Tuesday, April 11, 2017

Review: The Four Pillars of Investing

I would strongly recommend anyone serious about investments start their education with this book.  I first read The Four Pillars of Investing (McGraw Hill, 2010) by Dr. William J. Bernstein a few years ago. I reread it recently in preparation for this review. Like any good book, new insights and appreciation emerged on rereading.

The Structure of the Book

The author uses an architecture metaphor, asking what pillars should underpin your investment portfolio. His four pillars are:
  1. Theory of Investing
  2. History of Investing
  3. Psychology of Investing
  4. Business of Investing
I was hesitant to even list these pillars in the review, as they make the book sound heavy and boring.  But it is not that at all! Rather, it is one of the most interesting investing books I have read!

Each of the themes is covered in a number of chapters.  For example, Chapter 3 "The Market is Smarter Than You Are", is his take on the efficient market hypothesis.  As well as providing the statistics to show that most funds will be, on average, well, approximately average, he makes the strong case that you can't pick stocks and you can't time the market successfully in the long term.

I particularly liked the historical depth of the book, not just in the second section but throughout.  He starts off the history section with the statement: "About once every generation, the markets go barking mad." I loved the many historical tidbits I learned, such as that Isaac Newton had big investment losses in the South Sea Bubble, or about the early 'stock exchange' in the coffeehouses of Change Ally. While these examples may be considered trivia, the historical aspects of the book help us place boom and bust, risk and reward, within a long equity history.

The above is not the only clever opening statement.  The psychology section starts "The biggest obstacle to your investment success is staring out at you from your mirror." In chapters 7 and 8 he offers insight on investment emotions, and practical advice on how to reign in investor behaviour issues. It is full of gems like
"...asset classes with the highest future returns tend to be the ones that are currently the most unpopular."
In answer to the question "To whom do I listen?", Dr. Bernstein offers the same advice of many others to tune out the investment noise. He then goes on to summarize with remarkable simplicity and clarity the two aspects  that you may well need guidance with.
  • Your appropriate asset allocation
  • Being self-disciplined in your investments
While the majority of the book is concerned with establishing the four pillars, closing chapters deal with putting it all together (his so-called investment "assembly instruction booklet'). While the specific advice must be placed within the context of the time that the book was revised, now almost 8 years ago, the general theme of using low cost passive index investments, appropriately diversified across different asset classes, remains as true today as when the book was written.

Why I Liked It

I find that too much investment writing tries to jump to just the answers - without first establishing a base to critically evaluate any proposals. This book fills that void.

The book will help you see investments within a long term historical trend, quantitatively establishes the importance of asset allocation, and helps you avoid paying too much for financial services and reign in your own worst tendencies.

The writing style is clear, engaging and, dare I say fun?  The historical tidbits, and statements of principles through analogy and metaphor, make the book feel light, while teaching you some critical investment truths. He wrote the book with that aim – to appeal to an audience that did not embrace mathematics.

In an earlier review of a different book, I mentioned that after reading a book I ask myself the following four questions.
  1. Was my time invested in the book, time well spent?
  2.  Do I have confidence in the validity and balance in the presentation? 
  3. Was I engaged in the book? 
  4. What were the author's motives in writing the book? 
I enthusiastically answer YES to the first three questions.  While any author hopes to have some financial success with a book, I feel that Dr. Bernstein, first and foremost, wants to help individual investors have success and avoid blunders.

The Author's Other Books

The author has been prolific in his investment writing, and you may well be interested in some of his other books. Prior to this book, William Bernstein wrote The Intelligent Asset Allocator, a more mathematically based book than this one.  I have not yet read it personally, but plan to.  It has received high praise from readers.

More recently (published in 2012) his The Investor's Manifesto covers some of the same theoretical underpinnings as The Four Pillars of Investing.  It is richer in mathematical basis, and of course more up to date in the current index investing landscape.  I hope to give it a full review in the not too distant future.

You can get a full list of his investing books on his website, http://www.efficientfrontier.com, including his Investing for Adults series which I have not read.

