Risk and Complexity of Securities and Funds - a Promising Proposal

How does one know how risky an investment is, whether it's a stock or bond, a mutual fund or an ETF? How complicated and hard is it to understand or predict what the investment's return might depend on? For the retail investor, the basic answer is that you're on your own, having to wade through the security's Prospectus, which for Canadian securities can be found in SEDAR. Trying to compare several alternative possibilities that way is such a nightmarishly time-consuming task that most people likely don't even bother. It's one reason that as my investing years have accumulated, I am more and more oriented to the simplest possible investment structure.

The provincial regulatory authorities under the umbrella of the Canadian Securities Administrators have tried - ineffectually - to help by mandating fund risk rating, the latest revision and supposed improvement exercise of which is currently underway (see Ontario Securities Commission website here). But it relies only on one risk dimension - price volatility - which isn't nearly broad enough to capture real investment risk as I wrote in my last post referring to Howard Marks' fantastic discussion of risk.

Along comes six researchers from Singapore Management University with a promising proposal in A Risk and Complexity Rating Framework for Investment Products, an earlier free version being available here and a $15USD December 2015 version on the CFA website here. Their scheme has been built to work across more or less the whole swath of investing products and asset classes and it looks reasonably workable. In effect, it seems to condense the Prospectus into a rating.

Most important, it seems to capture a much broader characterization of risk and product complexity. Risk, for instance, includes ratings for six items - price volatility, liquidity, credit, duration / cash flow, leverage and diversification. That's a pretty good start, though I would be interested to see them add foreign currency risk and what might be called manager risk, which would assign a higher rating for actively managed funds over index funds, to reflect the fact that most active managers under-perform. As well, some way of including unexpected inflation risk would be very useful, though I cannot think of an easy way to put it in terms of their scheme method.

The rating of complexity is an intriguing proposal and something I like. If a financial product is too complex for me to understand, how can I know how it should fit into my portfolio? It is also likely to disappoint in some way, either by jumping up and biting at the worst possible time, or simply by excessive fee leakage. As the authors point out, "More complex structured products, generally with higher margins ...". Anything more complex than perhaps 3 on their 5 point complexity scale probably should not be available to the average retail investor. It is worth noting the authors' remark that institutional investors, who would likely have the expertise to understand complex products, generally avoid them and stick to basic products. Probably it's because they do understand the products that they avoid them.

The final reality the researchers recognize and try to incorporate is that the behaviour of securities in a crisis such as 2008 can change, notably that correlations of asset types can converge, that liquidity and leverage can have exaggerated effects.

The results of their calibration testing using 100 different funds ended up classifying some of the money market and bond funds with a higher risk rating - at 4 - than a few of the equity funds - at 3 out of 5.  That's an intriguing and useful result, a counter to the too simplistic notion that bonds are "safer" than equities. It sure would be interesting to see our Canadian regulators test the paper's method on Canadian funds and securities. I could foresee a regulatory website where any security's official risk and complexity rating could be found and compared to other user-selected securities.

Thanks to the indefatigible Ken Kivenko, a member of the OSC Investor Advisory Panel, for bringing this fascinating paper to my attention. Go for this one, Ken! According to the paper, no other country has such an investment product rating scheme yet. Maybe Canada could be first in an investor protection move for once?

Book Review: The Missing Risk Premium by Eric Falkenstein

Not many books can be summed up in one sentence but this one can be and author Falkenstein does it himself in this quote taken from his Falkenblog: "... risk is generally not related to expected return because people are more envious than greedy". This is a radical blockbuster statement with significant implications for both finance theorists and practically minded investors.

The book is a meticulous exposition and expansion of this quote - starting with a description of standard finance theory relating to portfolio management and asset pricing focusing on risk vs return, the "how things are supposed to work" according to the theory, which is basically that there is a expected return premium for taking on risk based on one and only one starting assumption "... that our happiness is solely dependent on our individual wealth and increases at a decreasing rate" i.e. people are greedy. Falkenstein proceeds to document the extensive finance research that shows how the theory simply does not work in the real world - empirically vacuous or bankrupt, as he puts it - and how the attempts to fix it have created a hodge-podge of adjustments devoid of intuitive sense. The basic idea that there should be a higher expected return for taking on more risk he says has been perversely twisted by defenders of the Capital Asset Pricing Model faith - anything that shows a higher actual return, like small cap stocks and value stocks, must be riskier, though no one can actually say how these types of assets are riskier.

In fact (the factual-ness of which he takes many pages to demonstrate - there are lots of footnotes to studies done by many researchers) - Falkenstein finds that the highest risk (in an intuitive sense) end of many asset classes displays markedly lower, not higher, returns. Examples in penny stocks, equity options, IPOs, currencies, corporate bonds, futures, real estate are cited. This is the empirical part of the explanation of why low volatility investing works - it eliminates the significant chronic return drag at the highest risk end of the spectrum.

Falkenstein then moves on to his theory, the "because" part of the quote at the top of this review. He proposes that instead of the standard utility function of absolute ever-increasing happiness with wealth that underpins present finance theory, we should instead use a relative utility function to understand asset pricing. Adopting relative utility means that it is assumed people primarily behave in a greedy fashion, in other words that they are happy or satisfied if they are doing well in reference to others. In investment terms, people use benchmarks to judge success. They want to outperform relative to some standard such as the TSX Composite. Under such an assumption, Falkenstein shows, with the same straightforward math as for the CAPM, that the risk premium is zero. A zero risk investment is no longer something like a no-volatility T-bill but a security that tracks the benchmark. He says this viewpoint explains asset pricing and indeed many other human behaviours (such as why 21st century humans are not happier than people of a century ago despite being a lot richer in absolute terms).

Falkenstein goes on to examine how and why people take too much financial risk and why he thinks his theory has been ignored for so long (his own PhD dissertation was on the subject in 1994 and he traces key ideas to others going back to the 1970s). The final chapter outlines how to benefit in a practical way from his findings and theory. That is the low volatility strategy. The proof is in the pudding he says and he cites studies and his own out-of-sample investing success as evidence.

This book is important to every investor. If he's right, it points to a better investing strategy through minimum variance or low beta portfolios. There are low volatility/ low beta ETFs available to ordinary investors. Falkenstein's theory implies that passive index ETF investing will do poorly (lower returns and higher volatility) in comparison to low volatility ETF investing (assuming, of course, that fees remain within certain limits). Unlike passing anomalies that have disappeared or for which there is no theory to support why outperformance should continue (we note the irony of referring to outperformance as a test of whether it's good or not but that's the way the world works!), this book offers such support. If he's right, the ideas of this book will be viewed as foundational to finance.

Even if you think he's wrong, the book will surely make you think hard. If you think you understand the what and why of finance theory, try to say why's he's wrong.

Much of it is not easy to read, as he slides into and out of highly technical statistical or economic issues. On the other hand, much of it is also highly intuitive and appeals to common sense using plain language.

Falkenstein is very aware of his rebel status in finance. "A crank is simply someone with a minority opinion among his peers, and the key to whether that person is considered a genius or stupid is whether he was correct, which is often known only with hindsight." Those who would dismiss him merely because he thinks the CAPM is fatally broken, in opposition to the mainstream of finance academics, are doing so too blithely. He is extremly conversant with the finance literature (208 footnotes in this brief book and reams of citations in his bibliography) and it sure looks like he understands the stats and math (here, I must express my own limitation in being able to judge this properly). Read his blog and his home page here to judge for yourself whether he knows what he's talking about. These sites contain links to many of his papers where much of the book's ideas are also found. There's even a hilareous video with toy people called Asset Pricing Theory Explained and a 5 minute summary of this book on this page.

