Lower gas prices can mean really big TFSA savings!

Many Canadians have grown accustomed to low mortgage rates and strong residential pricing, and now the price of gasoline is leaving a few more bucks in our pockets.  Don’t get too comfortable, because history teaches us that none of this is sustainable.  It is circumstances like the present that make seasoned money managers anxious.  While neophytes are happy to carelessly bathe in the sunshine, experts are usually getting ready for the next storm.  What can you do?  With lower gasoline prices providing some extra cash flow why not use the cash to bolster your savings?

One cloud on the horizon has been getting some attention of late.  The massive global financial stimulus that has caused interest rates to remain low for so long has had a predictable impact on our collective behaviour.  Canadians have borrowed money like there’s no tomorrow.

Household Debt vs Disponable IncomeAccording to data from Statistics Canada, our total borrowing has been on a steady incline since 1990, while servicing the debt has been eating away at our disposable income.  Sure, we tightened our belts some during the financial crisis, but the temptation to borrow at low rates has just been too much to overcome.

It is difficult to save money, when so little of one’s income is disposable.  And most financial advisers would recommend that it doesn’t make a whole bunch of sense to save money at all when you owe money.  It makes far more financial sense to pay down your debt.  Based on numbers alone, this is sound advice.  But our behaviour is seldom governed by numbers alone – we are indeed a complex species.

For example, contributing to your RRSP provides a tax savings in the same year your contribute right?  So where does it go?  A strictly numbers analysis espousing the merits of RRSPs would certainly factor in those savings to illustrate how effective they are at growing your wealth, but I am inclined to agree with the Wealthy Barber (David Chilton) who frequently points out (and I am paraphrasing here) that those dollars you supposedly ‘saved’ were most probably squandered, not saved.  If the tax savings were indeed invested, then it is true that one’s net worth might grow.  However the iPhone, piece of furniture or other consumer good bought with that tax refund hardly qualifies as savings now does it?

Does it make any sense at all to save when wallowing in debt?  I would argue most emphatically YES!  According to an IPSOS Reid poll published in October:  “The average working Canadian believes they would need $45,609 in savings to sustain themselves for a year should they be off work due to illness.”  Where would this money come from?  In real life, a portion of it would be required for food and lodging yet some of it will be needed just to pay the mortgage or rent.  I’d bet that the average Canadian polled would no doubt have seriously underestimated the amount needed to live on while not working (for whatever reason).  In the same poll roughly 68% admitted to having some or lots of debt – suggesting that 1/3rd of Canadians have none?  Pardon me if I suspect that a good percentage of those polled might also have been too embarrassed to answer candidly even if their responses remained anonymous – we are Canadians after all and loathe to taint our conservative image.

Now is an ideal time to bump up your savings!

Where will the extra cash come from to begin a more aggressive savings program?  Let’s start at the gas pump.  We all feel a bit of relief simply watching the price of gasoline come down when fueling, but has anyone really considered how much they might now be pocketing because of lower energy prices?  In April of 2014 Canadians were paying a near-record $1.50 per litre.  Just 6 months ago the price of gasoline in Toronto was 139.9 cents a litre and today (I am writing this on December 10) it is 103.9 cents.  That’s a whopping 25% decrease.  Say a motorist was spending $50 in after-tax dollars a week.  If they price of gas simply stays at 103.9 the cost savings are $12.50 a week which is equivalent to $650 of annual savings requiring about $1000 of your pre-tax income.  If there is more than one vehicle in a family? Let’s keep it simple and assume $1000 in annual family savings simply from the lower gasoline price.  Never mind that other energy costs (heating) and transportation costs (flights) will also create savings.  What if you simply invested that amount every year and earned a rate of return on it?  It will grow to a handsome sum.  Unfortunately, you will have to pay taxes on those returns but more about that later.

Growth in $1000 annually

 

Of course it’s unreasonable to expect gas prices to remain at these levels or fall lower.  It is also not wise to anticipate more generous rates of return.  In point of fact, it is foolhardy to expect or anticipate anything at all.  Returns will be what they will be, and gas prices are determined by market forces that the experts have trouble understanding.