In case you were wondering about his background, William Bernstein followed work in science into a career as a medical neurologist.  He lives in Portland, Oregon, and for a number of years his efforts are invested in financial theory and history, and investment writing. The Globe and Mail did a nice interview with him that is available here.

Concluding Thoughts

If you are just getting started in investing, this book is the perfect place to start.  It will help you think about the big picture before you start considering advice for specific investment instruments. The book is interesting to read, and provides a solid grounding.  It's not surprising that it has a large number  of positive reviews on Amazon and similar sites.

Especially for Canadian investors, this is not a DIY manual though. After reading the book you will need to go to other information sources (dare we say including our website?)  for help in putting together a specific intelligent portfolio for your investment situation.

If picking up the book used, make sure you get the 2010 edition, and not the 2002 edition.  Both are still available on Amazon.  The 2010 version has a red bar across the top of the cover.

 If you use an eReader, the book is surprisingly inexpensive on Amazon.ca - just CDN$2.61!  I am not sure if it is always this inexpensive, or a limited time sale price, but the book is an incredible deal at this price. The ebook is also available on CloudLibrary, should you have an account through your local public library.

I have no hesitation in placing this book in the top few investment books you should read! Enjoy! As one of the reviews on Amazon commented:
"What sets this book apart from other investing books is the breadth of areas covered, and also the writing style which is both "understandable and entertaining". A highly recommended read for any investor regardless of level."
I agree.  Whether starting out in investing, or if you have been an involved investor for many years, or even if you are a professional financial advisor, you will find real value in this book.

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a professional financial planner or investment advisor. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  No compensation by any company, organization or individual has been offered, requested or received for writing this column.

Books for Review: I will not promise a positive, or even any, review, but if you wish to submit your investment book for me to consider, contact me rhawkes (at) chignecto.ca. I am particularly interested in Canadian books.


Sunday, April 9, 2017

Do XAW, VXC Represent Global Stock Market ?

Do you know what proportion of the global stock assets are represented by US markets? those in Canada? Europe? China? A surprising number of investors have either vague or out of date answers. This post will provide some data on the global equity space, along with reflections on how that might inform your investing choices.

While most investors exercise some degree of home country bias,  for a variety of good reasons, it makes sense to invest globally. In this posting I propose a simple idea: why not invest in different markets according to the size of those markets?

Some Data

The size of economies is somewhat different from the size of equity markets in those countries, and it is a good question whether we should use stock market or economy size. I will work with stock market valuations in this post.

There are about 60 stock markets globally, and their valuations are shown in a really nice data visualization here. You can get the raw data with the most recent statistics here from the World Federation of Exchanges.

Kim Iskyan wrote an article for Asia Wealth Investing Daily in November, 2016 that provides statistics (taken from Bloomberg) on the sizes and growths of different national stock markets, with a look at the top ten. You can read his report here courtesy of Stansberry Churchouse Research.

Not surprisingly the US stock market is the largest by a significant factor, at 36.3% of the total.   China was second, at 10.1%, followed by Japan at 7.9%, Hong Kong at 6.3% and UK at 4.6%. Canada, followed by France, Germany,  India and Switzerland complete the top ten.

 If we accept the premise of investing globally in proportion to equity assets, about 36% of your equity investments should be in the US, 10% in China (with another 6.5% in Hong Kong),  8% in Japan, about 3% in Canada.

The World It Is A Changing

The article cited earlier points out that a fairly dramatic change in the relative capitalizations of different markets is taking place.  For example, from October 2003 to 2016, the US stock market while increasing in an absolute sense, dropped as a fraction of global stock assets  from 45.2% to 36.3%. The big increases were all in Asia, with China going from 1.5% in 2003 to 10.1% in 2016, Hong Kong from 3.0% to 6.3%,  and India from 0.8% to 2.6%. Stock markets in Europe and Japan all fell as a global percentage. Interestingly the Canadian market, with a slight rise from 2.6% to 2.9%, was the only top 10 'developed' market to show an increase.

