In the main episode, we covered different instruments used for investing. Underpinned by key concepts like future expected returns, asset pricing, and efficient markets. We applied those key investing concepts to common investment strategies. Like specialization vs diversification, speculation, and active vs passive management. In this case conference, we further unpack how we see that commonly play out in real-life dilemmas and questions.
The idea is that you will consider how the situations apply to you. It is not specific advice, but hopefully you can relate to aspects of them and use that in your own thinking or with your advisor. Listen to this case conference. Remember it next time you hear someone talking about what is hot or not.
Case 1: An incorporated professional concerned about “the upcoming recession”.
Case 2: Retiring physician wants to switch to low-cost index funds.
Case 3: The hot investment idea.
Transcript
- Intro
- Case 1: Incorporated professional concerned about “the upcoming recession”
- Case 2: Retiring physician switching to low-cost funds
- Case 3: The hot investment idea
Introduction
[00:00:02] BF: Welcome to the Money Scope podcast, shining a light deep inside personal finance for Canadian professionals. We are hosted by me, Benjamin Felix, Portfolio Manager and Head of Research at PWL Capital, and Dr. Mark Soth, aka The Loonie Doctor.
[00:00:17] BF: Welcome to our second case conference supplemental episode. We hope you’re finding these useful, and we’re happy to hear your comments about that. These cases are based on common scenarios that often lead people to make poor decisions with their investments. These are things that I’ve seen professionally and, Mark, I think you’ve seen with your colleagues and other people that you’ve talked to. The idea with these cases is that you’re going to consider how the situations apply to you. Our guidance to the hypothetical scenarios are not specific advice to you. But, hopefully, you can relate to aspects of them and use that in your own thinking or with your advisor.
Case 1: An incorporated professional concerned about “the upcoming recession”.
[00:00:49] MS: So, I’m going to get right in with our first case. It’s an incorporated professional who’s concerned about the upcoming recession, and it feels like a lot of us lately. So we’re going to examine the experience of this fester. Like many people, they’re worried about the recession. They hear about it in the news all the time and on the financial news. People are talking about it all the time, even in casual conversation. They’re a mid-career professional. They got over a million dollars invested in their corporation and their register accounts.
So they’ve got money at stake, and it’s making them nervous. They have adopted an index fund-based investing strategy. While their income is stable, they’re worried about a recession and how that might affect their hard-earned investments that they’ve managed to accumulate. They’re also – when thinking about all this, they have been sitting on a pile of cash in their corporation. They’re hesitant to invest it due to the economic environment, and they’re wondering if they should change their portfolio and what to do with their cash. I think this case is reflective of many of the conversations that I’ve had with colleagues. Ben, what would you tell them?
Future Growth & Inflation is Priced In
[00:01:45] BF: Yes. So the big thing that investors need to understand about economic news is that most of the time, it’s already priced in, as we talked about in the main episode on this topic. By the time you hear about it, it’s already in the price. The stock market is a forward-looking pricing machine. It incorporates expectations about the future into prices today. Market prices respond to new information if that information is different from prior expectations. That point is really important. I’ll try and give an example.
Expected economic news like GDP growth rates or inflation is already incorporated into market prices. So like today, future data that has not yet been announced but is expected is already in prices today. So we would not expect stock markets to change if the news when eventually released because news, of course, is backward-looking. So if economic news when it gets released is the same as what the market expected, we wouldn’t expect the market price levels to change. It’s unexpected economic events, which are by their nature unpredictable. That’s what’s going to drive big short-term changes in stock prices.
So if everyone’s expecting a recession today, prices already reflect what a recession would look like if it gets announced that we’re in a recession. That’s really important.
Example: Global Financial Crisis
I think a good example of how this can get investors into trouble is the behavior of the US stock market throughout the global financial crisis. The US stock market started to decline in October 2007, which was two months before the US National Bureau of Economic Research or NBER defined the economic recession as having started. So again, markets were leading the economic data. NBER defines the recession as having started in December 2007 and ended in June 2009.
Now, it’s important to note that the dates of a recession are not announced until much later. This is something. Like in this case, in December 2008, the start of the recession was announced a year after it was determined to have started and September 2010 for the end of the recession. More than a year after it was determined to have actually ended. It was crazy to think about because like we don’t know until after the fact whether we’re in a recession or not, but people are still worried about it.
[00:03:51] MS: But it’s funny, those announcements usually correspond to the worst possible and best possible times to ignore them.
