We bring out the Colono-Money Scope for this episode, Not only to take a deep look into how good investing helps to secure your financial future, but also to push past some of the “financial bullshit”. That is the academic term for “seemingly impressive verbal financial assertions that are presented as true and meaningful but are actually meaningless”. Some of that financial bovine feces is actually hazardous to your financial health.
We’ll explain how stocks, bonds, mutual funds, and ETFs work. Even these powerful instruments can be used for either investing or gambling. Learn to spot the differences and invest instead. That is not only about the products used, but the strategy. Bad products or strategies can be alluring if you don’t understand how financial markets work or know the evidence behind them.
Whether you are DIY investing or working with a financial advisor it is important to have some intuition around risk and expected return, and how incentives may influence the products presented to you. So, join us for a deep dive into key investing concepts that you can use to steer past the financial feculence and straight down the lumen to long-term investing success.
[0:00:02] BF: Welcome to the Money Scope podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital, and Dr. Mark Soth, aka The Looney Doctor.
In our last episode, we discussed how to build a stable platform to start investing by building financial resilience, including controlling debts, building a buffer to deal with cash flow crunches, and setting aside savings for short-term goals. That solid foundation is going to set people up both economically and emotionally to take some risk with their long-term investments.
Now, risk sounds scary. But over long periods of time, investing helps to grow our wealth to provide for us later in life, and reduces the chance of losing purchasing power.
[0:00:49] MS: This episode, we’re going to take a deeper dive into some of the basics of investment strategy. And the first essential thing to understand is actually the difference between investing and gambling. One of the tricky things about spotting that difference is that, in many cases, the same financial assets can actually be used for either investing or gambling. It’s not necessarily what it is. It’s how you’re using it.
And we’ll apply that filter to how we describe how different types of investments work. And we’ll cover some of the common ones like stocks, and bonds, mutual funds, exchange-traded funds. And you’ve probably heard of some of those, particularly from the people selling them. But we’re going to go deeper than that. And we don’t have actually any financial products to sell you. So, we’re going to take a good look in there for you.
[0:01:31] BF: We also want to make sure that you understand the underlying economics of financial markets. When you really understand what’s going on in there, I think it helps deal with fear that a lot of people have around this stuff. And we also want to understand how the incentives around financial products often make it, so that when something’s being sold to you or suggested to you, it’s in many cases going to increase the wealth of the person recommending it rather than increasing your wealth.
And to support that discussion, we’re going to review evidence on the performance of different types of investment strategies. I think having that evidence in your back pocket really helps to filter out and deal with financial bullshit. I hope that wasn’t jarring for anyone. Excuse the language. But that is a term used in academic literature to describe seemingly impressive verbal financial assertions that are presented as true and meaningful but are actually meaningless.1
[0:02:23] MS: You can find the reference for that in the reference section of the page.
[0:02:29] BF: I think whether you’re a DIY investing or working with a financial advisor, it’s really important to have some of that intuition around risk and expected return. And that’s the underlying economics that I mentioned, and how incentives might influence the products that are being presented to you. Or another way of saying that as I really think that even if you are working with an advisor, you need to be able to spot financial BS.
And likewise, if you’re in DIY investing, in one of our cases in the supplement episode, we talk about some of the exciting and enticing investment opportunities that can get presented to people. They’re often not as good as they seem. I think having that intuition is really important.
Now I don’t want you to start sweating. I don’t want to make anyone nervous here. But we are going to be bringing out the colonoMoneyScope for this one. The anaconda of scopes. Don’t be nervous. We’ve already done the prep, which as I understand is the worst part.
[0:03:19] MS: Anyone who’s had colon cancer screening or involved with colonoscopy will probably understand that reference. And similarly, this is a series business not to put off. This is something that’s vital. And today is going to be a vital procedure for the preventative care of your portfolio.
Great. We’re going to start off with a little bit about why we invest. And let’s think back to episode five when we introduced the concept of lifetime wealth and consumption smoothing. People save their money when they’re working so that they can fund their consumption when they retire.
And if you save your money and park it in a savings account, those savings might, if you’re lucky, keep pace with inflation over your lifetime. But taking some risk by investing is the way to increase your expected returns above the rate of inflation. And that’s going to be vital to your long-term security. If you don’t invest, then you must either earn more or spend less to make up for not growing your money.
And that means you’re going to be missing out in other ways. So, you miss out on opportunities now or later because you didn’t make your money work for you, because you have to make up that difference. And investing increases the size of your lifetime wealth pie so that you can consume more of it earlier and smooth that out, assuming all goes well, while still having lots of it left later, so that you’re not trying to gorge at one time and starve at another.
You also don’t know if you’re going to be forced to have a shorter career span than expected. This is a risk that I think people don’t appreciate until it kind of manifests for them. For example, a 2015 Angus Reid survey found that 48% of Canadians in their sample retire before they plan to. And that was at least due in part to issues beyond their control.2
Having this plan of growing your money over time is actually important because it gives you flexibility if things don’t become a goal as planned. And that’s actually relatively common. And some common causes were personal or family health issues. No one is immune to that. It doesn’t matter who you are. And about 6% retired later than expected usually because they needed more money.
The idea that investing is risky scares a lot of people. But risk is a complex topic. And while it’s true that there’s risks to investing, many people don’t realize the risks that they’re taking by not investing. And the problem there is that, due to the nature of compounding and exponential growth, people only realize that when the risk materializes and they don’t have the money that they need and not going to have that time to make it up at that point.
They also may regret having missed out compared to their peers who did get their money working for them and are much further ahead at that point. And you can’t roll back the clock and start over.
[0:05:50] BF: Yeah, the compounding piece is so important. We talked about that in an earlier episode when we talked about regret. And this is one of those foundational things, where by the time you regret it, it’s too late to do anything about it, because you need years and years to compound for the investing math to work in your favour.
I do want to illustrate this point that you’re making on how investing augments your savings with just a quick example that I did up in Excel. I got to preface the example by saying that it doesn’t take risk into account. But, again, risk is pretty complex. And I will address it after I give some numbers here.
Let’s just take a hypothetical person with $300,000 of annual income. We’ll just ignore taxes. They want to accumulate $3 million by the time they retire. And they plan to invest in high-interest savings accounts, which we’re going to assume for the sake of the example that they earn, the rate of inflation. They earn a 0% real of return. A 0% return after adjusting for inflation.
To meet their $3 million dollar savings target, they need to save a third of their income. $100,000 per year over 30 years. Now if instead they invested in a portfolio of stocks and bonds earning a 4% real rate of return, which is a bit lower than the historical real of return on global stocks for the last 123 years, they would only need to save about $50,000 annually. I mean, that’s pretty incredible. They cut their required savings in half to meet the same objective by taking a little bit of risk with their investments.
Now to address risk, and I think this is really important. And we are going to touch on this more as we go through the episode. In my example, the high-interest savings account matched inflation for 30 years. But if we go and look at historical data from around the world, the probability of losing purchasing power at a 30-year horizon by holding assets like a high-interest savings account, and the study I’m referring to, they use short-term government bills, but same kind of idea, the probability of losing purchasing power in that short-term, what we would generally think of as a safe investment, is much higher than the probability of losing money by holding stocks.3
It’s true that stocks are risky in the sense that they can be volatile. And that can scare a lot of people. And we’re going to hopefully address some of that fear throughout this episode. But they change in price from day-to-day. And many individual stocks can lose all of their value over their lifetimes or just have very poor long-term returns.
But the historical experience, when you look at more diversified portfolios, has been that markets in aggregate tend to deliver – relatively, stock markets, tend to deliver relatively good results for long-term investors. Again, that idea of investing is risky. Well, yeah, sort of. But so is not investing.
[0:08:26] MS: Yeah. And so, there’s a lot of risks there with not investing, buying the purchasing power. And I can think of how much harder I have to work for $50,000 a year in that example or how much less I could spend by doing that. And if something doesn’t go as planned, then it’s a big problem.
Now you did touch on a really important point on the difference between individual stocks. Many of which lose all of their value or perform very poorly. And that’s different from the stock market as a whole. One big thing that scares people off of investing is that they think it looks like gambling. But they’re not the same thing.
And my suspicion of a part of why that is is that its financial assets are less physically tangible and they’re complicated. That’s more complicated and less tangible than something like your house. People may understand their house or real estate, but they don’t understand their investments as well. And to be a successful investor, whatever you’re investing in is critical to understand the difference between investing and gambling.
