Oct 192014
 

Overreaction leads to market turmoil

Over the last several weeks investors saw a 10% correction in the Canadian stock market, and a 9% correction in the U.S. Someone with a $100,000 portfolio invested in index funds could have just lost $10,000. Ouch. :| Is this market sell off justified or is it simply an overreaction to some recent bad economic news? First, let’s review what those news are.

  • The Canadian dollar has dropped to a 5 year low
  • Germany’s economy is weaker than expected
  • The rest of Europe is still in a mess of unemployment and stagnation
  • Last week the Athens Stock Exchange in Greece tumbled more than 6% in one trading day.
  • ISIS is causing havoc in the Middle East
  • Ebola fears

I currently own shares in the Bank of Nova Scotia (BNS.) It’s one of the largest companies in the country and has been around for over 180 years. Over the last month the price of this stock fell 8%. Instead of asking where the stock will go from here, we should instead be asking does all the recent bad news justify an 8% drop in value for one of the largest banks in Canada? My answer is absolutely not. :P It’s important to remember that when we buy a stock we are literally owning a part of that company. This means we, as stakeholders in Scotiabank, are still entitled to split the $6.5 billion profit that the company makes every year, regardless of how the price of BNS shares performs in the short term.

14-10-overreaction

 

A lower loonie will likely spur economic growth and will not hurt Scotiabank’s profitability. Europe’s stalled economy is nothing new and Canadian banks don’t lend that much to Europeans anyway. The media has succeeded in sensationalizing the threat of Ebola in the U.S. Yes it’s a terrible disease, and there’s an outbreak in Africa. But Ebola will not hinder businesses in the U.S. and Canada from continuing to rake in profits. Literally more Americans have been married to Kim Kardashian than have died from Ebola – both a terrible fate. :(

For the intrinsic value of Scotiabank to actually fall by 8% substantial circumstances would need to be met, such as major accounting fraud or a 10% national unemployment rate, that would legitimately jeopardize the company’s ability to make money. The recent news is relatively trivial so an 8% correction of BNS shares seems like an overreaction. Imagine selling our stocks now only to see the markets rebound next month and regain all its losses. :|

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Mar 132014
 

Some people have a fear of losing money. This prevents them from taking the necessary risk with their investments, like buying stocks, to give the best probability of a long term return. The S&P500 returned 20% over the last 12 months, so anyone who holds American stocks like me have probably done well with their net worth over the last year :) Despite reaching new record highs however, we don’t hear people talking about the stock market too regularly these days because things are going really well. But what if the S&P500 had lost 20% over that same period? I bet it would get a lot more attention wouldn’t it :) Bear markets certainly give the media more to talk about.

14-03-joker lose money

This is because many people can’t stand losing money. In economics the tendency to prefer avoiding a loss rather than making a gain is called loss aversion. This psychological behavior prevents many people from making smart investment decisions.

Scientists have done experiments where they give monkeys a single banana each. Predictably the monkeys would appear satisfied :) The scientists then gave two bananas each to another group of monkeys and then took one banana away. Note that these monkeys still ended up with a free banana each, but they become noticeably angry and agitated at the scientists, as if they had just been robbed. So sometimes  1 ≠ (2-1).

In terms of behavioral finance,  we’re not that much different from monkeys. We feel pretty good about getting a $20 discount on a new pair of shoes, but we feel a whole lot worse if we realize we lost $10 because it had accidentally fallen out of our pocket. But learning how to process and react to losing money correctly is important to understanding the financial system. In fact Canadians who describe themselves as more knowledgeable investors are more likely to have experienced a major loss.

Here’s an easy experiment to find out if you are risk adverse. Pick a stock to follow and imagine you own it. Record how much it has increased or decreased after each day, and your feelings about it. Over time if you notice that you feel emotionally stronger toward losses than gains of the same magnitude then this means you have a lower risk tolerance for investing, which is fine. You simply value capital preservation more than potentially larger gains. Just be aware that the time when we should be taking on the most risk is when we’re young. If our investments fail at least we would still gain valuable knowledge and experience, which we probably can’t afford to do when we’re old and crusty :P

To me a dollar lost has the same emotional intensity as that from a dollar gained :) I don’t get upset if I lose on a stock trade because I know I can just as easily make it back next time. I can also sleep well at night during a recession because I know bear markets don’t last forever. Thinking about losses logically can make us more happy :D

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Random Useless Fact: While sitting in front of your computer, lift your right foot and make clockwise circles.
While doing that, take your right hand and draw the number 6 in the air.
For some people, your foot will change direction all by itself. Try it :)

Feb 232014
 

It’s so easy to make money in the market these days :D If you bought the Dow Jones index 18 months ago, your investments would be up 30% today!

