On Investing

Investing is both remarkably simple and remarkably complex. It is complex because it is counter intuitive. It is simple because the complexities can be resolved quite easily – but the solution is not what most investors expect.


The first thing to remember about investing is that, if you are an investor, you are taking on the role of a portfolio manager. As Sir John Templeton pointed out, the first role of the portfolio manager is managing the risk. It is not the purpose of this essay to show how that is done; investors can look at sources such as Risk and Return (in a Canadian wiki) or Risk Tolerance (in a companion American wiki), and links therein, for details. However, briefly put, if you are not interested in the links provided and in controlling your risk, you have no business managing your investments yourself, and should follow the steps given later.


The second thing to remember about investing is that cost management is vital. The necessary arithmetic can be found in two simple papers. The first paper is The Arithmetic of Active Management by Nobel Prize-winning author William F. Sharpe. For the link allergic, I will summarize Sharpe’s paper as follows:


Let us suppose that a market (stock or bond) has an investible index. For Canadian investors, the appropriate index might be the S&P/TSX Composite Index; for American investors it might be the Wilshire 5000. There are similar alternative indexes in both countries, and market indexes for many individual countries as well as the world as a whole. Sharpe’s arithmetic applies to all of them. Let us call this investible index I. Those investors that use a passive vehicle for investing in I will receive the index return less their costs – generally one or two tenths of a percent.


But the remaining investors in I – the active investors – must also receive, in aggregate, the total return of I less their expenses – typically one to two percent. In other words, as a group, active investors must underperform passive investors by their total cost difference. Over time, this results in the transfer of most of your assets to your broker, as shown in the second paper: Bequeathing Your Assets to Your Broker by William J. Bernstein. This does not mean individual investors cannot outperform; the math applies to the set of all active investors, not individuals. But individual outperformance comes at the cost of further group underperformance – and not everybody can be a winner.  You might also ask about Initial Public Offerings (IPOs) from which a small number of people can get very rich, and might not initially be in an index.  But it turns out that most IPOs underperform.


Your broker isn’t about to tell you all this.


Some people also think that their brokers have a Fiduciary Duty; that is, they will put their client’s interests before their own. But not only do brokers not have such a duty, the brokerage industry as a whole is solidly against invoking such a responsibility.


You might conclude from this that the brokerage industry is a legalized scam that is engaged in removing as much money from the client as possible. To some extent that is true, and has been shown in movies such as Boiler Room and The Wolf of Wall Street. But many, if not most, brokers are reasonably honest people trying to do a reasonably honest job, and they do, in fact, serve a useful purpose: a good broker will stop you from doing something stupid in a market panic. To that extent, using a broker (or better yet, a financial advisor) can be thought of as insurance: it has a negative expected return, but could in some circumstances save you a great deal of money.


If, on the other hand, you consult the appropriate planner and after that wish to do-it-yourself, you have a fairly simple remedy: buy a low-cost balanced index Mutual Fund (or, if you prefer, an actively-managed low-cost balanced fund, some of which may outperform: Sharpe’s arithmetic does not preclude individual outperformance), or an Exchange Traded Fund. In Canada, you might consider the Vanguard family of Asset Allocation ETFs, or an active fund such as Mawer Balanced or Leith Wheeler Balanced. You can also consider Simple Index Portfolios or the Canadian Couch Potato Portfolios, which have individual components and can be arranged in a more tax-efficient manner if you have both registered and unregistered accounts.


In the United States, you can consider the Lazy Portfolios or simply open an account at Vanguard US and put everything into VBINX.


And, if you do get $2.5 million ahead, you know what to do.



K.R. Betty

Lethbridge, Alberta

August, 2018



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