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The Mindless Investor Chapter 5 – Think Like a Trader

Highlights of this Chapter

Chapter 4 of The Mindless Investor was an interesting look at how Tyler got his start and progressed as a trader and we highly recommend taking a look at it. In keeping with the more instructive nature of this series of reviews, we chose to move ahead to chapter 5, which builds on the idea that trading success is more about self-mastery than market mastery. Understanding that systematic, methodical training can make you a successful trader is possible and it all starts by looking at the world the way a trader would.

Key Point #1: To be a trader, break free of the “investor” mindset

The Mindless Investor Review - Break Free of the Investor Mindset

In order to be a successful trader, you have to be willing to move in and out of a position when given the right signals to do so. Because traders speculate on price movements, they pay attention to the price “noise” investors try to avoid.

Key Point #2: Successful trading takes dedicated training

While timing markets is often considered hard to do, in reality many things are hard to do until one knows how to do them.  Anyone with money is allowed to participate in the markets, however that easy access is dangerous for most people and their capital. The biggest hazard for most traders is not having committed the time, effort and discipline it takes to learn how to trade well.

Key Point #3: Take it one step at a time

Learning the “what” of trading well is far simpler than learning the “how”.  One of the biggest cautionary notes is that before stepping into any kind of speculative activity, know how much you can afford to risk. Take time to learn and become confident at what trading involves before taking bigger risks in the market.

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Event Review: Stock Chatter – TD Waterhouse Discount Brokerage

We recently attended a roundtable event provided by TD Waterhouse Discount Brokerage entitled “Stock Chatter” at their downtown Vancouver Investor Centre.

This educational session lasted an hour and a half and provided the audience with an overview of current stock  market conditions and  two different approaches to equity valuation. The presentation also covered two case studies that provided a better understanding of stocks and important variables to consider when choosing them. The session also included opportunities for the audience  to ask questions.

Two different approaches to equity valuation that were covered were Discounted Cash Flow Techniques and Relative Valuation Techniques.

Discounted cash flow techniques covered the following topics:

  • Present value of dividends
  • Present value of operating free cash flow
  • Present value of free cash flow to equity

The relative valuation techniques covered included:

  • Price/Earnings ratio
  • Price/Cash Flow ratio
  • Price/Book Value ratio
  • Price/Sales ratio

Questions about both topics were answered well by the presenter

Another important subject covered during the session was the return on equity  (ROE), which is composed of profit margin, total asset turnover and financial leverage.  ROE is a measure of a firms profitability and is often known as a way of measuring the performance for shareholders. [Note: to learn more in detail on measures of company profitability and financial statements, click here]

Overall, the session was very informative and well structured. The presenter encouraged the audience to ask questions and was able to successfully answer them. Despite the small audience, discussions were informative and beneficial. The presenter also provided the audience with various handouts including presentation slides, charts and a dividend-focused report.

We were informed that the TD Waterhouse discount brokerage roundtable events would take place at the Investor Centre in downtown Vancouver on the first Wednesday of the month(excluding January)

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The Mindless Investor Chapter 2: Everyone Wants Your Money – Chapter Review

Highlights of Chapter 2 – The Mindless Investor

Three key points that are covered in this chapter of The Mindless Investor all revolve around investors taking responsibility for their financial decisions. Understanding that trading is a battle, that the market is filled with competing interests and that “the market” itself can be a source of information are key for self-directed investors to ingrain into their perspective of markets.

Key Point #1: Trading is war – Be prepared to defend your money

Mindless Investor - Trading is war

The first powerful bit of insight is the way in which Bollhorn frames trading as a war.  In the case of trading or investing, a conflict of opposing beliefs about the future of a stock happens with every trade.  It makes total sense, therefore, that the participants in the market are out to make money from other participants and why protecting your capital should be taken seriously.

Key Point #2: Be skeptical – Ask how the providers of information make money and from whom

Mindless Investor - Keep a healthy dose of skepticism

The market also has many moving parts – entire industries are built around bringing companies into this market and attempting to influence the purchasing (or selling) behaviours of its participants.  Brokerages, and the analysts they employ, have a tendency to be optimistic about everyone they either do work with or want to work with. As a result, there is a high degree of self-interest (and possibly “contrapreneurship”) that sometimes line up with investors’ goals but more often than not runs contrary.  The best ‘defense’ in this environment is a healthy dose of skepticism. Asking “how the source of my investment information is being compensated” is a simple but powerful way to decide whether your goals and that of your source are aligned.

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Discount Brokerage Weekly Roundup – Nov 30th 2012

On the heels of the results from the annual Globe and Mail Canadian Discount Brokerage rankings, the 2012 Morningstar Canadian Investment Awards were handed out on November 28th and included a “Best Discount Brokerage” category.  While not nearly as well known as the J.D. Power and Associates award for Investor Satisfaction, the Morningstar Awards offer discount brokerages the chance to submit themselves (for a fee) for consideration by a panel of judges for the title of “Best Discount Broker.”  This year, Qtrade took top spot and maintained their three year reign as the title holder of this award.   Certainly it’s a bright spot for them after recently having been displaced from the top of the Globe and Mail rankings by Virtual Brokers. To learn more about the Morningstar methodology for “Best Discount Broker” click here. BMO Investorline’s  “Advice Direct” also earned recognition for “Best Use of Technology” (another category for which entrants had to submit a fee to be considered).  Unfortunately, neither the list of candidates nor the scores were published so we are not sure how many discount brokerages participated in this year’s submission.