But the chart below may be a strong signal that these good times will likely be ending very soon! *gulp* 8-O The darker green line indicates the Dow stock market index today and its performance over the last 18 months. As you can see it’s mostly good news :D But the lighter cyan line above represents the same index, also over an 18 month period, but 85 years ago.

14-02-dowjonescompare

As you can see the 2 lines are very similar so far ;)  There’s probably something fundamentally the same within the different periods of time that’s driving this synchronicity :? It was right around this time of year back in 1929 when the market had a major correction, and by summer of 1929 the Dow had lost 20% of it’s value from the peak in early January. Does this mean the Dow will do the same this year in 2014? A 20% correction is not that rare for the stock market, and if the Dow continues to follow the historical trend set 85 years ago then maybe it’s time to sell some positions and lock in the profits. I mean, look at how eerily similar the 2 charts are :|

If you believe we are in for a downturn then maybe add more bonds, like XBB, to your portfolio as a bit of protection. But if you think the charts lining up is purely coincidental then carry on with your stock investing. Personally I have no idea what to think about this data so I’m going to sit on the fence and hold all my long positions, and will not buy any new stocks until April.

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Random Useless Fact: Most foreign students only seem smart because all the dumb ones stay in their home countries. #NoOffence

Dec 112012
 

One myth about investing in the stock market or any other market where prices fluctuate is that it’s risky. But people who know how to value a stock understand that it doesn’t have to be risky if they buy the right stocks at the right time. Volatility and risk aren’t always correlated. Some companies with steady growth such as Enbridge have been pretty stable over the years.

Enbridge stock chart, volatility and risk

That’s not to say ENB is a good buy today because whether a stock is reasonably valued or not is another topic. But here’s a look now at Caterpillar below, who manufactures construction equipment, heavy machinery, etc.. Notice how the stock is more volatile over the same period as Enbridge.

Caterpillar stock chart, Volatility and Risk

But that doesn’t necessarily mean CAT is a riskier stock than ENB.  CAT is a more cyclical company so its Beta is suppose to be higher. What makes a company safe to invest in for myself is a positive trend of earnings growth, dividend growth, and industry expansion. Both companies have had stable dividend growth over the last decade meaning managers are confident about their company’s future performance. Both companies have also increased their profits over the years. Pipeline companies are looking to expand their pipes across Canada, and In Alberta alone the government has forecast there will be 114,000 jobs in the construction industry over the next decade (o.O) ENB and CAT are both in growing industries with growing demand for their products/services.  Stocks can vary in risk depending on what kind of business they are, but volatility doesn’t necessarily mean risk. It just means at some point in time, there might be  a good opportunity to buy the stock at a great value ;)

Here’s what the Oracle had to say on the subject….

“Volatility does not measure risk. Past volatility is not a measure of risk. It’s nice math, but it’s wrong. If a farm in Nebraska used to sell for $2,000 per acre, and now it sells for $600 per acre, investment theory would say that the beta of farms has gone up, and than they are more risky than before. If you tell that to people, they’ll say that that’s crazy. But farms don’t trade daily the way stocks do. Since stock prices jiggle around, finance professors have translated that into these investment theories. It can be risky to be in some businesses. Risk is not knowing what you’re doing. If you know who you’re dealing with, and know the price you should pay, then you’re not dealing with a lot of risk. We have invested in a lot of sectors that have high betas. The development of beta has been useful to people who want careers in teaching.”
- Warren Buffett

Beta – The measure of volatility. Higher beta = bigger fluctuations in price. The overall market has a Beta of 1. If a stock is said to have a Beta of 1.5 then that means it will be 50% more volatile than the market.

Feb 262012
 

Many financial “gurus” advise home owners to make lump sum payments on their mortgages and pay them down sooner rather than later. I agree with this to an extent. However I worry people may be under estimating the power of opportunity cost here. Let’s work through the numbers and look at some facts instead of listening to main stream opinions.

Let’s say we won the lottery (●^o^●) and became $100,000 richer! Let’s decide if we want to put this money towards the down payment for a house in order to have a smaller mortgage, OR, invest all our winnings in the stock market index and take on a bigger mortgage.

