Canadian Finance BlogPortfolio – Canadian Finance Blog

The Psychological Effects Of Risk

Tom Drake — Mon, 16 Nov 2009 10:00:36 +0000

When investing, the degree of risk that you assume will most often provide a better return over the long run. This is why a GIC will provide a lower return than investing in stocks. While the stocks are riskier and and can certainly leave you with losses, over the long run you might be able to expect 7-10% with a properly allocated portfolio.

So if we understand the positive effects of investing in stocks over other safer investments, then why do we choose to invest in less risky products? While a certain level of risk aversion can be a good thing, would we make the same choices when faced with losing money?

Image by nDevilTV

Daniel Kahneman and Amos Tversky developed Prospect Theory in 1979, a study based on decisions that are made when presented with varying amounts of risk. What they found is that 80% of the people questioned would take a guaranteed $3,000 over an 80% chance of gaining $4,000. Now if these had been annual investment returns, the second choice would assume a risk of having a year without any gains. However, if you invested for the long run, your average annual return would be $3,200. Despite the second option providing a larger return, only 20% of those questioned made that choice.

Kahneman and Tversky then looked at the same question related to losses instead of gains. Now an amazing 92% responded that they would rather take the 80% chance of losing $4,000 over the guaranteed loss of $3,000. With the same math again, almost everyone chose an average $3,200 loss over the $3,000.

While you need to invest within your comfort level for risk, this research shows that the majority of us would choose a lesser return in an attempt to avoid risk. What I found interesting though was when our investments are losing money, and it’s unlikely to recover, we choose to increase our risk which leads to greater losses.

The theory seems to hold true in real life as well. Have any readers chosen a Canada Savings Bond over an index fund, to later look back at the gains you missed out on? Or held onto Nortel for too long while hoping your losses would be reduced?

The Psychological Effects Of Risk originally appeared on Canadian Finance Blog on November 16, 2009.

Book Review – The Four Pillars of Investing

Tom Drake — Thu, 01 Oct 2009 09:00:58 +0000

I’ve been looking forward to writing a review of The Four Pillars of Investing: Lessons For Building a Winning Portfolio as I found it to be very influential in my own investment strategy. While some readers may be familiar with this book, I wanted to share what this book is about for those who haven’t read it.

Before The Four Pillars of Investing, William Bernstein wrote The Intelligent Asset Allocator. This previous book, by his own admission, was “comprehensible only to those with a considerable level of mathematical training and skill.” This book conveys the same message as the first, but is easier to read and understand the concepts. Since the book is split into four pillars, lets look at each one.

Pillar One: The Theory of Investing

Pillar One discusses investing theory such as risk (and how to reduce it), as well as how an investment increases in value. One chapter is so obvious once it’s pointed out, that the market as a whole has the same return as the average mutual fund, since they make up the market. So by using simple index funds or ETFs, you can get an average return, no better, no worse… but you also reduce your fees and don’t have to guess what the next great mutual fund will be. The final chapter on theory looks at some possible portfolios consisting of index funds that will match the overall market return.

Pillar Two: The History of Investing

Pillar Two includes a great look into the history of both bubbles and crashes. While you can never be sure of when a major correction will come, or how bad it will be, it’s interesting to read about some of the previous manias and eventual busts. You can see many similarities to what we’ve experienced in this past year.

Pillar Three: The Psychology of Investing

Pillar Three goes into the behavioral psychology related to investing. Seeing these in print can serve as a reminder to avoid the temptation to jump into what everybody else seems to be investing in, since by that time you’ve likely missed the gain. Though most people selling you mutual funds like to use this as a marketing tool, you shouldn’t look at the past 10 years to assume what will happen going forward. Especially after reading this book, don’t start to believe that you are smarter than the market as this can lead to mistakes. There is also more advice to stick with “boring” investments, looking for market beating returns can lead to unnecessary risk. And after all, it’s impossible for everyone to beat the market average, since on a whole, they are the market!

Pillar Four: The Business of Investing

This final pillar convinced me to drop my actively managed mutual funds that same month. Pillar Four looks at how both stockbrokers and mutual fund managers do not have your best interests in mind, due to the simple fact of how they are compensated. Both charge you more for something you can do yourself. More importantly, it’s to their benefit to constantly move you in and out of investments, increasing their commissions while decreasing your return.

Right near the top of my list of recommended personal finance books, The Four Pillars of Investing should be read by anyone that is investing on their own. And for those that are using a commission based financial advisor, this book can open your eyes to the inherent conflict of interest they have and you might also decide to take over your own investments.

I’ll be giving away a copy of The Four Pillars of Investing later this month. I’m saving it to go with a few other surprises! If you want to be the first to find out about the giveaway, sign up for the RSS feed or email subscription.

