by WWM | Jul 26, 2017 | Investor Profile
Previously we considered how one’s risk tolerance and phase in one’s life cycle impact an individual’s investment strategy.
It is also very important to assess your unique investment objectives and constraints.
Today we will look at one’s investment objectives.
I like to categorize objectives (and constraints) by both time horizon and priority. Time can be grouped as short, medium, or long term. Priorities may be deemed low, moderate, or high.
If you require $20,000 for your wedding in 1 year, that is likely a short term, high priority objective. Planning to buy a brand new (mid-life crisis) sports car in 20 years may be a low priority, long term objective.
While we can go through every permutation, today we will aggregate into 5 groupings. All individuals share these common categories, however the specific objectives within a category will be unique to each person.
Emergency Funds
Although not really an investment goal, it should be an objective to maintain adequate liquidity to deal with any emergencies that may arise. Think of this an an extremely short term, very high priority objective.
I suggest that you hold approximately 3-6 month of basic living costs in liquid funds.
This should provide protection against short term emergencies such as job loss, personal injury, damage or loss of personal property such as your vehicle, or any other unplanned event that will drain your resources.
Liquid funds includes cash and cash equivalent assets. Savings accounts, money market funds, short term term deposits, etc. Assets that can be converted to cash very quickly and at no penalty to you for so doing.
Also, assets that are extremely stable (i.e., very low volatility and therefore low risk), yet have better return upside than simply hiding the cash under your mattress.
I would recommend money market or other funds to hold your liquid assets. These latter funds include certain low risk bond and equity funds, exchange traded funds, capital protection funds, to list a few examples. The keys being that you are able to sell them rapidly at little or no cost on disposal. Also, when you need to sell, the investment will be stable in price and not subject to wide swings (i.e., volatility or risk). This limits the use of equity funds or longer duration bonds.
I would also recommend brokerage accounts that provide money market interest rates on cash balances. Often these are termed, “sweep accounts.” They are useful and offer better rates than bank savings accounts.
I would not recommend holding many of your liquid assets in bank savings or chequing accounts. These accounts tend to pay very little or no interest on cash balances. And even with cash, you should try and get some sort of return.
Near-Term High Priority
This category reflects major goals whose time horizon is relatively short.
Examples may be a new home or vehicle, paying for your education, or even a trip if it is extremely important to you.
As the time to the goal is close, you want to increase the certainty of the investment’s return. You should invest in low risk, stable investments that provide a relatively known result.
Cash or cash equivalents would fall into this area. Short term bonds may also be useful investments. In certain situations, other funds may also be appropriate.
It is important to try and match the maturity of your asset to the expected date of the expenditure.
For example, you have $25,000 on January 1. On July 1, you must pay that amount as principal on a new home. You want to ensure that money is safely available when due. If you invest the money in a 1 year term deposit, you may not be able to liquidate on July 1 without penalty. However, if you invest in a 6 month term deposit, the investment will mature at the same time the money is needed.
If you invest in a higher risk equity fund, the value on July 1 may be greater than or equal to the $25,000 investment. But there is also a higher probability that it will be less than the $25,000 due to the volatility of the asset. If this occurs, you may need to forego the home purchase.
Be sure to match the asset risk-return profile and timing to your objectives.
Long-Term High Priority
This category reflects critical objectives whose time horizon is a long ways off.
An example would be in achieving financial independence at age 65. Another might be to buy a lake house or a winter condo in Florida by the time you are 50.
Because of the long time frame, you have the ability to ride out the ups and downs of highly volatile investments. This allows you to invest in assets that have relatively high risk and (therefor) greater expected returns.
The longer time frame also allows you to invest in less liquid assets. If you are currently 30 and are planning to buy a ski chalet by age 45, you have 15 years to work with. As the date approaches you can find a beneficial time to sell.
Compare that to only investing at age 44 for the chalet by 45. With very limited time, you cannot afford to hold volatile or illiquid assets that may not be disposed of, on time or at a profit, in one year’s time.
Remember, the longer the time frame, the greater the risk you can endure in your investments.
Yes, within reason, that is.
For long time horizons, a wide range of investments are suitable. These include equities, bonds, real estate, and other exotic assets.
Asset classes that we will look at in the next couple of weeks.