Falkenstein writes like a man in a hurry. Though generally very eloquent and quotable, sometimes his sentences are dense and must be re-read to detect implicit commas and awkward phrasing, sometimes words even seem to be missing or he assumes the reader knows technical stuff as well as he does. There's also no index - that would help for the paper version (search works fine in the Kindle on a laptop). These are quibbles.

Is he right? Time will certainly tell - about 2050 is the date he says the data will have gone on long enough for the doubters to conclude with statistical tests that he is right. Meantime, we can check his blog for evidence coming in as he reviews new articles on the topic, such as this post last May. The discussion of some EDHEC findings in that post and many accounts within the book of findings in finance research subsequently being negated when data errors and sampling problems, certainly induce caution in reaching a conclusion.

Nevertheless, the arguments and evidence is credible and convincing enough that, as a matter of disclosure, I will say that I have bought a significant position in a low volatility equity ETF.

Quotes:

• "The idea that to get rich you need to take risk seems to imply that risk begets higher returns, but this is just a logical fallacy, like using successful gamblers as role models for investing."
• "Although broad asset indexes contain the wisdom of crowds, they also necessarily contain a lot of foolishness that make them distinctly suboptimal portfolios. ... By ridding your asset classes of these objectively bad assets, you can improve your returns rather simply, and this has been demonstrated in real time via the dominance of low-volatility investing."
• "...like the latest miracle diet, the latest anomaly is treated skeptically by your average expert for good reason—because most have been dead ends based on selection biases or bad data."
• "when you measure distress directly, as opposed to merely inferring it from the size and value dimensions, such stocks deliver abnormally low returns, patently inconsistent with value and size effects as compensation for the risk of financial distress."
• "R-rated movies are the high volatility stocks of the movie industry."
• "Simon Lack notes that over the 1998-2010 period, a whopping 97% of the dollar profits generated by the hedge fund industry went to the fund managers, not the investors."
• "Risk takers dominate our lives via their disproportionate effect on our genes and their influence on our technology and culture. They did not become successful, however, merely by taking some abstract risk that is the same for everyone and then enjoy the higher rewards that came with it. They instead took the right risks, those consistent with their unique strengths, and reaped rewards consistent with a mastery of something important."
• "... children not only lie, but lie more the higher their IQ."
• "A major problem is that as most of the active and esteemed researchers have built their careers extending or modifying the current framework, it would be very costly to classify work built on bad assumptions as irrelevant, and so there is this strong desire to work within the paradigm and salvage all those mentor’s reputations."

Rating: 5 out of 5 stars, original and important, a must read

Book Review: The Rules of Risk by Ron Dembo & Andrew Freeman

The book isn't just about investing risk though the book's subtitle is "A Guide for Investors". This must have been added by the influence of the publisher since the more accurate description of the content is on the back cover: "A Dynamic Framework for Forward-Looking Risk Management". Likely the latter would have been judged too technical and jargonish to appeal to a broad book audience.

The book is a broad conceptual guide, and a useful one, to figuring out what to do about various financial risks one faces in life, like house buying, insurance or investing. There is some jargon (do you want to figure out your lambda?) but it presents mostly common sense argumentation and nothing beyond arithmetic in the numerical examples.

Despite some attempt to flesh out their methods, the book falls short of being a practical guide. I find it difficult to see exactly how I could systematically apply, in order to develop an overall financial and investing plan, all of their ideas in their multi-step process, which consists of:
1) Know the value of your holdings today - I'm ok with this one, I think, though an important caveat is the definition of "my holdings", which they do not explore. They seem to think of such holdings as consisting only of a portfolio of financial securities, which I believe is far too limiting. The single most valuable financial asset we own is ourselves, our own money-earning capacity, often called human capital. Unlike almost every other financial risk, which they explicitly define as those subject to changes in the [external] environment (i.e. that we can do nothing about directly), we can enhance, or neglect, our earning capacity through education, diet, health protection etc. I suppose the authors might respond that their book does not intend to go into that detail. And I suppose that doesn't matter as long as this book is only considered a conceptual, not a practical, guide. This book does not hand you solutions on a plate. You would have to do quite a bit of work to apply them to your own circumstances.
2) Pick an appropriate future time horizon - Though Dembo and Freeman acknowledge that most people are likely to have multiple future financial goals (car, House, retirement etc) with different time horizons, they do not flesh out how to deal with the resulting complexity when this fact is added into downstream steps below. Nor do they address at all what to do about the very real fact that life contains surprises and your best laid plans / time horizons may not be the ones that actually happen e.g. a good number of people retire sooner than they thought due to job changes or health. That really complicates the next step.
3) Choose a range of scenarios of the future, making sure to include bad extremes and assign a probability to each scenario - This is the range of future end results for "the portfolio under consideration". Of course there could or would likely be multiple portfolio possibilities an investor might want to consider. This is the point where I'd guess almost anyone trying to follow their method would give up. Huh? How do I make up scenarios and figure the odds? They touch on but do not resolve the issue on page 81: " ... there are many occasions when it is impossible to attach useful probabilities to an unknowable future, then we have to find ways to model the uncertainties we face."
4) Pick a benchmark - The benchmark seems to be a kind of base case to compare the scenario & portfolio combinations (& presumably the multiple time horizons). They say that one can choose whatever benchmark one desires.
5) Value your portfolio and benchmark for time horizons under all scenarios - a lot of mechancial work
6) Compute the appropriate risk measure based on values coming out of step 5 - Here enters one of the intriguing contributions of the book, the idea that something they call Regret is the best measure of risk to use instead of popular commonly used measures like standard deviation (aka volatility) or Value-at-Risk (VAR, used by institutional investors).

Regret, with a capital R, is what I found to be the most useful, as well as the most accessible and natural, concept in the book. It is a way of taking account of potential harmful outcomes to make better decisions. Regret deliberately embodies the emotional impact of negative possible outcomes. A wrong decision, as judged later, can gnaw away at a person forever after. Second, the Regret evaluation process of Dembo and Freeman tells us to assess the cost of preventing the big negative, which in many cases is just insurance. Then we decide whether the cost is worth it considering more the consequences of decisions rather than the probabilities of particular outcomes.

As the authors say, "It is a sensible rule of thumb that an operation should not take on positions that expose it to the worst possible outcome - that a catastrophic loss might occur, resulting in ruin." This way of thinking would be very helpful in considering, for instance, whether to buy long term care or critical illness insurance. The same loss may matter a lot more to some people than others e.g. Warren Buffett will never be interested in buying long term care insurance since he can easily afford the fanciest care imaginable.

The obverse of Regret is what they call Upside, a positive consequence that can result from a choice. The thinking process is the same - how much could the positive result amount to and is the cost of the "bet to enter the game" worth it?

The book also has several interesting or amusing bits:

• there are a number of praiseful references (this book was written in 1998) to the revised and improved risk management techniques of major investment banks following big losses in the 1980s and 1990s, rather ironic given the 2008 debacle; the notion presented by the book that these financial institutions were really trying to manage risk and avoid disastrous financial consequences instead of going willy nilly for the gigantic gains strikes me as rather naively quaint. Dembo and Freeman's own framework provides a handy simple tool to figure out the big banker's personal risk perspective - lots and lots of personal $$$ Upside with the worst personal Regret being fired and having to look for another job.
  
• Dembo and Freeman show in Chapter 3 that Kahneman and Tversky are wrong to say that people are irrational or making behavioural mistakes when they make choices that violate expected value (EV = probability x outcome) rationality. They also make buying lottery tickets an entirely reasonable and rational decision (spending a few dollars a week won't cause even poor people financial ruin but it could, despite the bad odds, make them rich, so there's lots of Upside and really no potential Regret).
  

Bottom line: Though the framework will get too complicated to apply to a total personal financial planning effort, it can apply to one-off decisions. The Rules of Risk is worth buying for its thought-provoking content and useful concepts.

