Bad Investment Advice for Canada’s DIY Investors
Dan Bortolotti of Canadian Couch Potato fame once ran an active podcast that included a segment entitled “Bad Investment Advice” (complete with spooky sound effects – oh, the horror!). He is now going to be a regular guest on the Rational Reminder podcast, which means a segment on bad investment advice is going to make a comeback.
Inspired by this bit of news, for this blog post I decided to write about bad investment advice or choices that I have observed, especially from my days as an investment representative supporting DIY investors.
I – Chasing High Returns
This could be called FOMO (Fear Of Missing Out) Investing. It means putting money into the hottest investment, almost always after the stock du jour has run up in price. A few years ago, this scenario was exemplified by Cannabis companies. These days, cryptocurrencies and AI stocks seem to have the strongest hold on people.
The Better Approach
Invest for the long term in a diversified portfolio of securities. Do not chase trends.
II – Timing the Market
There is a myth out there that one can figure out the best times to buy into the market and get out of it. This is, in fact, one of the goals espoused by many professionals. They will set a “price target” at a certain level and sell the position if/when it reaches that target. The evidence, however, suggests that this is seldom achievable, or at least not consistently. For individuals, it is even more common to wind up buying high and selling low.
The Better Approach
It’s very much a cliché by now, but instead of trying to figure out the best time to enter or exit the market, the more important thing is to spend “time in the market.” That may mean putting regular amounts into your RRSP to coincide with your paycheque, which is very easy if you have a group RRSP, or you may wish to contribute the full lump sum to your TFSA at the beginning of the new year.
III – Falling for Get-Rich-Quick Schemes
Social media is filled with recommendations to get involved in everything from options trading to infinite banking. At best, you are likely to generate little actual wealth from the scheme, or at worst, you could lose your entire investment overnight.
The Better Approach
Let me suggest a “get-rich-slow” scheme. Building wealth takes time and requires a long-term mindset and a disciplined approach. In the early months and years, your contributions will make up the bulk of any growth in your investments, but over time, the “miracle of compounding” (a saying often attributed to Albert Einstein) will lead to your investments growing by substantially more than any new money you may choose to invest.
IV – Ignoring Fees and Transaction Costs
“Don’t just stand there; do something!” That encouragement applies in many different fields of human endeavour. DIY investors like active trading platforms because they are believed to provide an edge in making more frequent and more easily managed transactions. However, they often fail to realize that their expenses in the form of fees and commissions are dramatically cutting into their growth. Even the commission-free platforms will have costs that you are not aware of.
For example, suppose you want to trade in a US stock. If you are an active trader, the kind who will buy into and sell out of a stock within a week, you may find yourself making money under one type of analysis but losing it after accounting for exchange costs. Imagine buying CA$ 10,000 of a US stock. The exchange rate is 1.355:1 (1.355 CAD = 1.00 USD). However, for buyers of USD, there is a markup of 2% charged by the financial institution. That works out to 1.3821 CAD for 1.00 USD. Your CA $10,000 is worth US $7,235.37. You buy your US stock. Three days later, you sell it for a 4% profit at US $7,524.78 for a gain in USD of $289.41. In CAD terms that’s a gain of $392.15! Not bad for a three-day holding period! Your sale in USD is then automatically converted back to CAD. Surprisingly, the official exchange rate is again 1.355:1. However, this time your financial institution charges a 2% markdown which works out to 1.3279. Your US $7,524.78 works out after conversion to CA $9,992.16, a loss of $7.84. Sure, it’s only a small loss but you thought you’d gained nearly $400.
The Better Approach
Pay attention to fees. Active trading may seem attractive, but it’s usually a better deal for your broker than it is for you, even when there aren’t any commissions.
V – Overleveraging Through Margin Trading
In this case, the miracle of compounding gets turned into the “tyranny of compounding.” We borrow to buy a house, and we borrow to buy a car. What could be wrong with borrowing to buy an investment, something we buy on the assumption it will go up in value? Sure, you want your investment to go up in value, but the investments you buy don’t care what you want, nor do they care whether you have borrowed against the value of the investments in your account.
At the time the financial crisis hit in 2008, I served a cohort of DIYers who were active traders. Almost all of them had margin accounts, that is, accounts that would allow you to borrow against the value of the investments. While the investments were going up, they were willing to pay the interest on the amounts they borrowed because their gains were compounding more quickly than their margin debts. They were willing to let the amounts that they had borrowed go up because the leverage worked in their favour. However, when positive returns became losses, they had to cover their amounts owing because they had to maintain a minimum of 30% equity in their accounts. Sometimes, formerly safe investments had their minimum equity requirements raised to 50% or even 100%, meaning they had to either deposit a big chunk of money or close out their positions. Occasionally, our credit risk department wouldn’t wait, and these active traders had their investments sold out before they even had a chance to do anything about it, wiping out their accounts.
The Better Approach
Don’t borrow to invest. Or if you insist on doing so, recognize the risks and limit the amounts borrowed to levels you can afford to quickly cover. Personally, I’ve had a margin account for over 20 years and never used it once! I’ve also been able to trade every kind of options strategy but have never done so. I’ve seen too many blown-up accounts to ever want to take on those risks.
