The Real 10 Commandments of Investing

Rob Carrick recently “gathered 10 of our favourite bits of investing advice, on topics ranging from stock-market risk to which mutual funds to buy” and called it the 10 Commandments. A commandment is “a command or order,” so something like “thou shalt not use the word commandment incorrectly” is a commandment. “Commandment” #10 is “Investors repeatedly jump ship on a good strategy just because it hasn’t worked so well lately, and almost invariably, abandon it at precisely the wrong time.” C’mon that’s not even a commandment! So what is the order here, that we should not jump ship on a good strategy that goes bad? or should we not use strategies? or should we abandon them at precisely the right time instead of the wrong time? The longer explanation does not leave things any more clearer, offering such advice as “ignore the slumps or use them as a buy-low opportunity,” or ” judge whether your fund manager has what Dreman calls a good strategy.” For what’s it’s worth, the only words of advice in there I thought were useful were Buffett’s (use low-cost indexes) and Malkiel’s (less fees are better).

A while ago a guy named Alan Haft (he wrote a book called “You can never be too rich”) made up his own 10 Commandments of Investing and it’s been in my drafts folder ever since I saw it. I think he sums up the most important things that people should do with regards to investing, they are well written, and they make sense. Here they are:

  1. Stick with the indexes
  2. Watch those fees
  3. Create a bond ladder
  4. Diversify
  5. Watch your money
  6. Don’t rush in
  7. Don’t take the risk if you don’t need the return
  8. Get out if something isn’t working
  9. Understand tax consequences
  10. Keep it simple

Here are some highlights:

1. Stick with the indexes
Leave the individual stock picking to gamblers and speculators. Very few people really understand how to successfully pick individual stocks, and if they do, the news that drives markets today is totally unpredictable, making individual stock picking a highly risky venture. Reams and reams of statistics prove index investing almost always outperforms the financial advisors, money managers, and stockbrokers. Stick with the indicies and you’ll likely wind up far ahead of the game. Care to speculate a bit on some individual stocks? Do it with a small portion of your money, but certainly not the bulk of it.

2. Watch those fees
Wall Street loves investors that don’t watch their fees. For those investing in funds, check out You might be shocked to find out the total cost your funds are charging you to own them year after year. Especially over the long haul, fees can destroy your returns. Minimize fees as much as possible by investing in low-fee, highly diversified investments such as one of my personal favorites, Exchange-traded funds such as those offered by

7. Don’t take the risk if you don’t need the return
Many people would do perfectly fine getting 7-10% returns on their money, yet their portfolios are invested in things that strive for well beyond that. Especially if you’re a retiree, if you doubled or tripled your money overnight, would you go out and buy a fancy new sports car? A mansion on the hill? Few of us would. And for that reason, always ebb towards the safer side of investing as much as you possibly can

Check out the original article for the rest!

Indexes Have the Advantage in Bear and Bull Markets

There was yet another Rob Carrick disaster in the Globe & Mail this week, a newspaper that I am losing respect for all the time. After reading the headline,
ETF advantage fades in down market, I knew it was going to be a beauty. He starts off by explaining that index funds and ETFs “clean up” in a bull market.

One of the top no-brainer investing moves is to put money in an exchange-traded fund or index fund if you want to clean up in a bull market.

But why just in a bull market? It is unfortunate that he doesn’t give any reason why indexes might perform better in a bull market (or bear market). The most obvious reason is that index funds or exchange-traded funds represent “the average” but have lower MERs. This same logic should apply to bear markets right? His whole argument that ETFs and index funds “beat” actively managed mutual funds in bull markets but perform poorly in bear market is weak. It rests completely on being selective about what past periods to look at and a belief that mutual fund managers are “market pros [that] are using their training and experience to pick the best stocks.” Couple that with reporters’ tendencies to write about both sides of the story, in this case searching for advantages and disadvantages to both index ETFs and mutual funds even if it means leaving readers with an unfair and inaccurate picture.