Lower Priority
This category may have short, medium, or long time horizons.
These goals have some importance, but they are secondary to the ones discussed above. Usually they are nice to have achieved. But if they are not reached, it is not crucial to your existence.
These usually involve discretionary spending objectives. That is, expenditures that are non-essential or voluntary in nature. Examples include: charitable giving, vacations, buying a boat, non-critical business ventures.
With lower priorities, you can match the investment risk to the time frame as we did above.
Many individuals though, take a more speculative approach in investing for lower priority goals.
As the objective is less important to the individual, the investor may invest in extremely high risk assets in the hope of abnormal returns. If it is successful, great. If unsuccessful and funds are not available to meet the goal, its lack of attainment was not critical.
Entrepreneurial
This category involves entrepreneurial or money-making ventures and covers any time frame.
Portfolio diversification is usually not an issue in this category. Instead, investors tend to take an “all eggs in one basket” view to their entrepreneurial activities.
As you can expect, this is normally a high risk investment with the potential for high rewards (or total loss).
That sums up the categories of investor objectives.
In future, as you develop financial goals, try to determine which classification each one fits into. Then, develop appropriate investment strategies and tactics to attain each goal.
Next we will look at common investor constraints.
by WWM | Jul 20, 2017 | Investor Profile
We previously reviewed how an individual’s risk tolerance impacts investment behaviour.
While risk tolerance is a driver in one’s investor profile, so too are an individual’s unique personal circumstances. Where an individual is at different stages of one’s life greatly influences the risk/return decisions that are made.
Today we will review the Life Cycle view of wealth accumulation. It does not address all the unique issues facing you, but moves us in the right direction to create an effective investment plan.
Accumulation Phase
Accumulation occurs early in your career. When you initially enter the work-force and for the first few years afterward.
Because you are young, there is a long time horizon for investing. Time is extremely important. The longer money is invested, the reinvested income on that money actually contributes more to total growth than most other factors.
Although you are finally earning real money and have the capacity to begin saving, your net worth is likely quite small. It may even be negative if you have significant debt from student loans, home mortgage, or car loan.
During this phase, your priorities may be liquidity for emergency funds, paying down debt, buying your initial or larger home, starting a family, saving for your children’s education.
And yes, beginning to invest for long term growth and retirement.
While you may not have significant savings, starting to invest as early as possible is best. The longer your money can grow, especially if you reinvest the income (and the income on that income), the greater your wealth accumulation (and the less in total dollars you need to contribute).
We will cover this concept soon when we look as the power of compound returns. A very important topic.
That said, paying down existing debt saves significant interest costs. Usually being paid with after-tax disposable income. While beginning an investment program when young is useful, do not necessarily do so by not reducing personal debt.
As we shall also see later, avail yourself of any investment plans that defer, minimize, or avoid tax liability on returns. The longer assets grow for your benefit and not the government’s, the greater the ability to compound returns.
In considering suitable investments, you should focus on relatively high risk, high return, capital-gain oriented assets.
Why?
Due to the long time horizon, you have a greater probability of riding out the ups and downs of high volatility (i.e., high risk) investments that offer greater potential returns.
Consolidation Phase
Consolidation takes place during the mid-to-late stages of your career. While a lesser time horizon than in the Accumulation Phase, the years until retirement are still very long.
By now you have reduced your debt and related cash outflows to service both the interest and principal. Your income and cash inflows exceed your expenses and cash outflows.
During this phase, you should begin to generate more than sufficient savings with which to seriously invest for retirement.
As your time horizon is still long, focus should remain on relatively higher risk, higher return assets.
But as you move through this phase and the time horizon starts to shorten, there should be a progressive shift to lower risk (i.e., less volatile) investment options.
Spending Phase
Spending commences at retirement as employment or business income ceases or slows.
Your debt is gone, your children grown and not needing support, and your required expenses should not be extensive.
Without a salary, income will be derived primarily from your investments and, possibly, pension. As a result, you want to increase the certainty of your returns by investing in lower risk investments.
One mistake made in this phase is to place too much reliance on low risk investments. Low risk assets will result in low returns that may not be adequate to meet your retirement goals.
