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,
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.
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.
I rather focus my attention on the US economy than on the Canadian economy.
I see the Canadian economy as huge gas station for the US and a huge ATM machine. The biggest drivers of the Canadian economy are the oil companies and the banks. You take those two sectors from the index and there is no Canadian economy.
Any Canadian investing his money in the Canadian index may think that he’s diversified but he’s not, he’s invested in two sectors: Financials and Energy.
The US economy is more diversified
On the other hand, the US economy is more diverse.
Generally, the easier way to invest in the US is to buy the S&P 500 index, this index represents the 500 largest companies of the US. This is one of the best set-it-and-forget-it strategies. Over the last 10 years, the S&P 500 index has increased in value 68 %. This time period includes the financial crisis of 2008 in which the US economy tumbled almost 50%.
If we look closer into the S&P index, we will discover that it is composed of many industries, all of them well represented in the index. Those industries are:
But as you can imagine, not all of those industries grow at the same rate. Some go up, others go down and others stagnate.
The US economy is constantly changing. 200 years ago 90% of the economy was based around farming. Nowadays no one thinks of farming. 200 years ago, we didn’t have a technology sector, now we can not live without technology.
Who is the leader and who is the lagger
I went back and looked at the Spider Industry Sectors for the past 10 years to see which industries have been producing most of the gains for the S&P and which industries have been a drag. Here are the returns:
Discretionary + 145%
Health Care +133%
Staples + 105%
Industrial + 73%
Materials + 42%
Utilities + 36%
Real Estate + 5% (This is a new sector, there is only 1 year of data)
Energy – 5%
Financials – 8 %
Here is a graphs which represents all those returns.
What narrative could we build from these numbers?
Reversion to the mean
There is the reversion to the mean theory which suggest that prices return to a mean average. If we believe this theory, Discretionary, Healthcare, and Technology, will either slow down or retrace. And Financials, Energy and Utilities will increase in value. People who follow this theory have a tendency to re balance their portfolio once a year, selling their winners and buying the losers.
I have news for these people: Agriculture will never be a major part of the economy. That time is long gone. Hunting whales to extract their oil to light lamps will never be a major player of the economy. Moby Dick is dead.
Following the trend
On the other hand, I see technology becoming a bigger player in our economy. I see healthcare growing as well. Medicine continues to advance, our life expectancy continues to grow, which means we will need more medicines, more doctors, more everything.
What to do???
It’s dangerous to predict the future. You never know which industry will go up and which industry will go down, that’s why we buy the index, to protect us from our incapacity to pick sectors. But if I had a little bit more money to play around, I would buy a bit more Healthcare and a bit more Technology.
If you had extra money to play with, which sector would you pick?
For years I have been promoting the advantages of global diversification.
My recommended portfolio
Generally, I recommend a portfolio of ⅓ Canadian, ⅓ US, and ⅓ international stocks. I claim that different countries run at different economic cycles, this means that as some countries’ economies are growing other countries’ economies are shrinking.
Avoiding home bias
The advantages of having a diversified portfolio of different geographical areas is that we can reduce home bias ( the tendency to buy stocks from your home country). For example the Canadian economy is only 2% of the global economy, it makes no sense to have a portfolio of only Canadian companies.
Does it work?
It is believed that having investments from different countries, decreases overall risk and increases long term returns. But is this true?
It has been my observation that in time of crisis, most markets are highly correlated, they behave in unison, thus rendering diversification useless. At the exact moment when you need that benefits of diversification the most, it’s the moment when you can’t have it. At any other time, global diversification in a nice academic theory.
It doesn’t work when you need it the most
Two examples come to mind. The time when the Greek government almost defaulted on their debt. At that time all the international markets were moving in unison, they were tanking. The other example was the financial crisis of 2008. All the international markets went down at the same time.