VI – Believing in “Safe” High-Yield Investments
High-yielding dividend stocks are a warning signal in my estimation. The yield is calculated by dividing the dividend payment by the share price. If the share price has dropped recently, the dividend yield will appear very “juicy.” However, a steadily decreasing stock price may mean that the underlying business is having trouble, signaling a potential cut to the dividend if not a sign of going out of business altogether. Some structured financial products trade on the Toronto Stock Exchange and are focused on generating high dividends. These, too, may be superficially appealing for those who are seeking income, but if you find that the share price is declining over time, it could mean that the so-called dividend is actually eating into the capital of the underlying security. Among other structured products to pay close attention to are Principal-Protected Notes (PPNs) and Principal-At-Risk Notes (PARs).
The Better Approach
Carefully analyze any high-yielding investment for the security of the underlying capital especially if it is offering yields higher than average market rates. I might even go further and suggest you simply avoid these types of assets altogether and choose broadly based equity and fixed-income investments.
VII – Neglecting Emergency Savings for Investing
The bad investment advice here is to be fully invested without maintaining any kind of emergency savings buffer. Failing to do so may result in needing to sell investments during a market downturn to cover unanticipated expenses. While some will argue that the risk of being fully invested can be addressed by having a line of credit available, a large-scale financial crisis, or even a policy change, may lead your financial institution to revoke your borrowing facility entirely.
The Better Approach
Establish an emergency fund of approximately three to six months of living expenses before focussing aggressively on investing.
VIII – Ignoring Taxes and Account Types
Many people have visions of using their Tax-Free Savings Account (TFSA) to invest in a qualified but highly speculative security in the hopes that they will have millions in tax-free money. While a million-dollar TFSA is doable over time, this sort of get-rich-quick scheme is probably reaching too far. In my view, the best place for investing in a speculative portfolio is a non-registered account where, if you lose money, you at least have the opportunity to claim a capital loss and use that to offset future capital gains. If you lose in a TFSA, the money is gone and you have lost your contribution room, too.
The Better Approach
I am not a fan of asset location strategies, simply because they can be difficult to maintain, but you should consider the judicious use of tax-advantaged accounts when you can and when it is prudent. For example, many Canadians think that now that the TFSA is available, investing in an RRSP doesn’t make sense anymore. While some Canadians may find the TFSA to be the better choice, especially with households at lower income levels, the advantages of the RRSP in the present, a tax deduction and the potential to qualify for a larger Canada Child Benefit mean that it should not be ignored. This is over and above the tax-deferred growth that the RRSP enjoys until the funds begin to be withdrawn at retirement.
IX – Focussing Exclusively on the S&P 500
The US securities market is by far the largest in the world. Furthermore, the constituents of the S&P 500 index represent the largest companies in the US. Because it has performed so well over the last decade or so, many investors ignore Canada and the rest of the world to put all their investment money into an ETF that tracks this index. While certainly more diversified than holding a handful of stocks, focussing exclusively on this index risks overconcentration, increasing vulnerability to political, economic, or regulatory changes.
The Better Approach
Even for the US, a 500-stock portfolio is arguably inadequate diversification. Some ETFs hold an index that tracks close to the total US stock market, with over 3,000 positions. However, investors should recognize that the US markets are not guaranteed to continue to outperform. Indeed, an earlier decade persuaded many Canadians to invest solely in Canada and avoid the US altogether. However, a better approach is to diversify globally including not just the US and Canada, but having holdings from developed international countries (Europe, Japan, Australia, etc.) as well as from the so-called emerging markets (India, Taiwan, South Korea, etc.).
X – Taking CPP Early to Invest the Payments and Increase Your Returns
A variety of reasons are given for beginning CPP payments as early as possible; among them is the worry that they will die before ever having had a chance to collect on the contributions they have made over the years. I will ignore that argument for the moment and focus on another one that is favoured by some DIY investors. The argument I have often seen online is that CPP provides a poor return on investment. This argument overlooks the fact that while expected market returns over the long term are likely to be positive, they are not guaranteed, and they may not happen when you most need the money.
The Better Approach
Unlike investing, CPP payments are guaranteed, inflation-adjusted, and actuarily sound for at least the next 75 years (as far out as actuaries will project). This is a safer and more reliable way to increase your investment income. Why introduce unnecessary risk to your retirement income planning, especially when our abilities to invest on our own may begin to fade? Despite the fear and anecdotal evidence that people die before they reach age 65 or 70, increasing longevity and the risk of outliving your savings argue for delaying CPP to increase your monthly benefit. I will add one caveat to this. The low-income person is well advised to take CPP sooner so that it has less of an impact on their eligibility for the Guaranteed Income Supplement (GIS). In the interim, that low-income person should put any extra savings from CPP into the TFSA to provide a separate tax-free income source that will have no impact on GIS.
There are a lot of myths and wrong-headed approaches to investing in Canada and around the world. Anecdotes about making these bad investment choices and being successful at the investment game do not guarantee or even make likely a similar outcome for you and me. We all like to think that we are better than average, but the odds are against us, especially when it comes to investing. The better choice is always a globally diversified low-cost investment portfolio.
Happy investing!
This is the 261st blog post for Russ Writes, first published on 2024-09-09
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.