Divestor

Michael James wrote an post explaining why he invests in index ETFs and not individual stocks, stating that it is about knowing his personal limitations:

After reflection, I’m convinced that my choice to invest passively in index ETFs is fundamentally a statement about my own limitations.

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This brings me to my next limitation: I don’t believe that I can figure out which money managers will outperform.

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As you might guess at this point, I have a third limitation. I don’t believe that I can figure out which advisors can pick winning money managers.

Knowing your own limitations as an investor is a very important skill, and Michael explains why he thinks he can’t outperform the index, nor can he choose money managers (or financial advisers that recommend such managers), so therefore he sticks to index ETFs.

This leads me to my next logical question: What makes him think that investing in an index is going to provide a superior risk/reward than holding cash inside a GIC? Other than pointing to a chart with some very long-term x-axis (30 years or greater), it is not clear to me why equity indexes should outperform cash.

Also, assuming that investing in “the index” is superior, what index should you choose to invest in? The TSX 60? S&P 500? Some midcap or smallcap index? Or a smattering of all of them?

One flaw most people have in the marketplace is the implicit assumption that stocks, as a whole, will outperform alternative investment classes (bonds, cash, commodities, etc.) over the long run. We could continue our historic 9%-a-year nominal climb up in the major indexes, or we could enter into a period of decline (e.g. Russia’s stock market in 1900 was the third largest market in the world by capitalization, and we all know what happened there), and we would not know either way at present which will be the case.

The only way an investor can outperform in the marketplace is by selecting investments that are trading below fair value. If an investor cannot explain why an index is undervalued when they purchase it, I would not automatically assume that the index would be outperforming alternative decisions at the time of investment.

An investor completely unwilling to dabble in equity risk (including preferred shares) would have a morally consistent argument by opting for the 100% GIC-only strategy. You can usually get higher returns with GICs than most bank debentures.

As I have said to some other relatives that have come to me seeking investment opinion, “Making 2% a year is a lot better than losing 10%.” Usually it takes such a loss before people realize the impact of such a statement.

The end of year trading is dominated by two forces, none of them fundamental in nature to companies’ economic prospects:

1. Window dressing – fund managers do not want to be seen with a year-end holdings of market “dogs”;

2. Tax loss selling – people that jettison positions in their portfolio with unrealized losses so they can harvest the capital loss for the 2010 tax year. Correspondingly there will be some supply at the onset of 2011 of 2010’s gainers.

This is probably why I have not been writing lately – I’ve been drafting up the 2011 outlook.

Since the last two weeks of December are usually a write-off, markets are more illiquid than usual. Retail investors can take advantage of the corresponding price swings to add or subtract positions if such swings are unusually sharp.

This is in direct response to Larry Macdonald’s post with respect to referral schemes and financial services. In his post, he how ING Direct has a referral scheme where people can receive $25 if they refer people that open up an account with ING Direct.

Another example is most Canadian finance websites proclaiming their love for a certain discount brokerage firm, an excellent review, and all the meantime displaying the referral code readers can use to sign up for the same firm.

Another example – pick your average TD mutual fund and tell me how much a financial advisor or salesman would receive by putting his client into the balanced fund of the day. Or the kickback an advisor gets by signing up his/her client in a whole life insurance scheme.

These sorts of marketing schemes absolutely bias the people that try to refer financial services onto others, whether funds, brokerage accounts or ING. This is primarily one reason why you won’t see me posting links to referral schemes. They undermine the credibility of the poster.

The only products and services I will be selling are mine.