And we started this episode by explaining why investing is important. But a lot of people, what they call investing is really actually more like gambling. And I know that’s important. Because the most common investments that people bring up to me when they find out that I’ve been interested in finances are actually closer to the gambling end of the spectrum. And they’re kind of shocked that I’m not all excited about it.
It’s actually kind of concerning. I’ve seen medical students gamble with their lines of credit and I’ve seen colleagues mid-career that kind of blew up their portfolios by not understanding the differences between investing and gambling. And, ironically, many of these are actually the same people who often feel that they know a lot about them investing since they’ve poured time and effort into it.
Personally, I didn’t fully understand this when I started either. And I was interested and poured a lot of time and effort into it. But the fortunate thing is I actually learned some really hard lessons pretty early on by doing that. What we want you to come away with from this section is being able to tell the difference between investing and gambling so that you can avoid those hard lessons or at least go into gambles knowing that you’re gambling and not investing. That may be your choice. The other reason to understand the differences from gambling is that even good investments can actually be turned into gambling instruments. Ben, what would be some of the differences between gambling and investing?
[0:10:34] BF: It’s easy to start with the similarities. And then the difference, we can contrast them. Investing in gambling are both risky and involve choice under uncertainty. That’s how they’re similar. They’re both risky and they both involve choice under uncertainty, where we’re making decisions about unknown future outcomes. That’s how they’re similar.
Now how they’re different is that gambling has a negative expected return and investing has a positive expected return. With gambling, you expect to lose money on average. And the longer you play, the more likely you are to use. I mean, the obvious example is a casino. You can go in and win –
[0:11:10] MS: I think that’s the statistical expectation. Not the person’s hope.
[0:11:14] BF: Correct. Yeah, the expected value is very specific language. But, yeah, you don’t go into a casino hoping to lose. But even if you can go in and get lucky in a casino, and even a lucky streak can last for a little while, the longer you stay in the casino, the more likely you are to lose because the odds are stacked against you. That’s how the game is built.
I mean, lottery tickets are another example that everyone’s familiar with. You expect to lose. You expect to pay your couple of dollars for the ticket, but you hold out hope that you might get lucky and win big. And, again, that hope is what drives people to do that kind of thing. Same as going to a casino. You hope to win, but you will probably lose.
Now the way that that type of distribution can be described where the lottery ticket is the classic example where you’re almost certainly going to lose. But if you do win, it can be a very, very big. That’s called a positively skewed distribution.
Now when it comes to financial markets, buying individual stocks is more like gambling than investing. Because most individual stocks underperform the market. Individual stock returns are positively skewed.
If you hold one stock, if you pick, “I think this stock is going to do well,” there’s a good chance you’re going to underperform very low-risk government bills and an even greater chance that you’re going to underperform the market as a whole over long horizons.4
Similarly, trying to time your exposure to certain types of financial assets. Like, I want to get into this type of stock because I think it’s going to do well. That’s going to tend to be a losing game as well. Now investing is different. When you invest in a diversified portfolio of stocks and bonds, you do expect a positive long-term return. And holding that diversified portfolio for a long time makes you less likely rather than more likely, in the case of gambling, to lose money. We’ll get into more detail later about why investing has a positive expected return later in the episode.
[0:12:58] MS: Right. If gambling is characterized by this probable loss, then why do people do it?
[0:13:05] BF: It’s a really good question. I think people have a lot of different motivations to enter into gambles. But the big ones, if I were to summarize them, are probably going to be hope, which I kind of mentioned a minute ago. You hope to win the lottery, overconfidence and thrill-seeking.
There’s a behavioural economist named Meir Statman. He’s one of the original guys behind behavioural economics. And he explained to us on a Rational Reminder podcast episode that people want two things in life. One is to be rich and the other is to not be poor.5
And his point is really that people are willing to accept a sure small loss in exchange for the opportunity to hope that they will win the lottery in that example even if it’s extremely unlikely. But the benefit of hope is that they get to spend a whole week or whatever period of time thinking about what they would do with their lottery winnings.
And I think it’s similar for speculative investments, at least on this explanation for why people gamble. They may be willing to invest in speculative stocks in exchange for the hope that they find the next Amazon or Apple. I mean, it’s really fundamentally similar to playing the lottery.
People also have the tendency to place an irrationally excessive degree of confidence in their own ability to trade stocks. That’s the overconfidence angle. They think they have an information edge that’s going to let them earn large profits even if or even though that is very, very unlikely.
Empirically, if you look at the data on overconfidence, it’s really interesting. More overconfident people trade more frequently and their performance is worse.6 And men who tend to be more overconfident than women similarly trade more than women and perform worse than women in their trading accounts.7
Then the last point I would make is on thrill-seeking. Some people just want the thrill. They’re sensation seeking is what it’s called in the academic literature on this, which means that they look for new intense and varied experiences generally related to risk-taking.
People who exhibit those characteristics, in this study, they measured it by people who have gotten speeding tickets. Those people tend to trade more in their portfolios.8 And a lot of investors just treat trading stocks and options as a fun and exciting gambling activity. It’s really used as a replacement for other types of gambling. And that’s another study that looked at that.9
[0:15:16] MS: So, I need to drive slower when I get called into the hospital.
You mentioned speculative investments. And that concept’s important to know. Investment prices are based on actually discounted future cash flow. That’s what it is we’re trying to buy. And you’re going to explain more on that when we take a deeper dive later on in the episode.
But the important point there is that the future by its nature is uncertain. If we’re buying future cash flows, that’s uncertain. All investments are going to involve some degree of speculation. But still, some investments are going to be more speculative than others are. Let’s take the example of a bond where the income is actually contractual.
As long as the issuer remains solvent, you’re going to get your bond coupon payment or your interest payments. That relative certainty is baked into the price too though. There’s a lower discount rate, which translates into a lower expected return. Because it’s going to be more guaranteed, you’re not going to expect a higher return in exchange for that.
Now, on the other hand, if the bond issuer ends up being, for example, the next Amazon, but, as a bondholder, you’re also not going to participate in that upside potential either. You’re going to get what’s in the contract.
Now down to the other end of the spectrum would be something like, say, a junior mining stock. And that would be something that usually has like no cash flow now. But it might deliver a huge cash flow in the future if it’s the jackpot. Or it could go bust and be worth nothing.
This, again, is baked into their prices through a high-discount rate, which translates into higher expected returns. But there’s also a good chance that the investment ends up worthless as well. A tiny chance that it ends up delivering huge returns sounds a lot like a lottery, particularly when there’s a high chance of it returning nothing.
The closer you get to the speculation end of the spectrum, the larger a role chance plays and the more skewed the outcomes are. In other words, the closer it is to gambling rather than investing.
[0:17:09] BF: Yeah. The riskiness of assets also to some extent – you mentioned earlier I think in the introduction about how some good investments can be used as speculative investments. And I think what’s relevant there is this idea of it’s called duration matching. And I’ll explain what that is.
Bonds are a good example. Bonds have these contractual cash flows. So, listeners, don’t get intimidated. We are going to go into more detail about what stocks and bonds are. We’re talking about them now, but we’re going to define them and explain them a little bit later.
With bonds, if you know that you’re going to need an exact dollar amount in 10 years, you can park that money in a 10-year bond, which is going to pay you interest along the way for 10 years. And then at the end of 10 years, you’re going to receive your exact dollar amount back at the bond’s maturity.
In that case, for that objective, the bond is a risk-free investment assuming that the issuer doesn’t go bust. We’ll say it’s a government bond for a stable government with little inflation. Now if you buy that 10-year bond hoping for interest rates to change tomorrow and you’re saying, “I’m going to buy this 10-year bond because I know its price is going to be sensitive to interest rates.” Tomorrow, that’s speculating.
And I think stocks can be thought of in an approximately similar way. If you buy stocks as a long-term investor, they can be relatively safe. But if you buy them to make a short-term gamble, they’re extremely risky.
[0:18:29] MS: Yeah. Picking the investments to match your investment horizon really does matter. And you can make a good plan to do that. However, the other thing is you can make that plan, but you have to be able to actually stick to that plan. Otherwise, you may inadvertently turn your investment into a gamble.
