January 2009

The latest GMO quarterly letter is now available (at least the first part), with some very interesting commentary on the US market. Some of the things discussed are:

  • American businesses have written down about $1 trillion in debt, but if conventional lending standards are applied they should write down as much as $12 trillion more.
  • Japan’s two decades of equity underperformance may actually be one of the easier ways out of such a situation as long as people aren’t willing to accept the full extent of their losses immediately.
  • Most of the losses weren’t in real wealth, and people will come to see that in time.

Although these may be seen as dire warnings, I don’t expect the future to be that bad (and not just beecause most of my investments are outside the US). While it may take some time for people who were counting on the market value of their assets at the peak of the market to get back there, they will recover eventually. For everyone else – particularly those who are buying now – the drop in prices makes the future much more promising.

As usual this is an enlightening perspective on recent events that’s rarely discussed, and well worth the read.


Active investment management is often ridiculed for poor returns compared to passive indexing (not often enough judging by its continued popularity). The few funds that do consistently outperform the closest index are difficult to find before enough investors flood in to drag down their returns. Based on this knowledge, I concluded a while ago that it would be very difficult to get investment returns significantly higher than the long-run average real return of stable stock markets such as those in the US, Canada, and western Europe.

This can certainly form the basis of a good investment plan and there’s nothing wrong with “only” getting the market average. However, reading The Snowball gave me another perspective on this. While choosing someone else to actively manage your money often comes at a high cost, there are a lot of potential investments that can have higher rates of return but require your direct involvement. The book includes many stories about how Warren Buffet used his money early on to start small (and often temporary) businesses that grew his capital significantly.

This definitely wouldn’t be the right thing for everyone to do. If you don’t want to spend a lot of time managing an investment or apply specialized knowledge that you already have, the easiest thing to do is still to buy index funds. Since I don’t have a job and I’m free to allocate my time any way I see fit this idea is particularly interesting. By setting aside some money for investments that I’m directly involved in I may be able to get higher rates of return than I would by investing in public companies. I’m interested in business in general, so having to spend time managing an investment wouldn’t feel like a waste of time. It might even help me learn more by exposing me to new challenges.

One simple example of a direct investment is real estate. If you find a property that has positive cashflow from the start the combination of those profits, the mortgage principal payments included in the rent, and the property value appreciation may give you a rate of return well above the average expected from stocks. Another example might be buying a small business that’s currently profitable.

Doing this successfully will require a big change in my perspective. So far I’ve pretty much always done things myself except for the cheapest services that would never be worth my time. Getting things done by investing money instead of time requires a different approach, but it seems to have a lot more potential.

A danger in this type of investment is that the time required actually makes the rate of return much worse. If you don’t account for this your time input may add hidden costs that turn it into a bad investment. If the income generated doesn’t depend directly on the time you put in there’s the potential for good returns including the cost of your time; there may be periods where you have to put in time that would earn you more money at your current hourly rate, and other times when you just have to check in now and then to see that everything is ok.

Another type of active investment is what Buffet later turned to: detailed analysis of the stock markets to find undervalued stocks and buy them. While this can also have higher returns if you put in the time to get a better understanding of the market than most investors it’s not something that interests me much. It’s also likely to be much harder now in developed markets than it was in the 40s, 50s, and 60s (although there are still times when the market presents obvious opportunities to those who can see them).

I’ve just recently started to think this way, so it will take a while to adjust fully and see the opportunities to increase my rate of return. Meanwhile I plan to continue investing in stocks, and start building up an account that can be used to fund active investments.

Do you look for ways to get a higher return than index funds? What’s your preferred method?

Lately, as my knowlege of investment grows, I’ve been wondering if market timing is always bad. Predicting the next month’s returns will always be virtually impossible due to the number of people pushing markets in different directions, but if investors forget some of the lessons of the last 10 years there may be a time when it’s clear that a market has to revert to the mean.

GMO‘s Jeremy Grantham has some interesting points – I started reading his quarterly newsletter just over a year ago. After many predictions in recent years that the S&P 500 would reach 1100 by 2010, what was once a very pessimistic outlook now seems a little too optimistic (of course with the recent volatility that could be a week away).

Grantham’s quarterly newsletters often talk about which asset classes he believes are overvalued and how this guides his investment decisions. This isn’t the day-to-day technical analysis type of market timing. Instead it relies on a very simple analysis, such as the fact that even after 2000-2003 the S&P 500 was well above the long-term growth trend. Faced with a growing awareness that stock markets can be stagnant for a decade or two, I’ve been thinking about how this could be integrated into an individual investor’s framework.

