Stock Market Investing

Wednesday, September 26, 2018

 Bonds - summary
• Bonds are simply a loan, with interest payments
• If held to maturity, the principle is returned (assuming
the issuer is not bankrupt)
• Many bonds can be sold prior to maturity, resulting in
possible capital gains or losses
• The major factors affecting the price of a bond are.
– Current Interest rates
– Credit quality of the issuer (borrower)
• The longer the term, the higher the interest rate you
get, and the more the value is affected by interest rate
fluctuations
• The lower the quality, the higher the risk and return
 Preferred Shares
• Another type of fixed income security.
• Not really a bond, but is considered part of the
“bond” component of a portfolio.
• Has many of the elements of a bond
– Par value
– Fixed payment amount
– Some have maturity dates
– Some are callable at the option of the issuer
– They can trade at a discount or premium to par, based
on current interest rates
 Preferred Shares – key differences
• The fixed payment is taxed as a dividend, not interest
– Tax effective income
• They are bought and sold on the stock exchange just
like stocks.
– They all have the suffix PR after the ticker symbol
– There are no commissions, just normal trading costs
• They are more secure than stocks, but less than bonds
• The major types of preferred shares are
– Perpetual
– Floating rate
– Rate resets
– Retractables
Preferred Shares – key differences
• Perpetuals
– Have no fixed maturity date
– Fixed dividend
– Long “duration” means interest rate sensitivity
– Can be redeemed by issuer at a specified date
• Floating rate
– Dividend payment floats every payment, based on
interest rate formula
 Preferred shares – key differences
• Rate reset (Very popular the last few years = 60% of the market)
– Dividend is fixed (5 years). Holder has then the option to
either
• Receive a new 5 year fixed dividend payout at current
rates, or
• Convert to a floating rate, which adjusts the dividend every
3 months
• People that bought these 5 years ago are hurting now.
• Retractables
– Holder has the option to redeem the shares at par on a
specified date
– not many of these
 Preferred Shares – Summary
• Should be part of fixed income portfolio
• As with Bonds, be careful if buying at a premium
– Check call date/redemption date
• Banks, insurance companies and utilities are big
issuers
• Read the prospectus to find out the details
• Other resources
– http://www.investingforme.com/data-
room/preferred-shares
– http://www.prefinfo.com/
– The Issuers website
 Summary
• We covered the definition of return
• We looked at the 3 main asset classes, or
types
– Cash and equivalent
– Stocks
– Bonds
• We looked at how they are priced, and valued
• We looked at historic returns
RISK
 What is Risk ?
• Risk is present in every aspect of life. It can be defined as the
possibility of something bad, or unexpected, happening
• Risk can be dealt with in 3 ways
– You can sometimes avoid it entirely (Don’t go skydiving)
– You can take steps to reduce it (Wear helmets, buy
insurance)
– You can live with it (the reward outweighs the risk)
• Investment risks can be thought of in the same way.
• When Financial Advisors talk about the “risk” of a stock or
portfolio, what are they saying ?
• It is likely not what you think
 Financial industry definition of Risk
• In investment theory, risk has a precise statistical
definition. It is defined as the standard deviation
of expected returns. In simpler terms, it is the
degree to which an investment has fluctuated
from its long term average
• Another commonly used term for this is volatility.
The more volatile an investment is, the riskier it is
defined as. The higher the standard deviation, the
higher the risk.
• When the Financial industry uses the term “risk”
for an investment, this is what they mean.
Nothing else.
 Canadian Equity Fund from BMO
• Sometimes the documentation will use a
broad category definition
 Canadian Equity Fund from BMO
• Sometimes the documentation will be precise
 Canadian Equity Fund from BMO
• Same fund 2 years apart
China Equity Fund from BMO
China Equity Fund from BMO
Canadian Money Market Fund from BMO
Canadian Money Market Fund from BMO
Risk comparison – using Standard Deviation
Fund Risk Category 5 year standard
deviation
Money market Low 0.00