For example, we already talked about investing money that you should have saved and then being forced to sell at a bad time in the last episode about saving and investing. Another way that we can sabotage ourselves though is by exceeding your emotional risk tolerance. And that could cause us just from a behaviour standpoint and our emotions and our behaviour are very powerful to sell something at the worst possible time. That’s just the way that we’re wired.
We get excited when we see investments go up. We get fearful and we feel uncomfortable when they go down. We may actually feel actual kind of pain in the same centers of our brain when that happens. And that excitement, when things are going up, can cause you to take excessive risks. Like, using your line of credit to buy crypto in the fall of 2021 was really exciting.
But on the other side, the fear during discomfort of watching it all fall could cause us to sell just as the market’s hitting a low just to make that pain go away and the discomfort go away. That’s the way we’re wired.
And a good check, a good gut check that you can use about whether you’re investing or gambling is how it makes you feel. And if you feel that you find your mood that it’s being affected by your investments, when they go up and down, your mood goes up and down, then that’s a red flag.
[0:19:55] BF: I would probably argue that crypto doesn’t have a positive expected return even if you hold it for a long time. But we can cover that in a future episode. I know that that crypto example was a hyperbole. That was an extreme example of borrowing to invest in crypto at the peak of the crypto market.
But I do want to put a little bit of emphasis on it because borrowing to invest, well, it can make sense in certain relatively niche cases. It has to be approached with a ton of caution. Using leverage improperly is a really good way to turn an investment into a gamble.
And I think like in your emotion-charged example, Mark, I think that leverage investing and speculation do often go hand-in-hand. If you find yourself using leverage or thinking about using leverage to invest, everything that we’re saying just requires even more careful consideration.
[0:20:40] MS: Yeah. The reason why I actually brought that example up is because around that time is when I kept seeing on Facebook or from people talking people actually asking about using their line of credit to buy crypto. Humans are humans. That really plays to it. And leverage really magnifies that fear, excitement. But using debt to invest it. The most exciting thing in investing should be listening to our podcast. And the only really kind of truly scary thing should be my corny jokes along the way.
Okay. Well, I guess the mix of fear and power that you feel when you buy your first investment, that’s also normal. But other than that, though, really, investing should be kind of boring but satisfying. And not only is that a good sign that you’re doing good investing. It also means that you actually can channel your emotional energy elsewhere into where it matters and not have it be consumed by investments peaking your emotions up and down.
We’ve danced around this topic. But I think it’s time to take a deep dive into the core of investing. Kind of some of the big concepts about financial assets. Financial assets are contractual claims rather than physical things. A bank deposit is a financial asset so are stocks and bonds.
Stocks and bonds are really kind of claims on discount of future cash flows. That’s we’re buying – when we buy a stock or a bond, we’re buying that cash flow. And there’s some overlap with real assets, physical assets like machinery or real estate. They can be used to conduct a business. And that those assets drive value from their ability to generate cash flows as well.
But the cash flow is largely what we’re talking about. Now, commodities are also another example that’s a little bit different. We talked about crypto. Whether that’s a commodity or not. There’s also gold and oil. Those are real assets. But they’re not expected to generate cash flows. Their value is based more on supply and demand rather than cash flow.
And it’s important to differentiate assets from financial accounts. A financial account would be something like a TFSA or an RRSP as examples. And those accounts are really just containers that we put financial assets or investments into. The investments are like the groceries and the account is like the grocery bag.
And I’m mentioning this because it’s a common misconception that you just go buy an RRSP at the bank or buy a TFSA at the bank. It’s really just an account. But when you do that, you’re buying it as a bundle usually filled with high-fee retail mutual funds as the financial assets.
Similarly, TFSA doesn’t need to be a high-interest savings account at the bank. It can be a TFSA that you open at a brokerage. And then you can invest and fill it with financial assets of your choosing rather than buying a pre-filled bag. And you can buy things that are expected to grow way more in the long run.
Our goal today is to help you understand how to pick your groceries. That’s the part we’re going to be focusing on. We want to make sure that you get good ones. And more importantly, we want to also make sure you avoid overpaying for highly-processed junk food and be able to recognize when you get presented with Investments that they’re shiny on the outside. They may have nice wrappers. But there’s worms hidden on the inside. And if you have some basic understanding, you’ll be able to pick up on that.
[0:23:54] BF: I think it’s hard to overstate how important it is for people to understand the concepts that we’re going to cover. All of it gets much less scary when you understand it. Even like, “Oh, the stock market went down 5% today,” stuff like that. Once you understand what’s going on behind the scenes, I think that gets a lot less scary or at least I hope it does.
There’s great quote from Chris Hadfield when he was on Rational Reminder podcast that I always like to come back to, which is that competence is the antidote for fear. Once you understand that investments represent claims on cash flows in the future, I think it gets a lot easier to think about day-to-day changes in markets.
Those cash flows can be from business earnings. Like, in the case of stocks, interest payments from bonds, or rents from real estate. Future cash flows are uncertain by their nature. This whole idea of discounted future cash flows is that the future cash flows are uncertain because the future is uncertain. You wouldn’t buy future cash flows dollar for dollar today.
If I came to you and tried to do a trade, you would not give me a $100 today in exchange for the promise to give you $100 in 10 years. It just doesn’t make sense. Nobody would do that. Instead, what happens is that future cash flows are discounted to a value that represents what they’re worth today. That’s the discount rate.
[0:25:09] MS: Yeah. It gets back to the whole money as a time machine idea that we’ve discussed a few times now. Money in the future is worth less than money that you have today. How much less depends in part on how certain you are that you’re going to receive it.
[0:25:22] BF: Yeah. When you buy a share of stock, you’re buying a piece of ownership of a company. And the stock’s price is based on its discounted future earnings. That’s the cash flows we keep talking about. And the discount rate is its expected return. It’s like how much less you pay for those future cash flows relative to what you expect to receive. That difference, I guess, or the number that equates those two figures is the discount rate, which is also the return that you expect to earn by holding that asset for a long period of time.
Now this is super important. Again, when you buy a share of stock representing discounted future cash flows, your expected return is the discount rate applied to those cash flows. The thing about stocks, and this is one of the reasons that we see the prices move around so much, is that their future cash flows are not guaranteed.
Stock prices change day to day because both discount rates and expected future cash flows change as new information becomes known. I think the COVID-19 pandemic is a recent example, but it’s also an extreme example to illustrate the point.
As the pandemic became increasingly real and more information kept coming out about what was happening and what it was going to do to the world, discount rates went up because the market started assessing these new uncertainties that the future became increasingly uncertain. And expected future cash flows for most businesses also went down. Because discount rates went up and expected cash flows went down, we saw a sharp drop in the value of most assets and markets as a whole.
Price Declines & Future Expected Returns
Now the funny thing, if we can call it funny, about market declines is that, after a decline, expected returns, discount rates, are typically higher than they were before the decline. But if you ask investors, objectively, measurably, expected returns are higher after a market decline. But if you ask investors what their expectations for the future are after a decline, they’ll typically have lower expectations about future returns.10
That’s kind of the opposite thing going on, where expected returns, discount rates increase after a market crash. But investor expectations get more pessimistic. Now this is one of the reasons that a lot of investors get themselves into trouble. And it’s why discipline and having a plan are so important.
Another point here is that not all companies have the same discount rate. A business that the market views as riskier is going to have a higher discount rate applied to its expected cash flows than a safer company. This also means that some companies have higher expected returns than others.
Strong Companies & Future Expected Returns
Another counter-intuitive observation related to discount rates is that the biggest and most successful companies don’t tend to be the best investments. This is a thing that I’ve heard many times over the years, that I’m just going to invest in this big, super successful company.
But if you go and look at the data from 1927 through 2019 for US companies, US companies trailed the US market by 1.5% per year for the 10 years after joining the list of the top 10 largest stocks.11 You’d think that all these big, stable companies that they’re going to produce great future returns, but it’s actually counter-intuitively not the case.
And again, it comes back to discount rates. The market knows that it’s a big, successful stable company. The discount rate is low, representing relatively low risk, which means expected returns are also lower.
[0:28:34] MS: This makes sense. Although we all want to buy the best stuff. It doesn’t necessarily mean that it’s the best investment. A large, more stable, profitable company, that’s a relatively safe investment. But because of that safety and everything being priced in for that, it’s going to have a lower expected return. It may not be functioning as we thought it was going to function even though it’s a good company.
