Feb 062017
 

Index investing is a great way to build long term wealth. It’s simple to implement, convenient, and you are guaranteed to make the same returns as the market, minus any fees. But is it right for everyone?

Taking a closer look at Index Investing

How Indexes Are Managed

There’s a common theory that retail investors shouldn’t try to beat the market since it’s almost impossible to do over time. But I’m not sure this is true. The “index” isn’t the holy grail of stock selection. Some folks from the S&P Index Committee sit in a room and decide which stocks to include in their index based on a set of criteria with arbitrary measurements. It would be preferable if prominent investors such as Ray Dalio or Warren Buffett were on this committee, but they aren’t. Lol.

The S&P/TSX Composite index is made up of 250 stocks, chosen by the committee. It’s intriguing how only 250 stocks are selected out of the possible 1500+ on the entire Canadian stock market. The methodology for selecting stocks to be included in an index contains guidelines for minimum weight in the market, price per share, market cap, and sufficient liquidity requirements. The index is reviewed quarterly and all Index Securities that, in the opinion of the Index Committee, do not meet certain requirements are removed. And for the S&P 500 stock market index in the United States, anywhere from 25 to 50 changes are made every year. It’s basically a handful of people getting paid to actively manage a list of stocks that they believe represents the overall equity market.

The Paradox of Index Investing

From what I’ve heard, the whole idea of index investing is to match the market’s performance using a passive methodology. But if picking individual stocks will underperform the market most of the time, according to the mainstream, then how can index investing work if it’s based on a managed list of stocks that is updated every quarter based on the decisions of some individuals on Wall Street? Why are they more qualified to pick stocks for the index than let’s say, personal finance bloggers? 😀

I don’t think it would be hard for a handful of competent value and dividend investors to get together, create their own list of 250 stocks, and then beat the S&P/TSX Composite index. Last year Nelson from Financial Uproar hosted a stock picking contest for personal finance bloggers. There were 14 participants, including myself. Our average investment return for 2016 was 30%. We beat all the major indexes in both Canada and the U.S. Since an index is meant to represent the average of the stock market, then all we had to do to beat the market was to just be better than average. 😉 Easy peasy.

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Sep 302015
 

Deciding what to do with new money

As the average global population continues to age there will be greater instances of wealth transfer from the old to the young. Most people will come into a bonanza sooner or later. Maybe it’s $5,000, or maybe it’s $500,000. Whatever the amount happens to be, it’s essential to grasp the significance of this opportunity and not squander it. A dollar saved is worth more than a dollar earned because of income and payroll taxes.

There is no shortage of questions on the internet that has the renowned format, “I have $X amount of money. What should I do with it?” The following snippets are taken from Reddit.

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First of all, congratulations for saving, earning, inheriting, winning, or however else you came into the money. 🙂 The simple answer to what you should always do with your new found fortune is this: Maximize the utility of that money based on your personal core values and financial situation.

But that might be easier said than done, so let’s elaborate. Maximizing utility means making the best use of that money and stretching the value of each dollar to its greatest potential. This is determined by your values and financial affairs, and to a degree, the current state of the economy. Values drive motivation and we’re all motivated by different things. Wanting to retire early requires a different set of values and financial strategy than becoming a home owner. Understanding your financial situation means knowing what money means to you.

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Aug 012014
 

There’s a saying that younger people should invest more in equities (stocks) and older people should buy more bonds. Some like to use the “100 minus your age” rule to determine asset allocation. Start with the number 100 and subtract your age. The resulting figure is the percentage you should allocate to equities, and the rest should be invested in bonds. For example a 30 year old investor could have the following portfolio:

70% = Vanguard Total World Stock Index Fund Investor Shares (VTWSX)
30% = Vanguard Total Bond Market ETF (BND)

This simple yet balanced portfolio should benefit from the long term growth of the U.S. and global markets, while providing fixed income stability 🙂 But should everyone follow this rule of thumb? Probably not. Age should not determine our asset allocation. Consider the following situations.

Economic Situation:

U.S. government 10-year bonds today only pay about 2.5% interest a year. But ten years ago they were paying twice as much. This means in order to achieve an adequate return on a fixed income portfolio today we would have to mix in higher risk investments such as non-investment grade bonds and mortgage backed securities. However at some point the risks will not be worth the expected returns. So in a low interest rate environment it may be prudent to lower our exposure to bonds, and stock up on more equities instead, at least until interest rates move higher.

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Three decades ago those 10-year government issued bonds were paying 15% interest a year due to a more robust economy and higher interest rates. In that kind of situation we want to be overweight in bonds because the 15% annual return is virtually risk free since it’s guaranteed by the U.S. federal government 😀

Personal Situation:

If a young person in his late twenties has $50,000 in savings, what should he invest in? We see questions like this on Reddit all the time, but it’s impossible to give a categorical answer without knowing the individual’s personal situation. If he plans to buy a home in a couple of years using his savings as a down payment then he should probably avoid risky investments and be 100% in bonds. On the other hand if he has no plans to purchase a big ticket item, and he works for a State university that offers a generous fixed income retirement plan, then he should probably invest most of his own savings into growth stocks.

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