Also, if returns are not linked to inflation, you may find your real returns worse than expected. At times, even negative. If this occurs, you may be unable to meet your retirement objectives.
A second mistake is to underestimate retirement needs. Yes, you are retired and many of your work related expenses vanish. And yes, with the kids gone, the mortgage paid, etc, many other traditional costs also disappear.
But these will be replaced by increased travel and entertainment costs. Expenditures you may not have made to such an extent previously. These are not “required” expenses. But if you do not factor in these additional costs when planning, it may be a very boring retirement.
In today’s world, you could easily retire between 55 and 62, yet live until over the age of 90. That means you may need retirement income for a at least 35 years.
If all your assets reside in low risk, income generating investments, you may be hard pressed to cover all your needs and objectives until death. With a still lengthy time frame, you may want to keep a portion of your wealth in assets with higher growth potential. Then, with each passing year, continue to slowly shift into safer assets.
Gifting Phase
Gifting is the final stage in your life. Hopefully a long, long ways off for you.
In this stage, you possess more assets than you need until the end of your life.
You begin to gift your wealth to others. This may include family members, but more and more people are becoming involved in philanthropic activities. These include direct donations to charitable or educational institutes. Also, some people set up trusts and foundations with their wealth to contribute directly to their charitable objectives.
Takeaway Thoughts
One takeaway is investments that may be prudent for you in one stage of your life, may not be best in another stage.
In your 20s, it may be appropriate to invest in mutual funds of emerging markets. These funds may exhibit relatively high risk but also offer potentially generous returns. But at 80, those same funds may make little sense in meeting your retirement objectives.
Conversely, at 80, a significant portion of your wealth may be in term deposits and short-term government bonds. This may be prudent in attempting to preserve your capital and generate steady cash flow. But at age 30, having a significant portion of your assets in cash equivalent investments likely is a poor strategy to follow.
A second takeaway is that your life cycle phase is based on your personal situation, not age.
You and a friend may both be the same age. But if he spent 10 years travelling the world as a scuba instructor and has just now completed a 10 year medical program, he may only be in his Accumulation Phase in his 40s. On the other hand, you started your career at age 22 and may have moved on to the Consolidation Phase by your 40s.
Age is not a determinant. Only your personal circumstances.
Getting married and having children while in your 20s may result in a significantly different investment program than for a single person also in their 20s. Life insurance may be one big difference.
A third takeaway is that you must focus on your own unique situation. What others are doing should have little, if any, impact on your investment strategy.
When listening to investment advice or strategies employed by others, always consider their personal situation and how it compares to your own before following their lead.
For example, a German friend tells you about a great potential real estate investment in Saskatoon, Saskatchewan, near where you live. The local market is hot and everyone believes the expected gains will be excellent. For her, it may indeed be a good opportunity. But if you already own a home in the community, a rental property in the same city, and a cottage at a nearby lake, it may not be a wise move.
This is because you may end up with too much exposure to the local real estate market (if you have not already done so) and/or possibly have invested too much in real estate as an asset class in general.
That gives you a few things to consider as you begin to address your own investment strategy.
Coming up, we shall look at common investor objectives and constraints.
by WWM | Jul 10, 2017 | Returns
When analyzing investment performance, it is important to understand the differences between the various calculations. Especially as the preparer will undoubtably choose the ones most favourable to his/her perspective, not yours.
In my last post we looked at median and arithmetic mean investment returns.
Today we review and differentiate two additional investment return calculations: geometric mean or time weighted return and the dollar weighted or internal rate of return.
A tad more complicated. But much more helpful with your performance analysis.
Geometric Mean (Time Weighted) Return
The geometric mean is also known as the time weighted rate of return.
It measures the compound growth rate of the portfolio’s beginning market value over the evaluation period. The geometric mean return assumes that all cash flows are reinvested in the portfolio.
To calculate the geometric mean you need to add 1 to each period’s return. Then, multiply the results together for each period. Next, take the root value using a root equal to the number of periods. Finally, subtract 1 and you get the result.
Not as easy a calculation as the arithmetic mean return, but not too complex.
In my prior post’s arithmetic mean example, we had three year returns of 10%, 20%, 5%. The arithmetic mean is 5%.
