Questions to Expose a Bad Advisor

What does one do if they really want their investment portfolio to do well but they really don't care for all the numbers and complexities of investing? Well, for one, if you can't take a bit of time to educate yourself on one of the most important financial decisions in your life, than I have no sympathy for you if your retirement goals come crashing spectacularly down when 60 rolls around. And if you think just having your bank advisor take care of everything will solve your problems, think again. If you are wise enough to have a professional fee-only advisor managing your investments, than you can probably rest easy. But for the rest of you, buyer beware if you are not educated.

The beauty is, very little education is necessary to give you the tools you need to ask smart questions. And smart questions often lead to dumb answers. And dumb answers lead to fired advisors which leads to better served investors. Read on to find some excellent places to start and then to read a great list of simple questions you can make your advisor sweat with.

First read this post on the 7 Most Common Investor Mistakes. It is great. Educate yourself further by reading books like The Wealthy Barber and Millionaire Teacher. They're accessible and fun. If you want just as excellent information but maybe in a less jovial presentation check out some stuff by David Trahair and The Little Book of Common Sense Investing. And if you want to completely immerse yourself, try a subscription to Money Sense. One issue will give you more financial knowledge than you've possessed in your entire life.

And start questioning your advisor. Ask him things like "Well, if you were so confident of these funds last year, why are you moving me this year? I trust your decisions and I would rather we stick with your first instinct." Make them develop an asset allocation that fits your needs and ensure they review your current portfolio status at least once a year to see if it aligns with your planned asset allocation. If you have more than 5 funds in your portfolio, start to ask some serious questions. If your advisor is contacting you more than once a year to change your fund purchase allocations, get a new advisor. They are churning your portfolio to get rich on commissions and aren't worth your time. It's not illegal but it sure as hell should be.

Some other questions to ask your advisor.

1. What is my internal rate of return over the last 1 year, 3 years, 5 years, since inception?

Any advisor worth their salt should be able to give you this information. If they hesitate, fire them. If they don't know what you are talking about, fire them and then tell all your friends to avoid them like the plague. In fact, post that on their door.

2. What is the aggregate MER of my mutual fund portfolio? Anything over 2% is seriously questionable and you best be seeing some absolutely mind blowing answers to the following questions to justify that charge.

3. Am I in any load funds?

Answer should be No. If even one answer is Yes, get out. You will likely be locked into those funds for 7 years without taking a penalty on sale of the units, but get rid of this advisor immediately. There is absolutely no justification for selling load funds.

4. Am I in any funds-of-funds? If the answer is yes, seriously reconsider this individual or institution. If they answer No to the following question, proceed cautiously but they can live another day. And that question is "Are the MERs of the underlying funds charged to the unitholders of the overlying fund?" If the answer is YES, get the sam hell out of there. You are getting charged TWICE.

5. How long have my funds been around? I once had an advisor try to sell me a fund showing me a performance chart from 2008. It looked like roses. Of course it did. The fund was born when the market was at its lowest point in decades. Everything has looked like roses with 2008 as a starting point. You should ideally be invested in funds that have 10 years of performance data. Leave plugging millions of dollars into shiny new funds to the other suckers out there. You are not one of them anymore.

6. How have my funds performed compared to their benchmark? If the benchmark is some really complicated name, be skeptical. If it is a big benchmark like the S&P 500, MSCI EAFE, TSX 60 or TSX Composite, then great. If they are underperforming their benchmark by anymore than 1%, they cannot possibly be justifying the expenses they are charging you. If they can't provide that info, that is terrible. Because you can get it for free at Globefund.com by comparing your funds performance to the index and comparing it to any index. So check it anyways for your interest. And then fire them. Conversely, you could check the numbers based on your last statement and then come in with a barrage of really tough questions about your fund performance. Ooh, that would make them sweat!

7. How could you assist me in constructing a portfolio of low-cost index funds or broad market ETFs? If they start going on about the pitfalls of index funds and ETFs and how they won't do it because it will hurt your investment outlook, get out now. If they are honest with you and say they recognize the strengths of those approaches but their company requires they sell their mutual funds in order for the "free" advice they provide you, then go ahead. Again, the key here is consistency. If you like and trust this person and they have you in a simple mix of broad based equity and fixed income funds and they don't stray from that approach, then you could do worse than to just stick with them.

