COVER

Building wealth the smart way

Three financial experts offer their prescriptions for successful investing

January 27 1997
COVER

Building wealth the smart way

Three financial experts offer their prescriptions for successful investing

January 27 1997

Building wealth the smart way

COVER

Three financial experts offer their prescriptions for successful investing

Buy low, sell high. That old adage of investing sounds easy, but even many experienced mutual-fund owners find it hard to avoid costly errors. Maclean’s invited three investment professionals—John Kaszel, director of academic affairs and research for the Investment Funds Institute of Canada; Wendy Brodkin, manager of asset consulting at Towers Perrin; and Eric Kirzner, adjunct associate professor of finance at the University of Toronto—to discuss the most common investment errors. Edited highlights:

Maclean’s: What kind of mistakes do you see mutual-fund investors making?

Kaszel: Mismatching objectives and unreasonable expectations are two problems that go hand in hand, and I think we’re going to be seeing a lot of them this RRSP season. You have individuals who are looking for regular income and yet they invest in a high-risk growth fund. If they understood what they were buying, they would have never bought that fund in the first place. The other problem is that everybody’s looking at those double-digit returns in 1996—some in excess of 20 per cent—but many of these funds are not going to be able to repeat those performances. So we’re encouraging fund representatives to temper their clients’ expectations.

Brodkin: I think the real mismatch concerns consistency—the investor who assumes that because he got a high return this year, he’s going to get a high return next year. In fact, it’s the opposite: if you get a high return this year in Canadian equities, your return next year is probably going to be zero. People think there’s some consistency built into it when in fact there is not. Kirzner: The way I look at it, there are two numbers. If you look at a balanced portfolio over the past six years, you’ll see it came in around 12 per cent a year. But if you look at long-term trends, the average is between seven and eight per cent. Equities come in around 10 per cent, bonds come in around six, maybe 6.5, treasury bills at four or five, based on long-term inflation of about three per cent. So the magic number is around eight, and that’s probably the best projection you can come up with for the future. Brodkin: What worries me is not what people overlook in picking funds, it’s that they’re picking funds in the first place instead of setting out a diversified investment policy and sticking with it for 10 or 20 years.

Kaszel: You’re right. A major error of a typical investor is the failure to look at a proper allocation among asset classes. A lot of

them practise diversification among funds—say, four different growth funds. That isn’t enough.

Brodkin: My favorite story involves a group of sophisticated directors on a corporate board in 1993 when the international markets did just great, 38 per cent, and their particular fund did 40 per cent. One of the guys said, ‘Heck, my mutual fund did 100 per cent.’ It turned out he was talking about a Hong Kong fund. Well, the Hong Kong market as a whole did 120 per cent that year. In other words, he wasn’t considering the market effect. Kirzner: I couldn’t agree more. I can’t tell you how many phone calls I’ve received from people saying things like, ‘My Latin American fund is down eight per cent. What am I going to do?’ Then it turns out he also has some European funds and they’re up 20 per cent. My approach is, look, it doesn’t matter what the Latin American fund is doing, it doesn’t matter what the European fund is doing. How’s your portfolio doing?

Maclean’s: How can investors determine what should be in their portfolios?

Brodkin: I get calls like this all the time. Frankly, I don’t think you can measure the worth of a good financial planner in this business. But where are the financial planners who are supposed to be telling people things like this?

Kirzner: The lesson is, do a good job in your asset allocation and 80 per cent of the battle is won.

Kaszel: But how do you know the appropriate percentages? There’s no unique solution.

Kirzner: No, but there are reasonable guidelines. My basic approach is 20 per cent safety, which means treasury bills, money-market funds and cash; 30 per cent income—that’s bonds,

i don’t think there’s any rhyme or reason for the fees being charged’

mortgages and GICs; and 50 per cent growth, or equities. And virtually every time I describe an asset-allocation program, it’s somewhere close to that range.

Maclean’s: Is the problem that there is a shortage of good financial planners?

Kaszel: You have to be careful. There are a lot of labels in this business: investment advisers, financial planners and so on. Most people are dealing with a financial services rep, and only about 15 per cent of them have the skills to do a proper analysis of the needs of the individual in light of what’s happening in the market.

They’re more likely to sell the flavor of the month.

Kirzner: I think sometimes people are getting the right message but it’s not what they want to hear.

Kaszel: You’re right. They’re hearing that their neighbor made 35 per cent, whereas they’re averaging 13 or 14 per cent. They’ll say to their rep,

‘Hey, why didn’t you put me into that fund that earned 35 per cent?’