First we must find out what is the cost of borrowing $100,000. Assuming our mortgage rate was 7% every year, by the time we pay off a $100,000 mortgage over 25 years, we would have paid a total of about $210,000 (according to RBC’s calculator). Which means we will be paying $110,000 in interest alone. So if we increase our down payment by $100,000, we save $110,000 on interest in the long run.

mortgage, paying down mortgage

But now let’s see what happens if we invest all of that $100,000 into the stock market index instead. Let’s say over 25 years we make an average of 6% a year. In the end our $100,000 would turn into roughly $429,000. But since we invested our $100,000 instead of adding it to our down payment, we have to borrow $100,000 more for our mortgage. From the last paragraph we know the cost of taking on an additional $100,000 mortgage loan will cost us $210,000 total (including interest.) So if we then took our stock investments after 25 years ($429,000), and paid off the extra cost of having a bigger mortgage ($210,000), we would still walk away with a $219,000 profit, in addition to paying off our mortgage as planned! Hey-Ooh! (^o^) Below is a chart of our investment returns.

mortgage, don't pay down the mortgage so fast

In the first example we left extra capital sitting in our house doing absolutely nothing, except to save us 110% in interest over 25 years. In the second example, we invested that capital instead so although we had to pay the 110% interest over 25 years, we also made 429% on our investments during the same time using the same capital. So maybe investing our money instead of aggressively tackling our mortgage isn’t such a bad idea :D

But wait a minute. What accounting sorcery is at play here when a 6% investment return can dramatically outperform a 7% mortgage rate? Well I’m sure you’ve figure it out by now (^_-) Each time we make a mortgage payment, our principle decreases. It’s the opposite of compound interest, because we pay less interest each time (not more) until eventually the entire loan is paid off. But investment returns on the other hand are the exact opposite and actually compound and grow, giving us higher returns year after year (not less.) Annual Compounding x 25 years = major win.

But it gets better! Our mortgage calculations are based on a 7% interest rate which is higher than average, even compared with long term historical rates. Not to mention rates are super low today. My current mortgage rate is just 2.6% as of 2014. So chances are we’ll probably end up paying a lower rate than 7% on average over the span of our mortgages. A cheaper borrowing cost means we’ll end up even further ahead.

But wait, there’s more! I used 6% for our investment returns to be on the conservative side. But North American equity markets have historically returned about 10% annually, and bonds average about 8% annually. Market returns are not guaranteed, but as long as we can average more than 3.1% return per year for our investments (since that will give us $210,000 which is equal to the cost of the mortgage) then we’ll be better off investing all of our extra cash, than trying to pay down the mortgage. The worst total return ever for any 20 year period in the history of the stock market is still a positive 3.1%, which was around the Great Depression years. What do you think are the chances of a balanced portfolio averaging less than 3.1% annual return over the next 25 years when that has never happened in the history of North American stock markets before? And are you willing to miss out on such a great risk to reward opportunity.

But it gets EVEN better! The interest paid on the $100,000 mortgage loan can be made completely tax deductible. Just use the $100,000 as part of the initial down payment first. Then take that $100,000 out as a home equity loan to invest in stocks, and now the interest on the loan can be claimed for investment proposes. So if your marginal tax rate in the 30% tax bracket like me then that 7% mortgage rate has just automagically dropped down to 4.9%. Meanwhile, our investment returns from capital gains and dividends receive preferential tax treatment (less than 30%) What a bargain! ( ^^) Even the tax man is giving us an incentive to invest via other people’s money because interest we pay on a loan for investment purposes is tax deductible.

And don’t forget about Inflation! If we stash away $100 under our beds today then by next year it will probably only be worth $98 or whatever. What happened to the missing $2? Inflation happened. The rising cost of living can be a pain, but it can also be a blessing to people who have debt. If you owe the bank $100 for example, then by next year if you haven’t touched the principle, that $100 balance you owe will only have $98 of purchasing power which means for all intends and purposes that $100 is now worth less, and it’s EASIER for you to pay it back. So a $100,000 mortgage, assuming a 2% inflation rate, will only be worth $98,000 by next year. Wow, we just increased our wealth by $2,000 in REAL terms by simply sitting on a mortgage :D Thank you inflation! The more debt we have the more we’ll benefit from inflation :) The U.S. has over $16 trillion of national debt. And its growing by billions of dollars every day because its government continues to spend more than they take in. Inflation is a method used by many central banks around the world to deal with their nation’s debts. They print money so their currency won’t be worth as much. Inflation will slowly chip away at debt, which will decrease the debt’s real value over time making it easier to pay back :) Debt is a depreciating liability, but real estate is an appreciating asset, so buying a home using debt is a double win!