As always, if they looked totally stunned, confused, blank, or otherwise threatened or frightened by your question, you should seriously consider leaving them. And I'm not joking. And I cannot emphasize enough that if you have an advisor selling you load funds, you need a new advisor.

In the end, if you feel too overwhelmed by the whole process but are very seriously concerned about the performance of your portfolio and you reaching your retirement goals, consider professional advice from a second party. Companies like Weigh House Investor Services offer services like PortfolioCheck where they look over your existing portfolio and give objective advice....well, basically on how bad it looks. They charge for the service of course, but if you are interested in leaving your existing advisor, they will also help point you in the direction of an investment manager they trust that will serve your needs better. Again, you will pay a bit out of pocket up front, but your long term returns will be substantially higher and compounded over your working life will mean a substantial increase in the size of your retirement fund. As a last resort of course you could e-mail MoneySense magazine and come grovelling on your knees requesting a Financial Makeover. You'll get all these experts pouring over your portfolio for free!

Please feel free to contact me with any questions. I am not a certified expert but I can often point you in the right direction.

The Devastation Wrought by Performance Chasing

As promised, I give you my third post on why using bank advisors, or really any commission-based or products-based advisor, is a bad idea for your retirement plans. The first was based on the historically higher expenses charged by this group of advisors. The second idea was what I've seen many people do which is hold all their money until February when they scramble to max out their RRSPs. Of course, my hypothesis that this would harm their long term returns was not upheld by the data, as I posted. But it is still a risky situation to put yourself in, if for no other reason than you may never get around to it and then you are leaving money uninvested that could be compounding its growth. This never was a great argument against advisors anyways since it is often the fault of the investor, not the advisor. Advisors would likely be just as happy to have those regular funds come in so they can collect regular trailer fees.

The common advisor practice of encouraging performance chasing is, however, the fault of the advisor and it most certainly is detrimental to the retirement goals set by the investor.

Performance chasing, in its most common form, goes like this. When you go for your yearly review with your advisor, he goes over a variety of funds that have done great over the past year and convinces you that, because they are on such a hot streak, you should move your money into them. This is often done with no regard to the stated goals of your portfolio or your desired asset allocation, which is incredibly reckless in itself because asset allocation alone accounts for 75-80% of portfolio returns.

Now, I was going to research the effects of this but turns out I already did. Here. On this very blog. Hmm. Go figure. In that post I studied the impact of switching all your investments to the top performing mutual funds reported in MoneySense magazine each year versus just keeping your money in a balanced portfolio of index funds and rebalancing yearly. The per year difference worked out to roughly 1%. What is the impact of a 1% performance difference over a 30-40 year investment horizon? Well, I'll take my own example. We put roughly $10 000 per year away for retirement. The difference in 1% performance would work out to about $250000. That's a lot of dough that I lost by chasing hot performers versus just buying and holding and sticking to my asset allocation.

But don't take my word for it. Here is some excellent data from various resources to prove my point.

S&P study: source here

-Over a five year study period, only 1.12% of funds maintained a top-quartile ranking by the end of the study period. Given the MASSIVE universe of funds you have to choose from, guessing which 1 of those funds will remain in the top quartile is a losing game.

Report by Jason Zweig here:

-over a 24 year period, the typical mutual fund underperformed the broad stock market by 0.55%

-but the average INVESTOR underperformed by 0.7%

-this spread is the COST of investors moving their money around too often by chasing performance

-perfect example provided in the article:

-Fund A earned 20.7% in 1996, but their average investor LOST 35%

-Fund B earned 26.9% but the average investor LOST 20%

-THAT IS THE COST OF CHASING PERFORMANCE

Another great report here:

-only 16% of top 5 five funds make it to next years list

-top five funds average 15% LOWER returns the next year

-top five funds BARELY beat the market the next year (0.3%)

-21% of ALL TOP FIVE FUNDS CEASED TO EXIST IN 10 YEARS TIME

-average equity investor earned a measly 2.6% in the same time period that the S&P 500 gained 12.2% and inflation was 3.1%

So what is one to do instead of chasing performance? It's simple. Asset allocation and disciplined rebalancing.

