My portfolio, like many others I suspect, is currently divided by countries for investments in stocks. For simplicity I use Canadian, US, and EAFE stock indexes. But as others repeatedly point out a country can be headquartered in the US and make a profit in China. Does it make sense to allocate by country, or would it be smarter to allocate by industry? This question was prompted by The Future for Investors by Jeremy Siegel, which I have recently started reading and which focuses extensively on industries.
It is correct to say that the country you invest in doesn’t mean as much as it used to; the laws and economic conditions can change the costs and taxes of a company but the biggest and best are taking profits from everywhere. Like an amateur investor who diversifies with 5 US large-cap funds (actively managed of course), it can be hard to tell the true exposure you have and you may not be truly diversified geographically. With industry allocations there is less blurring, although a company could operate in one industry while depending on another for sales or supplies.
Another positive element of industry allocations is that those who invest in a rapidly growing country frequently find themselves with average or below-average returns, because the growth doesn’t go to foreign investors. It might be that the right foreign companies operating in the right industries can actually get some of that growth. Emerging markets may be more likely to deliver profits to the developed-world luxury goods marketers who have a new demographic for their brand, rather than the investors in their poorly-regulated stock exchanges.
Allocating by industry could give you more control over your portfolio and maybe even less correlation; all countries can do poorly together, whereas the financial sector can blow itself up while other industries profit from negative trends. Furthermore, you may be able to profit from perceived trends; if technology becomes overvalued once again because of excitement about the future you can safely reduce your allocation to that industry while staying invested in the calmer ones.
Of course this weapon can be turned against yourself if you predict the future of an industry incorrectly. Depending on where you stand this may be much harder to do than predicting the future of a country. Adding to this, an industry’s future direction can be altered by things like government regulation that are difficult to control and predict on top of the variations in the economy. Although Siegel points out several industries that have done well it’s no easy task to predict them in advance and we may look back on them later and say that they just had a bull market for a period of time and then their performance fell off.
For one example I’m not so sure of the future of “consumer staples”, especially big brands of processed foods. As someone who cooks at home I mostly avoid them, and the usual anti-corporate movement might just take hold here in a weaker form. Consumption patterns could change and relegate the industry to the same history as North American manufacturing (which in turn might just grow in the future as people find out that offshore work has been taken to the point of negative gains or over-subsidized in some cases).
In the end all divisions are arbitrary, and all asset classes are inter-related. There is always some exposure that crosses the lines, and a big enough shift in one area will spill over to others. On the whole I haven’t seen nearly enough evidence to convince me that it’s worthwhile to use industry allocations for the current size of my portfolio. It may be of interest in the future though, most likely if I feel that one industry is valued well above the others like in 1999. It may not be applicable yet but I’ll certainly look at news and economic reports in a new light to see if this helps understand what is currently a good investment and where the danger lies.
Recently I’ve been seeing a lot of discussion about people who are avoiding investments in stocks now because they think something isn’t right. Whether it’s large businesses that inflate profits, plain and simple fraud, or governments playing accounting tricks with the whole economy, there is an arsenal of arguments that can be used for this viewpoint now (although I’m sure it never goes away even in normal times). Even Mark Cuban, who seems to enjoy poking at common opinions but is certainly not unsuccessful, advises individual investors to stay out of the stock market on his blog. Is it rational to stay out of the market until it’s more transparent, is it rational to invest because the good outweighs the bad, or do you take a chance and hope to make some profits before others wake up?
This article from Henry Blodget addresses this from the insider-trading perspective. I’ve recently seen (in The New Money Masters) that a number of well-respected fund managers don’t even think inside information would help them, but anyone can see that when you make a trade there’s a chance the person on the other side knows a good reason to buy or sell and you don’t. As the article rightly points out, these are games that traders play day-to-day with each other; if you invest on a monthly basis over the long term you can smooth things out quite a bit and get the average price over time.
