How to Tell the Difference Between Investing and Gambling!

gamblingI saw a question posted on a popular social network. The question was: ‘What is the difference between gambling and investing?” I’m inspired to reproduce (edited with permission) the following excerpt from A Maverick Investor’s Guidebook (Insomniac Press, 2011) which I believe provides as good an answer as one might find.

How to Tell the Difference Between Investing and Gambling!

“How do you develop ‘smart thinking’ and when do you know you’ve got ‘avarice’?”

My instinctive response would be: “You always know when you’re being greedy. You just want someone else to say that your greed is okay.” Well, I’ll say it then: greed is okay. The proviso is that you fully understand when greed is motivating your decision and live with the consequences. Avarice is driven by desire, which is not a trait of an investor.

Remember, it’s best if investment decisions are rational and stripped of emotion. Greed is associated with elation on the one hand, and anger (usually directed at oneself) on the other hand.

When decisions are motivated by greed, I call it gambling. In my mind, there are different sorts of gamblers. Some gamblers place modest bets, and if they win, they move along to another game. For me this might be roulette. There are those who enjoy playing one game they’re good at, such as blackjack or craps, hoping for a big score. Finally, there are those who are addicts. I can’t help those folks, so let’s assume we’re just discussing the first two types.

It’s okay to do a bit of gambling with a modest part of your disposable income. In fact, investors can apply some of what they know and have fun too. Unlike the casinos, financial markets have no limits or games stacked in favour of the house. It’s the Wild West, and if an investor understands herd behaviour and the merits of contrarian thinking, and does some research, the results can be quite lucrative. Whether using stocks, bonds, options, hedge funds, domestic mutual funds, foreign equity or debt funds, or commodity exchange-traded funds (if you don’t know what these things are and want to know, buy a book that introduces investment theory and the various types of securities), applying investment principles will help you be more successful.

gamblerTo put it plainly: counting cards may not be allowed in a casino, but anything goes when it comes to markets. Just don’t forget that most of the financial industry is trying to make your money their money. There’s a reason why a cowboy sleeps with his boots on and his gun within reach.

The fine line between gambling and investing is hard even for old cowhands to pinpoint. Investing also involves bets, but the bets are calculated. Every decision an investor makes involves a calculated bet—whether it’s to be in the market or not at all, biasing a portfolio in favour of stocks versus bonds, skewing stock selection in favour of one or several industry groups, or picking individual stocks or other types of securities.

I met a lady once in line at a convenience store. She bought a handful of lottery tickets, and I asked her, “Aren’t the odds of winning pretty remote for those lotteries?” Her reply was, “The odds are good. There’s a fifty/fifty chance of me winning.” Confused, I asked, “How do you figure?” I laughed aloud when she said, “Either I win or I lose; that’s fifty/fifty, isn’t it?”

A maverick investor knows there’s always a probability that any decision to buy or sell or hold can prove to be incorrect. The objective is to minimize that probability as much as is feasible. It’s impossible to make it zero. This is why financial firms have sold so many “guaranteed” funds lately. People love the idea, however impossible, of being allowed to gamble with no chance of losing. Whenever there’s a promise that you won’t lose or some other similar guarantee, my senses fire up a warning flare.

There’s usually a promise of significant upside potential and a guarantee that at worst you’ll get all (or a portion) of your original investment back. Many investors a few years ago bought so-called guaranteed funds only to find that the best they ever did receive was the guaranteed amount (extremely disappointing) or much less after the fees were paid to the company offering the product. If you think this stuff is new, trust me, it’s not.

guaranteedA fancy formula-based strategy back in the ‘80s called “portfolio insurance” was popular for a brief period. An estimated $60 billion of institutional money was invested in this form of “dynamic hedging.” It isn’t important to know in detail how the math works. Basically, if a particular asset class (stocks, bonds, or short-term securities) goes up, then you could “afford” to take more risk because you are richer on paper anyway, so the program would then buy more of a good thing. If this better-performing asset class suddenly stopped performing, you simply sold it quickly to lock in your profits. The problem was that all these programs wanted to sell stocks on the same day, and when everyone decides they want to sell and there are no buyers, you get a stalemate.