First, you choose an asset allocation that suits your needs. For most this can be as simple as the stock to fixed income ratio. Many suggest that the portion of your portfolio in bonds/fixed income investments should roughly equal your age. I choose to change mine only every 5 years. So when I turn 30 in March I will realign my allocation from my current 25% bonds:75% stocks to 30% bonds:70% stocks. This ensures that as I draw closer to retirement, when I can ill afford significant volatility in my portfolio, less of it will be exposed to stocks, which are inherently more volatile.

The specific breakdown of your asset allocation is a matter for discussion, but can be as simple as 25% bonds, 25% Canadian stocks, 25% US stocks, and 25% international stocks. It's that simple. With that asset allocation, all you need is four index funds, and you are gold. Even the most widely diversified passive portfolio I've seen has only 10 funds in it and that is for very sophisticated investors. Most retail investors can do just fine with 4, even 3 funds and get very broad market diversification that will suit their needs.

Now that you've settled on an asset allocation, you setup pre-approved withdrawals from your bank into those funds EVERY month based on those percentages. Then, every year, if any of your funds is really out of whack on its percentage, you REBALANCE.

So, in my portfolio, I have 37.5% in CDN equity, 25% bonds, 25% international, and 12.5% US. At the end of a year, if any one of those composes 5% more or less than I set it to at the beginning of the year, I rebalance. The beauty of this is that it forces you to sell overpriced funds and purchase underpriced ones, a recipe for success. Look at it this way. If I've been putting exactly 37.5% of my funds each month into my Canadian equity fund but it is suddenly taking up 44% of the worth of my portfolio, the only explanation is a significant rise in the value of that fund. Or if the US fund is down to 8%, it means that US fund has totally tanked. So I sell the gains in my Canadian fund and buy more of the US fund, because the former is bound to come crashing down and the latter is bound to come racing back up. I just locked in my wins and bought some funds on sale. Plus, there was NO EMOTION involved. Just the numbers.

Is there any evidence that rebalancing based on asset allocation actually trumps performance chasing? You bet there is. In this study, the various portfolios that were rebalanced ALL trumped the performance chasing portfolio, until you got into portfolios with very low stock allocations, which only makes sense. The "average" portfolio construction many would use outperformed the performance chaser by 2%. I read a lot of other academic literature that showed similar results.

Now, what do you do if you are in the unenviable position of having a bank advisor for your main source of investment decisions and retirement planning? First of all, get out. But I recognize that some may not be able to do that. So, if you can't get away from your bank advisor or you don't want to, despite what you've read here, at least know thine enemy.

In the next post, I will give you questions to ask your advisor that are sure ways to find out if they are working for you or for themselves.

The Day Pharmadaddy Ate Crow

So I planned on posting a triumphant article about the benefits of dollar-cost averaging versus leaving your RRSP contribution to the last minute. I was going to show the devastating impact of holding onto your money and dumping it in your portfolio on February 28 versus divvying it up over 12 months in smaller amounts. Now, there is no denying that the monthly contribution is better from a psychological perspective in that it is less painful to dole out $1000 a month to your investment portfolio than it is to hand over $12 000 in one sitting. But after doing some research, my preconception has been smashed. I ran two portfolios through Globeinvestor Gold, one purchasing $12 000 in investments on February 28, one purchasing $1000 per month for the same amount of time. The test ran from 2002-present. The damn portfolios ended up almost identical. And then I came across all the academic economics research that debunks the whole theory of the financial benefit of dollar-cost averaging. Sure, in some cases, if you invested lump sums each year right before a massive market crash, DCA will look a heck of a lot better. But on the whole, DCA and lump-sum investing seem to work out quite equal. Damn. I shall eat crow and admit that my hypothesis was wrong. In theory, DCA should win. If you were investing in fixed-interest investments, that would be true. If you held onto your money, you'd be missing out on twelve months of growth. But in the case of a diversified portfolio exposed to volatile stock markets, you could just as likely be missing out on twelve months of tanking markets. Guess I should have seen that coming! Oh well, at least I had the good sense to check the facts first! Hopefully my hypothesis about chasing performance will turn out a lot better!

All Those With Bank Advisors: Beware!

