Book Review: Simple but not Easy

Richard Oldfield was an investment manager for three decades, and he evaluated and appointed investment managers for a decade.  His book, Simple but not Easy: A Practitioner’s Guide to the Art of Investing, was first published in 2007, and his second edition, that I review here, came out in 2021.  The quality of the writing makes it a pleasure to read, but it comes from a time when “investing” meant stock picking, and few doubted that active investing based on star managers was the best approach.  For those who still think this way, this book offers many useful lessons, but others might see it all as advice on traveling by horse-drawn carriage.

The 2007 edition of the book is left intact with a new preface and a lengthy new afterword added for the second edition.  The new afterword provides interesting commentary on the modern investment landscape, but I still can only recommend this book to those dedicated to trying to beat the market.

Many themes in this book might have been controversial back in 2007, but seem well accepted today, at least by me: active managers are bound to make mistakes, “in aggregate, hedge funds are a con,” “leverage and illiquidity are the kiss of death,” fees drive down returns, investors need to avoid managers who are closet indexers, benchmarks are tricky, a manager’s approach can go in and out of style, forecasts are random at best, and valuations matter.

Some claims are a blast from the past.  Investors “can get almost all the diversification there is to get with a portfolio of as few as 15 stocks.”  No.  The author claims that ignorance and distance from the investing action are advantages for amateur investors.  “Investors in places remote from the City frenzy are arguably at a huge advantage.”  This idea that DIY investors can easily beat the pros used to be very popular, but it isn’t true.

The afterword written in 2021 is more interesting to me.  On bonds, “it is hard to justify using bonds as the counterweight to equities when they now yield almost nothing.”  This would have been written 3 or 4 years ago, and I certainly agreed at that time in the case of long-term bonds.

On electric cars, “there is no obvious reason why the traditional carmakers should not succeed with electric cars.”  To me, the obvious reason is engineering.  Tesla was hugely devoted to advanced engineering, to an extent that traditional car companies have had challenges matching.  U.S. car companies have covered up poor engineering with marketing for decades.  The author’s discussion of safety problems with self-driving cars left out the fact that human-driven cars kill people at a frightening rate.  We don’t need perfection to justify replacing the status quo.  Continued improvement can come later.

On the subject of the rise of passive investing, the author convincingly explains why active managers, on average, must trail passive investment returns by roughly their additional costs.  But he goes on to say “I think that it is possible to choose a group of active managers the majority of whom will outperform for the majority of the time.”  Oldfield’s own arguments make it clear that only a small minority of investors can hope to do this.

“The next ten years could … be a golden decade for active managers because the trend away from them has been too strong and is due for a large dose of reversion to the mean.”  This is just hopeful thinking from a former investment manager.  Active managers can only make up for their costs by exploiting other investors.  If the only other investors to exploit are index investors, the pickings are very slim.  Perhaps if 99% or more of investors were passive, there would be room for active managers to live off these pickings, but the proportion of investor money that is indexed is nowhere near that level yet.

This book is well written, and I would have enjoyed it back in 2007 when the first edition appeared, but now that I’m solidly in the index investing camp, I find its focus on trying to beat the market less compelling.  Investors who are still trying to beat the market with their own stock picks or who seek investment managers who can beat the market are its best target audience.

Indexing of Different Asset Classes

When it comes to stocks, index investing offers many advantages over other investment approaches.  However, these advantages don’t always carry over to other asset classes.  No investment style should be treated like a religion, indexing included.  It pays to think through the reasons for using a given approach to investing.

Stocks

Low-cost broadly-diversified index investing in stocks offers a number of advantages over other investment approaches:

1. Lower costs, including MERs, trading costs within funds, and capital gains taxes
2. Less work for the investor
3. Better diversification leading to lower volatility losses

Choosing actively-managed mutual funds or ETFs definitely has much higher costs.  For investors who just pick some actively-managed funds and stick with them, the amount of work required can be low, but more often the investor stays on the lookout for better funds, which can be a lot of work for questionable benefit.  Many actively-managed funds offer decent diversification.  Ironically, the best diversification comes from closet index funds that charge high fees for doing little.

