Strategic Investment Mixology – Creating The Holy Grail Cocktail

So what do your Investment Manager and your neighborhood bartender have in common, other than the probability that you spend more time with the latter during market corrections?

Antoine Tedesco, in his “The History of Cocktails“, lists three things that mixologists consider important to understand when making a cocktail: 1) the base spirit, which gives the drink its main flavor; 2) the mixer or modifier, which blends well with the main spirit but does not overpower it; and 3) the flavoring, which brings it all together.

Similarly, your Investment Manager needs to: 1) put together a portfolio that is based on your financial situation, goals, and plans, providing both a sense of direction and a framework for decision making; 2) use a well defined and consistent investment methodology that fits well with the plan without leading it in tangential directions; and 3) exercise experienced judgment in the day-to-day decision making that brings the whole thing together and makes it grow.

Tedesco explains that: new cocktails are the result of experimentation and curiosity; they reflect the moods of society; and they change rapidly as both bartenders and their customers seek out new and different concoctions to popularize. The popularity of most newbies is fleeting; the reign of the old stalwarts is history — with the exception, perhaps, of “Goat’s Delight” and “Hoptoad”. But, rest assured, the “Old Tom Martini” is here to stay!

It’s likely that many of the products, derivatives, funds, and fairy tales that emanate from Modern Portfolio Theory (MPT) were thrown together over “ti many martunies” at Bobby Van’s or Cipriani’s, and just like alcohol, the addictive products created in lower Manhattan have led many a Hummer load of speculators down the Holland tubes.

The financial products of the day are themselves, created by the mood of society. The “Wizards” experiment tirelessly; the customers’ search for the Holy Grail cocktail is never ending. Curiosity kills too many retirement “cats”.

Investment portfolio mixology doesn’t take place in the smiley faced environment that brought us the Cosmo and the Kamikaze, but putting an investment cocktail together without the risk of addictive speculations, or bad after- tastes, is a valuable talent worth finding or developing for yourself. The starting point should be a trip to portfolio-tending school, where the following courses of study are included in the Investment Mixology Program:

Understanding Investment Securities: Investment securities can be divided into two major classes that make the planning exercise called asset allocation relatively straightforward. The purpose of the equity class is to generate profits in the form of capital gains. Income securities are expected to produce a predictable and stable cash flow in the form of dividends, interest, royalties, rents, etc.

All investment securities involve both financial and market risk, but risk can be minimized with appropriate diversification disciplines and sensible selection criteria. Still, regardless of your skills in selection and diversification, all securities will fluctuate in market price and should be expected to do so with semi-predictable, cyclical regularity.

Planning Securities Decisions: There are three basic decision processes that require guideline development and procedural disciplines: what to buy and when; when to sell and what; and what to hold on to and why.

Market Cycle Investment Management: Most portfolio market values are influenced by the semi-predictable movements of several inter-related cycles: interest rates, the IGVSI, the US economy, and the world economy. The cycles themselves will be influenced by Mother Nature, politics, and other short-term concerns and disruptions.

Performance Evaluation: Historically, Peak-to-Peak analysis was most popular for judging the performance of individual and mutual fund growth in market value because it could be separately applied to the long-term cyclical movement of both classes of investment security. More recently, short-term fluctuations in the DJIA and S & P 500 are being used as performance benchmarks to fan the emotional fear and greed of most market participants.

Information Filtering: It’s important to limit information inputs, and to develop filters and synthesizers that simplify decision-making. What to listen to, and what to allow into the decision making process is part of the experienced manager’s skill set. There is too much information out there, mostly self-motivated, to deal with in the time allowed.

Wall Street investment mixologists promote a cocktail that has broad popular appeal but which typically creates an unpleasant aftertaste in the form of bursting bubbles, market crashes, and shareholder lawsuits. Many of the most creative financial nightclubs have been fined by regulators and beaten up by angry mobs with terminal pocketbook cramps.