I am a DYI investor. I've done and continue to do enough reading and have a simple enough financial situation that I feel comfortable with this. This will not always be so and there will be a point at which I will seek out professional help. But the last place I will go is my bank. Going to a bank advisor is one of the worst decisions you can make for your financial health, and over the course of 3 posts, I am going to show you why.

First we will discuss the impact of fees on portfolio performance. The second and third posts will discuss two tactics often employed by bank advisors that not only can I not understand but I believe they could never truly justify: the opportunity costs of lump sum investing and the devastating impact of chasing performance.

When I talk about going to an advisor for myself, I mean individuals who have no vested interest in the PRODUCTS they recommend but instead in the ADVICE they recommend. Bank advisors are handicapped by a limited product portfolio and, as such, you must purchase mutual funds from their bank. In some cases they will broaden the horizon somewhat, but they are still selling you actively managed mutual funds, a sure fire way to fall well short of expected returns (if you need me to explain why, look through some of my past posts or just comment, and I shall oblige with an appropriately indignant rant). Furthermore, most bank advisors have risen up from within the banks lower ranks, taking in-house training courses and learning "on the job". They have no more basic financial education than you or me. Of the 3 advisors I've already encountered in my travels by virtue of necessity in setting up my index investing account through TD, 1 was so delusional about actively managed mutual funds it was clear she was a lost cause, 1 looked at my situation and recommended a cookie-cutter fund-of-funds with an expense ratio of 2.5%, and 1 didn't know what index funds were. And I've heard enough stories from friends and family and in the media to know my experiences were not exceptional.

But if they are so detrimental to financial success, why does everyone use them? Why have the best advisors, that is, fee-only financial planners who don't sell products but advice, not caught on with the general public? One cynical answer would be that the big banks have a huge vested interest in promoting their advisors because that sells their products, which makes them money and brings more assets under their control. All of these are important factors guiding the success of their business, a pursuit that you cannot hold against them. But more pragmatically, fee-only advisors cost money. At least in the traditional I-can-see-the-money-leaving-my-bank-account sort of way.

But what if I were to tell you that bank advisors actually cost you a heck of a lot more than you think?

I'll admit, I've suffered the same pain of loss that comes with thinking about handing over $1500-2000 to a fee-only financial advisor for a comprehensive financial plan. But a simple hypothetical scenario will expose the fallacy of this reasoning.

Let's say I'm 30 and I have already built up a nest egg of roughly $100 000. For reasons beyond my control, I can no longer afford to save anything for retirement. I need this sucker to grow as much as it possibly can. Given my situation, I am holding off on retiring until 65, giving me a 35 year investment window. One hill I will die on is my asset allocation and so I tell my financial advisor I don't care what s/he puts me in, I want it to represent 40% fixed income and 60% equity.

To arrive at the numbers below I used my favorite online tool, Firecalc.com. This tool looks at all the American stock market data from 1871-present. When you enter your retirement time horizon as 35 years, how much you start with, and how much you plan to withdraw each year, it runs those numbers through every 35 year period in that time set. That is a lot of data!

In the first scenario, I walk into a bank. The individual dumps me into some bank-brand mutual funds. Considering an average MER of 1.6% (roughly the average of the big banks, particularly RBC and TD), at age 65 my portfolio would range from $125 757 to $628 782, averaging $287045. (As an aside: If you use other groups like Sunlife Financial or Investors Group, your MERs are likely closer to 2.5% and there are usually nasty load fees. At least the banks usually sell no-load funds.)

In the second scenario, I visit a fee-only advisor. They put me into passive index funds with an average MER of 0.4%. In this case my portfolio would be worth anywhere from $189 881 to $949 404, averaging $433 846.

The average difference is $146 801. What is my point? For one, fees matter. That small difference in management expense fees of 1.2% costs you almost $150 000 over 35 years. For two, bank advisors aren't free. You just paid for their advice with that money. How much could you have spent on a fee-only advisor each year over those 35 years for the same price? $4200. The most expensive I've come across so far is $2500/year and that was for a very comprehensive service.

So, you see, just because you aren't scratching a cheque or pulling money out of your account to pay that bank advisor, doesn't mean his advice is free. It comes at a substantial price. And the above considers that the advice and service they give you over your retirement saving years will produce as good results as that provided by a fee-only advisor. The above projections used the exact same portfolio with the exact same stock market return data. The only difference was the management fee paid on investments. In the next two posts, you will see that there is a pretty good chance that these fees aren't the only money you'll lose before retirement by employing a bank advisor.