Rating: 4 out of 5 stars

Managing Financial Effects of Health in Retirement: 2) Narrowing Your Own Chances of Problems

The figures in the previous post on health problems that could happen and their likelihood are averages for the population. Everybody's individual chances will be different partly based on genetics – ask yourself how many in your family have had the various ailments – and partly based on your lifestyle actions. You can tilt the odds in your own favour. The same kinds of factors that the life expectancy calculators use to estimate your lifespan will greatly influence your health while alive.

1. Diet – Eat fruits and vegetables. Eat foods with Omega-3 Fatty Acids (helps avoid Alzheimer's apparently). Eat fish and shellfish. Limit salt, caffeine (over 3 cups of coffee per day starts to do damage), high cholesterol and fatty foods. Drink some alcohol – 1 to 2 drinks per day – but taking more is to your detriment. Warning sign - being overweight, or even worse, obese with a Body Mass Index over 30. Oh, and remember to floss as it might keep a heart attack away, according to the Livingto100.com lifespan calculator.

2. Smoking – It's bad, there is no dividing line or upside. Smoking raises chances of cancer and stroke.

3. Friends and Family – Having regular social contacts, loving and being loved, obviously will improve emotional satisfaction with life but there is a spillover into physical health too. Keeping a pet dog or cat falls into this category as well.

4. Exercise – Nature-walking, mall-walking, golf, curling, tennis, treadmill, skiing, ballroom dancing, weights and, why not, sex. Take your pick, anything that requires muscle use, gets you moving, breathing a bit hard and the heart rate up helps bring about healthy life.

5. Brain Activity – Your brain is like your muscles. It needs regular workouts to stay in shape. Keeping your mind active can delay or avoid the onset of dementia. Reading books, blogs, magazines and better, trying to figure something out or learn something about whatever is of interest to you, will benefit your brain. Doing some sort of work, paid or volunteer, where there is responsibility and a sense of achievement, however small in the grand scheme of things, does wonders for the mind. It can also be a good social activity. On-going brain exercise may be a reason people with higher levels of education have lower incidence of dementia.

You can reduce health risks but the fact remains that you cannot eliminate them.

The next post in this series will look at the range of financial consequences of the various types of health problems, i.e. if you get cancer, have a stroke, or get Alzheimer's, what will it cost?

Managing Financial Effects of Health in Retirement: 1) What can happen and what are the odds?

"Odds are you don't know what the odds are."

Gary Belsky and Thomas Gilovich, Why Smart People Make Big Money Mistakes

Health is a big concern to most people as they get older. The image of a decrepit, half-deaf, frail, confused person immobile in a wheel chair haunts us all. Such a prospect is scary, not only for the feeling that life will be joyless and empty but also for the financial implications. Will costs of care bankrupt us? Will we become a resented burden on family? Are financial products that can provide protection like critical illness insurance and long term care (LTC) insurance necessary or worth the cost? How should we go about deciding whether to buy them and what are the alternatives?

Most Seniors Will be Healthy During Old Age and Never Need Long Term Care
This is the encouraging news. People do not get to 65 or whatever retirement age and suddenly become wheelchair cases unable to take care of themselves. In fact, the 2011 OECD report Help Wanted? Providing and Paying for Long-Term Care contains a chart showing that only 2% of the Canadian population as of 2007 was receiving LTC. Most of them are women over 80.

In another study (in the Eight Conference on Health Survey Research Methods), Michael Wolfson and Geoff Rowe of Statistics Canada projected levels of disability in Canada for the year 2021. In the chart below, presented by Wolfson using that data in Projecting the Adequacy of Canadians' Retirement Incomes, the predominant light grey area in the centre is the population with no disability at all and the next area outwards from the middle are those with mild disability, moving through ever darker bands of moderate to severe disability to institutionalized. Note that at every age group moving upwards the vast majority of men and women will be generally healthy and able to enjoy life, even for people in their 80s and 90s. Even in the 90+ age group, only 43% are likely, according to this projection, find themselves moderately or worse disabled.


There is a very gradual increase in the amount of disability with age, but no sudden abyss of decrepitude. There is an increase nevertheless.

The Big 4 Old Age Health Problems
The things that will hurt most, both physically and financially, are:

• Cancer – the biggie at 65, around double the rate of any other problem, hits 8.5% of women, 14.2% of men age 65

• Heart attack and Bypass surgery – affects men more than twice as much as women

• Stroke – tends to have long term consequences since 75% survive a first stroke and 60% are left with a disability according to Critical-Illness-Insurance.com citing the Heart and Stroke Foundation

• Dementia (including Alzheimer's) – much more a woman's disease, it is already significant at 65, rises with age and really spikes upwards in older age, affecting 35% of those over 85. With people living longer and medical advances controlling chronic diseases better, dementia will become an ever greater issue for the Baby Boom generation. The 2010 report commissioned by the Alzheimer Society, Rising Tide: The Impact of Dementia in Canada, projects that the number of people living with dementia will rise from 1.5% of the population in 2008 to 2.8% in 2038. Of course, almost all of that increase will be amongst older people. The following graph from the report shows the huge spike upwards from age 80 that is expected to occur.

The next post will mention a few of the actions we can all take to reduce those odds to live healthier longer. After that, it's on to the the financial consequences of ill health during retirement and then the options for dealing with the financial risk, like various forms of insurance and whether they are worth it. Meantime, where the heck is the darn dental floss?

Et tu Beta? A downside risk betrayal

A central tenet of modern finance theory is that Beta is the appropriate measure of the systematic risk of stocks. The idea is that the higher the Beta, the more a stock price varies when the overall market rises or falls and thus the higher the risk.

Nothing is sacred or safe. Researchers Victor Bahhouth and Ramin Cooper Maysami in Risk Prediction Capabilities of P/E During Market Downturns, on AllBusiness' Academy of Accounting and Financial Studies Journal, tested how well Beta and P/E (the Price/Earnings ratio) predicted downside risk of all NYSE and NASDAQ stocks during the year of the latest big crash up to the end of October 31, 2008. Their conclusion: " ... beta's power was insignificant in predicting stock price movements ... On the other hand, the price-earnings ratio exhibited significant power in predicting stock price movements and accordingly was a more reliable measure of risk." An unkind cut it is indeed.

I wonder how many people actually have tried to use Beta to assess individual stock risk. I suspect most who look at individual stocks fall into the fundamental value assessment camp and so have been using P/E all along. When I looked at Waterfurnace recently, I came across some finance website or other that showed a Beta of 0.5 or so for the stock, presumably because WFI has been ultra-stable, trading around $25 for about the last four years. It made no sense to me to consider that figure of any use in judging its upside or downside risk.

Investment Banks and Hedge Funds: the Bubble of the Past Quarter Century?

The Credit Bubble leading to the Crash of 2008. Who profited and where did all the money go? That's a question I have been asking myself since 2007 and the start of the credit / financial crisis. The answer I now believe is a) employees of investment banking; b) managers / employees of hedge funds; c) shareholders with stakes (i.e. whether as separate entities or whose profits flow up to a parent entity) in investment banking and hedge funds.

The Evidence: Read Baseline Scenario's Good for Goldman and Paper of the Year (hat tip to the Awl for the link) along with the April 15, 2010 speech by European Central Bank member of the Executive Board Lorenzo Bini Smaghi. The sources give stats and graphs showing that since around the mid 1980s employee compensation in these businesses has risen steadily far faster than any measure of education, risks or productivity would explain till it is around 40% more than it should be. This did not happen in the traditional banking side of things, only in investment banking and hedge funds. Smaghi says: "It is important to note that this is not due to rising compensation in “traditional” financial sectors like credit and insurance, but due to the large increase in compensation in non-traditional financial activities like investment banks, hedge funds and the like."