The problem is that mass produced concoctions include mixers that overwhelm and obscure the base spirits of the investment portfolio: quality, diversification, and income.

There are four conceptual ingredients that you need to siphon out of your investment cocktail, and one that must be replaced with something less “modern-portfolio-theoryesque”:

1) Considering market value alone when analyzing performance ignores the cyclical nature of the securities markets and the world economy.

2) Using indices and averages as benchmarks for evaluating your performance ignores both the asset allocation of your portfolio and the purpose of the securities you’ve selected.

3) Using the calendar year as a measuring device reduces the investment process to short-term speculation, ignores financial cycles, increases emotional volatility in markets, and guarantees that you will be unhappy with whatever strategy or methodology you employ —most of the time.

4) Buying any type or class of security, commodity, index, or contract at historically high prices and selling high quality companies or debt obligations for losses during cyclical corrections eventually causes hair loss and shortness of breath.

And the one ingredient to replace: Modern Portfolio Theory (the heartbeat of ETF cocktails) with the much more realistic Working Capital Model (operating system of Market Cycle Investment Management).

Cheers!

The Investment Gods Are Furious

Market Cycle Investment Management (MCIM) is an historically new methodology, but with roots deeply embedded in both the building blocks of capitalism, and financial psychology— if there is such a thing.

The earliest forms of capitalism sprung from ancient mercantilism, which involved the production of goods and their distribution to people or countries mostly around the Mediterranean.

The sole purpose of the exercise was profit and the most successful traders quickly produced more profits than they needed for their own consumption. The excess cash needed a home, and a wide variety of early entrepreneurial types were quick to propose ventures for the rudimentary rich to consider.

There were no income taxes, and governments actually supported commercial activities, recognizing how good it was for “Main Street” — as if there was such a thing.

The investment gods saw this developing enterprise and thought it good. They suggested to the early merchants, and governments that they could “spread the wealth around” by: selling ownership interests in their growing enterprises, and by borrowing money to finance expansion and new ventures.

A financial industry grew up around the early entrepreneurs, providing insurances, brokerage, and other banking services. Economic growth created the need for a trained workforce, and companies competed for the most skilled. Eventually, even the employees could afford (even demand) a piece of the action.

Was this the beginning of modern liberalism? Not! The investment gods had created the building blocks of capitalism: stocks and bonds, profits and income. Stock owners participated in the success of growing enterprises; bondholders received interest for the use of their money; more and better skilled workers were needed — the K.I.S.S. principle was born.

As capitalism took hold, entrepreneurs flourished, ingenuity and creativity were rewarded, jobs were created, civilizations blossomed, and living standards improved throughout the world. Global markets evolved that allowed investors anywhere to provide capital to industrial users everywhere, and to trade their ownership interests electronically.

But on the dark side, without even knowing it, Main Street self-directors participated in a thunderous explosion of new financial products and quasi-legal derivatives that so confused the investment gods that they had to holler “’nuff”! Where are our sacred stocks and bonds? Financial chaos ensued.

The Working Capital Model was developed in the 1970s, as the guts of an investment management approach that embraced the cyclical vagaries of markets. This at a time when there were no IRA or 401(k) plans, no index or sector funds, no CDOs or credit swaps, and very few risky products for investors to untangle.

Those who invested then: obtained investment ideas from people who knew stocks and bonds, had pensions protected by risk-averse trustees, and appreciated the power of compound interest. Insurance and annuities were fixed, financial institutions were separated to avoid conflicts of interest, and there were as many economics majors as lawyers in Washington.

MCIM was revolutionary then in its break from the ancient buy-and-hold, in its staunch insistence on Quality, Diversification, and Income selection principles, and in its cost based allocation and diversification disciplines. It is revolutionary still as it butts heads with a Wall Street that has gone MPT mad with product creation, value obfuscation, and short-term performance evaluation.

Investing is a long-term process that involves goal setting and portfolio building. It demands patience, and an understanding of the cycles that create and confuse its landscape. MCIM thrives upon the nature of markets while Wall Street ignores it. Working Capital numbers are used for short-term controls and directional guidance; peak-to-peak analysis keeps performance expectations in perspective.

