for us even if it didn’t pay them any commission? I doubt it.

The process of learning all these lessons is long and many times painful. It could take many years to discover that you are overpaying for actively managed funds. It could take years to diversify out of Canada. It could take years to stop believing in having gold as a fundamental part of your portfolio.

Winning the lottery and investments

Other investors get seduced into investments by the big technology companies. The Googles, Apples, Amazons of the world. They say: “If I would have invested $10,000 in Amazon 10 years ago, I would be a gazillionaire by now.” These investors might jump into a stock just based on the mass enthusiasm of the moment and many time they could win but also, the probabilities are high that they lose. “When to get in and when to get out” remains the most important question. After getting burn a few times, these investors (like me) might look for more conservative/predictable approaches or might pull out of investments all together.

On the long run, who are the winners?

The people I have seen succeeding over time, are the people who year after year make small improvements to their portfolio without increasing their risk. They find a better way diversify, to cut unnecessary cost, to get rid of expensive commission. After 10, 20, 30 or 40 years, they see that their asses have grown substantially and now they have reached the second stage of their financial life, the decumulation stage.

The decumulation stage

At this stage of their life there are many questions which come up:

  1. Will I have enough to retire?
  2. Will I outlive my money?
  3. Will I have some money left over to leave to my heirs?
  4. How much can I safely withdraw each year?
  5. Will I invest my money any differently?
  6. What it the correct asset allocation?
  7. From which account should I withdraw first.
  8. What are the tax implications when I start withdrawing my money.
  9. How much should I rely on my Canadian/Quebec pension plan.

All these are difficult questions to answer. Investors find bits and pieces throughout the years. Many times the information is not complete or many times there is too much information.

Filling the information gap

There are two alternative to fill the information gap.

  1. To educate yourself and buy books on how to approach asset decumualtion
  2. To hire a fee only financial expert for a second opinion. Please don’t consider talking at a commission based adviser. There will always be a conflict of interest.

I will do my best to continue writing blog post to narrow the gap between not enough information and too much information.

Looking for Fat Profit Margins

Birthday party with friends

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.

Business comparison

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.

Here we have the profit margins of the S&P 500 and all of its individual sectors for the 3rd quarter of 2017. The data comes from this research:

Energy 3.4%
Consumer staple 6.6%
Consumer discretionary 7.5%
Industrial 8.7%
Healthcare 8.6%
Materials 9.2
Telecommunications 10%
Utilities 10.2 %
Financials 13.6%
Information technology 19.2%

But does profit margins returns actually translate into stock market gains?

Here is my research as of November 15 2017

5 year returns

Technology 116%
Consumer staple 104%
Consumer discretionary 100%

2 year returns

Technology 42%
Consumer staple 30%
Utilities 26%

1 year returns

Technology 35%
Consumer discretionary 20%
Healthcare 17%

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.