[00:03:56] BF: It’s a very good point. So in this case, US unemployment had been above nine percent, which is high since May 2009. It reached a peak of 10% in October 2009. Real GDP growth in the US reached its low point for the recession in the second quarter of 2009. The official end date of the recession wasn’t announced until September 2010. So at the time, nobody knew. At the time that this bad economic data kept coming out, nobody knew that the recession was over because we didn’t know that date until the future.
Now, based on that, bad data continued to come out and look worse and worse in 2009. It was not obvious that things were getting better. All this gloomy data keeps coming out and keeps coming to light in the news. You’d think it was a bad time to own stocks, but it wasn’t, and this is the crazy thing. We know now looking back that the stock market bottomed out in February 2009 and then started on a strong rebound. It went on to have just a historic rise basically since then up until probably until COVID hit.
The question, of course, is why did the market start to recover so quickly and aggressively in the face of all of this terrible data coming out? It’s because the market at the time had expected the economic data to be even worse. The bad news that was coming out was better than what the market already had priced in. Again, the market’s a forward-looking pricing machine. But this illustrates a really big problem for investors within that, even if you have a crystal ball for the economy. Even if you do and you don’t, but even if you did, you can’t use that to predict the stock market.
Economic Growth & Stock Price
To make it even more counter-intuitive, lots of people worry about things like slow long-term economic growth and how that’s going to impact their investments. Like, “Should I be saving more? Should I not be investing in stocks because of all this sluggish economic growth I keep hearing about?” Empirically, there is a statistically weak but economically negative relationship between economic growth and stock returns. So call it a negative relationship between economic growth and stock returns if we want to be a little bit ambitious on the statistics. But at best, it’s a flat relationship. No relationship.
Countries with lower economic growth tend to have better stock returns than countries with higher growth.1 So all that to say, all of the economic news that we’re bombarded with day-to-day really should not inform our investment decisions. I think people get into a lot of trouble by missing out on returns in attempts to time the market based on all the stuff that they’re hearing in the media. Now, worrying about your Investments is not a good thing either. So if you do find yourself worrying often, it may be a sign that you’re not comfortable with your investment strategy or with your asset allocation or with your long-term plan. So worrying is not a good thing. That should be addressed in other areas, not by trying to time the market.
[00:06:28] MS: No. You don’t want to make changes to your portfolio, but it may be time to check how it fits in with your long-term plan. It may also be time. Maybe you’re uncomfortable because you don’t really understand how things work, so you should listen to this episode again. What about that cash that was sitting around waiting to be invested?
Investing Cash Piles: Rational vs Emotional
[00:06:44] BF: Right, yes. So in this case, they have a portfolio, and they’re wondering. Should I change that portfolio? But they’re also sitting on this pile of cash, and this is a case that I don’t know about you, Mark, but I see this all the time.
[00:06:54] MS: All the time.
[00:06:55] BF: Yes. It’s stressful, and I get it. You have this big pile of money, and people are averse to regret. They don’t want to make a mistake. I think it’s always unnerving. I’ve never seen someone who’s just comfortable with it.
[00:07:05] MS: No. It’s very unnerving, and it’s usually when the markets have already made a really good recovery. Now, they feel confident. They want to invest it all in. That’s when you get those calls.
[00:07:13] BF: Yes, exactly. There is a rationally optimal approach to this to what to do if you’re sitting on a pile of cash that is destined to be invested eventually. This is money that you know is going to be invested, you’re just not sure when you’re going to be comfortable doing it. So there’s a rationally optimal approach. I think there’s also an emotionally optimal approach2, and that portion is going to be different for every person, but we’ll try and talk through it.
Buying The Dip
We at PWL have done two papers that are related to this topic. One looked at this concept called buying the dip, which is the idea that if you’re sitting on cash, you’ll wait for the market to decline because you’re worried about the economic news, like we just talked about. So you’re going to wait for the market to decline, and then you’re going to invest. So we looked at that strategy. Then we also looked at dollar-cost averaging, which is this concept of gradually entering the market in a systematic way, usually in equal parts. So it might be like you’re going to split up your pile of cash and invest it in equal parts over 10 months or 12 months or something like that.
On buying the dip, we found that it’s sub-optimal most of the time, really just for the reason that market returns are positive most of the time. So during that period, when you’re sitting in cash, waiting for the market to drop, you’re typically giving up more returns than you gain by investing at the bottom. We looked at 10-year horizon for that experiment. We also tested this when the market was at all-time highs and found similar results.
That’s another one I hear that even if – it’s funny, right? There’s – you’re worried about the recession and the bad news coming out. But then when the market keeps going up for long enough, people start to worry about investing at the peak.