In the early 70s, investment professionals compared their equity performance cyclically with the S & P 500 from one significant market peak to the next — from the 1,500 achieved in November 1999 to the 1,527 of November 2007, for example. Equity portfolio managers would be expected to do at least as well over the same time period, after all expenses.

Another popular hoop for investment managers of that era to jump through was Peak to Trough performance —managers would be expected to do less poorly than the averages during corrections.

Professional income portfolio managers were expected to produce secure and increasing streams of spendable income, regardless. Compounded earnings and/or secure cash flow were all that was required. Apples were not compared with oranges.

Today’s obsession with short-term blinks of the investment eye is Wall Street’s attempt to take the market cycle out of the performance picture. Similarly, total return hocus-pocus places artificial significance on bond market values while it obscures the importance of the income produced.

MCIM users and practitioners will have none of it; the investment gods are furious.

Market Cycle Investment Management embraces the fundamental building blocks of capitalism — individual stocks and bonds and managed income CEFs in which the actual holdings are clearly visible. Profits and income rule.

Think about it, in an MCIM world, there would be no CDOs or multi-level mortgage mystery meat; no hedge funds, naked short sellers, or managed options programs; no mark-to-market lunacy, Bernie Madoffs, or taxes on investment income.

In MCIM portfolios, lower stock prices are seen as a cyclical fact of life, an opportunity to add to positions at lower prices. There is no panic selling in high quality holdings, and no flight to 1% Treasuries from 6% tax free Munis. In an MCIM portfolio, dividends and income keep rolling, providing income for retirees, college kids, and golf trips — regardless of what the security market values are doing.

Capitalism is not broken; it’s just been overly tinkered with. The financial system is in serious trouble, however, and needs to get back to its roots and to those building blocks that the Wizards have cloaked in obscurity.

Let’s stick with stocks and bonds; lets focus on income where the purpose is income; let’s analyze performance relative to cycles as opposed to phases of the moon; let’s tax consumption instead of income; and let’s not disrespect the gods, the “Bing”, or the intelligence of the average investor…

So sayeth the gods. Amen!

Change? What Change?

I have, for about 15 years, tried to understand why investment returns tend to be the way they are. I have noticed that over long periods the stock market moves in a very narrow growth trough. In my view there must be an attractor that makes the rate the one we see.

This is background.  It is insufficient to act upon as an investor.

I am reasonably convinced there is an attractor and for the Toronto Stock Exchange it is about 9 and 7/8%. This graphic shows how the total return index (Actual) has behaved from 1950 to now. Click for a larger image.

TSE attractor

The outside bands are the growth from 1920 at 9 7/8% plus or minus 3/8%. The graph is logarithmic.

There seems to be limits so that if the high band is exceeded, then the future actual return tends to be sharply lower and if outside or near the low band, it tends to bounce back. Something draws it back from excesses on either side.

It returns to some standard and that stand must make sense or it would not be so persistent. What makes it up?

I do not know with certainty but I have some candidate ideas.

  1. Since the stock index is in dollars, inflation will contribute some of the growth. Using the Bank of Canada records, that is 3.69% over the 1950 to 2013 period. Be careful with this one though, there are many ways to assess inflation and there is not a consistent set of principals used throughout the period.
  2. Productivity adds value. It is harder to know what that might be but it is likely about 2%.
  3. The size of the market matters. Population growth tends to create customers and thus business value. In 1950 there were 13.7 million of us and now there are 34.9 million. Average growth rate about 1.5%.
  4. Average wealth matters too because the stock market counts economic wealth alone. Real GDP per person has about tripled in the last 65 years. About 1.7% annually.

