Most people never achieve their financial dreams. Why? In many cases, they never understand how long-term wealth is created. They assume that investment success depends on picking a hot stock, finding an all-star investment manager, or avoiding market downturns. In reality, the blueprint for success is simple and straightforward. But you must rethink your notion of investing and take a different approach, which involves understanding markets and harnessing their power, then knowing yourself as an investor, and working your investment plan.Above are ten key investment principles or actions that can help you improve your odds of having a successful investment experience.
1. CRITICAL FACTORS IN THE PURSUITOF A BETTER INVESTMENT EXPERIENCEPREPARED FOR: John DoeDATE: 10/10/11
2. KEY INVESTMENT PRINCIPLESUNDERSTAND MARKETS KNOW YOURSELF1. Let markets work for you. 7. Don’t confuse entertainment with advice.2. Take risks worth taking. 8. Manage your emotions and biases.3. Invest, don’t speculate.HARNESS THEIR POWER WORK YOUR PLAN4. Hold multiple asset classes. 9. Avoid common investment mistakes.5. Practice smart diversification. 10. Plan for the long term—and stay the course!6. Keep costs low.
3. 1 LET MARKETS WORK FOR YOU MONTHLY GROWTH OF WEALTH ($1) 1926−2010 $100,000 $56,891 US Small Cap Value Stocks US Small Cap Stocks $13,666 $10,000 US Large Cap Value Stocks $4,599 S&P 500 Index $3,013 $1,000 US Five-Year Treasury Bonds US Treasury Bills US Inflation (CPI) $100 $81 $20 $12 $10 $1 $0 1926 1936 1946 1956 1966 1976 1986 1996 2006In US dollars. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is nota guarantee of future results. US small, small value, and large value index data (ex utilities) provided by Fama/French. The S&P data are provided by Standard & Poor’s Index ServicesGroup. CRSP data provided by the Center for Research in Security Prices, University of Chicago. US long-term bonds, bills, inflation, and fixed income factor data © Stocks, Bonds, Bills,and Inflation Yearbook™, Ibbotson Associates, Chicago (annually updated work by Roger G. Ibbotson and Rex A. Sinquefield).
4. Markets throughout the world have a history of rewarding investors for the capital theysupply. Their expected returns offer compensation for bearing systematic risk—or risk thatcannot be diversified away.An efficient market or equilibrium view assumes that competition in the marketplacequickly drives securities prices to fair value, ensuring that investors can only expectgreater average returns by taking greater systematic risk in their portfolios.This graph documents compounded performance of fixed income and equity assetclasses from 1926 to 2009, based upon growth of a dollar. It shows that equities haveoffered higher compounded returns than fixed income investments. Within the equityasset classes, small cap stocks have outperformed large cap stocks, and value stockshave outperformed growth stocks, resulting in higher returns and greater wealthaccumulation.Capital markets reward investors based on the risk they assume. Rather than trying tooutguess the markets, investors should identify the risks they are willing to take, thenposition their portfolios to capture these risks through broad diversification.
5. 2 TAKE RISKS WORTH TAKING SIZE AND VALUE EFFECTS AROUND THE WORLD 18.17 15.79 15.72 15.07 13.82 13.68 12.48 11.69 11.38 11.46 11.43 10.45 9.85 8.97 9.03 9.05 8.23AnnualizedCompound Returns (%) US US US CRS US Canad Emg. Emg. Emg. Emg. Large S&P Large Small P Small Intl. Intl. MSCI Intl. Canada a Canada Markets Markets Markets Markets Value 500 Growth Value 6-10 Growth Value Small EAFE Growth Value Market Growth Value Small ―Market‖ Growth US Large US Small Non-US Developed Canadian Emerging Capitalization Capitalization Markets Stocks Market Stocks1 Markets Stocks Stocks Stocks 1927–2010 1975–2010 1977–2010 1989–2010 1927–2010Average Return (%) 14.03 11.88 11.35 19.17 15.98 13.95 18.48 19.17 13.67 11.29 14.53 12.86 10.40 25.01 21.98 19.46 17.05Standard Deviation (%) 27.01 20.51 21.93 35.13 30.94 34.05 24.56 28.13 22.29 22.21 21.64 17.47 21.79 42.01 40.67 36.40 34.89 1. In CAD. All returns in USD except Canadian Market Stocks. Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results. US value and growth index data (ex utilities) provided by Fama/French. The S&P data are provided by Standard & Poor’s Index Services Group. CRSP data provided by the Center for Research in Security Prices, University of Chicago. International Value data provided by Fama/French from Bloomberg and MSCI securities data. International Small data compiled by Dimensional from Bloomberg, StyleResearch, London Business School, and Nomura Securities data. MSCI EAFE Index is net of foreign withholding taxes on dividends; copyright MSCI 2011, all rights reserved. Emerging Markets index data simulated by Fama/French from countries in the IFC Investable Universe; simulations are free-float weighted both within each country and across all countries.