[00:08:41] MS: Yes. Statistically, all-time highs are followed by more all-time highs. I mean, the market goes up more than it goes down.
[00:08:47] BF: Yes. All-time highs are more frequently followed by all-time highs than they are by crashes. So on by the dip, I would not sit in cash. In this case, they’re sitting on cash, trying to figure out what to do. Probably not the right strategy is to sit on it and wait for a market crash, waiting for the right time to invest because that’s going to make you worse off, rather than better off most of the time.
Lump Sum vs Dollar Cost Averaging
The next question, so we’ve decided, okay, we’re not going to buy the dip. We’re going to get this money invested. The next question is whether you go all in in a lump sum. Just invest the whole thing today. Or do you enter the market gradually over time using dollar-cost investing? So in that paper, we, again, found that investing a lump sum is optimal most of the time. But what I would say here is that there is a strong behavioral argument for dollar-cost averaging. Investors are regret-averse. They lack self-control. So I think setting up a systematic plan helps to reduce the regret of making one big decision, and it helps with the behavioral side of getting the money invested in the paper.
We’d make a comment that if you feel like you need the dollar-cost average, maybe your portfolio is just too risky. I think that’s also valid. If you really need the dollar-cost average, that’s fine. I think there are good arguments to do it, but it also may be a sign that your portfolio should be reviewed.
[00:10:01] MS: Yes, sending you a signal. I think that gets to why that systematic planning, knowing why you have it is really important. It allows you to develop good habits. For example, I don’t watch financial news really much at all anymore. It’s designed to make you click and look. That’s how they get paid money. Nothing attracts eyeballs like potential disasters. So there’s always going to be bad stuff in there, even though markets go up most of the time. So it’s better off not only for your investing but for your emotions to just ignore all that stuff and not waste your time on it. I don’t waste time thinking about whether to invest because of the markets. All I do when I think about whether to invest is do I need this money soon or not. If I don’t, I’m going to invest in it.
It’s funny how when you learn about this and the more you know, it kind of changes the way that you think about it. Now, I get really antsy when I see cash accumulating in one of my accounts. My biggest thing is, okay, I got to figure out do I need this or not because if I don’t, I want to get it invested. Because, otherwise, I’m just sitting on cash, and I’m wasting time when it could just be growing instead.
[00:11:03] BF: Yes. All right, move on to the next case.
Case 2: Retiring physician wants to switch to low-cost index funds.
[00:11:05] MS: Yes. Let’s go on the next case. So the next case is a different one. This is another thing that I encounter. I’m sure Ben sees it way more than I do. But this is a retiring physician, and they want to switch to a lower cost approach. It could be lower cost index funds or lower cost mutual funds, as we talked about in the main talk. It doesn’t matter so much whether it’s an ETF or a mutual fund. It’s more about the cost, and there’s high fee and low fee for both of those.
[00:11:31] BF: Yes. So we’ve got this physician looking at retiring. As part of their pre-retirement research, they came across the data about passive versus active management. Maybe they listened to episode six of this podcast and heard us talk about the data there. They felt sick to their stomach when they looked at their portfolio because it is filled with exactly what we talked about with high-fee proprietary tax-inefficient mutual funds and a lot of them. I mean, a whole jumble of different funds with overlapping asset class exposures which is tax-inefficient or can be tax-inefficient.
Now, they’ve got niche funds concentrated in a single sector that have tanked over time. They’ve got some cool-sounding names but not very descriptive like “precision tactical advantage growth fund”. Now, they thought that their overall performance is okay because, listen, they’ve worked a career as a physician, they had a good income, the portfolio did keep growing, and their advisor assured them that they’d have enough to retire on.
But on closer inspection and when they went and benchmarked their performance, they found that they basically lagged the major indexes that their portfolio is exposed to by approximately the amount of their fees, which as we discussed in the main episode, that’s exactly what you’d expect. Their retirement portfolio could have been way bigger if they had had the same returns but with lower fees.
Of course, that’s water under the bridge now. It’s already happened, but they do know that they want to make things better going forward. It sounds like it should be simple enough, but they’re worried that it’s too late to make changes because they’re afraid of realizing capital gains and paying more taxes, which is something that their advisor warned them about. They’re stuck in some proprietary funds that they can’t get out of, either due to lockups or penalties. So while they had these hesitations, they’re also aware that if they don’t make the change, the higher fees from active management are really going to hurt them throughout their retirement.
