Why Do Some Investors Watch The Pennies Carefully While Letting Dollars Slip Through Their Fingers?

On food purchases alone a wise shopper can often save $100 - $300 per month by buying carefully, shopping at Costco, comparing prices, etc. This shopper may spend a few hours more each month, compared to the shopper who just throws food items into the shopping card without even checking the prices, but for the cost conscious shopper this is time well spent.

The careful shopper gets as much satisfaction from getting a good deal and saving a few dollars here and there as a spendthrift might get by buying the latest novelty item. As a result of careful shopping, at retirement, this individual may very well have an investment portfolio of $2,000,000 or more.

So here is the question: Why would a wealthy shopper, one who carefully watches the pennies, willingly let $1,500 to $3,000 per month slip through his or her fingers without even giving it a thought?

The answer is simple. The savings on small items is easy to measure and although the amounts are much larger—the savings/higher costs related to an investment portfolio are slightly more difficult to measure.

If one is looking at the purchase of a package of paper towels and one package costs $8 and another almost identical package costs $6, the difference is easy to measure.

When it comes to investing, because of the unpredictability of the stock market, it may take a few years to be able to clearly see the difference between prudent and not-so-prudent management of one’s investment portfolio. Over many years it is not uncommon to see a difference of 2% or more between a well-managed and a poorly managed portfolio.

Looking to the future, it’s impossible to say exactly how much higher the return will be from a well-managed versus a poorly managed portfolio. But it’s quite easy to look back and compare the rate of return of one’s existing portfolio with a simple ETF benchmark. Wise investors can do better than a simple ETF benchmark—but no one who manages their money wisely should do worse than an ETF benchmark with the same level of risk.

For example, during the 3-year period from July 1, 2013 to June 30, 2016, a simple ETF portfolio with 60% in equities and 40% in fixed income would have earned an annualized return of about 9.5% after all fees. If investors had used ‘best in class’ active managers the return would have been a bit higher than the passive ETF portfolio—but the ETF portfolio is a good starting point to measure the cost of underperformance.

If an investor with a $2,000,000 portfolio is underperforming by 1% to 2% per annum, the $20,000 to $40,000 that is being thrown away is probably more than the total grocery bill for the entire year!

Some investors might say, “I can understand the difference between the prices of two identical food items but I’m not a knowledgeable investor and I don’t know how to measure the effectiveness of two investment portfolios.” To these people I would say you don’t have to be very knowledgeable if you are working with a firm that holds itself to the fiduciary standard and which provides you with an investment policy statement and a performance report which compares actual results against the proper benchmarks. It’s easy to compare the price between two identical food items—and it is equally easy (if you are receiving a proper performance report) to compare actual investment returns with the proper benchmarks.

It’s not complicated to become a wise investor. You simply need (1) a ‘goals based’ asset mix; (2) you want to work with a firm that holds itself to the fiduciary standard of care; (3) you need your advisor to provide you with an investment policy statement (in sufficient detail to be able to hold the advisor accountable) and which explains the investment strategy, the benchmarks, the allocation ranges for each investment mandate, the rebalancing strategy, fees, etc.; (4) you want to be well diversified and working with ‘best in class/most appropriate’ investment managers; and, (5) you need to receive a proper performance report which makes it just as easy to measure investment performance as it is to compare the price of two identical food items.

Over the next 20 years an investor with a $2,000,000 portfolio who improves performance by 2% per annum will have $1,000,000 to $2,000,000 more (ignoring income tax) to leave to family or to give to charity. In addition, this investor would have the satisfaction of knowing that he or she is managing money wisely.

On a risk-adjusted basis, any investment portfolio has the potential to earn the ‘market’ rate of return. Since you are taking all of the risk it only makes sense that you earn all of the potential return—rather than sharing it with the other participants in the financial services industry. You can determine whether these comments apply to you by doing a quick check to confirm that your 3-year return to June 30, 2016 is as good as a simple portfolio made up of three exchange traded funds. (See footnote) Assume the following are the annualized rates of return for the three years through June 30, 2016:

Sample ETF portfolio - 18% Cdn / 22% world equity / 60% fixed income would have earned about 7.9%.

Sample ETF portfolio - 24% Cdn / 36% world equity / 40% fixed income would have earned about 9.5%.

Sample ETF portfolio - 27% Cdn / 48% world equity / 25% fixed income would have earned about 10.7%.

Investment portfolios made up of ‘best in class/most appropriate’ active managers would have done better—but no prudent investor should have done worse than the return from a simple ETF portfolio. If you don’t know how you’ve done, or how to calculate your actual rate of return, or how it compares to the proper benchmarks, you should assume that you have suffered significant underperformance.

For the future, most experts believe that we should expect lower rates of return. In the past, if the benchmark returned 10% and you underperformed by 2%, then you left 20% of the potential return on the table. Going forward, if the benchmark return is 6% and you still underperform by 2%, now you’ve still taken all the risk but you’ve left 1/3 of the potential return on the table.

A prudent shopper who, on a risk-adjusted basis, has at least matched the minimally acceptable ‘ETF benchmark portfolio’ should be pleased that he or she is being consistent in wisely watching both the pennies and the dollars.

Warren MacKenzie, CPA, CA is a Principal and Stewardship Counsellor with HighView Financial Group. HighView is an experienced boutique investment counselling firm, dedicated to developing sustainable wealth solutions for Canadian families and foundations. Email: wmackenzie@highviewfin.com Tel: 416.640.0550

ETFs used in sample portfolios are: (1) S&P/TSX Composite Index ETF. (2) Vanguard Total World Stock ETF, and (3) iShares DEX Universe Bond Index.