Thursday, February 26, 2009

Back to Blogging

Just wanted everyone to know that I will begin "musing" in a week or so. Have not forgotten you...

Monday, February 9, 2009

What Would You Like To Know

Today's blog is going in an entirely new direction. This is my 50th blog since I began this new and interesting journey. I have received some very interesting feedback over the past few weeks - albeit usually by email. I want to know what you, the readers, would like to see. There is a comments section at the bottom of each blog and I want to find out what topics would be of interest. I have been focused mainly on the markets (for somewhat obvious reasons), but would be happy to veer off in a slightly different direction. Please tell me what you would like to know and I will be happy to research and provide that information.

Future topics could include:

Retirement planning which would include info on CPP, OAS, pensions, and the various forms of "income" from investments. We could also get into the structure of your investments.

Government benefits - Canada Pension Plan, Old Age Security, employment insurance, disability benefits etc.

Insurance products and their applications. This could include life isnurance, disability coverage, health plans and critical illness protection.

The next week will include no updates as I intend to focus on work - please provide your comments below (whether positive or negative) and based on those thoughts, we will see what direction this blog will take over the coming weeks and months.

Friday, February 6, 2009

History Has a Way of Repeating Itself

They always tell us that past performance is not indicative of future performance. As often as I have quoted this mantra, some individuals still like to forget this fact. If you consider the fact that the past 10 years was bad, then does it stand to reason that the next 10 years will also be bad? If you want historical numbers, why not REALLY GO WAY BACK IN TIME.

If you really want a historical perspective, how about taking a look at something for over 180 years. Is that sufficient time? The graph below may be hard to read but I'll make it simple. The black line is the divider - each column to the right represents the years that the US stock market posted positive returns. The first column is 0% to 10%, the second is 10% to 20% returns and so forth. On the left side of the black line, are the negative years. The first column to the left represents-10%-0%, the second column represents -20% to -10% and so forth.

What the chart points out is the simple fact that 70% of the time, returns are positive. In the majority of years, returns are from 0% to 20%. There are the obvious blips (last year was a big one), but in the past 184 years, there were only 9 years where the US markets declined more than 20%. There were 48 years in which returns were over 20%.

If this doesn't convince someone of the viability of equities over a long period as their investment of choice, I don't know what will.

Now before anyone accuses me of being boring and spouting out statistics and numbers, remember this - it is all about the statistics and numbers. History has shown that the majority of investors who react to negative market changes, fail to react to positive market changes too. Market timing is not based upon knowing when to get out, but also knowing when to get in. Missing by a few days wouldn't make that much of a difference right? Wrong !!!

Here's a great tool to help understand market performance. This link brings you to an online calculator from Dynamic that shows how fund performance tends to "level out" over long periods of time. By selecting different "holding periods", you can see how as you move to longer periods of time, the frequency of losses in the markets declines and eventually drops to zero.

Remember a simple fact when it comes to investing. As Warren Buffett says "We don't have to be smarter than the rest, we have to be more disciplined than the rest".

Wednesday, February 4, 2009

(Un) Emotional Investing

One of the most basic tenets of investing is that the higher the potential returns, the higher the associated risks. Pretty basic stuff - unfortunately some people tend to forget that when times are good. They promise not to panic when markets fluctuate, (and they will do so again at some point in the future) and they lose money. However after a sudden slump, your investments drop and fall below what you paid for them. The risk is now terribly real. You find yourself watching the business news, trying to understand what is happening and imagining the worst. It is now that you really understand what risk is really about. When markets are headed on a straight line up, the only questions advisors hear is "why did my fund only make 10% last year"? When they drop sharply like they did in 2008, people begin to question "why they invested in the markets". The graph below shows the typical market cycle and the "emotions" attached to that cycle.

It looks like a pretty simple thing to follow - red is a bad time to buy, and green is a good time to buy. Unfortunately, most people (experts included) don't know exactly when we are in a "green or red" time frame. When markets drop in value, people have a tendency to forget their long-term investment strategy. Risk tolerance questions and Know Your Client forms help advisors to understand your "investment psyche". Once you establish your comfort zone, stick with it regardless of the market (changes in your personal situation are different).