[00:13:09] MS: Yes. This is a common conundrum that’s faced by people when they’re considering whether to switch to a lower cost model, whatever that happens to be. I would say one of the things from hearing the case read out loud just now is that you have to have some financial compassion for yourself. We’re all going to find that we’ve made mistakes with our investing, whether it’s high fees or trading or whatever we’ve done. We can’t really change any of that. But we need to kind of forgive ourselves for that and let go of that emotional baggage and make a better plan to move forward with.
Separate Cost & Value of Products and Advice/Service
This often happens when we have some substantial money, and we realize how much the fees and the dollars are, rather than just the percentage. That may happen when your portfolio is getting big. The cost argument does have some validity, but it could be overblown to try to discourage a move to a different system with often someone else. There are aspects to this, though, that I think go beyond just the fees.
[00:14:01] BF: Yes. I think one big aspect to consider separate from the investment fees, so the investment product fees, is the cost of financial advice. So this physician, they’ve gained enough knowledge to know that they’re paying a lot of fees. Like maybe they listen to the podcast episode, but they haven’t gone and read your whole blog, Mark, and prepared themselves to be a full-on DIY investor. Maybe they don’t even want to make this into their hobby. They also don’t want to learn a ton about financial planning, which is a big part of investing.
If they want to continue working with a financial advisor, they’re going to need to find a new one, I think. Many financial advisors truly believe in the advice that they’re giving to clients, even if that advice is objectively sub-optimal. So they’re going to be unlikely to change their approach, not because they’re malicious. Although in some cases it could be because of incentives, but not necessarily in all cases.
I think that a really interesting study on this that looked at Canadian data actually, it’s in the Journal of Finance. The way that they tested this is that they found that financial advisors gave their clients objectively bad advice, but they did the exact same thing in their own accounts. They continue to do the exact same thing in their own accounts after they retired from being financial advisors.
So, if you go to someone that believes that has that much conviction in what they’re doing and say, “I want index funds,” out of the goodness of their heart, they’re going to try and talk you out of it. No. There can be incentives there too that make that situation a little bit more malicious. Anyway, I think that in this case, it probably means looking for a new financial advisor who is aligned with a lower cost passive approach to managing investments. Or using a fee-only financial planner and taking the time to climb the learning curve to manage their own investments.
[00:15:31] MS: Yes. There are ways to do that are relatively simple too. I do have a lot of advanced stuff on my blog, but I also think there’s easy ways with asset allocation, ETFs that can become very, very simple once you’ve decided you’re going to do it. The right answer to whether to get financial advice is that’s going to be unique to each individual. But I would say that a retirement drawdown plan and being able to spend with confidence in retirement, kind of knowing objectively that you’re probably not going to run out of money. I think they’re two areas where a financial advisor can be very helpful. So I would say that that’s part of that decision too.
Saving on Fees vs Paying Taxes
The second aspect is this fear of losing money to taxes by trying to save on fees. That’s usually used as kind of the stick to prevent you from taking the plunge. A few things to know. One, this is a non-issue for funds that are held within shelter to the account. So if this is a TFSA and RRSPs, those funds don’t trigger taxes when you sell products and buy new ones. Then there’s no capital gains tax in there, so you don’t need to worry about that. You can simply transfer those to a new TFSA RRSP account with whichever way you’ve decided to do that. If they’re proprietary funds, you could transfer them as cash.
Even with that, though, there’s still a couple important operational considerations with that. First, you definitely don’t want to take the money out of those accounts into your personal hands and then put them into a new account. That’s a taxable event, and that could be a one-way exit with a big tax bill. So you don’t want to take money out and move it. You want to have it transfer directly from one account to the same account type managed by the brokerages that are doing that. So they can do that quite easily. The receiving brokerage will initiate a transfer to your institution when you open the account, and they’ll follow whatever instructions you give.
Minimizing Time Out of the Market
The second aspect of that is that you want to minimize time that you’re not invested in the market. We’ve really touched a lot about that on case one that things tend to go up. If it’s proprietary funds, you’re going to have to sell them and spend some time in cash before you can buy whatever the new funds that you’re going to use are. You want to really minimize that time.
Now, from my experience, the fast way to do that is to move them as an all-cash transfer from whatever one account is to the other. You can’t really move them over anyways. For stocks or ETFs or non-proprietary mutual funds that you can move, you can just move those over to what’s called the in kind, which means they don’t get sold. They just get transferred to the new account. Then you can sell and rebuy them in a very short time frame because you have total control over that process.
[00:17:58] BF: Can I add a comment here, Mark?
[00:17:59] MS: Yes, great.
