This year marks the eighth in a row for the Top 200 tradition which, I’m pleased to say, has been very fruitful. It also happens to be another year in which MoneySense’s Top 200 All-Stars have managed to outperform the market. If you had bought equal amounts of the All-Stars and rolled your gains into the new stocks each year, you’d now be sitting on a 15.5% average annual return over the last seven years, not including dividends. By way of comparison, that’s almost 11 percentage points higher than the annual return of the S&P/TSX Composite (XIC), which climbed 4.6% a year over the same period. This year, you can purchase the list of our new crop of All-Star stocks online as part of our Top 200 Premium Package.

Last year we found that our All-Stars bested every single Canadian equity fund over the prior five years and we were compelled to peek at the numbers again. When we did, we discovered that over the last five years, our All-Stars have beaten more than 95% of Canadian equity funds, in either the pure or focused categories.

We’re pleased as punch with our performance record. If you had split $100,000 equally among our original All-Stars seven years ago, then sold them and rolled your gains into the new batch each year, your portfolio would now be worth $273,000—almost triple your original investment (not including dividends). Still, we want to stress that while we’ve done very well over the last seven years, those kinds of gains don’t come without risk. It’s almost inevitable that we will run into a soft patch. While we believe that our stock picking methodology should work well over the long term, we know—and you should too—that we can’t predict the future. This year’s All-Stars could disappoint.

And despite tough times in America, our U.S. All-Star stocks—those American stocks that combine the best value and growth attributes—have once again beaten the markets. Over the last year our U.S. All-Star team advanced 3.7% over the year, not including dividends. Meanwhile, the S&P 500 (SPY) trailed by 1.2 percentage points, gaining just 2.5% over the same period. Those aren’t huge gains, but they’re not bad considering the state of the markets.

We hope our track record will whet your appetite for this year’s Top 200 and Top 500. As in prior years, we sized up each of the largest companies in each country and graded each one on its investment merit. In our Premium Top 200 Package, we deliver an easy-to-use scorecard festooned with just the sort of information that appeals to most investors. In fact, we think the Top 200 gives you a more objective guide to large Canadian stocks than you’re likely to find from any other single source.

Importantly, the Top 200 and Top 500 offer a logical and consistent approach to selecting stocks that isn’t influenced by feelings or fleeting fads. Instead we take a tip from Mr. Scrooge and apply hard-headed reasoning. We do not rely on gut instincts or nog-induced visions of the future. Our results are based purely on the numbers. Our opinions about a company don’t enter into it.

We begin by identifying the largest 200 companies in Canada and largest 500 in the U.S. by revenue. Using Bloomberg data, we evaluate each stock, first for its attractiveness as a value investment and then on its appeal as a growth investment. (Value investors like profitable stocks that trade at low multiples of book value and pay juicy dividends. Growth investors like companies with expanding earnings and sales.) Our value and growth tests are driven by sophisticated calculations, but in the end we reduce everything about a stock to two grades: one for its value appeal, one for its growth potential.

The grades work just like they did back when you were in school. The best are awarded an A. Solid firms get by with a B or a C. Those in need of improvement go home with a D or even an F. A select group of stocks—those that manage to achieve at least one A and one B on the value and the growth tests—make our All-Star list. Only nine Canadian stocks and 20 U.S. stocks got the honour this year.

Our Premium Top 200 Package includes our list of All-Stars as well as sortable spreadsheets detailing everything investing-savvy investors need to know about Canada’s Top 200 and the America’s Top 500 stocks. As a bonus, we have also included ratings for the next 100 Canadian stocks by revenue (so ratings for the Top 300 Canadian stocks in all), as well as ratings for the next 200 American stocks by revenue (so ratings for the Top 700 U.S. stocks in all). Finally, we threw in a complete copy of the Top 200 and Top 500 stories from MoneySense magazine.

The real question is whether prices are low enough yet. To deduce that, I like to turn to economist Robert Shiller’s price/earnings ratio (P/E) for the S&P 500 to value the general state of U.S. stock markets because it provides a useful long-term guidepost. Shiller’s P/E is the ratio between current prices and average earnings over the last 10 years, the idea being that you can get a better sense of the long-term trend via 10-year average earnings rather than by short-term figures.

The graph to the right shows the history of Shiller’s P/E for the S&P 500. You’ll notice that the ratio is currently 19.7, which is high compared to its historical norm of 16.4. As a result, U.S. stocks could still have farther to fall. The situation in Canada isn’t much better, with Canadian stocks at fairly high levels. Even worse, we tend to be more exposed to downturns, due to the cyclical nature of much of our economy.

Those with a more bullish bent will point out that stocks have traded at far higher levels in the past. Also, the huge earnings collapse of 2008 was unusual—the lower earnings over the last decade might provide an overly bearish reading. As a result, Shiller’s P/E could be somewhat inflated.

