Adjusting Your Index Portfolio During Market Downswings

Theres no doubt markets are off to a horrible start to begin the year. Here is the current overview of North American markets to start 2016:

Dow Jones (8.67%)

S&P 500 (9.40%)

Toronto Stock Exchange (6.34%)

And many of the international markets are doing even worse. It's not exactly all sunshine and rainbows at this point. So, how can you respond effectively to this?

Stick to the same strategy we've been talking about since the beginning.

Continue with your monthly contributions but now you will likely be splitting them between the stock indexes only to increase you percentages back to your original allocations. If you are unable to contribute enough to your investments to reset percentage allocations, consider selling off some bond indexes (which have remained relatively stable this year) and buying more stock indexes instead. If you have not read our blog post on discussing % allocation click here.

All you can do is make the best of the situation and put your money to use so that it can build on itself in the future. If you were comfortable with buying S&P 500 stock indexes at the end of 2015, they are now at a 9.4% discount! It would be illogical to put off on buying more given we do not know the future of the market. Continue with the strategy and variance will ride itself out.

Stock may continue to drop, they may rebound, they may do a mix of both, no one knows. By continuing to buy during lows, you stand to benefit from downswings by having bought cheaper units. When upswings do occur, you will be there to reap the benefits.

In 2008 when the market crash occurred, the Dow Jones ended down 33.84% on the year (S&P 500 was down 38.49%) only to then rise for the next 6 years. The losses were more than made up for. The cheapest index units you could've possibly bought over the past 10 years were during this recession. Savvy index investors should think of the word opportunity when markets crash.


-Yinvestors.


keywords: index, index investing, stock market, index balancing, rebalancing index, index funds, e-series, S&P 500 index, S&P 500, TSX index, DJIA index, U.S. stock index, Canadian stock index, Canada index.
Graphs source: Yahoo Finance 

The Power of Time (and why you should start investing now)

I often see over the internet people asking questions such as:

- "I am 17 and want to learn about investing, where do I get started?"

- "I am a college student with $5,000 to invest, what are my options?"

- "Can I start investing with $1,000, and how?"

These are all questions that cross the minds of many young people and, to some extend, depict how our education system has failed. It is fascinating that so often business/investment education is not a critical aspect of education systems, while managing and investing money will be of fundamental importance for the rest of our lives. This blog is motivated to help people find answers to such questions in a simple manner so that they have a starting point to develop their investment strategies.

Regarding the last two questions that depict some fix amount ready to invest, some answers I have seen were that it's a small amount and probably not worth investing. While having $1,000 to invest will not give you much flexibility to trade individual stocks (commissions will eat your money away), you definitely have some options! Two clear-cut options are to buy bonds or index funds, where you will face a percentage fee that will be low due to your investment amount.

So is starting to invest $5,000 today worth it? Let's have a look.

We will assume our passionate youth investor has $5,000 and will be building himself a well-balanced index portfolio that yields him 7% annualized average. We will assume that over the years, he will contribute $1,000/year to his investments. Let's watch how his money grows over 50 years:

After 50 years, our investor is now a bit older and has contributed a total of $55,000 to his investment portfolio ($5,000 to start and $1,000/year afterwards). His portfolio value is now a staggering $553,814! How is that possible? Well, your best friend when it comes to investing is time. The younger you are, the more time you have to make your money work for you. Even if it is a small sum, it really does add up. That initial $5,000 alone would be worth $10,000 after about 10.5 years and by the end of the 50-year period, it would be worth $147,285.

Let's look at some of the assumptions here. First off, you never paid any taxes on your earnings, which could be the case if you made use of a TFSA. Second, a 7% return annualized is achievable with a balanced index portfolio, although if you were to hit a downswing right out of the gates, this would significantly impact you down the line (given your initial capital is 5x your yearly contribution). In this example, we simply assessed 7% as a linear return, which would not be the case, some years your might lose 5%, some years you might gain 12%. Regardless, the example does depict the power of time.

