Arnold and Zelda consider themselves to be good investors. Arnold has all of his wealth in bank GICs, a choice he knows and feels comfortable with. He bemoans the low returns – under 2% – that he is currently receiving, but he’s heard too many horror stories of stock market investing. As a result, Arnold may not be able to meet his long-term goals.
Zelda, on the other hand, had been persuaded to invest in bank mutual funds that were giving her fantastic returns in a charging bull market. Then came a market collapse – Black Wednesday. Seeing a 35% drop in her investments, a frightened Zelda promptly sold all her funds before she experienced greater losses, and deposited the money into a savings account where it still sits.
Arnold and Zelda are using emotions – fear and overconfidence – to make their financial decisions.
The behaviour of investors is well documented. People hope for a gain while simultaneously wanting to protect against losses. It’s easy to be irrational when your hard-earned money is at stake.
Fear of investing
Fear is usually caused by lack of knowledge, which makes people less confident about investing. Fear of investing often results in a significant amount of holdings in cash or low interest products, or selling investments at an inopportune time.
“I don’t know what I’m doing.” More often than not this has to do with a mind-set that says, “Not my thing.” You can hand over all investment decisions to a professional. However, investing with a pro shouldn’t be a one-way street where you just supply the money and he or she puts it somewhere. It’s incredibly easy not to pay attention once all the forms are filled out.
Do you know where your money is invested? Are you influenced by the nice, friendly man who promises huge returns for very little risk? Do you know what you are paying in fees and commissions and how that affects your returns?
It might not be your thing – but it is your money. Any professional should be able to talk to you in layman’s terms about what he or she is doing and why. It all boils down to taking responsibility for your money – discussion and collaboration. You need to feel confident and comfortable talking about your finances.
Optimism
When people listen to stories from friends, family, and co-workers about the killing they are making in the market they think, “Why not me?”
Then they take the plunge into stock market investing. The market has been going up and they assume it will continue to do so. This often results in portfolios that are too risky.
These investors also listen to mass media financial gurus and are encouraged to pursue the latest hot stock at peak prices. They tend to place too much credence in recent market views, opinions and events.
Overconfidence
People generally rate themselves as being above average in their abilities.
Overconfident investors are those who think they can beat the market. They don’t consider getting any help or look into other options because they think they know already. They may be dead wrong about things they think they do know.
Regret
Regret comes after realizing you’ve made an error in judgment. We all hate to be wrong. Faced with selling a stock, investors become emotionally invested in how much they paid for it, which brings about loss-aversion and holding onto their losers. There’s regret of having made a bad investment and facing a loss. There’s regret when a stock you were considering buying – but didn’t – has increased in value.
The real cost of investing
Investors can be their own worst enemies. Our personalities are a driving force in how we invest, so knowing yourself and facing your feelings about investing is of paramount importance.
When it comes to money and investing we are not always as rational as we think we are. We lose more money by making poor choices than by getting a low return.
Investing without emotion is easier said than done, especially in periods of uncertainty.
I have been through four or five market crashes and, rationally, I know it doesn’t matter in the long term. But, my stomach still sinks when my portfolio is down. We don’t like to lose.
However, implementing a well thought out strategy and sticking to it may help the investor avoid many common investing mistakes brought about by emotions.
I wasn’t always good with money. Back in college, I violated just about every personal finance rule you could imagine. My biggest offense was misusing credit cards. I racked up over $5,000 in credit card debt between my junior and senior year; making brilliant decisions such as bringing my credit card to the bar, taking out cash advances, and committing the cardinal sin of using one credit card to pay off another.
I got my financial act together a few years later and paid off my credit card debt. I was scared to fall back into the credit card trap so for the next few years I stuck to a budget and paid for everything with cash or debit. Here’s how I took that bad experience with credit cards and turned it into something positive:
No-fee 1% rewards cards
Once I had some breathing room financially I looked for ways to optimize my finances by cutting fees and earning more income. I learned about credit card rewards and decided to sign up for the PC Financial MasterCard. It paid 1% back in the form of free groceries; perfect for a growing family who shopped for groceries and diapers at The Real Canadian Superstore.
I was hooked. Every month I was able to redeem at least $20 worth of PC Points to help supplement our grocery bills. I started to funnel more and more of our family spending onto the credit card to earn extra points. Careful to use credit responsibly this time around, I made sure to pay off my balance in full each month and not put frivolous purchases on the card just to earn more points.
Switching to Smart Cash
A year or two later I discovered a better rewards credit card – the MBNA Smart Cash Platinum MasterCard. Before MBNA was bought out by TD Bank, its no-fee Smart Cash Platinum card was the best cash back card on the market. The card had a great bonus period where you could earn 5% back on groceries and gas for the first six months, then 3% cash back thereafter. As much as I love redeeming PC Points for free groceries, simple math said to make the switch to Smart Cash.
MBNA would mail a cheque whenever you earned $50 cash back and so now I was getting a cheque every other month. This was great!