The “insurance” might have worked if you actually could sell the securities just because you wanted to, but if you can’t sell, you suffer along with everyone else—the notional guarantee isn’t worth the paper it’s printed on. Remember these are markets, and even though you see a price in the newspaper or your computer screen for a stock, there’s no trade unless someone will step up to buy stock from you. The market crash that began on Black Monday— October 19, 1987—was, in my opinion, fuelled by portfolio insurance programs. The market was going down, so the programs began selling stocks all at once. There weren’t nearly enough buyers to trade with. By the end of October ’87, stock markets in Hong Kong had fallen 45.5%, and others had fallen as follows: Australia 41.8%, Spain 31%, the U.K. 26.4%, the U.S. 22.7%, and Canada 22.5%.

Minimizing the Probability of Stupidity

If you’re gambling, follow the same steps you would as if you were investing. If it’s a particular stock you are anxious to own, do some homework, or at least look at someone else’s research available through your broker or on the Internet. When I was a younger portfolio manager, there were limited means to learn about a company. I would have to call the company and ask for a hardcopy annual report to be sent to me. When it arrived after several days, I’d study it a bit so I didn’t sound too ignorant, then I’d call and try to get an executive (controller, VP finance, or investor relations manager) to talk to me. If asking questions didn’t satisfy my need to know, then I’d ask to come and meet with them in the flesh. Nowadays, you have all the information you need at your fingertips.

Money.ca is a PRIME example of just one such source of valuable information available to investors today!

Mal Spooner
Mal Spooner

Don’t get whipsawed by Risk Management!

Back in February of 2012, I recall a prominent CFO departing a global insurance company.  This particular individual was labelled “the highly regarded architect of a hedging strategy that proved key in rebuilding investor confidence in the wake of the financial crisis.”  The company had suffered financially during the prior market meltdown because of a huge exposure to equity-linked products;  pre-crisis the company had introduced investment products that guaranteed to return a substantial (if not all) amount of the investor’s initial investment.  The money was invested in the company’s funds which in turn invested in stock markets.  During the financial crisis, the value of these assets (stocks) held in the funds declined below the amount that was guaranteed spelling serious trouble for the company.  In response a stricter approach to risk management was adopted after-the-fact.

Sounds sensible doesn’t it?  But it just isn’t!  I’ve watched this pattern time and again over decades.  The fundamental flaw is a complete misunderstanding of what constitutes risk.

Risk is almost always equated to volatility.  For example, stocks move up and down rapidly with much magnitude so they are deemed more risky than bonds.  But are we really as averse to upside risk as downside risk?  Strangely people become more averse to volatility when they’ve suffered downside risk (and come to adore volatility when upside risk has rewarded them).  Because our internal model of risk is so much more complex than mathematics can reckon with, our efforts to ‘manage’ volatility can actually subject us to less volatility but more risk.  When we reduce risk (hedging strategies usually reduce volatility – both up and down) at the wrong times, we miss the chance to be rewarded by the kind of volatility we adore.  We are our own worst enemies.

The President and CEO of a completely different insurance company was quoted as saying this, also in February of 2012:

“We are maintaining our equity hedges as we remain very concerned about the economic outlook over the next few years. We continue to be soundly financed with year-end cash and marketable securities at the holding company of about $1 billion.”

 

This statement followed the company’s earnings release, having reported substantially increased losses from its investments – management had hedged the company’s equity position in 2010 (again, after-the-fact) and suffered investment losses in that year’s fourth-quarter because stock markets rose (instead of declining).  The actions designed to protect the company against volatility lost money.  Risk aversion after-the-fact caused the company to lose money and avoid potential returns from upside volatility.

Because the pain caused by the downside volatility suffered previously was still fairly recent, aversion remained at a high level causing the company to stick to its hedging strategy (in denial?) despite these huge losses, and it continued to lose money as the market continued to go higher and higher still.

