HEIRS TO INVESTMENT, SOME THOUGHTS FOR MY DAUGHTERS

DECEMBER, 2007

You now have some funds to invest. At some point (hopefully not too soon), you will have more money to manage. The following are some thoughts that may help you get started.

All You Need to Know About Investing

There is no great mystery about investing money although hundreds of books have been written on the subject making it seem more complex than it is. John Maynard Keynes, the most influential economist of the 20th century, summed it up very nicely noting that the secret to successful investment is anticipating other people’s anticipations. There are only two prime drivers of the stock market – Greed and Fear. The first drives the market up and the latter as you would expect knocks it down. Both can happen very suddenly. Neither is entirely rational except that both are in turn driven by the desire to increase one’s wealth. Greed causes people to jump on the bandwagon, often with very little analysis. People usually stay on that bandwagon too long to try to get the last bit of advantage from their investment. Once the market turns around, and sooner or later it always does, fear sets in and this just compounds the downward trend as the amateurs dump their shares. It is just about that simple. So what should the serious investor do about this?

Know What You Want

The most important first step for any investor is to know what he or she wants. You have to honestly assess where you want to be in a few years, how much you need to draw from your investments to live in the interim and what level of risk do you honestly feel comfortable with. Despite a career that may appear that I took many big chances, I am not a risk taker. Career moves were thought through as carefully as I could with a view to ensuring adequate current income but with the potential for upside gain. This is just another way of managing risk. My investment approach has been to look for steady growth over a number of years, knowing that those who stay invested in a reasonably prudent way over a long period are almost certain to see steady capital appreciation. This is not, however, what many people do. They try to ‘time the market’, i.e. guess sometimes on a day to day basis whether a stock will go up or down. If they do this well, and it is a lot of work, they will do better than the ‘invest and hold’ strategy. However it is very time consuming and mistakes can be costly. Of course those who try to invest with a long horizon also do regular re-evaluation. But this is usually based on a more global assessment of what the economy and in some cases certain industries will do. For example, several years ago I became very leery of the U.S. economy and felt that the U.S. dollar would be under extreme pressure because of rising Asian competition, huge trade deficits and the cost of the Iraq war. I instructed my investment manager to move some of my investments out of U.S. stocks and this certainly helped in the ensuing several years. But there is no way that I am interested in or capable of following the thousands of stocks available for investment worldwide. This would take an enormous amount of time and effort and frankly I have other interests.

So What Do I Do?

As a result of assessing what I felt I would be comfortable with and what suited my lifestyle, I have taken the approach of selecting a number of money managers who specialize in particular areas of the market, e.g. in large or small companies (often referred to as Large CAP or Small CAP companies based on the value the market puts on their shares or as it is known, the capitalization). Some of the managers specialize in Canadian Equities, some in the U.S., Europe or Asia. Usually there is one investment manager who specializes in fixed income securities such as Bonds or other debt instruments. This diversification is usually a good way to ‘play the market’. When there is a lot of speculative fever (GREED), Small CAP stocks such as start-ups will often do well and the Large CAP will languish. When the reverse happens however panic sets in (FEAR) and the Small CAP stocks can lose their value very quickly, sometimes so fast it is difficult to get your money out. So for me, as a patient and somewhat risk averse investor, a balanced portfolio is the logical approach. This conservative approach will not likely maximize your gains but is almost certain to minimize the downside. Over many decades, the stock markets have steadily moved up. The TSX Index for example was about 4,800 points in 1997. A decade later despite some ups and downs it is over 13,500. The DOW would show the same performance. More importantly, the stock market has out-performed inflation. This is a factor to factor in. One might think that money invested in securities such as bonds that will guarantee the return of your capital would be a good investment but they may return only say 5%. Much of the gain will be steadily eroded over time by inflation that probably runs 2.5-3% at current rates. You will get your principal back but by that time it will either be worth less in terms of buying power or at least will not have increased much. Bonds have a role, but often just as a ‘safe haven’ when the markets are anticipated to get really rocky.

Proposing the Pros

So if you feel comfortable with this overall approach, how would you go about selecting money managers?