Nonetheless, I think stock markets as a whole are not overly cheap. (Thankfully there are still a few bargain stocks to be had.) I also don’t feel nearly fearful enough. As a result, I don’t expect to shift my asset allocation toward stocks at this point. I’ll wait for better valuations and a bit of stark terror before making any dramatic moves.

2. Practise your trading
Take advantage of the free seminars, videos and articles that discount brokerages offer to their clients. Rick Robertson, associate professor at the Ivey School of Business, recommends trying the trading simulators. These demos use play money, so you can learn to trade without risk. Stick with shares from large companies at first, and trade “board lots” of 100 shares each, as these are easier to buy and sell than odd lots of shares from small companies.

3. Time to buy
When you’re ready to buy, type in the ticker symbol of the company and specify the exchange it trades on. Select “buy” and “market order” to buy stocks at the current price, and enter the number of shares you want. An order preview will show you the estimated cost with the commission. Then you’ll get a confirmation with your order status so you can tell if the order was filled.

4. Understand the price
Stocks are quoted with two prices: the bid price and ask price. The bid price is the highest amount a buyer is willing to pay for a given stock, while the slightly higher ask price is the lowest amount a seller will accept. If a company’s stock is traded frequently, the difference (called the “bid-ask spread”) should be only a few cents. Remember that market orders will be filled at the current price, and since prices change every few seconds, your final cost may vary somewhat from the estimate.

5. Advanced orders
Once you’re fairly comfortable trading, you may want to explore more advanced options. A ‘limit order’ allows you to specify the price you’re willing to pay. For example, say you want to buy 100 shares of XYZ Corporation, but you don’t want to pay more than $20. If you place a limit order at that amount, it won’t be filled until the price drops to $20 or less. Similarly, a ‘stop loss order’ can be used to automatically sell your stock if it dips below a specified price, allowing you to lock in gains. But take the time to understand how stop loss orders work: if you’re not careful, your shares could be sold at bargain-basement prices if the market suddenly plunges.

Preferred stock can often trump debt when it comes to how much you retain of the income. If you hold preferred shares outside of a tax free savings account (TFSA) or your RRSP, you will get a better tax treatment on the dividends. For a base income of  $50,000 per year at your job, additional preferred dividends of $2,000  will pay $283 less in federal tax than the like amount of interest income. If your holdings are within a TFSA or RRSP, the tax benefit disappears.

For some preferred issues, there is another plus that is not often mentioned. If you elect a dividend reinvestment plan (DRIP) certain issuers like Royal Bank and CIBC will reinvest your dividends in common shares of the bank. This way you become a holder of both types of issues for each institution without incurring any additional brokerage fees. For example, 500 shares of Royal Bank’s AD $25 par preferred will generate $562.50 in dividends a year which will buy about 11 of the bank’s common shares paying a dividend of $2.16 each. After five years, you will have received about $2,815 in preferred dividends and an additional $297 in common dividends and hold approximately 55 common shares of Royal Bank.

There are around 180 fixed dividend preferred shares listed on the TSX. In the table below we examined shares of this type issued by the five big banks. The results are impressive. To Oct. 11, 2011, the average year to date total return (capital gains plus dividend yield) for these 34 issues was 10.66%. The same average for the common stock of these banks was a decline of 0.53% and the TSX composite lost 9.9%. If you don’t want to buy individual issues, there are some ETFs that might be interesting. Claymore S&P/TSX CDN Preferred Share ETF (CPD) had a total return of 2.08% and a dividend yield of about 4.8%. Horizons Preferred Share ETF (HPR) comes in with total returns and dividend yields of (3.40%) and 4.25% respectively. iShares S&P/TSX North American Preferred Share Index has a total return of 0.24% and a yield of 4.41%.

But when it comes to investing, the possibilities are vast once your portfolio grows beyond $100,000. Problem is, much like Bertie Bott’s Every Flavour Beans (a devilish Harry Potter confection) the investing flavour you choose might wind up tasting like earwax. Alas!

That’s why the advice in Where to invest $10,000 still applies. If you aren’t intensely interested in the markets, you should probably stick with a good low-fee balanced mutual fund. After all, much like grilling a nice steak, if you poke and prod your portfolio too much then you’re likely to obtain less than desirable results.

But if vanilla really isn’t for you, let’s check out some other tasty ways to invest now that you have a more sizeable portfolio.

The lazy way to riches
In the “Where to invest $1,000” story, we introduced the idea of investing using passive index mutual funds such as the TD e-Series Funds, which rise and fall in tandem with the large market indexes. Long-time MoneySense readers will know that we call a portfolio of such funds a “Couch Potato portfolio,” as it’s so easy to execute, you rarely have to haul yourself up from the couch to tend to your investments. The goal is to take the returns the markets give you while keeping your investing costs as low as possible. This allows you to enjoy a big advantage versus high-priced fund managers who, far too often, fail to earn back the fees they charge investors.