Canadian Equity Medium 8.6%

China Equity High 14.5%

 What is Standard Deviation ?
• It is the statistical analysis of how an
investment price (or return) “deviated” from
its historical average.
• It will change over time, as its historical
average is recalculated
• It is used extensively in business, engineering,
statistics, etc.
• Formula is
Standard Deviation
 What is Standard Deviation ?
• Using standard statistical probability theory it
can be used to model future behaviour – with
caution
– An investment that has an average price of $36, and a
standard deviation of $6
• 68% of the time will range between + or – $6 of its
average (=1 standard deviation = $30 - $42)
• 95% of the time will range between + or - $12 of its
average (= 2 standard deviations = $24 - $48)
• 99% of the time will range between + or - $18 of its
average (= 3 standard deviations = $18 - $54)
 What is Standard Deviation ?
• Applying this to historical returns.
– An investment that has an average return of 8%, and a
standard deviation of 6%
• 68% of the time will range between 2% and 14%
(=1 standard deviation)
• 95% of the time will range between -4% and 20%
(= 2 standard deviations)
• 99% of the time will range between -10% and 26%
(= 3 standard deviations)
 Key points to remember
• When you see risk mentioned in investment
literature, it means the Standard Deviation of the
returns of the investment. Low risk does not
mean “safe”, it just means that the returns have
not varied much from historical average.
– Eg, if an investment has had a monthly loss of 1% for 3
years, it will show a standard deviation of zero for that
period. That is because its monthly loss of 1% has not
varied at all)
• It is based on historical results. There is an
implicit large assumption that the future will look
like the past.
 Other risk measurements
• There are 4 other commonly used industry
measurements of risk/return. It isn’t
necessary to understand these, but you will
often see the terminology. They are all
components of Modern Portfolio Theory
• What is Modern Portfolio Theory
 Modern Portfolio Theory
• Risk and return for a Portfolio can be plotted on a
graph
• The asset allocation mix that produces the highest
return for a given risk level, or the lowest risk for a
given return is called the Efficient Frontier
• This theoretical construct was developed by Harry
Markowitz in 1952, and is the foundation of Modern
Portfolio Theory
• It has almost no practical value, but you will come
across it often. Financial Advisors love to use it in
charts.
 The Efficient Frontier
Covariance is a
form of standard
deviation
calculation,
combining both
asset A and asset B
variance from
historic average
The Efficient Frontier
• The Efficient Frontier can
be calculated precisely in
theory for any Portfolio,
consisting of any number
of investments
• Practically, it becomes
impractical to calculate
beyond two or three
The Efficient Frontier
Why it is practically
impossible to calculate
the efficient frontier for
a portfolio

The correlation has to

be calculated for every
asset in the portfolio –
and it changes over
time
The Efficient Frontier

The shape of the

curve changes

The components of
the curve change
The Efficient Frontier
Financial firms will
display the efficient
frontier curve as
part of their sales
pitch