The financial crisis is behind us and now that markets are hitting all-time highs, record amounts of dollars are scrambling to get some upside volatility action. Too late?  It’s hard to put a pin in it, but intuitively might one conclude that if managing risk (or ‘risk off’ as they say on business television) was a bad idea during and immediately after the financial crisis, then perhaps chasing volatility (‘risk on’) might not be such a good idea at present?

It might seem as if I was picking on insurance companies earlier, but many pension funds, other financial services companies, portfolio managers and everyday investors follow the same destructive pattern.  Adoring upside risk but loathing downside risk – always at the wrong times – has ruined careers and put a serious dent in the life-savings of families.  More experienced money managers (there are fewer of us nowadays) increase risk when others are most averse to the idea, and begin to manage risk (hedging, raising cash balances) during periods of ‘irrational exuberance.’  They’ve learned the hard way that it’s easier to keep all the hair on your head if you avoid circumstances that make you want to pull it all out.

Mal Spooner

Investment Industry needs independent players!

The most recent print issue of Money noted that the big Canadian banks managed to earn $31.7 billion in 2012, just a few years after there was grave concern that they’d even remain solvent.

“There is no question that Canadian banks play a vital role; locally, provincially, nationally and inter-nationally. Without the banks, our economy could simply not function efficiently or effectively. But are the banks getting too big and going too far to gain market share and profits at the expense of their own customers?” (Quote from Spring 2013 issue of Money Magazine.)

In November of last year I published a piece entitled Banks own the investment industry! A good thing? In many respects allowing the banks to provide everything from our mortgage to investment services is incredibly convenient. But at what price? It has become near impossible for many smaller investment dealers to stay in business. Fraser Mackenzie is a recent victim of an industry that requires scale in order to compete:

At their shareholder meeting on April 29th, 2013 it was decided: “Our assessment of the current business climate has led the owners to conclude that deploying our capital in the continuance of our regulated investment dealer businesses can no longer generate an acceptable rate of return. Institutional interest in early stage mining and oil & gas companies, sectors to which we have been heavily committed, has dried up: as has the associated trading in the equities of early stage resource companies. Furthermore, the regulatory cost burden is increasing at a time that industry-wide revenues are declining. On balance, it makes sense for our shareholders to re-deploy their capital.”

Indeed, well over half of the total value of trading done on the TSX in a typical month is conducted by the banks.

My guess is their actual market share of all trading is far above half if we were to also include trading platforms not part of the Toronto Stock Exchange. The banks keep growing, and the regulatory burden also grows more onerous. In my estimation, the larger financial companies relish regulation as an additional barrier to entry. Regulatory oversight is a minor inconvenience to the big banks, whereas for less diversified specialty businesses (mutual fund companies, standalone investment dealers, investment managers) the added expense can be devastating.

Obviously there are huge benefits to scale – but do consumers really benefit or are these economies of scale all kept as bank profits? MER’s for their proprietary mutual funds might appear very reasonable, but it’s impossible to determine whether or not the plethora of fees I pay for other services are subsidizing these seemingly lower expense ratios. Transparency is near impossible. Although many banks did collapse as a result of the the financial crisis, the massive rebound in the profitability of those surviving banks (even though they lost ridiculous amounts of capital doing stupid things with asset backed securities, derivatives trading etc.) suggests that those everyday fees paid by consumers and businesses must exceed the marginal cost of providing these services by quantum leaps and bounds.

Another concern I have – besides the demise of competition in the financial services industry – has to do with motivation. It’s true that every business is designed to make money, but in days of yore a mutual fund company, investment manager or stock broker had to have happy customers in order to succeed. If they didn’t help the client make money, the client would go somewhere else. I believe that as each independent firm disappears, so does choice. Making a great deal of money from you no longer requires you to be served well. What are you going do? Go to another bank?