Now that your portfolio is larger, we have some good news. You can implement the exact same strategy with a new type of fund that has even lower costs: the exchange-traded fund or ETF. These funds are much like index mutual funds in that they passively follow a market index such as the S&P 500, but instead of being sold like mutual funds, you buy them on the markets, just like a stock. The ETFs you choose depend on your investment goals, your time horizon and your tolerance for risk, but we find that plonking 40% of your money into a good bond fund, and spreading the remaining 60% among Canadian and U.S. stock funds is the simplest way to start. If you do it through ETFs, you can reduce your fees to very low levels. For example, if you use the iShares S&P/TSX60 ETF (XIU), the Vanguard Total Stock Market ETF (VTI), and the iShares DEX Universe Bond ETF (XBB) for the Canadian stock, U.S. stock, and Canadian bond components respectively, then the annual fee on your portfolio will be a minuscule 0.19% a year.

Just remember, because ETFs are traded like stocks, you do get dinged with a brokerage commission when you buy and sell them. The commissions can really add up for small portfolios but, by $100,000, the big Canadian discount brokers usually offer online trades for $9.95 a pop, or less.

Much of the appeal of Couch Potato investing lies in its simplicity, so you don’t want too many funds. Still, if you’re up for it, expanding beyond just U.S. and Canadian stocks is a sensible thing to do. As a result, I suggest the Global Couch Potato variant with international stocks added via the Vanguard FTSE All-World ex-US ETF (VEU). Here you’d put 40% of your portfolio in the XBB bond ETF, 20% in Canadian stocks via XIU, 20% in U.S. stocks via VTI, and the final 20% in international stocks via VEU.

Don’t want to go it alone? If the thought of opening a discount brokerage account and buying ETFs on your own fills you with fear and trepidation, don’t worry. You wouldn’t be the first to feel daunted by the task. I still remember that my first trade, back in the day when you had to phone a real trader, was rather nerve-wracking.

Besides, if you’d like a little guidance you’re in luck: when your portfolio moves above $100,000, advisers will start to take an interest. Problem is, their advice often comes at a steep price. To help you out, I’ve sleuthed out a few ways you can get the basics without spending an arm and a leg. You might not get expensive wine and cheese service, but you will get core asset allocation advice and a friendly hand to help you build a customized portfolio.

One good choice is to enlist the services of investment management firm Phillips, Hager & North. PH&N is the granddaddy in the field and it still represents good value. The firm offers a very broad line of low-fee funds and when you sign up directly with them, you can get a dedicated adviser, portfolio planning, and a long-term investment strategy. All of which is included in the already low cost of their funds.

Another option is Steadyhand, a new entrant run by PH&N alumni Tom Bradley. You get the benefits of his experience, but you also get advisers who are still hungry and thus likely to work harder for you than others who may have had a few too many ice cream cones. Portfolio strategy is included with the low cost of their funds, and Steadyhand’s fees fall as your portfolio grows. At $100,000 you already get a discount and there are more discounts to be had at higher levels. In a break from usual practice, their fees also decline based on how long you’ve held their funds.

Getting started with stocks
At the other end of the spectrum, you might want to take a more active approach and start picking your own stocks. While it might not be the right thing to do for many investors, it would be hypocritical of me if I didn’t say that it can be great for some.

If you’re just starting to buy your own stocks, I suggest moving slowly for the first few years. The experience will likely to be educational and you don’t want to make mistakes with the bulk of your money.

Thus at first you should keep the core part of your portfolio in a good low-fee balanced fund, or a Couch Potato portfolio, and then supplement that with a handful of stocks. Put at least 80% of your money in the core and at most 20% in individual stocks.

Which stocks should you start with? I suggest large Canadian dividend stocks, preferably in different industries. While you can go wrong with big dividend stocks—I’m looking at you Yellow Media—they’re generally less volatile than their smaller brethren. Large businesses with good credit ratings also tend to have more staying power than smaller outfits. To whet your appetite, I’ve highlighted five in 5 great stocks to start out with, which show promise at the moment.

Start slowly when learning the ropes to figure out if buying individual stocks is something you really want to do. As your portfolio and experience level increases, allocating more money directly to stocks becomes reasonable. Just be warned, successfully picking your own stocks is harder than it looks and requires a great deal of patience and discipline. But if you have some aptitude for it, the returns can be most gratifying.

Aside from picking up an infinitesimal amount of calculus, I met a fellow keener in class who had the investing bug. He rattled on and on about odd things called mutual funds and how you could make a potload of money from them. Naturally enough, I promptly forgot about funds for about a decade while exploring calculus a bit more. But I rediscovered them after I had amassed just over $10,000 by playing the part of Beaker to a series of lovable Dr. Honeydews in a variety of laboratories.