Since I invest in index funds instead of individual stocks insider trading doesn’t apply as much unless it’s really affecting the whole market, but other factors that do influence the entire market could be a concern. However here as well it’s good to remember that there are short-term games and long-term strategies. Bad news naturally gets attention but it doesn’t mean the market is less honest than it was 50 years ago. There have been too many scandals and mistaken assumptions to remember in that time but the market has continued to grow and investors have continued to profit. As long as people eventually realize what doesn’t fit (such as a company with fake profits) and don’t keep pretending that it’s real, I don’t believe the impact will be too great.
Of course there are no guarantees. This is only a reasonable conclusion (I hope) and unreasonable events happen all the time. But since nothing is safe, I currently choose to trust in the public investment markets as a reliable way to make a profit (as long as I stay away from investments that don’t even offer the chance of a reasonable profit). The markets accommodate everyone; while this means you might be buying from a trader who’s driven the price up 50% it also means you aren’t forced to go along with anyone’s plans and you can make your own way. Some day when another trader has a new plan and desperately needs to get something that you’ve been holding for the last 20 years you might find yourself with an unexpected profit!
As we all know there are few reliable measures of when an asset class is particularly cheap or expensive… but maybe articles such as this one on gold are a candidate?
The story that emerges when you have the ability to link two paragraphs on the same page is an amazing example of mind-bending investment logic:
“Even when gold had turned into the un-store of wealth around the turn of the century, falling to US$252 an ounce from US$850 20 years earlier, he was defiant. […]
He had held and held and held, even as the gold price had plunged and plunged and plunged. He will be pleased with his resolve today, one of countless gold bugs savouring their stubbornly won success [as prices pass $1400]. […]
Of course, US$2,000 isn’t what it used to be. For gold to match the spike price of US$850 in 1980 in today’s inflated dollars, it would have to reach almost US$2,400 — more than 60% above where it now stands.”
Ironically the 40% real loss (over 30 years) isn’t that far from the worst of the stock market drop we experienced in the last couple of years, which certainly didn’t earn a glowing article praising stocks as the investment of the future as far as I remember.
As a parting shot at reason the author goes on to state that since gold has had such amazing returns over the last decade (this is true), it has now arrived as an official “good investment” that will deliver quality returns in the future (I’ll leave that part up to you to decide?).
This is a good illustration of the principles behind my investment plan, in reverse. Most of our investment decisions are clouded in uncertainty – but surely there is some room to decide as a somewhat rational investor when a market has been taken over by logic like this. At that point it would seem like a good idea to reduce participation in that market. Maybe there’s some way to take more profits before the emotional decisions reverse, but I’m happy to take a reliable return and a good laugh from the resulting media.
To introduce this blog I’ll be going through my overall approach to the investment process. A good place to start is with the fundamental ideas that drive my decisions. It all begins with an understanding of how the capital markets work. The most important part for me is what I get paid for when I invest, and how it affects each investment.
The investment returns of any asset come from only 3 sources:
- Current yield, in dividends or interest – the cash you actually receive this year for owning the asset.
- Changes in yield over the years – we hope that companies will increase their profits over time.
- Changes in valuation over the years – this largely happens due to the popularity of various areas of the market. This is usually expressed as the multiple between the current yield and the price.
The current yield is what separates any particular investment from putting your money in a high-interest account in the short-term, and while it can change without warning it’s the most stable of the three. Many stock investors don’t think about dividend yield but it does form an important part of the total returns you get so it plays a part in determining the performance.
The changes in yield over time will affect the future yield and value, and in some situations you can get an idea of what they’ll be even if we don’t know exactly how much (for example corporate earnings should grow at more than 0.1% most of the time), so in the long-term you can look at the effect they will have on your portfolio. If you remove the effects of inflation an increase in yield from stocks has to come from improvements within the businesses and growth in the economy. With bonds, the yield is more likely to go back and forth over a range since bond yields (after inflation and tax) can’t just increase forever. This is true of corporate profits too in the end; the increase always has to come from somewhere and sometimes they decrease when they’ve gone too far.