Total to here. 8.9%

The other could be things like:

  • Access to markets. The internet turns a local business into a global business for some products.
  • Cost reductions. Computers have replaced a lot of clerks. How many operators does Bell employ? Not many. What has happened to draftsmen? Some of these changes are picked up in productivity changes.
  • Competition because capital is not as crucial as it once was. It is possible to start a world class business and get it to the proof of concept level with much less capital than was needed to start old businesses like the car companies and the steel mills.
  • The rise of service industries is important too. Their margins per dollar sales is much higher than retail or manufacturing.
  • Better service and banking structures and better infrastructure
  • Longer lives.

Regardless of what makes it up, it seems to be a persistent number.

As an investor, it is not usually in your best interest to bet against the market long term without a very good reason. By that belief, it would be not so clever to expect yields over long times to be more than 10% less fees and costs to earn it. Call that 7% to 8%.

By the same token if you have a 40 year or longer time frame, then betting much lower may sound smarter, but you will shortchange the present. You cannot take the kids to DisneyWorld when they are 32.

There is always the systemic risk that some government or other will do something to make the attractor rate be much less. I suppose they could make it be much more but I will need to see evidence for that one. I already have evidence for the former.

Be wise. The world behaves in semi-predictable ways. Try to notice what drives it.  Notice the number, but pay attention to how that affects your meaning.

 

Don Shaughnessy is a retired partner in an international public accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

A Deeper View Of The Market

Finding cause and effect in the stock market is a fool’s game. There are way to many variables and there are people in the equation too.  Individually, people are almost fully unpredictable.  Nonetheless finding tendencies with the crowd as background may be useful.

As a case in point here is a graphic of the S&P500 from 1960 to about the present.

sp500 a

Ho Hum.  It goes up.  It goes down.  It fluctuates.  I should have bought in 1975 and sold in 1999.

In general, graphs of this type are misleading because the underlying reality in the 1970’s is not the same as the 1990’s, or any other time for that matter.  To get ideas about the underlying reality, we need to puzzle it out a bit.

This graph might help.

The flat top from 2000 to now is just smoothing out the excess values from earlier.  Eventually everything returns to the underlying fundamentals.  Reversion to the mean.  The stock market reflects underlying economy of long time periods.

I have added three lines to the graph above. The blue line is the old tendency line.  Most of the money in the market was professionally managed then.  The green line shows an inflection in 1987 and the red one another inflection in 1994.  The question is what could have caused the inflections?

sp500 B

1994 is not all that hard to guess.  I emphasize guess.  1994 saw the introduction of Netscape.  The first easily useable browser.  Once Netscape appeared, there was much more information readily available to everyone.  Plus the internet looked like the new gold rush.  1994 is also in the midst of the introduction of exchange traded index funds.  It could be any or all of these as the driving force for change.  Less skilled individual investors maybe, or demand for index stocks, or pie in the sky stocks.  Not much chance any will recur.

1987 took me longer to find a reason.  Another guess but an interesting one.

If you are a fund manager, your governor is your ability to tolerate stress.  You are, every hour of every day dealing with hunches, guesses and uncertainty.  Randomness can harm you.  You need to be a minute ahead of the pack.  A smart trader once told me that the only way to survive is “Sell until you sleep.” Traders get more cautious as the stress builds.

What was different in 1987?

Fluoxitine.

You know it better as Prozac.  Introduced to market in 1987.  Do you suppose traders who feel better, and maybe sleep better, buy more stock at higher prices?

Maybe.

The lesson is the same no matter the reasons.  Stay focused on markets in general ways.  Day to day details are too confusing.  You cannot expect to win the fluctuation game for long.  In the long run you make a fair return and for anyone under 86, the rest of your life is statistically likely to be more than 10 years.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

More On Decisions

All decisions include an element of risk.  That is why some people have trouble with them.  Even people who deal with the risk part effectively and presumably make “better” decisions are sometimes wrong to do it the way they do.

For the weak decision makers, notice that a decision that can be reversed at no cost has no risk.  Don’t waste your time over-analyzing it.

For the stronger decision makers, a decision that has had the risk analyzed out is not necessarily a correct decision.  Eliminating risk does not make it right.