Global investing is an idea that it’s nice in the textbooks but almost useless in real life. Yes, as the textbooks tells us. If we invest over a 20 year period or longer, our investments line are smoother when we are properly diversified. But as investors, will we have the stomach to see all our national and international investments tumble at the same time?
Lack of better ideas
In spite of all of its shortcomings, I will still champion my ⅓, ⅓, ⅓ portfolio of Canadian, US, and International ETFs. Not because I am a strong believer, but because I lack any better ideas.
There are a lot of similarities between investing and cooking a meal.
Just like every meal should be cooked according to the taste of the person eating it, investing should be done according to the risk profile of each investor.
So what are the ingredients.
The principal ingredients are:
Low cost ETF, preferably from Vanguard (the lowest cost leader),
Some bonds, if you are risk averse (but I don’t recommend this), this is like adding a block of tofu to your meal. It’s good for you but it’s tasteless.
Some individual stocks ( I don’t recommend this either). This is like adding red peppers, a bit can add taste, too much it can ruin your meal.
My favorite investment recipe:
For Canadian investors I like to suggest the following recipe:
⅓ Canadian Index ETF,
⅓ US index ETF, and
⅓ International index ETF.
Depending on how much time and how much interest you have in your portfolio, you could add subcategories. For example. The Canadian part could be subdivided into three subcategories: big companies, Medium size companies and small companies. The same can be done for the US part.
With time, some investors like to build elaborated portfolio which include many asset classes. On the other hand, other investors opt for simplicity. Both are legitimate ways to build a portfolio. For example, for someone in the US, they might buy one big broad index called “The total market index,” or they might opt buy all kind index subcategories individually.
Also, as investors reach their investments objectives, they may decide to add more safe assets or they may decide to add more risky assets.
For example, imagine that as a Canadian my objective was to accumulate one million dollars. I have built my ⅓, ⅓, ⅓ recipe. If I had an additional $100,000. I could say to myself.
I am on track for my retirement, I want to reduce volatility, I will put this new money in boring bonds. Imagine that you are adding a tofu block to you stake.
On the other hand, another person could say. I have met my one million dollar goal. If I had an additional $100,000 I would put it in the real exciting names that continue showing in the business news. If I win, I will be delighted, if I lose, I still have my one million dollars to take care of my retirement. Imagine that you are adding a jalapeno to your meal. Be careful, if you add too much you could ruin everything.
The final touch
In cooking, you have to let your plate simmer for a little bit. In investing, you have to let it sit long enough to let the magic of compounding grow your portfolio. There is no shortcut to this… good investment takes time, there is no other way around it.
Recently my friends have been asking me about Bitcoin. The truth is that I don’t know anything about it, but I can tell you one thing, it does look like a bubble.
Thinking about Bitcoin made me think about the South Sea Bubble of 1720.
The South Sea Bubble of 1720
In 1711 the South Sea Company was founded. Due to its political connections, the company won a monopoly to trade with the Spanish colonies in South America.
The promoters of the company told the investors that South Americans were waiting in its shores with pots of gold to be exchanged for British textiles. After a few exploratory trips the imagination of the investors went wild, even the promoters of the stock started believing their own story.
On January 1720 the stock was worth 128£. On August it was worth 1,050£. That’s a rise of 750% in just a few months, in December it had collapsed back to 124£ and shortly after the company was closed.
On 2008 the cryptocurrency Bitcoin was created. It is supposed to be a peer-to-peer network where people can accept payments from this form of currency.
I am not going to argue for or against the merits of the currency, all I want to point out is that most people are buying Bitcoin not as a currency, they are buying it because other people are buying it and the end goal is to sell it to someone else. In short, the business plan is to buy it with the hope of finding another sucker who will buy it at a higher price. None of the current buyers are buying Bitcoin in order to pay for their groceries at the supermarket.
