A Happy New Year

The Canadian markets are still celebrating their holidays and the TSX is closed on Monday.

Posting will resume then, along with the year-end update and predictions for 2011.

It is always good to take a refresher away from research. Keeping your mental batteries charged throughout the year is just as important as making good investment decisions – one leads to the other.

End of year decision-making

Posting will continue to be light in the final couple weeks of the year. Part of the luxury of not having to be forced to deploy capital is that I can be patient, and this time of year is usually a good time to do anything other than work-related work!

I did manage to unload a few more debentures of a very poorly performing corporation that I have written about in the recent past; this is purely about mitigating potential credit risk in 2011.

Also, I have been investigating the potential usage of cheap leverage given that it is unlikely Canada will be increasing its short term rates soon. This kind of notion is unfortunately a year too late, but there are still options available that would seemingly yield some fairly low-risk return on investment.

Indexing is also an investment decision

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.