Should You Buy Only Stocks You Understand?

Like many good questions, the answer to the question posed in the title is yes, but also no.  Let's elaborate.

Before we start, we assume that you have decided to hold some individual stocks in your portfolio, and that is a good choice for your financial situation.  That decision is a whole question in itself, and not a simple one to answer, and we will deal with in a future post.

Perhaps Warren Buffett is the best known proponent of the idea that you should only invest in what you really understand. Indeed number 7 on a list of Buffett investing quotes is "Never invest in a business you cannot understand."  Berkshire Hathaway Inc. invested mainly in big name companies operating in areas that he understood. Also, while others were rushing into technology stocks, Berkshire Hathaway Inc. stayed largely on the side (although recently holdings of Apple have been significantly increased).

It seems obvious that you should really know a company before you invest in that company.  No matter how many balance sheets you examine, how many analyst reports you read, it might be argued that you must understand the field the company operates in to truly understand it at the deepest level. It is only through that knowledge that you can reasonably predict how the company's financial situation is likely to change in coming years. Do you really understand fuel cells at a scientific and engineering level, if not why are you considering buying stocks of Ballard? Do you really know the pharmaceutical industry? If not, why are you considering Valeant?

So let's say you  have extensive work experience and academic background in the banking business.  You understand banks and insurance companies at a deep level.  More than any other area of the stock market, you feel qualified to choose which companies have a bright future, and which not so much. Indeed as Alexander MacDonald has pointed out, if you had invested only in Canadian Banks you would have out performed an other North American sector over the past 25 years.

The problem with that approach, however, is that it totally lacks in diversification, and therefore your investment portfolio is expected to be more volatile. A second possible problem is that you might depend too much on your personal expert viewpoint, and not give sufficient weight to the views of investment analysts. The 2008 financial crisis emphasized this point.

However, it is important to think about diversification across your entire financial holdings.  For example, if you have TFSA, RRSP and unregistered accounts, it is not necessary that each be fully diversified, but rather that in total your holdings are. There may well be tax reasons why your holdings in unregistered are different than in the RRSP.  The fact that TFSA accounts are not part of international tax treaties means that certain types of holdings should not be held there (more on that in a future post).

So back to our question on stocks.  If you do decide to hold a number of stocks in one or a few categories, because that is what you understand well, make sure that you balance that with broad holdings in the rest of your portfolio. Not only should no one stock represent a large part of your portfolio, but also no stock category should be a major part.

Some will work in companies where stocks in the company are either part of your compensation, or offered at an attractive price.  While it makes sense to hold those stocks, make sure that it does not represent all or most of your investment holdings. There is a good article on this topic by Eric Rosenberg here.

What are your thoughts on this topic?  Why not leave a comment?  As always, thanks for reading!

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 has not received any compensation from any financial company for writing this column, and has no association with any company mentioned.  I do hold a small number of individual stocks, but neither of the two mentioned by name in this column.

When is the MER not what you think it is?

Although I don't follow the model portfolios exactly, I am a big fan of the principles of the Canadian Couch Potato. It has demonstrated the virtue of staying invested in a diversified, low cost, small and easily understood set of broad index funds.  It is called couch potato since you rebalance about every year, but otherwise just leave it alone. The simple couch potato portfolio has had solid performance and limited volatility over the long run, bettering many mutual funds, all with very low fees.

I suspect most readers are already very familiar with the Canadian Couch Potato  but in case you are not, I urge you to regularly consult their website, and to give full consideration to their model portfolios. Recently they have also started a podcast series that I also recommend.

The folks at Canadian Couch Potato have model balanced index portfolios for conservative to aggressive investors. They show how to implement them using ETFs, Tangerine investment funds, or TD e-series products. Interestingly, the long term performance only varies slightly across the different risk portfolios, but that is a topic for another post.

The other day I was examining their ETF based model portfolio (see screen capture below), and I was struck that the values they gave for weighted MER for each portfolio seemed too low to me.

Screen capture (Feb 2017) of the Couch Potato model ETF portfolios. Note the weighted MER line.

Although I don't hold the BMO bond ETF ZAG, I had recalled that the MER for it was 0.23%, and I knew that the Vanguard Canada broad Canadian equities ETF VCN (which I do own) has a MER of 0.06% and the iShares All World Except Canada equity ETF XAW (which I also own) has a MER of 0.21.  Even without a calculator, there was no way, using these numbers, the weighted average MER on the conservative couch potato portfolio would be only the 0.12% stated.

Just to be certain, I first checked with both morningstar.ca and with BMO directly, and sure enough both currently (late Feb 2017) give 0.23% as the MER for ZAG. I proceeded to calculate the weighted MER for some of the portfolios using that value, and for the conservative model portfolio it was 0.209%, versus the Couch Potato value (see screen shot above) of 0.12%, while for their balanced portfolio, with 40% Zag, 20% VCN and 40% XAW, I calculated a weighted MER of 0.188 versus the stated value of 0.14.