In addition, financial industry growth has taken an even larger share of GDP. Here is a fascinating graph showing US data from Research Affiliates LLC (reproduced with their permission - and thanks to blogger Preet Banerjee of WhereDoesAllMyMoneyGo.com for arranging this; the slide is also available as part of the Claymore-produced slide presentation Fundamental vs Traditional Index Investing on the Advisor.ca website - N.B. I have added to Research Affiliate's chart the red Bubble line)

The Fundamental Index Methodology used by Research Affiliates is built using four accounting measures of sector size to weight the index - sales, income, dividends and book value. It thus reflects the long term growth of the Financial Services sector in achieving actual results. Unlike the infamous Tech bubble of 2000, which was reflected in the brief spike of unrealistic share prices shown in the market cap weighted index on the left side of the slide, the Financial Services bubble has been building for decades. It has been made up of real sales, real profits and real dividends flowing to real companies and people.

When exactly did the Financial Services secular bubble start? That's a bit hard to tell, since as Smaghi discusses, the growth of Financial Services is a good thing up to a point since there is more efficient allocation of savings to capital investment and faster economic growth. But beyond a certain point, which he says the financial sector certainly surpassed, the excessive risk-taking and unproductive allocation cause bubbles and crashes, like the Tech bubble itself. "... excessive rents reaped by the financial industry lead to increased risk-taking which can endogenously generate boom and bust episodes..." Thus the expansion of financial services since the 1960s has not been all bubble, some of it has been beneficial.

I've drawn my Bubble line at the point in the late 1980s when salaries began their vertiginous ascent (see Fig.2 of Smaghi's attachments in this pdf), a point at which there is also a sudden higher rate of increase in the share of financial services in the Fundamental Index (i.e. when they started to make gobs of money) in the above chart.

What is the right size for Financial Services and where will the sector settle out?
It is more or less universally agreed that the Financial services sector is too big. The shrinkage has already started. The Fundamentals show it - note the shrinkage in sector size from 2007 onwards in the above chart. Markets expect it too - note a much bigger change in share in the above chart. This difference between the trailing results-influenced Fundamental Index and Market Cap Indices shows up in popular ETFs:

• USA - in Vanguard's Market Cap VTI, Financial Services = 16.4% as of 31 July 2010 vs Powershares RAFI PRF = 20.9% as of 31 Aug 2010
• Canada - iShares TSX Composite XIC = 29.6% vs Claymore Canadian Fundamental Index CRQ = 45% as of 3 Sep 2010
• World - Vanguard All-World ex-US VEU = 25.8% as of 30 April vs PowerShares Developed RAFI ex-US PXF = 28.9% as of 3 Sep 2010
  

Regulators will impose new regulation to control and to deliberately reduce the size of Financial Services (as the Paper of the Year post reports, regulation is the only thing that effectively controls the size of the sector, not market forces). But the authorities don't know how much to reduce -
Lorenzo Bini Smaghi: "...we still run into practical problems if we try to establish the right “threshold”[size of the financial sector], and research in this field has been very limited".

And there is lots of expert debate and disagreement about how to go about it (e.g. William Buiter at FT.com, others at FT.com, Smaghi's review of options), never mind the sometimes politically-motivated actions of governments (e.g. punitive revenge-seeking laws, which though perfectly justified in my opinion, they don't necessarily help the individual investor make money / avoid losing more).

It looks as though one measure sure to come is higher capital requirements of banks per the Financial Post. How much that will constrain the size of the financial sector is very hard to predict.

Investing Implications
When Larry MacDonald says he would be leery of investing in the US financial sector except for Goldman Sachs, maybe he's right. But the US financial sector has the lowest share compared to any major world index so maybe the market has already anticipated and priced in the effect of regulation-imposed slimming. Maybe it has even over-reacted, as can happen in crashes after bubbles. If the market has over-reacted, the Fundamental Index may still be closer to the eventual settling point than the market-cap index.

Lately the Canadian banks, who on the face of it have the most out-of-line highest proportion of the total stock market amongst Fundamental indices anywhere, and thus might be the most likely candidates for regulatory reduction, seem only somewhat likely to be heading towards shrinkage. Finance Minister Flaherty has publicly resisted calls for additional bank taxes (see the Toronto Star back in April). All five major Canadian banks are ranked among the Top 50 Safest Banks in the World and all 5 in the Top 10 for North America by Global Finance. And the proposed capital ratios mentioned in the Financial Post report are well within existing levels at all the major Canadian banks. Some are even talking of re-instituting dividend increases (see speculation on MoneyEnergy and in the Financial Post's Dividend hikes expected from National Bank, then Scotia and TD) so maybe it is a case that strong Canadian banks, already getting a significant chunk of their business outside Canada, are ready to expand into a shrinking less competitive sector beyond Canada's borders.

Bottom line: as an index investor with holdings in the Fundamental-weighted Index Funds like PXF, CRQ and PRF, I may be at slightly higher risk than Cap-weight investors in North America if the share of financial services is destined to return to pre-bubble days of 1986. I believe there is an appreciably higher risk for the non-North American Rest-of-the-Developed World (PXF). For now, I am not changing my portfolio strategy away from Fundamental Indexing to Market-Cap Indexing. Time will tell.

Stocks and the Long Term - Some Solid Research to Consider

It is a cliché that one should only invest in stocks if one has a long term horizon but often this advice is dispensed with a definition of long term using a number pulled out of the air or even without any number at all! Is long term five years, 10, 15, 20, 25, 30?

Thanks to the fine IndependentInvestor.info website (you will need to register to see content but it's all free and unbiased info) for uncovering some credible answers. As one should expect, there isn't a single number but a sliding scale of declining risk with extension of years invested. How Long is a Long-Term Investment? The 1 in 9 Rule summarizes the paper by economist Pu Shen of the Kansas City Fed, available at How Long is a Long-Term Investment.

Some of Shen's Discoveries

• showing risk on the basis of a one-time investment at the start (the typical "if you had invested $10,000 in Fund X in 1970, it would be worth $ZZZZZ today") understates the chances of losing money; the more realistic scenario, where an investor puts in money gradually over time, which he calls repeated investments, took at least 24 years before a positive real return on stock investments was always achieved. Stocks = the Center for Research in Security Prices Index, an index for the entire U.S. stock market from 1926 to 2002. The one-time method always showed positive returns after only 19 years, a difference of 5 years. The reason is the net effect of two opposite forces - time diversification (which reduces risk) and shorter effective holding periods (which hurts). Check out Shen's chart 2 below
  

• stocks never under-performed bonds (US Government 20 year bonds) after at least 26 years holding period (repeated investment method used), not exactly a mere blink of an eye.
  
• though the risk of stocks declined progressively with longer holding periods, the odd time they did have poor results, and even after 20 years the worst stock vs bond under-performance was still quite a hefty difference - check out Shen's chart 5 below. Sobering data, I'd say.
  

• quote: "Worse than investing in stocks right before a market crash is liquidating stocks shortly after the crash." (He says this in the context of people needing to retire then but of course a retired person does not typically spend all his/her money, or cash everything out, the day of retirement.) The worst possible 20 year holding period for stocks was ending in 1974 but from then on, there was a bumpy but ever-upward recovery. Moral of the story: hang on, don't panic, don't sell everything, try to sell as little stocks as possible after a crash - viz 2008 crash and 2009 recovery to date.
• even after 25 years holding period bond investors only beat inflation 34% of the time!! Now that's what I call risky. Stocks always beat inflation over 25 years and beat bonds 99.8% of the time. Stocks for the long-term indeed.

She shows that it is very misleading and harmful to define the long term for stock investment as five or even ten years, such as this article does. One should also keep in mind that Shen's paper did not factor in the annual fund expense fees and tracking error that an actual investor would face. This would lower returns and extend necessary holding periods.

