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Why we overprotect ourselves from the stock market

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armourThe price of safety in a low-rate world is high.

Even legendary investor Warren Buffet lamented recently the sad misfortune of those who parked their money in cash equivalents or fixed income investments, saying they have have missed the party over the past nine months as Wall Street rocketed to all-time highs.

“It is brutal. I don’t know what I would do if I were in that position,” Mr. Buffett said at Berkshire Hathaway’s annual meeting in Nebraska. “I feel sorry for people that have clung to fixed-dollar investments.”

Take the GIC, the best five-year rate among major banks is 2.2% at RBC. If held in a taxable account, the after tax return could be as low as 1.1%.

Over the past 12 months, an investor that was 60% invested in the TSX and 40% invested in the S&P 500 would have earned about 8% after fees compared to an armoured up investor who would have earned 2.2% locked into a five-year GIC.

And yet there is still $134-billion invested in GICs of five years or more as of December 2012, data from Investor Economics suggests.

Much of this was invested at rates a little higher than 2.2%, but there still remains some serious money invested at low rates, and the expectation is that much of it will be reinvested right back into GICs when it comes due.

A recent poll by Edward Jones found that a full 11% of Canadian investors don’t even know what they own. But of those that do, most are stubbornly holding on to cash and GICs and plan to add more of the same to their portfolios in 2013.

I believe a five-year GIC is an investing mistake today for two reasons.

1. People avoid stocks because of a fear of losses, even though over five-year periods, the chances of meaningful losses are very low, and there is a reasonable chance of significant gains.

2. Many people – especially retirees, feel that their investment time horizon is much shorter than it actually is. If they view their investments over a longer time horizon, then they might see that losses in diversified stock investments almost never happen.

A recent study from investment firm Franklin Templeton tries to better measure this fear. The study suggested that while 60% of Canadians think that the stock market will go up in the next year, half of Canadian investors indicated that they will be adopting a more conservative investment strategy in 2013. This compared to less than one quarter (22%) who will get more aggressive.

Investors often overprotect themselves from the risks of the stock market.

If we look at five-year periods since January 1950 the TSX would have outperformed a 2.2% return roughly 90% of the time. If you factor in fees of 2%, it still would have done better than a 2.2% return about 80% of the time. The worst five-year return was minus 1.9% or minus 3.9% including fees of 2%. The best five-year return was 25.8% after fees. So the five-year range was an outperformance of 23.6% down to an underperformance of 6.1%.

So it is true that you could do better in a GIC about 20% of the time (not factoring in taxes), but the downside is not too deep, and the upside you are giving up is significant.

I believe that if most investors used a 20-year time horizon, they would see an almost 0% chance of losing money

Now, if you believe that losing any money at all is not acceptable then you would buy the GIC. The question is why would you be so fearful of losing any money? Based on the past 60+ years, if investing in the stock markets for five years, the downside risk is fairly small.

What if based on history the downside risk was essentially 0%? Would that make the investment decision better?

I believe that if most investors used a 20-year time horizon, they would see an almost 0% chance of losing money.

I am often told by 70-year-old clients they don’t likely have a 20-year time horizon. In many cases I think they do have at least a 20-year time horizon on at least a large percentage of their savings.

Let’s say a 70-year-old couple has $500,000 in savings. Based on their expenses and other income, they expect to draw out $15,000 a year from this savings. Since they are in a ‘draw down’ stage they believe they must now be conservative with the bulk of their investments.

If that $500,000 grows 5% a year on average, then the $500,000 will actually grow by $10,000 every year even with the $15,000 withdrawals. In their case, I would suggest that the time horizon is at least 20 years, and probably 30 years plus.

The odds are that at least one member of this couple will be alive in 20 years so these investments need to last at least that long. If they can achieve 5% returns and draw $15,000 a year, then they will have over $760,000 in 20 years. They will effectively have had $500,000 at age 70, and proceeded to never touch the principal for 20 years. Based on that logic, the bulk of that money should have been invested reasonably aggressively.