Decisions that matter, or are hard and expensive to reverse, need more work than ones that are reversible, but good decisions are not capsules.  What is the good or even “the best” now, may not end well.  Good decisions don’t stop once they happen.  In the beginning a “good” decision must include attention to the part that measures the after decision effects.  A perfectly sound decision at the point that you make it can turn out wrong and if you don’t monitor it, it will cost a lot.

It is what happens later that prove out whether a decision is good or bad.  You measure the goodness in terms of their effects.  A weak beginning decision can turn out well.  A good one can turn out badly.

Serendipity matters.  Think vulcanized rubber, think penicillin, think the glue on PostIt Notes.  All are outstanding outcomes that arose from weak opening decisions or accidents.

Some properly made decisions turn out badly.  The Edsel, RCA Computers, New Coke.  Quitting well-made decisions early is the hallmark of a competent operational manager.

Make sure you know how you will keep track of the decisions.  Know who is responsible and how often the decision will be tested.  As former CEO of General Electric, Jack Welch has said, “If you cannot measure it, you cannot manage it.”

Decisions are not points, they are time line events.  They need to be managed and accounted for over long periods sometimes.  When building the decision include the oversight as part of the process and as part of the cost.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Are More Choices Good For You?

More choice equals more freedom, therefore “Good!” seems like the self-evident answer.  As with all other self-evident answers, this one is wrong. That wrong result has significant impacts on financial advisers and on their clients. Reality is that the more choices you have the more dissatisfied you will be, and the more dissatisfied you are the more changes you will make, and the more changes you make the poorer will be your outcome. And you will make the changes even when the outcomes are good enough, even very good.

Consider my friend Eugene. He is a super-organized master of detail. Many years ago, in July of that year, he paid off the mortgage on his home and as the result had money to invest each month. His investment vehicle of choice was a Registered Retirement Savings Plan, (RRSP) which would give him both savings and a tax advantage. But which one?

Being super organized, he prepared a spreadsheet. (Actually a lot of large paper sheets taped together on the dining-room table with inked columns and rows.) Each column was a possible RRSP plan and each row was a characteristic of that plan. The detail in each box he derived from an almost infinite number of brochures that he acquired from every bank, trust company, credit union, insurance company, stock broker and fraternal organization that he could find.

It was to be a supremely rational decision, but choices impaired rather than helped.

As the end of February deadline approached, he became more frustrated. According to his wife, at one point there were 174 plans in the matrix. What should he do? What did he do?

He made an excellent choice. He took the money he had set aside and they went to Hawaii for two weeks.

Why was that a good choice? Because it did not deal with the RRSP decision.

By having many choices, he guaranteed eventual dissatisfaction. No matter how good his first choice might have been he would have found in a year or two that there was a better one he should have made. Dissatisfaction leads to weak decisions in future. By choosing Hawaii he avoided the choice/dissatisfaction problem.

Eventually he accepted “good enough to get what I want” as a reasonable option.

For advisers, offering many options seems like a good idea. It makes you look impartial. Pick what you like, I can do it. But it does not work. You are the expert, the client is the one who knows the least technically so why should they make the decision.

If a doctor treating you for serious disease #7 said, “There are four choices for treatment. Here are the risks and probable outcomes for each, which do you want?” you would be appalled. You would likely say, “Which do you think is best?” or, “If you were me, which would you choose?” You would not be accepting of, “But I am not you and you need to decide.”

Marketing folks believe that clients value choice, it is a part of their differentiation approach. The evidence, from author and professor Barry Schwartz, is that while clients value choices, they don’t want to make them and when they pick from many they tend to be more dissatisfied with the outcome. That makes for poorer client relations.

When there are fewer choices, people expect less. There is room for a pleasant surprise. Today, with all the choices, people expect too much and are dissatisfied when it does not appear.

How do you manage expectations and performance successfully when perfect is the minimum?