International Diversification for the Canadian Investor: partial evidence

There is much published material on how international diversification benefits US investors but surprisingly little on the topic from the perspective of a Canadian investor. While one would normally expect that results from one country will be repeated elsewhere, as with so much else in investing (e.g. mutual fund MERs are too high, bonds return less than stocks over the long run), it is always worthwhile to look specifically at the Canadian experience.

In 2007 two graduate students from Simon Fraser University, Lei (Jeff) Wang and Luoxin (Peter) Wang took a look at the period 1996-2006 in their thesis Can Canadian Investors Still Benefit from International Diversification: A Recent Empirical Test. They wanted to figure out how much benefit could be obtained from international diversification in recent years given the rise in world economic integration and the convergence of stock market returns, which we all observed last autumn as markets crashed together in perfect unison. They took account of currency shifts to estimate real returns for portfolios optimized using equities and/or bonds from the USA, UK, Japan and Hong Kong combined with Canadian stocks, bonds and T-bills/cash.

Their results are positive but less strong than I would have hoped or expected. Despite correlations that did not exceed about 0.7 amongst any of the asset classes and a number of negative correlations (especially bonds vs stocks), the benefits of both return enhancement or risk reduction (aka reduction of volatility / standard deviation) were quite modest. The main benefit came from the addition of international bonds, which provided a hedge against inflation for the Canadian investor. The optimized portfolios they came up with are decidedly unusual - most have a 0% weight in US equities and not a single one has any UK or Hong Kong equity component.

Part of the problem with the weak benefit they found is that, as they note, in this particular period of 1996-2006 the Canadian stock market outperformed everyone else's. That may not, probably will not, be the case forever, especially since the Canadian stock market is so concentrated in only three sectors - financial services, resources and energy. Thus, diversification should work better over a longer period in the future than their results show. A second point worth considering is that they found a fairly significant inflation-hedging benefit during a period when inflation in Canada has been consistently low. That also may not be true forever. It's good to have a supplement to real return bonds as an inflation hedge. The final point, which they do not discuss and which is probably significant, is that their portfolio construction method included no rebalancing. They calculated the single optimal portfolio for the duration. Rebalancing provides the "buy low-sell high" mechanism for enhancing portfolio returns and reducing risk. Perhaps they can do a PhD to do more calculations.

Benefits of Investment Diversification for Retirees

A few weeks ago I noted in my review of Moshe Milevsky's excellent book Are You a Stock or a Bond? that further diversification beyond the US stock, bond and T-bill portfolio he used could provide more benefit. I've done a bit of research and number crunching and take a look at these benefits!

Diversification can:

1. Raise the possible safe withdrawal rate from the investment portfolio by 1.5% a year, perhaps considerably more. Safe withdrawal rate is the percentage amount that can be taken out and spent every year while minimizing the chance of running out of money before dying - a 4% rate on a $100,000 portfolio means taking out $4,000 per year and raising that 1.5% means being able to spend $5,500 per year.
   
2. Reduce the chances of running out of money by anywhere from 3 to 10%.

Most of the benefit of diversification comes from the potential large reduction in volatility, or swings in the portfolio. Diversification helps enormously to reduce the sequence of returns risk (the chance of having bad markets at the start of retirement) which can send a portfolio on a downward spiral from which it never recovers. Retirees face this damaging risk, which is quite different from investors in the accumulation phase, because they are taking money out.

The table below uses Milevsky's formulas, which incorporate the risk of dying along the way, for calculating the risk of running out of money before death. It shows a few hypothetical (but based on realistic numbers) calculations and a couple of results using historical data.

Hypothetical Calculations:

• Weak vs Strong Diversification, keeping the same 4% withdrawal rate - the slight increase in return combined with the large reduction in portfolio volatility (standard deviation from year to year) means that there is a 10% better chance that the money will last till death - which would you rather have an 87% chance of not running out or a 98% chance?
• Weak vs Strong Diversification but boosting the withdrawal rate - for the same risk of 87% chance of successfully having the money last, an extra 2.7% could be withdrawn. That's $2,700 extra for every $100,000 in the portfolio.
• both these scenarios assume a 50% chance of living 19 or more years e.g. a 65 year old getting to 84, which is about the current number according to Milevsky

Historical Data

• TSX from 1958 to 2008 (i.e. including the highly "volatile" 2008!) produced a 2% higher return than the hypothetical scenarios but the volatility is about the same. The comparison portfolio is from the conservative 50 portfolio (50% fixed income) from IFA Canada, which is quite broadly diversified with Canadian, US and international equity holdings, fixed income and real estate, though it does not include other potential asset classes such as commodities and real return bonds. There is still a huge reduction in volatility in the IFA portfolio to 8% from the 15% of the TSX alone. This would have allowed the withdrawal rate to be 1.8% higher with the exact same 97% assurance of not running out.

By playing with the numbers in the spreadsheet, it becomes evident that the longer the expected time in retirement, the stronger the effects.

Bob Clyatt's interesting book on how to semi-retire, Work Less, Live More, shows similar results using the approach of reconstructing actual data for a US investor from 1927 to 2004. He estimates that an internationally-diversified, value- and small-tilted portfolio would allow investors to increase their safe withdrawal rate by 1.5% or more per year. His analysis addresses the needs of much younger people (the semi-retirees) who essentially need their portfolio to last indefinitely, 40 years or more.

PS: Those who want to try Milevsky's formula with their own numbers should read a A Gentle Introduction to the Calculus of Sustainable Income. If you use OpenOffice instead of Excel, be aware that the GAMMADIST function parameters are in the same order as for Excel, not as the OpenOffice help documentation says (that caused me some head scratching till I "reverse-engineered" the correct way to do it).

The moral of the story - in retirement, diversification is a huge opportunity to both boost income and/or reduce the risk of running out.

Another Estimate of the Equity Risk Premium

Canadian academics Glen Donaldson, Mark Kamstra and Lisa Kramer estimate that the equity risk premium (the amount equities should return over risk-free treasury bills) is about 3.5% on US equities (give or take 0.5%) in their November 2008 paper Estimating the Equity Premium, which is available for download at SSRN. They claim their estimate is more precise because of simultaneously considering dividend growth rates, interest rates, Sharpe ratios, price-dividend ratios, volatilities and excess returns.

As usual, in using this conclusion to plan and estimate future portfolio rates of return, one must consider the assumptions, and this study's validity is bounded by the use of data covering about the last 50 years of US experience and the presumption that the future will be like the past.

Compare these results to other estimates I've blogged about, all with higher numbers of 5% or more:

• the book review of Bradford Cornell's The Equity Risk Premium
• various others like the Canada Pension Plan Chief Actuary, Rick Ferri (author of AllAbout Asset Allocation) and the US Social Security Administration's Chief Actuary
  

Figuring Out How Risky to Make Your Portfolio - Ignorance is No Excuse

One of my pet peeves with those risk preference questionnaires from financial companies is the notion that a person's reaction to the possibility of a more or less large temporary dip in the value of a portfolio justifies a more or less heavy asset allocation to cash, bonds or equities. e.g. see the "Comfort Levels" portion of this typical questionnaire at Edmond Financial Group.

That's like your lawyer telling you to ignore laws because you dislike them.

It is true that if a dip makes you react and sell out at a market bottom then it is bad news. To continue the analogy, you went too fast in your car, had a crash, got a big fine, and now swear never to drive again. Does that makes sense? The problem is not the car or the law, but you and the poor behaviour.

In fact, it is too true that a majority of individual investors buy high and sell low, under-performing their mutual funds by a large margin. e.g. Cause of Low Returns for 401k Plan Participants on the IFA Canada website and The Sad Reality of Mutual Funds at InvestmentU.

Behavioural finance is the study of people making stupid money and investment decisions. It describes how people actually behave, not as they should do.