 Do XAW and VXC Represent World?

So how would you build an ETF portfolio consisting only of TSX listed ETFs that faithfully represented the entire global equity market. While specialized ETFs representing almost any market now exist, and you could build an ETF portfolio to almost exactly represent the world's equity markets, the MER would be high for so the many specialized products.

Most use ETF products like XAW from iShares or VXC from Vanguard Canada to represent most of the world.  These track different indices, with XAW tracking the MSCI while VXC tracks the FTSE global index.

Both XAW and VXC have excess weight on the US equity market, with XAW at about 54% and VXC at almost 56%, whereas the actual size of the equity markets suggest that only about 36% should be in US equities. Both under represent  emerging markets, with a total emerging market share of 11.5% in XAW and 7.8% in VXC currently. Note that VXC does not include any Canadian equity at all, so you should include at least 3% of your investments in a broad Canadian ETF such as VCN or XIC.

A simple way to make your global equity ETFs more representative of the entire world is to include about 20% of your holdings in XEC or VEE emerging market ETF (even though there are emerging holdings already in the XAW and VXC).  This would reduce the US holdings to about 44%, neareer to the 36.1% of the global equity assets, and similarly for other developed markets.

Another option would be to make up your global holdings using VEF (developed markets except the US, but including Canada), VUN (or some other widely represented US holdings) and XEC (or VEE) for the emerging markets component.  In this way you can adjust your US, other developed and emerging market holdings to the exact amounts you desire. If  Scotia iTRADE is your discount broker, VEF and XEC are both commission free to buy and sell, making this option even more attractive.  If you want to include China as a separate component, ZCH could be used, although remember you do have China represented in XEC or VEE. Also, the number of individual stocks within ZCH is limited.  If you want to add some Canadian home market bias (see below), XIC or VCN (or many others) could be added.

But I Want to Minimize Risk!

While it is natural to look backwards, as the excellent book The 3 Simple Rules if Investing reminds us: only look forward. It is true that volatility has in the past been greater in emerging markets. However, with high developed market equity valuations, unusually low interest rates, and political uncertainty in several developed economies, it can legitimately be asked whether the more governmentally controlled 'emerging'  economies such as China may offer lower future volatility.

Just as passive investors are urged to own all (or really a major part) of a domestic market,  it could be argued that the same principle would argue to hold most of the world equity assets proportionately in a global equity portfolio. 

Why Home Bias?

I'm sure they have been written, but I can't recall reading an investment commentary on the virtue, or lack thereof, of home bias.  This is a topic for a future column, but I considered reasons that you would want to show some home bias in your investments.
  • Your income needs are related to the inflation rate in your home economy, so significant Canadian holdings make sense.
  • As we argued in a post about holding individual stocks, it makes sense to invest in what you best understand, and that for most is the Canadian market.
  • While government intervention is only one of many factors, it does influence the rewards and risks of different types of investments. You will understand the political climate of your own country best.
Only you can decide what amount of home bias you want to have in your investments.  It probably makes sense to have less home bias in your accumulation phase than in retirement when you are withdrawing regularly from your funds.

Concluding Thoughts

Of course there are good reasons to not weight investments only according to the relative size of that countries equity assets.  For example, risk will vary in different countries. Also, average valuations, as expressed by P/E or other measures, may be significantly different in different regions.  Also, we know the North American stock market much better, and that familiarity might help us make better choices.

You should expect more than a rule of thumb about what fraction to be held in Canada, US and internationally based on the situation of ten years ago.  Make sure that your financial advisor discusses international holdings, and in particular emerging economies, in a current, evidence based fashion. If you do decide to have extra North American assets, make sure that it is a deliberate choice.

The international ETF space continues to change, so make sure to investigate the holdings of each ETF with current data before you make any decisions. We will be reviewing emerging market ETFs in a future post.


This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a financial planner or investment advisor, and reading this column should not be interpreted as obtaining individual financial planning or investment advice. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  The author of this column holds the following ETFs mentioned in this article in one or more account I manage: XEC, XIC, VCN, VEF and VXC.  I use Scotia iTRADE discount brokerage services.  No compensation by any company has been offered, requested or received for writing this column.