Brodkin: Again, it’s unrealistic expectations. One of my clients says the problem is that people think investing is exciting—there’s a sense of greediness. In reality, investing is boring. You take your money and you invest it. If you want some fun, go to Las Vegas. Kirzner: Or take two per cent of your portfolio and set it aside for excitement. Otherwise, you’re talking about ‘lottery syndrome’—the fear of missing out on the big one. It’s a mental demon and it’s very dangerous.

Maclean’s: Do you agree that investors aren’t getting good advice?

Kirzner: I agree we’ve got a long way to go in training advisers, but we’ve also got a long way to go to educate the public. I like the comment that people think investing is supposed to be exciting instead of hard work. It turns out that the person who’s been willing to grind it out for the past 20 years with a nice, steady assetallocation program has done very well.

It’s hard to imagine a diversified portfolio that hasn’t performed well over the past 20 years.

Brodkin: I don’t think it’s that people aren’t trained or educated well enough.

I think the point is that there are no generally accepted standards for investing.

What are realistic expectations?

Kaszel: The current standard is that more is preferred to less.

Maclean’s: You mentioned the excitement-seekers. What kind of mistakes do those people make?

Brodkin: Number 1, people look at the short term rather than the long term. I know people who have been sitting on the sidelines [rather than investing] in U.S. equities for a couple of years now, waiting for the crash. Well, even if the market did crash like it did in 1987, a year later it would be back to the same level. So why do people care, unless they need the money now? And if they need the money now, they shouldn’t be in the equity market in the first place.

Kirzner: Exactly. You’ve got to sit back, build that portfolio and let the returns come to you. If you tactically trade, you run the risk of being out of the market at the wrong time. That’s very dangerous. You shouldn’t be changing your mix unless your needs change.

Kaszel: But once you establish your portfolio, there should be some management. I think people are sometimes too passive to make some modest corrections or adjustments. Brodkin: Yes, but there’s a danger in tinkering. I’ve seen even very sophisticated investors say things like, ‘My money managers aren’t doing well—I’m going to flip over into an index fund, which simply tracks the market.’ And all of a sudden you go into a bear market and they’re saying, ‘Gee, I’m underperforming so I’d better flip back.’ They’re going back and forth and they’re getting whipsawed.

Kirzner: That type of trading occurs at the individual investor level and at the portfolio manager level, and all it leads to is dead-weight losses and costs in terms of being out of the market at the wrong time. That’s the biggest mistake people make. Brodkin: Coming back to [making corrections or adjustments], I think the danger lies in how much they’re going to adjust their portfolios.

Kaszel: I’m talking about modest adjustments. There are some people who establish their portfolios and stick with it, no matter what. Personally, I believe strongly in rebalancing your portfolio over time to take account of market movements. Kirzner: In other words, if you’re targeting a ratio of 40-percent debt, 60-per-cent equities, and as a result of a strong equity market the balance has moved to 30-70, rebalancing would mean selling equities and buying debt to bring it back to your target. That’s all.

Maclean’s: Suppose an investor understands diversification and asset allocation. What should that person keep in mind in choosing specific funds? For example, what about things like loads—commissions—and management fees?

Kirzner: I think a lot of people focus on loads and ignore the interaction with annual advisory fees. Some investors focus on no-load funds and overlook the fact that those funds may have higher advisory fees. You have to look at the entire package. Kaszel: That is a valid point, but I don’t think costs are that critical. I believe the expected return is more important. Management fees and related costs are more relevant for a fixed-income fund, such as a money market fund, where the costs represent a high percentage of the return, as opposed to equity funds where the costs as a percentage of expected return are considerably less.

Maclean’s: What’s your perspective on fees?

Brodkin: Number 1, I don’t understand why anyone’s paying anything for any fixed-income money market fund or bonds.

Kaszel: There are structural costs that have to be borne. Brodkin: I don’t know how we got into this mess, but I don’t think there’s any rhyme or reason for the fees that are being charged. The other point is this load business—this is the thing I can really get excited about. The loads are being charged to pay for the sales force, and what the sales force is doing is giving lousy advice because they’re not being paid directly for it. I mean, how many financial planners out there are actually paid for financial planning? Five per cent, tops?

It’s called ‘lottery syndrome—the ear of missing out on the big one’

Kaszel: Barely five per cent. But that’s a function of consumers. A proper financial plan can take from eight to 10 hours. You’re looking at $100 or $125 an hour for the expertise. And consumers will not shell out $1,000 or so for financial planning advice.

Brodkin: They’d rather buy a lottery ticket.

Kaszel: My point is that there has to be dramatic change before we have more financial planners delivering services on a fee basis as opposed to relying on things like trailer [advisory] fees.

