Saturday, March 5, 2016

Buffett's Advice to Young People

Dear readers, I will be away for the next 3 months studying for an exam. I see some of you have left comments – I will respond to you in June.

In the meantime, I’d like to leave you with a speech given by Warren Buffet to a young audience. The video is almost 20 years old but the advice is timeless. Some of the key takeaways:
  • Qualities of great employees: integrity, intelligence, and energy. You must have integrity in order for the others to matter. 
  • The importance of forming good habits at a young age in order to develop into the kind of person you most admire. 
  • Do what you love, not what makes you the most money
  • Stay out of debt and live frugally. Compare two people: one with net credit card debt of $10K paying 18% while another has net savings of $10K growing at say 8% over the long-term. You want strive to become the latter at an early age. 


Thursday, February 4, 2016

You Gotta Be Here

Source: Kenn Leonhardt

In 2010, Vancouver BC hosted the Winter Olympics and the city ran catchy marketing slogans including “The Best Place on Earth” and “You Gotta be Here.”

Vancouver has supernatural scenery with the ocean and mountains in the backdrop. We have world-class ski resorts just 30 mins away from the city core and enjoy a very moderate climate.

We also have some of the most expensive real estate on earth. In fact, last month the average detached house in Greater Vancouver has surpassed $1.8 million!

Source: REBGV

As you can see from this graph, prices of detached homes have gone parabolic in the past year. The locals here are dangerously in love with real estate and it seems it’s the only market they ever talk about. You got to be here to witness it.

According to the annual Demographia housing study, Vancouver real estate is regarded as the 3rd most expensive in the world (based on average housing prices divided by average local incomes).

Source: Demographia

Our housing valuations (Price/Income and Price/Rent ratios) are now over 3 standard deviations from their historical norms. Yes, I know. Something that’s expensive can become even more expensive and that’s why I’m a trend follower instead of a value investor.

So what's the point I'm trying to make?

I want to show you (especially if you’re a local) something that may surprise you. I want to show you that as hot and exciting as Vancouver real estate might look, boring old bonds would have made a better investment over the past 40 years.

Going back to the price graph above, a single detached home went from about $80K to $1.8M in 39 years. That’s an annual price growth of 8.3%. If you count rental income, then the total return would be closer to about 10%.

Over the same period, an Aggregate Bond Index such as AGG (which mostly contains AAA-rated government bonds with an average 5-year maturity) grew at a total return of 8%. OK, not quite as high but consider these important things:

  • Bonds are low-cost. They don’t have the enormous costs of property tax, insurance, maintenance and repairs. Just property tax alone in Vancouver would be $34K/year on the average $1.8M house.
  • Bonds are more liquid. To sell a home in Vancouver, realtor fees alone would be $60K on the average $1.8M average house. To sell a bond ETF, it would cost you $10 and it would be instant and painless.
  • Bonds are less volatile
  • Bond indices are more diversified

When you factor in the high costs of owning a home, we can say that the total return for a detached home is closer to 9% annually. I’d much rather take the 8% that bonds gave and have the benefit of lower volatility, better diversification and better liquidity. (Actually, I’d much rather take the 18% that GEM has produced over that same period but I’m making another point here).

Despite all these points, no one ever talks about bonds. That would just be a buzz kill at cocktail parties and nobody wants that!

I’d like to end with a quick discussion on interest rates. Here’s a chart for the 10-year US Treasury Yield going back over 100 years:


The stellar growth in both bonds and Vancouver real estate for the past 30 years was on the back of falling interest rates. In fact, if you look at pre-1982 and post, you can see how rising and falling interest rate environments have affected bonds: 

Going forward, we no longer have that tailwind of falling rates. Instead, over the next 20 years we may see something more like the 50s and 60s. This would mean a low-return environment for bonds and real estate.

And when you also factor the current stretched valuation of Vancouver real estate, I wouldn’t be surprised to see a couple lost decades in this market.