6. To pursue higher expected returns, investors must take higher risks. But only certain risks offeran expected reward—and science has helped identify these risks.The two major equity risks are size and price (as measured by book-to-market ratio—or BtM).These appear in the Canadian, US, and international markets—strong evidence that the riskfactors are systematic across the globe.This graph demonstrates the higher expected returns offered by small cap stocks and value(high-BtM) stocks in the US, non-US developed, Canadian, and emerging markets. Note thatthe international, Canadian, and emerging markets data are for shorter time frames.Small cap stocks are considered riskier than large cap stocks, and value stocks are deemedriskier than growth stocks. These higher returns reflect compensation for bearing higher risk.A multifactor approach incorporates both size and value measures—and exposure to marketsaround the world—in an effort to increase expected returns and reduce portfolio volatility. Aneffective way to capture these effects is through portfolio structure.
7. 3 INVEST, DON’T SPECULATE PERCENT OF WINNING ACTIVE MANAGERS July 2005–June 2010 7% 9% 12% Canadian Equity US Equity International Equity Over time, only a very small fraction of money managers outperform the market after fees, and it is difficult to identify them in advance.Source: Standard & Poor’s Indices Versus Active (SPIVA) Funds Scorecard Canada, Second Quarter 2010.
8. In an efficient market, stock prices reflect all publicly available information—and only newinformation causes prices to change as market participants adjust their views of the future.Since new information is unknowable in advance, most fund managers who try to beat themarket through stock selection and market timing fail to deliver long-term value.As shown above, few active fund managers can outperform their respective market indices.For the five-year period through 2009, only 9% of US Equity managers outperformed theirrespective benchmarks, compared with 10% for International Equity managers and 7% forCanadian Equity managers.Worse yet, many active funds failed to survive the entire five-year period. Active fund survivalwas only 39% for US Equity, 53% for International Equity, and 47% for Canadian Equity. Non-survivors either ceased doing business or were merged into other funds.
9. 4 HOLD MULTIPLE ASSET CLASSES RANDOMNESS OF ANNUAL RETURNS 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010 Highest Return 37.72 40.72 37.81 31.70 36.18 25.07 2.58 34.77 23.47 24.11 35.72 9.82 2.56 63.86 35.35 34.71 39.18 28.62 24.88 28.45 20.37 2.39 31.32 22.49 22.47 30.13 4.27 -21.94 42.73 23.33 28.35 32.22 26.15 24.17 12.24 19.35 -3.79 30.15 17.49 19.56 26.10 1.96 -22.85 35.05 21.50 23.56 24.87 21.65 22.53 7.41 4.36 -5.03 28.96 15.28 10.97 26.08 1.41 -24.88 27.47 17.61 22.18 17.17 18.16 19.52 5.17 4.12 -12.45 26.74 14.47 10.95 22.11 -5.25 -25.55 25.12 14.59 21.30 14.99 4.78 16.86 0.78 1.63 -16.02 19.07 11.49 10.69 21.66 -7.92 -30.67 15.97 13.29 18.98 11.92 4.60 13.94 0.65 -6.40 -16.72 13.57 10.97 9.79 17.25 -9.70 -31.53 13.85 10.26 9.39 6.22 -0.03 4.59 -5.54 -11.56 -16.75 11.60 8.42 4.16 16.58 -10.09 -33.00 10.98 9.16 6.56 5.89 -1.59 2.35 -7.68 -12.57 -17.33 7.46 7.80 3.05 15.76 -15.63 -33.27 9.26 2.22 4.61 