Investors who pick their own stocks to hold for the long-term, including dividend investors, do well on costs, but typically put in a lot of work and fail to diversify sufficiently.  Those who trade stocks actively on their own tend to suffer from trading losses and poor diversification, and they put in a lot of effort for their poor results.  Things get worse with options.

Despite the advantages of pure index investing in stocks, I make two exceptions.  The first is that I own one ETF of U.S. small value stocks (Vanguard’s VBR) because of the history of small value stocks outperforming market averages.  If this works out poorly for me, it will be because of slightly higher costs and slightly poorer diversification.

One might ask why I don’t make exceptions for other factors shown to have produced excess returns in the past.  The reason is that I have little confidence that they will outperform in the future by enough to cover the higher costs of investing in them.  Popularity tends to drive down future returns.  The same may happen to small value stocks, but they seemed to me to offer enough promise to take the chance.

The second exception I make to pure index investing in stocks is that I tilt slowly toward bonds as the CAPE10 of the world’s stocks grows above 25.  I think of this as easing up on stocks because they have risen substantially, and I have less need to take as much risk to meet my goals.  It also reduces my portfolio’s risk at a time when the odds of a substantial stock market crash are elevated.  But the fact that I think of this measure in terms of risk control doesn’t change the fact that I’m engaged in a modest amount of market timing.

At the CAPE10 peak in late 2021, my allocation to bonds was 7 percentage points higher than it would have been if the CAPE10 had been below 25.  This might seem like a small change, but the shift of dollars from high-flying stocks to bonds got magnified when combined with my normal portfolio rebalancing.

Another thing I do as the CAPE10 of the world’s stocks exceeds 20 is to lower my future return expectations, but this doesn’t include any additional portfolio adjustments.

Bonds

It is easy to treat all bonds as a single asset class and invest in an index of all available bonds, perhaps limited to a particular country.  However, I don’t see bonds this way.  I see corporate bonds as a separate asset class from government bonds, because corporate bonds have the possibility of default.  I prefer to invest slightly more in stocks than to chase yield in corporate bonds.

I don’t know if experts can see conditions when corporate bonds are a good bet based on their risk and the additional yield they offer.  I just know that I can’t do this.  I prefer my bonds to be safe and to leave the risk to my stock holdings.

I also see long-term government bonds as a different asset class from short-term government bonds (less than 5 years).  Central banks are constantly manipulating the bond market through ramping up or down on their holdings of different durations of bonds.  This manipulation makes me uneasy about holding risky long-term bonds.

Another reason I have for avoiding long-term bonds is inflation risk.  Investment professionals are often taught that government bonds are risk-free if held to maturity.  This is only true in nominal terms.  My future financial obligations tend to grow with inflation.  Long-term government bonds look very risky to me when I consider the uncertainty of inflation over decades.  Inflation protected bonds deal with inflation risk, but this still leaves concerns about bond market manipulation by central banks.

Taking bond market manipulation together with inflation risk, I have no interest in long-term bonds.  We even had a time in 2020 when long-term Canadian bonds offered so little yield that their return to maturity was certain to be dismal.  Owning long-term bonds at that time was a bad idea, and I don’t like the odds any other time.

Once we eliminate corporate bonds and long-term government bonds, the idea of indexing doesn’t really apply.  For a given duration, all government bonds in a particular country tend to all have the same yield.  Owning an index of different durations of bonds from 0 to 5 years offers some diversification,  but I tend not to think about this much.  I buy a short-term bond ETF when it’s convenient, and just store cash in a high-interest savings account when that is convenient.

Overall, I’m not convinced that the solid thinking behind stock indexing carries over well to bond investing.  There are those who carve up stocks into sub-classes they like and don’t like, just as I have done with bonds.  However, my view of the resulting stock investing strategies, such as owning only some sub-classes or sector rotation, is that they are inferior to broad-based indexing of stocks.  I don’t see broad-based indexing of bonds the same way.