Does the uncertainty we must live with mean that savings might just as well be spent on the fly?  As I tell students studying to be financial planners; one must start somewhere and there are two things worth acknowledging up front:

1)  The power of compounding (letting money earn money by investing it) is very real, as evidenced by the table.

2)  It makes sense to have a cushion in the event of a loss of income, the desire to pay down some debt, make a purchase or just retire.

Yes it makes more financial sense to have no debt at all, but the majority of Canadians will borrow for those things they want now rather than later, like a home or car.  If you must borrow, why not save as well?  Fortunately we have been gifted the perfect savings vehicle.  The Tax Free Savings Account introduced in 2009 has advantages that make it an ideal place to park money you are saving at the gas pump.  The returns you earn in the account are tax-free.  With GIC rates as low as they are, you might be inclined to say ‘so big deal?’ But any financial adviser over 45 years of age (I admit, there aren’t many) can tell you that low interest rates are temporary, and besides you can and will earn better returns over the longer term in equity mutual funds just as an example.

TFSA Contribution LimitsOf course there are limits (see table) to what you are allowed to contribute, but best of all they are cumulative.  In other words, if you haven’t contributed your limit since 2009, you can ‘catch up’ at any time.  Including 2014, you have a right to have put up to $31,000 into the account.   Also the contribution limit rises (is indexed) over time with the rate of inflation.  Perhaps most important, you can withdraw money from the account tax-free.  Your contributions were already taxed (there’s no tax deduction when contributing like when you put funds into an RRSP), and the investment returns are all yours to keep.  Using your TFSA means that won’t have to pay those taxes and the effects of compounding aren’t diminished.  To top it off, you are allowed to replace any money you’ve withdrawn in following years.

The seasoned money manager will want some flexibility in the event that he is blindsided.  With your TFSA savings you too will enjoy more flexibility.  If interest rates are higher when you renegotiate your mortgage, taking money out of your TFSA to reduce the principal amount might help reduce your monthly payments to affordable levels.  Should the economy take a turn for the worse over the next several years and you lose your job, then you’ll have some extra cash available to retire debt and help with living expenses.  For younger Canadians saving money at the gas pump? Investing the extra cash flow in your TFSA account will certainly help towards building a healthy deposit for your first home.

  • Don’t squander the cash you are saving thanks to low energy prices.
  • Your TSFA if you have one, allows you to invest those savings and the returns you earn are tax free.
  • If you don’t have a TFSA, then get one.
  • Be sure to use only qualified investments and do not over-contribute. The penalties are severe.
  • Money earned on your investments is tax-free.
  • Take out cash when you need it, and put it back when you can.
  • When you retire, money withdrawn from your TFSA does not count as taxable income.

 

Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.
Mal Spooner is a veteran fund manager and currently teaches at the Humber College School of Business.

 

 

 

 

 

 

 

 

 

 

 

 

 

S&P 500 Index: Morning After 401k Musings

March 2000 witnessed the S&P 500 Index breach the 1,500 barrier for the very first time… seven and a half years later, it was in just about the same position.

Inter-day October 15th, after an incredible bounce from its 56% drop through March 6th 2009, the S&P was just 20% above where it had been 14.5 years earlier… a gain of roughly 1.4% per year.

Just how low will it go this time? and are you prepared… this time?

The long term chart (Google “s & p 500 chart”, look mid page and click “max”) shows the volatility over the past fifteen years. Just for kicks, see if you can find the “crash” of 1987  (October 19th).

Could any stock market image be more beautiful? Could any be more in-your-face damning… tactically?

What if your 401k investment strategy had required selling before the profits started to erode?

What if your 401k strategy made you hold equity-destined cash until Investment Grade Value Stocks fell at least 20% before selective, patient, cautious buying began?

What if your 401k investment strategy called for at least 40% of your investment portfolio to always be invested in income purpose securities?… securities rising in price so far today, in the midst of a major sell off.

Such an approach has been available since the 1980’s for a lot of happy investors who have never had to change their retirement dates; and the same program has been available to 401k investors since March 0f this year…  but you have not been allowed to know about it!

