One of the big challenges of the financial industry is that most compensation and profits are driven by the sale of financial products like mutual funds and RRSPs.  Unfortunately for Canadians, most financial advisors do not get paid to do financial or retirement plans.  In fact most financial advisors are not paid for advice.  All of their plans and advice are “FREE”.

Since I am trying new things for my blog, I produced this fun video about the advice given by much of the financial industry.

Although the video is design to be fun and humorous, there is some truth to the information.  Let’s dig in on a few comments I hear too regularly:

You need millions and millions of dollars to retire happy

I’ve seen this far too many times where people jump to the conclusion that you need millions and millions of dollars to retire happy and successfully.  Do you need a million dollars to retire happy? If you want to travel 365 days of the year, fly first class, stay in 5 star hotels and eat in fancy restaurants all of the time, then you will probably need millions and millions of dollars for retirement.  At the same time, I am willing to bet you know people today who are busier in retirement than before they retired, who are retired successfully, living happy and productive lives in retirement without millions and millions of dollars in their RRSPs.

You can’t count on your pensions and especially government benefits

I believe that pensions and government benefits form the foundation of retirement income because it has the characteristics of the perfect income.  It’s guaranteed. It comes in every month regardless of the economy, interest rates, or the stock market.  And it goes up every year to some factor of inflation.  We should never ignore these pensions.  Far too often, I have seen retirement plans that generalize or ignore pensions.  This makes no sense to me.  In fact, I know and have met many people who are living wonderful retirements on their pensions, Canada Pension Plan (CPP) and Old Age Security (OAS).  My dad is one of these people and for these people, they may not have needed to invest in RRSPs.

If you think about it, proper RRSP planning requires an understanding of what your future marginal tax rate will be at the time of withdrawal.  If you have a good pension, CPP and OAS, you may not retire into a low tax bracket.

We do not charge anything

As mentioned, the primary form of compensation and profits in the financial industry are driven by the sale of financial products like mutual funds and RRSPs.  Unfortunately for Canadians, most financial advisors do not get paid to do financial or retirement plans.  In fact most financial advisors are not paid directly for advice.  Just like in the video, all of their plans and advice are “FREE”.  So how do advisors get paid? Canadians pay for this free advice in the form of high product fees like Management Expense Ratios, Front end loads or Deferred Sales Charges.

It’s a win win for everyone

When markets are down, it is not a win for the client because they lose money.  When markets are down and the clients are losing money, the financial advisor and the financial institution still get paid.  Maybe they get paid less but they still get paid.  Is that really losing?

When it comes to the fees, the rate never changes whether the investment gains or loses.  When returns are strong, one could argue that the split of profits between the investor, the advisor and the institution is much more reasonable than when the investment is losing money.  In that case, the investor bears all the costs.

I look for actively managed funds that beat the market

Everyone wants to beat the markets but unfortunately for investors, the success rate of actively managed mutual funds is very low.  Most actively managed mutual funds underperform the market because it’s not easy to do especially when the fees put you at a disadvantage in the first place.

The irony, is lower fee products have a better chance of beating actively managed funds simply because of lower fees.  Investors (and Advisors) go to great lengths to try to beat the market with great stories, ideas and strategies but they ignore the easiest and best way to improve performance which is to simply lower fees.

I can show you funds that beat the market

Hindsight is easy.  Predicting the future is impossible.  Many advisors will look at past performance as proof that funds and managers can beat the markets.  The problem is no manager will beat the markets all the time or even most of the time.

The investment industry always uses the disclaimer “Past performance is no indication of future performance.” Despite that disclaimer, it is the most common research for determining future performance. Too much emphasis on past returns is bad research because it is one dimensional.  Good research is about employing multi-dimensional research.  Bad research leads you to chasing performance.

All advisors are not bad

Although this article may appear to be tough on financial advisors, the truth is there are bad advisors but there are also good advisors.  Good advisors give great advice and put together great financial and retirement plans.  Good advisors can still sell products as a form of compensation but they will help clients reduce fees and justify their compensation.  Good advisors deserve to get paid as long as they deliver value.