Let's now look at a different case, let's compare the same investor who decided to spend his $5,000 and held off investing for another 10 years. Can't be that bad can it? Well let's have a look over that same 50-year period:

So actually, it's pretty significant. In the second case, a total contribution of $45,000 has been made, as compared to $55,000 in the original case (an extra 10 years at $1,000/year contribution). Let's look at the end result though: our delayed investor has a portfolio value of $274,507 versus the more diligent investor with $553,814 - over twice the amount! How is that possible? Again, think back to compounding. The 7% you made your first year off the $5,000 has made 7% from itself every year, this progression reiterates itself every interval and for your contributions. This is how you can establish wealth off not much starting capital!

The sooner you begin investing, the better off you will be. Even a small sum can grow into a fortune under the correct conditions. Don't listen to those telling you a small sum isn't worth investing! You have to start somewhere and if the small sum even just motivates you to save up money, it is immensely valuable.

Here is a link to the table breaking down the number for the graphs depicted above (graphs may not load, but table works). Comment below if you have any questions and please give the blog a G+ follow! More posts on similar topics coming soon!


-Yinvestors.


keywords: youth investing, compounding interest, compounding growth, growing money, how to make money grow, investing, money growth, index funds, index investing, money. 

Index Funds and Mental Strength

One of the key characteristics of good long-term investors is drawing the line between making sound investments and emotions. When the stock market crashes, it is common for people to panic and sell off their investments without really understanding why this is happening and being critical as to whether the quality of their investments is still present. Logically speaking, if the quality of the stock has been maintained but the overall market is tumbling, the stock is becoming progressively cheaper. This is an easy concept to understand, but much harder to practice when your life savings are on the line. The emotional element of investing outlines why smart-analytical people can become losing investors. In this article we will discuss why index funds provide emotional comfort when investing in the market, which may be especially important to youth encountering monetary swings for the first time. 

With the correct mindset and investment strategy, managing
your investments can be an enjoyable experience! (source)

Not Trying to Predict the Market

When investing in indexes you are not trying to predict the market. For the most part, you are adding to your investments along the way - at least once a year. By continuously adding to your investment you are reducing variance over the long term. For example, if a given index is down 5% a certain month, through monthly contributions you are lowering your average cost per unit. Not trying to predict the market also means you do not hold off on adding to your investments because the market seems expensive. Even if the market is at a 5-year high, if you choose to hold off on contributing to your portfolio waiting for it to drop, you are somewhat trying to predict the market! What if the market remains relatively stable for the next five years? What if it rises another 20%, or what if it drops 20%? How will you know if it will not drop another 30%? Money is better invested and contributing to dividends since market dynamics are excessively complicated and impossible to predict over any extended period of time. Following the same principle, if you are about to contribute to your investments but markets are tumbling, is it worth waiting? The concept of trying to predict the lowest an individual stock will fall is referred to as 'catching a falling knife'. No one knows how low it will reach and if you misevaluate, you might get cut. This principle somewhat applies to index investing. If you are worried about the state of the market, you could choose to contribute your money in smaller amounts and more often instead.

If you are limited in your ability to add to your investments, another potential strategy would be to keep a certain (but small) percentage of your portfolio in cash, say 5%. This may be a more legitimate strategy to investors buying individual stocks as by the nature of their investments, their portfolios will be less diverse. Meaning it is more likely for a market crash to impact all your investments, versus an index investor than has money in foreign markets and bonds. Having a fix cash allocation gives you the flexibility to buy cheaper units of stocks or index if markets slump. For Index investors, owning bond indexes in your account that provide more stable returns and still give you buffer to rebalance may well be a better strategy. 

You Cannot Blame Yourself for Swings

One of the benefits of owning a well-balanced index fund portfolio is that the swings will be much smaller as compared to owning individual stocks. When substantial swings do happen, it will be because of global market dynamics that no one could've predicted accurately. This means that as an investor, you should be rather emotionless towards swings. You cannot be down at yourself for your recent stock purchase, since you've bought the whole market! By having your money invested in indexes, you are giving yourself a chance at experiencing greater returns than fix investments and keeping ahead of the inflation curve. On average you are making a winning investment. The greatest swing the DJIA experienced in the last 10 years was 7.87% in one day (which is a massive swing for an entire market). If you had 30% of your portfolio allocated in the DJIA, you would've experienced a decrease in value of (0.3*0.00787)*100=2.36% in portfolio value (or $236 on a $10,000 portfolio).

