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How To Predict The Future

October 24, 2011 Leave a comment

As we’re seeing now, something that is a doomsday scenario one month can be a positive outcome the next month. This gives us a good reminder of the context around predictions for the future. For example, the big question in Canada is where interest rates will go. Everyone who is asked will happily tell you what is “sure to happen”. There are a lot of reasons to believe they will rise slowly, but the story is only clear once it’s already happened.

Did americans in the 70s expect to be hit by over a decade of crushing inflation, only ended when the Fed got a chairman who raised interest rates without a care for his future career? Or did they see what seemed like a normal and gradual increase at first, and only make sense of the shift after it hit them? Of course this is just one small part of financial history. A couple of years ago I expected a faster recovery and a steady increase in interest rates, but hidden problems have dragged things out for far longer and we don’t know when they will end.

This is the best way to predict the future. Don’t just take the most likely outcome, even if it is really the most likely. Instead look at a variety of possible scenarios and past results to get more depth. Yes it’s confusing. But you have a much better chance of knowing what’s coming if you really try.

The Punchline To The Last 3 Months Of News

October 20, 2011 1 comment

“Sovereign debt fears easing as institutions anticipate Greek default”

Apparently a recent survey found that 92% of institutional investors expect a default in Greece (with 70% expecting it by April). And yet the number expecting an imminent global recession has fallen from 40% to 25%.

If you read the news at all recently you would be forgiven for being surprised by this. It was supposed to be the end of the world “if” there was a default. Now that we’ve switched to “when” it’s business as usual.

Things could have been worse. Maybe a surprise default would have frozen credit across the world, banks would have collapsed, and no one in the world would have a job or a dollar anymore. But investors behave in strange ways. When times are good they are unable to predict any surprises that could negatively affect their plans. And when times don’t look good they don’t stop going through doomsday scenarios and selling everything in sight.

Those who bought when everyone else was running away may be on their way to a quick profit. Unfortunately stock prices continue to rise and we may be headed back to moderately overpriced territory, limiting the great buying opportunities in the near future. What else can we find to scare investors with?

Allocation Adjustments For October 2011

October 13, 2011 3 comments

Although my allocation was most recently updated in January, I believe this is a good time to revisit it since the market has changed quite a bit. Given the size of my portfolio I don’t expect the changes to make a big difference in the dollar returns but it’s worth seeing what happens if I do this. The most important thing about this step is that it’s a chance to reconnect with the long-term principles I want to base my portfolio on.

Here’s the new allocation:

  • Bonds 10-15% (was 20% in January, at 14.3% today)
  • CDN index 25-27% (was 26.6% in January, at 27.3% today)
  • US index 30-33% (was 26.6% in January, at 29.5% today)
  • EAFE index 28-32% (was 26.6% in January, at 28.8% today)

And here are the index numbers:

  • DEX Universe Bond Index: Yield 2.55%
  • TSX: Dividend yield 2.83%, earnings yield 6.7%, P/E 14.85
  • S&P 500: Dividend yield 2.23%, earnings yield 8%, P/E 12.58
  • EAFE: Dividend yield 3.47%, earnings yield 6.9%, P/E 14.54

Just like the start of the year, the yield indicators for the 3 major stock indexes are fairly similar. However I have weighted them a bit differently for several reasons. The canadian market has had a good decade and may be benefiting from commodity prices now, so it might have a little more downside risk. However it has the short-term advantage of avoiding currency volatility. The US market is still home to some of the best companies and the canadian dollar was helping to buy more until recently; if it rebounds it may give another boost. The european market also has a lot of good international corporations and may be too pessimistic at the moment. It provides a good diversifier for the others too.

The big difference comes from bonds though. They have done too well (the 1-year return is around 7%), and now two indexes have dividend yields higher than the bond yield. Having a bond allocation at the start of the year has helped a lot. It could just as easily have dragged down returns though, and the current interest rates don’t interest me that much. I may be foolish in keeping a bit in case even better stock buying opportunities turn up but we’ll see.

Over the last few months I’ve taken advantage of days when stocks have dropped and bonds have risen to new highs to move small amounts from bonds into stocks. That’s why the bond allocation has drifted lower, and I may do additional small moves if the right opportunities come up. If the markets reverse themselves I’ll have locked in a bit of profit. I may have been too early but you never know when you’ll lose an opportunity to buy at lower prices because the bottom is at a different level every time. The real question is whether I’m making moves that increase the long-term value of the portfolio, and I strongly believe that trading out of something that’s been doing too well helps that.

