Category: Finance

If a 10-year government bond yielded 8%, and a fixed income investment in some corporate debt for the same term gave out 6%, what would you invest in? Assuming sovereign default is not an issue, every rational investor would take the government bond.

So the floor price for the corporate security would be a yield of 8%, if that security was perceived as having zero default risk.

It is likely investors would demand a premium over 8% to justify the extra risk that is embedded in the corporation.

However, if the government bond yield went up, the yield for the corporate security should rise an equivalent amount.

Finance textbooks would like to isolate this to a single variable, but the reality is not that clear – finance and economics are a multivariate game, and hence you cannot say that a 1% rise in government bond yields would result in a 1% rise in the corporate security. However, more often than not, you would see a rise of “around” 1% assuming default is not in play.

Since income-bearing equity is a perpetual claim on a corporation’s residual assets and cash flows, it would suggest that an increase in long-term government bond yields would also increase the yields on equity (hence, lower prices).

Paying attention to the Bank of Canada long-term government bond rate, currently around 3.6%, would partially explain price movements in very “yieldly” equities.

If long-term rates rise, yield chasers will be burnt. Your only defense – shorten your portfolio duration.

As 2010 comes to a close, it is always good to review the year.

In particular, in the financial markets, there were two issues which dominated the headlines: The Deepwater Horizon Oil Spill, and the May 6, 2010 “Flash Crash“.

In my opinion, the Flash Crash was the bigger story in financial circles. It is a harbinger to come as there was nothing done to effectively mitigate the problem.

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.