"... even if behavioral finance describes how investors actually do behave, it may not describe how they should behave. That is, investors may abandon their behavioral biases once they have the benefit of financial education and financial planning advice." John Y. Campbell and Luis M. Viceira in Strategic Asset Allocation Portfolio Choice for Long-Term Investors.

I'm all for that solution - investment knowledge and education. Once the risk-reward relationships of various types of investments are clear and especially the difference between short- and long-term investment returns of equities vs other asset classes, most people can modify their behaviour to match their real capability to bear risk, and their time horizon and investing goals (the other parts of those risk questionnaires). This is particularly important for long term goals like retirement, where the only hope of generating a large enough sum is to have a healthy dose of equities. Ignorance should not be an acceptable excuse.

Benefits of a Diversified Portfolio in Retirement

Whew! I was pretty sure that holding a portfolio of uncorrelated assets would be just as worthwhile in retirement when withdrawals are being made as it is in the build-up phase before retirement but now I've found someone has crunched the numbers to demonstrate the fact. And the results are impressive.

Retirees are much more concerned to avoid downside risk, the risk of loss that cannot be recovered when poor returns occur, especially several years in a row of negative returns, such as happened in stock markets from 2001 to 2003. The opportunity to make up for losses by working harder or longer is not available to retirees. Capital preservation comes before everything. That fear is the reason many retirees stick to safe bonds, GICs, money-market funds. Unfortunately, such investments have low rates of return too.

In The Benefits of Low Correlation, Craig Isralesen shows that a balanced diversified portfolio is an attractive alternative. He calculates the results from the point of view of a US retiree withdrawing 5% a year (and adjusted upwards by 3% a year for inflation) from a hypothetical portfolio consisting of equal weights in seven different asset classes: large cap US equity, small cap US equity, non-US equity, intermediate term US bonds, cash (T-bills), REIT and commodities. He uses actual return data from 1970 to 2006. He works out the portfolio return and volatility but also shows - and this is the key part for a retiree - how much and how often the portfolio would go down, considering that the withdrawals were also taking place. What is particularly interesting and instructive (after all, he is a university prof) is that he starts with a portfolio of only two assets (the US equities) does all the calculations and then adds another one till the full seven are included. The progressive benefit of downside risk reduction, portfolio stability and return enhancement (or reduction, when a lower return asset like cash is added) comes out very clearly.

It is not the actual numbers he calculates that are important - a real portfolio would have transaction costs and tracking error and the future will not be exactly like the past. Plus a 4% withdrawal rate would reduce even further the risk of a reduction in the portfolio's value in any year, enhancing its sustainability. It is the effect and the magnitude of the effect of diversification through uncorrelated assets that is worth noting.

Here is part of Israelsen's conclusion:
"There are several quantifiable benefits of lowering the correlation of a retirement-withdrawal-mode portfolio's component assets. First, there is a dramatic reduction in the volatility of the portfolio's performance (i.e., lower standard deviation of return). Second, there is a significant reduction in the worst-case portfolio loss, or maximum drawdown. Third, the likelihood (or frequency) of loss is minimized. Fourth, performance does not suffer if sufficient diversification is achieved."

As a mini example of the benefits touted by this study, in my own portfolio, shown at the bottom of the blog, the huge rise in commodities and emerging markets has partially offset the fall in US and European equities, providing stability in the past year.

The lesson I draw is that a diversified portfolio is a viable alternative for a retiree, close to the safety of cash but with much higher returns. Happily, passive index mutual funds or ETFs provide a practical way of implementing such a portfolio. Finding new uncorrelated assets to put into the portfolio, such as inflation-indexed bonds (RRBs in Canada TIPS in the US), which Israelsen did not consider, will have similar benefits of further risk reduction or return enhancement, or both.

Currency Risk in an International Portfolio - Extreme Value Theory

On his Investment Ideas blog post Currency Hedging Necessary? of May 7th, Larry MacDonald cites the Chou funds annual report 2007 letter and several academic studies ((The Performance of Currency-Hedged Foreign Equities by Lee Thomas and (Hedging Currencies with Hindsight and Regret by Meir Statman and Kenneth Fisher) referred to therein saying that removing the risk arising from currency exchange swings is unnecessary. The long term (15+ year) returns were about the same for portfolios with and without hedging, as was the traditional measure of risk, standard deviation.

Is that the end of the story, the definitive answer for the investor who wants to hold a diversified portfolio that includes substantial international holdings? Apparently not.

Gary Klopfenstein and Fred Stambaugh of BancOne Currency Advisors show in Currency Risk Management in International Portfolios that the traditional measure of risk - standard deviation - used in the above studies does not adequately reflect currency movements. Big swings / extreme events in currency occur far more often that standard deviation based on a normal distribution says they should and this causes big, hidden downside risks. Instead they apply Extreme Value Theory and show that portfolio returns can be significantly improved while risk is reduced. This is accomplished not through traditional methods of currency futures or options (assumed in the hedging done in the traditional studies) but through something termed active currency management, which Banc One conveniently offers as the Banc One Currency Advisors Currency Overlay Program (a fancy label is required to market this to the target institutional investors).

Unfortunately, how that works is not described, nor is the study named that purports to show a 0.5% per quarter improvement in returns while eliminating "calamity risk". So it's hard to tell if this is a real prophylactic for a foreign investor or just another magic elixir. And then of course, can the individual investor do something similar or are there reasonably priced products that do so?

Beware of Financial Advisers offering Nasal Spray

Came across an amusing tidbit in GlobeInvestor magazine enticingly titled The link between your love life and your investments. It was based on a serious research study called Oxytocin Increases Trust in Humans (do a Google search and see how often the article shows up).

The researchers found that men would become more socially trusting and readier to take risks when the "love chemical" oxytocin was squirted up their nose. The experiment is described this way by GlobeInvestor:
"An investor could choose to give any amount of money to a “trustee.” Once invested, that sum would be tripled, but the investor couldn’t control how the trustee used the funds. Enriched by this windfall, the trustee could opt to share the proceeds with the investor, and both players would then get a nice payoff. Or, the trustee could be selfish and hoard the profits."

Nice way to describe how investing works, huh? The adviser triples your money without queston, the only doubt being whether he/she will steal it.

Now I know to refuse all nasal spray when meeting with financial advisers or brokers no matter how bad a cold I have! (Can it be laced in coffee at investment seminars!? Will anti-oxidants counter the effects?) We'll also have to monitor the progress of efforts to transmit smell through the Internet. Imagine receiving a spam investment solicitation email laced with oxytocin.

Or, maybe the technique could be reversed to develop a risk aversion blow test, sort of a risk breathalyzer. It could be descriptive - "you have a very low risk tolerance, sir" - or prescriptive - "your oxytocin level is wayyyy too high, no investing for you for a month."

Have a good day. ;-)

A Worthwhile Investment: Real Return / Index-Linked Bonds

An investment portfolio is like a house. It may be complete and look fine overall but there is always some improvement to be done. In my investment portfolio, the next renovation project will be to rip out some of my regular fixed income and install some real return bonds. Here's why I'm going to do it and how. I think it's something everyone should do, much like a kitchen renovation, since it always adds value.

What are Real Return Bonds (RRB)?
To quote Bylo, whose primer Real Return Bonds for Canadian Dummies I highly recommend (many of the links cited below I found at his website),
"Real Return Bonds (RRBs) are Government of Canada bonds that pay you a rate of return that is adjusted for inflation. Unlike regular (nominal) bonds, this feature assures that your purchasing power is maintained regardless of the future rate of inflation."
Their other name, often used in other countries - index-linked bonds - comes from the fact they are linked to an inflation index like a CPI (Consumer Price Index). Both the principal and the coupon aka interest payments go up with inflation. Another excellent brief description of inflation indexed bonds, with reference to the US version called TIPS is in the Investopedia article titled Inflation-Protected Securities - The Missing Link.