Global Inequality

I finally got around to reading a book I've had on my list for a LONG time: Stocks for the Long Run by Jeremy Siegel. Considered a seminal work of financial writing ranking up there with The Intelligent Investor by Benjamin Graham, I've always thought it necessary to read it to round out my knowledge base. I'm so glad I did.

Among other things, it will assuage the fears of even the most conservative investor, conclusively showing that a buy-and-hold strategy of investing in a diversified portfolio of stocks and bonds is the best way to amass wealth over long time horizons.

What I found most interesting though was a discussion on the gap that exists in our world between population concentration and wealth allocation. That is, just because a nation has lots of people, doesn't guarantee that it will be wealthy. In fact, quite the opposite appears to be true. In the book, the author publishes three graphs, breaking up various nations and regions in the world. One pie chart shows each nation/region as a percentage of world population, one as each nations' GDP as a percentage of world GDP, and one as each nations' total market capitalization of listed public companies in their national stock exchanges as a percentage of total world market capitalization of public companies.

The graphs show the substantial disparity between wealthy and poor nations, particularly between that vague dividing line of developed and developing nations. But because the data is a bit old, I decided to update it. I accessed World Bank, UN, IMF, and OECD data to compile the most accurate graphs I could on the same basis but for 2010, not 2005 as was done in the book. Considering how much the BRIC countries (Brazil, Russia, India, China) have grown in that time I thought maybe some things have changed. How wrong I was.

The above graph shows various nations/regions in the world, with their corresponding percentages of population, market capitalization of public companies, and GDP. As you will see, some of the least populous nations have the most wealth, the US and Western Europe standing out most starkly. China, with almost 1/5 of the world's population, contains less than 10% of its GDP and equity capital. Africa contains 15% of the world population but only roughly 2.5% of both GDP and equity capital.

Highlighting the discrepancy further, the above graph shows the same data but lumping the nations of the developed world and those of the developing world. You can see from this graph that the developed world contains only 15% of the world population, but contains over 70% of its equity capital and over 60% of its GDP.

Finally, if you normalize each data point by population it gets really interesting. Little Hong Kong actually skews the whole graph. This small, densely populated region of the world contains A TON of the world's equity capital, creating $350 000 of market capitalization for each citizen within its borders. Of course, that makes sense for an island that is essentially one big stock exchange. But you'll see that the developing nations almost drop off the screen and the data are very stark to look at in raw form. The lowest of the developed regions, Singapore and South Korea, sit around $25000 GDP per capita with Eastern Europe, the closest of the developing regions coming in at only $8500.

I'm proud to see my home nation on there punching well above its weight. Canada has the second highest GDP per capita of the listed regions and the highest market capitalization per capita, excluding Hong Kong. (As an aside, if you compare the market capitalization of the Toronto Stock Exchange per capita in the Greater Toronto Area to that of the Hong Kong Stock Exchange per capita in Hong Kong, Toronto wins!)

Of course the causes of the above data are well beyond the scope of this discussion. I just think the data itself is interesting and raises challenging questions. Hope you enjoy it as well.

Investment Manifesto Appendix II: The Index Advantage

In researching the plight of Mr. and Mrs. Smith, something kept popping out at me. The financial industry has us all convinced that they can provide value with their services. If we give them our money, they will spin it into gold. That is the whole point of mutual funds and mutual fund managers. They are so utterly intelligent and prescient that they can beat the millions of other individual and institutional investors whose millions of investment decisions made every second of every trading day determine the returns of the market.

That is what we are led to believe. But a unique group of funds put the lie to this whole line of reasoning.

I mentioned before that I chose TD for all my research. It's a company I know well, they have a broad portfolio of mutual funds, and they've been around for awhile so there is plenty of data available. TD, like many other banks and investment firms, offer bundled mutual funds. An example of one of these funds is TD Managed Balanced Growth.