2.85 -5.66 0.39 -8.82 -13.45 -20.43 5.46 2.80 2.57 15.58 -17.11 -35.17 3.45 0.43 Lowest Return 3.30 -10.82 -11.05 -8.30 -10.80 -16.55 -22.85 2.86 2.25 2.29 3.93 -29.73 -47.33 0.36 -2.05 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009 2010Canadian Fixed Income 4.61 2.85 4.60 4.59 5.17 4.36 2.39 2.86 2.25 2.57 3.93 4.27 2.56 0.36 0.43Canadian Large Cap 28.35 14.99 -1.59 31.70 7.41 -12.57 -12.45 26.74 14.47 24.11 17.25 9.82 -33.00 35.05 17.61Canadian Value 34.71 11.92 -5.66 2.35 28.45 4.12 -17.33 28.96 17.49 22.47 15.76 1.96 -33.27 42.73 13.29Canadian Small Cap 21.30 17.17 -0.03 24.17 0.78 20.37 -5.03 34.77 7.80 9.79 21.66 1.41 -47.33 63.86 35.35US Large Cap 23.56 39.18 37.81 13.94 -5.54 -6.40 -22.85 5.46 2.80 2.29 15.58 -10.09 -22.85 9.26 9.16US Value 22.18 40.72 21.65 0.39 12.24 1.63 -16.02 7.46 8.42 4.16 22.11 -15.63 -21.94 3.45 10.26US Small Cap 18.98 32.22 4.78 24.88 -7.68 25.07 -20.43 30.15 10.97 3.05 16.58 -17.11 -24.88 27.47 23.33US Real Estate 37.72 24.87 -11.05 -8.30 36.18 19.35 2.58 11.60 23.47 10.97 35.72 -29.73 -25.55 10.98 21.50International Large Cap 6.56 6.22 28.62 19.52 -10.80 -16.55 -16.75 13.57 11.49 10.69 26.10 -5.25 -30.67 13.85 2.22International Value 9.39 5.89 26.15 16.86 0.65 -13.45 -16.72 19.07 15.28 10.95 30.13 -9.70 -31.53 15.97 -2.05International Small Cap 3.30 -10.82 18.16 22.53 -8.82 -11.56 -3.79 31.32 22.49 19.56 26.08 -7.92 -35.17 25.12 14.59In Canadian dollars. Charts are for illustrative purposes only.Canadian Fixed Income is Canadian One-Month Treasury Bills. Canadian Large Cap is the S&P/TSX Composite Index. Canadian Value is the MSCI Canada Value Index (net dividends), andCanadian Small Cap is the MSCI Canada Small Cap Index (price-only). US Large Cap is the S&P 500 Index. US Value is Russell 3000 Value Index. US Small Cap is CRSP 6-10 Index. US RealEstate is the Dow Jones US Select REIT Index. International Large Cap is the MSCI EAFE Index (net dividends), and International Value is the MSCI EAFE Value Index (net dividends).International Small Cap is compiled by Dimensional from StyleResearch securities data; includes securities of MSCI EAFE countries in the 10%-1% of ME range; market-capitalization weighted;each country capped at 50%; value defined as the top 30% of book-to-market; rebalanced semiannually. Canadian T-bills provided by PC-Bond a business unit of TSX Inc.; copyright © TSX Inc.,all rights reserved. MSCI data copyright MSCI 2011, all rights reserved. The S&P data provided by Standard & Poor’s Index Services Group. Indices are not available for direct investment. Indexperformance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee of future results.
10. There is little predictability in asset class performance from one year to the next.The above slide features annual performance of major asset classes in the Canadian, US, andinternational markets between 1994 and 2009.The top chart ranks the annual returns (from highest to lowest) using the colours thatcorrespond to the asset classes. The bottom chart displays annual performance by assetclass.The data reveal no obvious pattern in annual returns that can be exploited for excess profits.The charts offer additional evidence of market efficiency and make a strong case for investorsto hold multiple asset classes in their portfolios.