Once they both pass away, what happens to the money? It will likely be inherited by their children who may even pass it down to the next generation. Now you are looking at a 30-year-plus time horizon for this money.

Over 20-year periods since 1950, the worst performance on the S&P 500 (US Market) was 7.0%, while the best was 19.4%. For the TSX, the worst was 6.2% and the best was 14.1%. Even if you factored in fees as high as 2%, and chose to use the worst performance period, a $100 investment in the S&P 500 would be worth $265 in 20 years. This is using the worst period and factoring in a relatively high 2% investment fee.

Maybe it’s time to shed some of the armour.

Written by Ted Rechtshaffen, President & CEO of TriDelta Financial.
Reproduced from the National Post newspaper article 13th May 2013.

TriDelta 3rd Q 2012 Market Outlook

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What Happened in the Quarter

The third quarter can be summarized by two major government announcements:

  1. The European Central Bank announced the Outright Monetary Transactions programme aimed at providing significant monetary support to ensure that the “Euro Will Not Fail”. The new bond-buying plan is aimed at easing the eurozone’s debt crisis. The ECB aims to cut the borrowing costs of debt-burdened eurozone members by buying their bonds.
  2. Later in September, the US Federal Reserve Bank headed by Ben Bernanke announced Quantitative Easing 3. This included a commitment to buy $40 billion in mortgage backed securities each month from Fannie Mae and Freddie Mac (the US version of the Canadian Mortgage and Housing Corporation – CMHC). This is in addition to the $2 trillion in Treasury bonds that it bought in QE1 an QE2.

Both of these actions and the expectations of these actions drove markets higher during the quarter. Among the biggest beneficiaries were precious metals, energy, and other commodities – sectors of the market that lagged for much of the year.

The Toronto market was up 6% on the quarter after having fallen over 6% in the previous quarter.

The bond universe market was up 1.2% on the quarter.

How did you do?

At TriDelta Investment Counsel we have two main types of clients. The first group seeks conservative growth and income and are invested in our ‘Pension’ model. The second group is looking for growth, which is delivered via our ‘Core’ model.

Pension Clients:

This group is typically in retirement or close to it and looking for less volatility, higher income and steadier 5% to 10% gain, especially while interest rates and GIC rates are so low.

Most pension clients grew by 1.5% this quarter (after fees).

Our Pension model (based on 60% stocks and 40% bonds) returned 5.5% year to date (after fees). So far on the year we are very pleased to see that our Pension portfolios are delivering the type of returns that they were designed to deliver.

While the performance this quarter was not as strong as the super charged stock markets, it is important to remember why. Our approach is based on finding a mix of bonds, preferred shares and dividend paying stocks that will provide a steady level of income. The capital gains growth from the portfolio will usually come from companies that are rarely flashy in the short term (like the precious metals index) but act more like the tortoise than the hare. Companies like Trans Canada Pipelines, Philip Morris, and Colgate Palmolive.

These are the type of companies that will not jump meaningfully upon hearing about the latest round of quantitative easing.

Dividend Changes in Q3 – Pension

One area of Pension focus for us is to hold companies with stable and growing dividends. In terms of dividend changes this quarter we saw 7 dividend increases and no decreases:

  • Microsoft boost its quarterly dividend by 15%
  • Phillip Morris boost its quarterly dividend by 10.4%
  • Norfolk Southern boost its quarterly dividend by 6.4%
  • BCE boost its quarterly dividend by 4.6%
  • CIBC boost its quarterly dividend by 4.4%
  • Emera boost its quarterly dividend by 3.7%
  • Verizon boost its quarterly dividend by 3.0%

 

Core Performance Clients:

This group of clients is looking for greater growth, less concerned about income, and want to beat the market over time. Ideally for peace of mind, these portfolios will still have less volatility than the market overall. We call this group Core Performance portfolios.

Most Core Performance clients grew by 2% this quarter (after fees).