So far, since the creation, Bitcoin’s has grown more the 300% per year. To put it in perspective. Think of Warren Buffet, the richest investor in the world. He made his fortune by growing his investments at a rate of 20% per year. If we believe in the Bitcoin speculation craze, we all will be richer than Warren Buffett in less than 5 years. At a given moment we have to put our imagination on check and come back to reality.
Here are some amazing facts:
April 2010. 1 bitcoin = $0.003 US
July 2017. 1 bitcoin = $2,500 US
Five Steps of a Bubble
Economist Hyman Minsky says that a bubble has five stages: displacement, boom, euphoria, profit taking and panic.
Displacement. Investors discover a new way of doing something, a new technology, a new paradigm.
Boom. Prices start creeping upwards, but quickly gain momentum as people start spreading the news.
Euphoria. People jump into the investment out of fear of missing out. Buy now and do due diligence later.
Profit taking. At this time, some people realize that prices will not continue going up for ever and start cashing out their investments.
Panic. As more and more people start cashing out, the rest of the people realize that current prices or growth rate is unsustainable and every one tries to get out before the next person creating a sudden drop in prices.
It is my believe that Bitcoin has all the characteristics of a bubble.
Displacement. Bitcoin is a new way to transfer wealth from one person to the other. Its blockchain technology is a revolution in the way people do transactions. There is a permanent record of a transactions without the help of attorneys, notaries, nor bankers.
Boom. Prices started creeping up slowly and accelerated as the news spread.
Euphoria. Now, everywhere I go, people ask me about Bitcoin, everyone wants in. They don’t really understand it but hell, if everyone is making money, why not?
Profit taking. Eventually some players will say to themselves: “Hey I am happy with 100% or 200% return on my money, I will take this dollars home. As some smart players take their profit other will follow.
Panic. Some people will see the smart money leaving and they too will try to cash out at the peak. People will be in a hurry to sell to the next idiot, but the supply of idiots will run out.
Time will tell. The only thing that I can tell you for sure is that the past growth rate is impossible to sustain.
I have used other people’s money in real estate and in the stock market.
Other people’s money have catapulted me to out of economic stagnation.
Five years ago I heard about a website called Airbnb where people can rent their property to tourist and earn more than if they rented their properties to regular tenants.
After many sleepless nights because I was constantly thinking about offering a property through Airbnb, I decided to give it a try.
I borrowed $50,000 from friends and family at 10% interest rate.
Then I went to the bank and used the $50 as a 20% down payment for a $250,000 property and I started Airbnbing. It worked as a charm. Usually the rent for an apartment of that value in my neighborhood is about $1,200. But I was bringing home over $3,000 every month. Eventually I was able to pay back my debt of $50,000. My friends were sad to see those 10% interest checks stop coming.
The stock market
For many years, I have been fascinated with the stock market. I drank the kool aid. The rhetoric is that on the long run, global markets give a return of about 8%. The only trick is to withstand the short term ups and down. I have read in a few places (but never done the research myself) that on any 20 year period, the stock market in the US has never lost money. So that’s my business plan. I borrow money for 4% then I invest it in the stock market with the hope of getting 8%. If everything works out, my profit would be 4% (8% – 4% = 4%).
Last year my global portfolio went up about 14%. After paying 4% for the use other people’s money, I made 10% without a single dollar out of my pocket. I don’t know how to calculate a return when I didn’t put any money out of my pocket. I guess that having credibility and being trusted is as important in business as having capital.
By the end of this year I want to reduce my leverage to 10 to 1. This means that for every $1,000 of mine, I will borrow $10,000 from other sources. I will continue this process until I reach $1,000,000 at which point I will start paying down all my debts.
What I am doing, borrowing money and investing it, is extremely risky. It’s a combination of madness and naivete. I have endured many nights of poor sleep. I would not recommend what I am doing to anyone.
If you are interested in using other people’s money, here are some ideas.
How to use other people’s money
Before you start. Be aware that markets don’t go straight up. Know that they can go down by a lot. During the year 2008 the US market went down as much as 50%.