11. 5 PRACTICE SMART DIVERSIFICATION S&P/TSX INDEX vs. A GLOBAL PORTFOLIO Canadian Model Equity Index 100% 1991−2010 1 Portfolio S&P/TSX Canadian Large Cap Index Composite It’s not enough to Annualized Return (%) 9.80 Annualized diversify by security. Standard Deviation (%) 16.91 Deeper diversification involves geographic and asset class 10% Each Global Model diversity. Holding Diversified Canadian Large Cap Index Canadian Large Cap Value Index a global portfolio Equity Index 1991−2010 1 Portfolio Globally Canadian Small Cap Index helps reduce risk International Small Cap Index and increase Annualized Return (%) 9.74 Diversified US Large Cap Index US Value Index expected returns. Annualized Standard Deviation (%) 13.87 Portfolio US Small Cap Index US Real Estate Index International Value Index International Large Cap IndexFor illustrative purposes only. In Canadian dollars.Canadian Large Cap is the S&P/TSX Composite Index. Canadian Value is the MSCI Canada IMI Value Index (gross dividends) for June 1998-present, and Barra Canada Value Index for January 1982-May 1998. Canadian Small Cap is the MSCI Canada Small Index (gross dividends) for January 1999-present, and Barra Canadian Small Cap Index for July 1990-December 1998. US Large Cap is theS&P 500 Index. International Value is the MSCI EAFE Value Index (net dividends), and International Large Cap is the MSCI EAFE Index (net dividends). International Small is: 1970-June 1981, 50%UK small cap stocks provided by the London Business School and 50% Japan small cap stocks provided by Nomura Securities; July 1981-present, compiled by Dimensional from StyleResearchsecurities data; includes securities of MSCI EAFE Index countries, market-capitalization weighted, each country capped at 50%. US Value is the Russell 3000 Value Index. US Small Cap is the CRSP6-10 Index. US Real Estate is the Dow Jones US Select REIT Index. S&P/TSX data provided by S&P/TSX. Barra data provided by MSCI Barra. S&P data provided by Standard & Poor’s Index ServicesGroup. MSCI data copyright MSCI 2011, all rights reserved. Russell data copyright © Russell Investment Group 1995-2011, all rights reserved. CRSP data provided by the Center for Research inSecurity Prices, University of Chicago. Dow Jones US Select data provided by Dow Jones Indexes. Standard deviation is a statistical measure of risk. Generally speaking, the higher the standarddeviation, the greater the risk.1. Date range selected is the longest common time series of whole years of data available. Rebalanced quarterly.Indices are not available for direct investment. Their performance does not reflect the expenses associated with the management of an actual portfolio. Past performance is not a guarantee offuture results. Not to be construed as investment advice. Returns of model portfolios are based on back-tested model allocation mixes designed with the benefit of hindsight and do not representactual investment performance.
12. Many Canadians concentrate in their home stock market. They choose Canadian stocks andmutual funds—or use several brokers who focus on Canadian equity investing. Many of theseinvestors may not consider their portfolios to be undiversified. Yet, from a global perspective,limiting one’s investment universe to a single stock market is a concentrated strategy withpossible risk and return implications.This slide compares a concentrated Canadian stock portfolio, as represented by the S&P/TSXComposite Index, to a globally diversified portfolio holding ten equally weighted asset classes.The January 1991−December 2009 time frame offers the longest data set in which returns forall featured asset classes are available.Over this period, the globally diversified portfolio had a slightly higher annualized return and asubstantially lower annualized standard deviation. The reduction in volatility can also be seenby the decrease in the distribution range of quarterly returns.Diversification should not be defined by how many stocks or funds an investor owns—or howmany brokers one uses. A diversified portfolio should include asset classes that are exposedto different macro risk factors, with different dimensions of risk and return across the globe.Many Canadians use fixed income to reduce the risk of their equity portfolio that is highlyconcentrated in the Canadian equities market. Yet, they forgo the benefit of globaldiversification. While adding fixed income to a portfolio will reduce risk, it will also reduceexpected returns. Global diversification is a more efficient means of risk reduction. Once theequity portfolio is globally diversified, an investor may consider adding fixed income to furtherreduce the portfolio risk, given one’s risk preference and financial profile.
13. 6 KEEP COSTS LOW NET GROWTH OF $1 MILLION Assumes 6.5% Annualized Return over 30 Years 1% Fee $4,983,951 $5,000,000 Over long time periods, high costs can drag down wealth accumulation in a portfolio. $4,000,000 2% Fee $3,745,318 Costs to consider include: • Management fees 3% Fee $3,000,000 $2,806,794 • Fund expenses • Taxes $2,000,000 $1,000,000 1 3 5 10 20 30 TIME (years)In US dollars. For illustrative purposes only.