But I promise not to mention any of this at a party.

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Sunday, January 17, 2016

Get Rich Slow

With the recent declines in the stock market, I was reminded of this article I read in the WSJ journal written on May 14, 2015: Chinese Investors Are Staying on the Risky Margins

The article explained how “China’s rocking stock market has encouraged typically conservative investors to embrace leverage. They are borrowing money to buy stocks and ride a rally that has seen the Shanghai Composite Index more than double in a year.

The article was written just 3 weeks before the Shanghai index peaked. The chart below shows how the index doubled in less than a year before erasing the majority of those gains in just 7 months. You can also see how margin debt went up over 5-fold before the market peaked. 

Source: WSJ,

The most striking part of the article was the story of one Chinese trader:
“Kevin Zhang, formerly a senior manager at a state-owned company in Shenzhen, started with a five million yuan ($800,000) stock portfolio last year. He borrowed an additional 10 million yuan from his broker, and the value of his initial investment doubled in a year.
But he isn’t satisfied. At a dinner for big investors arranged by his broker, Mr. Zhang found that several of them made 10 or 20 times their initial investment last year. These people had borrowed money from other channels, such as umbrella trusts, now banned, that allowed people to borrow up to 10 times their investment money. 
This year, Mr. Zhang gave up his stable job, with an annual salary of a million yuan, to be a full-time investor. Work wasn’t that busy at the state company, but it got in the way of trading. He says he came out of a meeting one day and found he had lost a year’s salary in an hour, so he decided he should focus on investments. 
Mr. Zhang knows the market looks bubbly. The price-to-earnings ratio of stocks on Shenzhen’s growth enterprise board is close to 100 times. But he believes the government is keen for the bull market to continue. “I’m going to leave the market after I double my money again,” he said. “That will be enough for me to live the life I want to live.”

Again, this was just 3 weeks before the Chinese stock market peaked.

This is a classic example of how our emotions kill us in the markets. Too many people get lured by the prospect of rapid gains that they take absurd levels of risk, often at precisely the wrong times. Only a disciplined, systematic approach with a long-term mindset wins in the markets. Warren Buffet has a great quote: “The stock market is a device for transferring wealth from the impatient to the patient.” I couldn’t have said it better. 

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Saturday, December 5, 2015

High Valuations and Low Yields

This is how your average buy-and-hold investor probably feels right now if they are looking to deploy new capital for the long run.

Today, bond yields are puny while stock valuations are rich. In fact, we currently have one of the worst yield and value combinations in history as seen in the charts below dating back to 1880:


Notice on these charts the years 1921 and 1982, when valuations were very low and yields were high. This launched the two largest bull markets in stocks ever, with the S&P 500 gaining over 4-fold in the Roaring Twenties and 15-fold from 1982-2000. And that's not even including dividends.

Now look at the years 1902, 1929, 1965 and 2000 when we had the opposite: high valuations and relatively low-to-medium yields. This led to all four secular bear markets in the past century, with each one lasting over a decade.

We can visualize this better by creating a scatter plot of the above data. We plot stock valuations (S&P 500 Shiller P/E Ratio) on the vertical axis and 10-year Bond Rates on the horizontal axis. The color of the dots will be used to indicate the future 10-year nominal, annualized, total return of a 60/40 portfolio containing the S&P 500 and 10-year treasury bond fund. This plot is shown below: 

Data for this plot from:

The dark red dots indicate the weakest future 10-year returns while the dark green dots indicate the strongest 10-year future returns. Black diamonds are for years after 2006 which we don’t have future 10-year returns for yet. One thing immediately jumps out: Dots in upper left hand of graph correspond to very weak future returns while dots in lower right correspond to strong returns. Everything else is a mix.

Currently, we are sitting in an area that would suggest a high likelihood that stocks will be weak (annual returns under 6%) for the next 10-years. Although admittedly, my chart only gives a very rough idea of future returns, a model with better predictive power has been produced by market analyst John Hussman. According to his chart below, we see that future 10-year returns on the S&P are likely to be near 0%.