You can’t use it because your 401k plan rules don’t allow you to invest in 40 year old “makes-a -lotta-sense” strategies, just because they have a new label and/or not enough millions under management… who’s protecting whom?

This is precisely how the big operators keep new and innovative solutions on the sidelines. Tough luck investors… you’ll just have to bite the bullet and watch your “by-design” speculative portfolios crumble  for the third time in fifteen years.

Pity, but one-size-fits-all rules are every bit as bad for your financial health as one-size-fits-all products. How are those TDFs doing… and with all that experience and mega millions under management.

 

Inside Modern Portfolio Theory – For Emperors Only

Maybe it’s just me, but when I hear “Monte Carlo”, I can’t help but think “casino”…

My previous article post dealing with the income growing opportunities of 401k account “drawdown” elicited some interesting commentary from the MPT community.

Apparently, if we apply the proper mathematical algorithms to all stock market probabilities, including all possible cash flow scenarios, we will be able to deal with 401k participant expectations better…

I can’t control the warmth and fuzziness that has taken over my financial feelings… future predictions that possibly, maybe even more often than not, can reduce my drawdown to a less painful level than otherwise, while doing nothing to boost the income generated by my portfolio is certainly bringing on a huge sigh of relief…

What!

I’m the type of investor who cringes when he hears market analysts explain how investors are “placing their bets” but how can you possibly sleep at night when you know that your 401k selections are “probably” being designed using the “Monte Carlo” algorithm subset of Modern Portfolio Theory?

Check it out if you wish, but if you aren’t rolling-on-the-floor, LOL, when you finish, have I got a new suit of clothes for you: http://en.wikipedia.org/wiki/Monte_Carlo_method

How many soontobe retirees (including myself, eventually) would even pretend to understand it. Really, a show of hands would be appreciated. How many of you think that these probability games are “investing”.

Retirement income is not (and should not be) about gambling. A fundamentally sound (i.e., quality) portfolio that generates 6% or so income (tax free, even) is easy to put together… yes, in today’s low interest rate environment.

4% to 5% in the 401k space, convertible upon rollover to the 6% variety is doable as well. You need to make a market value drawdown an opportunity to grow the income… faster.

Once the retirement income has been secured, then you can tour the world’s casinos until the excess capital is gone.

The MPT portfolio that bursts like a 4th of July “finale” in my weakened brain is reminiscent of the magical Junk Bond Portfolios of the ‘1980’s.  Don’t worry  about it, investors, we’ve put all these fundamentally speculative securities together in such a brilliant manner that the sum of the junk has been transformed into non-junk.

As of August 31st, 2014, the Vanguard Target 2015 portfolio was still 51.8% invested in the World’s Stock Markets and generating less that 2% in spending money…

Yes, it is true, the inmates really have taken over the asylum.

401k Drawdown… OMG

“Drawdown” has become the most feared word in the 401k vocabulary, just as “Total Return” has become the most worshipped phrase. OMG, how will plan participants be able to retire if their portfolio market values stop rising!

“Well, yeah,” you might say, “isn’t that what investing is all about. If you’re in the right sectors and the right funds, your drawdown will be minimized.” Well , yeah, that could be a viable drawdown minimization scenario if we had a crystal ball that could identify the “right” vehicles.

We don’t, and a litany of supportive sector correlation statistics just doesn’t change the basic facts of investment life that still are referred to respectfully by some as the “Market Cycle”.

Can you remember how easy portfolio management once was, simply by applying basic “QDI” principles to portfolio content selection and profit taking disciplines? It was a time when navigating an investment portfolio through the unpredictable, cyclical, undulations was indeed, a labor of love and respect for economic fundamentals… with strategies based on cyclical realities.

MPT charlatans, with “Frankensteinian” creativity, have transformed text-book-defined speculation into a passive sector-timing process based on probabilities… games of chance yet to be tested through any form of market correction.

In a program with no promise of income and no concern for fundamentals, is it any wonder market value drawdown is so feared.