The last factor – popularity – is more of a counter-sign. I can’t even begin to try timing market opinion to speculate on prices. However I can make my own judgement of whether people are overpaying or selling out too cheaply. If done well this won’t be the same as perfect timing but should have a positive influence from buying assets that later increase in price with popularity, and reducing holdings before they decline. I want to be buying from people who have given up and selling to people who have lost sight of fundamentals. In fact this is the reverse of what most people think of as market timing – they try to buy as the price rises and sell as the price falls, while I would start to sell and the price is going up and start to buy when it’s going down.
This leads to one of the central points where Value Indexing is different. The main idea that lead up to this approach was that I don’t just buy at any price. I want to analyze an investment (in this case a market index) to see if the numbers are reasonable. If a broad enough bond index is yielding a real return of 10% I’m happy to take that any day, but if stocks have an earnings yield of 2% and don’t have the long-term growth prospects to justify it I won’t invest much in them.
Historically it has been a safe bet that the popularity of a market will swing between both extremes over time rather than just staying put in the middle. Sometimes this shift can take 10 or 20 years, while at other times it can happen in 5 years. This means that the decisions resulting from this approach could look very different from one decade to the next. US stocks over the last 40 years are a great example as they were declared dead in the 70s, while everyone was buying in by the end of the century. This change in popularity led to a higher return for anyone who held an investment over the whole period.
These are the main sources of returns (and often losses) that I’m concerned with on the level of individual investment options. By understanding these well and keeping track of how each asset class changes over time, I can decide on the asset allocation that seems reasonable to me and put my capital in the right places. As long as I’m always invested in assets that have a reasonable current yield and a minimal chance of losing most of their popularity I’ll be happy. At best, by paying attention to the price I expect that there may be some additional return – profiting from the long-term volatility in emotions.
In the 4 years that I’ve been studying investing and managing my own investments, indexing has always been the approach that stood out for me. It helps an investor avoid some emotional mistakes, but it can still expose you to downturns as other investors shift from one end of the emotional spectrum to the other. As it gets more popular this is likely to be magnified. No one can predict every downturn. What you can do is decide if a market’s price is unusually high or low and invest accordingly. If you flip this around this means looking at the earnings or yield of an investment, which is what any good investment decision should be based on.
The main purpose of my approach is to make indexing a bit smarter. I would prefer to have index funds instead of actively managed ones, but many people who talk about indexing don’t make any attempt to decide if the market as a whole is a worthwhile investment. If that’s beyond your level of understanding you shouldn’t try it, but I believe it is possible with the right knowledge. Most investors don’t just buy one asset class so they need to decide on an allocation between many options. That’s where the Value Indexing approach comes in.
As my introductory post states, my aim is to follow market indexes while adjusting my exposure to individual investments based on whether I find them attractive. In the long run I believe that stocks in developed countries will provide reasonable returns, while bonds will largely avoid losses. Without trying to choose individual stocks I can decide which markets are more attractive at the moment and shift more assets there. This usually doesn’t mean large changes; it would take an extremely high valuation to force me out of stocks entirely and I would prefer to make a gradual change over several years instead of putting everything into cash one day.
In the long run I hope that this approach allows me to enjoy indexing while avoiding a few of the bigger and more visible risks. This means a slightly lower chance of big losses, and potentially slightly higher returns over time. It may not be very much but I can take pleasure in avoiding excessive speculation even if I don’t get a big reward for it.
This post isn’t about paper gains or ponzi schemes – it’s about real real returns. A huge mistake many uninformed investors and their advisers make is not using real returns when looking at the future. And it gets even worse when they expect unrealistic long-term returns on top of that.
This might seem crazy – after all, most people just throw around nominal returns all the time and it’s true that when you’re comparing one investment to another the 2% difference is mostly the same whether it’s real or not. Adding to that, no one can know future inflation any more than they can know what the performance of the stock market will be.
There is one big reason you need to work with real returns though – everyone has to live with inflation. It doesn’t matter what numbers you type into a spreadsheet today, $1000 in 40 years will be worth less than $1000 today. Not only that, but the assets you have at that point in time won’t change based on the type of calculations you do (unless you make different investment decisions based on the results).