Interest Rates & Asset Pricing
And the other factor that can affect discount rates across the board is the level of market interest rates as well. This is getting to a bit of the mathy part of how things are discounted. But discount rates are theoretically a combination of the risk-free interest rate and a risk premium.
Investors by their behavior are going to price things differently if they can get something risk-free that pays them well. They’re going to expect more in return for taking the risk. When the risk-free rate changes, which would be the interest rates on really risk-free debt, then the discount rate changes as well.
We’ve lived through that in some interesting ways. During the period from the 1980s through 2020, it was an interesting period and that interest rates fell very dramatically. Since 2020, they’ve been on a steady merge upwards since then. And we can see the changes in market discount rates can affect the prices of some of the stock more than others.
This could be one of the reasons why some of the tech companies saw their prices increased dramatically in 2020 because interest rates dropped. So, that the way that the math discounts that is going to be different. When the rates rise, then the prices of those same companies drop.
These are companies with earnings that are far in the distant future. And that makes them therefore more sensitive from a price standpoint do these changes in interest rates. Lots of people were investing heavily into tech before the crash because they attributed the price increase to a new paradigm shift of work from home, and online life and all the tech companies that are going to make that possible and profit from it. But whether interest rates cost tech prices to tank or the market reassess that what the new normal looked like and revised down cash flow expectations for those companies, it’s actually pretty difficult to disentangle that. It’s probably a combination of both.
But this would be another example of a cautionary tale for investors. There’s so many factors that affect asset prices. But investors often create these narratives to explain what they’re seeing. We did a lot of that during the pandemic. A lot of narratives were created and people tried to invest along those lines. But those narratives are often wrong because it’s also sensitive to all of these other conditions that are playing in there. We’re going to talk about the challenges of getting calls like that right when we talk about the choice between active and passive investing later on in the episode.
[0:31:08] BF: Let’s move on to bonds. We talked about stocks. We’ve mentioned bonds a couple of times throughout the episode. Stocks are generally viewed as riskier investments. Whereas bonds are generally viewed as safer investments. Now because of that, keeping in mind what we’ve mentioned about risk and expected returns, because bonds are generally safer, they’re also generally going to have lower expected returns than stocks.
Now within bonds, the same general principles of risk and expected return are going to apply with the big difference between stocks and bonds being that, in general, bond cash flows are known because bonds have contractual, what are called coupon payments. Contractual payments that have to be made to bondholders. Whereas we just discussed stocks have uncertain future cash flows that change with market conditions because the bond is contractual. Like, you know. You can map out exactly what cash flows to expect.
Bonds issued by a corporation may default. Meaning that the company is unable to make its payments. Relatively rare. But, I mean, it certainly does happen. And even then, bondholders do have a claim on the company’s assets. If a company goes bankrupt and is not able to pay its bondholders, the bondholders are creditors. When the company sells off its assets, the bondholders may still recoup some of their investment.
Riskier bonds – just like in the case of stocks, riskier bonds are going to have higher expected returns than safer bonds. All else equal. For example, a corporate bond should have a higher expected return than a developed market country government bond. Since governments tend to be more credit-worthy than corporations.
Interest Rate Changes & Bond Prices
The interest rate sensitivity that we briefly mentioned with stocks is a much cleaner relationship with bonds. Because unlike stocks, bond cash flows are known. They’re more certain. Bond prices mechanically respond to changes in market interest rates. When interest rates go up, bond prices go down. And when rates go down, bond prices go up. And we saw an extreme case of that in 2022.
The reason for this mechanical relationship is that bonds issued at the previous lower interest rates become less attractive relatively. Their prices are going to fall such that their expected return matches the expected return for otherwise similar bonds issued at the new higher rates. Longer maturity bond prices are going to tend to be much more sensitive to changes in interest rates because they have interest payments much further into the future to account for when market rates change.
If you have a bond paying a 5% coupon for one year and interest rates increase to 6%, yeah, your 5% bond is not making it that much worse off than if you had a 6% bond. But if it’s a 30-year bond, that’s a lot of coupons that you’re now missing out on at the previous lower rates.
Bond Risk & Expected Return
[0:33:50] MS: Yeah. I think with bonds, it’s important to remember a few things. They’re safer than stocks in the sense that their cash flows are known. And their prices tend to be less volatile. But in the long run, they’re expected to provide lower returns than stocks. And bonds are not risk-free.
In some cases, like in 2022, they can be risky in terms of their price volatility. And bond returns are meaningfully negative in 2022. And I think this is another good opportunity to mention the often-inverse relationship between recent returns and expected returns.
Bonds had a very low expected return for many years due to the falling interest rates. And the prices were getting higher and higher. And this was bad news for long-term investors. Because putting your money into safe bonds was almost certain to lose you purchasing power in the long run because the interest rates were so low.
And we did endure a year of very poor bond returns in 2022. But as that happened, future expected returns went up because of the price of drops. The future was starting to actually look better even though the president was not making us feel great.
Interest rates went up. Bond prices went down. But for long-term investors, this was actually good news. And this also speaks to what we mentioned earlier with matching the horizon of your investments to your goals. If you had the money that you needed in the near term and bonds in 2022 and you just happened to catch that at the wrong time, you might be very sad. But if you’re a long-term investor, the 2022 Bond markets were good news and it’s going to look good for you moving forward.
[0:35:19] BF: Those are some tough conversations with clients in 2022 when bond returns were negative and we’re trying to explain like, “No. No. No. This is good news.” That’s not always easy to explain.
[0:35:30] MS: Eventually, you get not just the price. You get the interest payments too.
[0:35:33] BF: That’s exactly it. Is that over the long term, the higher interest payments after bond yields went up will more than recover the price decline that you have in that one single year. You get this one year of pain. And if you’re only holding the bond for one year, if you’re holding a 10-year bond for one year, then, yeah, that pain is all you get. But if you’re holding the bond for 10 years, you get the one year of pain and then you get 10 years of higher interest payments or higher yields.
And if you hold it for longer than 10 years, well, at a certain point, you’ve broken even on the price decline and your future returns are now going to be much higher than they would have been in the old world of low interest rates. That concept is super important.
At PWL, when we updated our financial plans based on new bond yields even taking into account the fact that bond prices had fallen, our clients’ financial plans had improved pretty dramatically because of the now higher bond yields. But again explaining in that one year. And this is one of the challenges with investor psychology. Explaining in that one year when prices have declined that, “No. No. this is good news,” that’s not always so easy.
I think understanding how asset pricing works is super important. To understand how risk and expected return are related and why asset prices are constantly changing. Risk and expected return are related. That means that if someone suggests they can give you an unusually higher return, they’re probably recommending something very risky. Or maybe in a worse case, something very fishy. Seriously, like a lot of fraud could be caught just by looking for ridiculous promises of high returns.
[0:37:06] MS: Yeah. And that often is hidden in there too. That’s why when you hear that, if it’s not readily apparent where that risk is, then it means something’s being missed or not told to you.
[0:37:19] BF: Yeah, yeah, definitely. Chasing hot trends doesn’t tend to be a recipe for success. Hot asset classes tend to have high prices on low expected returns. And then on the other side of that, expected returns are highest when markets are most uncertain. Uncertainty can definitely be scary. And that’s the hardest time to stay invested, which I guess is kind of why expected returns are higher. Expected returns have to increase to continue to entice people to invest when things have become riskier.
But when you know you’re goals, and when you have a plan and you can remain disciplined, taking advantage of those higher expected returns when things get scary is really important. That’s when – I mean, you think about prices fall, expected returns rise. If you sell at that point, you don’t get to take advantage of the now higher expected returns.
It’s kind of like you referenced earlier, Mark, that if you aren’t disciplined, you can turn investing into gambling. That’s exactly the point. Even if you have a positive expected return investment, if you can’t hold on to it, then you’re not going to realize those positive expected returns.
[0:38:18] MS: Yeah. And I think one of the things that makes it difficult for us to actually behave well is that we don’t understand really how markets work. I think that’s why this next section we’re going to talk about, which is efficient markets, is really, really important. because if you understand this, then you have a much easier time understanding why it is that you need to remain disciplined and the way things are happening. And if you don’t understand it, then you’re going to go along for the ride with what everybody else is thinking.