[00:17:59] BF: One case where I’ve seen this get really messy on in cash versus in kind. This is one of the things that we always look at before transferring an account over. But one way they can get ugly is in the case of a separately managed account, so many banks and wealth management firms have like a – it’s kind of like the create a fund. But instead of owning units of a fund, you own the actual underlying securities in your own account, but they manage it like a fund. It’s called a separately managed account.
You could have hundreds or – I don’t know. I’ve seen thousands. But you could have hundreds of securities inside of your actual accounts. If you transfer those in kind in order to not be out of the market, you could end up paying pretty significant trading commissions to get out of that portfolio on the other side in a discount brokerage.
[00:18:45] MS: Yes. Wow. That would be a big mess if you had that kind of pooled portfolio of hundreds of stocks. That’s part of why using funds is so much more efficient for us and when we’re trying to practically manage things. Beyond just the diversification issue, just the whole trading cost gets out of control very quickly.
Capital Gains Taxes Now vs Later
Yes. It’s important to understand that the other thing that we know about is that if it’s in a tax-exposed account, then there could be some capital gains taxes. So beyond just those trading fees that we just talked about, if you have something in it that’s in a tax account, so not a TFSA or an RRSP but something like a corporate account or a personal cash taxable account, then capital gains from selling something and then moving to something else could trigger some taxes.
One thing I’ve realised about capital gains is to understand there is that tax liability there, and it really functions as tax deferral. You’re going to have to pay taxes on that eventually when you sell to get that money. The difference is between the paying the taxes now versus paying them later. That’s and that’s what tax deferral is. So the way the tax deferral works is if your tax right now and your tax rate later is exactly the same, then only true tax cost to paying now versus later from a tax standpoint is the present value of the tax bills. But there’s also this money time machine concept. So you’d rather pay tax later than now, all else being equal. But otherwise, the tax bill is going to be very similar.
So where tax deferral is a bigger tax savings, so not just deferring it into the future but actually saving money, is if you have a tight tax bracket now. Then you’re deferring paying tax on that high-tax bracket off into the future, and you’re going to have a lower tax bracket in the future. So you shift the tax not only in the future but also into a lower tax bracket. So that’s how tax deferral can also be tax savings.
Capital Gains in a Corporate Account
This becomes important. Like in a corporate account, realizing capital gain is usually not a major problem. The corporate tax rate on capital gains is flat. There’s no tax brackets really. So that’s going to be the same. It could reduce the small business deduction and bump the corporate tax rate up in some provinces. However, if you’re retiring and you’re not going to have active income from your business, then that doesn’t really matter anymore. That small business deduction only applies to active income. So that’s not really going to be a consideration in retirement.
Now, let’s say you are working, and you get this one-year corporate tax bump. Well, in Ontario and New Brunswick, there’s an anomaly that even makes that beneficial actually, just because of the way that they’ve broken tax integration. But the other issue is that it’s going to be a small change in a one-year tax bump. The other thing I would say that if you realize capital gains within a corporation, that adds money to what something called your capital dividend account. We’ve mentioned it briefly in one of the other episodes. Don’t worry. We’re going to come back to that in some more detail later.
But what it functionally allows you to do is to use the tax-free part of that capital gain, and the corporation actually give that out to yourself as a tax-free dividend. You could do that instead of paying yourself regular dividends because you need money to live on. So you can move it out in a tax-efficient way. So it may actually be a bit of a bonus. We’ll expand more on that in a later episode. But I think the bottom line with this little section on the corporation and realizing capital gains is that realizing capital gains is not something that should probably stop you from changing your portfolio for the better. There’s enough mechanisms that you can deal with that.
[00:22:06] BF: I agree with that. What about the personal taxable account where it’s a bit different?
Capital Gains in a Personal Taxable Account
[00:22:11] MS: Yes. A personal taxable account is a bit different because unlike a corporation, we have tax brackets. So you start bumping yourself up to higher income levels. Then you change how much tax you’re paying. We mentioned with tax deferral with the tax bracket now and the tax bracket in the future. Those tax rates are going to affect whether you’re paying more or less tax. So the issue would be is if you’re in the same tax bracket now as you will in the future, then it’s not really going to be much of an issue because you’re going to take that money eventually anyways.
But let’s look at a situation more closely. It’s a bit more complicated in some ways. I’m going to give it a next scenario just to illustrate it. But I’m using a scenario that’s going to be a bit of an extreme case because if the extreme case isn’t so bad, then that makes the better cases better. So this is an extreme case. Let’s say this is a case we’re talking about as someone who’s close to retirement. So their portfolio is pretty close to its peak size probably, and they probably do have a lot of capital gains there. So this is going to be an extreme example already, compared to if you realized and wanted to make these changes earlier in your career.