In the second paragraph, he mentions that ETFs did not perform that well between Sep. 1, 2000 and Oct. 31, 2007 but from 2002 onward they performed much better than actively managed mutual funds. He thinks he has it all figured out; index ETFs perform poorly in a period that includes a bear market.

. . . the advantage of ETFs isn’t so clear over a longer period that includes a down market. The past seven years are a good example. If you bought ETFs at the peak of the last bull market on Sept. 1, 2000, and held until this past Oct. 31, your returns would look puny compared with many popular Canadian equity mutual funds.

He even suggests that investors consider “investing in the Canadian market, but through mutual funds rather than ETFs” because “the S&P/TSX composite is looking shaky right now after a five-year bull run.”

He describes accurately how the S&P TSX Large Cap index did poorly after Sep. 2000 and explains one of the reasons for this: the fact that Nortel made up close to one third of the index whereas mutual funds were limited to about 10% exposure for each stock. So when Nortel lost almost all of its value after 2000, the index, with more Nortel exposure, would have faired much worse than actively managed mutual funds (in fact, the index performed so badly that the “capped” S&P/TSX 60 index was created after the Nortel debacle). The index would have also faired much better than the actively managed funds between 1997 and 2000 because of Nortel’s gains thus compensating for the loss from 2000-2002; however, he conveniently leaves out the 10-year figures (1997-2997) and only uses a “seven-year comparison prepared especially for this Portfolio Strategy column.” His reason for not using 10-year data is that “a 10-year slice is of little use because many funds and ETFs haven’t been around that long.” I find that rather odd because the TSE/S&P TSX Composite has been around since 1977 and the TD Canadian Index mutual fund have been around for 10 years! Of course I agree that “many funds and ETFs haven’t been around that long,” but since we’re only looking at Canadian equities here, isn’t one Canadian index enough? After all, he only looked at one index for the 7-year period.

I decided to get my own figures from Morningstar’s Fund Selector:

  Number of funds that beat the TD Canadian Index Fund Total number of Canadian Equity funds % of funds that performed worse than the TD Canadian Index Fund
3 yr. 90 279 68%
5 yr. 25 218 89%
10 yr. 23 68 66%

My Method: Using Morningstar’s Fund Selector I searched for funds in the “Canadian Equity” category that have a 10-year return greater than -50%. This allowed to me to find out how many funds have been around for the past 10 years. Then I searched for funds that had performed better than the TD Canadian Index fund over that same 10 year period to determine how many funds beat this index fund. I then repeated the same procedure for 5 yr. and 3 yr. periods. The TD Canadian Index fund’s performance over the 3, 5, and 10 years periods was 19.8%, 20%, and 9.2% annualized, respectively.

As you can see from the table, the indexes beat a large percentage of actively managed mutual funds over the past 3, 5, and 10 year periods. Note also that there is some survivorship bias in these figures. Presumably, in 1997 there were more than 68 mutual funds in the “Canadian Equity” category but only 68 “survived” until 2007. One can assume that the ones that did not survive were more likely to have performed worse than the index, hence their reason for being discontinued, retired, or merged with other funds. So the percentage of funds that performed worse than the TD Canadian Index Fund is likely to be higher than 66% if we could somehow include funds that existed in 1997 but no longer exist in 2007.

Indexes can do even better than this if only the MER was lower. The TD Canadian Index fund has an MER of 0.85% but the iShares CDN S&P/TSX Cap Composite Index (XIC) has an MER of 0.25%. XIC does go back 5 years; however, it wasn’t always tracking the TSX Composite; it used to track the TSX/S&P LargeCap 60 index so I will not look at its performance values. Let’s assume that if XIC (in it’s present form) had existed 10 years ago, it would have performed 0.6% better than the TD Canadian Index Fund over that same period due to its lower MER, or 20.4%, 20.6%, and 9.8% annualized over the past 3, 5, and 10 year periods, respectively. This approximation is consistent with the fact that in 2006 the TD index returned 16.4% but XIC returned 17.0%, a difference of exactly 0.6%. I re-ran my fund searches on Morningstar and here is what the performance would be if XIC existed 10 years ago in its present form with an MER of 0.25%:

  Number of funds that beat the hypothetical iShares CDN S&P/TSX Cap Composite Index (XIC) Total number of Canadian Equity funds % of funds that performed worse than the hypothetical iShares CDN S&P/TSX Cap Composite Index (XIC)
3 yr. 63 279 77%
5 yr. 14 218 94%
10 yr. 20 68 71%

As we see once again, the S&P/TSX Composite Index with a 0.25% MER has outperformed over 71% of all actively managed mutual funds in the “Canadian Equity” category in the last 10 year, 5 year, and 3 year periods ending in Oct. 31, 2007. I have not cherry-picked any period and I have shown three different periods, not just one. I have not thrown out any periods based on whether or not they include or don’t include either bull markets or bear markets. The original article only looks at one bear market and concludes that indexes perform worse than active management in bear markets. I am not at all convinced that this is a consistent truth or “rule.” There is lots of data from the US for example that shows that over long periods of time (which include more than just one bear market) indexes handily beat actively managed mutual funds. In A Random Walk Down Wall Street, Burton Malkiel quotes a Lipper study (2007 edition, pages 267-268) that found that from Dec. 31, 1985 to Dec. 31, 2005, the S&P 500 index beat 82% of mutual funds and on average performed 1.5% better than the average fund per year. I would find it very hard to believe that one could increase performance even more by switching from indexes to mutual funds at certain times, or even holding some balance of mutual funds and indexes. Even if we looked at more than one bear market and it turned out that indexes did perform worse in every bear market, without being able to predict when future bear markets start and end, would this information be helpful? How would you know when to switch to mutual funds and then back into index ETFs for the next bull market? You would be guessing and in the end you would lose out due to commissions spent on buying and selling the ETFs and the higher MERs on mutual funds.

Link Fest – November 12, 2007

  • UK Housing Hurting – The British Housing bubble, “spurred by a borrowing spree, thanks to interest rates at 40-year lows from 2001 to 2006” may be in its last days after the “average home almost tripled in value in the past decade.” It looks like properties bought as investments are going to be the hardest hit (just as they will in Vancouver): “Gabay says so-called buy-to-let properties, which investors acquire for rental income, are more vulnerable to a fall in prices . . . As interest rates rise, buy-to-let investors are making less profit on rental property, which may drive down housing demand and prices.” There are already many properties in Vancouver where the owners are not making up their mortgage payments with the rent (a few searches on MLS and Craigslist are all it takes to verify this, in addition to my own research while looking for  a new place for rent in July ’07.
  • Buyers get real returns” – Apparently “if you’re purely interested in accumulating wealth, it’s hard to beat homeownership over the long term, according to a discussion paper (Are Renters Being Left Behind? Homeownership and Wealth Accumulation in Canadian Cities“) completed earlier this year by UBC real-estate professor Tsur Somerville and student research assistants Li Qiang and Paulina Teller.” The results vary by city, but even in “in those cities where it is even possible to accumulate more wealth than owners, renters must be extremely disciplined. They must invest on average nearly 80 percent of the difference between the annual cost to owners and the cost to renters . . . this is approximately equivalent to 9% of a person’s gross income.” 9% of gross income does not seem that bad. If one looks at Table 4 of the study it is not that bad for renters especially if they invest the difference between rent and a mortgage (100% in this case) in lower cost investments. They would have achieved 77% of “owner wealth” if invested only in GICs and 124% of owner wealth if invested in the only the TSX index with 0.75% annual expenses (ie. MERs). I noticed some possible bias in this study and that is that they used the years between 1979 and 1996 as starting years and 25 years OR 2006 as the ending year, then averaged all these scenarios. The later years are thus weighted more heavily in their average. The year 2004 is used in each scenario but 1979 is only used in 1.
  • Mishs Global Economic Trend Analysis: What Factors are Affecting the U.S. Dollar? – Just one paragraph here of note: “The housing bubble in the US is well known, but the bubble in Canada, the UK, China, and Spain is just as big (if not bigger) than the bubble in the U.S. In particular, the bubble in Vancouver is as massive as the bubble in Florida or California ever was. Vancouver housing prices are destined to crash. Don’t ask me when, but only fools are buying at these prices. The housing bubble in Australia was the first to start deflating.”
  • Buy the fund, or buy the company? – Rob Carrick discusses buying stock of mutual fund companies. I found this comment amusing: “Investors can even take their cues from CI chief executive officer Bill Holland, Paul Desmarais, founder of Power Corp., which controls IGM Financial, and AGF CEO Blake Goldring who all have “the majority of their wealth” tied up in their stock as opposed to the funds, Mr. Almeida added.” These guys are smart, they know that it doesn’t make sense to buy mutual funds when 2% or more (on average) of the return is eaten up by MERs every year. Carrick also comes right out and mentions that “with mutual funds, investors typically get market-type returns minus the fees collected by their managers . . . The allure of fund companies is that their business model allows them to collect fees on assets under management during the good and bad times.”
  • Who, in the real world, can afford to live here now? – Another housing story about Vancouver. I knew that the percentage of their income people are now spending on their home has gone up, but I was surprised to learn that “here in Metro Vancouver . . . In the second quarter of 2007, the average owner of a two-storey home spends 73 per cent of the family’s pre-tax income on financing and maintaining that home.” 73% of pre-tax income? How does this average Joe get approved for such a mortgage (or is it a variable-rate?). Or an ever better question, how does average Joe buy food after paying taxes?

