Archive for the 'Psychology' Category

Pitfalls of Do-It-Yourself (DIY) Investing: Checking Your Account Daily

Since switching to E*Trade I am noticing an all-to-familiar behaviour creeping back into my daily life. It is something that I have not done since I had my TD Mutual Fund account in 2005. Last year I had an advisor and I pretty much never knew how my portfolio was doing except for those monthly statements I would get in the mail. I loved those days. Now I find myself checking my E*Trade account online about once a day, depending on the week. This week and last week were bad but the week before that wasn’t so bad. Checking your portfolio daily is bad for so many reasons. Reasons that are so obvious that I am not going to waste time mentioning them.

I am thinking of changing my password to something really complicated and giving it to my wife. Then once every 3 months or so (about the time it will take for enough cash to build up to buy some more ETFs) I will ask her for it. That might actually work.

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My Portfolio’s Performance for 2006

I finally crunched the final numbers and here is how we did in 2006:

Annualized returns
From: 2006-01-01 to 2006-12-31
TD Stuff: 14.24%
Templeton International Stock Fund: 28.79%
S&P TSX 60 Index ETF: 13.28%
E&P Growth Opportunities Fund: 5.97%
CI Value Trust Fund: 8.89%
TD Canadian Bond Fund (Wife): 8.30%
TD Canadian Bond Fund (Dave): 4.19%
Cash (Wife): 1.71%
Cash (Dave): 6.17%
Overall: 12.17%

I got these numbers by making a list of all the inflows and outflows; not just into the entire RRSP but into cash, into the investments, out of the investments, out of cash, and so on. Every transaction is a double-entry transaction, except for the final balance (outflow) and the cash inflows from my chequing account (inflow). I could have just looked at cash flows into my RRSP and the final balances but I wanted to see the breakdown between the different components. Once I had the cash flows for each individual investments I did an Internal Rate of Return for each individually. I also did an overall calculation for the entire portfolio (shown at the bottom). Considering that the EAFE index went up 23.47% last year, the S&P 500 went up 13.62%, and the TSX went up 14.51%, we didn’t do too well. All of the stuff there except for the “TD Stuff” we only owned since March when we switched to Clearsight from TD. So I lost to the the indexes I mentioned above. The reason is because we had a sizable bond portion of about 25% and we were also carrying around a lot of cash (not literally) this year for whatever reason. Well part of the reason was that Clearsight dumped my advisor after they were bought by Wellington West and I ceased communication with them after that as I switched to E*Trade. So I didn’t do any trading during that time and our cash pilled up a bit too much.

The reason that my cash account went up by 6.17% annualized is because the dividends from the iShares S&P TSX 60 Index ETF (XIU) do not get reinvested (ie. it’s not a DRIP) but instead go into my cash account. So the dividends show up as sort of a capital gain in the cash account. One way for me to fix this would be to aggregate the cash inflows and outflows from cash and the iShares XIU and get the annualized return for that combination. That would give the annualized return including inflation. But once I buy another dividend-paying ETF, then what? The final 12.17% annualized return takes into account all the unrealized capital gains and dividends that went into the cash account and the dividends on the TD Canadian Bond Fund that were reinvested.

I really love these calculations. It really shows how well YOU did regardless of that the mutual fund’s NAV or the ETF’s market price did. Look at the TD Canadian Bond Fund for example. My wife got 8.3% annualized on hers and I only got 4.19%. This was because I bought it at a worse time. What’s the lesson here? That you should try to time the market? NO! You can’t time the market (so give up trying). The best way in my opinion is to trade completely randomly (hard to do) or just trade at some regular interval (easy to do) regardless of what the market is doing. Too many investors panic when their investments lose value and chase performance in bull markets. These behaviours lead to lower annualized returns for your portfolio, regardless of what the underlying mutual fund or ETF’s published returns were.

I wrote about investors and their bad timing before. Here is one of the quotes from that blog post:

The results indicated that, as with most active funds, investors’ timing decisions were costly when it came to index funds. The dollar-weighted returns for virtually all large-cap index funds were worse than their official returns for the trailing 10-year period through the end of the third quarter 2005. As the table below shows, poor timing cost Vanguard 500 shareholders 2.7 percentage points of returns per year over the past decade. That’s not chump change.

So I hope to see from these calculations how good/bad my timing is. By this time next year I will have an all ETF portfolio so I will be able to compare my annualized return in index X with the return of index X over the same period.

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Bad Timing

Here’s an article I found a long time ago, entitled “When Index Funds Go Bad [registration required: may I suggest].” It has been sitting in a draft post for a long time and just today my last post inspired me to publish it. The title doesn’t accurately describe what the article is about. What she talks about applies to all investments, not just stocks. Here’s the main thesis:

Indeed, investors of all stripes are notorious for their poor timing: They often purchase investments after periods of strong performance and sell them belatedly after periods of weak performance. Those timing decisions thus have a major–and negative–impact on the returns shareholders actually pocket.

