Sunday, November 25, 2007

MEASURING RISK

ACME's International Market Fund, touts a recent ad, has had average annual returns of 31.52%, 25.59%, and 11.78% over the past one, five, and ten year periods. While knowing past returns is great, what investors' should really be provided with is a proper measure of risk: what is the likelihood, say, of experiencing negative returns?

Enter the standard deviation, a statistical measure that helps quantify how much we can expect an investment to vary around it's mean. For example, take an asset that has an average annual return of 11% (such as the EAFE index from my previous post). Knowing that this asset has a standard deviation of about 20% helps us deduce that 68% of the time it's return will take on a value of 11% plus/minus 20% (assuming this asset follows a normal distribution) . In other words, there is a sixty-eight percent chance that it's returns will be between -9% and 31%. We can also infer that 95% of the time, returns will be the average plus/minus two standard deviations (or between -29% and 51%).

So how risky is investing in the TSX? Looking at the 1982 to 2006 period, the average annual return was 9.9% and it's standard deviation 17.9% (see table below). Consequently, 95% of the time we can expect returns to be between-25.8% and 45.6%. Risky enough for you?

Sunday, November 18, 2007

BACKGROUNDER: EAFE INDEX

The MSCI EAFE index is an international equity index which represents 21 countries in developed markets outside North America (EAFA stands for Europe, Australasia and the Far East). Japan and the UK comprise nearly 50% of the index (see table of country weights below). EAFE has been around since 1969, has an average yearly return of 10.97%, and has a standard deviation of 21.40% - making it quite volatile.

Canadian investors can hold EAFE in their portfolios through funds such as XIN or TD's International Index.


Monday, November 12, 2007

ROB CARRICK ON CURRENCY HEDGING

Rob Carrick from the Globe and Mail wrote a column this weekend outlining 3 scenarios for the Canadian dollar. More interestingly, he constructed four sample portfolios to deal with these scenarios:
  1. Canadian dollar will appreciate: use (currency) hedged funds to protect against a higher loonie.
  2. Canadian dollar will depreciate: use non-hedged global equity funds. Carrick still recommends that 20% of this portfolio be allocated to hedged funds.
  3. Canadian dollar will stabilize at current levels: use hedged and non-hedged funds.
  4. Keep it Simple: use a 50/50 approach between hedged/non-hedged funds and ETFs.
Note from below that his appreciation example still allocates 10% to a non-hedged fund. I point this out because the foreign portion of my RRSP portfolio is fully hedged to currency movements. I should probably revisit this.

Saturday, November 10, 2007

SIMPLE STUPID RRSP - Update

One of my plans for this blog is to keep notes on my investment experiences; to keep an investment diary, if you will. I'm particularly interested in how much volatility I will be able to tolerate and how I will feel when my investments are down.

So I just checked the performance of the Keep It Simple Stupid RRSP and found that it is down about 1% since inception (August 07). How do I feel about this? Not much, I'm glad to say. Thus far it feels like a little volatility. Let's see if I feel the same way one month from now.

Sunday, November 4, 2007

GO CANADIAN DOLLAR - Think twice before buying US equities.

As I write this the Canadian dollar is trading at $1.07 to the US greenback and most Canadian finance articles I'm reading are suggesting you should jump into US equities - these are cheap by historical standards and the Canadian dollar is bound to retreat. This blog's opinion is that no one knows were the loonie is headed next. Consequently, you should save yourself a lot of stress by insuring your portfolio against currency movements.

First, let's discuss some factors contributing to the loonie's strength and the dollar's weakness.
  • The US has a current account deficit of roughly $760 Billion (USD) (or -5.6% of GDP) and a budget deficit of approximately $200 Billion (or -1.5% of GPD). The current account deficit points to weakness in the greenback as it reflects that Americans are buying more than they are selling to the rest of the world. As they must sell dollars to pay for these imports, this deficit should put downward pressure on the US dollar.

  • In contrast, Canada is the only G7 country with a twin surplus: our current account surplus sits at $22 Billion (USD) ( or 1.8% of GDP) and our budget surplus is at $12 Billion (or 0.6% of GDP).

  • Furthermore, commodities comprise 35% of Canada's exports and our proven oil reserves stand second only to Saudi Arabia's. As long as China and India continue to grow and demandthe type of goods we export, the underlying strength in the loonie is bound to continue.
In short, as long as the US continues to spend more than it earns and China/India's growth continues to put upward pressure on commodities, the underlying strength of the loonie should persist.

Now let's discuss how you can protect your portfolio against further currency movements: buy funds tracking foreign indices that are hedged to Canadian dollars. Every bank has one, I believe. RBC has this one, for example, that tracks the S&P 500. I use XSP in my portfolio.

I'll finish this post with the main reason why you should use foreign funds that are hedged to Canadian dollars: sleep. These funds save you a lot of worry with regards to currency movements. If you expect to retire in Canada, why add currency risk to your portfolio?

Saturday, November 3, 2007

MYOPIC LOSS AVERSION

Last week I wrote on why we should stop checking the market on a frequent basis: as you narrow the time scale at which you view an asset's returns, the probability of viewing a positive return decreases. This post will expand a little on this topic by introducing the concept of (myopic) loss aversion.

Loss aversion is a concept introduced by two behavioural economists, Amos Tversky and Daniel Kahneman, which states that people have a stronger sensitivity to losses than to gains. Researchers have measured this sensitivity and found that we regret loses 2.5 times more than similar sized gains. In other words, the psychological impact (pain) I feel from losing $100 is two and a half times the impact (pleasure) derived from winning $100.

Myopic Loss Aversion, introduced by S. Bernatzi and R. Thaler to explain why equities offer such a higher premium over bonds, expands on loss aversion by discussing how long term decisions are evaluated by their short term results. Under myopic loss aversion, investors are too anxious and evaluate the performance of long term investment decisions by focusing on short term results.

The lessons we should take from myopic loss aversion are as follows:
  1. By checking the state of my portfolio on a frequent basis, I expose myself more to short term volatility than to long term results. As I increase this frequency, the probability of viewing negative returns increases (see this previous post).
  2. Given that the pain of a x% loss is 2.5 greater than the joy of the same x% gain, the costs of monitoring my portfolio on a daily basis will probably exceed any positive return I might view.
  3. The pain experienced by focusing on short term results might push me to change investment strategy. Given that I invest with a long investment horizon in mind (i.e. four decades from now when I retire) I will be basing any changes on (meaningless) volatility.
Given this knowledge, can someone please tell me why I continue to check the status of the Simple Stupid RRSP on a daily basis?