Another big piece of news for self-directed investors came in the form of an increased contribution limit to tax-free savings accounts (TFSAs).  Most Canadian discount brokerages offer TFSAs so for those who choose to invest via their TFSAs, the news is definitely welcomed.  Starting in January 2013 Canadians will be allowed to contribute a maximum of $5500 dollars (instead of the previous limit of $5000 per year).  To learn more about which discount brokerages offer TFSAs, click here.

If you want to learn more about TFSAs themselves, check our special “The Mighty TFSA.”

Event Horizon

As we turn the corner into December, an interesting opportunity for individuals to sit and discuss some investing related topics is being held at the TD Waterhouse Discount Brokerage centre in downtown Vancouver.  The event, entitled “stock chatter” will take place on December 5th from 1:30 PM to 3:00 PM.

Best Discount Brokerage Tweet of the Week

This past week saw the finale of Financial Literacy Month but also it was the conclusion of the now infamous “Mo-vember”.  @Jitneytrade deserves a tip of the hat for getting their team on board and actively participating in this great event.  Check out their tweet here which has the link to their movember ‘stache pics.

The People Have Spoken

Questrade is one of the most active discount brokerages when it comes to offering discounts and promotions.  Recently they’ve offered individuals either an iPad mini if they transfer in $100K or a chance to win one of 10 ipad minis for a smaller deposit.   The retail value of an ipad mini is $329.  In our discount broker deals section, we’ve seen deal “value” far higher for smaller deposit sizes, and so it piqued our curiosity – what do others think of this Questrade promotion? Is an iPad mini enough value to deposit $100,000?  Sure enough, the Questrade promotion caught the attention of some folks on the following Red Flag Deals forum.

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The Mindless Investor Chapter 1: You Can Beat the Market – Chapter Review

Highlights of Chapter 1 – The Mindless Investor

In the introductory chapter of The Mindless Investor, Tyler Bollhorn sets up several important ideas and goes through some common pitfalls of most self-directed investors. Here are three key points from chapter 1.

Key Point #1: Most Stocks Don’t Beat the Market

Mindless Investor - Overcome Being Average

The first and most important theme of the first chapter is about overcoming being average.  According to Tyler, realizing that most of the stocks don’t beat the market most of the time is essential to getting beyond average returns. Getting away from being average means doing things that may seem to go against the “common wisdom”.  It is exactly that conventional wisdom, however, that Tyler puts forward as the enemy to most individual traders.  Despite what many think, smaller traders have several advantages compared to the larger participants.  The key is to understand how to use their size appropriately.

Key Point #2: Don’t Get Emotionally Attached

Mindless Investor - Don't Get Emotionally Attached

A second important theme of this chapter is being in the right frame of mind to be a successful trader. Successful traders are those who don’t get emotionally attached to the stocks they trade, they simply focus on what matters most – whether they have managed their risk and whether the stock is performing as it should.  Learning how to win and lose correctly are critical skills.  They start with understanding that winners have to be allowed to run, and that losing is part of trading.

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A 30 second primer on trading in markets

Trading In MarketsDefining a market is as simple as picturing a boxing ring with two opposing opinions representing the fighters.  One of these opinions places a bet on an increasing value of a share price while the opposing side wagers that the share price will decrease in value.  This is the simplest way to visualize the market: a boxing match with buyers in the blue corner and sellers in the red corner.  The most important aspect to understand is that both sides cannot win.  For every winner, there is a loser and this simple premise is what creates a market.

Markets therefore arise out of the need to connect people who have something with people who want something.  The more participants in this equation, the more accurate the true value of this something becomes.  This is called the market value.  If there are no buyers and no sellers, there is no value, and ultimately, no market.

Like in any boxing match and more importantly, the market, both sides will take hits.  The difference between people who lose money and those who profit is that these folks understand how to properly absorb and react to the hits.  The key is to not shy away from the markets for fear of losing, but to adapt and learn the techniques for winning along the way.

If you’re interested in learning more, check out a full length article on understanding markets here.

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The case of the “vanishing trader”

As stock markets vanishing traderhave continued to flirt with highs not seen since before the great financial crisis of 2008 and the heights of the dot com bubble before that, there has been a recurring discussion of the “light volumes” that have taken markets to these highs.  A lot of airtime has been spent trying to figure out where the traders who are “supposed to be” there actually are. When people say things are “supposed to be” a certain way in the markets is usually when you need to raise some red flags.

It is a well-known belief amongst traders that volume is a sign of conviction – the more participants believe a certain condition to be true, the greater the reliability of the move.  Of course it is near impossible to know the absolute number of participants acting on a certain belief, and so proxies like price or volume serve as indirect measures of investor sentiment. Like any ‘rule of thumb’ in the markets, however, it is valuable to take a closer look at the charts to see whether or not this ‘rule’ holds water.