Source: Hussman Funds

You might be saying “This is not fair. We just recently came out of a weak decade!”

Unfortunately, it’s what the data tells us. While the 2000’s were difficult, the current decade has been very good to us so far. It would be very healthy for the market to churn sideways, digest gains of recent years and set itself up for a great bull market further down the road.  

That doesn’t make me feel any better!” you might say. OK, I do have some good news for you.

The scatter plot above only gives a rough forecast for average annual 10-year returns. It doesn’t tell us a thing about the path that those returns will take. 

While in the long-run (5-10 years) markets are tied to valuation and mean-revert, they are dictated by momentum in the short-term (6-12 months). This is why valuation is not a good timing tool - it does not tell us when to enter and exit markets the way momentum does. These two points are really the key differences between value and momentum to understand. Please also refer to our post: The Philosophy of Momentum that tries to explain how momentum works in the market.  

So just because we are likely to face a challenging market environment doesn’t mean we can’t profit. If we look back to 2000, we also had high valuations and low yields. What happened next? Essentially, the stock market went nowhere over the next 12 years (as the valuation model correctly predicted), but in the process there were two times when stocks halved and two times when stocks doubled. In this highly choppy environment, the Global Equities Momentum (GEM) model continued churning out nice positive returns. 

The graph below shows how GEM performed against stocks and bonds in the first decade of this millennium. 

Over this decade, GEM gave a total annualized nominal return of 11.4% while a 60/40 portfolio returned just 2.8%. Furthermore, GEM only had one negative year during this whole period, and even that was a mere -7%. Now that is alpha! In terms of our scatter plot, GEM just turned a dark red dot into a nice green dot.

Side note: While GEM produced admirable returns during the 2000’s, they were quite a bit less than its past 40-year average return of 17.8%. This is not surprising given the challenging market environment.

In summary, today’s high stock valuations and low bond yields will likely mean a fixed 60/40 portfolio will not make much money over the next 10 years. However, the ups and downs during this period are likely to allow tactical GEM investors to achieve better risk-adjusted returns.

This is the real beauty of GEM. We don’t need to worry about valuations, yields, or whether the economy will accelerate or slow down. We don’t need to worry about lost decades. We are in a system that will dynamically change depending on the environment. It’s the buy-and-hold crowd that needs to be worried, arguably now as much as 15 years ago.

Happy holidays and see you in the new year!

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.

Sunday, November 8, 2015

Slow and Steady


Why is it that every time you hear your average investor talk about markets, it’s usually about the latest high flying glamour stock? It’s because our lizard brains get lured by the thrill of fast gains and bragging rights.  

Let’s look at Apple for a moment. Apple is now the largest company in the world by market cap. It has more cash than the GDP of New Zealand or combined GDPs of Vietnam, Morocco and Ecuador. If Apple were a country, it'd be the 55th richest country in the world.  There is no doubt this company can be considered one of the greatest tech success stories in history.

If someone were lucky enough to put money into Apple when it IPO’ed back in late 1980, they would have enjoyed an almost 300-fold gain on their investment. In comparison, had that same investor put their money in the S&P 500, it would have gained 15-fold – which is puny in comparison.

This leads your average retail investor to ditch investing in broad market ETFs and chase the next Apple. But these “investors” don’t realize how extremely difficult it is to correctly predict which micro/small cap stock will become the next giant success story. Nor do they seem to realize how much risk they are taking on by holding concentrated positions in volatile growth stocks.

I remember from 2012-2013 how much hype there was around the company 3D Systems Corp (DDD). Watercooler chatter, CNBC pundits and Twitter – everywhere you looked there was feverish excitement over DDD. The stock gained over 10-fold in those two years. Where is it today? Back to square one. 