And as we’ve mentioned, the worst possible time to buy stuff is when it’s expensive and that expected returns are low. But that’s when people want to buy everything. And the opposite is also true. We need to understand how that pricing works to make sure that we feel like we’re doing ourselves the best that we can.
And one of the most incredible things about a financial market is actually their ability to Aggregate and process tremendous amounts of information through the trading that’s going on within them. And no single investor can possibly have access to all of the information that will affect the price of a stock or a bond.
But the aggregate of all the investors together is going to have all of the available information that’s there. And that’s going to get reflected in the price, which is a good representation of all of that available information. If you own a stock, and I think that I have some information that you don’t have, then I may be willing to offer you a higher price for that stock than what you think it’s worth because I think I’ve got this special piece of information.
And by agreeing on a price together for this transaction, we’re both inputting both of our sides of the information for that piece into the price. And financial markets do that with many, many, many traders competing to bring you unique information to the market. It’s not just me and one other person. It’s everybody together constantly using their information to try to find that price with each other and get the best profits. Everyone’s in there trying to earn a profit, but no single trader can possibly have all that information. It’s the aggregate of all of those transactions going on and all the information that’s there, all the information and the probabilities of things happening.
Really, the product that we get from these markets is actually the prices that they give us. And since prices contain all of that information, we can infer what the discount rate of the market is and the aggregate of all those competitive traders together. Because they’re all applying, consciously or subconsciously, this cash flow for financial assets type of model.
And if you take more risk by investing in assets with higher discount rates, then you do expect to earn a higher return. But it’s not a free lunch. You are actually taking more risk. And the idea is that all of this relevant information is already priced and that’s what’s called the efficient market hypothesis.
All of this information efficiently prices assets for us. And if we understand and put some faith into that efficient market hypothesis and the collective intelligence of all the investors around and all of the big companies and everybody who’s trying to play in the markets to make a profit, bringing all of their information to that auction block, then there’s no value in us trying to express what we perceive as our informational edge to try and earn a profit. Because we don’t know more than everybody does collectively.
This is really hard for us to do as professionals from a sort of mental and behavioural standpoint. We’re used to being smarter and we work harder. And that gives us better results. And that’s been our lived experience in our careers. Ben, can you explain the economics behind this idea a little bit better so that our academic overachiever, intellectual audience can have some faith beyond what I’ve just said?
[0:41:49] BF: I’ve I think you’re right that it is hard for people who are used to being good at stuff and used to putting in time into work and that giving them good results. For people like that, financial markets are particularly humbling. Because if you’re used to having an edge and, all of a sudden, you show up to financial markets, that edge usually goes away.
The simple reason for that though is that markets are highly competitive and the competition is fierce. There are huge firms with tremendous talent and resources trying to be the ones to profit from bringing new information to the market. Most retail investors can’t compete.
Before placing a trade on a stock that you think is going to do well, thinking that you’re expressing information, you have to ask yourself who was willing to sell it to you. And why you think you know more than them? Chances are it was a very well-resourced hedge fund or pension fund that you’re trading against.
But it gets even more interesting than that. Even with the highly-skilled and well-resourced professional traders, they don’t necessarily have an advantage either. There’s this concept called the paradox of skill, whereas the level of participants skill in a competition increases, the outcomes are increasingly determined by luck rather than skill. Those well-resourced, very intelligent traders are trading against each other. If a retail investor shows up, you’re probably in trouble. But even the expert traders, they don’t necessarily have a persistent edge.
[0:43:10] MS: Yeah, it’s kind of like an elite bike race. The top competitors are all going to be near the maximum human output that’s possible and they all have the best equipment. They’re all pretty equally amazing. The winner may be the rider who gets the right gust of wind or missed a pebble on the road. And those are the elite athletes.
And with investing we are not likely even the most trained or best-equipped athletes there. We should just focus on following along for the ride and trying to avoid injuring ourselves.
Specialization Works In Our Career. Not in Efficient Markets.
It’s tempting for us to try and train actually to specialize more. Maybe we can try. If we work hard enough, we can get there. And specialization works well for us in our careers. In medicine, the more we specialize in an area and become experts through managing high-volumes of a specific problem, the better the outcome we get. And that’s partly because we work on near-term problems. And we have control over many of the variables.
And this is common with other non-medical business owners as well. We can research, control our business strategy. We can manage our human resources and our supply chain. We can specialize in a niche that helps us to understand and mitigate the risks better for whatever business environment we’re operating in.
This is one of the reasons why some of us as professionals or business owners have a hard time mentally shifting around to use sound investing strategies. When it comes to investing, most investors are actually far better served by diversifying rather than specializing.
The collective intelligence of an efficient market as a more complete picture of all the information affecting prices than any individual is it’s all priced in. We can’t out specialize the market price unless we know something that no one else does. And if you think you know something that nobody else does, ask yourself who’ll be trading with you. Just as Ben said. And while you’re acting on that, why they’re acting on that information as well. Why do you think you know more?
Not to be discouraging. And you probably don’t. Probably don’t know more unless you’re insider trading, which is illegal. All investments will carry risk. And all investors are competing to find the most attractive investments. Assets, prices will respond to that to the point where they reflect the average of it.
These expected returns are also called priced risks. They’re priced risks. And that means you cannot eliminate them. They’re always going to be there. Fortunately, though, risk and return, expected return are closely related. And we get compensated for taking that risk. What we can also do is recognize that we don’t have special information and avoid taking excessive risks through stock picking or market timing.
And, of course, things will happen that are unpredictable. There’s idiosyncratic events that are unpredictable and they happen. Sometimes a specific company, industry, or region will be effected. For example, a CEO could say something on Twitter that moves a stock, or the government could change the regulations for an industry, or a country could experience some kind of natural disaster. We call that specific risk. And it’s not predictable. And therefore, we don’t get compensated for taking it with the asset pricing.
Fortunately, though, we can actually reduce that uncompensated risk by diversifying. We want to make sure that all the risks we take are compensated or mitigate them as much as we can if we’re not going to be compensated.
Compensated Systematic Risk
[0:46:18] BF: You touched on a market. I want to drill down a little bit more though on this distinction between two types of risk that really matter in investing. One is systematic risk. That’s the type of risk where you earn a positive expected return for purchasing discounted future cash flows.
Systematic risk is also known as priced risk, as you said, and non-diversifiable risk. It’s priced because it’s reflected in the discount rate, which is reflected in the price of the asset. It’s non-diversifiable because you can’t make this type of risk go away by diversifying.
Diversifiable Uncompensated Idiosyncratic Risk
And then the other main type of risk is called idiosyncratic risk or diversifiable risk. And this is the type of risk associated with the specific circumstances of an individual company. Like you gave the example of maybe a tweet or someone said something inappropriate that causes the company to decline in value. That type of risk is not priced. It’s not associated with differences in expected returns. Typically, investors want to diversify away their idiosyncratic risk by owning multiple companies in their portfolio.
The number of companies, the exact number of companies needed to diversify idiosyncratic risk away depends on how you measure risk. But as a generalization, I would say that more diversification is going to be better than less most of the time.
The distribution of individual stock returns tends to exhibit extreme skewness. Meaning that most stocks don’t do very well, but a relatively small number do extremely well. And the result is that you’re more likely to miss out on winners than losers by trying to pick and choose individual stocks.
How Much Diversification Do You Need?
[0:47:46] MS: Yeah. We use diversification to diversify away that uncompensated specific risk. That way we are rewarded for the investments that we do take, the risks that we do take in investing. A practical question though does follow from that. How much diversification do you need to do that in real life? And you mentioned that it’s complicated and that it’s not really definitive. It depends on how you define things.
But basically, the short answer is a lot more than most people think. I mean, some studies have suggested that around 30 stocks is sufficient to eliminate an uncompensated risk.12 But while that may eliminate idiosyncratic volatility, there’s other studies that have found that portfolios with as many as 100 stocks are still likely to underperform the market over long time horizons due to that skewness13 and stock returns that you’ve been mentioning.
And still, other studies14 have found that different approaches to how securities are weighted and rebalanced can improve long-term outcomes for a relatively concentrated portfolio. But that’s getting beyond the basics and into the weeds a bit.
[0:48:41] BF: I think that the good news is, the fortunate thing, is that even if we did decide to let’s go into those weeds, I think the ending recommendation is still going to be pretty similar, which is that most investors should diversify as broadly as possible both within markets and across markets. That means owning as close as possible to all stocks in each market that you invest in.
