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Author: Jacko2 Big red star, 1000 posts Old School Fool Add to my Favorite Fools Ignore this person (you won't see their posts anymore) Number: of 3296  
Subject: Re: confused Date: 11/19/1999 11:26 PM
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<it seems as if we, as canadians, cannot get any huge gains in investing in the foolish four method on the TSE>

I agree and disagree with your comment. Backtesting that has been done by myself and others leads me to these conclusions:

1. Ignoring the cost of commissions and taxes, high-yield strategies applied to the TSE35 (or if you found CWatt's work, on the 30 market cap leaders) work on the TSE. By "work", I mean that the strategies, over a period of years, do beat the TSE35 (or TSE300) index total returns, and for some of the strategies, at a statistically significant level (ie, it's probably not by chance). These results are consistent with what has been found to work on the Dow and (if you look at the test results over at Fool UK) on the London FTSE (the Financial Times index of 30 leading UK companies) (pronounced "Footsie"). It is also consistent with James O'Shaughnessy's results in his What Works on Wall Street.

2. It is also equally clear that the returns based on TSE35 strategies do not approach the level achieved when the strategies are applied to the Dow. I'm not surprised by this, given the different make-up between the two indexes and the economies of the two countries. Though it is interesting to note that up until about the early 1990s or late 1980s, the long term returns from large-cap stocks in both the US market and the Canadian market were pretty close (about 11% a year). It's only been the smoking hot performance of the US markets since about 1993 that has blown away the Canadian returns.

3. When you talk about "huge gains", it's important to put that into perspective. Remember: long term, the average return of the "market" (as expressed in large-cap stocks) has been about 11% yearly compound growth (CAGR). (I'm talking nominal return, of course; the real return has been closer to 7%.) The argument for mechnical investing is this: As small investors, we have been led to believe that mutual funds are the place to be. But studies show that most mutual funds don't match even the market index in performance. That is, more than half the mutual funds fail to beat "the market". Some proportion of funds do beat the markets, but studies have shown there is no reliable way to pick those winners. It's a crapshoot.

So, what does a small investor do? Well, the next best thing to beating the market is tying the market; that way you'll beat anywhere from 80% to 66% of mutual fund managers (who aren't dummies, by the way). Hence, in the US, companies like Vanguard, which sells a huge variety of really low-cost index funds. And you've seen it catch on more in Canada in the past couple of years (see the offerings from Altamira and Royal Bank). For an even lower-cost alternative, since about 1994 we've been able to invest in "index participation units": those are the TIPS (TSE35) and HIPS (TSE100) and now the S&P/TSE 60 in Canada; and in the US: QQQ (Nasdaq); SPY (for various S&P indexes); and DIAmonds (for the Dow).

But can a small investor do better than the market, and do so simply? Apparently, yes, if you follow a suitable high-yield strategy. How much better? Well, as I said above, better in the US than in Canada, but it's still pretty good in Canada. For the US, it seems that the high-yield strategies have ended in the low 20% CAGR; for Canada, the best strategies seem to end in the upper or mid-upper teens (16% to 18%) for CAGR.

Is 20% better than 16%? Sure. Of course. But if you're stuck with the foreign content limits in your RRSP, you'll take 16%, believe me. And in doing so (assuming the future doesn't differ materially from the past), you'll beat all but a handful of mutual fund managers.

Do your compound math homework. A return of 15% per year over many years will make you quite rich, even from a relatively modest (say, $10,000) start. That's "huge" enough for me. And the market history in the US of the last four years notwithstanding, it's probably a return that's pretty hard to get consistently (I'm talking long-term: 10 years or more). Look at the professionals. Why should we, as small part-time investors, think we can do better? Some can, no doubt. But I'll bet most won't. Getting an extra 1 or 2% average return over the market is pretty darn good shooting, and that little bit of extra return, when compounded over sufficient time (at least 10, but preferably 20 years), produces huge gains in wealth.

Warren Buffett's one of the wealthiest guys in the US, and one of the best investors we have seen. His average return, in Berkshire Hathaway, has been in the mid-20%'s since the mid-1960s. So if I can pursue a strategy that gets me into the upper teens, I'm happy.

You asked about profitablity. Because the Canadian return is lower, compared to US, you have to watch the commissions even more than in the US. That means you'll need a higher principal amount to start with. At bottom, perhaps $1250 per stock (and you'll be buying 3 to 5 stocks, depending on the particular variation you choose), though more helps (say, closer to $2,000).

And you have to watch taxes, so it's a pretty good strategy to pursue inside an RRSP. But even if it is outside an RRSP, where can you invest, simply, with a decent chance that your return will average better than the market? Though I will admit this: it would be a good study to do. When you buy an index fund, you can buy and hold, and you don't have to sell until you want to. With the mechanical strategy you are selling each year, and thus incurring tax liability. You typically don't sell all your holdings in each year, though; there is overlap year by year, but even so, there will be a loss of principal compared to pursuing an index strategy.

As for particular strategies, have you seen CWatt's work, from a couple of months ago (do a search on his name)? He gives some worthwhile strategies to pursue. There are ways to make it work, but in general, except for the RP4 strategy, the variations that work in the United States don't work (comparatively; they still beat the market, most of them) in Canada. You have to find the ones tested to have worked in Canada, such as RP4 and the PE3 (or is it the dropPE3 now?).

Don
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