The first problem is how you can decide if an asset class is overvalued or undervalued. For a stock market index you can look at long-term real return if enough historical records exist (there’s a lot of studies about the US market but I’d like to know more about the canadian market; in other countries there’s not much data at all) and P/E ratios. While there can be market-changing factors – for the last two decades there have certainly been more investors in the market than a century ago, which probably bids up prices a bit – it’s hard to forget the lesson of 2000: fundamentals always count. Of course it’s still hard to know which ones are coincidences and which ones matter. A real return trend of over 100 years should be fairly reliable – if there really is a deviation it should be acompanied by something like a big change in the GDP, although that can be temporary too.

The second decision is what to do if an asset class is overvalued or undervalued. If all equities around the world are overvalued, parking cash in bonds for a long time may not be a gain unless the markets truly are flat and the dividend yields are low. If it’s a bull market or a bubble there may still be gains to be had from sticking to an asset allocation and steadily moving profits into other asset classes until the correction.

Asset allocation may be the key to this idea. One of the reasons to rebalance regularly is that a growth in one asset class increases risk – if you think your risk tolerance is for 60% equities, you don’t want to be at 75% because it’s more risky. If there are obvious signs that a certain asset class is overvalued it would become more risky, so it makes sense to reduce the allocation. If it’s severly undervalued it becomes much less risky, so the allocation could be increased. This only matters in relation to other asset classes though – if everything goes down by 10% there’s no reason to change your allocation. 

This is a difficult decision, but decisions like this shouln’t be made lightly so there’s always time to consider the relative merits of different asset classes.

Even with the extended periods of slow growth that have happened before and will happen again I firmly believe that dollar-cost averaging into a large market index over a long period makes for a very reliable investment. However the history of the markets shows that there are times when the market is obviously inefficient. If there’s a way to make some adjustments for that without paying a higher price it would be very useful.

Have you changed your view of any investing risks recently? Do you think you can know when to change your allocation to get better returns?

Today I came across an older blog post about the evils of term life insurance. While this has been discussed endlessly already, the post brought up a few things I hadn’t heard before.

One of the main reasons given to avoid term life insurance was that premiums rise as you get older – for obvious reasons, someone who is 95 will have to pay close to the actual amount they’re being insured for or it won’t be worth it. It’s easy to imagine an insurance salesman striking fear in people’s hearts with this fact. But when you stop for a second you realize that in many cases getting life insurance at 95 is just about as ridiculous as getting life insurance for a newborn baby. It has one real purpose – to protect people who depend on you if you die unexpectedly and can’t earn money anymore. Hopefully most people aren’t depending on their ability to earn money for themselves from day to day at 95, let alone have other people depending on them.

Another interesting argument was that Warren Buffet himself buys permanent life insurance policies from people who want to cancel their policies in exchange for a cash payment from the insurer, and considers them a bargain even after paying more than the insurer would. Although this is used to imply that permanent life insurance is a good investment, it’s instructive to stop and think about the framing for a second. All this means is that if you buy permanent life insurance, the insurance company will offer you a payment to cancel it but it will be an amount that gives them all the advantage! This doesn’t sound like the type of arrangement where the policy holder has anything to gain.

A third reason given is for tax avoidance. If it’s true that certain types of insurance give you a way to invest with less taxes that could potentially allow you to leave more behind than if you invested the money yourself in a taxable account. The advantage this gives you depends a lot on what investments you’re offered and what fees you’re charged though. And unless you can also withdraw the money tax-free, the only way to use it yourself is to borrow against it and pay interest which is just as bad as taxes as far as I’m concerned.

Taking a small incentive for insurance and trying to turn it into a central part of your investments sounds very suspicious to me. Maybe this allows you to pay the premiums when you’re 95 out of tax-free investment growth – but you need to consider whether or not you really want to be insured when you’re 95. Not to mention the chance that you could end up in the same place as the canadian income trust investors of ’06. Where do you get insurance against that risk?

These are only a few ideas to watch out for when buying insurance. They weren’t written by someone who actually sells insurance, but it seems like there’s no end to the ways to make a potentially bad choice sound like it has no downsides. I’m sure there are some people who shouldn’t get term life insurance. It’s also true that “buy term life and invest yourself” is often brought up regardless of the context based on assumptions that probably aren’t challenged enough. But seeing things like this only reinforces my belief that the downsides to it are mostly imaginary.

What do you think? Are there any concrete reasons to get universal/whole/permanent life insurance?