Differing Opinions on US Currency Investments for Canadians

A fellow blogger (Y HAT) has a somewhat different view on investmenting USD currency investments:

As I write this the Canadian dollar is trading at $1.07 to the US greenback and most Canadian finance articles I’m reading are suggesting you should jump into US equities – these are cheap by historical standards and the Canadian dollar is bound to retreat. This blog’s opinion is that no one knows were the loonie is headed next. Consequently, you should save yourself a lot of stress by insuring your portfolio against currency movements.

First of all, there is no right answer. Just like there is no formula for how much fixed-income you should hold versus how much equities, or how much emerging markets/small caps you should hold versus everything else. It’s all about how much risk you can handle. Certainly the advice that you should “save yourself a lot of stress by insuring your portfolio against currency movements” does not apply to everyone.

I agree that “no one knows were the loonie is headed next,” just as no one knows where the Canadian equities market is headed next or where the bond market is headed next, which is why I hold a bit of each to reduce my overall risk and/or increase my overall returns through diversification. In the long run though, by the time I retire, I don’t think swings in the USD/CAD exchange rate will amount to any significant gain/loss in my portfolio, but I may have gained more significantly through rebalancing (better with less correlated assets) and lower costs. Maybe in the future I will look back and with perfect hindsight I will wish I had bought XIN instead of VEA, but my present opinion is that I do not think anyone needs to get their knickers in a knot over purchasing US dollar-based investments.

Ask Dave: US Dollar Investments Inside Your RRSP

With no more foreign holding limits inside RRSPs, a lot of people are looking into holding foreign currency investments inside the RRSP. In fact my first ever “Ask Dave” post was about this very topic (see “Ask Dave: USD Holdings In an RRSP“).

Another reader recently wrote me with similar questions. Rob writes:

I’m confused. I want to own US $ investments in my RRSP. RBC Direct advises that all RRSP investments must be in CDN $. They didn’t know what a “wash trade” was. With the Cdn $ at $1.08+ is this a good time to own US $ denominated equities or a USD ETF? If so, can I do this in an RRSP or does it have to be held outside?

