Saturday, 4 August 2007

Book Review: What Kind of Investor Are You? by Richard Deaves


The title does this book an injustice - it should be something like "What Kind of Investor Should You Be?" Though there is ample descriptive content within its covers, the fundamental aim is prescriptive - giving guidance on how to approach investing. The subtitle - A guide to finding the investment solution that is right for you - more aptly describes the book.

Author Richard Deaves is a finance professor at McMaster University and he uses his background and training to incorporate the results of the vast academic research in finance. The value and the achievement of this book is his ability to select and simplify that content into a compact handbook. Investing can easily be dauntingly complex and this book will be especially useful to the newcomer who needs to know where to start. In fact, I've passed my copy along to my teenage daughter who is just starting to get into investing with her savings. Deaves assumes the reader knows little about investment terminology so he explains all terms he discusses.

The appeal to the more advanced investor comes from excellent references and from additional tidbits and pieces of information. Some of the unique and valuable elements of that nature, to me at least, are:
  • the Canadian data and perspective
  • the discussion of the enormous effect of psychology and emotions on investing results
  • the possibility of picking the mutual fund manager who will be successful in future (as opposed to those who have been successful in the past) and how to implement such a strategy
  • how investment clubs fare
  • the fact that half of the actual skill of mutual funds managers comes from stock picking ability and half from style choices (small cap vs large cap and value vs growth); this is interesting because a do-it-yourself investor purchasing Exchange Traded Funds (ETF) can achieve the same benefit from the style factor with little effort.
Another unique feature of the book is an associated on-line self-assessment tool for an investor that aims to evaluate investment knowledge, personality and temperament. I did not try this questionnaire since the copy of the book I have does not contain a password to access it. This is likely because my copy came direct from the publisher for review purposes and was not purchased at retail. Thanks to Mike at Insomniac Press for supplying a copy.

Subjects Covered in the book:
  • basics - returns, risk, diversification, portfolios, correlation, valuation, market efficiency, stocks, bonds
  • mutual funds - pros and cons, costs, performance
  • stock/bond direct investing - explains why most people don't do well
  • indexing and ETFs - how they work, pros (mostly) and cons, common Canadian and US choices
  • asset allocation - meaning and importance, how this works through portfolios, role of risk tolerance
  • retirement - issues of inflation, investment horizon, sequencing of returns, annuities
  • psychology - common pitfalls and their bad effects
Each chapter has a brief summary page, with useful footnotes and suggested readings for those seeking more detail. Due to the wide scope of topics, there is not extensive treatment of any one area in a book only 244 pages long. But Deaves manages to intelligently summarize the gist of subjects and to weave the whole into a coherent story. He concludes that most people are much better off as passive index investors using ETFs, as opposed to the options of buying actively-managed mutual funds or assembling a portfolio from individual stocks and bonds. As to whether a person should be a do-it-yourselfer or should rely on a professional advisor, Deaves says both are viable but to be effective the DIYer must be willing to gain the knowledge and the discipline to follow a good plan.

In the final chapter (page 225), he presents a simple portfolio of four ETFs that would be a good starting point for anyone:
  • XBB - iShares Canadian Bond Index Fund
  • XIU - iShares S&P/TSX 60 Index Fund
  • IVV/XSP - iShares CDN S&P 500 Index Fund
  • EFA/XIN - iShares CDN EAFE (Europe, Australasia and the Far East) Index Fund
Note that I have added the ticker symbols since they are not in the text (something I would have wanted to see there). Note also that XSP and XIN are currency hedged, in other words the effect of currency swings relative to the Canadian dollar have been removed by the iShares managers through currency trading. At the time of writing, the XSP and XIN iShares funds sold in Canada on the TSX were not currency hedged but they are now (that began in November 2005). EFA and IVV are the unhedged versions available through US markets. Those are the versions that Deaves would likely advocate buying today since he includes currency risk within his assessment of foreign investing and concludes that foreign diversification is worthwhile.

Interesting Quotes
  • ''Using data from 26 international stock exchanges, researchers have shown that when there is more sunshine, stock prices tend to rise.'' (page 86) is that why there isn't a stock exchange here in Scotland as prices would never rise? why doesn't the NYSE move to Arizona?
  • ''... the average Canadian (mutual) fund fell short of its benchmark by roughly 1% per year.'' (98) Take this with another statement by Deaves ''The main positive element is clearly professional money management.'' (57) One might question how it is a benefit to entrust one's money to mutual fund managers if they cannot even meet the market average. From the perspective that the index return can easily be obtained by investors through ETFs (the low costs of the ETF do admittedly cause a slight under-performance relative to the index but still ahead of mutual funds), professional management is not an advantage. However, most individual investors do a very poor job, and get poor investment returns due to under-diversification, over-trading, momentum-chasing, home bias and other mistakes that Deaves details. So, in that sense, mutual funds professional management can be better than bad DIY. Nevertheless, for the rest of us who follow the humble passive indexing strategy, we can expect to do better than most of the professional mutual fund managers.
  • ''Apparently many investors think that their funds are performing better than they actually are.'' (104)
  • ''... educated people are not only more confident than those with lower levels of education ... but they are also more overconfident.'' and ''... it is not just amateurs who are overconfident, but also people in their fields of expertise.'' (115) in other words, beware of the professionals and especially of yourself!
  • ''... despite its fame, the Dow is a weak index.'' (131) could we call it the Paris Hilton of stock indexes?
Two Caveats

There are two areas where I find the book lacking and disagree with its conclusions. The first is the use, or not, of real estate investments, in the form of REITs or a REIT ETF within even the simplest portfolio. Deaves does not think it worthwhile or necessary to own a real estate security. But the very basis for diversifying internationally - the non- or negative-correlation of such holdings with Canadian equities, or other equities for that matter - is even stronger with real estate. It would thus be even more beneficial to include real estate in a portfolio than US or foreign stocks. The second point of disagreement is Deaves' acceptance of the principle that people should reduce their equity exposure as they get older. In the last chapter, the sample portfolio further simplifies this to having the same percentage of fixed income in the portfolio as one's age e.g. is you are 50 years old, then you should have about 50% of your total investments in fixed income. Some retired people I know can easily live off their inflation-indexed lifetime pension, in which case their overall investment portfolio essentially already has a more or less perfect very large fixed income component. A much better principle would be to set the investment portfolio asset allocation based on when and how much one needs the money. In the course of the text, Deaves does discuss various factors that suggest exactly that principle but his simplified summary doesn't reflect it.

Overall, however, this is a very useful book, particularly for the beginning investor, but even advanced investors can likely learn a thing or two. Some people who have been investing for years may gain great benefit if they stop being haphazard and adopt the sound principles that Deaves puts forward. Four out of five stars. The book was published in 2006 by Insomniac Press. Buy it from Chapters Indigo.

1 comment:

FourPillars said...

Great review!

I'm not sure how much advantage "professional money management" gives an investor if they are prone to frequent switches and enjoy chasing hot funds. You can accomplish those things with mutual funds as well as ETFs.

Mike

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