I could see from the weighted MER values in the model portfolios that the difference must be in ZAG, since the differences were higher for the portfolios more highly weighted in that, so I dug around a bit more. The ZAG MER value that they used in their calculations was 0.10%, not 0.23%, I was able to determine by backward engineering from the weighted MER. If I assume that value for the ZAG MER, I obtained 0.118 for the conservative portfolio and 0.136 for the balanced one, both consistent with the weighted MER given on the Canadian Couch Potato site. So you ask, which is the correct value for the ZAG MER, 0.23% or 0.10%?

The stated MER for funds is normally obtained from audited financial statements.  Of necessity that is based on results from the recent past, since the auditors only get to work after the financial documents for the financial year have been completed. In the BMO ZAG case an asterisk notes that the MER is based on the 2015 year audited statements.

Since that time, BMO have announced lowering of management fees on a number of their ETFs, including this one. For ZAG, they lowered the management fee to 0.09, and they estimate that that will result in a current MER of about  0.10. Problem solved.

There are several implications for investors, however. The true MER is based on audited financial documents.  Since management fee is the dominant component of most ETF MERs, if that is announced as lowered, we can expect the MER will drop by a similar amount. For most ETFs the MER is pretty stable from year to year.  If the MER has dropped significantly, we need to evaluate whether we are confident that it will stay at this lower value, and if the return of the fund will change due to the different amount of investment advice, supposedly related to the management expense.

Secondly, when making long term ETF choices and comparing similar products, it is important to go beyond the stated MER, to make sure that there are not significant recent changes that will influence the current and future effective MER. For example, with the previous MER for ZAG, it appears obvious that the similar bond ETFs VAB from Vanguard Canada and XQB from iShares have lower MER values.  That situation is reversed, however, with the lowered management fees for ZAG.

While the MER is to be based on audited statements, the management fee can be adjusted to the current value.  An easy way to check if there has been a significant change is to examine both the MER and management fee for the fund you want.  Normally the management fee makes up most of the MER.  If they are very different, check around for announcements of recent management fee changes, and in particular check company statements about whether the lowered fees are temporary or a long term change.

Some readers will correctly point out that the difference here is small enough that it may well be lost in your overall financial fees.  If you had invested $10,000 in ZAG the difference per year in the two MER values would be $13.

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: VAB, VCN, XAW and XQB.

Review: The 3 Simple Rules of Investing

Link to purchase book.

A few months ago I read the excellent book, The 3 Simple Rules of Investing, by Michael Edesess, Kwok L. Tsui, Carol Fabbri and George Peacock. In their book, they make the startling statement that "everything you've learned about investing is wrong".

So what are their three simple rules?

1. Simplify Your Options
2. Look Only Forward
3. Tune Out Noise

You will need to read the entire book to hear their rationale, but not surprisingly they favour broad, low cost index funds over specialized investing instruments.  They also favour a long term approach, and to 'tune out' the vast majority of advice you will hear or read from financial writers and advisors.

By look only forward, they warn against placing too much faith in how a certain fund has done in the past. As we all know 'past performance does not guarantee future results'. For example, as David Berman (among others) has written, the simple strategy of investing in the Canadian big bank that performed worst in the past year, yields better results than trying to pick the best bank stock in more sophisticated ways, or holding a basket of banks.

As well as their three simple rules, the authors identify seven deadly temptations.   Some of these are obvious and widely accepted, such as 'Don't try to beat the market', while others may seem contrary to common sense.  They urge small investors to not follow what most wealthy and sophisticated investors do. This is not because it would be difficult or impossible, but rather because most high worth individuals use high powered financial advisors and typically pay large fees for expert advice. There is little indication that this advice has resulted in better investment returns. Warren Buffett has emphasized this point in his 2017 statement, making the claim that high worth individuals have spent $100 billion in unnecessary fees.

While I would not agree with everything in the book (for example, I believe they argue for too much simplification), I do support the main tenets. I certainly recommend that you read this book as one part of your investor education. As one Amazon reviewer has written "If you read only one investment guide in your life, make it this one elegantly boiled down to the essence of what makes sense and makes money."

I agree 100% with their statement: "Don't trust it all to the expertise of someone else". Indeed my decision to start this site was largely because I fear that too many trust too blindly in investment advice. You can, and should, learn about your financial options, and you should take ownership of your financial future.

It's interesting that they also warn about over reliance on modern 'scientific' financial theory. That will be a topic for some future column.

Some of their advice is very practical, and can be immediately applied to your portfolio.  They argue that it does not make sense to hold a large number of specialized funds for diversification, if in total they essentially mimic the entire equity market.  Why not just get one total market fund?

I highly recommend The 3 Simple Rules of Investing!

From time to time I will review investment books.  Have a favourite?  Why not leave a comment, and we will consider making it a topic for a future column (or if you prefer to review it yourself, we welcome guest posts.)  If you were going to read three Canadian investing books, what would they be?

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

Disclosure: I have read this book and have no association with the publisher or authors.  I did not receive a copy of the book, or any other benefit, for writing this review.