Kirzner: But that gets to the heart of what’s wrong with the industry— its lack of transparency. A typical investor sees a no-load fund and assumes that a salesperson isn’t being paid. In fact, the salesperson is getting a portion of the advisory fee.

And they may not be earning what they’re getting.

Maclean’s: Is the problem that consumers are unwilling to pay for independent advice, or that the industry is overcharging?

Brodkin: I think it’s both. And the reason that consumers are unwilling to pay for advice comes back to this lottery-ticket idea. They don’t think that it’s hard work so they don’t put any value on it. This brings me to another point. If people don’t have the time to monitor how their fund manager is investing, they should consider an index fund that will just give them the market return. That way they don’t have to worry about how the fund is run. Because one of the big problems now is that these mutual funds are not being monitored—everyone thinks that someone else is looking at them. Kaszel: What do you mean by monitoring? Do you mean whether the manager is deviating from stated objectives? Brodkin: I mean things like unauthorized transactions. Or a slow deterioration in results because they’re not investing the way they were before. Those are the things that can happen when the managers know that no one’s looking at them.

Kaszel: I thought you were concerned that fund managers may alter their strategies to reflect new developments. You’re alluding to questionable activities?

Brodkin: Both. Style slippage and questionable activities.

Kaszel: I’d like to think my portfolio manager would adjust his strategy to reflect new realities. If he can get an extra one or two percentage points because his research indicates he’s better off overweighting the oil sector, I’d be happy with that.

Brodkin: I’m not just talking about management styles. For example, a manager just cost one of my clients $1 million because they didn’t allocate certain securities to the client’s account. The response was, Whoops, sorry, we forgot. Our computer system didn’t do it.’ So I’m talking about real mistakes. Or in some cases it may be dishonesty—who knows? And in the case of a mutual fund, with a whole bunch of investors, there’s a dilution of accountability. My background is in auditing, so I look for high-risk situations. And that is a high-risk situation, where everyone thinks someone else is monitoring.

Kaszel: But there’s so much information collected on mutual

funds. There’s a lot of informal monitoring and if there’s something unusual it comes out pretty quickly. The fear of negative publicity is quite high.

Maclean’s: If the problem is that most investors are ill-equipped to do this kind of monitoring, what should they do?

Brodkin: This comes back to the financial planner. That person’s job is, number 1, to make sure his or her clients have a diversified portfolio; number 2, to make sure they’re getting the returns they should be getting; and number 3, to make sure that nothing funny is going on. Kirzner: There’s another point I want to slip in and it gets back to the active/passive question. Investors have to be careful when looking at long-term returns because the lists are biased upwards.

I call it ‘survivorship bias.’ If you list the performance of funds over the past 10 years, the funds that disappeared over that period don’t make the list. They disappear either because they did so poorly they closed down, or they changed Kaszel: the fund their name for cosmetic reasons or they were swalIndustry’s fear of lowed up by other funds. So whatever the numbers negative publicity show for the performance of equity funds over the

is quite high past 10 or 15 years, there’s an upward bias because it

doesn’t include the real dogs that disappeared. Brodkin: That’s one of the problems with the emphasis on return and performance-measurement standards, when in fact everyone knows that the numbers themselves don’t mean anything. Kaszel: Well, if we didn’t have those standards a lot of people would be cooking things up.

Brodkin: They already cook things up.

Kaszel: Well, it’s not as bad.

Maclean’s: We’ve just been through a wildly bullish year and there’s clearly a lot of nervousness about a possible crash. It sounds like the sort of environment in which investors can easily go wrong.

Kaszel: Well, I think everyone’s looking at the future and making certain assumptions. If we have stable interest rates and a reasonably good market, mutual funds are still going to be the in thing. But the key is to have a balanced portfolio. Don’t go for the home runs—go for the singles. Brodkin: And if you have a financial plan or an investment policy, use your RRSP contribution this year to rebalance back to it. You might want to put more money into fixed income this year just to balance off what’s happened with equities. But these are changes on the margin, not to any great extent.

Kirzner: Yes, I would only tilt. If my long-term target is 20 per cent safety, 30 per cent income, 50 per cent equity, I wouldn’t even try to predict what’s going to happen this year. If I was really nervous, I guess I would put a higher proportion of my RRSP contribution this year into fixed income instead of equity, but that’s the only concession I would make to nervousness. And frankly, if you have the stomach for it and you’re in for the next 10, 15 or 25 years, don’t even tilt. Go with 20-3050 and be done with it. □

if we didn’t have those standards, people would be cooking things up’