I’ll implement the change by adjusting the amounts added starting next month to match this allocation, and otherwise continuing to make gradual moves as the market gives me opportunities. I’m trying ranges instead of fixed targets to see if that helps guide my decisions better. But in any case if I lose access to my portfolio for a few years I won’t be overly worried about how it’s doing.

What Are We Occupying Now?

October 11, 2011 2 comments

The Occupy Wall Street protests seem to be catching on – to the point where I now have cousins calling to occupy nearby cities on Facebook. After many accusations that the media ignored them for the first few weeks, there seems to be a breakout of coverage recently. And as the NYT reports, the targets of the protests are panicking. So what’s really going on?

One of the things the protesters have going for them is that their stated goal is so vague that almost anyone can identify with it after a while. And there are surely some things that few people would agree with such as bankers and traders being paid large bonuses for causing a loss, and some decisions that impact everyone being made out of the reach of the average person. This gets the protestors a certain level of sympathy from nearly anyone who looks at the situation.

However, there is a danger that the protests will draw in more extreme views (if this wasn’t a part from the beginning). Anything that starts out by opposing the norm can quickly turn into a “big tent of crazies” where everyone who’s unhappy comes together. Businesses, including banks, need to run on their own and just like with criminal courts I prefer not to lock away everyone suspected of doing something wrong. I’ve also seen from the inside how people are sometimes held back from doing something reasonable just because it would look bad to people who know nothing.

I’m generally not a fan of protests since a lot of them seem to be motivated more by people having an adventure rather than doing something constructive. I’ve certainly had quite a few advantages in life but when I started my business I chose to go into an area where I was starting from nothing and create my own opportunity. It’s worked out for me and I suspect that quite a few people could put their effort into something productive instead of protesting and get similar results.

The best thing about these protests may be that they’re so vague they mostly get people to think rather than pushing for a specific outcome that only benefits a few people. It already seems to have changed the tone of media reports on the economy to refocus on issues that were forgotten. That’s a good thing because too many people have given up, simply reacting to events or ignoring them altogether because they think they can’t do anything. So I’m not entirely against these protests but I’m too busy building a better economy to attend one. If you think something isn’t quite right, you don’t need to march around all day. Just remember that you still have choices and you can speak out against things you don’t agree with. The extremists on either side only get heard when everyone else shuts up.

The Problem With The Stock Market

October 4, 2011 3 comments

… is that everyone is in it. If you think Wall Street executives have a lot of power to get government intervention when things aren’t going their way, you should see what happens when the average person’s retirement plans are threatened by falling stock prices! (or so they think)

The stock markets as an investment may be similar to residential real estate market at some point in the future. Of all the major assets you can invest in, residential real estate is one of the most difficult because people spend large amounts of money emotionally in that market and actual investors get pushed around by this. At many times in the past real estate has been an great investment, but once it was decided that it should be a great investment for everyone, it was doomed as an asset class.

The stock market is becoming less of a real investment market, where investors are rewarded for making wise choices. It’s becoming more of a market for hope, big enough that those who make wrong decisions are often rescued at the cost of those who did the right thing. As far back as October 1987, a falling stock market was serious enough to draw immediate government actions.

This will naturally lower returns and take away opportunities for those who prefer to buy at a low price. Higher returns than we’ll see in the stock market can still come from other markets that don’t operate at a large enough scale or affect anything critical enough to get this kind of intervention. Or maybe regulatory attitudes will change in the future and give the stock market its edge again.

That doesn’t mean stocks will have no return since there are good reasons to get good returns on a reasonable amount of capital through business equity. It just means that if we minimize the number of people who really lose, everyone will lose some potential. Just like a market with no short sellers, a market supported by governments hides the true risks and makes everyone pay for the safety (which may not even be real).

This is of course good for a lot of people, since everyone needs to plan to support themselves and access to an investment market that doesn’t eat them alive helps with that. But if we want to guarantee everyone a decent return that return will naturally be lower.

I’m still basing a lot of my plan on the stock market but because of this change in its nature we have to expect lower future returns.¬†And I will experiment with other investments to see what can make the best use of my capital. I’m not sure that we’re buying stocks at their true prices today, and that means we’re giving up some of the returns.

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