COMM371/COEC371 – Investment Theory

Lecture 6
Investment Strategies for Individual Investors

Instructors

Prof.LOGO
Alberto Mokak Teguia
VERSIONS
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wordmark are in blue. However, there may be special circumstances where the logo has to appear on a colou
Jose Pizarro
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Today’s Problem: Individual Investor’s Problem

Jessica, 37, is pursuing a career as a neurosurgeon and works

long hours. She hasn’t taken a vacation for a few years and
accumulated about $35,000 in spare cash. She wants to put it to
work. What should she do?

Max, 24, just found a few job as a flight attendant for Air Canada.
He intends to save about $1,000 per month and wants to invest
in financial markets. What’s your advice?

You just opened a TFSA account (tax-free savings account).

What assets should you buy?

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Today’s Class

Available Instruments: Individual Assets, Mutual Funds, ETFs,

Robo-advisors, etc.

Cost of Investment

Investing with Purpose: SRI and ESG

Picking Stocks

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Investment Instruments

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Investment Instruments
Individual securities: Savings accounts, certificates of deposit
(CDs), bonds, stocks, etc.

Portfolios: Mutual funds, exchange-traded funds (ETFs), hedge

funds

Commodities: Precious metals, oil, coffee, etc.

Foreign currencies

Real estate (REITs)

Venture capital (VC)

More exotic: Art, wine, diamonds, etc.

Other

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Mutual Funds (MFs)

A collection of investments, such as stocks, bonds or other funds
Mostly, actively-managed – managers pick the most “promising”
stocks
Mostly, open-ended – as more people invest, the fund issues
new shares
Specialize on specific types of investments: government bonds,
large-cap stocks, stocks from certain countries, etc.
Balanced MFs invest in both stocks and bonds; they may also
hold some cash and derivatives to offset certain risks
Return of a MF depends on the fund manager’s skill at picking
investments
There is no evidence that managers can persistently beat the
market

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Mutual Funds (MFs)

Fidelity liquid alternatives, CIBC Mutual Funds, Europac, etc.
Canadian Mutual Fund Search

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Exchange Traded Funds (ETFs)

Similar to mutual funds, but they are traded on an exchange

Types:
– index ETFs (most ETFs): attempt to replicate some index based on
stocks, bonds, commodities, currencies. Examples: S&P 500, TSX
60, specific industries (healthcare, energy, etc.)
– commodity or currency ETFs: gold, silver, agricultural products, etc.
– other ETFs: leveraged ETFs (bull or bear funds) replicate a
multiple of the performance of an index (e.g., 2x S&P 500, or −3x
Nasdaq 100)

Other characteristics:
– fees: typically lower than mutual funds
– tracking error: how well does the fund replicate the performance of
the target index?
– liquidity: how much trading occurs every day?

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MFs v. ETFs

Very similar assets, but some important differences

Trading
MFs are traded OTC (directly from fund companies or banks, usually
with involvement of advisors), usually once per day
ETFs are traded on exchanges during trading hours

Fees and expenses

MFs usually higher than ETFs, often multiple types of fees (e.g.,
purchase, management, redemption, account maintenance, etc.)
ETFs generally lower fees than MFs and more transparent fee structure

Availability
MFs usually only have access to products that your bank/adviser offers
ETFs with typical brokerage account get access to all ETFs in Canada
and U.S. (also other countries)

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Robo-Advisors

Automated, algorithm-driven financial services with little to no

human supervision – allow putting your portfolio on “auto-pilot”

Typical setup (how they work):

– Set up an investment account with a broker or bank;
– Answer a series of questions about your investment goals such as
horizon and intended investment contributions and your risk
tolerance;
– Receive a pre-set portfolio of ETFs that “match” your goals and risk
preferences.

Examples:
– Wealthsimple, Questwealth Portfolios
– BMO SmartFolio, RBC InvestEase – will offer you their own ETFs

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Costs of Investment
Management Fee: If you invest with a mutual fund/ETF, you pay
a management fee: from 0.10% for ETFs up to 3% for some
mutual funds.
– Robo-advisors charge around 0.50-0.80% on top of the underlying
ETFs’ fees.
Brokerage Fee: Fee to open/maintain account ∼ $100 per year
(if your portfolio is < $15, 000) + a small fee ∼ $5/10 per
transaction
Bid-Ask Spread: The spread between the price at which you
can buy an asset and the price at which you can sell the same
asset at the same point in time
Price Impact: The price impact that an investor can make by
trading on an asset, pushing the price up when buying and down
when selling
Do not underestimate the cost, especially the management
fees!
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Management Fees