Make recommendations. Accept some responsibility. Do not try to dump the decision risk to the unknowing client. If you are concerned about the liability find another client. One who gets it.

No matter the choice someone makes, it will never be the best one. It does not need to be the best. It merely needs to be good enough to reach the goal.

Decide that “good enough” easily implemented and easily monitored for management and easily monitored for connection to your plan is what gives you freedom.

More choice increases risk because it expands the reasons for dissatisfaction. (With a lot of choice there is an implicit opportunity cost.) When dissatisfied, you change something. Change hurts outcomes because change costs and so you cannot afford to do it very often. By having more choices, your risk of loss increases even if all the choices are good ones.

When you think about it, how badly served would you be if you put all your money into a balanced portfolio with a manager who had a decent record. They study the market and select investments. They reallocate to keep the predetermined ratios. You do little other than check to see if they are still investing as you expected them to do and supply the capital.

I have never checked to see if an average, or a little above, balanced fund is the answer but my instinct is that over a long time, I would be ahead both money and satisfaction.

The best satisfier is getting what you want.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

The Intermediate Term Is The Killer

The Winklevoss twins came up in conversation recently. 

As you may recall, Cameron and Tyler Winklevoss were the Olympian rowers from Harvard who claimed they had the seminal idea for Facebook.  They may have been right too.  They sued and the trial produced an award of $20 million cash and $45 million worth of Facebook stock.  Not bad by my standards, but a tiny fraction of the ultimate value of Facebook.  They were not happy.

Why did they go to trial again to appeal the award?

I don’t know, but I can estimate that they and their advisers made a common mistake.  They did not fully understand that you cannot create business value, it evolves.

When valuing start-ups, people think about the new venture in two parts, while in fact there are three.

  • First, people understand the short term. It is made up of the idea or opportunity, the perception of markets, the capital requirements of time, skill and money.  All of the other things that go into a plan for a new business.  Exciting stuff.
  • Second they can imagine the long-term.  Maturity.  The self-completing entity.  Market domination with a ready flow of customers and the skills and resources to deal with them.  Peaceful wealth.

People can see the short term and they can imagine the long term, but they miss the steps in between.  The third part, the in-between, is where most new businesses fail.

Business is a little like chess.  Both the opening and the end-game are reasonably straightforward.  There are few pieces that have moves and not many tactics that have value.  The middle game on the other hand, is nuanced and complex.  From a developed opening to the end game there are practically an infinite number of possibilities.  Some good, some brilliant, but most mediocre to poor.

In a business, getting to the end game is a problem.  There are many variables, most previously unseen, and none simple.  Worse, their interaction is hideously complex.  The easy opening and the inevitable winning end game seem not so connected any more.

A geologist friend once told me that finding gold was the easy part of the venture.  Once you have gold, you need financing, a capable construction contractor, a mine, power to the mine, a workforce, perhaps a refinery, transportation to and from the mine, solid legal positions, good government relations, and management.  With gold, there is a ready market as distinct from other minerals, but you still have to establish yourself.  And the problems don’t stop there.  For example, there will be unions, price fluctuations, environmental issues, or anomalies in the ore that may require amending your mine plan or refining methods.

In the Winklevoss versus Facebook trial, the judge pointed out that theirs was a good idea and that it had value, but the real value of Facebook was in the execution of the idea not in the creation of it.  The intermediate term.

Smart judge!

Execution is key.  Sometimes, the wild card is a death or disability of a partner or key person.  You can insure those and you should.  Unless you are a stress junkie, insurance is an easy solution to another wise difficult problem.

Build options.  Avoid building such a way as there is a dominant customer, supplier, source of finance or key employee.  Beware of leases for space that is special to you.  Never let a machine know that you need it to work.  Backup your electronic data.  Building options is the ultimate control.

If you cannot understand the complexity of the intermediate term and know how you are addressing or will address it, you need not worry about the long term.  If there is one at all, it will be much less than you hope.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario.