Another key characteristic that distinct index investing versus common stock investing is the risk assessment of losing your entire capital. Assuming that the company managing the index is reputable (such as Vangaurd, BlackRock, banks etc.), it becomes effectively impossible for an index portfolio to go bust. You would need major governments (provincial and federal) to fail to meet bond payments and all major companies to go broke, both domestic and international. Taking the concept of 'too big to fail' to a whole new level.

Remain Realistic About Your Investments
Regarding the mental game, it's also important to be realistic about market returns and understanding that investing in index funds requires a long-term outlook. It's very possible that you could lose money on your investments over some period of time, this does not mean you are making bad investments! Markets fluctuate year-to-year, but do go up on average. Keep a long-term outlook and continue to lower your average cost per index unit during index slumps.

Post any questions below and give a Google+ follow!


-Yinvestors.


keywords: index investing, index funds, mental strength, market dynamics, e-series, index funds. 

What Exactly is an Index?

- Sure all this index talk sounds great, but what really is an index and how does it represent companies in the market?

The most simple way to explain an index is that it is a list of stocks.

You have common indexes such as the Dow Jones Industrial Average (DJIA), Standard & Poor's 500 (S&P 500) and Nasdaq that consist of the largest public companies in the U.S. In theory, you could create you own index and track some segment of the market. For example, you could create a Canadian banks index, decide on a weighing system and track it over time to depict how banks as an index unit are doing. Indexes provide a simple way of tracking a group of stocks without having to process too much information. It's all about reducing sample size to gain a general image of market dynamics.

- So where did this all start? And how does it actually work?

The first Index was created in 1896 by Mr. Dow and appropriately named the Dow Jones Industrial Average. At the time, it consisted of 12 of the biggest companies in America (today it consists of 30). The value of the DJIA was established by adding the the prices of the 12 companies together and dividing by 12, providing a simple average. While there are flaws in doing this, it was a simple and efficient enough method at the time. 

It is now more common to use a market capitalization (market cap = share price * number of shares outstanding) method of weighing companies within an index. For example, if a company has a market cap of $5,000,000 and the complete value of all stocks in the index is $500,000,000, this company would represent 1% of the index. Let's say the stock dropped by half in value, while all other stocks remained unchanged, the index would drop by 0.5% in representative value. To calculate the actually price of an index, an index-specific divisor is used. The divisor accounts for structural changes within companies, such as share repurchases and mergers. In the example of the S&P 500, the sum of all 500 market caps are divided by the divisor, giving the index level (or value of the index). To give an idea, the current index level of the S&P 500 is $1880 and has a 52-week range of $1812-$2134.

- So why does knowing this matter?

As an investors, its always beneficial to be knowledgeable on what you're buying. Understanding how an index price fluctuation actually relates to individual stocks can be beneficial (and vice versa). You may also be interested in assessing how heavily weighted some of your favourite companies are within their respective index. Understanding how an index is designed can also help you asses the effectiveness of your index fund. For example, the three biggest companies in the S&P 500 are: Apple, Google (Alphabet) and Microsoft. An effective index fund should probably hold these companies as their top holdings, as they will have the most influence of any company on price fluctuations of the index (remember they are weighed by market cap!).

Knowing how an index is computed also depicts how an index could be down over a given time period while most of the stocks within the index could actually be up. This could be the case if a few stocks (or specific industries) in the index were down significantly, bringing down the complete index.

- How does this relate to index funds?