At the time, I felt that $10,000 was a tidy sum for a young fellow—enough to think about alternates to a bank account anyway. So after some pondering, I moved my grubstake into mutual funds. If only I knew then what I know now. But you can profit from my experience. Here’s what I’d tell a younger me about investing, if I had the chance.

The importance of fees
To begin with, there are only a few things that you can really control when heading to the market to make your fortune. It is important to realize that the market is just there. It doesn’t care if you make or lose money—and there are many ways to lose money.

That’s why you should launch your offensive for profits from a secure foundation. Instead of immediately seeking the very best opportunities, it can pay to aim to limit your losses. And it shouldn’t come as a surprise that fees are an important source of such losses. To make money from a small base it helps to be thrifty because many financial institutions seem to prey on the middle class and poor these days.

To highlight how important keeping costs down can be, let’s look at the miracle of compounded interest. The notion is simple. If you can grow your money—even at a low rate—over a long period, then you too can be rich as Croesus. More concretely, if you grow your $10,000 nest egg at 4% a year over 30 years, you’d have just over $32,400. Both higher rates of return and longer investment periods would improve your results considerably.

But unfortunately, all too many investors don’t realize that their funds charge annual fees—and the effect of those fees compounds too. A fund’s fee will rarely be highlighted as part of a sales pitch, but you can spot it in the fund’s prospectus, or you can look it up in your fund’s fact sheet online. It’s called a management expense ratio, or MER. Usually, if fees are mentioned, they’ll probably be referred to in some diminutive fashion. Something like: “It’s only 2%, just think about how much money you’ll make.”

It’s true that 2% doesn’t sound like a lot, but let’s say that you hold a mutual fund for 30 years and it earns 4% a year, on average, before fees. That means that almost half of all of your growth will be snatched back from you in fees. As a result, your $10,000 would grow to about $18,100, which is a good deal less than $32,400. That’s why it’s well worth your time to keep an eye on costs—after all, annual fund fees in Canada are often in the 2% to 3% range.

Three enemies of growth
Taxes are another bane to investors. Despite the government’s desperate need to fund new $400-million hockey arenas in Quebec and G8 gazebos in Ontario’s cottage country, I suggest structuring your affairs so as to minimise taxes as far as is both sensible and legal. For most people, the best way to pay less tax over the long run is to hold investments inside a Tax-Free Savings Account (TFSA) or an RRSP. Outside tax-sheltered accounts, taxes can act a bit like a 2% to 3% annual fee on stock returns over the very long term. Interest income from bonds and GICs is taxed at an even higher rate.

I hate to bring it up, but next I must address an even more insidious way that you can lose your hard-earned savings. It is called inflation. That’s the tendency of money to lose purchasing power over time and it is generally caused by the government printing too much currency. Inflation is the reason why ice cream cones cost 10 cents in the distant past whereas now they cost $3. These days inflation is running at 3.1% annually, which means that even if you avoid the risks of the market by stashing your cash under your mattress, you’re still losing 3.1% of your money’s value every year.

There’s one more threat to your growing portfolio: Your own behaviour. Specifically, it’s the tendency we have to buy high and sell low. Most people can sit in a savings account and sleep well at night. But they seem to lose their heads in the stock markets and it’s easy to see why. The markets gyrate and plunge frequently. In early 2009 many investors woke up to discover that their portfolios were only half as big as they were a couple of years earlier. Problem is, very few investors seem to dive in and actually buy low during such downturns. More commonly purchases are made after a good rally, and investments are sold after a big decline. As a result, history has shown that investors lose—very roughly—2% a year over the long term due to such behaviour.

So let’s do a rough summary: Fund fees might reduce your returns by 2.5% a year, taxes another 1%, say inflation nibbles off 3%, and bad timing another 2%. Gulp! Unless your money is earning an annual return of more than 7.5%, your savings could actually be shrinking. How can you avoid this nasty fate? By minimizing taxes, fees and bad timing.

So where should you invest? I’ve already suggested making use of TFSAs and RRSPs to reduce taxes, but what about fees and bad timing? The solution for the vast majority of investors is the humble low-fee balanced fund. It’s the unsung star of the investment world.

Balanced funds are a one-stop shopping experience for portfolios, and they hold a diversified selection of both stocks and bonds. Usually such funds invest about 60% in stocks and 40% in bonds, or equal amounts in both stocks and bonds.

Because balanced funds contain a big dollop of bonds, their returns tend to be much less volatile than those of stock funds. As a result, it is usually much easier to sleep well at night. You might lose a bit during market crashes, but the declines will be more palatable that those from stocks alone. History has shown that most investors handle balanced funds relatively well and don’t suffer too much from the buy-high, sell-low syndrome. That helps to minimize your losses from bad investing behaviour.