Rob, you can certainly own US $ investments inside an RRSP (ie. any US stock (this includes ETFs)). As for US$ mutual funds I’m not really sure (as I’ve never done it) although you probably could. If RBC Direct truly does not allow you do hold USD investments in your RRSP (I would be REALLY surprised if they didn’t), find another broker. The one restriction that the Canadian banks and brokers place on customers (although there is nothing in Canadian laws/regulations that forces them to do so, see “Foreign Currency Investments and Exchange Spreads Inside Your RRSP” and this class action lawsuit against BMO for more information) is that you may not hold any foreign currency inside an RRSP. All cash inside an RRSP must be in Canadian dollars. As a consequence of this ridiculous restriction, if a USD investment is sold, the proceeds must be converted into CAD, then to buy another USD investment, the CAD cash is converted into USD again. Hence huge foreign exchange rate spread-related costs, and hence, wash trades’ raison d’être…

I am not surprised that RBC Direct did not know what a “wash trade” was as I think TD Waterhouse is the only one that offers it (and even then, they will only do it for a phone trade, not an online trade). Refer to the Canadian Capitalist’s site on how to make a wash trade. At the time (August 2006) the Canadian Capitalist said that “as far as I know, RBC Action Direct, which is our primary brokerage account does not offer this feature.”

It is impossible to predict what the US or Canadian dollar will do at this point. Much like with the Vancouver housing market 2 years ago in Vancouver, would it defy all odds and go up even further? Or would it come crashing down as it seemed destined to? The pundits and economists will say whatever they want but they have no clue what will actually happen (although there have been some rumblings about possible Bank of Canada currency intervention measures). I say don’t worry about timing your purchases of USD investments and don’t ask the question “is this a good time to own US $ denominated equities.” Instead you should think long term and ask “should I have US $ denominated equities in my portfolio (for the next 10+ years).” You especially should not be trying to “time” investments in USD investments (or any other currency) because the costs of buying and selling USD investments inside an RRSP are huge unless you use wash trades. Your best bet to minimize costs is to buy them once and hold. For more on the costs associated with USD investments inside an RRSP, see “Foreign Exchange Costs Associated With USD Investments in an RRSP.” If you really want to speculate, use a non-RRSP US$ trading account.

It’s good to be diversified and not have all your investments in Canadian dollars, although if you plan to retire in Canada you definitely want to have most of your retirement assets in Canadian investments as you approach retirement and not expose yourself to unnecessary currency risk (see “US vs. Canadian dollar investments made inside an RRSP” for more detail, especially bullet point 2). You will also incur lower costs (assuming you don’t incur too many foreign exchange-related costs). Observe the difference in MERs between the Canadian iShare XSP (0.24%) vs. the American iShares’ IVV (0.09%) or the Vanguard’s VTI (0.07%), for example. Adding foreign currency investments also decreases the correlation between the different components of your portfolio even further, thus providing more diversification, and in the end, a higher risk-adjusted return.

Send your questions for my “Ask Dave” posts using my contact form. I look forward to hearing from you. My queue of questions is not long, but it’s not short either, so I may take anywhere from a few days or a few weeks to respond. Thanks for your patience.

Ask Dave: Index ETFs and Rebalancing (or lack therof)

I while ago I bought Vanguard Europe Pacific ETF (VEA) for the international portion of my portfolio and one reader had the following comment:

Just a quick question. With regards to balancing one’s portfolio, would ETFs like VEA (and I see there is now one that encompasses the whole world excluding the US), not pose a problem? If for example the European markets did well one year but the Pacific markets performed poorly, then one would be unable to rebalance by selling a European based ETF’s (like VGK for example) and buying more Pacific based ETF’s (VPL for example). With everything in one basket one could not take advantage of the gains to be made by selling high and buying low. Is this assumption correct? Or is it true that because VEA comprises 75% VGK and 25% VPL, that it would reflect any net changes made by owning a combination of both VGK and VPL?

Your assumption is correct, one could not take advantage of the gains to be made by selling high and buying low the stocks in one region vs. another. These rebalancing “bonuses” are small, but more importantly, they may completely disappear after trading costs are taken into account. VEA does not contain a fixed percentage of VGK and VPL underneath. It contains the market cap weighting of all its components. Market cap-weighted indexes have several advantages as investments:

Market value-weighted indexes have lower trading costs. If you made your own index, and the index never added or removed stocks the stocks would be bought once and never sold. As one stock goes up in value, it maintains the desired allocation in the index. This keeps trading costs low as one essentially rarely needs to make trades, except for when stocks are dropped or added from the index. Market value-weighted indexes have the lowest MERs, and other indexes like fundamental-weighted indexes, or fixed-weight indexes have higher MERs due to increased trading within the index.