Likely even fewer people realize there are ways to invest systematically in large & diversified market indices that can outperform even Apple! Global Equities Momentum (GEM) is one such strategy, which I argue is the best (very simple, robust and stable while having low portfolio turnover, maintenance and costs).

The chart below shows what I mean.

Update (Nov 27, 15): I realized the S&P 500 data in this graph does not include dividends. With dividends, the S&P 500 would have grown 3,900% from 1981-2014.

Since Apple’s IPO, GEM has outperformed Apple in terms of total return. Not only that, but it did it with much less volatility. The tables below show the drawdowns for both Apple and GEM:

We see that Apple investors would have had their faith severely tested numerous times. There were four torturous periods where investors would have lost between half to more than three quarters of their portfolio. In comparison, GEM had fewer and much less severe drawdowns - all of which were under 20%.  

Isn’t this neat? It shows that systematically trading broad indices is more important than finding and holding a basket of home-run stocks. Yet most of Wall Street and most retail investors are blindly doing the latter.

By investing systematically in broad markets, you not only achieve better risk-adjusted returns but also save yourself a lot of time and stress. No more spending countless time pouring through company financials, listening to CNBC or forecasting market trends in search of the next great stock. No more holding concentrated positions in volatile stocks and having night terrors about company-specific risk.

You just can’t put a dollar value on stress reduction. Welcome to the wonderful world of systematic index investing. 

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.

Saturday, October 3, 2015

Should we consider Gold?

I read a post on Mebane Faber’s blog a few months back about something he calls the “Three-Way Model.” It’s a simple trend following model that uses 3 ETFs: Stocks, Bonds and Gold. The rule is simply: Invest equally in whatever is going "up" (ie. 3 month moving average > 10 month moving average). The results over the past 40 years have given a 12% annualized return (see below).

This is not nearly as good as GEM’s 18% compounded annual return over the same 40+ year back-test period. Nevertheless, this got me wondering: What would happen if we added gold to GEM’s relative momentum engine?

In a previous post, Markets are Interconnected, we saw that GEM already indirectly profits from US Dollar and commodity cycles when it switches back and forth between US and non-US stocks. But curiosity struck me and so I took a look at adding gold to the model. The below chart shows this modified model (in blue) compared against the original GEM (in red):

By adding gold to the model we get a compounded annual return of 21%, up from the original model's 18%. Over the past 43 years, the modified model would have taken a mere $100 and turned it into a staggering $400,000!

Now before we go running out on the streets of Syracuse naked shouting “Eureka!” let’s take a closer look. 

First, the modified model's higher returns came at the cost of higher volatility. The standard deviation of the modified model shot up to 18%, which is up from 13%. So the Sharpe Ratio didn't improve that much at all. Second, the modified model made 40% more trades over the 43-year backtest period.

Third, and most important, is that all of the modified model's higher returns were concentrated in the '70s. In 1971, President Nixon took the United States off the gold standard. This decoupling from the US dollar led gold to quickly rise to a level determined by the market, instead of being artificially suppressed.

Take a look at the chart below. It shows the modified model (blue) and gold (purple). From 1971-1980, gold increased almost 18-fold! If we remove this period from our backtest, we actually see that the modified model produces lower returns yet has higher volatility than the original GEM. 

Finally, below is a distribution of monthly returns for both the original and modified model as well as the S&P 500.

We can see that the original model (red curve) produces its mean return with greater consistency than both the modified model and the S&P 500. Furthermore, the original model doesn't rely on just a few strong outlier months like the modified model.

Hence, we can conclude that the original GEM is the best. Without the one-time boost that gold received in the '70s, the original GEM offers higher returns with lower risk. Furthermore, the original GEM already profits indirectly from cycles in the US dollar (and hence commodities like gold) due to its switching between US and non-US stocks. 
I think this post is a great example of why you should not blindly strive to optimize backtest results. You want a model that will do well even in the absence of special one-time boosts.  