Take the Canadian stock market. If you’re invested in Canada, you want to own as close as possible to all the stocks in Canada. And that’s how you get your exposure to the Canadian equity risk premium., the risk premium for owning Canadian stocks. But then, also being invested in as many markets as reasonably possible.
In my example just now, you probably don’t want to just be invested in the Canadian stock market. If you think about recent world events, if you’re all invested in Eastern Europe or in Russia market, stock markets, then you would have had seen what some pretty nasty systematic region-specific risk looks like with the invasion of Ukraine.
I mean, if you think about it, whether you had 10 holdings or held the whole market in those regions, you felt the pain of that shock. But if, on the other hand, Russia was just a tiny fraction of your globally-diversified portfolio, you would have been minimally affected.
Another dimension of diversification worth mentioning is industries. Having your whole portfolio in a single industry even if it is globally diversified. Again, probably not a good idea. Because industry-specific risk is not a priced risk.
Unavoidable Systemic Risk
[0:50:03] MS: Yeah, it’s also important to note that diversification doesn’t mitigate all risks away. Only risk-specific to companies, countries or industries, there’s still this systemic risk that hits everything. The pandemic was a good example. There’s market-wide shocks and they predictably will happen. It’s just unpredictable when or how they’re going to happen. And if you’re hearing stories about how that’s going to happen while those stories are priced in.
I mean, fortunately, humanity and markets also adapt and emerge on the other side. As long as you stay broadly invested and stick to your plan, then you can also ride that recovery too.
Let’s just take a moment to recap. We’ve covered a lot of territory there. We covered that people probably need to invest in order to meet their long-term objectives. Financial assets or claims on discounted future cash flows. Day-to-day volatility and financial asset prices is due to changing discount rates. And that’s because of the changing cash flow expectations.
Competitive markets drive the prices of the financial assets and reflect their riskiness. Meaning that to the extent that markets are efficient, earning higher expected returns means taking more risk. And there’s no free lunch there. Long-term investors can earn positive expected returns while short-term speculators are gambling. And unlike in our careers, diversification is probably wiser than concentrating.
With that background, I want to touch on one of the oldest debates in finance. Whether you should passively sit back and own all of the markets, all the stocks in the market., or try to pick and choose which stocks to own., and try to time your exposure to stocks in an effort to ride the ups and avoid the downs. All that trying to outperform the market.
And this is important because the idea that we can use our skills or knowledge and connections to earn higher than average terms is very appealing to people of the type that tend to be successful in their careers as well. Just as importantly, the idea that we can do all of this is often sold to us by brokers and advisors. And they have an incentive to sell products that aim to beat the market. That’s where no one’s going to buy it unless they can project if there’s that value there.
[0:52:05] BF: Yeah. There’s that piece of it. It makes a better sales pitch. The other thing there is that a lot of these actively-managed products, and we’ll get into what that means in a second, they tend to have higher fees. The higher fees create an incentive in some cases for those products to be sold as opposed to a lower fee product. And that can happen with all kinds of different incentives behind the scenes. But the important point is you’re more likely to be sold a high-fee product than a low-fee product by somebody who has an incentive to sell that to you.
[0:52:30] MS: And it sounds more sophisticated and exciting too.
[0:52:33] BF: Yeah. We’ll do an episode in the future on alternative investments and other asset classes where that complexity piece and that allure, I think is really strong. But it’s also really, really dangerous. This is investing basics. We’ll do advanced investing and cover some of those topics.
In broad terms, the idea of just owning the market and not trying to do anything fancy is called passive investing. And on the other hand, trying to beat the market by picking stocks and timing the market is called active investing. These are just the conventional names for those two approaches to investing.
There is a gray area in between active and passive investing. And we can explore that in a future episode. That’ll go in the advanced investing episode. Passive investing is just accepting that the market has priced everything correctly and all you should do is collect the risk premiums baked into prices with a diversified portfolio.
Active investing is implicitly assuming that market prices are consistently wrong in a way that can be exploited by smart investors. Actively managed funds are going to tend to have significantly higher fees than passive funds because a lot more goes into active management. You need to have teams of analysts, and expensive portfolio managers, and expensive technology systems and all that kind of stuff. And they charge a higher fee for that obviously.
In the late 1960s, academic research started to come out suggesting that most professional money managers who used active management to try and beat the market were not actually delivering anything special.15 It’s kind of interesting actually because we needed a model to figure out what returns a portfolio should be producing in order to figure out whether active managers were actually doing anything special. And so, we got this model starting in the 1960s.
After controlling for the expected return from simply taking on the risk of the market, what they found once they had this asset pricing model is that fund managers were not delivering additional returns beyond what would be expected by chance. You basically had fund managers charging high fees but not giving you anything special in return. You could have just been owning the market and collecting that market risk premium.
Then by 1975, the first index fund launched. Index is a group of stocks designed to represent a market. The S&P 500 is an index many people have heard about. That’s an index of 500 stocks designed to approximately represent the US stock market.
Index funds are the quintessential passive investment because they’re just representations of investing in the market. A market itself is not investable. An index is a representation of a market. You can invest in a fund that invests in the index.
When the company Vanguard launched the first Index fund, they were heavily criticized at the time for being un-American and kind of being quitters, “You know what? You can beat the market. You got to be a smart active manager.” We’ve had people on the Rational Reminder podcast who were involved with that whole Index fund movement. And the stories they tell about how they were criticized, it’s pretty intense.
[0:55:25] MS: It’s fascinating. Yeah, it’s fascinating.
[0:55:28] BF: Then the thing that happens though is more academic research keeps on being pumped out suggesting that active managers don’t tend to beat the market. And index funds on the back of that research and on the back have just lived experience by investors, index funds increasingly gain popularity.
Today, index funds are common. Anyone who’s investing has even a little bit of – dip their toe in the water of investing. You’ve probably heard about index funds today. And they’re also extremely common in the portfolios of individual investors and investors in general actually. Institutions as well. And index funds make up a huge portion of the assets held in funds around the world. There’s so much complex in investing.
Not All Index Funds Are Good
We do have to be careful saying that just index funds are kind of objectively a good thing. Since index funds have become increasingly popular, fund providers have created index funds that look a lot more like an active fund than a traditional index fund that just owns the market.16
The paper that documents this, they kind of suggests that there’s some marketing spin here where consumers started to view index funds as good. Fund company said, “Okay. Well, we’ll make a high-fee product that behaves like an active fund, but we’ll make it track an index so we can call it an index fund.” That can get you into trouble. Because if you buy something just by the label index. I just wanted to make that point because we can’t just shut off our critical thinking and assessing an investment just because it’s labeled as an index fund.
[0:56:50] MS: Yeah, I think that’s a great point. And you did mention the aspect of fees with that. You can make it look like an index and have a lot of fees. And I think we need to understand the active-passive management debate, the impact of fees. And it’s vital to understand when you’re choosing your investments.
Active Management & Downside Protection Claims
Part of that is because when someone tries to sell you something, they need to convince you of their value. And it’s very common and learning argument that goes along the lines of, “Oh, why blindly track the market when you can have a professional manage your money?” And, of course, that’s going to cost you more money to do it. But it’s worth it because they’re definitely worth their price. Or why hold on to Investments when a recession is coming? That’s dumb. You need an expert that’s going to see that and adapt your portfolio, which, of course, means a lot of research and resources and people trying to do that. We said it’s really hard.
And we have experts that seek out opportunity and take advantage of it. There’s all sorts of ways you can spin it to make sound like the cost that you’re paying is definitely going to outperform and be worth it. We need to see how that actually pans out.
[0:57:46] BF: Yeah. I mean, those kind of fear tactics and just arguments for why you need active management. Those have been around for a long time. They’re still around today. But like you said, Mark, let’s go to the data. When you actually look at active fund performance, the problems you run into when you hear all of those pitches for active management is that there’s very little evidence supporting the ability of active managers to deliver on those types of promises. They don’t add consistent value by, for example, navigating recessions.17
There is a recent example in the COVID-19 crisis. Most active funds underperformed passive benchmarks even if there are skilled managers out there.18 There’s another interesting point here, which is that the market for manager skill is also efficient. Theory and evidence both suggest that investor dollars flow to the most skilled managers to the point that the managers are no longer able to deliver anything special.19 Those studies are to me extremely interesting.