Founder and President of Strategic Imperatives, Dan Richards ranks among today’s leading authorities on strategies for financial institutions and financial advisors. In a recent video interview, he discusses the impact of the recent market meltdown on both investors and advisors and the results will surprise you.

The pyramid on the left shows something that I have often related to people. 92% of the returns of an investment portfolio, be it stocks, bonds or mutual funds are dependent upon the mixture of assets you hold. 6% of your returns are dependent upon which investment company's plan you bought, and the remaining 2% on when you bought or sold. This assumes you bought investments on a regular basis (monthly or less), and didn't bail at the first hint of a market decline. In other words, if you are aggressive and hold all of your money in the stock market, 92% of returns are based upon the Canadian stock market. The other 8% are affected by which Canadian equity fund you bought and when.

How do we remain "unemotional" about our investments. Here are a couple ways to approach it.
  • By agreeing and arranging to dollar cost average (DCA) by making preauthorized purchases of the same amount of money each month into the same investments. Each year you can review the amount you deposit and see if you can afford to do more. Look at the chart below - see if you can guess the returns for a lump sum on January 1st or monthly purchases for the full year. (Answer below in big bold red).
  • By realizing that a long term goal is just that - long term. If your need is short term, then invest that way. If you're 38 and plan to retire "around 60", then realize that markets will have sharp drops at least 3-4 times before you retire.
  • Picking a future date (say 5-10 years from your estimated retirement date) and then and only then making any dramatic changes to your plans

All that being said, you still need to be mindful of serious problems. The stock going through a major correction is not something you or your advisor can control. Losing your job, divorce or the loss of a spouse, or a major health problem are factors that require you to reexamine your plans. Other than that, it makes little sense to change your plans every time the markets go up or down.

The chart above shows the actual monthly purchase prices if you DCA'd for the year 2001 (our last recession). A lump sum on January 1st meant a loss of 13.9%. DCA still produced a loss but it was only 1.1%

Perhaps the best advice of all comes from Warren Buffett. In his annual "Chairmans Letter" to shareholders in the Berkshire Hathaway group he stated. The line separating investment and speculation, which is never bright and clear, becomes blurred still further when most market participants have recently enjoyed triumphs. Nothing sedates rationality like large doses of effortless money. After a heady experience of that kind, normally sensible people drift into behavior akin to that of Cinderella at the ball. They know that overstaying the festivities -- that is, continuing to speculate in companies that have gigantic valuations relative to the cash they are likely to generate in the future -- will eventually bring on pumpkins and mice. But they nevertheless hate to miss a single minute of what is one helluva party. Therefore, the giddy participants all plan to leave just seconds before midnight. There's a problem, though: They are dancing in a room in which the clocks have no hands.

Monday, February 2, 2009

Retirement Lasts Longer Than Market Corrections

It might be an obvious statement to some, but it's one I feel needs to be made: a person's retirement will last longer than this market correction — much, much longer. It might be hard to think about this right now, given how much the markets have dropped, but it is important to keep perspective in these times. It's perspective that people need, and generally people have responded in an appropriate manner. If you can understand that your investments will rebound during their lengthy retirement, you will pull through the market adjustment.

There are five key risks to retirement income: longevity, inflation, withdrawal rates, asset allocation and health care. The purpose in identifying these risks was to help advisors develop retirement income plans for their clients. While it defined them in a bull market, they continue to be just as important in helping shape people's thoughts on retirement planning in today's volatile markets. Let's take a look at each of the five key risks taking into account the current market volatility.

The simple fact is that retirements are getting longer. In some cases, they can be as long as your working life — 25 years or more for many people. But as retirements increase, so do the risks, and so should the planning. The longevity of Canadians is not going to reverse just because markets are volatile and the economic outlook is uncertain. There has been a substantial increase in life expectancy at birth over the last 25 years, but it may be even greater in the next 25 years. So even if some of you choose to retire later than you had planned, the length of your retirement is likely to be just as long as if you didn't delay your retirement.