The easiest (and perhaps laziest) way to do this is to retain a ‘manager of managers’, i.e. a major organization with broad international experience to

* Examine with you your aims and risk tolerance
* Ensure that you are invested in a way that you can get the cash flow you need without unduly diluting your capital
* Take into account any particular concerns that you may have as the investor, e.g. you may be averse to investing in arms manufacturing companies.

The ‘manager of managers’ or prime manager will then recommend perhaps half a dozen specialty managers each covering one of the various areas such as noted above. (The number of managers depends somewhat of course on the size of your capital as many good money managers will not accept too small a block of money to manage.) The fee you pay for this service is normally based on the total amount of money managed by the prime manager and of course gets lower as the amount increases. If anything, for the last few years I was over diversified and had too many managers resulting in somewhat overlapping diversification and higher management fees than I needed to pay. It is for this reason that I have consolidated with one prime manager, Royal Bank Private Counsel. Will they do as well in terms of preserving and growing the portfolio? We shall see, but it will be far easier to manage this process for all of us. If your interest in life is other than closely managing funds, this is likely a good approach and this is where we are starting. RBC has agreed to consolidate all of our investment tranches (a fancy term for parcels of money) to give all of us the lowest overall total management fee.

These tranches are

* My RRIF (Registered Retirement Income Fund): this must stay separate and must be paid out at a minimum rate annually. It can however be rolled over tax free to your mother on my death.
* Glenna’s RRIF: this is very small but is treated the same way and again must be kept separate.
* Four Halls: this is the largest tranche and is in the company that is controlled by me.
* Your new accounts: RBC accounts have been opened in each of your names to contain your new capital.
* Glenna’s Inheritance Account: like your new accounts, this has derived from an inheritance from her parents (it may at some point be rolled into Four Halls for simplicity of management but for the moment it is kept separately). 

By pooling all of the above, the likely average management fee will be about 1.2% of the assets managed each year. As this includes the safekeeping of the securities, selection of managers, accounting and trades, this is a preferred rate.

Mine! Mine! Mine!

However the money gifted to you is yours to do with as you wish. Initially it will be invested by RBC essentially in the same way as the rest of our investment tranches but RBC will review this with you and you can change this if you wish. You can:

* Decide how much you wish to draw out each month (if any). While the value of the account will obviously go up and down with the market to some degree, over time it should produce around 8% annually. You could therefore increase the payment you receive if you wish. The payment will be slightly more tax effective to you as it will be a combination of dividends, capital gains and interest, the first two of which are taxed at better rates than interest alone.
* You can of course withdraw capital at any time. This might happen in any case if you draw a fixed amount per month and the ‘yield’ (any combination of dividends, interest and capital appreciation) dips below the 6% or whatever you have chosen to withdraw. This will balance out over time and if the draw is in the 6% range, should allow for some capital appreciation over time.
* You can also elect to invest in a different way by working with RBC to select different types of money managers.
* Finally you can of course elect to move your funds away from RBC.

Managing the Managers

Working with your prime manager to select sub-managers does require some discussion. While it is hassle-free to leave it to the professionals I caution that you should not abdicate from all responsibility. You should always have at least an annual face-to-face meeting with your prime manager to discuss their overall performance. You may want to have this more often but certainly never less. A good way to assess their performance is to look at how they are performing relative to their own objective (which should be stated in their proposal to you and agreed with you). The performance of course will go up and down annually as the markets gyrate but over several years, they should be on or exceeding their objectives as set out for you. Just as important, however, is to assess the performance of the managers they have selected for you. Each will have one (or in some cases more than one) benchmark that matches their particular area of specialty. For example, if the manager specializes in Large CAP U.S. stocks they may compare their performance to the DOW. This is an index made up of very few stocks but tracks the largest and most heavily traded companies in the U.S. If they are in the Small CAP U.S. market, they may use the Russel 2000 (this covers a much larger group of smaller companies). If they are specializing in the Far East, the benchmark could be the EAFE (Europe And Far East) Index. Fixed Income Managers may compare themselves to the return on Treasury Bills. Whatever their benchmark, over time (2-3 years) these managers should exceed their benchmark. Just meeting the benchmark is not good enough! Why? Because you are paying them to do better than you could do if you invested directly in the securities making up the benchmark. And, yes, you can do this in a very easy manner. You could invest in what are called Index Funds. These funds invest in all the stocks in whatever the Index is in exactly the ratio they are represented in that Index. In other words, if you are invested in a DOW Index Fund and the DOW goes up 1.5% in a month, your portfolio will go up exactly 1.5% less a small administrative fee. As you are paying a larger fee, you should expect a larger yield. RBC will provide this type of data for you in a form that should be very easy to track. If you want to stay in the same sector, but are not happy with the performance of the particular sub-manager, you can insist that RBC recommend to you other managers with a better track record. RBC will of course be tracking the sub-managers on your behalf and they should come to you with recommendations for changes. You may of course decide to move out of the sector entirely or reduce your exposure to that sector if you wish. The point is, you are paying for above average performance by choosing managers who will pick stocks they believe will do better than the broad index which will include stocks that are there because their capitalization is large, they are widely traded or some other criteria not related to how well that company is expected to do in the future. This is an easy thing to monitor as you will likely only be dealing with about half a dozen sub-managers but it is very important that you do this.