Real estate

Owning Real-Estate Investment Trusts (REITs) is certainly less risky than owning a property or two.  I’ve chosen to avoid additional real estate investments beyond the house I live in and whatever is held by the companies in my ETFs.  So, I can’t say I know much about REITs.  

However, I don’t think the advantages of indexing that exist with stocks automatically carry over to real estate without checking the details.  Someone would have to examine REITs to see if they can play a positive role in investor portfolios.  Do REITs have hidden costs?  Are other market participants able to exploit REITs when trading properties?  What are the costs of managing passively-owned properties?  Perhaps someone has examined these questions in sufficient detail, but I haven’t seen the analysis.

Some of these problems apply to stock indexing as well.  For example, there are circumstances where traders can exploit the way that index funds respond to changes in the list of stocks making up indexes.  However, major index ETF providers have responded with changes to how they do business that reduce such costs to low levels.  I don’t know if REITs are able to do the same.

Commodities, Hedge Funds, Venture Capital, Collectibles, Cryptocurrencies, other Alternatives

Any time I look at index-style investing in other asset classes, I find more questions than answers.  What answers I do find often keep me away from these asset classes rather than draw me in.  It would take a lot to convince me to make any of these asset classes part of my own portfolio.

Conclusion

I’ll never claim that how I invest is the best way.  I seek reasonable long-term results with a reasonable amount of protection against extreme events, such as stocks market crashes, high inflation, or outright corruption.  In some cases, I stay away from asset classes for well thought out reasons, and in other cases, I stay away out of my own ignorance.  I’m good with that.

Book Review: The Canadian’s Guide to Investing

Authors Tony Martin and Eric Tyson have updated their book, The Canadian’s Guide to Investing, but it certainly does not seem very up-to-date.  Despite a few references to ETFs and some updated examples, most of the text seems decades old and no longer very relevant.  There are some good parts, but there are better choices for investment books.

The book makes reference to many things that used to be true.  Extensive discussion about “funds” is almost exclusively about mutual funds with little about ETFs.  Buying stocks is “costly unless you buy reasonable chunks (100 shares or so) of each stock.”  You can “call the fund company’s toll-free number” and invest by “mailing in a cheque.”  “A great deal of emphasis is placed on who manages a specific fund” – this is mostly a thing of the past.  “Invest in a handful of funds (five to ten).”  There is discussion of real estate “declines in the late 2000s.”

There are repeated references to MERs of 0.5% to 1.5% as being “low.”  Even the ETF discussion on this point says index ETFs “typically have MERs of less than 1 percent.”  I suppose 0.05% is less than 1%.

The authors advise people to avoid limit orders and use market orders when you intend to hold for the long haul.  They seem to consider limit orders as being only for trying to get equities for cheaper than the current ask price.  A good use of limit orders is to offer a price higher than the current ask price (or lower than the current bid price when selling).  This will usually give you the market price, but will prevent the trade from executing if markets move quickly against you just as you’re entering the trade.

The book advises people to rely on credit-rating agencies for bonds, which is interesting in light of the abject ratings failures leading up to the great financial crisis.

On asset allocation, “playing it safe” is to use your age as a bond percentage, “middle of the road” is age minus 10, and “aggressive” is age minus 20.  They go on to break down the stock allocation characterizing owning mostly Canadian stocks as “play-it-safe,” and having half your stock allocation outside of Canada as “aggressive.”  I don’t see anything safe about avoiding U.S. and international stocks.

The authors tell investors “who enjoy the challenge of trying to pick the better [fund] managers and want the potential to earn better than market level returns, don’t use index funds at all.”  Chasing star fund managers is an old and losing game.

At one point, the authors promise to help investors in “spotting a greatly overpriced” market so you can “invest new money elsewhere.”  It turns out that this method uses price-earnings ratios.  Shiller’s CAPE10 measure of U.S. stock market price-earnings has been above 20 since 2010, a period where U.S. stocks have grown by a factor of nearly 6 (including dividends).  This is not a good period to have skipped.