Unfortunately for the good advisors, the bad ones make it easy to poke fun at the financial industry and especially at financial advisors.  I think good advisors can use this information as an opportunity to stand out in a sea of mediocrity.  I’ve seen both good advisors as well as bad ones so hopefully this article helps people recognize some of the differences between the two.  Just remember not all advsiors are created equal.

Am I being to hard on advisors?  Do you think the truth might hurt a little?

Tom and Marilyn, have 18 different investments in two RRSP portfolios.  Most people would think that with 18 investments, you must be diversified but are they diversified properly?  When I ran a correlation analysis, 15 of the funds were highly correlated and only 3 of the funds were not correlated.  Not surprisingly, they were funds invested in different asset classes.  Let’s delve into correlation analysis a little deeper.

What is efficient and effective diversification?

In this diagram we have two portfolios with 5 different investments.  The first portfolio has 5 investments that do the exact same thing.  All 5 investments go up and the same time and all 5 investments go down at the same time.  These funds are highly or positively correlated.  The second portfolio is more efficient because it simply has a portfolio of 5 investments that do different things at different times, which helps mitigate risk. These funds are not correlated or negatively correlated.  This is called efficient diversification.

I’ve been watching correlation data quite closely and it really does show that effective diversification comes from asset diversification, not investment diversification.

What is investment diversification?

When you hold lots of different investments but not necessarily in different asset classes.  Tom and Marilyn had a portfolio that was a good example of investment diversification.  Here’s another example I ran into recently:

Jason has a RRSP plan with CI Mutual Funds.  He has 7 different investments but they all have high exposure to equities.  Let’s take a look at the correlation of these 7 investments

As you can see, the funds are highly correlated.  In fact, 4 of the funds (CI Interntational, CI Portfolio Balanced, CI Portfolio Growth and CI Maximum Growth) are all almost perfectly correlated (a number close to 1).

What is asset diversification?

Asset diversification is really another term for asset allocation.  Correlation charts show that asset allocation is very important.  It is important to diversify between cash, bonds and stocks mainly because these assets do not move in sync with each other.  Here’s a chart showing the correlation of different asset classes

Cash, Bonds, Gold, Global markets and Canadian Equities are all correlated differently.  You can see this in the numbers or the colors.  One interesting point is the global markets are not as negatively correlated as you might think.

Geographic diversification is less important than you might think 

If you look at this correlation chart looking at different world markets, you can see that the world markets are moving more and more in sync.  Just think about the economic downturns in the world in 2002, 2008 and 2011.  Markets around the world went down together.  There were not many places stock investors could go to, to get away from the market drops.  The only way to diversify properly was to go to different asset classes like cash or bonds.

This data comes from the past 3 years but the data is similar for longer time frames.  World markets are more in sync than ever because of globalization and technology.  Economies and markets are around the  world are more linked than ever.

Sector diversification is important

Unlike global diversification, sector diversification appears to be very important.  Here’s a chart of the TSX sectors and the correlation data shows that sector do not move together all the time.

As you can see from this chart there are a two sectors are highly correlated like Real Estate and REITS (Real Estate Investment Trusts).  Mining and Health Care are least correlated.  In fact, the data suggests that health care is an important sector to own for diversification purposes.

Proper diversification for Jason

If we go back to Jason, remember his portfolio was diversified by investment but not by asset or sector  Here’s an example of how Jason could change his portfolio within CI Funds to diversify better

If you take this to another level, Jason may want to look outside of CI for potentially better investments.  Jason may want to look at alternatives to mutual funds to access investments with lower fees.  For now, I hope these correlation charts help you to understand the science of diversification a little better.  Generally it’s more important to diversify by asset and by sector than it is by geography and by investment.

What do you think about diversification and correlation?  Do you think these chart make a difference when it comes to designing and managing portfolios?