Double Blind

Since March 1, 2005 was the last day to contribute to your RRSP and still have the deduction eligible for the 2004 tax year, a lot of people probably have made decisions to purchase mutual funds or a GIC. While purchasing a short-term GIC (i.e. one that can be cashed at any time) is a good decision when you’re waiting to make one, obviously it is not a long term solution. Worse yet are those that pick some random mutual fund that their advisor suggests is the ‘hot pick’ and forget about it until exactly 12 months later when it’s time to repeat the cycle.

The problem with most mutual funds (e.g. the ones at TD Waterhouse, BMO, etc.) is that they charge too much in management expense fees. Specifically for their actively managed funds, they charge up to 2.8% of managed assets. This is insanely expensive. Let’s pretend your average management expense is 2.5%. For every $1000 you invest in the fund, you’ll effectively pay $25 a year straight to management whether they earn a return or not on your investment. While this doesn’t seem like a lot, the problem is that throughout the years, the cumulative amount of management expenses will become massive, especially as the portfolio accumulates value. Each dollar that goes to management expenses should actually be compounded back into the fund. You will not accumulate assets nearly as quick as you should and there are more efficient ways to manage a portfolio.

Here I suggest two “brain-dead” methods of investing for people that want a minimalist approach to their portfolio. I will venture to guess that the following method will beat the S&P 500 over a thirty year period, but it will not beat it by much. I can say without qualms that it will beat investing in funds that charge 2.5% of portfolio value a year, however.

Brain-dead method 1: Invest in exchange-traded sector funds, not index funds as most financial media would suggest. One reason is because you can reduce your portfolio expenses by a factor of 10 but still retain a huge amount of diversification. You can find cheap sector funds on IUnits (0.55% for their Canadian sector funds), or better yet, SPDRindex.com (0.29% on average) which enables you to invest in specific sectors. By investing in these funds instead of the regular trash that institutions get most people to invest in, you will end up saving a ton of money in the long run. If you manage to accumulate $50,000 worth of assets in the form of mutual funds, you’ll end up paying about $125/year in management expenses, compared to $1250/year for ordinary mutual funds. The only disadvantage is that you incur a commission every time you trade these products, just like a regular stock ($29 at most places). But if you’re planning on investing more than $1000, it’s cheaper to invest in one of these than a regular fund with high expenses.

What to buy? The brain-dead algorithm is the following: Every year when RRSP season is coming and you’re making a deposit into your account, put your money in a sector fund with the second worst 2-year performance amongst all the sectors. Keep your money in this sector indefinitely (until you want to cash out for whatever reason). The reason why you choose the second worst performing sector in the last 2 years is that you’re virtually guaranteeing yourself diversification in a sector that is eventually bound to make a rebound in the future.

Eventually, over a long period of time, you’ll have your money evenly diversified amongst all sectors in the most optimal manner possible, which will take over the function of an index fund. This is the reason why you choose sector funds instead of index funds – when you buy an index fund, you’re buying a spread of every industry sector, no matter what the price is. By splitting your investments by sector, you will be buying cheap.

I do have an observation on index funds in general: The big indexes (S&P 500, TSX 60, etc.) should never be invested in. There is too much money following these indices and thus you should keep your money more narrowly pointed in specific sectors, buying when the sectors are cheap. If you must buy an index fund, choose the least followed index – ideally you or your friends should have never heard of it.

This brain-dead method keeps the ‘effort’ in investment to be limited to looking at a list of about 10 choices every year (plus or minus a few depending on how many sectors you’re looking at) and just examining their two year charts to see which one is underperforming and then hitting the “buy” button.

Brain-dead method 2: Invest in individual stocks of large companies (probably index components) that you know will be around for the next 30 years. This isn’t as easy as it sounds! To give an example, it’s virtually guaranteed that the Royal Bank of Canada will be around in some form. If you want more ideas to research, check out the components of the TSX 60. Is it conceivable that ATI Technologies will be around in 30 years? Probably not. I would also tend to avoid resource-based stocks until the underlying commodity (oil, steel, coal, etc.) has depressed to such a point where the shares have become cheaper.

The idea would be to set a price alert when the price of a stock has dropped by some pre-set level (like 15-25%. Take a look at the charts of some of these banks) and then buying shares in that company when it has dropped your pre-set amount. You would keep a watchlist of about 20 companies (that you know will survive and grow for 30 years) and then buy their stock when the price has dipped. Most often the stocks will drop due to some scary reason (a foreign crisis in debt of some company, threats that the bank will go insolvent, etc.), but this is what will make the stocks cheap and a perfect time to jump in. The last good time to jump into banks was late in 2002, but I can’t recall what the reason was for the decline in stock price. There will be another opportunity in the future – it’s just a matter of waiting and timing it. Despite what most advisors say, marketing timing is completely appropriate – demand the right price for what you are buying.

This is probably a viable strategy dealing strictly with the big 5 banks (TD, BMO, Royal, Scotia, CIBC) and other financials/insurance corps (Power Corp, Manulife, Sunlife, etc.) – they will all continue to dominate our economy for the next generation. If you just purchase shares of these companies at the right price, you’ll probably do better in your portfolio over an extended period of time than most mutual funds. This brain-dead method requires a little more research than the first brain-dead method, but you’ll probably get a better return on your money – I’m willing to estimate you’ll do better than the S&P 500 because you won’t pay anything other than a single commission each year.

This entry was posted on Tuesday, March 8th, 2005 and is filed under Best Of, Finance. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.