BLACK MONDAY, BLACK SWANS AND TURKEYS

October 19th was the 20th anniversary of Black Monday, the moniker given to October 19th, 1987, a day when the Dow Jones Industrial Average fell by 22.6% in a single day. They say history doesn't repeat itself; it rhymes. So on this anniversary, let us remember a very important investment lesson: beware of the Black Swan.

A Black Swan is a term, recently made famous by Nassim N. Taleb, to describe an unforeseen event of extreme severity that, due to human nature, we regard as extremely improbable - i.e. when pigs manage to fly the stock market will experience a fall of 22.% in a single day.

The Black Swan is Taleb's parable for the problem of induction:

"No amount of observations of white swans can allow the inference that all swans are white, but the observation of a single black swan is sufficient to refute that conclusion".

Black Monday should remind us to not be complacent about risk. I have decided to put 70% of my savings into stocks in order to chase high returns. And everything seems fine as I have never lived through a drastic market correction. However, just because I have never seen stocks fall by 20% or more, this does not mean I should rule out this scenario. Chances are, there's probably a 20% drop out there with my name on it.

Taleb also uses the story of a turkey just before Thanksgiving to illustrate the Black Swan. Throughout his whole life, the turkey has come to regard humans as wonderful benign creatures that show up several times a day to provide food. All his experience points him in this direction. That is until Thanksgiving, when something very unexpected will change the turkey’s mind.

STOP CHECKING THE MARKET

It's time that you stop monitoring your portfolio's performance at the end of each day. And all those times you check what the market is doing throughout the day? You have to stop that too. Why? It turns out that the probability of making money decreases as you narrow the time scale at which you track an asset's return. All that portfolio monitoring is just stressing you out.

The table below, taken from Fooled by Randomness by Nassim N. Taleb, displays the probability of making money from a portfolio with an annual average return of 10% and a standard deviation of 15%.( A standard deviation is a measure for the variability of returns. For example, the standard deviation for this hypothetical portfolio tells us that 68% of the time our portfolio will yield returns between -5% and 25%; 95% of the time returns should lie between -20% and 40%).

Note from this table that as we decrease time scale at which we monitor returns, the probability of making money decreases. If we track this portfolio's performance over one hour, for example, the probability of experiencing positive returns is only 51.3%. As Taleb explains,

"Over a short time increment, one observes the variability of the portfolio, not the returns. In other words, one sees the variance, little else."

In essence, by constantly monitoring your portfolio's performance you expose yourself mainly to its variance and the meaningless stress attached to this volatility: you're in the black one minute, only to find yourself back in the red in the next.

IS YOUR PORTFOLIO'S EXPECTED RATE OF RETURN TOO HIGH?

How realistic is it to forecast that your investment portfolio will grow by 8% or more?

To determine my monthly RESP contributions, I calculated that by saving $140 per month I should be able to cover a good portion of my son's future university costs. Assuming an annual rate of return of 7%, sixteen years from now this monthly payment should come to $63,000 (note that I'm including the CESG contribution in this calculation). However, am I being overly ambitious in expecting a rate of return of 7%, per year?

The table below contains data on annual real equity returns over a 103 year period. Note that the real rate of return on Canadian equities has been 5.9%*. Assuming an annual inflation rate of 2.5%, this translates to a nominal rate of return of 8.4%. If 40% of my RESP contribution is going into a bond fund that returns 5.94%, I can safely expect my son's RESP portfolio to earn 7.4% per year.


In short, using the last 100 years as a guide, we have reasonable evidence to assume a rate of return of 8.4% for the equity portion of our portfolio. However, if a significant portion of your portfolio is comprised of bonds, it may be time to revise your expectations.

*You can refer to this post for an explanation on the difference between the geometric vs. arithmetic mean.

INVESTMENT FEARS & LONG RUN EQUITY RETURNS

One of my deepest investment fears is saving diligently over the next 10 to XX years, placing a good portion of my savings into stocks, and have the market move absolutely nowhere over this time frame. I also worry about showing up on the scene five minutes before the end of the party, similar to someone investing in the Nikkei (Tokyo Stock Exchange) just before the end of 1989.

In short, I am a worrywart that sometimes questions the popular belief that future long rung equity returns will outperform close to risk free investments, such as government bonds or sticking my money under the mattress.

I recently read Irrational Optimism, a paper by three London Business schools professors that studied the performance of 16 country stock indexes over the lat 103 years in order to challenge the notion that, over an interval of 20 years, equities provide positive real returns (i.e. provide returns that will beat inflation). Their research found that, "aside from the U.S., only three other equity markets... have never experienced a short fall in real returns (before costs and fees) over 20 years". Can you guess what country I was very and extremely excited to find in the top three?

That's right, Canadian equity stock markets have not had one 20 year period with negative real returns (see figure below).

So as long as I'm investing in Canadian, Australian, Danish or American equities over a period of 20 years, I can be somewhat reassured that I should beat inflation over my investment horizon.

INTRODUCING THE SIMPLE STUPID RRSP

Earlier this year I decided to sell the various funds I held in my RRSP and build a simple ETF portfolio: the Keep-It-Simple-Stupid RRSP.

The portfolio has what I consider an aggressive position in stocks: 75% is in equity index funds and the remaining 25% in a Canadian short bond fund. It's composed of four ETFs, each with a 25% weighting: XIC, XSP, XIN, and XSB. I bought these funds in August. Here is how the portfolio has fared since then.

ONLINE SAVINGS

Wow. HSBC will be increasing the interest rate on their online savings account to 4.25%. Meanwhile RBC is offering 4.0% and ING 3.75%.

What makes this interesting is that competition is beginning to drive these rates closer to the Bank of Canada's overnight rate, which is currently at 4.5%. I have always been jealous that US banks offer online savings accounts with rates above the federal funds rate. With some luck and a little more competition, maybe Canadian banks will get there.

HOW DIVERSIFIED ARE YOU?

My RRSP portfolio is composed of exchange traded funds (ETFs) that replicate the returns of the TSX composite index, the S&P 500, Morgan Stanley's Europe, Australasia and Far East index (EAFE), and a short term bond index. I hold all these funds with the aim of building a global diversified portfolio. Unfortunately, it turns out these holding are not bringing the diversification I hoped for.

An article in The Economist earlier this year highlighted that, over the past five years, international stock markets have shown a 95% correlation to the S&P 500. I just plotted the year-to-date performance of my ETFs and they all appear to be moving in tandem.

In short, although I have manged to build a low-cost global portfolio, I have some work to do when it comes to diversification.