Also, with retirement, you’re more likely to have some reduction in taxes if you deferred money into retirement, and you’re going to take it out slowly over time, hopefully, be in some lower tax brackets. So this would be a case where I think if we’re going to have a problem, this is where it’s going to be. So let’s look at an example here. Let’s say we have – I’m going to pick nice, roundish numbers, a three million dollar personal taxable account. Of course, this is probably just one part of someone’s retirement portfolio if they have a really big one or it could be all of it. Most people would use their other accounts too.
Example Fee Savings vs Capital Gains Taxes in a Personal Account
So they have three million dollars in this taxable account. One million of that is unrealized capital gains. They’re going to plan to make a change that reduces their fees from one and a half percent to half a percent. So one percent reduction and we’ll assume a six percent market return pre-fees. We’re also going to assume that the high-fee funds and low-fee funds both basically match the market minus their fees. So we’re going to – whatever management strategy is being used is not going to trail the market. That’s going to be the case with passive management. We’re not so sure about active management. But let’s give it the benefit of the doubt.
To make this extreme, we’ll assume that they’re going to realize the full one million dollars at the top. Now, all at once in the top marginal tax bracket on Ontario. So out of that one million dollar capital gain, they’d have to pay $267,000 in tax. So it’s a big tax bill, and it leaves them $2.73 million to invest. Now that they’ve taken that upfront, tax hit. The money is going to grow one percent a year faster because I’ve got this lower fee drag. So the $2.73 million growing faster would catch up to the pre-tax value of that untouched three million dollars growing one percent per year slower by around year 10. So you take that upfront tax hit, but you make it up with faster growth by around year 10.
But that’s only in the pre-tax value of the account. So that’s what you’d see on your investment statement. But what a lot of people don’t realize is that there’s actually taxes baked into that. So when we realize those capital gains and paid the taxes on them, we remove that tax liability. That capital gains tax liability got reset to zero at that point. Then only the growth from then on actually is going to trigger more capital gains taxes, whereas in the account that we didn’t we just left it at three million dollars with that unrealized gain. It still has that tax liability baked into it. As it continues to grow, that tax liability is going to continue to grow with it as well.
You have to actually look at the after-tax value of those accounts when you go to realise those capital gains and pay either the rest of the tax bill if we’ve paid some of it already or the full tax bill if we left it for the future. That’s going to be a bit messy because it depends on what your tax bracket is like at withdrawal. But we’re going to take the extreme case. Let’s say that they are in the lowest tax bracket when they take the money out and they contribute, as opposed to taking it out and paying the highest tax bracket. Well, that means that it’s around year 10, so they’re going to break even because it’s going to be pretty similar to what the pre-tax value was.
But most people aren’t going to drop from the highest tax bracket to the lowest tax bracket. They’re going to be somewhere in between that. If they were in the higher tax bracket at the time of withdrawal, as well as when we assumed it was the worst-case scenario at the beginning, then they’re going to have all that advantage of that lower fee drag on their growth, and the taxes are going to be almost the same. So they’d actually make up that difference within about a year. Anything after that would just be further ahead for them.
This is a very simplified portfolio. So worst-case scenario with this example is that year 10, they break-even, and anything after that is further ahead. Let’s say they live another 20, 30 years. Well, in this simple portfolio, by around year 30, that fee difference is going to make a two million dollars difference due to that growth. So really, that capital gains tax to make the switch was just a tiny pebble on the road. This is just an illustration. Real life would be more complicated. They’d be drawing money at variable rates, and market rates are variable and not smooth.
But the basic message from the complex case is that there’s going to be an initial tax hit, but that also resets the tax liability. The higher growth can make up for that over time, and how fast depends on your tax brackets. But worst-case scenario in that situation might be in maybe 10 years. Hopefully, your retirement is going to last much longer than that. So you need to analyze it for your situation quite carefully. If you are switching to new advisor, this is a good way to test their mettle and see that they’re going to give you good value for the advice that they’re providing. I just used a simplistic calculator for my website.3
Ben’s experience onboarding clients switching to their lower fee DFA funds
[00:28:00] BF: When we’re onboarding a new client because we often get like this exact situation where someone has realized that they’re paying too much in actively managed fund fees, and they want to switch too, they would still want to have a financial advisor. But they want a lower cost investment strategy. We had a lot of new clients like that, and we often spent a lot of time upfront doing exactly this, thinking about how to do the transfers, thinking about the tax implications, all that kind of stuff. So it is important.