Inflation was a hot topic a few months ago, but you don't hear much about it at the moment. Instead, deflation — widespread falling prices — is the topic du jour. Deflation isn't likely to happen, because governments and central banks are aware of the conditions under which it could happen, have the tools to prevent it, and will use them as necessary. Although it seems remote at the moment, concern about inflation will again emerge, probably sooner rather than later. It might result from a resumption of growth in global commodity prices, or from a resumption in global growth. Regardless, it is highly likely to occur in the next several years.

Similarly to the situation for deflation, central banks have the tools to keep inflation low and inflation expectations well contained. The Bank of Canada has done a good job on inflation in the past decade and has a strong commitment to keeping it under control in the future. Nevertheless, you can expect an average annual inflation rate of at least 2% per year going forward. In real numbers as they’d affect a retirement income plan, inflation at 2% annually over a 25-year period reduces the purchasing power of your income to approximately 60% of its original value. Interest rates on short-term government securities and longer-term government bonds may rise a little over the next few years as investors move away from the safety of government securities and back to other types of securities in search of higher returns, but interest rates on government securities are not likely to rise enough to provide the protection against inflation that most retirees are looking for. Therefore, clients need to look beyond the current urge to be in "cash" and consider the role equities should play in their retirement portfolio.

Withdrawal rates
Most clients have been reasonable about their incomes from their portfolios. Some people may be thinking of raising their annual withdrawal rates in order to maintain specific income streams from portfolios that are valued less than they were a few months ago. Yet research has demonstrated time and again that for people in their mid-sixties, an inflation-adjusted annual withdrawal rate of 4% is the ideal rate to extend portfolio life to its maximum.

This raises the very basic question of how clients can keep their withdrawal rates down when their portfolios are also down. There aren't any easy answers, though it has to do, in part, with how quickly markets recover. For clients who are counting down to retirement, depending solely on the whims of the markets over the next couple of years does not make sense. In this case, a thorough examination is in order: of clients' other sources of income, projected expenses in retirement, flexibility of retirement date and whether clients are candidates for working during retirement. Depending on their specific situation, an increased monthly contribution to retirement savings may be required. Both increasing their monthly contribution and investing it at a time when markets are volatile may require some pretty thorough discussions. But I am convinced that much as investment performance is important, so too is the amount contributed by clients.

Asset allocation
The fourth risk to retirement income is asset allocation. There are some basic rules for asset allocation that apply to almost everyone — equities, fixed income and cash. Research has shown that having equities in a portfolio is likely to result in the longest portfolio life.
It also takes into account the differences in appropriate asset allocation for average markets and extended down markets. Clearly the correct answers tend more toward the latter than the former, at present. The mistakes made most often in asset allocation are having too much of one asset category — a mistake especially to be avoided at the moment. But moving from a general discussion to what is appropriate for a specific client absolutely must consider the client's situation, especially risk tolerance.

I have said many times before and I repeat now that many people simply don't understand what risk is. The challenge now is try to put some perspective on market risk so that clients are not driven to the risk-averse end of the spectrum at the expense of the returns they need. Obviously, this particular discussion must be wide-ranging and include all sources of income, specifically which ones are guaranteed (CPP, OAS, pension, annuities).

Health care
The fifth risk to retirement income is health-related expenses, particularly out-of-pocket health costs, but also age-related costs such as the help that may be required for housing and daily care in the later years of retirement. Like longevity, the need to prepare for health-related expenses doesn't change just because markets are volatile. What volatile markets — and the accompanying increase in uncertainty about retirement income — may accomplish is to help people realize that they should give some serious thought to these costs, and to their choices now and as they age.
Another specific planning area to consider is to consider a Long Term Care Plan, or to build a separate 'health-care' fund.

None of us can control the markets, but there is a great deal we can control and this is the time to do just that. Knowing all sources of retirement income and their characteristics, facing various economic and market prospects head on and preparing to be flexible enough to react to events as they unfold are likely to improve your prospects in a big way.