With market value-weighted indexes, one never ends up holding on to dogs. Imagine it is the early 1900s and you own shares in a fixed sector-weighted index (did such a thing exist back then?). The index contains 25% financials, 25% railways, 25% consumer goods, and 25% manufacturing (or a fixed percentage of each individual stock, it’s the same thing). Every year the index is rebalanced. Pretty soon railways start to go out of style as air travel is invented and highways are built. The 1960s arrive and “tech” stocks are all the rage. The index rebalances religiously, which leads it to purchase a lot of railway stock which continues to do badly, meanwhile it has missed out on the rise in tech stocks. The worse railways do, the more you have to buy in order to keep your portfolio balanced (in addition to paying more commissions). You now wish the index had altered their weightings to contain less railways. One way to do it might have been to not fix the amount allocated to each sector and just use market cap-weighting instead. Or use market cap-weighting while taking into account large changes in what is going on in the market. For example, one could have envisioned a “smarter” version of the S&P 500 index that underweighted tech/IT stocks in around 2000 (selling high) and went back to their appropriate market cap-weight in 2002. Of course we only wish we had a crystal ball back in 2000 that could have warned us that tech stocks were about to fall. It seemed inevitable, just as it did in 1997. Unfortunately there is no foresight in the market and there was no telling if tech stocks would not have kept climbing after 2000. Furthermore, if you believe that markets are largely efficient, there is no such thing as “buying low” or “buying high” and it is not possible to “take advantage of the gains to be made by selling high and buying low” as there are essentially no “gains” to be made. There are only “losses” to be incurred through increased costs of trading and higher turnover.

In the scenario you described you said “If for example the European markets did well one year but the Pacific markets performed poorly, then one would be unable to rebalance by selling a European based ETF’s (like VGK for example) and buying more Pacific based ETF’s (VPL for example).” Personally I would get a bit nervous in buying more VPL. How do you know it is at a “low”. What if it actually at a “high” of even greater future “lows.” I was in an investment club from around 1999-2005 (the club ended in 2005). We consistently thought we were buying stocks at “lows.” We bought stocks like Nortel, Nokia, 360 Networks, Global Crossing, Lucent, etc… after sharp declines only to watch them decline even further (often with another purchase on the way down for good measure). So this is the problem I have with fixed allocations and rebalancing. If you bought 75% VPL and 25% VGK and held them in your portfolio. How do you know if 25% VGK is “just right”, “over-valued”, or “under-valued.” If it falls to 15% now how would you classify it? If it was over-valued before, now it might be just right. If it was just right before it might be considered under-valued now. But if it were truly under-valued (in the sense that the equities in VGK are worth far more than what the market is valuing them at) most likely other smart investors would have already taken advantage of it (as if you’d be the first to realize it!) and so it’s most likely that those equities are “just right.”

I blogged a lot about Equal Weight Indexes in the past:

  • In Non-Market Cap Weighted Indexes: The Next Big Thing I ballyhooed equal-weighted indexes and lamented the lack of equal-weighted indexes in Canada. My opinion of equal-weighted indexes would soon change.
  • In Equal-Weight S&P 500 Index I came to the full realization that RSP, the S&P 500 Equal Weighted index only performed better because of its higher concentration of mid-cap stocks.
  • In Too Many Choices (or why I am ready to give up) I mentioned that “I have now come to the realization that RSP is very similar to the S&P 400 Midcap Index which is also available as an ETF (MDY). It is very highly correlated . . .”

Regrettably, I don’t think equal weight indexes are all that I initially hyped them to be. I did some searching on the web for more information on the advantages of market cap-based indexes over fixed weight indexes but had trouble finding any information at all, however, I think my reasoning above makes sense. As in many arguments over financial instruments and investing strategies, cost is again a huge factor.