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Investing with Purpose

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Investing with Purpose

Standard investor preferences: mean-variance optimization
=> company’s objective:
“Conduct the business in accordance with [shareholders’] desires,
which generally will be to make as much money as possible while
conforming to the basic rules of the society, both those embodied in
law and those embodied in ethical custom.”
– Milton Friedman

Recent trend: Many investors want to make money/invest in

financial markets and make the world a better place
=> Financial services industry: Sustainable Investing, Socially
Responsible Investment (SRI), Impact Investing, ESG investing
(Environmental, Social, and Corporate Governance), etc.
=> Firms: ESG emphasis, practices & disclosure, PR campaigns,
e.g. 2019 Business Roundtable: “Economy that serves all
Americans” – Jamie Dimon, CEO of JP Morgan Chase & Co.
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Investing with Purpose: What Do We Know?

Could work in theory: Heinkel, Kraus, & Zechner (2001), Pastor,
Stambaugh, & Taylor (2022)

Growing demand by investors

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Investing with Purpose: What Do We Know?

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Investing with Purpose: What Do We Know? Cont-d

Impact/sustainability is very hard to measure => low correlation

among major ratings
– For example, Berg, Koelbel, & Rigobon (2020) consider ESG
ratings by six prominent rating agencies: KLD (MSCI Stats),
Sustainalytics, Vigeo Eiris (Moody’s), RobecoSAM (S&P Global),
Asset4(Refinitiv), and MSCI
– The differences in ratings are mostly explained by different sets of
rated categories and different measurements within categories

Mixed evidence on firm and portfolio performance, partially due

to measurement issues
– If measurement error is removed, high ESG firms should deliver
lower returns in equilibrium. Why?
– This doesn’t mean that investors are worth off when investing in
ESG firms.

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Market-based Solutions for Climate Change

EU Emissions Trading System (EU ETS) is designed to reduce
greenhouse gas (GHG) emissions.
How it works:
– Total cap on the amount of GHG by major emitters (e.g.,
manufacturing, electricity producers, aviation, etc.)
– Some receive emission allowances (credits) for free, some buy
them from other players in an auction, some do both.
Why it works?
– Market-based incentive to reduce emissions (improve technology,
switch suppliers, etc.)
– Funds are used for climate and energy related projects.
Similar markets in California, Eastern States of the US, Canada
(still under development) (Why market fragmentation is a
problem here?)
Carbon credits-based investments: The KraneShares Global
Carbon ETF
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Picking Stocks

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from: 1980 to: 2018 Download as: JPG Download data API
US Listed Firms: Much Fewer than Before
USA - Listed companies

9,000

8,000

7,000

6,000

5,000

4,000
80 83 86 89 92 95 98 01 04 07 10 13 016
19 19 19 19 19 19 19 20 20 20 20 20 2

Source: The World Bank

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Do Stocks Outperform Treasury Bills?

Most individual stocks do not!
But broadly diversified stock market portfolios do!
Evidence comes from the analysis of all common stocks that
were ever listed on the NYSE, Amex, and NASDAQ exchanges
(the CRSP database from 1926 to 2016)
There were 25,332 firms that issued common stocks between
1926 and 2016
Monthly stock returns: only 47.8% are larger than the one-month
short-term government bond (Treasury bill) rate
Buy-and-hold return over stocks’ full lifetime: just 42.6% of stocks
have a return that exceeds the return on investing in one-month
Treasury bills over the same horizon
Source: Bessembinder, Hendrik. “Do stocks outperform Treasury bills?.” Journal of
Financial Economics 129, no. 3 (2018): 440-457.

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Annual Buy-and-Hold Returns, All US Stocks in

1926-2016

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Decade Buy-and-Hold Returns, All US Stocks in

1926-2016

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Life Time Buy-and-Hold Returns, All US Stocks in

1926-2016

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Role of Diversification

If individual stocks, on average, lose money, why does the stock

market go up?

Stock market is broadly diversified portfolio that includes all the

stocks

There are a few stocks that are highly profitable and they drive
the whole market

In fact, only about 4.3% of the 25,332 firms that issued common
stocks are responsible for 100% of wealth creation by the US
market in the 20th century

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Top Performers

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Key Lessons

While the overall stock market outperforms Treasury bills, most

individual common stocks do not

The positive performance of the overall market is attributable to

large returns generated by relatively few stocks

Stock-picking is an extremely hard full-time job.

Broad diversification is the key!

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Summary

Many different investment instruments are out there => Use

them wisely
Don’t underestimate the costs, especially management fees and
taxes => Open a TFSA today
Stock picking requires both time and skill => Save yourself a lot
of trouble, invest in an index

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Not All Diversification is Smart

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