Unfortunately, that gravy train ended when TD decided to change the Smart Cash card and reduce the benefits that it paid. Since I wasn’t earning the most cash back anymore I had to go back and research my other credit card options.
A new cash back king
Enter the Scotia Momentum Visa Infinite card. I cut ties with MBNA and its watered-down Smart Cash card and signed up for Scotia’s top cash back credit card; one that I still use to this day for all of my grocery and gas spending.
This was the first time that I had paid a fee to use a credit card – the Momentum Visa Infinite comes with a $99 annual fee – but I did the math and determined that the 4% cash back earned on grocery and gas purchases more than offset the annual fee.
Hacking my way to even more rewards
Bigger cash back incentives led to bigger earnings. Even after factoring in the annual fee I was still cashing in on close to $500 per year in rewards with the Scotia card alone.
Now this was becoming a game to see how much cash back I could earn on my everyday spending. Instead of funnelling all my purchases onto one card, I realized that the best way to boost earnings from credit card rewards was to use two, three, or even four cards.
Related: The best credit cards in Canada
Optimizing credit card spending meant using one card for groceries and gas, one for dining and entertainment, one for travel, and one for everything else. Last year I used six credit cards to earn over $1,500 worth of rewards.
I’ve come a long way since college, when my credit card hacks involved cash advances and balance transfers instead of hunting for sign-up bonuses and travel perks. Using credit cards this way isn’t for everyone, but I’m happy with how my experience with credit cards has changed for the better.
The SPIVA Canada Scorecard looks at the performance of actively managed Canadian mutual funds versus that of their benchmarks. The results over the long-term show that the majority of active managers underperform their benchmarks. And it’s not even close. Here are the biggest losers:
Canadian Dividend & Income Equity Funds – Only 6.67% of the active Canadian Dividend & Income Equity Funds outperformed the S&P/TSX Canadian Dividend Aristocrats over the past 12 months. None of the active funds were able to outperform the S&P/TSX Canadian Dividend Aristocrats over the five-year horizon.
U.S. Equity Funds – Just 2.9% of funds in this category outperformed the S&P 500 (CAD) over the past five years, while only 3.13% beat the index in the three-year period.
Global Equity Funds – Over one- and three-year periods, 5.95% and 4.21% of the funds outperformed the benchmark, the S&P Developed LargeMidCap, respectively. When viewed over the longer five-year period, only 2.83% of active global equity funds able to beat the benchmark.
It’s hard to argue in favour of active management when you see results like this. Only a handful of actively managed mutual funds outperform their benchmark over the long-term, and of the ones that do outperform, you need a crystal ball to identify them in advance.
So what does this mean? The next time you meet with your advisor and he or she recommends the banks’ Canadian, U.S., or Global equity mutual funds, ask about – no, insist on buying their index-fund equivalent. Rather than paying 2% MER or more for an actively managed fund that has a very small chance of outperformance, its index fund cousin will track the benchmark closely in exchange for a very small fee (around 1% or less).
You can read the full SPIVA Canada Scorecard here.
This week(s) recap:
Last Monday I answered some criticism of my two-ETF portfolio.
Last Wednesday Marie continued her financial management by the decade series with a look at the twenties.
And last Friday I looked at whether Millennials really fear the stock market or if there are other factors at play.
This Monday I explained how some mortgage brokers are committing fraud.
On Wednesday Marie asked how much choice is too much choice?
And finally on Friday’s financial makeover we looked at starting over after a divorce.
Weekend Reading:
A 1.5% trailer is the epitome of what is wrong with financial advice in Canada, says Benjamin Felix, an investment advisor with PWL Capital.
Watch out for advisors pushing segregated funds, an area that is excluded from upcoming regulatory changes to the investment industry.
Index funds; the worst investment strategy except all those other forms that have been tried.
John Bogle is the champion of index fund investing, so it’s surprising to learn that his son – who’s also named John – runs an actively managed mutual fund.
Kerry Taylor offers some sound advice on how to talk to small kids about money.
Do you really need an emergency fund? Here’s Money Time Blog’s John Ryan on why he’s never had one.
Sandi Martin reveals the budgeting resource that everyone has but nobody uses.
Preet Banerjee explains whether you’ll pay more or less tax after Trudeau’s proposed middle-class tax cut in this latest Drawing Conclusions video.
A good look at why couple’s with age gaps face an uneven financial path when it comes to retirement.
Nelson Smith gives an insider’s view of Canada’s mortgage fraud problem.
A Canadian artist confesses that he doesn’t want to be rich, he just wants a fulfilling life.
We’re paying too much for our telecom needs, argues Alan Whitton, who says that Canadians pay an average of $203 per month for phone, internet, and cable.
Finally, a look into how the economic downturn in Calgary has crippled the event planning industry. Low oil prices mean companies are pulling the plug on Christmas parties and extravagancies like having acrobats pouring champagne from the ceiling…
Have a great weekend, everyone!