In some cases, between stuff like proprietary funds with liquidity restrictions or with penalties to sell and tax implications like on the personal side, we’ve got the tax rates to use up. In some cases, this can be a multi-year endeavor to execute a transfer properly.
[00:28:42] MS: Yes. Spread it out a bit.
[00:28:43] BF: Yes, exactly.
[00:28:44] MS: That’s often where people end up in real life. I just wanted to make a worst-case scenario to show that even then, even with the worst-case scenario, you can usually make it up.
Using Donations of Appreciated Securities
[00:28:52] BF: This is somewhat off-topic, but I just want to say it because it would be applicable in this case. One thing this person may consider doing with their appreciated securities in their taxable portfolio, if they plan on making donations because they’re coming up for retirement, if they’re planning on making donations, they could use some of those appreciated securities to make a donation. If you donate securities in kind to a registered charity, you forego any tax on the capital gain. The charity gets the full pre-tax value of your donation, and you get your donation tax receipt for the full pre-tax value. So totally off-topic but in this case would make sense.
[00:29:25] MS: It’s a great point, so I’m going to one-up that even more, just to say that if it’s from a corporation – we’re actually going to have an episode on giving and donating to charity because it’s really important. But in a corporation, you even get a bigger benefit from that. So that capital dividend account I was talking about, where you could give yourself a tax-free dividend, if you donate that to charity, not only do you not have to pay tax on it. You can use it against the tax that you’d pay from other investments, and you could get the whole amount out as a tax-free dividend, not just the half of it that’s excluded from capital gains tax. So it’s like a super way to give to charity and offload that liability and actually get money into your hands more efficiently.
[00:30:03] BF: Yes. It’s a good one-up. I’ll take it.
Case 3: The hot investment idea
[00:30:06] MS: Bring us out back to case number three here, the hot investment idea. I love getting these. So our final case, we have a young business owner who’s paid down their business loans, and they started to see serious cash flows roll into their business on a regular basis. They’ve gotten out some savings to cover business expenses for six months, and their personal finances are solid. So they’ve made that base we’ve talked about. They see the opportunity to build generational wealth, and they don’t want to waste it. It’s going to be something big. They’re aware of index funds but think that with their domain-specific knowledge that they can spot opportunities for a much greater investment return in the market.
The hot tips in sectors you are familiar with.
Now, if we see this in medicine all the time, there’s all sorts of medical companies out there. Because we’re doctors, we can spot the potential of that medical advance. So we could pick any hot trend, whether it’s something medical for a physician or crypto or artificial intelligence, electric vehicles. Those are all recent examples that have been pretty public. But you may have something related to whatever your business is. So if this person came to you for advice, what would you tell them?
[00:31:07] BF: Well, yes, listen. This is a conversation I’ve had many times too. It’s human nature or something to just think that because we know something that we can take advantage of big trends. I think that the simple important point to understand is that even if you know for certain which sectors are going to take off, and you don’t know that, but even if you did, investing in the highest growth industries or sectors or companies is not a winning investment thesis for long-term investors.
Again, you can get lucky. I mean, I know people that invested in cannabis stocks before. That market really blew up, but it blew up twice. It blew up going up, and it blew up going down again. That’s the crazy thing about some of these trends is that even if you’re early, like in the cannabis case, you also had to know when to sell. So, I mean, this stuff’s really hard to get right. But in most cases, people aren’t early. They usually decide that this next big thing is the next big thing when the prices have already gone up. So there are some pretty interesting underlying economic and behavioral factors at play here.
Exciting Technological Revolutions
The main idea, I think, is kind of what we’ve talked about in the main episode is that asset prices reflect expected future growth already. So when you see something that is a potentially huge new market when it comes to technologies or trends or whatever, people are going to tend to get very excited about that, and asset prices are going to reflect that. They’re going to get very high.
There’s all sorts of research on this that attributes it to different things. There are some pretty technical stuff that I won’t go into because it’s kind of complicated, just about how asset pricing works. There are some mathematical formulas in there called Jensen’s inequality. Anyway, too much. More simple stuff, like people just get excited. They get overconfident. They get too excited, and asset prices end up getting really high.
Now, instead of getting high returns, what typically tends to happen is that investors get lower returns than the market. If you go back through history, I mean, you can go back all the way to canals and railways than more modern times. We’ve got electric utilities and automobiles and the Internet. You go back through all of these trends and investors that tried to capitalize on them when they were exciting, when they were just – when the market was realizing how exciting these technologies were, investors in them tend to lose. The suppliers of financial capital tend to lose.