On the positive side, the authors advise against buying expensive cars: “set your sights lower and buy a good used car that you can afford.”  When it comes to index investing, “you can largely ignore the NASDAQ.”  “To find a home that meets your various desires,” taking “six months to a year [to find the right house and neighbourhood] isn’t unusual or slow.”  “Begin your search without [a real estate] agent to avoid … outside pressure.”

The authors have some interesting takes.  “One of the best tactics is to focus only on [retirement saving and paying off your mortgage] and ignore [saving for university or college]” until later.  They also offer extensive advice concerning owning a small business and determining if readers are suited to it.

The authors would need to put extensive work into this book to bring it up to date.  As it is, I can’t recommend it to others.

Tax Rates on RRSP Contributions and Withdrawals

Recent Rational Reminder podcasts (319 and 321) have had a debate about tax rates on RRSP contributions and withdrawals.  Most people agree that when you contribute, you’re lowering your taxes at your marginal tax rate.  The debate concerns withdrawals.  Some say that RRSP withdrawals come at your “average, or effective tax rates, not your marginal tax rate.”  Here, I address this question.

With Canada’s progressive tax system, the first part of your income isn’t taxed at all (or is taxed negatively when you consider income-tested government benefits), then the next part of your income is lightly taxed, and marginal tax rates increase from there as your income rises.

A question that comes up in my own portfolio accumulation and decumulation planning is what order to stack income each year.  Is it CPP and OAS that are taxed lightly and RRSP withdrawals taxed more, or should I stack the income in some other order?  What about other income from non-registered savings?  Maybe everything should be assigned the same average tax rate.

The truth is that this is only a struggle because we’re trying to assign tax rates to one strategy in isolation.  Whether a strategy is good or not cannot be decided in isolation.  It only makes sense to compare two or more strategies.  When we compare strategies, it becomes obvious how to handle tax rates.

Let’s try to create two strategies that isolate the RRSP as the only difference.  Strategy 1: no RRSP.  This strategy might include TFSA contributions or other elements, but it does not use RRSPs.  Strategy 2: everything from strategy 1 plus RRSP contributions while working, and RRSP withdrawals after retiring.

Comparing the two strategies during working years, we should think of RRSP deductions as coming off the highest part of the total income because that is the difference between the two strategies.  If we apply the deduction somewhere in the bottom or middle of the income range, then the other income (that is the same in both strategies) will be taxed differently in the two strategies.  We want to find the net difference between strategies, and that comes from treating the RRSP deduction as coming at the marginal tax rate.

During retirement years, we end up with a similar argument.  Both strategies will have the same income each year, except that Strategy 2 will have additional RRSP withdrawal income.  To isolate the differences in income and taxes between the two strategies, we must think of the RRSP withdrawal as being the last, most highly taxed part of the income.  So, it’s taxed at the marginal rate.

At this point, we should comment on what we mean by marginal rate.  It is usually defined as the tax rate on the last dollar earned.  However, we usually aren’t discussing amounts as trivial as a single dollar.  Larger amounts can easily span multiple marginal tax brackets.  So, it’s possible for your RRSP deduction to give part of its tax savings at one rate and part at a lower rate.  

So, when we say that RRSP contribution tax savings occur at your marginal rate, this might actually be a blended rate, not to be confused with your overall average tax rate.  For example your marginal tax rate might be 43%, your tax savings rate on RRSP contributions might be partly 43% and partly 38% for a blended rate of 40%, and your average tax rate might be 25%.

This effect becomes larger for RRSP withdrawals, because the withdrawals tend to be larger than the contributions.  If your income consists of CPP, OAS, and RRSP withdrawals, your RRSP withdrawals may be the bulk of your income and may span multiple marginal tax brackets.  So, even though we say you pay tax on the RRSP withdrawals at your marginal tax rate, this is actually a blended rate that may not be too much higher than your average tax rate.

