Few would disagree that greater transparency in the financial markets is a good thing. After all, the efficient market hypothesis states that all known information is freely available to all investors. Society is obsessed with information and data, all of which impacts the way we think. The volume of information is so much — the analogy we like to use is that it is like drinking out of a firehouse. Part of absorbing all of the information is determining its validity and bias.
Imagine if you and all of your neighbours had the value of their homes priced every day. In the spirit of full transparency, it is decided that an electronic ticker should be placed on the outside of every house. Every morning at 6:30 a.m. the electronic ticker would show the value of your home. The values would change until 1 p.m. every day. If the value dropped, the numbers would be in red, if the value increased the numbers are green, and white would indicate no change in value. Each room and area within your house and the yard are priced in real time, the aggregate of which equals the total value posted on the outside of your house.
Imagine leaving your driveway in the morning and your house was valued at $743,000. After a hard day at work, you pull back into the driveway and you see a red sign and you can’t help noticing that your home has dropped $6,000 in value and is now at $737,000. You could look at your neighbours’ values, go inside and check which rooms or areas dropped the most in value. This would be a rather depressing level of transparency. One benefit of the housing market is that you don’t have this exact dollar amount at any point in the day and the focus is longer term.
Greater transparency is not necessarily a good thing unless investors can psychologically accept the stock markets for what they are. They are unpredictable and can be volatile at times. This will not change. Those who do not accept that are bound to fluctuate from periods of fear, hope and greed. Fear stems from the underlying thought that “this time is different” and the stock market may never recover. No one wants to lose their hard-earned money. Some people are better equipped to cope with the stock market. Greed is just as blinding as it can create irrational exuberance and behaviour that is not disciplined. The most successful investors are those that accept the stock market for what it is and do not get emotional on noise and news.
A disciplined approach ensures a portfolio is diversified. There are many ways to obtain diversification, some have more transparency than others. The best way to illustrate this difference is to compare different investors, both with $1 million in a growth portfolio (100 per cent equities).
Mrs. Wilson has decided to purchase 44,000 units (at $25 per unit) of a mutual fund. If she wanted to, she could look at the end of each day and check on the price per unit. For the most part, Mrs. Wilson just looks at her monthly statement to see the overall change in value from the previous month. Mrs. Wilson can also request what the top holdings are in the mutual fund at the end of every month if she so desired.
Mrs. Brown also has a growth portfolio. Mrs. Brown wanted to lower her cost of investing and purchased direct holdings rather than mutual funds. When setting this up for Mrs. Brown, we communicated both the lower fees and greater transparency that she will see with her investments. The disciplined approach we mapped out involved purchasing 32 different equities with approximately $31,250 in each company. The equities will be invested in different sectors and geographies. The direct equity approach provides full transparency.
A well-designed portfolio will have some investments that will do better and worse than other investments. Macro items such as energy/commodity price changes, interest rate changes, foreign exchange fluctuations, and political announcements can all impact holdings — not all these changes will be in the same direction. A term in finance to describe this is correlation. A properly designed portfolio should not be fully correlated.
Mrs. Wilson doesn’t really have to understand correlation, as the only transparent number that she sees is the end-of-month number of the mutual fund. Mrs. Brown, on the other hand, must fully understand correlation to psychologically prepare for the variances. Mrs. Brown can check her holdings in real time throughout the day. At any point in time, Mrs. Brown may look at her 32 individual equities.
The full transparency revealed of the 32 companies purchased, five increased significantly in value (more than 5 per cent), 16 increased slightly in value (between 1 to 5 per cent), five had little change (between -1 to 1 per cent), four declined slightly in value (between -1 to -5 per cent), and two declined sharply in value (more than -5 per cent). The natural tendency is to question why we purchased the six investments that declined in value, especially the two that declined sharply.
Mutual funds also have successes and failures; however, the detail is hidden. All you see with mutual funds is the combined change in the unit price, not the changes in value of each underlying position.
Although the transparency is greater with direct holdings, it is important to psychologically prepare for the detail. We also try to manage expectations by explaining that not all investments will move in the same direction during a certain period. We encourage clients to focus on reducing the overall cost of investing, increasing the tax efficiency, and focusing on the overall rate of return for all holdings combined.
One of the benefits of holding direct names is the ability to customize. For example, Mrs. Brown has mentioned that she does not wish to hold energy companies. She can specifically choose to exclude a sector or overweight another. This type of strategic decision can be done when direct holdings are purchased. It is not possible for Mrs. Wilson to provide these types of instructions when purchasing a mutual fund.
Transparency can be a double edge sword. Those who can focus on the big picture, rather than getting wrapped up in the details, will be in a better position to make rational decisions. We stress with clients that with greater transparency comes increased anxiety for people who do not have the ability to process the big picture correctly in the scope of a long-term investment plan. We remind clients that constantly looking at your investments will not help the markets go up.
Monitoring investments, even on a month-to-month basis, is a very short time horizon. When markets have declined, we will often tell clients that they should just put their statements to the side and not look at them this month. We also remind clients that when the markets decline, that is often the opportune time to get cash invested if you have funds that are on the sidelines. As Portfolio Managers, we have many discussions with our clients to better prepare them to deal appropriately to market volatility.
Kevin Greenard CPA CA FMA CFP CIM is a Senior Wealth Advisor and Portfolio Manager, Wealth Management with The Greenard Group at Scotia Wealth Management in Victoria. His column appears every week at timescolonist.com. Call 250.389.2138, email [email protected], or visit .