One of my favorite examples is railways versus technology stocks. I have data going back to 1989 on this. So from 1989 to now, you think about how much the technology sector has expanded and how impactful it’s been and how high the returns of some technology companies have been, all that stuff. You think about railways.
[00:33:36] MS: Internet and social media.
[00:33:37] BF: Right, all that. This is based on the tech index, which captures all that stuff. Then you think about railways from 1989 to now. They’ve been a declining industry, not growing. Their share in market capitalization has gone down. Nobody hears about railroads, all that kind of stuff. But over that period, 1989 up until – I think this data – I think it’s up to 2022. Railway was a beaten tech over that period by more than two percent a year. Over that period, 1989 to, whatever, 2022, that’s a lot. That’s big. We talked about how much a two percent fee matters, same thing, two percent return.
More recent examples of these types of things have been, I mean, you mentioned electric vehicles. Cannabis is another one that I mentioned. The ARK ETF, that one was crazy. That one had people going nuts. This is an ETF that invested in a whole bunch of innovative tech sectors. They had a set of technology. They said these technologies are going to be revolutionary, and therefore we’re going to invest in them.
Chasing The Star Fund Manager
For a period of time, that fund did have incredible returns. The manager was a woman named Cathie Wood. She was in the news everywhere and everyone. We had clients calling us saying like, “Why wouldn’t we just invest everything in the ARK Fund because like they’re investing in all these new sectors? They’re going to change the world.” What happened with ARK was it went up, up, up.
Funny enough, actually, I made a video on picking star fund managers, and I didn’t address ARK specifically. Like I didn’t name it, but it was – really like it was kind of about that. I talked about a bunch of past high-flying managers that were investing in tech and had these huge returns but then crashed. I think my video came out like at the peak of her fund returns, and they just crashed, crashed, crashed after that, and investor lost a bunch of money. But that’s illustrative of what tends to happen.
[00:35:15] MS: It does. It happens that way. When everyone’s talking about it, it’s when it comes up. I’m chuckling because when you mentioned the ARK, I had a fellow that I work with who literally around that time told me about their ARK investments and how much they gone up, and they just didn’t know what to do with them. Like, well, you should just counter lucky star, sell it, and move on. I think they actually did, and that was right at the peak probably, so dumb luck. It’s not that I had any insight or anything other than beyond. If you understand how this works, if you did get lucky on something, you might want to move on before your luck runs out.
[00:35:47] BF: I mean, just talk about gambles. So in this case that we’re talking about, you can gamble and win. You cannot capitalize on your domain-specific knowledge to earn above-market expected returns. It’s gambling because it’s not a long-term buy-and-hold investment. Like I mentioned with the cannabis example and the ARK example you just gave, you can buy something. It can go up. But then you have to sell it because, typically, with these types of things, what happens is they come back down.
So it really is a gambling market timing play that, hey, I mean maybe with a little bit of your money, if you’re really passionate about something, you can give it a try. But for any meaningful amount of money, I would be extremely cautious. If we think longer term, and I’m not saying you should do this necessarily, but betting on less exciting or shrinking industries like the railway example, which really we can even zoom out a little bit, companies with lower prices, those have higher expected returns than companies with higher prices. We’ll get maybe more into that in a more advanced episode but –
[00:36:42] MS: You’re already wearing the t-shirt, Ben, so –
[00:36:44] BF: Yes, that true.
[00:36:46] MS: Value versus growth is what we’re talking around in the background. We probably made people’s heads explode with what we’ve gone through. So I think that’s where we’re going to wrap up where our case conference goes. But I would say this is and along with our other episodes are probably things you’re going to left and listen to more than once. This episode, next time you get a hot stock tip, come back and listen to case number three and think about railroads and technology. That railroads and technology is a good mental check to have when you hear about the next hot story.
[00:37:14] BF: All right. Well, we’ll see everybody in the next episode.
Footnotes
- Ritter, J. R. (2012). Is economic growth good for investors? 1. Journal of Applied Corporate Finance, 24(3), 8–18. https://doi.org/10.1111/j.1745-6622.2012.00385.x ↩︎
- Statman, M. (1995). A behavioral framework for dollar-cost averaging. The Journal of Portfolio Management, 22(1), 70–78. https://doi.org/10.3905/jpm.1995.409537 ↩︎
- Taxes & Switching To DIY Investing — Physician Finance Canada (looniedoctor.ca). ↩︎
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