Bank advisers offer these funds to thousands of investors every day across the country. How do I know this? Besides personal experience of course, the evidence. Of the myriad of funds TD sells, the TD Managed Balanced Growth portfolio is eighth in total assets held. Otherwise known as $2.9 billion. And as you'll see below, the other 7 above it are held within many of these packaged funds so their asset ranking really only proves the point further.

These funds are actually funds of funds. By that I mean the overlying fund does not purchase individual companies to match the investment style of the fund. They purchase other FUNDs.
I looked at the four different categories of packaged funds for which TD has 10-year return data. There are four different types of packaged fund with five different investment styles in each.

Types:
Managed: a fund purchasing other funds from within TDs portfolio of funds.
Fundsmart Managed: same as above but purchasing funds within TD and from other companies.
Managed Index: meeting the benchmark objectives of the fund merely by purchasing TD index funds.
Managed Index-e: same as Index but using the e-Series index funds instead of the run-of-the-mill index funds. The only difference is that the e-Series funds are ONLY available online and thus have lower operating costs.

Investment Styles:
Max Equity Growth: 0% fixed income. 100% stocks (35% CDN, 32% US, 35% Intl)
Aggressive Growth: 20:28:25:27 (as above)
Balanced Growth: 40:20:20:20
Income & Moderate Growth: 55:15:15:15
Income: 70:10:10:10

If you believe the financial industry hype and were to rank the returns of these funds since 2003 (the investment horizon of our Mr. & Mrs. Smith) you would rank them in the following order by type, descending by return:
Fundsmart Managed, Managed, Index, Index-e.
Here's why. The Fundsmart Managed are Smart after all. They have access to the whole fund universe, so their genius money managers can use their highly developed skills to find the best funds out there and make scads of cash. The Managed fund managers can pick the best funds, but only within TD. The Index funds, well all they do is follow the whole market. Ha! What kind of loser would hop on board a ship with no captain at the helm? And the e-Series funds? The lowly individual investor can purchase these, on their own, with no help from any professionals and only needing the assistance of branch staff to setup the account, never to interact with them again? Good luck.

Too bad for the fund industry. The ranking, in ALL FIVE investment style classes, is the exact opposite. That is, the one with the most amount of fund industry involvement had the lowest return, and the e-series Index fund had the highest return.

Two other conclusions jump out from this study. The first is found by comparing between investment styles. Within a given fund type, that is Managed or Fundsmart Managed, the return went in lockstep with the percentage of assets allocated to fixed income. This makes sense since the last 8 years have been marked by incredible equity volatility. So as you went from Balanced Growth to Income and Moderate Growth, your return increased because more of your assets were protected in fixed income instruments.

The second conclusion leaps out at you from the page when comparing WITHIN investment styles. Here you compare Managed Income vs Fundsmart Managed Income vs Managed Index Income vs Managed Index Income-e, for one example. As said before, -e wins and the most heavily managed fund loses. What is the relationship here? It turns out that in all 5 investment style groupings, the main contributor to return is EXPENSE, the management expense ratio, or how much it costs to operate the fund. The correlation is -0.86, which is INCREDIBLY STRONG. This means that as the MER goes up, the return on investment goes down.

The fund industry's argument has always been that you pay a higher MER in return for market-beating returns. Obviously not. In every case, the highest ranked fund was the Managed Index e-fund, which had the lowest MER. The inverse can be said for the Fundsmart Managed fund in each group.

But now here's the kicker. In the case of the Managed Index e-funds, all TD is doing is what you can do yourself from home. The fund managers do nothing more than purchase units of the TD e-series index funds at percentages aligned with the asset allocation prescribed by the investment style of the fund. Thus, if your investment style, and that of the fund, is conservative, you might buy 55% in TD Canadian Bond Index-e, and 15% in each of TD US Index-e, TD Canadian Index-e, and TD International Index-e. It would take you a whole of 10 minutes to set this up and you could never look at it again.

If you did this, your average MER is 0.47%, while the MER of the Managed Index Income & Moderate Growth Fund-e, where they do the EXACT same thing, is 1.25%. They charge you 0.78% of your investment for 10 minutes of work once a year. In my case, I invest roughly $10000 per year. That's $78, or a whopping $468 an hour. Wow. That might not sound like much, but the solo approach won with 4.93% annualized return versus 3.92% for the Managed e-fund. A $100000 lump sum investment in 2003 would have foregone over $12 000 in gains. $12 000 for the privilege of pushing a few buttons for 10 minutes every year. That works out to $9000/hr. No wonder people give the financial industry a hard time.