The geometric mean return though is = [(1-0.1)(1+.20)(1+0.05)]1/3-1.0 = 4.3%
Note that the geometric mean is always less than the arithmetic mean. Good to know for quick calculation checks.
In our second arithmetic example, we had two periods with results of 100% and -50%. Year one we went from $1000 to 2000. Year two, we fell from the $2000 back to our original $1000. Ended up right back where we began, so our actual return was $0 and 0%. Yet our arithmetic return is 25% ((100-50)/2).
This makes no sense. Enter geometric or (hint hint) time weighted mean returns.
In looking at the geometric return, we see that this is addresses the illogical arithmetic result.
The geometric mean return = [(1+1.00)(1-0.50)]1/2-1.0 = 0%
This calculation reflects the reality of how returns are impacted by prior periods’ accumulated results.
Unless you need to know the calculations for exams, I suggest you not worry too much about them.
The key is to know that arithmetic mean returns are useful for independent data, whereas geometric mean returns are best used for investment results where the data is interdependent to some degree.
Also, when comparing arithmetic to geometric returns, arithmetic results will always be higher for identical data.
Dollar Weighted (Internal Rate of) Return
You may see comparisons between time weighted (geometric) and dollar weighted returns (internal rate of return).
Dollar weighted returns calculate the interest rate that equates the present value of the cash flows from all investment periods under consideration plus the end portfolio market value to the portfolio’s beginning market value.
In essence, it is the internal rate of return for the portfolio.
For example, on January 1, 2015 you invest $1000 in a 1 year term deposit earning 10% interest. On January 1, 2016 you reinvest the proceeds of $1000 into another 1 year term deposit earning 15%. You also invest an additional $2000 into the same term deposit. On December 31, 2016 you receive $3565 in cash.
Going through the manual calculations starts to get tricky here. Fortunately there are many good financial calculators that do the work. Or, if simply analyzing data, returns are often provided in different forms.
As for our example, by plugging the data into my handy HP 12C we get a return of 13.66%.
Dollar weighted returns provide useful information as to growth of a portfolio.
However, dollar weighted measures are not usually very useful in evaluating portfolio performance. That is because the return is affected by events outside the control of the portfolio manager.
Changes in funding, such as client contributions or withdrawals, will impact the dollar weighted return. This makes it difficult to compare the performance of two managers over time.
When evaluating two separate funds in which you wish to invest, do not put too much emphasis on the dollar weighted returns in your comparison.
That concludes our initial look at investment returns.
Next up, we will consider how risk and return relate to investor profiles.
by WWM | Jul 4, 2017 | Returns
We will review three common investment returns that are useful to understand and differentiate in analyzing performance.
Today we cover arithmetic mean investment returns. This is the most common measure and one that you use in daily life.
We will also compare mean versus median returns. Median being a term you may also encounter.
Next post will cover the other two important return calculations; geometric and dollar weighted average returns.
Mean versus Median Returns
The mean is the average of all the individual data points.
The mean is not the median, another term you may encounter.
The median return is simply the physical mid-point for all the individual results.
For example, you have 5 years of investment results: 10, 5, 22, 12, 11.
The arithmetic mean is the average of all results. Add the results and divide by number of years. In this case, 12.
To calculate median, you must rearrange all the data points from lowest to highest. Then find the exact mid-point.
In this example, we re-list the data in ascending order as: 5, 10, 11, 12, 22. The number at the mid-point is 11. That is the median. Do not forget to place the data in ascending order regardless of time period incurred.
Median Usefulness
The median is useful in letting you know that half the results are above 11 and half are below.
Medians are less sensitive to extreme scores (ie., outliers), so may be a better indicator for smaller sample sizes. Means can be impacted by a few extreme results, so provide better information in larger sample sizes.
In our example above, let us change the one data point from 22 to 220. The mean changes from 12 to 51.6. While it is indeed the arithmetic average, when compared to the other numbers in the sample, it appears unusual.
Does it really represent the “average” result from that time period?
If a mutual fund salesman tells you that his fund has averaged 51.6% over 5 years, you may expect that to be indicative of next year’s return. In reality, four of the five prior years had returns equal to or below 12%. Which do you think is more likely next year?
However, the median still remains at 11. The outlier had no effect on the median. If the fund salesman told you his fund had a median return of 11% over the five years, that is more representative of the prior years’ results.