Even better, if you look for them, you can find excellent low-fee balanced funds in Canada. Because I know many people like to deal with their bank, I’ve picked a solid low-fee balanced fund for each of the big banks in 8 great funds to stash $10,000 in. I also included a couple of excellent funds from Calgary-based Mawer Investment Management. You can get both Mawer funds with a $5,000 initial investment through a discount broker, or wait until you have $50,000 and invest directly with Mawer to avoid the brokerage fees.

Much of that internal grappling comes from misunderstanding how the stock market really works. Couple that misunderstanding with our race to become rich, and we do everything wrong. We buy when our mutual funds are soaring, then we sell them or cease adding to them when they slump. We give up much of our gains to pricey fund managers, even though after fees, their funds trail the performance of cheaper investing options such as index funds. We’re confident we can predict where the market is going, though even the professionals have a terrible track record when it comes to forecasting the market’s ups and downs. In short, our greed and confidence can work against us, keeping us from realizing our true investing potential.

I can’t promise to collar your inner doppelganger, but I can help you understand how the stock market works—and how human emotions can sabotage the best-laid plans. Once you understand how your own all-too-human behaviour is affecting your investing, you’ll experience greater financial success.

When a 10% gain isn’t a 10% gain
Imagine a mutual fund that has averaged 10% a year over the past 20 years, after all fees and expenses. Some years, it might have lost money; other years it might have profited beyond expectation. It’s a roller coaster ride, right? But imagine, on average, that it gained 10% annually through all the bumps, rises, twists, and turns. If you found a thousand investors who had invested in that fund from 1990 to 2010, you would expect that each would have netted a 10% annual return.

But on average, they wouldn’t have made anything close to that, because most investors shoot themselves in the foot. When the fund has a couple of bad years, too many investors react by putting less money in the fund, or stopping their contributions entirely. They’re often prompted by their investment advisers, who say, “This fund hasn’t been doing well lately. Because we’re looking after your best interests, we’re going to move your money to another fund that is doing better at the moment.” And when the fund has a great year, most individual investors and financial advisers scramble to put more money in the fund, like feral cats around a fat salmon.

This behaviour is self-destructive. Investors sell or cease to buy after the fund has become cheap, and they buy like lunatics when the fund becomes expensive. If there weren’t so many people doing it, we would call it a “disorder” and name it after some dead Teutonic psychologist. This kind of behaviour ensures that investors will pay higher-than-average prices for their funds over time. Whether it’s an index fund or an actively managed mutual fund, most investors perform far worse than the funds they own—because they like to buy high, and they hate buying low. That’s a pity. And it can make the difference between retiring early and not retiring at all.

John Bogle, the founder of U.S. investment management giant The Vanguard Group, describes in his 2007 book, The Little Book of Common Sense Investing, that the average actively managed U.S. mutual fund reported a 10% annual gain from 1980 to 2005 after fees and expenses, but investors in those funds averaged just 7.3% over the same period. Their fear of low prices prevented them from buying when the funds were low, while their elation at high prices encouraged purchases when fund prices were high. Such bizarre behaviour has devastating financial consequences, as investors give away 2.7% annually because of their knee-jerking alter egos.

As this example shows, over a 25-year period, that’s a pretty expensive habit:

$50,000 invested at 10% a year for 25 years = $541,735.29
$50,000 invested at 7.3% a year for 25 years = $291,046.95
Cost of irrationality = $250,688.34

But what if you didn’t care what the stock market was doing?
As investors, you really don’t have to watch the stock market to see if it’s going up or down. In fact, if you bought an index fund for 25 years, with an equal dollar amount going into that fund each month (called “dollar-cost averaging”) and if that fund averaged 10% annually, you would have averaged 10% or more. Why more? If you put a regular $100 a month into a fund, that $100 would have bought fewer units of that fund when prices were high, but it would have bought more units of that fund when prices were lower.

Most investors don’t do that—they exhibit nutty behaviour
Combine the crazy behaviour of the average investor with the fees associated with actively managed mutual funds, and the average investor ends up with a puny portfolio compared with the disciplined investor, who puts in the same amount of money into index funds every month. The following table categorizes the behaviour of the two types of investors, assuming both will be working—and adding to their investments—for at least the next five years.

I’m not going to suggest that all index investors are evolved enough to ignore the market’s fearful roller coaster, while shunning the self-sabotage caused by fear and greed. But if you can learn to invest regularly in index funds and remain calm when the markets fly upward or downward, you’ll grow far wealthier. Below, you can see examples, based on actual U.S. returns between 1980 and 2005.

The figure on the left side ($84,909.01) is probably generous. The 10% annual return for the average actively managed fund has been historically overstated because it doesn’t include sales charges, adviser wrap fees, or the added liability of taxes in a non-registered account.