Place today’s ETF and Mutual Fund equity content into the three Major Meltdowns of the past 30 years, and it’s likely that you’ll see the very same drawdown numbers… or worse, because of the artificial demand for a finite supply of real securities.

Drawdown happens; corrections are inevitable. The same MPT hocus pocus that, theoretically, is placing 401k dollars in the right sectors is, perversely, exacerbating the problem by blowing up the highest security price balloon ever, even higher.

Keep in mind as well, advisors and fiduciaries all, while we wonder at the brilliance of those who have created this ethereal (surreal), market fantasy land, that it is they (not you and I) that wield the fatal “pin”.

When the bubble bursts, remember these thoughts:

Drawdown minimization is accomplished by: investing only in “investment grade”, high quality, securities (fundamentally speaking); then diversifying among them sensibly within two “purpose delimited” security buckets; and regarding realized “base income” as the primary purpose of the income allocation and the secondary purpose of the equities.

With strict buy, hold, and reasonable profit-taking disciplines governing portfolio operations, drawdown minimization, continual income growth, and rapid recovery is virtually a sure thing… a sure thing that isn’t possible in a 401k environment that has kicked fundamental quality and income growth principles to the curb.

401k Plan Fiduciary and Performance Responsibility

Anyone who influences the investment product mix should likely be a fiduciary… but only if the selected investment managers are fiduciaries as well.

Yes, that eliminates all Mutual Funds and ETFs, since neither admit fiduciary responsibility. But Mutual Funds, ETFs, and Collective Trusts could be recommended by plan fiduciaries who are not paid for product placement.

Plan sponsors could be required to use: fee only plan advisors, non-product investment education providers, and 3(38) fiduciaries, TPAs and record keepers that help keep all the fiduciary bases covered.

Collective Investment Fund Trustees and Investment Managers are fiduciaries.

If Plan Sponsors do all the above, their responsibility is covered, and plan participants can be responsible for their own investment mistakes… subject to the product alignment rules outlined below.

What happens in the case of an individual brokerage account option within the plan? Are Plan Sponsors responsible for the performance of these portfolios? Perhaps, but just from a qualification standpoint… Rules that impose fiduciary liability on employers will eventually kill defined contribution plans dead!

So how should we deal with investment performance?

What constitutes poor performance, and how can performance be judged when all plan participants will have somewhat different investment objectives and risk tolerances?

If I want an income building, convertible-at-retirement CIF, that’s my choice… investments with income or “working capital” preservation objectives can’t be judged with a market value ruler.

If I get a 50% match from my employer, that’s an annual 50% gain on contributions… my good fortune, my business, my selections. Similarly with cost. If my program develops a convertible, 6% income, portfolio, why should it matter if the expense ratio is higher than with standard 401k income products?

Again, participant’s choice… leave the employer alone.

My solution would be an investment menu “warning system” based on product risk assessment and a system of controls on individual portfolio content.

The menu composition rules and participant selection controls would be based on risk recognition and income production instead of market value history… higher quality plus reasonable income should equal a more secure retirement.

All participants currently have access to  “performance”, “income production”, and “expense” information;  few convert the data into realistic performance expectations, or risk assessments.

A simple warning label could flag high risk products.  Plans must have less than 20% “high risk”  and at least 30% “low risk” opportunities in selection menus containing between 20 and 40 selections.

Participants must select at least 10 products… no more than two “high risk”, no less than three “low risk”. No high risk and all low risk is the “default” within three years of retirement.

No single portfolio position could exceed 25% of the portfolio… any excess would automatically be reallocated among four default positions. None of the “most risky’ products could be “default” choices, and at least one of the least risky must be.

Done. No DOL aggravation required.

For more information, contact a qualified 3(38) fiduciary at either QBOX Fiduciary Solutions or Expand Financial.

The Investment Gods Created Volatility… and it was good

Have you noticed how paranoid people are getting about market “volatility”.

OMG, cries the DOL, we’re going to fine employers if their 401k plan participants don’t grow their balances as fast as the average plan around the country… thus making the Federal Government a participant in roughly half the 401k plans in every audit time frame.