Index funds track these major indexes by purchasing stocks of many (sometimes all) of the companies within the index. You can expect that your index fund will have top holdings of the largest market caps within an index. Looking back to our article on the top holdings of e-series, for TDB 902 (S&P 500 index fund), the top 3 holdings were in fact:

Apple Inc. (3.3%)
Alphabet Inc. (2.5%)
Microsoft Corp (2.5%)

The metric used to asses how well an index fund tracks its target index is R-squared. R-squared is a common statistics metric that asses the strength of correlations between two sets of data. The values range from 0-100%, where 100% would present a perfect fit. When assessing the effectiveness of an index fund, you'd expect this value to be in the high nineties. For example, the 1-year R-squared value of TDB 902 is 99.00%, its 3 year value is 98.70% (Yahoo link). This signifies the index fund has been very accurate at tracking the S&P 500.

If you have any questions regarding indexes, comment below! Happy investing!


-Yinvestors.



keywords: index investing, index funds, what is an index fund, e-series, index, what is an index, index funds Canada, stock indexes, how does an index work

The Case For and Against Rebalancing Your Index Portfolio

Case For Rebalancing

Owning a well balanced index portfolio is a strategy to reduce volatility within your investments. Over time, some indexes will over-perform while some will underperform. In order to maintain a high level of protection against market volatility, it is good practice to rebalance your portfolio at least once a year. When rebalancing, you are looking to lower risk exposure, but not maximize long-term returns. Meaning the volatility of your investments will be lowered but so will your average expected long-term returns. Vangaurd has compared how two hypothetical portfolios (50% global bonds, 50% global stocks) would have differentiated from 1929 to 2014 with or without rebalancing. Regarding the benefit of balancing, the annualized volatility was dropped from 13.2% to 9.9%. This is because stocks have historically had higher returns than bonds, thus over a larger sample size the portfolio becomes progressively more stock-heavy and therefore more volatile.

One benefit of rebalancing is being honest about the time horizon of your investments. Any given year when the stock market experiences a loss, the investor with a greater bond exposure will do better. Bond indexes tend to provide an almost linear return. Here is how the Canadian Bond index has grown (with reinvested interest) since inception in 2000. 

TDB909  Canadian Bond Index Performance Since Inception

Source: TD Canada Trust

Clearly having a greater exposure to this index in your portfolio will offer risk protection versus more more volatile stock index. You expected returns on the flip side will be capped lower. This index has actually increased in value in 9 of the past 10 years, with returns ranging from -1.6% (2013) to +9.1% (2011). (fund fact page)

If we compare it to how the Canadian stock Index has done since inception in 1999 (with the use of DRIP).

TDB900  Canadian Stock Index Performance Since Inception

Source: TD Canada Trust

While still exhibiting an upward trend, the road is more bumpy here. In the past 10 years this index has increased in value 8 of 10 years, with returns ranging from -32.9% (2008) to +34.6% (2009). (fund fact page) 

Note that when assessing historical prices, these represent indications of volatility, risks and historical trends, but do not present future predictions on returns. 

Another benefit of indexing is that it forces you to stay up to date with your investments. If at least once a year, you analyze your portfolio and add money to it, you are being a proactive investor! This in itself is very valuable. Another benefit of rebalancing is that it forces you to add money to investments that have had mediocre results, not to the winning funds. This way you are not engaging in any sort of performance chasing (i.e. putting your all your contributions in the index that has had the best returns last year).

Case For Not Rebalancing

You could also make a strong case for not balancing. Since balancing is a strategy to reduce variance, not maximize returns, you may decide it's not worth it. You just have to be ready to accept that your portfolio will be more exposed to market fluctuations. Going back to the Vangaurd comparison, the annualized return of the balanced portfolio was 8.1%, while that of the unbalanced one was 8.9% (over the 85-year assessment). While this is a hypothetical scenario, it does indicate a notable difference in returns. If you do not value rebalancing, then you could also simply omit investing in bond indexes altogether, as this will further increase your chance of obtaining maximum returns. This comes down to a personal question of how comfortable you feel with handling risks within your investment portfolio. Personally, I find that having some small bond allocation is a good idea. If global markets drop and you have no additional money available to invest but hold 15-20% of your portfolio in bonds, you can sell some to purchase cheaper stock indexes. This enables you to remain more versatile with your investments and gives you more flexibility to react to external market dynamics.  