Book Review – The Four Pillars of Investing originally appeared on Canadian Finance Blog on October 1, 2009.

Fee-Only Financial Planners

Tom Drake — Wed, 13 May 2009 11:00:20 +0000

Looking for some professional help with your investments, budget and retirement planning? You should look for a financial planner. Looking for someone to do this with your best interests in mind? You should hire a fee-only financial planner.

Fee-only financial planners get their income from you, at $100-$250 an hour, to create a financial plan suited for you. Their fees are clearly laid out so that you know exactly what you are paying for and how much.

Commission-based financial planners have an inherent conflict of interest since they might make more money selling you a mutual fund with a higher MER, which also includes a higher commission for them. Paying these higher hidden expenses could cost you more in the long run, especially if you’re not on the financial path that’s right for you.

While I’m sure there are many commission-based financial planners that do not let this sway their decisions, going with a fee-only financial planner, at the very least, gives you peace of mind that both you and your advisor are working towards the same goals… yours.

Fee-Only Financial Planners originally appeared on Canadian Finance Blog on May 13, 2009.

How To Setup and Rebalance TD e-Series Funds

Tom Drake — Thu, 26 Mar 2009 10:00:23 +0000

There is a bit of effort you need to put in to invest in TD e-Series Funds, but it is worth it. First of all, you need to apply using the pdf available on the TD Canada Trust website.

The Account Application is pretty straightforward. You’ll need to provide information like your name, SIN, date of birth, and banking information.

The next couple pages are the Wealth Allocation Model and then the Investor Profile. Fill out the Wealth Allocation Model to provide your Total Point Score. This score will show you which asset mix would be right for you. TD will review this and want the asset allocation to match your score. Because of this, if you are quite sure of what allocation you want, you may want to adjust your score to match that.

The Portfolio Worksheet is where you enter the exact asset mix you want and the amount you are investing, both as a lump sum and pre-authorized purchase plan. To keep it really simple, many investors with a long enough investment time frame might benefit from a equal split into:

Fixed Income 25% – TD Canadian Bond Index
Canadian Equity 25% – TD Canadian Index
U.S. Equity 25% – TD U.S. Index
International Equity 25% – TD International Index

Next is a simple Understanding & Consent form to sign. In the Transaction Form you have to re-enter the information from the Portfolio Worksheet. These two asset mixes do need to match.

Then mail it in to TD e-Series Funds Administration. The full address is on the first page of the pdf. Once everything is setup, TD will mail you your login information.

Once a year, you should rebalance your portfolio back to your original asset mix. Using my example above, if you have a certain amount available to invest, put it into the under performing funds to bring them back up to 25%. If you do not have enough new money to re-balance, you can sell some of the better performing funds and put it back into the others. By rebalancing, it forces you to buy low and sell high.

These steps will provide a diversified portfolio, investing in the entire index that the funds track. You can rebalance it yourself and you will be paying a Management Expense Ratio (MER) of less than 0.5%.

How To Setup and Rebalance TD e-Series Funds originally appeared on Canadian Finance Blog on March 26, 2009.

TD e-Series Funds

Tom Drake — Wed, 25 Mar 2009 10:00:17 +0000

TD e-Series Funds may be the simplest way for someone to invest in a diversified portfolio with low Management Expense Ratios (MERs). Below are the four funds that you can use to build a rather complete portfolio and would work well for regular contributions into an RRSP or RESP.

TD Canadian Bond Index tracks the performance of the DEX Universe Bond Index. The Universe Index is comprised of Canadian investment-grade bonds which mature in more than one year. It has a MER of 0.48%.

TD Canadian Index tracks the performance of the S&P/TSX Composite Total Return Index. The S&P/TSX Composite Index is comprised of Canadian issuers traded on the Toronto Stock Exchange. It has a MER of 0.31%.

TD U.S. Index tracks the performance of The Standard & Poor’s 500 Total Return Index. The S&P 500 Index is comprised of 500 widely-held U.S. issuers. It has a MER of 0.33%.

TD International Index tracks the Morgan Stanley Capital International Europe, Australasia and Far East Index. The MSCI EAFE Index is a broadly diversified index consisting of equity securities of companies domiciled in developed markets outside the U.S. and Canada. It has a MER of 0.44%.

Not only do these four funds invest you in the entire index, their MERs are about 2% lower than the average mutual fund. This 2% advantage can go along way when investing over a long term.

Tomorrow’s post will detail some of the advantages that the TD e-Series Funds have over other mutual funds and show you how to open this type of account.

TD e-Series Funds originally appeared on Canadian Finance Blog on March 25, 2009.