Employers use investment plans (401ks) as an employee retention benefit… but by what stretch of the imagination are employers responsible for the financial ignorance/naiveté/ laziness/poor judgment of their employees?

Isn’t this just another overreach by regulators who seem focused on making it as hard as possible for private businesses to remain viable? Why not require unbiased investment education instead and create some productive jobs for a change… most adults are willing to accept responsibility for their own mistakes.

Since the dawn of investment time, market value change has been the lifeblood of investing and speculating… a distinction that “Modern Portfolio Theory” (itself a long-con of great imagination) has hypothetically correlated out of existence.

Without market volatility , there would be no chance of profit and no risk of loss. The absurd “Major Prediction Theater” proposes that past correlations and relationships will be repeated in the future, and that risk can be minimized by gaming with the numbers….

The investor need only select the right mix of speculations. But even if the mumbo jumbo is solid, theoretically, market value volatility remains the reality, and some funds, products, methodologies, and hypotheses outperform others… it’s the performance parameters that require adjusting, not the employer’s fiduciary responsibility.

So instead of relying on Wall Street’s most self-serving hypothesis ever, why not embrace the investment god’s gift of market volatility… as many of us have done effectively since investment puberty?

Regulators only appear to be stupid… they know that neither employers nor employees have the inclination to become proficient investors. They know that businesses fear the pox of a compliance audit… making compliance job designations the fastest growing, non-productive, industry in the economy.

And here’s the kind of decision-making the regulatory Gestapo produce:

“Mr. Jones, we’re fining you a gazillion dollars because your retired participants’ 401ks grew only 2% over the last 3 years and the markets were up 15%; clearly you failed in your fiduciary responsibility”.

“But these people are retired, your lordship.”

Their portfolios are producing over 6% in spending money, less insane federal income taxes (light bulb moment: think how a no tax on retirement income rule would benefit everyone), while the best of the best Target Date Funds pay around 2% before taxes .”

“Not my problem sucker, since when did income become the objective of a retirement program”.

The Very Best 401k Plans

I just read an article that listed six features of “great” 401k plans: high company contributions, instant eligibility, immediate vesting, low fees, auto enrollment, high employee contribution rates.

I agree, but something is missing. What about the investments… a black hole of understanding, in spite of all the information available on the internet. Neither participants nor plan sponsors are fluent in what’s inside the program.

Performance numbers don’t produce understanding or develop reasonable expectations. The focus is on market value “performance” … and expense ratios, regardless of their impact on participants.

Just google a few bond or target fund names see how difficult it is to determine the “yield”, i.e., the income you receive in retirement.

The Vanguard Target Retirement Income Fund, for example, yields less than 2% and has a 30% stock market exposure… the same company’s 2015 “target retirement program” is 52% invested in the stock market, now at about the highest prices in the history of mankind?

The income generated by this extremely popular program (the spending money of retirement) is a disgraceful 2% or so. Hey, these numbers are from their website… and proudly?

But it’s not totally their fault…. more income could increase expense ratios or impact “market value” performance numbers… and the DOL is coming.

401k regulatory “wizards” don’t help very much… nowhere in their search and destroy missions is any mention of income received by people when they choose to retire. Instead, they focus on market value performance and costs of the mix of products available.

Barely anyone speaks of “convertibility” of the program into a real live retirement income machine… certainly not the government. In the mind of the Federal Government (an oxymoron?) it seems, a taxable 2% in employee’s pockets (after low expenses) is somehow better than 6% taxable with a higher expense ratio… it’s da law!

The market value of fixed income purpose securities are expected to “perform” in the same manner as common stocks … and they look at me like I’m smoking something funny!

Although 401k plans are not pension plans (even the modern variety of inadequate income development programs), they are looked at as such by nearly everyone…. especially politicians. In my experience with 401k plans in general, only one type of “investment” product has a focus on the income objective that should actually be the main “target” of any retirement program.

If 401ks are perceived by participants (and much more importantly) by the regulators as retirement programs, one would think that advisers would make a concerted effort to find more suitable income producers to put inside them..

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

The swarming of AAPL.