Inflation-adjusted Interest vs Real Yield
It is important to keep straight that there is difference between the inflation-adjusted coupon interest return and the real yield return you get when you buy the bond on the market. When you buy some of the Canada RRB maturing Dec 1st, 2021 with a 4.25% interest coupon (set in 1991 at original issue), you do not receive 4.25% as the real return on your investment, nor do you receive that as the cash payment of interest every six months on June 1st and December 1st.

• Real yield: supply and demand in the market sets the yield through changes in the price you have to pay for the bond. For instance, the price quoted (at the time I looked it up) on CanadianFixedIncome.ca in the Real Returns tab in the bottom panel of the page showed that the current real market price of $130 for every real $100 of bond works out to a real yield of 1.75% per year. You can check the recent real prices at the bottom of this Bank of Canada web page .
  
• Inflation-adjusted cash payment: the Bank of Canada publishes here the inflation adjustment factor to multiply times the interest coupon. It changes every day as inflation marches on, slowly or quickly. For May 9, 2008, the factor is 1.35179. The semi-annual interest payment is notionally 1.35179 x (4.25% / 2) = 2.8726% though it is only paid on June 1st when the inflation factor will be 1.35537. The holder of $1000 face value of this RRB will receive interest of $1000 x 1.35537 x (4.25% / 2) = $288.02.
  

That 1.75% sounds pretty low compared to other government of Canada bonds seen on the same page at around 4% but those other bonds will not be adjusted for inflation by the government and so the expected inflation rate is factored into the price, i.e. about 4 - 1.75 = 2.25%. If inflation is actually lower over the next 13 years than 2.25% then the RRB is not as good a deal but if it is higher than that the RRB wins.

In retrospect, we should have loaded up on RRBs ten years ago when the real yields were 4%! The Bank of Canada publishes data on the real yields of the federal government RRBs back to 1998. Yields have drifted steadily downwards ever since 1998. The average during 1998 - 2008 is 2.94% and the last time it was 3% was 2003. Another BoC page shows yields in recent months and illustrates the fact that fairly significant changes can occur in a few months - it was up to 2.2% last June/July.

What would it take to send yields back up to 4+%? Frankly, I'm not sure but the period when yields were highest was during higher inflation in the 1990s.


Why Own Them in a Portfolio?

1. Inflation-protected interest and principal - for those who want or need cash flow and principal, e.g. for income in retirement, guaranteed to be free of inflation risk and default risk (is the Government of Canada likely to default on repayment in 2021?) RRBs are a godsend. A big risk with long term nominal bonds is inflation since higher rates, over and above what is assumed and built into the nominal rate, can destroy the principal value of long term fixed income investments as surely as default. RRBs are a superb tool for capital preservation if held to maturity. Meantime, the cash flows are automatically increased for inflation so your purchasing power is conveniently maintained. Back in November 2007, journalist Jonathan Chevreau published this interview with finance prof and author Zvi Bodie who strongly believes in RRBs. As inflation threatens again to start accelerating, the value of RRBs is rising.
   
2. Asset class diversification benefits - RRBs have the wonderful property of being uncorrelated or even somewhat negatively correlated with regular fixed income, equities and real estate, as well as Canadian currency fluctuations vs the US dollar. See the Altruist Financial Advisors Reading Room page listing of articles under the heading Inflation-Indexed Bonds for the academic research that demonstrates these effects. The diversification benefit refers to the opportunity to lower the overall volatility i.e. risk, of a portfolio through including RRBs. One of the studies in the list - TIPS As An Asset Class by Peng Chen and Matt Terrien - (TIPS are the US version of RRBs) concludes that "TIPS offer investors an option for portfolio diversification that no other instrument can replicate. ... For investors with most of their portfolios invested in traditional financial assets, the inclusion of TIPS reduces the risk and increases the return of the entire portfolio."

How to Fit Inflation-Indexed Fixed Income into the Portfolio

• the research studies indicate that RRBs should replace a portion of normal bonds, especially the longer maturities; this makes sense given that RRBs themselves are long maturity bonds
• the exact proportion of normal bonds vs to hold is not a single number; at Libra Investment Management these calculations show that the RRB allocation can be anywhere from 15% up to 100% of fixed income and the previously cited TIPS As An Asset Class study indicates it should be most of the fixed income allocation in the portfolio.
  
• since RRBs are taxable as interest, which attracts the highest tax rate (see the description of the tax treatment in the Prospectus at the BoC), RRBs should be held in a tax-deferred registered account like an RRSP, RRIF, LIRA etc

The Mechanics of Buying
Bylo's previously mentioned webpage neatly describes the choices. The only thing to add is that in Canada there are not many offerings to choose from. The Government of Canada has five series outstanding:

• 4.25% 01Dec2021
• 4.25% 01Dec2026
• 4.00% 01Dec2031
• 3.00% 01Dec2036
• 2.00% 01Dec2041

The Dec2041 issue seems not to be quoted on the Canadian Fixed Income site and may not be readily available. Similarly, bonds from the Quebec, Ontario and Manitoba governments may not be available. Phone the bond desk of your broker to find out what they have. The provincial RRBs will yield slightly more than the federal ones. It doesn't really matter as it is not necessary to hold more than as the default risk is not an issue.

In calling my broker, the minimum purchase amount was indeed $5000, not the $1000 the Bank of Canada prospectus says (in the secondary market where you and I trade, the BoC's prospectus rules do not apply).

The biggest issue with buying them now is the low yield. Between the time I looked up the current rates and the end of the day on Friday, the yield on the Canada 2021 issue had fallen from 1.75% to 1.68%. That's the mid-market rate, halfway between the buy and sell. Factor in the higher price (meaning a lower yield to you) from the broker and the real return is even lower. It's a tough choice between holding off and waiting for a better rate in the 2% range or going for the diversification benefits now.

A quick follow-up note - found this Bank of Canada research paper World Real Interest Rates: a Global Savings and Investment Perpsective, which concludes that low real rates are a global phenomenon and that changes occur slowly over years. From their graph on page 2, it would appear a 1% shift in a year is about the most that could happen.

Since the real rate is driven, according to the paper, largely by the balance of global investment vs savings, if we are in a period of economic slowdown, what are the chances of a resurgence in the real rate soon?

Correlation & Standard Deviation: Worthless Risk Tools for the Investor?

Retired mathematician and investment aficionado Gummy (see link to his great website in my Resources sidebar on the right) wrote a provocative entry (see the lower part titled Correlation means ... what?) on his website in which he casts doubt on the value of standard deviation for risk measurement and correlation for risk control.

He shows, and I am sure his math is impeccable, that an example portfolio with standard deviation of zero as a result of holding two perfectly negatively correlated assets, can lose a lot of money. Huh? Standard deviation as the accepted measure of risk is one of the bedrocks of finance theory. Negatively correlated assets are the foundation of hedging and building portfolios more protected against loss. What gives?

The basic reason I believe that we are ok continuing to believe in standard deviation and negative correlation as essential investment principles is that reality has not ever worked and by all logic should never work the way his example does. For one asset or asset class to produce negative returns in seven out of ten years and to have an average negative return of over 6% per year for a decade is very unlikely. For an uncorrelated second asset to exhibit the same steadily downward behaviour at the same time (Gummy's second asset goes down an average of 3.7% per year) is even more improbable. I went back and scanned Roger Gibson's book on Asset Allocation (my review here) for his many charts and tables of investment returns. Even in the worst period of the 1930s, while stocks were going down year after year, other asset classes like bonds were still producing positive returns. Over ten years, almost no asset class will average negative returns. For example, Seeking Alpha has just published charts of the latest Major Asset Class 1, 3, 5, 10 & 15 Year Returns. Not one had negative annualized ten year returns.

