Investing, Investing Basics

Common Investment Strategies and their Shortcomings

by Max Kirouac CFA® – Investment Counsellor, BMO Private Banking

Success in any endeavor requires a good strategy. Given the high stakes involved with stock market participation, countless strategies have been developed to try to outperform the market. These range from fundamental analysis of financial metrics to tracking the patterns that are produced when a stock’s price is plotted on a line graph. This article is intended to focus on the shortcomings of the most common investment strategies that I’ve come across…

Common Investment Strategies No. 1: Investing in stocks with high dividend yields

The appeal behind this strategy is intuitive: target stocks with the highest dividend yield to earn maximum income off of your portfolio. But how did that stock end up with such a high dividend yield anyway? Dividend yield is, by definition, derived from a stock’s price. A stock trading at $100 with a $3 annual dividend has a 3% dividend yield (pretty basic stuff). If that same stock’s price fell to $10, its dividend yield would increase to 30%. Does that mean that the stock is a good buy?

Companies are not required to pay dividends. In fact, companies are legally barred from paying dividends until more senior obligations (such as debt payments) are made. As indicated above, a high dividend yield may actually be indicative of a deteriorating stock, as the yield has skyrocketed because the stock price is in freefall. In situations such as these, it is highly likely that the company will slash its dividend to shore up its flailing financial position.

If a company’s stock price has been stable but their dividend yield is higher than industry average, this doesn’t necessarily mean that the stock is a winner. Dividends are paid from a company’s free cash flow once its other obligations have been met. There’s a reason companies in the growth phase don’t usually pay dividends: they are funnelling free cash flow back into the business to fund additional growth. A high dividend yield may be indicative of a company that is putting little money into fueling its own growth. This can hurt the long term prospects of both the company and its stock. Besides, your focus should be on total return of a stock, not just dividend yield. If you happen to be holding positions in a taxable account, dividend income is less desirable than capital gains from stock price appreciation because capital gains are taxed more favourably (more on investing in your TFSA here).

Don’t be blinded by the appeal of a high dividend yield. Take some time to realize why a stock’s yield is so high, and whether it’s sustainable.

Common Investment Strategies No. 2: Chasing past performance

This investment “strategy” is so pervasive that it has a name: regret aversion bias. How many times has someone told you that they almost bought Amazon stock at its IPO, or that they almost bought bitcoin when it was 50 cents? There is likely 1 of 3 things happening in each of these cases: 1) these individuals are subject to imperfect recall; 2) they are attempting to show you how smart they are because of an investment they almost made; or 3) they are dwelling on the past and therefore particularly susceptible to regret aversion bias.

When an individual suffers from regret aversion bias, they struggle to let go of the past and move on, so they recreate the past as best as they can in the present. When it comes to investing, this involves buying positions now that you wish you had purchased earlier. While this may generously be called momentum trading, it is a sure-fire way to do damage to your portfolio. Those people who regret not buying bitcoin at 50 cents buy it at $20,000 instead.

You don’t want to wind up like Uncle Rico from Napoleon Dynamite, chronically obsessed with missed opportunities and unable to leave the past alone. Forgive yourself for missing out on the few positions that have had truly transcendent returns. The easiest way to minimize regret aversion bias moving forward is by establishing rules for investing and sticking to them. Perhaps that includes a small amount of capital earmarked for a stock that you believe will realize astronomical returns just so that you don’t live in regret of what might have been.

Common Investment Strategies No. 3: Uninformed diversification into alternative asset classes

I would consider “investing” to be any activity involving a cash outlay with the intent to earn more money than you originally paid. The traditional asset classes comprising an investment portfolio are stocks and fixed income (and possibly a small cash component), but I constantly hear individuals espouse the benefits of putting money into asset classes such as real estate and gold. The problem is their arguments in favour of such strategies are often painfully uninformed.

The appeal behind assets such as real estate and gold is tangibility. These assets are physical items that you can hold in your hand, and therefore seem to have inherent value. Further, individuals focus on the recent run-up in real estate prices in markets such as Vancouver and southeast Ontario and want a piece of the action (ahem…regret aversion bias). This may be shocking for some, but real estate prices are not guaranteed to go up, especially on an inflation-adjusted basis. Just ask someone who owned property in Phoenix before the crash of 2008. Or anyone who has ever owned property in Detroit (once the fourth largest city in the United States). Real estate is as susceptible to bubbles as other asset classes.

Take an individual who purchased a home in 1990 for $150,000 and now proudly boasts that it is worth $300,000. This would equate to an annualized rate of return of 2.34%, before accounting for maintenance costs and property taxes. Over the same timeframe, the S&P 500 annualized rate of return was 9.9%. $150,000 would have grown to $2.55 million over the same 30 year span. The immediate counterargument to this is, “You can’t live in an investment portfolio”. While that’s true, you also never need to replace your investment portfolio’s furnace. Real estate investing has been demonstrably lucrative for some, but it is far from a guaranteed path to riches. Those that are able to profit from real estate consistently bring professional-level expertise. Just because the Property Brothers can do it doesn’t mean you can.

Gold is an entirely different animal. It remains topical because of its status as a “safe haven” asset. When other asset classes plunge, gold jumps. However, in exchange for safety, gold sacrifices upside. My one argument against gold is that, relative to equities, its returns are paltry. Its annualized return over the same 30 year period we used for stocks and real estate is 4.7%. Not bad, but this includes a huge run-up in the first 12 years of the new millennium. While gold just recently saw an appreciable increase (rising to $1,681 USD per ounce in late March), it is still off its all-time high of $1,895 USD per ounce in 2011. That’s nearly a decade of negative return.

It is often doomsayers that find sanctity in the tangibility of gold, as if its physical form will protect its value in the event of societal collapse. While gold does have industrial uses, its value is derived largely from its scarcity. If society collapses, scarcity will not preserve its value. As recent developments have proven, people do not clamour for gold when they fear for their well-being. Instead, they go to Costco and buy as much toilet paper as they can fit in their car.

We live in a copycat world; it is inevitable that successful strategies will be co-opted until whatever benefit they originally offered disappears. If you have come up with a clever investment strategy, chances are there are thousands of other investors who have thought of it, too. Investing can be as simple or as complicated as you choose to make it. Just don’t expect returns to rise in line with the complexity of your strategies.

For more articles similar to this one (The Shortcomings of Common Investment Strategies) by Max Kirouac, click here.

Opinions are those of the author and may not reflect those of BMO Private Investment Counsel Inc., and are not intended to provide investment, tax, accounting or legal advice. The information and opinions contained herein have been compiled from sources believed reliable but no representation or warranty, express or implied, is made as to their accuracy or completeness and neither the author nor BMO Private Investment Counsel Inc. shall be liable for any errors, omissions or delays in content, or for any actions taken in reliance. BMO Private Investment Counsel Inc. is a wholly-owned subsidiary of Bank of Montreal.

Max Kirouac
About Max Kirouac

Max Kirouac, CFA®, is an Investment Counsellor at BMO Private Banking in Winnipeg, Manitoba. If you would like to discuss this article more with Max, connect with him on LinkedIn.

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