Friday, April 7, 2017

Developed or Emerging: Classification Systems

Before we can consider in detail the question of how much should be invested in different international markets, and how, it is necessary to be clear on what we mean by terms like emerging and developed. Markets are classified by the major index companies. As an investor it is important to know what index your passive ETF or index mutual fund follows, and which countries are, and are not, included in that index.

MSCI Classification

MSCI (Morgan Stanley Capital International) provides one of the major classification systems used in the index investing world.  They divide equity markets into Developed, Developing and Frontier divisions (there is also a Standalone market index. with national exchanges not included in any of the previous three; this mainly includes very small or very isolated exchanges). You can see the details of which country is in which classification here.

FTSE Classification

The other primary classification system is provided by FTSE (now part of the combined FTSE-Russell). FTSE stands for Financial Times Stock Exchange. They divide markets into Developed, Advanced Emerging, Secondary Emerging and Frontier. You can see current country inclusion in the categories of the FTSE here. Of particular utility is their Matrix of Markets that lists stock markets by country against index segments.  This is a simple way to see if a particular country is in an index based ETF.

Things Change

The indexes are periodically reconsidered - for example FTSE update their list usually in March of each year. The process of deciding if countries should be moved to another category is complex.  Metrics are established for that process, looking at aspects such as transparency, accountability, liquidity and size of the market.  FTSE-Russell explain their process in a white paper available here. In the MSCI classification Pakistan will move from Frontier to Emerging in May 2017.

Should We Be Doing This?

Many have commented that the term emerging economy is obsolete and should be abandoned.  Certainly markets like China and India are rapidly growing and are similar in many ways to the markets in the developed category. While five characteristics are claimed to represent emerging economies and markets, application of these descriptors is difficult.

Also, there is a problem with any category system in that two stock markets with only slight differences might result in inclusion in different indexes. For example, why are Poland and the Czech Republic included in developing, yet those economies are similar in life style, economy and political environment to neighbouring European countries that are in the developed category? There appear to be similar discrepancies in Asia.

But we do need some way to lump together economies and stock markets that share similar characteristics.  One option might be to assign a grade to each stock market on a scale (say 0 to 100) based on how developed it is.  Then we could have indexes that track only markets with a score in a certain range.  While the result might be almost identical to the current system, there would be better transparency of results.

Final Thoughts

The Vanguard ETFs follow the FTSE index, while generally speaking the iShares ETFs follow MSCI. Vanguard have a really nice listing that links ETF products against the index they follow all on one page.

While the country inclusion is pretty similar in the MSCI and the FTSE, there are differences.  For example, FTSE place South Africa in developed, while MSCI do not. The Chinese stock market is divided into A and B categories, historically on the basis of whether foreigners were allowed to invest on that market. How the A Chinese stock markets are handled affects international index funds.

In a future posting I will I discuss the fraction of global equity assets in different markets, and the implications on how we should invest globally.

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a professional financial planner or investment advisor. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  No compensation by any company, organization or individual has been offered, requested or received for writing this column.





Monday, April 3, 2017

Review: Portfolio First Aid

I picked up a copy of Portfolio First Aid at my local public library, intrigued by the title and impressed by the author team. Micahael Graham, PhD (Economics) was Chairman of the Board at Toronto investment firm Heathbridge Capital Management Ltd. at the time the book was published (2005), and had worked in investment industry for more than 40 years. He currently runs MGIS.  Co-author Bryan Snelson is a Vice-President and Investment Advisor at RBC Wealth Management.

What I Liked

Any investment book is only as good as the quality of the advice it offers. Given the expertise of the authors, one can have confidence in this book. An investment book also needs to be clear and engaging, and I would give this book high marks in both.

The writing is clear and precise.  I liked the use of boxes to draw attention to important points. The titles of these. In both these boxes and in sections titles effectively draw the reader in. By current standards the 2005 book is somewhat lacking in illustrative material, but the black and white visuals and tables explain key ideas effectively.