Any investment or asset class must ultimately be expected to have positive returns. Otherwise, why would anyone invest? The beforehand expectation is of course not always what happens, especially where individual companies are concerned. That's why I believe that I am better off with funds and ETFs that spread the individual company risk over many companies so that the expected pattern of positive asset class returns emerges.

With respect to correlation, the patterns are variable according to the choice of interval, as the upper part of Gummy's post shows in his analysis of correlation according to the number of days, and they are also unstable over time even for a set interval (which he does not explore). Even with these considerable imperfections, non- or negative correlation between asset classes yields diversification benefits in a portfolio in the form of a reduction of risk, or chance of loss.

To illustrate, I took Gummy's data and graphed the cumulative value of each asset X and Y, separately and as a 50-50 portfolio. The results are in the chart you see. Would you rather have owned asset X or Y or the portfolio of the two? Suppose along the way in some random year, unknown in advance, you had needed to sell, what would be you be better off with, one or the other asset or the portfolio? I think I'd rather have the portfolio despite the steady 5% loss year after year.


Just for fun, I also tried out another portfolio best practise, which is to periodically rebalance the portfolio back to the original 50-50 allocation to each asset. Lo and behold, rebalancing once a year after each year's return produces a portfolio whose individual assets vary much less in dollar value year to year and whose end value is considerably higher - 60% of the starting investment vs only 52% - than the non-rebalanced portfolio. To be more realistic, the cost of trades would have to be subtracted from the rebalanced portfolio but the impact would depend on the size of the portfolio - as the amount invested got very large the impact of that trading cost would become very small. In other words, even with trading costs, the rebalanced portfolio would probably come out ahead.

From a practical point of view, the only type of investment asset that one is likely to find with perfect and predictable negative correlation to another is insurance. e.g. through the use of options. But insurance comes at a net cost that will reduce overall returns. Conversely, no asset classes have perfect positive correlation, which means that at least some diversification benefit can always be obtained with different assets.

In the real world it worth remembering that there is no such thing as a risk-free asset. Even T-bills, though they are free of default risk, are subject to inflation and taxes that have at times in the past resulted in net losses in real purchasing power terms.

The practical world is messy and imperfect as Gummy found but the principle of using standard deviation as a measure of risk is still very useful to the investor, as is seeking out asset class combinations in a portfolio with positive long term returns as negatively correlated as possible.

Book Review: The Equity Risk Premium by Bradford Cornell

The equity risk premium is the difference between the rate of return on common stock and the return on government bonds or T-bills. For the individual investor, the amount of the premium is a critical input to investment planning for savings and for retirement. When those ubiquitous savings calculators ask for your estimate of future growth of your investments, it is important to use a realistic estimate, otherwise you may be sorely disappointed years down the road.

The objective of this book is to examine the equity risk premium in detail and come up with an answer, as the sub-title - The Long Run Future of the Stock market - suggests. Little did I know beforehand that it could be looked at from so many angles. Cornell summarizes and integrates the findings of the many financial economists who have carried out all the slicing and dicing of the data up to the 1999 date of publication. As such it is an invaluable monograph of the subject and the six pages of references provide any finance aficionado or student the core reading list to see the original material. The book itself presents little or no math, confining itself to basic formulas like the dividend discount model and the Sharpe ratio as the support for the often subtle economic logic.

The author writes clearly, carefully and directly with no embellishment and no deviation from the central topic. The style may be a bit dry but that is not a deficiency in my mind, since clarity and precision are paramount. Entertainment and pizazz are not the aim. The book did not provoke boredom, though one must keep in mind that I also read books on tax out of interest. The intended audience is intermediate to expert level.

The book seems quite linear in the progression of its argument, which is a testament to good organization of the material. There are only 217 pages in the book, including 22 pages of a table of monthly return data for US stocks, government bonds, T-bills and inflation from 1926 to 1997 (why bother with that anyhow?)

What does Cornell conclude from his review of all the evidence and studies?
"The future will not be as bright as the past. ... from 1926 to 1997, the average equity risk premium was 7.4% over treasury bonds and 9.2% over treasury bills. Investors cannot reasonably expect equities to produce such large premiums going forward. Instead, premiums are much more likely to be on the order of 300 to 400 basis points [i.e. 3 to 4%] lower."

But, he says, "... even with a lower risk premium, stocks still remain an excellent long-run investment in comparison to bonds." That's because stocks at a lower premium can reasonably do better by around 5% per year. A key reason is that stocks do better in the face of inflation.

The absolute real (after deducting inflation) expected rates of return, with the downward adjustment to equities as Cornell suggests, would work out to (using his data in table 1.3):

• T-bills 0.5% per year
• Long-term/ 20 year Treasury bonds - 2.5% per year
• Equities (S&P 500) - 5 to 7.5% per year

Cornell gives advice to pension plans and individuals saving for retirement: "... fixed benefit funds face two choices: they can increase (1) funding for the plan, or (2) the fraction of the fund invested in common stocks. ... Employees on fixed-contribution plans or who are funding their own retirement plans face the same tradeoff. To achieve an expected dollar standard of living in the face of declining expected returns on equity, they must either save more or increase the fraction of their portfolio allocated to common stocks."

Apart from these core conclusions (which we ignore at our own peril), there is much else to savour in this book, which a few quotes will serve to suggest:

• "Fama and French reported that stock returns tend to be mean reverting, so that periods of abnormally high returns tend to be followed by periods of below-aerage returns." (page 55)
• "... in the years following 1926, when detailed stock market data became available, the United States led pretty much a charmed life. ... As of 1926, it was not clear that the future was going to be so bright." (60) ... compared to countries like Germany, France, Italy, Russia and Japan; I think of this as using Tiger Woods to portray the average golfer. Would someone please tell me whether the US will continue to be so wonderful for the equity investor?
  
• "... the collapse of the gold standard led to a worldwide bias toward higher rates of inflation." (75)
• "Given the widespread distribution and acceptance of the Ibbotson data, it is not unreasonable to assume that today's investors have significantly different beliefs than their depression-age predecessors regarding the long-run risk-return tradeoff offered by common stocks and competing fixed-income assets." (174) i.e. today's investors have a pretty rosy picture of stocks.
• "A bubble, however, is inherently unstable. Because it is not based on fundamental valuation, all that keeps a bubble going is the expectation of higher prices next period." (185)
• quoting then Federal Reserve chairman Alan Greenspan in 1998, "The abrupt onset of such [stock market] implosions suggests the possibility that there is a marked dividing line for confidence. When [it is] crossed, prices slip into free fall - perhaps overshooting the long term equilibrium - before markets will stabilize." (190) ... i.e. there is money to be made in market panics

One paper cited by Cornell is the paper A Century of Global Stock Markets by William Goetzmann and Philippe Jorion at the Social Science Research Network. Within that paper is the comforting information that one does not have to pick the next "USA-like superstar stock market country"... we find that the performance of a globally diversified portfolio is much closer to the performance of U.S. equities, averaging 4.0%" (they found the U.S. performance was 4.3%). Canada's real return was far behind at 3.19% and the UK's was even worse at 2.35%. Global diversification, anyone? P.S. no, I cannot explain the difference between the return numbers in this paragraph and those of Cornell cited above - no doubt there are differences in methodology like inflation calculation, time periods, adjustments of the data to compare amongst countries.

About the only criticism I have of this fine volume is its high price, $100 CAD on the dust jacket, though it sells for $47.51 on Chapters. There is also a typo in formula 3.2 on page 103 - the book shows the constant growth form of the dvidend discount model as k= Div1/(P+g) whereas it should be k=(Div1/P)+g. The text below is correct, however. My rating 4.9 out of 5.