The topic of this blog post should come as no surprise to anyone, and yet I am sure it is the topic that causes the most dread. Even more dread than the idea of having to budget or track your spending. There are so many horror stories going around about people who have invested and lost everything. Other stories of people who have had unbelievably epic wins, which we suspect are just stories. So what is the truth about Investing? Let’s take a look.
I started my personal financial journey, where most of you did, with a basic savings account. The interest rate, generally, wasn’t much to look forward to. But it was the first time I experienced the magic of my money working for me, instead of me working for my money.
The next step for me was Canadian Government Bonds, and some Ontario Government Bonds for variety. And for the first few years this was great. The returns were so much better than a savings account. I am not old enough to be able to sing the praises of Bond interest rates seen in the late 70’s and early 80’s (okay, I am old enough, I just wasn’t rich enough back then). It didn’t take long for the declining Bond interest rates to sour my new found happiness.
At this point in my journey it was suggested that I try investing in Mutual Funds. I understood that Mutual Funds were a pool of investors’ funds that were used to purchase a mix of stocks and bonds. And this mix was determined at the creation of the fund. The balancing of these assets was actively managed, and as a result some of my returns would be used to pay for this service. My local Bank was more than happy to sell me Mutual Funds, especially if I didn’t know what Mutual Fund I should be buying.
Your Bank is required to assess your “Risk Tolerance”, typically by a short list of questions, and make sure that the fund they sell you is within your Risk Tolerance. At no point was I educated on the real risks involved, nor given a context for the questions about Risk Tolerance. So without guidance my Risk Tolerance came back as “Low”. So I was sold units of a Balanced Fund. I think I held that fund for 4 years and definitely didn’t get as much back as I had initially invested, and forget making any sort of return.
Mutual Funds left me very bitter about investing for several years after that. Ironically it wasn’t the very high Management Fees (MER) that soured me to investing. Instead it was the lack of a simple piece of financial advice: If you are not currently Living Within Your Means you have no business investing. Everywhere we look we are told that we should ALWAYS be Saving and Investing. This is wonderful advice, if your individual financial situation is LWYM friendly. Mine was most definitely not when I bought that Mutual Fund.
As a response to this set back I did what most people do, I turtled. The money I had in my RRSP account I stuck into a Guaranteed Investment Certificate (GIC) and promptly forgot about it. Despite requiring my direct instructions at renewal my Bank was more than happy to keep rolling my money into whatever GIC term (length of investment time) was being promoted at the time of renewal. This unasked for action was the excuse I needed to continue to ignore my investing for many more years than was healthy.
It was several years later, after I had managed to get my finances in order, that I returned to investing. At this point I was far more knowledgeable about finances and investing. I wanted to make up for lost time and started doing lots of research into individual companies. I spent hours and hours every day doing research. Then I bought individual stocks using the Discount Brokerage offered by my Bank.
At first I was doing well. I had focused on stocks with “proven” dividend paying track records. They also had very high yield dividend payments (this usually means it isn’t sustainable). Some of my stocks did very well, both in dividend payments and increases in share price. A few did okay. Some were small losses over the long run. But there is one in particular that was a painful loss. The CEO held a news conference on Wednesday reassuring investors that the company’s finances were in order and the dividend was sustainable. On Friday there was another news conference where the CEO admitted that they had been lying for years about the company’s financial wellbeing. The stock tanked instantly and the dividend virtually vanished overnight.
While my individual dividend paying stocks started to crumble and fall apart I had been doing a lot more reading about personal finance. A friend pointed me towards Index Investing. If you have listened to the news I am sure you have heard some of the following terms: NASDAQ, S&P 500, S&P 60, or DOW Jones Industrial Average. These are just some examples of indexes or collections of stocks that are traded on certain stock markets.
The S&P 500 is an American stock market index. It contains the 500 largest companies that have stocks listed on the NYSE (New York Stock Exchange) or NASDAQ (National Association of Securities Dealers Automated Quotations). Now that the silly definitions are out of the way, this index represents the top 500 stocks traded in the United States. The index also has a complex formula for representing each of these companies “evenly” compared to each other. What matters is the index doesn’t represent just 1 share of each company, but several shares of each company to give them “equal weight” or value within the index.
Where the S&P 500 is the 500 Largest Companies there are other indexes that focus on many other market breakdowns. Some of the most common are: medium sized companies; small sized companies; specific sectors (ie. Metals, Energy, Technology, Financial, etc.); and some are “broad spectrum indexes” or “Total Market” (ie. Total Market US Index would be every US stock being traded).
When people invest in the stock market they are trying to make lots of money, obviously. The way people measure their success in the stock market is to compare their returns against the Index returns. With all of the professional traders and fund managers (people who invest other people’s money like Mutual Funds do) around the world you might expect that there are some who are very good at what they do. Unfortunately stock markets are very complex and have a way of defying even the “experts’” expectations. It is very rare for a trader or fund manager to consistently beat (make more than) the index return.
So if most people make less with their stock picks every year than the average return of the entire stock market why wouldn’t you invest in the entire market yourself? This is the fundamental approach behind Index investing. But there are a few problems with this approach: 1) it isn’t practical for an individual to buy each and every stock out there; 2) the S&P 500 Index is a calculation not a physical thing; and 3) trying to adjust your trading daily to account for the balance of stocks within the index is impossible.
Remember we discussed Mutual Funds and the fact that they are a collection of many people’s money. With a large enough pool of money this would overcome issue #1. It would also be a single place that had the right balance of all the stocks in all the right proportions as the index, solving #2 and #3. But Mutual Funds have a very high fee structure, especially in Canada, and that would eat away at your gains very quickly.
Many companies, such as Vanguard, have proposed a solution to this problem: Exchange Traded Funds (ETF). An ETF is: 1) a pool of funds from many investors; 2) follows a basic formula, like the S&P 500 Index; 3) is automatically balanced by computer algorithms, so no active manual trading / management; and 4) can be bought and sold the same way as a stock is. This allows you to buy any Index you want, easily, cheaply, and with a very small management fee (where Mutual Funds are 2.5% or more a good ETF is 0.15% or more).
I know this last section has been rather heavy, and may have started to lose some of you. But it was important to build a basic understand of what an index is and how you can invest in an index. In the next post we will be able to move on to the value of this approach. And more importantly I want to share the numerous financial epiphanies that I experienced as a result of starting down this path; simple ideas that have surprising depth and insight when considered just a little bit differently than normal.