What do the numbers say?

We pulled data from the S&P 500 for the last 22 years and plotted the monthly closing price of the S&P 500 index against the volume of shares traded.  One of the most startling things that jumps out is the huge surge in trading volumes that took place from between 2006 and 2009 where monthly volumes shot up from between 1-2 billion shares/month   from 2000 to 2006 to a peak of between 6.5-7.5 billion shares per month between 2008 to 2009. Why were there so many more shares being traded? It could be any number of factors from increased frequency of trading (i.e. same number of participants but more frequent trading) or greater numbers of participants or both.  Examining why is a bit beyond the scope of this article, but some simple points to ponder can be gleaned by overlaying the volume of shares traded with the performance of the S&P 500.

First, with sharp moves down in price, volume moves sharply higher – this happened noticeably from mid-2000 to late 2002 (bursting of the dotcom bubble) as well as between early 2008 and early 2009 (financial crisis).  Second, in the large moves up in the markets between early 1995 and mid-2000, as well as from 2003 to 2008, a good portion of those initial upward moves happened on relatively stable or “boring” volume.   What is possibly perplexing about the move up from the early 2009 lows is that this rise in prices has been happening while trading volumes have been in relative decline.  Of course the large number of shares traded happened during times of heightened enthusiasm or extreme pessimism.

Keep calm and carry on

While difficult to draw any firm conclusions, greater “emotion” tends to bring with it parabolic shifts in market participation.  If more participants are ‘bullish’ about the market, we see surges in volume and price, and likewise if we see sharp drops in the price there is also a sharp spike in volume as traders duck for cover.  What is interesting in the most recent run up is the absence of emotion in volume, indicating that perhaps it is the more level headed participants that have been at work in the markets while the emotional buyers are either licking their wounds or too uninterested in participating or both.

As we near the previous highs in the S&P 500 index, on either light or abated trading volume, the market history might offer up the important lesson that it is possible to see sizable moves up in the market price even in times of “boring” volume (case in point AAPL as it crossed the $700 threshold).   It may be difficult, if not impossible, to determine what the “normal” level of volume in absolute terms is or should be, especially given the “new normal” of algorithmic and high frequency trading, as well as greater presence of discount brokerages, lower trade commission rates for trading and low interest rates.  Nonetheless, the “vanishing” trader(s) might very well be the emotional crowd – who for now, it seems, have all opted to line up for new iPhones instead of boring old stocks.

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The Mighty TFSA

Tax Free Savings Accounts (TFSA)

Many of you are probably familiar with the saying: “the only sure things in life are death and taxes.” Well, as of January 2009 there’s been a little ray of hope as far as those taxes are concerned. In February of 2008 the Canadian Minister of Finance (Jim Flaherty) announced a new program would start in 2009 that would forever change how Canadians can choose to save their hard-earned money.

Before the TFSA was introduced, if you saved or invested your money(the money you would have already been taxed on) you would then go on to be charged more taxes if those savings or investments made money. Many Canadians felt that they were being punished despite trying to do the right thing by saving or investing. While many of those same rules are still in place, the reason a TFSA is so innovative is because it gives Canadians an option to save and grow their money without having to pay any taxes on it. Sounds like a great option to us.

What is a TFSA exactly?

A TFSA is a special type of account that enables Canadians to grow the money in the account tax-free. Whether the money is in cash or is invested in allowable products (such as stocks or GIC’s) any money made within a TFSA account will not be taxed. For example, when most people saved money in a bank they generally put the money is a savings account. Aside from keeping the money safe, there was the added bonus of gaining some interest for parking your money there. The consequence of earning some interest is that it can be taxed as income by the government. In a TFSA, however, any money earned in the TFSA is not taxable by the Canadian government – ever.

How it works?

Most large Canadian banks as well discount brokerage firms offer a TFSA. Opening a TFSA is generally as simple as opening any other account at these institutions. In order to qualify for getting a TFSA however you have to meet the following criteria:

  1. You have to be a Canadian resident
  2. You have to have a Social Insurance Number
  3. You have to be 18 years of age or older

The government has set a limit on the amount of money you are able to contribute into your TFSA in any one year. In the first year of the program (2009) the amount was set at $5000 and every subsequent year this amount increases according to the inflation rate.

The good news is that you are able to carry forward any unused contribution room to future years so even though you might not have opened a TFSA in 2009, you have accrued the contribution room since that time. The CRA will provide the contribution room figure on your income tax statement (called the Notice of Assessment).

To help understand better how a TFSA works, let’s walk through an example. Suppose you had $1000 to save in the first year (2009) and you decided to put that $1000 into a TFSA. Your contribution limit for the year was $5000 but since you only used up $1000, you’re left with $4000 of extra room for that year. As of January 1st the following year your contribution room would increase by $5000 plus any unused contribution room from the prior years ($4000) bringing your grand total of contribution room to $9000. The exact amount of contribution actually is slightly more than $5000 each year because of inflation. Your personal amount can be found on your tax return or via Canada Revenue Agency’s “my Account” website [] .