However, if you are a fund salesman, what closes the sale better? Telling a potential investor that the 5 year average return is 51.6% or that the median return over that period is only 11%? I shall wait while you ponder this toughie!
Median Not Great in Real World Investing
That said, other than its relevance for small sample sizes and extreme results, I find the median of little real use in investing. But as you can see from the above example, knowing both the median and mean averages can provide better overall context.
Despite the potential impact of outliers, mean return can be quite useful in investing. Knowing the average results over a period of time or other criteria is important to the decision-making process.
There are a variety of mean calculations. Depending on the formula employed, the average returns can differ significantly.
Further, certain mean returns are good for some calculations, but are less relevant for others.
Arithmetic Mean Return
In our example above, I used the arithmetic mean calculation.
An arithmetic mean return is simply the sum of all the returns divided by the number of returns.
For example, you are analyzing an investment whose returns over the last three years were -10%, 20%, and 5%.
The arithmetic average return is 5% = [(-10+20+5)/3].
Pretty simple. Something you often calculate in everyday life.
Good for Independent Returns
Arithmetic mean returns are useful when data in the series is independent from each other.
For example, the arithmetic mean is relevant when calculating the average exam results for a class of students. The performance of each student is independent of the others (assuming no one is cheating by copying another student’s answers!). How you score is not affected by the students sitting around you.
Or when measuring the mean height of all the students in your class. The height of the student on your right should have no impact as to your own height.
But Investment Performance is Inter-Dependent
However, in investing, performance between periods is inter-related.
For example, if you invest $1000 and earn 100% in the first year, you start year two with $2000 in capital. But if you lost 50% in year one, you would only have $500 in capital at the beginning of year two.
In year two, let us say that you had a 20% return. In one scenario, your $2000 would grow to $2400. However, under the second scenario, your $500 would only grow to $600.
Same percentage gain of 20%, but significantly different monetary change.
You can see how the cumulative investment performance is inter-related to past results.
Negative Returns and Arithmetic Returns
A problem with using the arithmetic mean return for investment calculations is that negative returns skew average returns and sometimes make the results irrelevant.
For example, you invest $1000 on January 1, 2015. On December 31, the investment is worth $2000 and there were no cash flows during the year. Your annual and holding period return for 2015 is 100%.
You hold the investment throughout 2016 and at December 31, the value has fallen back to $1000, with no cash flows. Your holding period return for 2016 is -50%.
Your arithmetic mean return for the two years is 25% = [(100-50)/2].
But at December 31, 2016 you have exactly what you initially invested on January 1, 2015. Your return is 0%. It did not increase, on average, by 25%.
Always remember that negative returns skew arithmetic mean return calculations.
Also remember that arithmetic mean returns bias the average upwards.
To deal with the shortfalls of arithmetic means is where the geometric mean return becomes important. We will cover both geometric and dollar weighted returns next time.
by WWM | Jun 28, 2017 | Returns
In Common Investment Returns we reviewed a few basic measures of returns.
In Assessing Investment Returns we looked at having to analyze returns within proper context.
Today we will see the need to look within the return itself when evaluating true performance.
This is because all investment returns are not created equal.
Gross versus Net Returns
Gross returns are before expenses, transaction costs, management fees, and taxes are deducted to arrive at net return.
Fund and managed portfolio performance may be reported on either a gross or net basis. The trend is to require reporting on a net basis, but there are often variations between countries.
Make sure you know which is reported in your jurisdiction as well as any costs that might be omitted from the performance calculation. Everyone likes to spin their return figures as positive as legally possible.
Investment Costs to Monitor
Various expenses, transaction charges, and management fees are common in mutual and hedge funds, as well as in managed portfolios. When reviewing funds, you can usually ascertain any additional costs to the fund that negatively affects performance.
Key ratios to review are the Management Expense Ratio (MER) and Total Expense Ratio (TER).
We will discuss these costs when we look at mutual funds as an asset class. They vary significantly between funds and can have a great impact on your portfolio growth.
With stocks and bonds, you do not need to worry about management fees.
Don’t Forget Taxes
Taxes are extremely important when assessing returns. Unfortunately, many investors ignore taxes in their analysis.