14. Active managers seek to beat the market through stock selection and market timing. Theygenerally charge higher fees than passive managers as compensation for their perceived―skill.‖ Their active strategy also leads them to trade more frequently, which incurs highertransaction costs.High fees and costs can inflict a significant penalty on net investment returns and terminalwealth, as the attached graph demonstrates for various cost levels.Over a long period of time, such as thirty years, the difference between a 1%, 2%, and 3%annual fee may determine the quality of your lifestyle in retirement.Passive investments generally charge lower fees than the average actively managedinvestment, while eliminating the costs of researching stocks and reducing both trading costsand tax impact.
15. 7 DON’T CONFUSE ENTERTAINMENT WITH ADVICE • The television, print, and online financial media are in the business of entertainment. • The emphasis is often on short-term, sensational, and emotionally charged headlines. • These messages can compromise long-term focus and discipline, and lead to poor investment decisions.
16. Building wealth in the capital markets is a long-term endeavor that does not frequently capturemedia attention. The business and financial media look to more sensational news to attractreaders and keep advertisers.The short-term focus is particularly obvious in articles that dispense investment advice and areframed to appeal to human emotion, especially fear and greed. Investors should view thesemessages as entertainment, not advice, and resist the temptation to act on them.
17. 8 MANAGE YOUR EMOTIONS COMMON COGNITIVE ERRORS AND BIASES • OVERCONFIDENCE • FAMILIARITY • SELF ATTRIBUTION • MENTAL ACCOUNTING • HINDSIGHT • REGRET AVOIDANCE • EXTRAPOLATION • CONFIRMATION
18. Behavioral finance examines the influence of social beliefs, psychology, and emotion on economic decision making. Research suggests that humans are not naturally wired for making good investment decisions, due to cognitive errors and behavioral biases. Investors who are aware of this tendency are better positioned to avoid:• Overconfidence: People overestimate their ability to anticipate future investment results.• Self attribution: Investors may take credit for their successful investment decisions, while blaming bad outcomes on outside influences.• Hindsight: When viewing past outcomes, investors may apply selective recall and conclude that future movements were obvious at that time.• Extrapolation: Investors may expect recent market results to continue in the future, and may place too much weight on certain factors or recent events.• Familiarity: People may limit investing to areas in which they are familiar, resulting in a false sense of control.• Mental accounting: People partition their wealth in categories, resulting in inconsistent and fragmented financial decisions.• Regret avoidance: Investors who have experienced painful financial events tend to avoid those investments or markets in the future.• Confirmation: Investors seek out or interpret information that confirms what they want to believe about an investment, markets, or their own skill.
19. 9 AVOID INVESTMENT MISTAKES COMMON INVESTMENT PITFALLS • NO INVESTMENT PLAN • MARKET TIMING • LACK OF MANAGER SCRUTINY • WRONG TIME HORIZON • CHASING PERFORMANCE • FORECASTING • OVERCONCENTRATION • EXCESSIVE RISK TAKING
20. In today’s sophisticated marketplace, investors have access to information, advice, and toolsto help them grow wealth effectively. With these resources at hand, it would seem natural thatpeople could pursue a successful investment experience.But lack of insight, emotions, and the temptation to speculate keep many investors fromreaching their financial goals. Without a well-defined investment plan, they may pick moneymanagers for the wrong reasons and make other decisions that increase risk in their portfolios.By understanding markets and the nature of risk, and by learning to manage their emotions,investors may avoid mistakes that can compromise returns.
21. 10 KEEP A LONG-TERM PERSPECTIVE— AND STAY THE COURSE! 9.14% 3.83% S&P 500 ―Average‖ Equity 20-Year Annualized Return Fund Investor (time weighted) 20-Year Annualized Return (dollar weighted) Comparing time-weighted index returns to dollar-weighted fund returns suggests that the ―average‖ equity fund investor buys high and sells low while owning a given fund for less than five years. Source: DALBAR Quantitative Analysis of Investor Behavior (QAIB), 2011.
22. Each year, Dalbar measures mutual fund investor performance using data from industry cash flowsversus market indices.The research shows that the ―average‖ equity fund investor significantly underperforms the marketaverage, as represented by the S&P 500 Index. (In this study, the market average is considered aproxy for a ―buy-and-hold‖ investor.)The main reason for this poor relative performance is lack of investment discipline. The short-termfocus of many fund investors compels them to buy high and sell low, and to hold funds for less thanfive years, on average.So, investment returns depend on investor behavior. Those who invest for the long term and stay thecourse typically earn higher returns over time than investors who attempt to time market highs andlows.