Disciplined index investors who don’t sabotage their accounts can end up with a portfolio that’s easily twice as large as that of the average investor over a 25-year period.

Small details like these can allow people with middle-class incomes to amass wealth more effectively than their high salaried neighbours—especially if the middle-class earners think twice about spending more than they can afford. Even if your neighbours invest twice as much as you each month, if they are average, they will buy actively managed mutual funds, and they will either chase hot performers or fail to stay committed to their investments when the markets fall. They’ll feel good about buying into the markets when they’re expensive, and they won’t be as keen to buy when they’re on sale.

I don’t want you to be like your neighbour. Avoid that kind of self-destructive behaviour and you’ll build more wealth.

It’s not timing the market that matters; it’s time in the market
There are smart people (and people who aren’t so smart) who mistakenly think they can jump in and out of the stock market at opportune moments. It seems simple. Get in before the market rises and get out before it drops. This is referred to as “market timing.” But most financial advisers have a better chance beating Roger Federer in a tennis match than effectively timing the market for your account.

Vanguard’s Bogle, who was named by Fortune magazine as one of the four investment giants of the 20th century, has this to say about market timing:

“After nearly 50 years in this business, I do not know of anybody who has done it successfully and consistently. I don’t even know anybody who knows anybody who has done it successfully and consistently.”

When the markets go raving mad, jumping in and out can be tempting. But stock markets are highly irrational, and characterized by short-term swings. The stock market will often fly higher than most people expect during a euphoric phase, while plunging further than anticipated during times of economic duress.

Doing nothing but regularly putting money into an index fund might sound boring during a financial boom, and it might sound terrifying during a financial meltdown. But the vast majority of people (including professionals) who try jumping in and out of the stock market allow their emotional judgments to hurt their profits, as they often end up buying high and selling low.

What can you miss by guessing wrong?
Studies show that most market moves are like the flu you got last year, or the mysterious $10 bill you found in the pocket of your jeans. In each case, you don’t see it coming. Even when looking back at the stock market’s biggest historical returns, Jeremy Siegel, author of Stocks for the Long Run and professor of business at University of Pennsylvania’s Wharton School, suggests that there’s no rhyme or reason when it comes to market activity. He looked back at the biggest stock market moves since 1885 (focusing on trading sessions where the markets moved by 5% or more in a single day) and tried connecting each of them to a world event.

Seventy-five percent of the time, he couldn’t find logical explanations for such large stock market movements—and he had the luxury of looking back in time, and trying to match the market’s behaviour with historical world news. If a smart man like Siegel can’t make connections between world events and the stock market’s movements with the benefit of hindsight, then how is someone supposed to predict future movements based on economic events—or the prediction of events to come? It’s as improbable as guessing which of the moths frantically flying around your light bulb is going to be fried first.

If anyone ever convinces you to act on their short-term stock market prediction, it could end up being a very expensive mistake. Let’s look at the U.S. stock market from 1982 through December 2005 as an example.

During this time, the stock market averaged 10.6% annually. But if you didn’t have money in the stock market during the 10 best trading days, your average return would have dropped to 8.1%. If you missed the best 50 trading days, your average return would have been just 1.8%. Markets can move so unpredictably, and so quickly. If you take money out of the stock market for a day, a week, a month, or a year, you could miss the best trading days of the decade. You’ll never see them coming. They just happen. More importantly, as I said before, neither you nor your broker is going to be able to predict them.

Legendary investor and self-made billionaire Kenneth Fisher, who writes a column in Forbes magazine, had this to say, about market timing:

“Never forget how fast a market moves. Your annual return can come from just a few big moves. Do you know which days those will be? I sure don’t and I’ve been managing money for a third of a century.”

The easiest way to build a responsible, diversified, investment account is to invest regularly with stock and bond index funds. Many people view bonds as boring because they don’t produce the same kind of long-term returns that stocks do. But they don’t fall like stocks are apt to do either. They’re the steadier, slower, more dependable part of an investment portfolio. A responsible portfolio has a percentage allocated to the stock market and a percentage allocated to the bond market, with an increasing emphasis on bonds as the investor ages.

But when stocks start racing upward and everyone’s getting giddy on the profits they’re making, most people ignore their bonds (if they own any at all) and buy more stocks. Many financial advisers fall prey to the same weakness. But those ignoring their planned allocations between stocks and bonds set themselves up for disaster.

How can you ensure that you’re never a victim? It’s far easier than you might think. If you understand exactly what stocks are—and what you can expect from them—you’ll fortify your odds of success.

On stocks: What you really should have learned in school
The stock market is a collection of businesses. It isn’t just a squiggly bunch of lines on a chart or quotes in the newspaper. When you own shares in an equity index fund, you own something that’s as real as the land you’re standing on. You become an indirect owner of all kinds of industries and businesses, via the companies you own within your fund: land, buildings, brand names, machinery, transportation systems, and products, to name a few. Just understanding this key concept can give you a huge advantage as an investor.