Einstein Was Wrong

Einstein reputedly said “Compound interest is the most powerful force in the universe.” I suppose it is possible that he said that, but I doubt it. Compound interest was not a point of discussion when Dr. Einstein was young and was barely considered by the time of his death in 1955.

It matters not if he said it. The statement is obviously wrong.

The most powerful force in the universe is compound taxation. Perhaps you have not heard of that. Let me explain.

If you pay income taxes, you are playing a two-person, zero sum game. In this form of game, player one wins what player two loses and vice-verso. In the tax game, the players are you and the government. Any part of the investment return you lose, they keep.

To understand the game you need to notice that when you pay income taxes, you give up two things.

  • Thing 1 – the money you send to clear your obligation, say 40% of what you earned. You know about that.
  • Thing 2 – 100% of the interest that money you sent could have earned. You do not normally notice that.

Suppose we examine this by looking at your account and also looking at another account that has your tax money in it and also earns income the same way that you do.

If interest rates are high or if you have a long time, Thing 2 will be vastly larger than Thing 1. You might want to build that idea into your plans. Loss avoidance is important. If you can avoid tax you get to keep both accounts. Like with a tax free savings account or life insurance.

For example, for each $1,000 invested when interest rates are 5% and the tax rate is 40%:

Account One

Account Two

Year

Earn

Pay

Have

Receive

Earn

Have

A

1

50

(20)

1,030

20

0

20

B

11

67

(27)

1,384

27

14

326

C

32

125

(50)

2,575

50

102

2,190

D

36

141

(56)

2,898

56

135

2,894

E

57

262

(105)

5,392

105

507

10,744

A As expected

B Year 11 Growth in Account A is less than Growth in B

C Year 32 Growth in A is one half of growth in B

D Year 36 Account A and Account B are equal

E Year 57 Account A is One half of Account B

Interest rates have typically been higher than they are now. Try it with 9% returns.

Account One

Account Two

Year

Earn

Pay

Have

Receive

Earn

Have

A

1

90

(36)

1,054

36

0

36

B

7

123

(49)

1,445

49

28

383

C

19

232

(93)

2,716

93

193

2,425

D

21

258

(103)

3,018

103

247

3,091

E

28

372

(149)

4,361

149

550

6,807

F

57

1,711

(685)

20,041

685

9,512

115,888

A As expected

B Year 7 Growth in Account A is less than Growth in B

C Year 19 Growth in A is one half of growth in B

D Year 21 Account A and Account B are equal

E Year 28 Growth in B is triple Growth in A

F Year 57 Account B is almost 6 times larger

Higher tax rates would matter but not as much as the rate and the time. At 9%, Account B is larger than Account A at year 57 with any tax rate over 14.7%

We can reasonably expect that returns will not stay low forever. Look again at the 9% example. In 28 years, you will keep accumulated income of $3,361 while the value of lost taxes is $6,807. If you are a 60 year old couple the odds are better than 50-50 that at least one of you will be alive in 28 years. Unless you intend to spend all your money before then, some of your investments are exposed to this scene.

Any drag on the yield your investments earn is very expensive over a long time and especially if rates are high.

Without tax management, no financial plan is optimal.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com

Framing – Half Full or Half Empty?

Imagine that I am holding a glass that is partially filled with water. Is it half full or half empty? Either answer is acceptable because they can both be perceived as being correct.

I am still holding the same half-filled glass, but I now tell you I just drank some of it. Is it half full or half empty? Most individuals will now answer the question with half empty because they have a mind’s eye picture of me drinking some of the water.

I am still holding the same glass, but I now tell you I just filled it from the faucet. Is it half full or half empty? The answer to the question now becomes half full because you have a mind’s eye picture of me adding some of the water.

Framing refers to how the method in which information is presented can influence your decisions. As a result, the choices that you make are influenced significantly by the way problems are framed. Framing decision problems in a positive way generally results in less risky choices. While negative framing of problems tends to result in riskier choices.