Be ready to think long term. It would take years to build a significant portfolio and build a track record which will give you credibility.
Most likely you will have to have skin on the game, which means that you will have to put your own money at risk.
Here it is:
Margin account. When you have a broker’s account, the broker might lend you up to 50% of the value of a security to make your purchase. Imagine that you want to buy $10,000 of Royal Bank stock. You could put $5,000 and the broker will lend you the other $5,000. The broker will keep the stock as collateral until the debt is paid. If the value of the stock goes down, you could get a “Margin Call” informing you that you have to sell the stocks or put in more cash. On the other hand, the broker will be willing to lend you more money if the value of the stock goes up. Beware, this is not a free loan, the broker will charge interest, usually Prime rate plus 1% or 2%.
Line of credit. If you have good credit and a stable relationship your the bank, the bank will be happy to lend you money through a line of credit. The interest rate for that loan in generally Prime Rate plus 1% or 2%. If you have a house or any other property as a guarantee, the bank could lend you money at a lower rate.
Friends and family. This the most common yet most dangerous source of funds. Your family and friend know your character. They know whether you are the kind of person who will pay the money back no matter what or if you are irresponsible and always getting into financial difficulties. There is a lot more at stake than money. If you ever default on your margin account or your line of credit, the banks will write that off as the cost of doing business, but if you don’t pay your family and friend, the stigma will never go away. You will be for always, a non trusted person. The conversations at Christmas time and Thanksgiving can be awkward, and who knows, maybe there will not be a place for you at the table.
Big disclaimer. This is my personal view of the the financial world. This portfolio is ideal for someone with a VERY high risk tolerance. It has happened during the past few years that I have shared my portfolio with people who don’t have the same risk tolerance and then start calling me when the market goes down a few points or sell their holdings at a lost.
Most financial advisers advocate a mix portfolio of stocks and bonds. The main reason for this recommendation is to reduce volatility. To deal with the human factor. Our reptilian brain goes into panic mode when we see our holding decreasing in value and do a panic sale. Researchers claim that the pain from losing one dollar is twice as big as the pleasure of gaining one dollar, thus it become very difficult to stay in the market as equity prices are declining and to alleviate some of that pain we add bonds to our portfolio.
It has been demonstrated over and over again that stocks outperform bonds by a wide margin. Also, it has been demonstrated that on long periods of time (20+ years) stock are as a safe (if not safer) than bonds. But it takes years (if not decades) of character building to take the downturns of the market as they inevitable happen.
I have to say it, I don’t have bonds in my portfolio, I have built a tolerance for high volatility. I know that the market doesn’t go straight up, there are peaks and there are troughs and I have learned to live with it. I know that over the long term, I am better off holding stocks than bonds.
Fighting the Home bias
Numerous studies have demonstrated that most investors have a home bias. They like to invest in their home territory. Canada is only 2% of the global market. It doesn’t make sense for a Canadian to keep all his money at home. Canada economy is a natural resources economy, greatly influenced by the prices of oil or gold. By investing in the economies of other countries we can reduce risk and reduce the volatility of our portfolio.
Index investing makes global diversification easy.
I believe that index investing is an excellent way to diversify. When you invest in an index, you eliminate the risk of failure of any one company. At times, companies like Nortel and Blackberry were the darlings of most Canadians. Those who had direct ownership of those stocks suffered great losses however; however, Canadians who owned the index, they recuperated completely. Today, almost everyone is in love with Apple inc. Just keep in mind, that Apple is a phone seller, at any given moment, consumers can turn their backs on their overpriced Apple products and many Apple investors will suffer. By owning the index you can eliminate the risk of owning a single stock.
My ideal portfolio
As a Canadian, I like to divide my portfolio in three equal parts, ⅓ Canadian holdings, ⅓ US holdings and ⅓ the rest of the world holdings. My favorite vehicle to achieve this is through ETFs (Exchange Traded Funds) and the leader in the industry, due to its low price is the company Vanguard.