It is only an
illustration NOT an
actual calculation
 Efficient frontier conclusion
• It is a theoretical model, based on historical analysis of
returns and volatility
• It is totally impractical to attempt to calculate it with an
actual portfolio
• Even if you could, there is no assurance at all that it will
apply to the future
• The Financial industry uses it as a sales technique.
• The only real message is that diversification is important
 Other Risk measurement techniques
• The 4 other most frequently used measurements
of risk/performance are
– Alpha
– Beta
– R Squared
– Sharpe Ratio
• They are complex calculations, not usually easily
accessible, and of limited value
• They are based on historical measures of risk and
return
Other Risk measurement techniques
• Alpha
• This measures the risk adjusted performance of an investment
against a target index. Any improvement over the index is
considered the “Alpha”. Essentially it separates out the
performance of the index from the performance of the security,
taking into account the risk. You will see Fund Managers talking
about “seeking Alpha”. It simply means beating the index, using
the same level of risk.
• Positive Alpha means the manager succeeded. Negative Alpha
means they didn’t.
• Most fund managers have negative Alpha
• Most funds don’t even report it because of that
 Risk measurement techniques
• Beta
• This is a measure of the volatility (risk) of an
investment compared to the market as a whole. It
measures correlation.
• An investment with a Beta of 1 will move in line with
the market. A beta of 1.2 means that the investment
will theoretically be 20% more volatile than the
market.
• Beta .8 means that it will be 20% less volatile than
the market
• Beta is often reported
Risk measurement techniques
 Risk measurement techniques
– R Squared
• This measures the percentage of a funds movement that
can be explained by movements in the index. As a
percentage, it is based on 100.
• EG a fund with an R Squared of 85 means that 85% of the
funds movement is explained by movements in the index. It
means it is highly correlated.
• One practical use of this is that you should avoid paying
active management fees for a fund with a high R Squared
number
• Often not reported, unless you are a paid subscriber to a
fund service such as Funddata
 Risk measurement techniques
– Sharpe Ratio
• This measures risk adjusted performance. It helps
indicate whether investment returns are due to smart
investing, or excess risk. It is calculated by subtracting
the risk free rate of return from the investments return,
and dividing it by the standard deviation.
• The greater the Sharpe ratio, the better the risk
adjusted performance
• Not usually reported unless you have a subscription
 Risk measurement techniques
• Do not worry about these measurement techniques
• They are based on past results
• They are based on mathematical formula, and are very
theoretical.
• They are all based on the concept of risk being defined
as the fluctuation from an historical average
• They are of limited practical value to an investor, and
are not easy to get current data on them
• Financial advisors love to talk about them.
Risk from a useful
perspective
 Investment risks
• Risk number 1 – Capital protection
– Your investment can drop in value, below what you
originally paid for it
– Key point to remember is that you only actually
lose money if you sell the investment. This is
known as a “realized” capital loss. If you haven’t
sold the investment you have an “unrealized”
capital loss, meaning you do not have an actual
loss – yet.
– You can get income tax relief on realized capital
losses, by offsetting them against realized capital
gains.
 Investment risks – sample Bankruptcies
Shareholders were wiped out
• Nortel • GM
• Air Canada • Chrysler
• Eatons • Worldcom
• HMV • Lehman
• Consumers distributing • Enron
• Stelco • American Airlines
• Olympia and York • Washington Mutual
• Quebecor World • MF Global
• Tilden • Texaco
• Miracle mart • Calpine
• Abitibi • Global Crossing
• Campeau • Pacific Gas and Electric
 Investment Risk
• Risk number 2 – Inflation/interest rate Risk
– Inflation risk relates to the loss of buying power with
your cash
– If inflation is 5%, and today you can buy a bag of
groceries for $100, then next year the identical bag
will cost $105
– If you only have $100, or $102, next year, your only
option is to buy less groceries, or cheaper.
– Inflation in Canada has been relatively modest for
some time – between 1.5% and 2.5% per year for the
last 20 years.
– It hasn’t always been that way
Inflation in Canada 1915 - 2018
 Impact of Inflation
• Between 1973 and 1983, inflation averaged
approx. 10% annually
• This means that, during that period your dollar
dropped in purchasing value 57%
• If you did not get salary increases in that period,
your standard of living was cut in half
• If you had investments that were affected by
interest rates, they would have dropped in value
by at least 57%
• Persistent high inflation can be a killer, if on a
fixed income
 Investment Risk
• Risk number 3 – Income security/adequacy
– Relates to how certain the income from your investments
is, and whether it is sufficient for your needs
– Critical for people who need the income to retire, or meet
cash obligations
– Persistent low interest rates can cause this to be a big
problem
– Can cause people to take more risk in their investments
than they should.
 Investment Risk
• Risk number 4 – Turning it into cash
– This relates to how easy and quickly you can sell the
investment for cash. It is known as “liquidity”
– Investments that are very liquid can be sold immediately,
with little cost or effort. Those that are not liquid may not
be able to be sold for some time, or may cost a lot, or
make a big price difference
– It is very important to match the timing of when you need
the cash with the liquidity of the investment
 Investment Risk
• Risk number 5 – Currency/exchange risk
– This relates to investments that are in currencies
other than the Canadian Dollar
– Investments that are in foreign currencies carry a
double risk – the investment itself, and the risk of
currency fluctuations
– If you had bought a $US investment in 2009, in 2013
that investment would have been worth 30% less in
Canadian dollars, just through currency changes
– If you bought $US investments in 2014, those were
worth 25% more in 2015
– Investing outside Canada can have advantages, but
adds an additional risk
 Investment Risk
• Risk number 6 – Value fluctuations
– This relates to how much the value of your investment
can jump up and down over a relatively short period.
It is known as “volatility”
• An investment that is very volatile can be like a roller-
coaster, with big ups and downs.
• An investment that is not very volatile will tend not to have
big swings in value.
– If you need the cash, and an investment has to be sold
within a short period (1 -3 years), then low volatility is
better. Otherwise it may have to be sold when it is
down in value
– This is the risk factor used in the industry
 Investment Risks
• Risk number 7 – Concentration Risk
– Simply explained, means too many eggs in one basket
– Having all of your savings in only a few investments,
significantly increases overall risk
– If one of the investments goes bad, it has a huge
negative affect on your portfolio. (The flip side is that
if it does very well, it has a huge positive impact – the
risk/reward equation in action)
– Concentration risk is reduced by diversification –
having your money spread over a larger number and
type of investments
– It can be difficult to achieve ideal diversification
 Simple Concentration Risk example
$60,000 in 3 investments $60,000 in 6 investments
– Investment A $20,000 – Investment A $10,000
– Investment B $20,000 – Investment B $10,000
– Investment C $20,000 – Investment C $10,000
– Investment D $10,000
• Investment C is lost
– Investment E $10,000
• $60,000 is now $40,000
– Investment F $10,000
• Loss on Portfolio is 33% • Investment C is lost
• $60,000 is now $50,000
• Loss on Portfolio is 16%
 What is diversification
• The simplest definition is not to have all your eggs in
one basket.
– It can reduce variability (risk)
– It can increase returns for a given level of risk
• This is one of the most misunderstood topics in
investing.
• For diversification to work optimally you must have
– A sufficient number of investments in the portfolio
– The investments should not be correlated to each other.
Ideally they should move in opposite directions.
– A very large number of investments, all of similar type, is
not proper diversification.
How Diversification Reduces Risk
 How Diversification reduces risk