She then looks at “dollar-weighted returns to gain a better understanding of how investors have really fared, because dollar-weighted returns account for cash flows in and out of a fund.” The results, in my opinion, are quite staggering:

The results indicated that, as with most active funds, investors’ timing decisions were costly when it came to index funds. The dollar-weighted returns for virtually all large-cap index funds were worse than their official returns for the trailing 10-year period through the end of the third quarter 2005. As the table below shows, poor timing cost Vanguard 500 shareholders 2.7 percentage points of returns per year over the past decade. That’s not chump change.

There is a chart given which gives the dollar-weighted returns and the official returns for many index funds. Over a 10-year period the gap between the two returns ranges from -0.8% to -6.18%. The whole article is excellent and I highly recommend reading it. I will just provide the last paragraph as I think it sums things up pretty well:

Clearly, index investors aren’t immune from the behavioral biases that can produce bad results from good funds. Although many of indexing’s most vocal proponents (Burton Malkiel and Jack Bogle, for example) also preach the importance of disciplined, long-term investing, it appears that many investors didn’t heed that advice. True, investors were challenged by one of the most precipitous bubbles in stock market history, and I take some comfort from the fact that asset flows into index funds have smoothed out over the past few years. But many still have a propensity to pile into the hottest funds at just the wrong time. Witness the recent strong inflows many energy funds have experienced this year. I mistakenly assumed that index funds were less likely to invite such behavior, but this study proved me wrong. I still think index funds provide investors a great way to get low-cost, no-fuss exposure to the stock market, but they are good investments only if shareholders use them wisely and maintain the long-term orientation that’s necessary to benefit from all they have to offer.

Investors are always being told to pay attention to MERs. To look at low-cost ETFs as an alternative to index mutual funds or actively-managed mutual funds. Some people take this to the extreme, recommending ETFs (with MERs of around 0.25-0.5%) instead of index mutual funds (with MERs of around 0.5-1%). To save a few percent on your annual return? As this study shows, a much more important factor affecting your portfolio’s performance has to do with keeping your head. This is something that is easier said than done. As Benjamin Graham said on page 8 of The Intelligent Investor,

We shall say quite a bit about the psychology of investors. For indeed, the investor’s chief problem–and even his worst enemy–is likely to be himself.

This is what investing intelligently is all about. This kind of intelligence, explains Graham, “is a trait more of the character than of the brain.”

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Investors May Let Emotions Drive Decisions

I found this excellent article, “Investors May Let Emotions Drive Decisions” on The Mess That Greenspan Made.

Much of economic and financial theory is based on the notion that individuals act rationally and consider all available information in the decision-making process. However, researchers have uncovered a surprisingly large amount of evidence that this is frequently not the case,” Tilson wrote in a paper called “Psychology & Behavioral Finance.”

One problem: We’re too emotional. A study published in “Psychological Science” co-authored by professors at Stanford University, Carnegie Mellon University and University of Iowa pitted people with normal brains against people whose limbic systems, the brain’s emotional center, were impaired.

The paper asks whether a neural systems dysfunction that curbs emotion can lead, in some circumstances, to more advantageous decisions. The answer, in terms of investing, was yes.

In the study, people were given $20 in play money and could invest it $1 at at time. Winning or losing was decided by a coin toss, the winners would win $2.50, more than tripling their initial investment. The losers would lose the dollar they invested. The odds were clearly in the investors favour. Yet the people with normal brains became more conservative after losing. The people with impaired limbic systems did not.

“Medical study confirms brain impairment HELPS improve investment returns,” Ajay Singh Kapur, chief global equity strategist at Citigroup, wrote in a summary of the study.

He uses the study as an argument for fighting instinct and getting into the market when investment sentiment is most negative and exiting when investor sentiment is high.

Benjamin Graham talks a lot about NOT thinking too hard when it comes to investing (unless you make it your full-time job like him) and keeping a simple, conservative approach: “It is no difficult trick to bring a great deal of energy, study, and native ability into Wall Street and to end up with losses instead of profits.” As well, there is the quote I gave at the bottom of this article.

This is one of the key aspects of the Intelligent Investor, “harnessing your emotions.” In the commentary for the Introduction, Jason Zweig writes:

What exactly does Graham mean by an “intelligent” investor? Back in the first edition of this book, Graham defines the term–and he makes it clear that this kind of intelligence has nothing to do with IQ or SAT scores. It simply means being patient, disciplined, and eager to learn; you must also be able to harness your emotions and think for yourself.”

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