Perhaps it will not appeal to all readers, but I like how we come to know the authors through commentary throughout the book.  For example, on pg. 8 Michael relates the experience of flying to Winnipeg on Oct. 19, 1987, Black Monday, for a pre-planned meeting with investors. What do you say the day after markets have lost 23% in one day?

I particularly liked Chapter 7 Show Me The Money: Investing for Income. You will find coverage of dividends, real return and corporate bonds, laddered bonds, income trusts, dividend funds, preferred shares and much more.

After I finish reading a nonfiction book I always ask myself these four questions.  One is, was my time invested in the book, time well spent? Do I have confidence in the validity and balance in the presentation? Was I engaged in the book? What were the author's motives in writing the book? To the first three I could confidently answer YES for this book.

With respect to the last question, I suppose any author team always have mixed motivations for a book, but I do feel that in the case of this book there is an authentic desire to contribute to the well being of investors. The authors write in the preface
"There is nothing worse than having to inform an investor that his or her hard-earned savings has been badly mauled-sometimes irreparably"
They feel that with careful analysis and attention to a portfolio the odds of that can be lowered, while retaining reasonable returns.

Not That Book

One of the online reviews of the 2009 version of this book, a very negative review, complains that the book has little specific advice to offer, and emphasizes use of professional advisors more than it should. While I feel that the reviewer has been unfairly harsh, it's true that Chapter 4 You Need Financial Help! and Chapter 5 It's Always About You: Working With Your Advisor assume that the correct choice for most is to work with a financial advisor, rather than DIY investing. Perhaps because of this assumption, as the negative reviewer noted, little in the book that is detailed enough to guide the DIY investor in specific decisions.

I view this book as contributing to understanding the big picture of investing.  A recipe book for DIY investors it is not. Discount brokerage accounts are mentioned on 4 different pages in the 2005 book, but not as a recurring theme.  ETFs find mention on 5 different pages in the book.

That is not to say the book does not get involved. Chapter 9 Running With Scissors: Prescriptions for Managing Risk, for example, covers bond ratings, market risk, interest rate risk, default risk, lost-opportunity risk, purchasing power risk, stop-loss orders, options, calls, short-selling, puts, hedge funds and covered calls. They urge individual investors to avoid many of these, however.

Concluding Thoughts

I liked this book and recommend it to Canadian investors for inclusion in a list of your first 10 investment books. I should point out that I reviewed the 2005 book, but an updated book on the same theme,  by these authors plus Cindy David, CFP. You can get the 2009 book at Amazon.ca in hard or soft cover. You can pick up the 2005 edition from Amazon.ca and independent booksellers and you can probably find it at low cost from used bookstores, or free from a public library.

While no on can predict the future, there are many worrisome signs about the investing landscape these days.  It's a perfect time to consider how you can guard against the catastrophic losses, and this book will help.

Toronto based freelance financial journalist Jade Hemeon wrote the following in his review of the 2005 book on Amazon.ca.
"A useful and entertaining tour of the investment world that hits all the significant ports of call. Written by two veteran financial advisors in a vividly descriptive fashion, it offers sage advice enhanced by personal anecdotes and humor. This book will help investors avoid costly mistakes and develop a strategy that can withstand the drama of shifting market moods."
I could not say it better! Give this book a read, and you will come away with a deeper understanding of the investment world.  But don't expect the book to be a step by step guide to DIY investing, or you will be disappointed.

This posting is intended for education only and should not be considered investment advice. The reader is responsible for their own financial decisions.  The writer is not a professional financial planner or investment advisor. For major financial decisions it is always wise to consult skilled professionals. While an effort has been made to be accurate, any statements of fact should be independently checked if important to the reader.

Disclosure:  No compensation by any company, organization or individual has been offered, requested or received for writing this column.

Books for Review: I will not promise a positive, or even any, review, but if you wish to submit your investment book for me to consider, contact me rhawkes (at) chignecto.ca. I am particularly interested in Canadian books.