Our Core Performance model (based on 60% stocks and 40% bonds) returned 9.7% year to date (after fees), with a healthy part of the gains coming in the first quarter.

The numbers are quite positive although we saw a little portfolio drag of higher cash balances in the Q3 performance in our Core Performance portfolios. We look forward to adding some more momentum to the portfolio over the next few months as opportunities present themselves.

Some of the trades we made this quarter and why?

In Pension Portfolios:

  • We sold a Manulife bond that had a coupon of 4.08% and came due in 2015.
  • We bought a Manulife bond that has a coupon of 5.06% and comes due in 2041.

Rationale – The short term Manulife bond had a yield to maturity of 2.57%, and we replaced it with a bond from the same company that has a yield to maturity of 6.02%. The 2041 bond also has a current yield (the coupon payment of 5.06 divided by the purchase price of $86.50) of 5.85%.

We will not likely hold this bond to maturity, but feel that the significant increase in yield (while holding the same company), will benefit investors in the short to medium term, while we remain confident that long term interest rates will remain low (or lower) over that time.

  • We sold Barrick Gold

Rationale – This was a difficult decision. The stock was purchased for most clients around $40, dropped to $31, and came back to $37 when we sold it for Pension clients. The volatility is what made us sell the stock. It remains in our Core portfolios as it passes the financial hurdles of the Core model and the speculative nature and volatility of the stock is more appropriate for that mandate.

In Core Portfolios:

  • We did the same Manulife bond trade as noted above in the Pension portfolios.
  • We bought Tesoro Corporation. It is up 16% since our purchase.

Rationale – Tesoro is an independent petroleum refiner and marketer in the United States with two operating segments: refining crude oil and selling refined products in bulk and wholesale markets and selling motor fuels in the retail market. They had a great earnings report this quarter and continue to prove themselves as one of the best operators in the refining space. Growth wise they have two expansions that should contribute positively to earnings shortly and help accelerate growth. The stock ranks very well and is breaking out of a 11/2 year range that should provide substantial support.

  • We sold Discover Financial Services.

Rationale – The stock had a really good run and was up 45% YTD when we sold it. There was some concern about high valuations and their entry into new market segments such as student loans. So far the stock has continued to do well in August and September.

Our Investment Outlook and how it will impact your portfolio

We believe that some of the market gains in Q3 have been driven by ‘hot air’. By this we mean that it is relatively easy for governments to print and throw money at a major economic problem. What is difficult is seeing fundamental economic improvements on the ground and in the economy.

On the positive side there continues to be signs that the US housing market is stabilizing, with price gains in many markets. Housing market changes tend to move slowly, and a turn from one direction to another can be a significant signal. We are hopeful that this slow shift in US housing will provide one of the foundations for an improving economy.

The other big positive is that historically when the government provides economic stimulus and provides lower than average borrowing costs for consumers and companies, the markets tend to benefit. We have certainly seen some of this benefit in the U.S. market, and think that in the medium term that will continue.

On the negative side, there are a few items:

  1. The China Purchasing Managers Index is at 47.8. This is very low and suggests weak growth in China.
  2. Eurozone Purchasing Managers Index is at 46.0, historically a very low level, and one that indicates a continuing high unemployment and low (if any) growth in the region.
  3. Spain, Greece and Italy have been out of the news for a while, and markets have seen solid increases. At some point, they will make negative economic headlines again and the market will see a pullback.
  4. The U.S. “Fiscal cliff” is the popular shorthand term used to describe the conundrum that the U.S. government will face at the end of 2012, when the terms of the Budget Control Act of 2011 are scheduled to go into effect.

Among the laws set to change at midnight on December 31, 2012, are the end of last year’s temporary payroll tax cuts (resulting in a 2% tax increase for workers), the end of certain tax breaks for businesses, shifts in the alternative minimum tax that would take a larger bite, the end of the tax cuts from 2001-2003, and the beginning of taxes related to President Obama’s health care law. At the same time, the spending cuts agreed upon as part of the debt ceiling deal of 2011 will begin to go into effect.