Another potential argument for not investing in bond index is that they represent a higher MER than both North American stock index options. Therefore by investing in stock indexes, you are paying less to own an investment with greater potential returns (not the case for the international stock index). 

Whether or not to use rebalancing will be a personal decision, although it is considered to be good practice. If you have any questions about rebalancing, comment below!

-Yinvestors.

keywords: index balancing, index funds, e-series, etfs, exchange traded funds, MER, management expense ratio index funds, td e-series, index investing, index investing Canada, best Canadian index funds

The Importance of Dividends and Why You Should Use DRIP

Following up on our previous post explaining e-series and how they offer a DRIP program (Dividend Reinvestment Plan). In this blog post, we will analyze the importance of reinvesting dividends for long term growth. Dividends are an important portion of your earnings, they represent your only earnings that are ensured within the market a given year. Dividends fluctuate over time, for example, during the market crash of 2008, many companies that were historical dividend payers cut their dividends in order to retain funds for recovery. Here are the current dividend payout of four common e-series index funds:

TDB900 - Canadian Stock Index

(.531/20.67)*100 = 2.57% (variable, annually)

TDB909 - Canadian Bond Index

(0.034/11.71)*100 = 0.290% (variable, monthly), or 3.48% (annually, assuming no compounding).

TDB905 - International Stock Index

(0.213/8.78)*100 = 2.43% (variable, annually)

TDB902 - U.S. Stock Index 

(0.745/46.99)*100 = 1.59% (variable, annually)

Sample Equation:

(last distribution/current price)*100= dividend % (or interest, in the case of bonds)

Note that these are variable and the percentages are a function of the current price and the most recent payouts (which was throughout December 2015 for the three stock index and on January 29, 2016 for the bond index). The payout itself is dynamic as it can change depending on the characteristic of the index portfolio, but also if companies within the portfolio change their dividend payouts (for better or for worst). The bond index is the only one to payout monthly, currently at a rate of 0.29%/month or 3.48%/year (if not reinvested); if DRIP is used, effective annual interest rate would actually be around 3.54% due to compounding. Note that for the bond index it is interest, not dividends, that you are receiving. 

Now let's assume you have the following portfolio allocation:

30% Canadian Stock Index @ 2.57% dividend yield

15% Canadian Bond Index @3.54% dividend yield (compounded monthly)

25% International Index @ 2.43% dividend yield 

30% U.S. Stock Index @ 1.59% dividend yield

You would obtain an average dividend yield of around 2.39% per year. On a $10,000 investment, this amounts to $239. Not so bad for earnings from dividends alone! Assuming you made no additional contributions to your portfolio, the following year you would stand to earn even more due to compounding.

Now lets assume your $10,000 investment somehow remains completely stagnate in market value over the next 50 years (and assuming yearly re-balancing), here is how your 2.39% dividends would compound:

Compounding Dividends Impact

$ amount (year)

239.0 (1)

244.7 (2)

250.6 (3)

256.6 (4)

262.7 (5)

302.7 (10)

383.3 (20)

485.4 (30)

778.5 (50)

Your initial $10,000 would now be a portfolio valued at $33,353 due to DRIP alone! Had you not used DRIP over the complete 50 years, you would've earned 50*$239= $11,950 - but by reinvesting dividends, you have now accumulated $23,353 in dividends, or 95.4% more money! While using a 50 year time scale is a bit extreme, it depicts the power of compounding interest by using a dividend reinvestment program. Click here to view the complete breakdown.

Let's look at a more concrete example relating to e-series. Below are two graphs that show how $10,000 would've grown in the U.S. stock index (TDB902) over the last 10 years with or without DRIP.