So, when comparing the strategies that differ only in RRSP contributions and withdrawals, the argument that RRSP withdrawals come at your average tax rate might be sort of true in the sense that they will likely be at a blended rate, but we get the correct answer when we think of RRSP deductions and income as coming at the top of your income.  We can only answer such questions properly when comparing two or more accumulation and decumulation strategies rather than analyzing one strategy in isolation.

Picking Up Nickels in Front of a Steamroller

Suppose a casino offered the following bet.  You roll six fair dice.  If anything but all sixes shows up, you get $20.  But if all sixes show up, you lose a million dollars.  There are a number of practical problems with this game.  The casino would demand a million dollar deposit in advance, and the odds are way too sensitive to imperfections in the dice and to player skill at not throwing sixes.  But this is a thought experiment designed to shed light on real world financial events.

Initially, few people would play this game, because losing a million dollars is too scary.  But if you watched someone playing, even all day, you’d likely never see a loss.  You’d just see the player collecting $20 every 10 seconds or so building up to many thousands of dollars.  The fear of missing out (FOMO) would set in for some and tempt them to play.

Over the long haul, the casino expects to pay out $933,120 for every million dollars it wins.  So playing this game is good for the casino but a bad idea for the player.  However, it’s easy to forget about the losses if you only see everyone winning $20 every play.  Games like this are referred to as “picking up nickels in front of a steamroller.”  The $20 payoffs are the nickels, and the million-dollar losses are when you get flattened by the steamroller.

The yen carry trade

So what does this have to do with real life?  There are many “games” in real life that resemble this hypothetical game more than people would like to admit.  When interest rates were much lower in Japan than they were in the U.S., it seemed profitable to borrow yen at a low interest rate, convert it to U.S. dollars, and collect high interest on U.S. dollar deposits.

This sounds quite profitable, so why did I say it only “seemed profitable”?  Well, all was well as long as interest rates and the exchange rate between yen and U.S. dollars were stable.  However, a rise in the value of the yen and higher Japanese interest rates (the steamroller) could more than wipe out any profits from the interest rate spread (the nickels).

Unlike the hypothetical dice game where the potential loss of a million dollars is prominent, it’s less obvious with the yen carry trade.  You might convince yourself that the value of the yen and Japanese interest rates would change slowly enough that you could exit your positions profitably.  However, many others would be trying to unwind their positions at the same time, each one trying to be among the first to get out.

Excessive leverage

Rather than just invest a fraction of your wages in stock markets, you could borrow extra money to invest more.  The stock markets may gyrate, but they keep rising.  If you can just wait out the gyrations, you’ll be sure to eventually make more money (the nickels) than if you didn’t borrow.

The problem is that if you borrow too much, and your creditors see that you’re in danger of becoming insolvent, they may demand their money back or impose high interest rates that eliminate your profits.  A sudden stock market crash (steamroller) could wipe you out before you get a chance to wait out the market decline.  Modest leverage can be reasonable, but it takes some skill to determine how much you can borrow safely.

The great financial crisis

Many Wall Street firms made apparent profits selling insurance against mortgage defaults in the form of exotic financial instruments like credit default swaps (CDSs) and collateralized debt obligations (CDOs).  In this case, the nickels were the insurance premiums they collected, and the steamroller was the wave of mortgage defaults across the U.S.

It’s tempting to say that everyone involved was naive or incompetent, but employees of a firm have different interests than the firm itself does.  While the party was ongoing, the apparent profits piled up, and employees collected their share in the form of huge bonuses.  When the steamroller crushed their firms, these employees didn’t have to return their bonuses.  It was like playing the dice game with someone else’s money.  The employees would take a cut of each $20 win, and let others deal with the million dollar loss.

Long-Term Capital Management

The LTCM hedge fund employed Nobel Prize winners to beat the markets, and it seemed to work for a few years.  They used complex models of how markets work to squeeze out profits (the nickels).  Unfortunately for them and their investors, markets eventually stopped working the way the models expected (the steamroller) for long enough to wipe out past profits.

Conclusion

There are many financial schemes in the real world that resemble picking up visible nickels in front of an obscured steamroller.  If you think you've found a way to beat the markets, try to figure out where the steamroller is.