Heir Today, Gone Tomorrow

If you decide to go out on your own, there are many possibilities. Not everyone is enamoured with professional managers. A book written some years ago was called A Random Walk Down Wall Street. It purported to have proven that over a long period of time, choosing stocks totally at random produced results equal to that of most money managers after adjusting for their fees. Some managers of course did manage to outperform the market indices. However if the random approach is generally true, it is just another reason for paying attention to your managers! But if you decide to invest on your own, how might you do this? There are as many theories as there are stock markets and just about as many fads. Here are a few:

Value Investing

This sounds completely logical and is the way most money managers tend to operate.

You choose stocks that:

* Have not too much debt (and therefore can survive a downturn)
* Are well managed
* Are in a growth industry (no buggy whips)
* Appear to be undervalued by the market
* Are not likely to be side-swiped by currency fluctuations (remember that a stock can do well in its own country but when you convert the yield back into Canadian dollars, which are the only dollars you can spend, the return can be drastically altered). Recent investments in the U.S. market have demonstrated this.
* Are likely to be a take-over target and hence see their value increase.

It obviously takes a lot of work to figure all this out and you certainly hope that your sub-manager is doing this on your behalf. This means that another way of evaluating a sub-manager is to choose one that only selects perhaps 25-40 stocks. Realistically this is all most companies can adequately follow. If they are trying to manage hundreds of stocks, they are really in the index business and are not likely to provide added value to you.

Does Value Investing work?

Well sort of. However it flies in the face of my earlier observations and those by Keynes that the market is really driven by GREED and FEAR. The Value Investor often misses the gains that can be made by riding the trends. Of course they will argue that this also mitigates against losses when the market goes the other way. Recently Value Managers have almost boasted about the fact that they avoided the recent Tech Bubble or the volatile Energy field. The reality is however that they have underperformed many of their peers who took a more aggressive approach.

There is an alternative.

Momentum Investing

Go with the flow! This is the philosophy that you should not really care whether you are investing in a good company or not. If everyone likes it, the price will go up and often go up quickly. A good example of this is what happened to Nortel. However be prepared for a wild ride. Once FEAR replaces GREED, the stock can crash from hundreds of dollars per share to a few cents and often in a matter of weeks. Again Nortel is the perfect example of this but there are many others. So how can you protect yourself against this if you want to play in this pack? The approach is to bracket your investment, e.g. you set firm limits on what you will accept as a gain and a loss. For example you may determine that if a stock you have invested in because you think everyone else is going to invest in it goes up say 15%, sell. If it goes down 5%, sell. You do this by registering a sell order at a particular price and you put in a ‘stop loss’ sale order to minimize your risk when the momentum changes. You must discipline yourself to adhere to these limits. You may miss some profit by selling out too early but do not get greedy. As Warren Buffett and many others have said, you never go broke taking a profit. Using this approach, you will not win on every stock but you will capitalize on what really drives the market (GREED) and will minimize your losses when FEAR takes over. If you are willing to play this game, you can probably make gains that would be missed by the Value Investor. But if you really want to increase your risk and the possibility of gain, you can move even farther away from my suggested conservative approach.

Making Money With What You Don’t Own

There are two common ways to do this:

* Selling Short
* Buying on Margin.

