Ever wonder why so many smart, successful business people and professionals get scammed by the likes of Bernie Madoff, Kenneth Lay and Jeffrey Skilling (Enron), Bernard Ebbers (WorldCom) and the most recent Sam Bankman-Fried (Crypto currency)?  In this article, I will cover several sound investment ideas which you may already know and yet, countless investors lose significant amounts of money because they do not follow one or more of them.

Buy low – Sell high

What could be more obvious? Yet most investors do the exact opposite. If you look at a graph of the of stock market performance, you will see peaks and valleys. If you superimpose a second graph of daily sales volumes over the same time period, you will see that the two curves are almost identical. What does that mean? It means that most purchases occur at the peak, just before the market downturn and very few people are buying at the bottom just when the greatest gains are about to come. Most people buy high and sell low. Seems stupid but hindsight is 20-20. You cannot spot a top or bottom until months after they occur. At the time, you cannot tell the difference between a market correction and a longer bear market or between a sucker rally and the beginning of a sustained bull market.

Why do people (including professional fund managers) behave like this? FOMO (fear of missing out) – everyone is talking about the money they are making in the market and so you want some of that action. Some brokers say, “the trend is your friend.” It is not! A better expression is, “Bulls sometimes win, bears sometimes win, but pigs always get slaughtered.”

Rebalancing

Unless you are a gambler, as opposed to an investor, you should have a diversified portfolio. To use a simple example, you could have 20% invested in each of the following asset classes: Canadian bonds, Global bonds, Canadian stocks, US stocks and international stocks. Rebalancing means that whenever, one asset class moves away from the target allocation (20% in this example), you rebalance by buying more of what went down and selling what went up to bring everything back to the target allocation. This means you are always selling high and buying low. That will already put you ahead of the herd who are doing the opposite.

How often should you rebalance? You could do it every quarter or every six months. Perhaps a better idea is to watch your portfolio at regular intervals (but no more often than weekly) and rebalance when any asset class goes 2% above or below the target allocation. Note that 2% of 50% (should you have 50% in stocks and 50% in bonds) is 1% so when stocks are 51% of your assets, you sell 1% and buy 1% more in bonds. For the 20-20-20-20-20 example that I used earlier, 2% of 20% is 0.4% so when an asset class increases to 20.4% or drops to 19.6% you rebalance. There are more sophisticated formulas for rebalancing and you could use different time periods or different percentages as a trigger to rebalance but my suggestions are simple and will help you avoid FOMO. Whatever rule you choose, stick to it.

Index Funds

As an investor you can buy stocks, bonds, options, derivatives and so on but it will be hard to be diversified. A mutual fund gives you a much broader range and you get professional management. The problem is studies of mutual fund performance over any 10-year period show that virtually all under preform the market. If you look at one year some funds will do well. Fewer at 3 years and fewer still at 5 years. At 10 years you will hard pressed to find a winning fund manager. I can think of only two long term winners. Warren Buffet is one but his stock, Berkshire Hathaway, sells at a large premium to net asset value so you are betting that his future performance will significantly out preform the market in order to cover the spread. Further, he is getting on in years and no one knows how much longer he will be able to run the company. Peter Lynch is another legendary fund manager but he retired years ago and today advises investors to buy index funds.

That is also my recommendation. As Mayor of Hampstead, I suggested that we invest our employees’ pension fund in index funds but I was out voted by the entire council. After 10 years I asked for a study of our performance vs the indices. Of course, we had under performed the market and finally the councillors listened and we switched to mostly index funds.

If you have an investment advisor, you are probably paying 1% of assets whether you have a good or bad year. With a Canadian mutual fund your Management Expense Ratio (MER) is probably 2-2.5% per year and that is for a fund that will likely under preform the market. US and other mutual funds may have an MER of about 1% but rarely less than that. Investing in Index funds will give you better performance and a lower MER. Index funds are designed to track the relevant market and should do better for you than a fund manager or advisor.

There are two types of index funds – ones sold by banks or other investment dealers and ones that you can buy on the stock exchange (exchange traded funds -ETFs). Both should have identical performance but the latter has lower MERs. If you use a discount broker and do your own online trading, you will pay very little for the privilege of beating almost all the professionals in the long term.

Tax Considerations

If you read my article on Income Tax Reform, you know that I would like to see virtually all deductions and tax credits eliminated but until that happens, you need to take advantage of our tax system. Houses tend to increase in value over the long term and if you live in the house until you sell it, there will be no tax on the increase in value. That can be a huge saving. If you are earning money and are at the marginal tax bracket of about 50%, you should put the max into an RRSP every year. You will get a healthy tax deduction and the money will grow tax free in the RRSP. However, you will pay tax when you take the money out. If that is at retirement or in a year when you are unemployed, you will probably pay little, if any, tax on the withdrawal. Basically, if your expected tax bracket will be lower when you withdraw the funds than what it is now, investing in an RRSP makes sense. The other main tax deferral strategy is to invest in a TFSA. In this case you get no tax deduction but the money grows tax free and there is no tax to pay on withdrawals. If you have the funds, put the max in both RRSPs and TFSAs. If you have a small income and a low marginal tax rate, the TFSA is the first choice. If you have kids that you expect to go to university, an RESP is an excellent way to grow your money tax free. All these vehicles can hold ETF index funds. You can discuss, with an accountant, these and other legal tax minimization strategies but the key point is to invest in tax deferred vehicles before investing in non-tax-sheltered ways.

What you earn is dependent on performance, what you pay for the performance and what you take home after the taxman takes his share. All three are important.

Buying stocks

Obviously, I do not recommend buying stocks. Aside from diversification and the other points made above, consider a few more. Stocks are not bought. They are sold. There is always a story that your broker or friend will tell you. If something must be sold, is it really a good buy? IPOs (Initial Public Offerings) are also sold because the brokers get good commissions for pushing them. Very few do well in the first year. Should you want to buy the stock, wait 6 months to a year and you will probably get a better price.

What about hot tips? If an insider is giving you the tip, it is illegal and your buying based on the tip may get you in trouble. If it is not an insider, probably enough people already have the news and it is built into the stock price already. Or the tip may be because someone is leaking info, true or not, to pump up the price before they dump it. The golden rule is if it sounds too good to be true, it is.

Scams

To return to my opening paragraph, why do so many smart people fall for investment scams? Successful business people have relationships with suppliers and others based on trust and their friendships at the golf club, in charitable organizations, etc. So, what do smart scammers do? They go where the wealthy can be found. They join top golf clubs, get involved in the prestigious charities, frequent the best restaurants, and go on high end cruises. They are personable and easy to chat with. They drop names of their wealthy, powerful friends. Eventually, they talk about their investment idea and hook their prey. They tell how much money others have made (playing on FOMO). If it is a Ponzi scheme, and most of these frauds are to some extent, early investors do get generous payouts which come from the new investors. They, in turn, talk to their friends and the scheme snowballs until it can no longer be sustained. Successful doctors, lawyers and business leaders do well because of their relationships. They tend to be trusting and are perfect victims for the unscrupulous. 

Investing is NOT a way to make a lot of money

If you want to make a lot of money, start a business, work hard, and save as much as possible. While the odds will be against you, 6% do end up making more than being an employee. Saving is also a good strategy. At the 50% marginal tax bracket, every dollar saved is the equivalent of $2 earned.

Investing is for preserving wealth and earning enough to stay ahead of inflation. Follow the tips in this article and the odds will be in your favor.

Last note: I will be travelling so expect my next article late January. If you enjoy reading my articles (whether you agree or not with everything) please share/forward them and encourage others to subscribe.