The prime directive (to borrow an expression from Star Trek) of the financial services behemoths is profits. The financial advisor’s role is to enhance corporate profitability. Financial advisors today are increasingly handcuffed not just by regulatory compliance, but also ‘corporate’ compliance. Wouldn’t an investment specialist whose only mandate is to do well for his client be more properly motivated (and less conflicted professionally)? Would your investment objectives be better served by an independent advisor who is rewarded only because you the client are earning profits (and not because you are earning his employer more revenues)?

It isn’t necessarily true that an independent advisor is any better than one employed at a bank. I personally know of hundreds of outstanding advisors working at banks and insurance companies. But it must also be true that a satisfied, properly motivated, objective and focussed financial professional will do a better job whether he/she is at an independent or a bank.

We can’t begrudge the banks their success but left to their own devices, they’d all have merged into one by now. In December of 1998 then Canadian Finance Minister Paul Martin rejected the proposed mergers of the Royal Bank with the Bank of Montreal and CIBC with the Toronto-Dominion Bank. We know from our U.S. history that government and regulatory authorities are frequently frustrated by the political muscle (lobbyists, lawyers) of the large financial firms. Ultimately having one gigantic Canadian bank – providing all our financial services, investment needs, insurance requirements – might (or might not) be a worthy corporate ambition, but it’s hard to imagine such a monopoly being good for the likes of us. After all, just consider the progress that has been made in telecommunications since Bell Canada (or AT&T) was forced to reckon with serious competition.

The banks need independent players. Not only should banks discourage the obliteration (by bullying or by absorption) of non-bank competition, they should use their political muscle to keep the regulators from picking on Independent players. Government agencies cannot help themselves – if they are impotent against the strong they naturally attack the weak – even though when all the weak are dead the regulators would have no jobs. You don’t need a police force when there’s nobody you can effectively police.

Independent players create minimum standards of service and ethics, and fuel industry innovation. In every instance, the independent is a bank customer too. Mutual fund and investment managers pay fees to banks, buy investment banking offerings, custodial services and commercial paper and also trade through bank facilities. Independent dealers provide services and financing to corporations deemed too small to matter by larger financial companies; that is, until these businesses grow into large profitable banking customers. Put another way, why not adopt the Costco model where smaller independents can shop for stuff to sell to their own customers, and higher end specialty shops and department stores can all remain standing, rather than the take-no-prisoners approach of Walmart?

Let’s hope that the few surviving independent firms can be allowed to thrive, and if we’re lucky perhaps new players will arise to provide unique services to Canadian clients and homes for advisors who are inclined to specialize in managing and not just gathering assets.

Mal Spooner

 

 

 

 

 

You want back into stocks…but should it be growth or value?

Decades ago, the academic community and financial services industry, in an effort to better understand what causes good versus bad rates of return in stock markets, began studying differing styles of investment management. There isn’t a hope of my staying awake long enough to cover even a sampling of the variety of styles that are out there, so I’ll keep it simple. Two styles in particular get plenty of attention: growth and value.

With the growth style, portfolio managers use their ingenuity to identify companies that are growing most rapidly. Since I carried around a BlackBerry (aka CrackBerry) for many years, I’ll use its creator Research in Motion (RIM) as an example. When the company was first getting its legs, it offered me and other research analysts a free trial of a little device with a monochrome screen that allowed you to send and receive text messages. We became addicted to them overnight and believed that this kind of service would catch on. Early movers can grow businesses very quickly with sufficient research depth, management expertise, and capital. We professional money managers provided the capital to RIM and the rest is history.

Early on, RIM was a growth company because even though they weren’t profitable and wouldn’t be making money for many years, the company kept selling more and more units. Revenues grew like crazy and, with some occasional disruptions (a market crisis, the technology bubble bursting), so did the stock price.

Portfolio managers who specialize in companies such as RIM are commonly called growth managers. The funds they manage are “growth funds.” The portfolio will usually have many stocks in various industries. They can be fast growing companies in slow growth industries or companies benefitting from an industry that is suddenly growing. Growth stocks can be very expensive. Investors expect the company to grow fast and so are willing to pay a higher price. However, you’ll have to buy a book explaining price/earnings (P/E) ratios, P/E to growth rate ratios, price/sales (P/S) ratios if you really want to get into security analysis yourself.