Manager Skill Becomes Self-Defeating
We talked about market efficiency and stock prices, right? Where it’s if there’s a stock that has its price too low, well, that’s an inefficiency that everyone’s going to try and get their information in there and they’re going to bid the price that stock up to the point where its price reflect its expected return. The same thing happens with active fund managers.
We’re not saying that fund managers are not smart. We’re not saying that they’re not skilled. But the challenge is, if there is a skilled fund manager that delivers some good returns, dollars are going to flow to them to the point where they can no longer allocate those dollars in a way that delivers returns to investors.
[0:59:11] MS: Even if you picked someone. Like, you could try to pick the Amazon as a company, but you had to have picked it before it became such a big, dominant company. And you could pick Berkshire Hathaway as a management fund and those managers. But you’d have to pick them all before that happened and before they achieved all of that success to really cash in.
[0:59:31] BF: That’s exactly it. You’ve got to identify them before the market does. Just like with stocks. If you want to pick a good manager, you have to identify an inefficiency in the market for manager skill. Which, again, similar to picking stocks, is super hard.
Most Active Managers Underperform. By A Lot.
There are a couple of good industry reports that track the performance of actively-managed funds versus indexes. SPIVA is one. That’s done by Standard and Poor’s. They’ve been doing this for a little over 20 years. They have data going back for a little over 20 years.20
If you look at the 10-year performance numbers for Canada, percentage of funds that have lagged the index is 85% to 98% depending on the market that we’re looking at. Now that’s performance net of fees. It’s important to note though, passive ETFs tracking the same indexes would have also lagged their index. I’ve heard that counter argument from proponents of active management a few times where, yes, it is true that if we compare the performance of passive ETFs to their indexes, 100% of them will have underperformed.
But the difference is the magnitude of the underperformance. Because the index funds might have underperformed by whatever, 35 basis points. 0.35% a year on average because of fees, and transaction costs, and maybe some withholding taxes. But if you look and actively-manage funds, the magnitude of underperformance is more in the order of 1% to 2% a year because they have higher fees and costs.
There’s another report from Morningstar that looks at that.21 They show that it is about that 1% to 2% a year of annual performance lag on average. When they separate funds by their fees, the highest fee funds tend to lag the most and are also the least likely to survive. Fees are related to performance. We kind of know that in a bad way. You can’t think that you’re going to get the best performance by using the most expensive manager. It’s very different from other domains of life where paying more gets you more. In this case, paying less gets you more. There are also lots of published academic papers documenting this active manager underperformance phenomenon.22
Manager Persistence: Winner Today & Loser Tomorrow
[1:01:24] MS: We talked a little bit about this with Warren Buffett and other people. There are active managers that may not trail the market. Some active managers will outperform. And sometimes active managers deliver eye-popping performance results. And those then attract a whole bunch of investor inflow dollars.
The problem is that the active manager performance is also not persistent. And we saw that with some of the big funds during the pandemic that were pretty popular. It means picking the best manager from a previous period does not increase your odds of outperforming in the future. In fact, picking the past winners tends to make you worse off than picking the losing funds. And there’s data to support that as well.23
One of the reasons is maybe the concept of decreasing returns to scale24, where a skilled manager, they’re rewarded with investor dollars. But the ability to use those dollars to generate outsized return then diminishes. In other words, the managers are rewarded for their skills still. I mean, they still collect all the fees and all the money that comes from all the inflows. But the investor are not able to share in the rewards unless they identify that manager before everyone else. Kind of like picking the winning stock before everyone finds out about it.25
Those interest reports we mentioned earlier tracked this. For Canada, they found that not a single fund that was in the top quartile in the previous five-year period remained in the top quartile for the next five years.26 Picking the winner now is likely to underperform. You can’t just pick the right manager.
[1:02:51] BF: Yeah, there’s academic research on that too. It’s this whole concept of manager persistence. And the evidence is not so good.
[1:02:58] MS: Yeah. We’ve talked about stocks, and bonds, and active versus passive investing. But to finish today’s procedure, it’s important to clearly explain two important investment vehicles that we can use. One is mutual funds and then one is exchange-traded funds or ETFs. And these are investment vehicles that are pooled funds. And they enable investors to purchase a single unit. And then with that, they get access to a diversified portfolio through the fund.
You don’t have to go to try to buy thousands of stocks to be diversified. You can buy one unit of the fund. And the number of types of stocks depend on the fund’s objective. For example, a total US market fund would hold thousands of US companies. But in contrast, a niche fund to cover Canadian banks may only hold the six major banks. Just by virtue of buying a fund it does not mean that you’re diversified. You have to look what the fund is actually trying to do.
[1:03:47] BF: Now, this is super important. It’s kind of like the cautionary note I gave earlier about index funds are not inherently good. Mutual funds and ETFs are similar. They’re just wrappers. ETFs and mutual funds are not inherently good or bad. It’s the underlying strategy and the cost of implementing that strategy that matters to investors.
[1:04:05] MS: Yeah. And there are some divisions that you can tell a bit about. Mutual funds will come in different series. There’ll be an A series that’s usually sold via commission-based mutual fund sales advisor. There’s F series that are usually used by fee-based advisors that’ll charge you fees in another way. And then there’s D series that can be bought by a DIY investor using a discount brokerage.
And as you can imagine, the A series is going to have higher fees that help to pay for the commissions to the sales advisors. Whereas the F and D series will have progressively lower fees than that.
But that said, the fees will differ. And based on the investment strategy and the company issuing the product, generally, mutual fees or fund fees are often higher than ETF fees for a couple of reasons. You can probably tell us a little bit more about that, Ben.
[1:04:49] BF: Yeah. Mutual funds, they’re going to have slightly higher operational costs than ETFs since mutual fund units are bought and sold through the fund company, which results in some record-keeping costs. While ETF units trade on the open market. There’s just a little structural difference there that can slightly increase cost.
But I think that’s probably relatively minor. And especially for larger funds, it’s probably almost irrelevant. The more important piece is that most ETFs are passively managed while most mutual funds are actively managed.
We have data on this. We do a report on this once a year. PWL does. In 2022, we found that 97% of mutual fund assets were actively managed while only 30% of ETF assets were actively managed.27
[1:05:32] MS: This is important. And just to be clear, there are high-cost ETFs. Some of those actively managed ones would be what those likely are. And there’s low-cost mutual funds as well. It’s not just ETF or mutual fund that matters. It’s the cost. But to generalize, ETFs will tend to have lower costs.
And the other thing is ETFs, they can be bought and sold directly on an exchange using a discount brokerage. They’re publicly traded securities. And in contrast, some of them can actually be proprietary. And that means you can only buy them and hold them at the institution that you bought them from. For example, a bank. And then you’d have to sell those mutual funds to move your money, which can be a real nuisance.
The other thing to finish up with is a bit about investment costs. Literature on investing very clearly demonstrates that fees and costs matter. We talked a bit about that already. And fund management fees and operational costs are one source of those costs. And those are easily visible. And they wanted to be able to identify that.
This is a practical point about identifying it. You can often see a lot of that in what’s called the management expense ratio or MER you’ll hear it referred to. But active and passive funds differ on another dimension of cost as well. And you don’t always see that very easily in the funds’ MER. They also have Trading Expense Ratios. So, they have to buy and sell things within their fund.
And as you can imagine, a fund that’s more actively managed is going to have more of those trading costs. And you’ll find that in a document called the Manager Report of Fund Performance. But you have to kind of dig for it. The MER is usually presented right up front on the literature now for whatever the product is. But they can be quite large, particularly for these active funds. And it would not be unusual for the uh trading expense ratio of an active fund to actually exceed the MER of an index fund. Trading expenses are also typically around zero for a passively-managed fund ETF.
Taxes are another big challenge for that active environment. It’s not just picking the renters and the losers and trying to tailor it. It’s the buying and selling that they do. And when you buy and sell things, that also brings another layer in which is tax. And sometimes those transactions are taxable transactions inside the fund. And those taxable gains then need to be distributed to the fund holder. After taxes and trading and everything, the gap and performance between active and passive managers is actually even larger.28
[1:07:48] BF: There’s an interesting research on that showing that even cases where funds have an alpha, where they’ve produced excess risk-adjusted performance, when you look at them on an after-tax basis, that alpha goes away. It is a really important consideration.