Mutual Funds vs Exchange Traded Funds

While purchase of individual stocks and bonds makes sense in some investing plans, for most seeking a diversified investment portfolio, mutual funds or exchange traded funds (ETFs) will be the choice.  In this post we introduce these products, and examine the differences and similarities between these investment vehicles.

Mutual Funds

Mutual funds are offered by all of the major financial institutions, as well as by companies operating only in the mutual fund space. The folks at FundLibrary keep track of the Canadian funds available (using the Fundata Canada database), and as of early 2017 there were 17,471 different mutual funds operated by 449 companies in Canada. The actual number of funds is larger still, since a number of funds have different clones that hold essentially the same products (there may be a form of the fund when it is sold through a discount brokerage, and a different form for those sold through financial advisors).

You can purchase mutual funds through your financial institution, through some financial advisors, or through a discount brokerage (in a few cases those with large holdings can purchase them directly from the fund company).

The expense structure for mutual funds can be complicated, but the situation is becoming simpler and much more transparent due to recent legislation. You will pay a percentage of the holdings each year to account for the operations of the mutual fund (the costs of purchasing and selling stocks, administrative costs, etc.) There may, or may not, be charges at time of purchase or redemption in addition.  We will look in detail at the costs of mutual funds and ETFs in a future column.

Some mutual funds track an index (e.g. the TSX Canadian stock index, or a bond index), but many have a more complicated structure, aimed at for example providing regular income or providing the right mix of stocks and bonds for a certain retirement age.

If one is going to just hold a few financial products, a balanced fund, that holds a mix of stocks, bonds and possibly other instruments, can be the simplest choice. For example, the Phillips Hager & North (PH&N) balanced mutual fund RBF1950 holds a mix of about 36% bonds, along with equities from Canada, the USA and internationally. By going to the information sheet linked above you can see the holdings, cost, and past performance of the fund.

Exchange Traded Funds (ETFs)

As the name implies ETFs are bought and sold on a stock exchange.  For most individual investors it will only be economical to hold ETFs if you have a discount brokerage account (a topic for a future column).  You purchase and sell ETFs through this brokerage account.

In Canada the major players in the ETF field are iShares by Blackrock,  BMO Asset Management, First Asset, Horizons ETFs, and Vanguard Investments Canada,

The idea of an ETF is that it holds a number of financial products, usually stocks or bonds, in a package. In most case the products held match some index (or compilation of several indexes according to a formula).

For example, the iShares XIC ETF tracks the Canadian composite stock index, so in one product you hold essentially a bit of each company on the TSX, in proportion to the size of that company.

As another example the Vanguard VUN ETF tracks essentially the entire US stock market, with an index including companies of different sizes and from all sectors.  It holds a little more than 3500 individual stocks.

Some ETFs hold bonds, with a common example being the Vanguard VAB ETF, which invests in high quality government and corporate Canadian bonds with a variety of durations.

Comparison

As the above demonstrates some ETFs and mutual funds will hold very similar products, although in general more mutual funds are active, in the sense of not simply tracking an entire stock exchange index. They have a lot in common, in that they both hold a number of products, usually at least 50 and often thousands of individual stocks.

• How bought/sold:  ETFs are bought and sold on a stock exchange, while mutual funds can be bought and sold without a brokerage account. You sell ETF's in terms of number of units, while you redeem mutual funds in dollar amounts generally.
• Price: The price of a mutual fund is set once a business day (at end normally), and you redeem or purchase at this price in dollar units (there is usually some minimum price).  The cost of an ETF will, like a stock, go up and down throughout the day. 
• Guarantee/Risk: There is no guarantee on the value of either a mutual fund or an ETF. These are not like investment bank accounts and GICs and they do carry risk that you can lose principal value. The amount of risk depends on what the holdings are in the ETF or mutual fund, rather than one being in general more risky than the other.
• Costs: We will explore this in more detail in a future post, but in general the annual management costs will be lower in ETFs and in mutual funds. However, there will be a per transaction cost so when you buy and sell ETFs there will be this additional cost (there are exceptions we will explore in future columns). In general it does not make sense to do frequent trading in small amounts of an ETF due to these costs.
• Transparency: In general both products are transparent regarding holdings, past performance, etc., although the situation is most clear for ETFs that track an index.
• Reinvestment: Normally ETFs will offer a DRIP option to reinvest dividends in additional units, if that is your wish, and normally mutual funds can be set up similarly if desired.
• Name: Most ETFs have a three letter stock exchange designation, such as VAB or XIC, while in general mutual funds have a combination of letters and numbers in a longer name such as RBF1950, with the first letters designating the mutual fund company (RBF means Royal Bank Fund, who handle PH&N funds now) and the latter part being the number of the actual mutual fund.

This posting is intended for education only. The reader is responsible for their own financial decisions.  The writer is not a financial planner and reading this column should not be interpreted as obtaining individual financial planning advice. For major financial decisions it is always wise to consult skilled financial 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 funds in the mutual fund (RBF1950) and all ETFs mentioned in this column (XIC, VUN, VAB).