TriDelta’s defensive stance (with higher than average cash balances) will remain until we see a meaningful 5%+ pullback in markets, so that we can find some better entry points. An example might be outside of Canada. We currently have a meaningful position in the U.S. markets. We will likely be expanding our non-Canadian positions for two reasons. The first is that the Canadian dollar is currently very strong, and we believe it is at the high end of the range making it a good time to invest outside of Canada. Also, we continue to look for greater diversification from the core energy and materials that Canada has in abundance.

When we look at the movements of the markets in the last quarter, through the list of positive and negative items that we are facing, we believe that one of the list of four negative items will be the focus of markets’ attention at some point this quarter, and will lead to a pullback that we can take advantage of.

In the meantime, our portfolios (while a little conservative) are well positioned to continue to see some growth in most market situations.

TriDelta Investment Counsel Investment Committee – October 2012
Cam Winser, CFA, VP Equities
Edward Jong, VP Fixed Income
Ted Rechtshaffen, MBA, CFP, President and CEO
Anton Tucker, CFP, FMA, FCSI, VP, TriDelta Financial Partners

 

Key Indicators of the Global Financial Markets

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The TriDelta Investment Process

In addition to the bottom up analysis of Fixed Income and Equity investments, our investment committee also conducts a detailed monthly review of macro factors that affect the global financial markets.

This top down analysis involves reviewing several types of fundamental, economic, technical and geo-political market data.

When looking at the fundamentals of each market or region we are essentially trying to see what value is currently being attributed by the market and what returns are expected. For the global equity markets we review the price to earnings ratios and other valuation measures to assess the value of each market relative to one another and historical ranges.

Country or region’s valuations are then compared and contrasted with historic and estimated earnings growth trends, any revisions and gross domestic product. This review provides insight on markets attractiveness – over, under or fairly valued and growth expectations relative to history.

Key Indicators

Our analysis of the geo-political situation around the globe is another key element that influences portfolio decisions. Economic growth is typically associated with political climate and so too, market activity. A recent example is France where on May 6, 2012, François Hollande became the first Socialist to be elected president of France since 1995. This swift and somewhat surprising outcome has many economic ramifications, not least of which is that it will be seen as a challenge to the German-dominated policy of economic austerity in the euro zone, which is suffering from recession and record unemployment.

Technical factors are another indicator that our investment committee reviews. This analysis focuses on sentiment and trends. Sentiment indicators provide useful clues such as market bottoms in an oversold market. Interestingly many of these such as the ‘Bull/Bear’ indicator are contrary indicators and . When readings are at an extreme people are excessively optimistic or pessimistic and the markets are usually ready for a change in direction. These events usually happen once or twice a year and are usually the most opportunistic times to make strategic changes to a portfolio.

Analysis and review of current economic data is performed to determine a variety of aspects including where certain countries are in their economic cycle and cyclical opportunities. Numerous government statistics such as jobs data, consumer price index (CPI), capacity utilization, gross domestic product (GDP) and housing data help us determine the state and direction of the economy.

We review the shape of the yield curve and changes to credit spreads as part of our fixed income analysis. This in depth monthly review reveals shifting yields for various maturities, which enables us to gauge income expectations and the level of risk investors are willing take in order to generate extra yield. We look for the ‘sweet spot’ and adjust the portfolio accordingly although shifts are seldom monthly, but rather evolve over many months.

Collective Wisdom

All of these indicators provide clues and collective wisdom that influences our investment decisions. Things such as sector allocation in equities to credit considerations in fixed income.

None of us have a crystal ball, but just as the saying, “the more I practice, the luckier I get” goes, so too do we find that the more research and application of collective experience, the better our performance.

TriDelta’s strict adherence to a disciplined approach and risk management shifts the odds into our client’s favor, which in turn provides the peace of mind we promise.

This article was written by Cameron Winser, VP of Equities, TriDelta Financial Partners. Click here to learn more about TriDelta Financial’s investment strategy or contact us with any questions about our financial planning services.

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