Highly Highly Medium

Correlated Uncorrelated Uncorrelated
 Summary of risks
1. Capital protection
2. Inflation/Interest rate
3. Income security/adequacy
4. Turning it into cash (Liquidity)
5. Currency exchange
6. Value swings (Volatility)
7. Concentration
 Investment types and risks summary
• Investment Types • Risks
– Cash – Capital protection
– Stocks – Inflation/Interest rate
– Bonds – Income
security/adequacy
– Turning it into cash
– Currency exchange
– Value swings
– Concentration
 Risk analysis - Cash
Category Impact
Capital protection No risk

Inflation/interest rate Strongly affected

Income security/adequacy Income is secure, but likely inadequate

Turning it into cash No risk

Currency exchange No Risk

Value swings No Risk

Concentration Some risk
 Risk analysis – Fixed Income
Category Impact
Capital protection Little risk if held to maturity.
Significant risk if not

Inflation/interest rate Strongly affected

Income security/adequacy Income is secure, but likely inadequate

Turning it into cash Some risk – eg 5 year GIC’s

Currency exchange Only if foreign bond

Value swings Significant risk, based on interest rates

Concentration Some risk
 Risk analysis – Shares
Category Impact
Capital protection Significant risk

Inflation/interest rate Little risk

Income security/adequacy Income is secure, but likely inadequate

Turning it into cash Normally no risk

Currency exchange Only if foreign shares

Value swings Significant risk

Concentration Some risk
Investment type/risk matrix
Cash Bond Stock

Capital protection

Concentration
Inflation/interest
rates
Income security/
adequacy

Turning it into cash

Currency exchange

Value Fluctuations
 Investment/Risk conclusions
• All investments have risks, of one kind or another.
• First step is to understand the risks. The risk
factor used by the industry is only one of the
factors to be concerned about.
• You can’t avoid investment risk, but you can
manage it
– Choose the risks that you are most comfortable with
– Have an investment strategy and plan that reflects
your risk profile
• Investment mix
• Investment timeline
– Be properly diversified to minimize risk
 Investment market place
Mutual Wrap Alternative
Stocks Bonds accounts
Funds
Hedge
Funds
GIC’s/ Term ETF’s Fund
cash deposit Of
Market Funds
Linked
Warrants
GIC Structured
Debentures Seg.
Funds Product
REITS Options Index
Funds
Managed
Mortgages Futures