Understanding how the shares of Apple Inc. managed to get squashed so badly has much to do with knowing a bit about investor psychology and modern market dynamics. It wasn’t very long ago that shares in AAPL were universally loved – about a year ago now, CNN made it known that Poland, Belgium, Sweden, Saudi Arabia, and Taiwan all had GDPs that were less that Apple’s market value (around $500 billion at the time).

It’s all about probabilities. If absolutely everything is going well, encouraging publicity abounds and everyone you know has both the iPhone and owns the stock, then the only thing that is left to occur is suddenly something (sentiment, earnings disappointments, hurricanes) not-so good-happens which cools investor enthusiasm. When a stock is widely held, the subsequent selling can prove disastrous for all shareholders.

In September of 2012 AAPL traded a tiny bit north of $700 per share and is now in the neighborhood of $420 give or take. Losing 40% of one’s investment in a bull market is painful.

On business television you’ll hear lots of Apple pundits (who still own the stock in their portfolios) say the company is worth far more than the share price would suggest. This may or may not be true, but the fact of the matter is that the share price does represent what it is worth to investors right now! Doesn’t it?

The answer used to be yes, but with the increase in the popularity of short-selling it is difficult to determine nowadays what a company is really worth. In many instances there is absolutely no connection between the actual economic value of a business and its stock price.

Swarming is the term now applied to the crime where an unsuspecting innocent bystander is attacked by several culprits at once, with no known motive. Because swarming at street level involves violence, it is criminal. However in financial markets it is perfectly legal and different because there definitely is a motive. The motive is to rob shareholders of their invested dollars.

In a recent (April 6th, Thomson Reuters: Reuters Insider) interview Bill Ackerman, founder of Pershing Square Capital Management and who is described as an ‘activist’ investor, admitted “There is something inherently shadowy or evil about short-sellers.” Ackerman gained notoriety when he publicly claimed the company Herbalife was nothing more than a pyramid scheme, suggested the stock was worth zero and admitted his company had an enormous short position.

When any company today stumbles (or is perceived to have stumbled) it ignites something akin to a swarming. For example, this quote is from CNBC.com on November 10th, 2012:

“The question has been asked by nearly every Apple watcher following a brutal two-week stretch that began with a worse than expected earnings report, quickened after the ouster of a high-profile executive and culminated with news this week that it had fallen behind competitor Samsung in the smartphone wars.”

Although one might expect the stock to decline under the circumstances, the subsequent pummeling of the share price seems a bit cruel. What happened? Have a gander at this graph of the short interest (the total number of shares that were sold short) since about a year ago. To gain perspective, in April of 2013 the short interest has grown to 20,497,880 shares. The dollar value of this is about the same as the Gross Domestic Product of the entire country of Malta.

In English, short-sellers detected vulnerability, and swarmed AAPL. The irony is that short-sellers borrow the stock from real shareholders (via third parties) in order to sell it on the market. After the selling pressure wreaks havoc on the stock price, the short-seller then buys shares at a much lower price, returns the ‘borrowed’ shares to those real shareholders and keeps the profits.

The irony is that short-sellers claim to be providing a public service. Bill Ackerman was simply exposing a company that he believed (discovered) was misleading its shareholders. He even went so far as to say he didn’t even want the profits – they would be donated to charity. The problem is that it isn’t just some big bad corporation that is punished, but its shareholders and in due course even its employees.

I’ve never claimed to be all that smart, but I just can’t figure out how aggressively attacking a company’s share price, selling stock that the seller doesn’t even own, for the sole purpose of transferring the savings of innocent investors into one’s own coffers (whether it goes to charity of not) is a noble thing. Isn’t it kind of like a bunch of thugs beating someone up and stealing his/her cellphone declaring it was the loner’s own fault for being vulnerable?

How can you stay clear of being a victim?

  • Avoid owning stocks that have become darlings. When it seems nothing at all can go wrong, it will ,and when it does there’s sure to be a swarming.
  • If there’s evidence of a growing short interest in a company, best not own the stock.
  • Instruct your financial institution that your shares are not to be available for securities lending purposes.
Mal Spooner