Real returns make your plans safer. If you plan to spend nominal returns it’s virtually guaranteed that you will be disappointed in the future. If you calculate real returns you’re more likely to actually get what you expected, and you’re also more likely to get more than you expected. I’ve learned from running a business that good surprises are always more pleasant than bad surprises, and safe plans that make you work a little harder but usually work out in the end are the best way to go.
Estimates will be wrong – but if they’re reasonable, and they’re over a long enough time period, they can be better than giving up and saying “who knows what will happen”. It’s true that many people don’t know how to estimate inflation and may go in the wrong direction so you need to find a reference that works for you. But at its simplest this can come down to working with the long-run real return instead of looking at nominal dollars.
After all, given enough time other investors will adjust to inflation and performance will vary accordingly; a profitable company selling a good product will increase nominal profits as inflation rises, so the long-run real return is likely to be a more stable and consistent measure than the nominal stock price increase.
You don’t necessarily need to estimate inflation year by year. Some investors choose to calculate the real returns in one big step – adjusting their estimated assets in 40 years for 40 years of inflation. This is fine too; either way you need to make sure that your plans are based around something you can “realistically” expect to get – hence the “real” returns 🙂
All my projections are based on real returns, since that’s all I expect to have in the end. In the short term this does depend on whether we’re likely to be in a higher- or lower-inflation environment, while long-term projections can be simpler to do by simply adding up average real returns over that time period (ie 5% real return for 20 years = a 165% gain).
Taxes are important too – after all most investments can’t be used without paying the tax first. Right now I still have enough TFSA and RRSP room to be fairly flexible with taxes, but I do need to account for the taxes on income generated from RRSPs. For other investors this may be a bigger concern if they have a substantial unregistered portfolio and it has to be calculated correctly to know what you’ll actually get.
Are any parts of your investment plans based around nominal rather than real returns? What can you do starting now to make sure that everything you have planned is real?
This blog is about the evolution of my personal investment strategy. Following many great investors, I hope that sharing my perspective will be helpful to others and allow me to understand it better, as well as see contrasting views and facts that I missed. In the end there are few hard facts and a lot of opinions that can’t be proven until they don’t make a difference, so I welcome all views!
This blog is about what I’m thinking and doing and why, along with anything that might be of interest to those who share my views. I may make a few mistakes along the way, but one of my measures of success will be to largely avoid lagging common indexes over a period of several years. I expect that at some times I’ll be behind for a year or two but if my rational decisions do worse than a simpler approach for no good reason, they aren’t rational in the end.
This blog is not about
- Beating the market
- Excessive investment returns in general
- Simple formulas
- “Guaranteed” success
- Market timing
- Economic cycle timing
- Detailed security analysis
Although my approach is no grand strategy I chose the name “Value Indexing” for this blog because it represents the key elements that I focus on. I prefer index funds like many other self-taught investors because they provide easy stability and diversification, and avoid the risk of underperforming with a high-fee active fund. However I pay close attention to the allocation between indexes. Other investors will go as far as indexing their allocation to the relative size of various markets in the world but I believe that can be a big mistake.
Like value investors I’m sensitive to price and the actual return the investment is earning. Although I said above that this isn’t about fixed rules and formulas, judging investments based on what they actually earn is a bit of a fixed rule. I don’t care what anyone else says – a long-term investment that’s earning 0.5% is just too expensive for me and not worth it. On the other hand if someone will sell me a safe government bond that will pay me a 10% real yield I would be happy to free them from the burden of owning that!
The results that I hope to get are more stable and consistent returns, with some potential for small outperformance at times from avoiding a few common emotional mistakes or even acting on the other side of them to make a profit. I won’t know if I’m right until it’s too late to do anything about it, but at least I can be confident along the way that I’m not exposed to some of the bigger downsides of the market.
Who might be interested in this? Anyone can do what I’m doing, but it’s not a simple approach. I believe it takes some interest in finance and economics, and it helps to have the mindset that lets you see through the current popular view of the market, whatever that is.
I hope some of my writing will be informative and enlightening to you, and that you’ll let me know what you think – particularly if you disagree!