Here are the ticker symbols which best represent Canada, the US, and the rest of the world:
VCN. FTSE Canada All Cap Index ETF. It represents all the big, medium and small companies is in Canada. Its expense ratio is 0.06%. One year return as of June 29, 2017: 9.54%.
VUN. U.S. Total Market Index ETF. It represents the whole US market. Its expense ratio is 0.16%. One year return as of June 29, 2017: 18.15%
VIU. FTSE Developed All Cap ex North America Index. It represents developed markets except US and Canada. One year return as of June 29, 2017: 20.84%.
The average rate of return of these three holdings was 16.17%.
Here is a graph which represents the three different holdings.
Most advisers suggest re-balancing at least once a year. That means, selling some of the big winners and buying some of the big losers. I don’t bother with that. What I do is this. If I have some extra money to invest, I invest it in the one that is lagging. If want to take money out, I do it by selling some shares of the biggest gainer. I do this re-balancing not at particular per-scheduled moment but as the needs of my life changes. Sometimes, if I need money and I don’t want to disturb the balance of my portfolio, I take money out of my line of credit and then I pay it back either by a stock sale further into the future or by making more money in my other activities.
These are my investment principles unique to my circumstances. Your risk tolerance might be totally different. Don’t consider this article as investment advice, consider it as me sharing a snippet of my investment life.
Ever since I have I have been interested in finance, I have met people who predict the end of the monetary system as we know it. In such a horrific scenario, gold would be the only valid currency. I believe, if the world ever came to that scenario, the things of real value would be guns, ammo, canned food and a fishing pole.
I think investing in gold is a dumb idea for the following reasons:
Gold is a non producing asset. It’s not like investing in real estate where you can rent your property, investing in land of cattle where you see your investment grow. It’s not like stocks or bonds where you will get a return for your money. No, gold is just a dumb metal which just sits there and do nothing.
Most people who invest in gold, they do it through an exchange. If ever, the stock market fails and all the institutions around it, the same thing will happen to gold investments. Gold holdings will evaporate just like all the stocks and bonds. When you invest through an exchange, you are only holding bits and bites in a computer screen. No one is going to come to your house and deliver bars of gold.
By law, Canadians and United Staters (misspelled on purpose) are not allowed to hold bars of gold. They can only hold gold coins (which are exchanged as collector items at a high premium) or jewelry. If ever there is no rule of law where the whole financial system has failed, there will not be rule of law to protect you from a person who can take it away from you by violence.
Opportunity cost. Many gold bug pundits recommend holding about 5% of your portfolio in gold. If gold is not going to save you from financial Armageddon, if you can not convert it into tangible bars of gold, then holding any gold at all, even 1% of it will have an opportunity cost of investing that money into an asset which can provide a real return.
If you hold physical gold, you have to protect it and insure it, this means that your gold will become a recurring expense. After doing you cost analysis, you will be worse off year after year.
We have to have faith in humanity, we have to believe that our social system will protect us from the chaotic scenario where gold could become a real currency. If we continue believing in the rule of law, very few investments can do better than the stock market.
Many investors feel lured by the magic of the stock market. They hear about amazing IPOs (Initial Public Offerings) and they hear stories such as: ” If you would have invested in (Insert company name) 5 years ago, you would have been a godzillionaire by now.”
Others feel enticed by penny stocks, they want to find that one stock which moves from $0.10 to $0.15 in one week and they plunge right in.
Those above mentioned scenarios are part of the learning curve. At times we are lucky and we make a nice return, other times we fall on our faces right away. Either way, investors or speculators eventually drop out or decide to learn more.
So, here is the question again: When should we buy individual stocks?
In almost all my previous articles I have promoted investing in broad based Index funds or ETFs (Exchange Traded Funds). In particular, for a Canadian, I suggest to invest 1/3 of the Portfolio in a Canadian Index fund, 1/3 in a US Index fund and 1/3 in an international index fund. That way you have global diversification and your portfolio is less volatile than if you had just Canadian stocks.