Business earnings and stock price growth are two separate things, but over the long term they tend to reflect the same result. For example, if a business grew its profits by 1,000% over a 30-year period, we could expect the stock price of that business to appreciate similarly over the same period.

It’s the same for a stock market index. If the average company within an index grew by 1,000% over 30 years (that’s 8.32% annually) we could expect the stock market index to perform similarly. Long term, stock markets predictably reflect the fortunes of the businesses. But over shorter time periods, the stock market can be as irrational as a crazy dog on a leash. And it’s the crazy dog’s movements that can—if we let them—lure us closer to poverty than to wealth.

The stock market is a dog on a leash
I used to have a dog named Sue who behaved like we were feeding her rocket fuel instead of dog food. If you turned your back on her in the backyard, she’d enact a scene from the television show Prison Break, bounding over the five-foot-high fence in our yard and straining diplomatic relations between our family and those whose gardens she would destroy.

When I took her for extended runs in open fields, she was able to burn off some octane. I would run in a single direction while she darted upward, backward, right, then left. But collared by a very long rope, she couldn’t escape.

If I ran from the lake to the barn with Sue on a leash, and if it took me 10 minutes to get there, then any observer would realize it would take the dog 10 minutes to get there as well. True, the dog could bolt ahead or lag behind while sticking its nose in a gift left behind by another canine. But ultimately, she couldn’t cover the distance much slower or much faster than I did—because of the leash.

Now imagine a bunch of emotional gamblers who watch and bet money on leashed dogs. When a dog bursts ahead of its owner, the gamblers put money on that dog, betting that it will sprint far off into the distance. But the dog’s on a leash, so eventually it’s destined to either slow down or stop while the owner catches up.

But the gamblers don’t think about that. They ignore the leash and place presumptuous bets assuming that the dog will maintain its frenetic pace. Their greed wraps itself around their brains and squeezes. Without that cranial compression, they would see that the leashed dog couldn’t outpace its owner.

It sounds so obvious, doesn’t it? Now get this: the stock market is exactly like a dog on a leash. If the stock market races at twice the pace of business earnings for a few years, then it has to either wait for business earnings to catch up, or it will get choke-chained back in a hurry. But a rapidly rising stock market can cause people to forget that reality: they pile larger and larger sums into stocks with delusional confidence. I’ll use an individual stock to prove the point.

Coca-Cola bounds from its owner
From 1988 to 1998, the Coca-Cola Company increased its profits by 294%. During this short period (and yes, 10 years is a stock market blip) Coca-Cola’s stock price increased by 966%. Because it was rising rapidly, investors—including mutual fund managers—fell over themselves to buy Coca-Cola shares, pushing the share price even higher. Greed might be the greatest hallucinogenic known to humanity.

The dog (Coca-Cola’s stock) was racing ahead of its master (Coca-Cola’s business earnings). A rational share price increase must be in line with profits. If Coca-Cola’s business earnings increased by 294% from 1988 to 1998, we would assume that its stock price would grow by a percentage that was at least similar, maybe a little higher, and maybe a little lower. But Coca-Cola’s stock price growth of 966% was irrational.

Coca-Cola’s stock price vs. Coca-Cola’s earnings

Can you see what happened to the blazing Coca-Cola share price (in dark blue) when it got far ahead of Coca-Cola’s business profits (in light blue)? The dog eventually dropped back to meet its owner. After blazing ahead at 29% a year for a decade (from 1988 to 1998) Coca-Cola’s stock price eventually “heeled.” It had to. You can see in the chart that the stock price was lower in 2011 than it was in 1998. But, during the past 21 years, when were most people drunkenly pouring money into Coca-Cola shares? In the late 1990s. Why? Because the stock had been “performing well.” And most of those investors haven’t made a penny in profits over the last dozen years. Too many of them either sold or shunned the shares when the stock became cheaper in 2003 and 2004.

Ironically, a $10,000 investment in Coca-Cola stock in 1990 would have been worth nearly $100,000 by early 2011 (in U.S. dollars) with reinvested dividends. That’s an annualized return of about 11.5%. But few Coca-Cola shareholders earned anything close to that because of their giddy preference for rising prices and their fear of discounts.

I’m not suggesting that you should run out and buy Coca-Cola shares. What I am suggesting is that whether people invest in index funds, actively managed mutual funds or individual stocks, most investors significantly underperform the investment products they own.
If you can defeat that enemy in the mirror by investing regular monthly sums—or by increasing your contributions when the markets fall—you can make twice as much money as your neighbour, even if you own the exact same investments.