A value manager is more interested in buying and owning cheap stocks. Some companies grow slowly but pay their shareowners high dividends as compensation. A stock can be in an industry that is out of favour with the investment herd, or an industry can be out of favour entirely, making all the stocks in the sector cheaper. There are measures such as price/book ratios (P/B) and price to net asset value ratios that analysts use to gauge whether a stock is cheap or not.

Growth funds are considered riskier or more volatile than value funds. For instance, if the market is going higher because of a particularly strong economy, then the growth fund should go even higher still. A value manager might not perform as well as a growth manager in a bull market but won’t do as poorly in a bear market. A value manager is therefore considered more conservative.

A strategist friend of mine of TD Newcrest Research allows me to use his charts on occasion.  One of the most telling charts compares growth stocks in the S&P 500 Index to Value stocks.  The adjacent chart is an older one.  When the line is rising, growth stocks are significantly outperforming value stocks.  You can see vividly the technology bubble – growth stocks skyrocketing relative to value stocks – prior to the bubble bursting in the year 2000.

The shaded areas are periods of economic stimulation (US Federal Bank monetary easing).  During these periods it’s not unusual for growth funds to perform much more strongly than value-oriented funds.

Conventional wisdom says that conservative investors who can’t stomach as much volatility should use value funds and that investors who don’t mind a wild ride should use growth funds. Alternatively, you can invest most of your money into a value fund while also putting some into a growth fund so that you might occasionally get more returns in a buoyant market with at least a portion of your savings.

Why not growth when growth is performing and value at other times?

There are portfolio managers like me who hate being pigeonholed into either one of these styles. However, it is inevitable that one label or the other will be associated with a money manager because of the way consulting services are compensated and the way mutual funds are marketed (when growth is sexy, it only makes sense to promote the growth manager).

A maverick investor who understands the ebbs and flows of market sentiment will want to be invested in their favourite growth fund at the right time and to switch into a value fund at other times.

Whenever I’ve recommended a more active approach to selecting mutual funds in print or on television, such as using a growth fund and switching into a value fund when appropriate, I always get the same question: “How do you know when to switch?”

There is an easy answer, but nobody likes hearing it. The answer is: “You will know!” You should switch when your intuition or emotions tell you not too. It is that simple. If the fund you own has been doing extremely well and drifted up towards the top quartile or is now in the “best performing funds” category (rankings are available from a wide variety of publicly available services) and so you’ve begun to love it dearly, it’s time to switch into a different style of fund.

Here is a more current chart.  In this case the shaded areas are periods of recession, and we are all aware that for the past few years monetary stimulus has been the norm.  Not surprisingly then, growth stocks – avoided by most investors like the plague – have been outperforming value stocks.

As investors divest their income biased stocks (and bonds) they will naturally be tempted to move the money into the better performing growth style.  However if history (and experience) is any guide, they’d be well advised to focus their attention on stocks and funds that have not yet participated in the recent market rally.  In the event that government policy, encouraged by the rebound in the housing market, strong corporate earnings and slowly improving employment outlook, becomes less stimulative then value will in all likelihood become the place to be.

Mal Spooner

 

 

 

 

 

Banks own the investment industry! A good thing?

Let’s face it!  In the battle for investment dollars the Canadian banks are clearly the winners!  Is this a good thing?

Once upon a time, the investment business was more of a cottage industry.  Portfolio manager and investment broker were ‘professions’ rather than jobs.  Smaller independent firms specialized in looking after their clients’ savings.  There were no investment ‘products.’  The landscape began to change dramatically – in 1988 RBC bought Dominion Securities, CIBC bought Wood Gundy and so on – when the banks decided to diversify away from lending and began their move into investment banking, wealth management and mutual funds.

Take mutual funds for example.  Over the past few decades Canadian banks have continued to grow their share of total mutual fund sales* – this should not surprising since by acquisition and organic growth in their wealth management divisions they now own the lion’s share of the distribution networks (bank branches, brokerage firms, online trading).