And it reduces our financial risk!  A Pew research center study found that between 2009 and 2011, most American households experienced a decrease in their net worths, and only 7% of households saw their wealth grow :D What’s the secret of these successful households? The study points out that the these 7% of households have most of their wealth held in stocks, bonds, and retirement accounts. But the other 93% of Americans have on average just 33% of their wealth in the markets, while half their net worth comes from their homes. We all know that between 2009 to 2011, stocks rebounded from the recession, however U.S. housing prices remained flat to negative. So if we make extra payments on our mortgages then we risk over exposing ourselves to the real estate market and deny ourselves the opportunity to properly diversify our investments. And diversification, as the study points out, was how the top 7% got wealthier. If we want to become wealthy too we have to invest in stocks and bonds like the rich do. Some people may argue it’s risky to invest while still in debt, but they don’t realize that it’s also risky to aggressively pay down a mortgage and not diversify their asset portfolio (^_-)

If Canada’s home prices have a major correction in the future, at least we would have other financial assets to cushion the blow to our wealth. But here’s the brilliant part – even if real estate prices continue to increase we would still benefit because our homes will be worth more money! So it doesn’t matter if home prices rise or fall. We win no matter what direction the real estate market goes in :D This is because regardless of how much money we allocate to pay down our mortgage it will not affect the future market value of our home. However, whether or not we invest in the stock markets today WILL have a direct impact on the future profits of our stock portfolio. If we miss an opportunity now to capitalize on the financial markets then that potential profit is lost forever. But if as long as we have a home, then 100% of it’s future market gains goes directly to us whether we have a huge mortgage on it or if it’s been completely paid off. This is why diversification is so important, and why we shouldn’t underestimate opportunity cost. Besides, even by simply making the minimum mortgage payments, we are STILL adding equity to our homes anyway. So even if we allocate 100% of our savings to invest in the financial markets the real estate portion of our asset allocation will still be growing in dollar terms ;)

Finally here’s one last tip. We used a 25 year amortization period. Think about how much more our investment returns can grow if we gave it 30 years to compound instead. A longer time horizon will also decrease our investment risk. For the record, my current mortgage is amortized for 35 years (ʘ‿ʘ) The longer we spread it out the better our returns will be.

So when people say they want to increase their mortgage payments by $500 a month, or make a lump sum payment of $10,000, or aim to pay off their mortgage 10 years in advance, it all sounds good on paper, but I hope they understand just how much money they’re potentially NOT making, and how much asset allocation risk they’re taking on, by being overweight in real estate :(

My mortgage in 2009 when I bought my condo was $215,000. Today, in 2014, the balance is only down to $200,000. So I’ve paid on average just $3,000 a year towards the principle which I made sure was the least amount possible :) I could have easily shortened my amortization period, doubled-up my payments, etc, to have a principle balance of just $150,000 today. But instead of doing that I invested every spare penny I saved. My condo is now worth $50,000 more than my purchase price. And I have over $100,000 in the financial markets thanks to the last several years of better than average stock market performance. My net worth would not be nearly as high today if I had aggressively tried to pay down my mortgage.

That being said, borrowing money from a home, or investing rather than paying down debt, will increase your financial risk. We are talking about leverage after all, which is what a mortgage is. So if you don’t want to risk losing your home, or not being able to finance the extra debt, then please pay off your house as soon as you can. But if you want to live dangerously like me (o_O) and don’t mind the risk, then invest your extra cash instead of leaving it tied up in your home. Focus on investing and only make the minimum payments on your mortgage, and by the time you retire there’s a pretty good chance that you’ll be much better off than other home owners who only prioritize on paying off their mortgages :D Good luck!

  • stock market index - A weighted average of some of the largest and most popular stocks. An ETF that one can buy to track this performance would be the IVV for example.
  • capital – Money which can be put to good use
  • 30% tax bracket – In Canada, if your annual income is between $40K and $70K then there’s a good chance your marginal tax rate is around 30%.
  •  leverage – Borrowing money to buy something or to invest