Taxes can affect your investment performance in two ways.
First, the investment you own may have taxes deducted at the source. For example, foreign dividends or interest may have taxes withheld by the issuer. In many instances, you may get a foreign tax credit for taxes withheld in another jurisdiction, but not in all cases.
Perhaps you own preferred shares paying out 10% annually. If the dividend withholding tax is 25% and there is no treaty allowing you a foreign tax credit, you only receive an actual return of 7.5%.
Had you factored in the foreign tax effect when selecting the asset initially, it may have made the investment unattractive.
Second, in most countries, taxes are payable on passive investment income or capital gains earned on investments. You need to factor in the tax payments as part of your overall portfolio performance.
If you earn 10% in interest income, your gross return is 10%. But if you must pay 40% of that amount in taxes, your net return falls to 6%.
Different Tax Rates Impact Investment Decisions
Earnings from interest, dividends, and capital gains are often differentiated by governments and taxed at varying rates.
For example, in Canada, interest income is taxed at the highest rate for all investment income.
Capital gains are included in income at only 50% of the gain. This causes the effective tax rate on capital gains to be less than for interest income. Additionally, capital losses may be carried forward or back for a number of years to offset other capital gains.
Dividends from eligible corporations receive dividend tax credits that reduce their effective tax rate. Whereas dividend income from non-eligible corporations do not generate a dividend tax credit.
Whichever form you generate your income stream will have implications for taxes payable and your net returns. This can be incredibly important when analyzing and selecting potential investments.
Perhaps you have two Canadian investment options. One offers an annual interest payment of 15%. The other offers a guaranteed capital gain of 12%. If you only consider the gross returns you should take the interest stream.
But if you factor in that capital gains in Canada are only included in income at 50% of the gain, the numbers change. If you are in a 40% tax bracket, you would have a net return of 9% on the interest. Whereas the capital gain would have a net return of 9.6%. An improvement over the interest only investment.
Also, in many jurisdictions, tax is payable when the income is considered earned, not necessarily when it is physically received. We will see how this works below.
Realized versus Unrealized Returns
Realized returns are those where you have received the cash. You receive a dividend or interest. You sell an investment.
Unrealized returns are those that are only on paper.
This can be a tricky area. In my mind, investment gains are not real until the cash is in my jeans.
Unrealized Gains and the Housing Bubble
I believe that unrealized gains contributed to the housing bubble in many parts of North America. Initially, when someone buys a house they usually take out a mortgage. Banks typically lend between 75-95% of the appraised value.
When house prices were rising many individuals had their homes re-appraised at higher levels than when they bought the house. With this extra equity, people took out home equity loans for a variety of purposes.
As the housing market substantially slumped and values fell, these individuals often found themselves with more home debt than the house was actually worth. Faced with greater debt than value, some just walked away from their homes.
When assessing investment performance, it is fine to consider unrealized returns as well as realized ones. However, make sure that you do not count the proverbial chickens before they hatch.
Until your investment is actually sold and the proceeds are in your bank account, much can happen to the asset value. Often, negatively. Do not spend your gains before you really have them.
More Tax Considerations
A second concern with unrealized returns relates to taxes.
At times, interest or dividend income may be accrued but not paid out by the investment.
For example, a dividend is declared in November and payable as at December 20. You physically receive the dividend distribution on January 15. At December 31, you have yet to receive the dividend, but the income is considered accrued.
In many jurisdictions, the tax authorities treat accrued income the same as if you had actually received it.
If you do not want to pay tax on returns not yet fully realized, be careful with the timing of the payment stream of your asset. In some cases, especially with accrued interest income, the impact from taxes is harsh.
As I often recommend dividend or interest reinvestment plans to aid in generating compound returns, you must be careful here. You will “receive” the income, but as it is immediately rolled back into the investment, there is not associated cash in the bank. However, you are still expected to pay the tax due on the income. Keep this in mind when reinvesting income.
Base versus Local Currency Returns
We looked at the difference between base and local currencies in our review of systematic risk.
Always be careful when dealing in multiple currencies. It is crucial that you compare foreign currency returns to the currency you use in everyday life.
That gives you three common variations between investment return calculations.
We will look at three different examples of mean investment returns in our next entry.