An added strategic advantage most recently has been the capability of the banks to successfully market fixed income funds since the financial crisis. Risk averse investors want to preserve their capital and have embraced bond and money market funds as well as balanced funds while eschewing equity funds altogether. With waning fund flows into stock markets, how can equity valuations rise?  It’s a self-fulfilling prophecy.

Many of the independent fund companies, born decades ago during times when bonds performed badly (inflation, rising interest rates) and stocks were the flavor of the day, continue to focus on their superior equity management expertise.  Unfortunately for the past few years they are marketing that capability to a disinterested investing public.

The loss in market share* of the independent fund companies to the banks continues unabated. Regulatory trends also make it increasingly difficult for the independent fund companies to compete.  Distribution networks nowadays (brokers, financial planners) require a huge and costly infrastructure to meet compliance rules.  Perhaps I’m oversimplifying, but once a financial institution has invested huge money in such a platform does it make sense to then encourage its investment advisers and planners to use third party funds?  Not really! Why not insist either explicitly (approved lists) or implicitly (higher commissions or other incentives) that the bank’s own funds be used?

Stricter compliance has made it extremely difficult for investment advisers to do what they used to do, i.e. pick individual stocks and bonds.  In Canada, regulators have made putting clients into mutual funds more of a burden in recent years.

To a significant degree, mutual fund regulations have contributed to the rapid growth of ETF’s (Exchange-Traded Funds).    An adviser will be confronted by a mountain of paperwork if he recommends a stock – suitability, risk, know-your-client rules) or even a mutual fund.  An ETF is less risky than a stock, and can be purchased and sold more readily in client accounts by trading them in the stock markets.  Independent fund companies that introduced the first ETF’s did well enough for a time but not surprisingly the banks are quickly responding by introducing their own exchange-traded funds.  For example:

TORONTO, ONTARIO–(Marketwire – Nov. 20, 2012) – BMO Asset Management Inc. (BMO AM) today introduced four new funds to its Exchange Traded Fund (ETF)* product suite.

In fact, the new ETF’s launched by Bank of Montreal grew 48.3% in 2011.  When it comes to the investment fund industry, go big or go home!  You’d think that Claymore Investment’s ETF’s would have it made with over $6 Billion in assets under management (AUM) but alas the company was recently bought by Blackrock, the largest money manager in the world with $29 Billion under management.  It will be interesting to see if the likes of Blackrock will have staying power in Canada against the banks.  After all RBC has total bank assets twenty-five times that figure.  Survival in the business of investment funds, and perhaps wealth management in general depends on the beneficence of the Big Five.

Admittedly, the foray of insurance companies  into the investment industry has been aggressive and successful for the most part.  With distribution capability and scale they certainly can compete, but the banks have a huge head start.  Most insurance companies are only beginning to build out their wealth management divisions.  I can see a logical fit between insurance and investments from a financial planning perspective, but then the banks know this and have already begun to encroach on the insurance side of the equation.  Nevertheless I would not discount the ability of the insurance companies to capture signficant market share.

So, is it a good thing that larger financial institutions own the investment industry?  Consider the world of medicine.  No doubt a seasoned general practitioner will feel nostalgic for days gone by when patients viewed them as experts and trusted their every judgement.  The owner of the corner hardware store no doubt holds fond memories of those days before the coming of Home Depot.  Part of me wants to believe that investors were better served before the banks stampeded into the industry but I’d just be fooling myself.  Although consolidation has resulted in fewer but more powerful industry leaders, the truth is that never before have investors had so wide an array of choices.  Hospitals today are filled with medical specialists, while banks and insurance companies too are bursting at the seams with financial specialists.

It is not fun becoming a dinosaur, but this general practitioner has to admit progress is unstoppable.

Malvin Spooner

 

 

 

 

 

 

 

 

*The industry charts are courtesy of the third quarter Scotiabank research report Mutual Fund Review.  The annotations are my own.