Let’s say that you follow my recommended portfolio and you decide to invest $6,000 every year. If you invest $2,000 in each of those funds you will be on track to achieve your financial goals. Now, after meeting those goals, if you run into any additional money, then may use that money as “play money” and invest it in individual stocks.
Some ideas to buy individual stocks
The Canadian economy is divided into different sectors, for example:
What I would do is to start with one representative of each industry. For example, in the financial sector, I would chose one of the banks, Let’s say Royal Bank.
In the Telecommunication sector I would buy one of the internet providers, let’s say Telus. So on and so forth.
Then I would look at their stock value and only buy the stocks which seem to be going up. Immediately after buying, I would put a “Stop loss” order. This means that if the stock drops more than a set money amount or percentage, the broker should sell automatically. When you put an automatic stop-loss you protect yourself from big losses and you detach yourself emotionally from your investment.
For example. As of Today, June 12, 2017, the whole energy sector is down, so I would not buy any stocks in the energy sector. But let’s say I did, let’s say I bought Enbridge, which today is trading at $52.12. Then I would put a stop loss. Many expert recommend putting a stop loss at 7%. In the case of Enbridge, if the stock drops more than $3.65, then your broker would sell automatically the stock for you.
The idea is to let your profit run and to cut your losses short. If Endbridge goes up, you move up your stop loss. If you Enbridge goes down, then the maximum you would loose is 7%. If you do that with all the industries, then you will be diversified, you will participate in the market when it is going up and you will be in cash when the market is going down.
I am a money coach, don’t hesitate to write me if you want to talk about money or anything else that is going on in your life.
Practically every investment website or book talks about investments in percentages terms instead of absolute amounts. They says things like… “you should invest X percentage in stocks and X percentage in Bonds.”
But believe me, investing 50% of your $5,000,000 portfolio in stocks doesn’t feel the same as investing 50% of $50,000.
A person with $5,000,000 could have 100% of his portfolio in bonds. At 2 % he will earn $100,000 per year. No need to think about diversification.
A person with a portfolio of $50,000 invested 100% in bonds at 2% will get only $1,000. This person will have a hard time living out of his investments.
Those are very dramatic differences, yet the percentages are the same.
My approach would be to figure out what is the bare minimum a person needs to live. Let’s say a person lives with $2,000 per month or $24,000 per year. Now, I will make the assumption that the stock market will continue growing the the rate of 8%. Then I will divide $24,000 by 8% = $300,000. I would like to have $300,000 in stocks before I put one single cent in bonds.
One of my friends, his name is Elijah, 32 years old, started investing for the first time this year. His initial capital was $3,000. Does it make sense to have one single dollar of his saving in bonds earning less than 2%? Of course not. I asked him to invest 100% of his portfolio in the Canadian index. As he accumulates more money, we will try to diversify into the US index and some International index.
I have seen plenty of portfolios in which the financial adviser allocates a big percentage of the portfolio in bonds, even if the client has a small amount of money.
In Management fees
Most actively managed mutual funds in Canada charge 2.5% – 3% as management expenses ratio. On $100,000, that would be $2,500 to $3,000.
When you compare that with the expense ratio of and index fund or ETF of 0.10%, we realize that people who have actively managed funds are getting screwed. The dollar amount an index fund or ETF is about $100.
Of course, financial adviser who work on commission, don’t want you to see the real numbers, they rather work with percentage, they rather keep the figures abstract. It is up to the consumer to do the math to realized how much the adviser is taking out of his pocket.
When deciding how much money to allocate to each asset class, think of it in absolute money amount. And when a financial adviser tell you that he will charge you a “small” percentage for his services, please do the math.
I am a money coach, don’t hesitate to write me if you want to talk about money or anything else that is going on in your life.