Oh, and in case you're wondering the difference between DIY and TD Managed Balanced Growth, the most popular balanced fund in their arsenal? $18000 over 8 years from $100000. More poignantly, if you gave up the returns sacrificed to the management expense of the fund over a 40-year investment horizon, you would suffer dearly. Investing $5000 per year for 40 years at a rate of 3.04% (Managed) versus 4.66% (DIY) would cost you..........$175 000.

Investment Manifesto Appendix I: The GIC Approach

This is a followup to my previous post. I mentioned there that the clients in question were so distraught with the failure of their money to grow in the market that they wanted to move everything to GICs. It just so happens that someone else has thought of this already. His name is David Trahair, and he wrote an intriguing book called Enough Bull, that highlights just such an approach. Trahair, disgusted with the financial industry and the impact on investors of the Lost Decade (as 2000-2010 is now being called in financial circles), outlines, as the subtitle states, How to Retire Well without the Stock Market, Mutual Funds, or Even an Investment Advisor.

He introduces the concept of a GIC ladder and there is beauty in its simplicity. Let's say you have $100 000 to invest in 2003, like our fictional Mr. & Mrs. Smith. You take $20000 and buy 5 GICs, each maturing 1 year after the other. So you buy a 1-year, 2-year, 3-year, 4-year and 5-year GIC. For those who don't know, GICs are Guaranteed Investment Certificates, which, as they say, are guaranteed to pay you the stated interest rate each year for the term of the GIC. Typically, the longer the term, the higher the interest rate. The catch is you can't redeem it without penalty until the end of the term, but the bank rewards you for your delayed gratification by sweetening the interest rate.

Now, when the 1-year GIC matures, you sell it and purchase a 5-year with it. You do the same for the 2-, 3-, 4- and 5-years when they mature. Eventually you have five 5-year GICs. And every year, one of them matures. You sell it and purchase another 5-year GIC every year. This way, each year you are locking in a portion of your portfolio at the prevailing interest rates for that year.

How would such an approach work for Mr. & Mrs. Smith? I found the historical GIC rates from 1970-2011 and backtested such an approach. Of course the results are slightly boosted by the heady interest days of the 80s. But I don't imagine anyone was celebrating 17% GICs when they were paying 20% on their mortgages.

Again, I tested a $100 000 lump sum investment and compared it to a theoretical conservative index portfolio started in the same year. The results were rather surprising.

The index portfolio gained an impressive 9.6% per year, turning $100 000 into $4.3 million in 41 years. The GIC approach fared nicely as well though, coming in at 8.31% per year. While this may seem like a small difference, the magic of compounding ensures that the final result is drastically different. The final portfolio is valued at $2.6 million. Thus, the couple forgoes $1.7m in gains. Some might consider this a small price to pay for sleeping soundly for 41 years. And in case you're wondering, the GIC portfolio outpaced inflation which clocked in at 4.4% per annum.

What if this approach was taken by our fictional couple in 2003? No crazy interest rate spikes to rely on in this period. Did it still produce respectable results? Indeed it did.

$100 000 invested in 2003 in such an approach would net roughly 2.92% per annum, versus about 5% in a conservative index portfolio. They forgo about $25000 in gains. But they still beat inflation, although barely, at 2.05% per annum.

So if you are interested in GICs, I recommend reading Mr. Trahair's book...and treading cautiously. In the markets, nothing is never free. And that goes for risk and safety as well. With risk you pay with volatility. With safety you typically pay in the form of unrealized gains. But it all comes down to what you can live with. Just don't sell yourself short and follow two VERY important rules.

Rule #1: DO NOT buy GICs from the big banks. Their rates are AWFUL. Use INGDirect, Ally, or Achieva Financial. TDs current 5-year non-cashable GIC rate is 1.65%. Achieva is offering 3.5%, Ally 2.75%.

Rule #2: Don't run scared to GICs. Do it because it makes sense for you. If you still think investing in a broad-based portfolio of stocks and bonds is the way to investment success, then d it. Don't put your money in a GIC mattress because your adviser screwed you. Fire your adviser.