Results are hypothetical results and are NOT an indicator of future results and do NOT represent returns that any investor actually attained. Additional information regarding the construction of these results is available upon request. Past performance is no assurance of future success. Please see our disclaimer page for more information.

Saturday, September 5, 2015

Power of Compound Interest

If you care to learn only one thing about investing, it should be the concept of compound interest. This is a core topic everyone should know about and is truly what got me excited about investing. I first learned about compounding when I read The Wealthy Barber at age 17 and it remains one of my top 3 most important investing concepts today. 

Compound interest is simply interest on top of interest. Let’s say you are earning a 5% return each year and started with $100. At the end of year 1, you would have $105. But at the end of year 2, you would have $110.25 – an extra quarter.  “A measly quarter!” you say? I know this might sound minuscule and boring but the effect of compounding builds exponentially over time to an enormous amount. 

Very few people I know understand just how powerful this effect really is. Someone who hasn’t been introduced to compounding may think that a 20% annual return will grow your portfolio about twice as much as a 10% return. This is completely wrong. Let’s take a look at what happens when $10,000 invested today grows at various return rates of 5%, 10%, 15% and 20%. 

At the end of 30 years, the portfolios growing at 5%, 10%, 15% and 20% were worth $43K, $174K, $662K and $2,378K, respectively. After 30 years, the 20% portfolio was 14 times larger than the 10% portfolio and after 40 years, it was 33 times larger.

Notice how just three things influence the portfolio value:
  1. Time horizon
  2. Rate of return
  3. Invested capital

As investors, we can become wealthy if we maximize our investment time horizon, rate of return and invested capital. It is easiest to do the first one – just start investing as early as possible. The effect of compounding isn’t really seen in the first 10 or even 20 years but after that – it builds rapidly. You may have heard that phrase “The best time to start investing was in your 20s. The second best time to start is today.” I couldn’t agree more.

The second factor – rate of return - requires significantly more work to maximize. It took me a lot of time and research to find a strategy that has the potential of generating double digit returns while managing risk (please refer to my performance page for more info). Lucky for you, this blog and the book Dual Momentum Investing should be able to accelerate the time needed for you to implement a sound & robust strategy. Keep in mind that a strategy isn't the only thing you need to ensure a high rate of return. You will need unwavering, ironclad discipline to stick to your strategy through thick and thin.

Invested capital is the third factor. 10 years ago I graduated from university with not a penny in my bank account, although thankfully I had no debt. Each year since then, I have been good at saving over 30% of my after-tax income and putting it into my investment strategy. It is highly important you put aside at least 10% of your monthly income for investing. A good way to implement this is by setting up a Pre-Authorized Chequing (PAC) plan that automatically funds your investments each month before you have a chance to spend that money. Forced savings can work wonders. 

In the chart above, the 20% return portfolio dwarfs all other portfolios. When plotting something growing exponentially over a long time frame, it helps to use a log scale on the vertical axis. In a log scale, each level on the scale is 10-times greater than the previous level. Below is the result. 

Now we can better see what’s happening in each portfolio. Look at the 15% portfolio - isn’t it amazing how a mere $10,000 can be turned into almost a million in 30 years?

Here’s a neat little rule when trying to think about compound interest in your head: The number of years it takes for your investment to double is roughly equal to 72 divided by your rate of return. So if you earn 20% per year, it takes only about 4 years for your money to double but if you earn just 5% per year, it will take about 14 years.

Since it's back to school week, I want to leave you with some homework: 

Download a financial calculator app on your phone. Type a few scenarios that meet your own personal criteria (initial investment amount, time frame, rate of return) and see what you can grow your portfolio to. Show this fun little experiment to your family & friends. Everyone I’ve ever shown this to immediately gets excited about investing. 

The app I like to use on my Android phone is called “Financial Calculators.” You can find it here. Below is a screenshot of the “TVM” (Time Value of Money) calculator included in this app. Enjoy