Case A: TDB902 last 10-year return with DRIP

Source: TD Canada Trust

Case B: TDB902 last 10-year return without DRIP

Source: TD Canada Trust

This indicated a difference in portfolio value of $21,742 - $18,284 = $3458, or a portfolio worth 18.91% more. In the second graph, the investor still received dividends but decided not to reinvest them. If we focus on the last term on the graph, and taking the current 1.59% dividend yield, investor in case A would make $345.70 in dividends, while investor in case B would only make $290.72. This difference again would continue to magnify over the years as investor A would enjoy compounding growth while investor B would not, as depicted in the prior example.

Reason to use DRIP:

• Allows your dividends to compound year after year
• Free program (e-series)
• Easy to set up
• A great way to contribute annually to your investments

For long term investors, there's really is no good reason to not be using the DRIP program if it is available and free, so I suggest you do so! If you have any questions regarding dividends or DRIP programs, please ask below!

-Yinvestors.

Note that dividend section was written in relation to the price and payouts at the time this article was written, please view this TD page for up-to-date prices and payouts for index and mutual funds. 

keywords: e-series, index funds, index investing, dividends, DRIP, dividends, dividend reinvestment plan, high dividend index, dividend yield, compounding dividend, index funds, Canadian stock index dividend, Canadian bond index interest, dividend reinvest. 

e-Series Top Holdings Breakdown

When you purchase an index fund, you are purchasing a very small portion of a pool of stocks. Some index funds can have hundreds of stocks within the fund. In this short article we will discuss some of the major holdings of common e-series index funds. Note that this article reflects only the major holdings at the time of the writing and that these can and do change overtime! This article stands to give an idea of what major stocks are held within some of key e-series funds. 

TDB 900 : Canadian Stock Index (Tracks TSX)

Top 5 Holdings (%):

Royal Bank of Canada (6.7%)

Toronto-Dominion Bank (6.1%)

Bank of Nova Scotia (4.1%)

Canadian National Railway Co. (3.7%)

Suncor Energy Inc. (3.1%)

Total Investments: 250

Fund Fact page

TDB 902: U.S. Stock Index (Tracks S&P500)

Top 5 holdings (%):

Apple Inc. (3.3%)

Alphabet Inc. (2.5%)

Microsoft Corp (2.5%)

Exxon Mobil Corp (1.8%)

General Electric Co (1.6%)

Total Investments: 504

Fund Fact Page

TDB 905: International Stock Index (Consists: MSCI Europe, Australasia and Far East Index)

Top 5 holdings (%):

Nestle SA (1.8%)

Novartis AG (1.7%)

Roche Holding AG (1.5%)

Toyota Motor Corp. (1.4%)

Royal Dutch Shell PLC (1.4%)

Total Investments: 935

Fund Fact Page

TDB 908: Nasdaq Index Fund (Tracks Nasdaq)

Top 5 holdings (%):

Apple Inc (14.6%)

Microsoft Corporation (7.4%)

Google Inc. (6.5%)

Amazon.com Inc. (3.8%)

Facebook Inc. (3.4%)

Total Investments: 110

Fund Fact Page

The Canadian Bond Index, as expected, consists of a variety (1229 investments in total) of bonds with various coupons and maturity dates. The Top 10 holdings are all Federal/Provincial Government bonds (Fund Fact Page). 

For youth investors interested in putting their money in individual stocks, but who may not have enough money to warrant transaction fees, realizing what the top holdings are of these common e-series funds may be intriguing. Say you only had $500 to invest and wanted to be a shareholder of Apple, purchasing the TDB 908 e-series fund would allow you to indirectly place 500*0.146=73 dollars of that $500 into Apple, while avoiding transaction fees and also exposing yourself to 109 other stocks. The top holdings can also give you some slight idea on the dividend payout of the fund. For example, the top 3 holdings of TDB 900 are all large banks that pay out strong dividends, meaning that you could estimate the overall fund to pay decent dividends (and it does, at slightly over 2.5%). Click here for an article on dividends and the use of DRIP.

-Yinvestors. 

keywords: e-series, Canadian index funds, top e-series holdings, index funds Canada, index investing, dividends, DRIP.