You can make (or lose) money when stocks decline in price. This is selling short. If you think a stock will go down, you can sell shares even if you do not own them. However, you are on the hook to deliver the shares within a very short space of time at whatever price you sold them. You are betting that if the share price does go down, you can buy the same security at a lower price and pocket the difference. Of course, if the share price goes up, you lose. An even more risky procedure is to buy on margin. This is leverage big time. Again leverage works both ways. This is simply borrowing money from your broker to invest. For example, if your credit is good, your broker may buy the securities with you putting only 20% of the cost of the securities as a deposit. Say for example you buy $100,000 worth of some stock and put down only 20%. If the stock goes up 20%, you will have doubled your investment. However, if the stock goes down even 5%, you broker can and likely will demand more cash to cover the difference or may call in the whole loan. The broker has the right to sell you out at any time as the stock is used as collateral. While the upward potential is tempting, the downside risk can lead to bankruptcy. I have never felt comfortable with debt and therefore have never bought on margin. However it is a commonly used approach. A big factor in my comfort level is sleeping well!

Is There Real Money In Real Estate?

How often have you heard ‘your home is your most important asset’? Actually it is not an asset at all in the normal sense it is a liability. Unless your home is also a rental property, it is a drag on cash flow and only produces a return on investment when you sell it and perhaps not even then if you properly account for it. The house will likely go up in value but you have to assess the net carrying costs over the years.

These include:

* Mortgage interest
* Property taxes
* Insurance
* Heating and lighting
* Repairs, upgrades and maintenance
* The lost opportunity cost, i.e. what you could have earned investing your money elsewhere.

Of course, you have to live somewhere and you also have to take into account the rent that you would otherwise have had to pay. I am not suggesting that one should not own a house, particularly if it is mortgage free but the interest you pay on a 25 year mortgage could easily double the cost of the mortgage. Again people get greedy. Recently in the United States for example, as property values escalated, home owners re-mortgaged their properties to say 80% of the new value. This put cash in their hands which they promptly spent. As was completely predictable, when the property values started to fall and/or the interest rates on the mortgage escalated, the individuals could no longer finance their new mortgages and foreclosures became rampant. Many people lost all the equity in their homes and sometimes even more.

Get Rich (Or Poor) Quick Schemes

There are hundreds of these and new ones are invented everyday. Some are tax avoidance investments. These can be helpful but always look at the underlying investment. If it does not make sense as a stand-alone investment, it does not make sense as a tax avoidance scheme. Like many others, I have been burned in things such as MURBs (a tax avoidance real estate scheme a few years ago) because the real estate market collapsed, the cost of carrying properties went through the roof and there was no income on which to avoid tax. Furthermore bear in mind that real estate is not necessarily a liquid investment, i.e. cannot be converted to cash just when you want to. A current fad is derivatives. These are essentially investments whose value is derived from the value of something else. There are many varieties to this but lumped together they are just another form of trying to get leverage and as we know this works both ways.

Do Your Own Thing

There are lots of other ways to make your money work for you including investing in your own business. You have already each done this. If you have a well thought through business plan and know exactly how the product or service will make real money after all expenses, this can be a very satisfying experience. However when examining a business, bear in mind that you can never really develop wealth by selling yourself by the pound. If you are effectively renting out your time and expertise, there will not be enough hours in the day to make a large amount of money on your own. A preferred approach would be to use your time and talent to develop a product or service that you can replicate, i.e. hire and train others to do what you do so that you end up managing the process rather than being the sole source of income. Once you get the hang of this, you can open up branches, franchise the operation or otherwise expand it. Ultimately you can sell the company if you wish as it will have stand-alone value. You cannot sell yourself in the same way. Investing in your own business does mean that you will be investing a huge amount of time in whatever it is but it is a wonderful way to leverage your investments in a way that is completely under your control.

In Summary

This is a conservative document. I have obviously taken the approach of betting on the tortoise and not the hare. But then a tortoise can live for a hundred years. Hares are often out-foxed and might have a life in the fast lane but only for a while. In any case, I am starting you out on the path of Value Investing. Beyond this, the choices are yours.

Just remember, if you are not greedy, you will not have much to fear.

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