Excerpted with permission of the publisher John Wiley & Sons, Inc., from Millionaire Teacher: The Nine Rules of Wealth You Should Have Learned in School by Andrew Hallam. Copyright © 2011 by John Wiley & Sons (Asia) Pte. Ltd. This book is available at all bookstores, online booksellers and from the Wiley website at www.wiley.ca or call 1-800-567-4797. More information at facebook.com/millionaireteacher.

]]> http://www.moneysense.ca/2011/10/03/the-enemy-in-the-mirror/feed/ 1 http://www.moneysense.ca/2011/05/16/cheap-safe-and-raring-to-go/ http://www.moneysense.ca/2011/05/16/cheap-safe-and-raring-to-go/#comments Mon, 16 May 2011 17:45:17 +0000 Norm Rothery http://www.moneysense.ca/?p=14277 Do you want a bit more zip from your value stocks? Join me as I explore a combo that might put a little more spice in your portfolio. The secret is combining the thrifty fundamentals of value investing with the price trends of momentum investing.

For value I’m going to employ a classic double-barrelled approach that has served me well for many years. Put simply, I’m looking for stocks that are both cheap and relatively safe.

On the cheap side, I want to be able to buy lots of earnings for a low price. That is, I seek stocks with low price-to-earnings ratios. While low-ratio stocks are viewed with disdain in some quarters, studies show that they tend to outperform over the long term.

Turning to the safety side of the equation, debt is critical because a profitable company with little debt is unlikely to go bust. More specifically, I opt for firms whose assets exceed their debts.

Similarly, I also like to keep an eye on interest coverage, which indicates how easy it is for a firm to pay its debts (you can look this number up online at MSN.com). Surprisingly, using interest coverage to gauge a firm’s credit worthiness yields very similar results to those offered up by the big debt rating firms. Roughly speaking, if a large stock has an interest coverage ratio higher than 2 then it probably has a BB, or better, credit rating.

Stocks should also generate healthy amounts of cash flow. Strong cash flows tend to confirm a company’s earnings power and they provide some assurance that the earnings figures haven’t been overly manipulated. It’s not a perfect fraud detector but it is a good thing to double check.

If you think these value requirements sound strict, you’d be right. Only a few Canadian stocks managed to pass all the value tests. But now I’m going to narrow the list even more by using a dollop of wisdom from the world of technical analysis.

More specifically, I want to look for stocks trading near their 52-week highs. The idea being that while we already have cheap stocks, we also want the market to recognise them as showing signs of improvement. That way we get bargains whose prices are already on the mend. (The 52-week-range technique in discussed in more detail in “A crystal ball for stocks”.)

I’ve selected four of the most interesting candidates for your consideration from the few stocks that braved their way through both tests:

Danier Leather (DL) is at the top of my list. It’s a small stock that I hold in my personal account and it is in the sometimes fickle business of selling fashionable leather coats and accessories.

Danier has something of a checkered past and I’ll highlight some of its warts first. Several years ago the company tried to expand its operations into the U.S. but the effort ended in ignoble failure and a hasty retreat. The firm was also plagued by prolonged litigation related to its initial public offering, which was resolved favourably only a few years ago. To cap off the bad news, the economic slowdown of 2008-09 hit the company’s profits hard because Canadians thought twice about buying new leather coats in a recession.

All the sour news pushed Danier’s stock to very low levels. But the company made lemonade out of lemons and began buying back shares by the bucketful at low prices. In doing so the company managed to reduce its share count by almost 30% between 2008 and 2010. Even better, its business perked up, losses turned into profits, and its shares have climbed. The firm now trades at a price-to-earnings ratio of 9.

Breakwater Resources (BWR) is a zinc miner with operations in British Columbia, Chile and Honduras. It’s also developing a new mine in Quebec, which is slated to open in 2012. While zinc is Breakwater’s primary product, it also produces gold, silver, lead, and copper. Now I admit that I’m not a huge fan of resource companies because they have a tendency to gyrate wildly and lack pricing power. But Breakwater may have more than a little room to grow because it’s currently trading at roughly $6, and it wasn’t that long ago that it’s stock was trading for more than $20. At a price-to-earnings ratio of 5, the company should do well, provided commodity prices don’t collapse.

Domtar (UFS), a Fortune 500 pulp and paper firm, has significant operations in both the U.S. and Canada. The company is also the largest of the four selections, it trades at about 6 times earnings, and pays a modest 1% dividend yield.

Goodfellow (GDL) is a Canadian wood distributor hat has been on my radar for several years. Surprisingly, the firm has a reasonably consistent earnings history and has been profitable in each of the last 10 years. That’s a big plus given the tumultuous times we’ve been living through. It also trades at 9 times earnings and provides a dividend yield near 5%, which is mighty fine because I like being paid to wait for better times.

Good luck — and, as always: Do your own due diligence before buying any stock and make sure that it’s a good fit for you and your portfolio.