I do also want to touch on the difference between fund fees, which we were just talking about, and advice fees, which we sort of touched on. It is confusing because those fees, in the case of the A-class funds that Mark mentioned, they’re bundled together. Those different mutual fund classes, we’ve got the F-class mutual funds. Those don’t have any advice fees built into them. That means that you’re only paying for the cost of the fund.
Now you would typically get an F-class fund from a fee-based financial advisor. Meaning that the financial advisor is charging you some agreed upon fee directly in exchange for portfolio management and advice. A commission-based fund, that’s the A-class fund. Although there’s like a ton of possible different fund classes, but A class is typically going to be the commission-based one. That’s got the advice fees built into it.
That means that the fund is paying a portion of the fees that you pay to the fund to the person or firm who sold it to you. That causes all kinds of problems. There’s a clear conflict of interest there. Because if I’m a commission-based financial advisor and I want to get paid, well, I have to sell you a fund that has this commission structure built into it. And those funds tend to be higher fee in general.
Even when you disentangle the advice fee and the fund fee, those just tend to be like higher cost, actively-managed funds that are sold on that commission basis. If you have a financial advisor who you’re not explicitly paying, if you haven’t like signed a document agreeing on the percentage or dollar amount that you’re paying in fees, there’s a good chance that they’re earning those trailing commissions from a mutual fund that they sold you. Due to the built-in advice fee, A-class funds are going to have much higher fees than F-class funds. But it’s important to note that to compare your total fees between an A-class and an F-class fund, you would have to also, on the F-class side, add in the fee that you’re paying directly to the financial advisor.
On average, in Canada, in 2022, commission-based equity funds have an MER of 2.25% while F-class funds are at 1.07%. But to reiterate, with the F-class, you would then have to add in the fee that you’re paying to an advisor. That might be 1%, or more, or less depending on the situation.
[1:10:02] MS: Yeah. That’s really important. You have to know what you’re paying. You have to know the fund costs and the advisor costs together. We often latch on to one and not the other. And that cost is only one side of the equation. A financial advisor can provide some good value for the money that you’re spending. But if they provide good planning advice and coaching, there is a cost and a value-sided equation. And we’ll examine that critically later on the podcast series.
However, I would say that the investment management piece is likely a minor source of value other than the convenience and reliability of not having to do the basic tasks yourself. Plus an added layer of protection between your emotional brain and the buy-sell button. I mean, those are probably more important.
I mean the average retail fund fees in Canada in 2022 were 1.76% for equity and 0.89% for fixed income funds.29 And this is an average that includes-commission based and fee-based funds. It’s a bit messy since some of those fees are going towards advice rather than fund management. But if you look only at the F-class funds, the fees, as mentioned, be more like 1.07% and 0.71%. These are actually still amongst the highest in the world in Canada. That’s important to know.
Whereas, if you contrast the index mutual funds and ETFs to each other, they’re available at a much lower cost. Below 0.3% on the high end and much lower on the low end. You can even get some ETFs with .03% fees. That difference of fees can make a big difference in the long run.
Let’s say, just for the sake of easy numbers, that the difference in cost between an actively managed portfolio and an index fund is 1%. It’s like actually swimming with an anchor. If the holdings go and your fund goes up by 10%, well, you get 9% because that fee gets taken away. They go down by 10%, you actually get -11%. The fee is still there, whichever direction the markets are going.
And a percentage is one number. But on a million dollars, 1% is $10,000. If you think about the cost of $10,000 per million per year, it registers differently. Let’s compare two investors. Both have a pre-tax expected return of 6.25%. One invests in index funds that cost them 0.25% a year. The other invests in active funds with an MER of 1.25 a year. That a 1% difference. And they both save diligently. They put $100,000 per year for 30 years.
At the end, when they’re ready to retire, the lower fee portfolio has accumulated $1.4 million dollars more than the higher fee portfolio. And if you start adding in the trading expenses of an active fund, which could easily add another 0.1%. Often more. And you add in some of the tax drag that comes along with the trading going on inside the funds. Let’s say, together everything’s 0.5% with that trading and taxes. The difference in wealth after 30 years with these assumptions is like $2 million. It’s big money in real dollars when it’s maybe just a small percentage difference.
[1:12:57] BF: Well, Mark, the patient’s heart rate really took off with that last segment. I do have a couple more issues though that makes it even worse. You won’t get the average return of actively managed funds. Your specific fund will perform some amount better or worse than average. Now that could be good news if you can pick a winning fund as we’ve talked about. Because the winners can win quite big.
But similar to stock returns, active manage of returns exhibit substantial skewness.30 That means that well you could get lucky picking a winning fund, most funds are going to perform a little bit worse than average. And in some cases, a lot worse than average. And it’s also just important to note that that introduces another layer of uncertainty.
Forget about everything else. Forget about average performance and all that stuff for a second. The other issue that it introduces is uncertainty about you don’t know where between – on which side of the average and to what extent you’re going to fall. That makes planning for the future that much harder.
[1:13:51] MS: Yeah. I agree. I’m not comfortable with these vitals though. I think we better end the procedure. But that’s okay. We’ve gotten in some good experience with the basics of how to drive this big, massive Colono-Money-Scope around some of the basic anatomy of investing. And we even learned how to spot some of the financial bovine feces along the way or financial bullshit to use the proper academic terminology. Overall, this is a pretty good excreting exam.
For our post-op debrief, in this episode we introduced the basics of why we invest and why we should be careful to invest rather than gamble. We discussed what you’re paying for when you buy a financial asset as an investment interest. An investment, you’re buying its expected future cash flows. And the future is uncertain by its nature. But the market price is the average of the collective knowledge of all of the entire competitive market.
[1:14:41] BF: Yeah. And the market is really good at pricing financial assets since everyone wants to profit by bringing new information to the market. Since information is dispersed, it’s virtually impossible for any one investor to consistently beat the market without true insider information. Even full-time analysts only get pieces of the total picture and they can’t predict the future consistently either.
One thing that you can be sure of is that if you’ve seen it, read it, heard about it from family or friends or probably even if you’ve thought about it, it’s already reflected in market prices.
[1:15:10] MS: Yeah. And it’s true that the occasional profit opportunities will pop up in the market and some investors will exploit them. But the problem is that even a skilled fund manager or an investor cannot consistently take advantage of them enough that they can turn a profit, especially net of fees and taxes.
There is a lot of data to support the lack of persistence in active manager performance. But we still struggle with all this as professionals because we’re so used to specialization leading to better outcomes in our daily work.
[1:15:39] BF: Inefficient markets – the smartest way to invest by far is by diversifying broadly to capture the expected returns reflected in market prices. We get compensated for taking on priced risk. But we do not get compensated for the idiosyncratic risks that poorly diversified investments and gambles exposes to. Since we can’t control or predict future market returns, smart investors focus on the things that they can control, which are things like their fees, their costs and their taxes. Actively managed portfolios are going to tend to have higher fees and costs, and worse, tax efficiency relative to passive funds.
[1:16:13] MS: Yeah. And overall, investing lifetime, fees compound. And that could easily eat a third of your portfolio if you’re not paying attention to it. And that also brings us to your homework. If you use mutual funds or ETFs, look at what the MERs are. Look for those expense ratios. If you use a financial advisor, find out what you’re paying them and also find out what the combination of both the fees of the products and their fees together add up to. Because that’s what you’re actually paying.
And a financial advisor can provide valuable advice. But the value relative to cost is generally hindered by using high-fee funds. And if they are using high-fee funds, then you want to ask why that is. And when you listen to the answer, remember the evidence that was presented in this podcast. If you want to see the difference that fees makes, you can plug your numbers into the T-Rex Score on larrybates.ca. That’s how I did the quick demonstration of fees eating a bunch of a portfolio’s growth that we talked about in the session.
[1:17:06] BF: Yeah. Avoiding speculative investments, high-fees and uncompensated risk is only part of building a successful portfolio. We hope that you’ll join us for the case supplement to this episode where we’ll discuss an established professional with a portfolio and a pile of cash to invest who’s worried about the economic news. A retired physician who wants to switch to index funds but feels stuck. And an early career professional who wants to bet big on investing in a high-growth industry and. Then in our next episode, we’ll elaborate on the other aspects of being a successful investor, putting these pieces together with an asset allocation strategy. And then also, where to locate those investments using different types of investment accounts.