The most widely cited study of decision framing was called the Asian Disease and was completed by Tversky and Kahneman (1981). It demonstrated that individuals systematically reverse their choices when the same problem was presented in different ways.

In financial markets, corporations commonly rely on a positive framing effect when they announce a stock split. A stock split is a corporate action in which a company’s existing shares are divided into multiple shares. Two-for-one is the most common form of a stock split. For example, a company with 500 shares currently trading at $10 per share will issue 500 additional shares, bringing the total to 1000 shares, which should result in the stock price trading at a revised $5 per share.

This price decline should occur because, although the number of shares outstanding has increased, the total dollar value capitalization of the shares and the underlying financial condition of the company remains the same as the pre-split value. There was no additional investment value added as a result of the split.In a study (Garcia de Andoain 2009) that evaluated the effectiveness of corporate stock split announcements, it was shown that “after an announcement of an upcoming split, share prices increased, which was caused by investors that reacted favourably to the announcement by buying more shares”.

The announcement of a stock split frames the perception that investors have about the shares in a positive way, since they will now have more of the investment. Ironically, a stock split can result in increased trading costs for individual investors when they buy and sell the corporation’s shares in the marketplace. This occurs because trading costs are frequently based solely on the number of shares traded, rather than the value.

Framing can also influence how you view data presentations. If you are told that “35 times out of 100 an investment strategy fails” this tends to have a more negative frame than being told “65% of the time this strategy is successful”. Therefore, if you are told that “35 times out of 100 an investment strategy fails” your decision choice is likely to be affected by both your more accurate understanding of the odds calculation of the data, but also by the negative frame in which it was presented.

The next time a financial advisor presents a data sequence to you as an evidence for accepting a risky decision, try reversing the format of the presentation and the frame that is being used, so that you truly have an accurate understanding of the choice.

Kill Them While They’re Small

Math professors love to hand out problem sets.  Many a weekend was consumed resolving these.  One of my friends pointed out that problems are only problems if you don’t know how to solve them.  If you know how to solve them, they are merely questions.  The distinction is true outside the walls of a university too.

We get confused some times. We fix things that are not broken and apply difficult methods to easy questions.  For example, as Harvey MacKay has pointed out, “If you can solve a problem by writing a cheque, you do not have a problem, you have an expense.”  Too bad they are not all that easy.

Problems without known answers, come in two forms.  Big enough that you must deal with them and small enough that you can ignore them.  The trick is to know the difference.  Right?

Probably wrong!  It is the “ignore” part.  A problem you can ignore forever is not a problem to begin with.  I routinely ignore the traffic problems in New Delhi even though it ranks 5th in the world for traffic congestion.  So far no adverse consequences.

Small problems that you ignore, but cannot ignore forever, accumulate.  Eventually you have a large bag full of them and the bag takes on a life of its own.  Jordan Peterson at University of Toronto contends that stress results from the the accumulation of small undone tasks.  A bag of small problems is itself a big problem.

You cure the big bag of small problems issue by using two criteria:

  1. Can I ignore this forever?   if yes, ignore it forever.    if no,
  2. If it were a hundred times bigger how would I deal with it?

The 100-times bigger problem must be solved.  Understanding how you would relate to it at that size, will give you insight into how to remove the little problem.   For example, warranty claims when you could redesign a part to cure the problem.  Then  you must act on it and empower systems or people to keep it at bay.

As you do this, you will find that it takes less time than the ignoring method.  Remember that the ignoring method keeps issues coming at you while the solving method is done once, done forever.  (Well almost that good)

Once in a while, certainly not every time, facing down the little problem, gives you insight into what could have become a big problem in the future.  Even more rarely it gives you the insight into an opportunity.  The rare occurrence of these will pay you for all the effort elsewhere.

Killing big problems while they are small is a competitive advantage.  Use it.

Don Shaughnessy is a retired partner in an international accounting firm and is presently with The Protectors Group, a large personal insurance, employee benefits and investment agency in Peterborough Ontario. don.s@protectorsgroup.com