I used to have a good memory and, umm….where was I going with this again?

…seriously, I found that this year the to do list has its limitations. It is easy to jam dozens of items onto a to do list and never get to most of them. In other words, time is not being made to complete each item on the list. After missing paying on two bills by a day each, I have moved personal finance items from the to do list to appointments. The due dates of bills are now posted as appointments in my calendar. Appointments are made to finish my taxes and to review my portfolio.

I ended up moving to this method after reading an article by a new father about trying to stay in shape. His essential point was that the only way to exercise was to book his training sessions as appointments and to treat them like business meetings. After all, people who are late or never attend business meetings are not in business for very long. When he did not  make appointments to work out, there was a natural tendency to make excuses  (now, if you religiously complete each item in your to do list, there is no need to change).

The key though is to treat it like an appointment. Close the door, move all distractions and just get to it. I will let you know how it goes.

As a clarification on last week’s post on the Home Renovation Tax Credit (HRTC), it was stated that landlords may qualify for the HRTC. They do not. The passage has been removed from the post. Sorry for any confusion and, as usual, please make sure you seek qualified accounting advice.

Today’s post is a continuation on the effect of choice on our personal finances. Yesterday’s post dealt with how the paradox of choice impacts on our finances generally. Today’s post deals with the effect of too much choice on asset allocation and costs.

When an issuer launches new mutual funds or exchange traded funds, this is typically spun as a good thing for the investor. The conventional line of thinking is that more choice allows the investor to customize their portfolio better. However, as with most product launches, the issuer and their shareholders tend to be enriched often at the cost of the investor.

In particular, too much choice tends to wreck havoc on asset allocation and costs in several manners:

1. Drift towards greater equity allocation than desired. Regrettably, many investors buy based on the name of the fund (my initial mutual fund investments were based on this criteria). In good times, they purchase XYZ equity mutual fund or ETF.  In bad times, these same investors purchase a newly issued ABC balanced mutual fund which is supposed to protect their downside risk while giving a little upside. The problem is that ABC balanced fund has equities in it already and, combined with XYZ fund or ETF, pushes the investor into greater risk/reward than they may have intended. A 2001 study confirmed this fact. The more equity based products a retirement plan offered, the greater the participants had money invested in stocks.
2. Investing in higher fee products. If you believe increasing product advertising contributes to the concept of too much choice (after all, how else do you cut through the noise except by, umm, contributing to it…), it also directly impacts on costs paid by an investor. Richard Thaler and Cass Sunstein, in their excellent book Nudge, quoted a 2007 study that ads by the financial industry tended to result in investors investing in higher fee vehicles (how else was the Super Bowl ad paid for?), higher risk (again, more exposure to equities), trendy sectors and home bias., one begins to understand how many investors looked at their portfolio in late 2008 and discovered they were over exposed to their risk tolerance.
3. Too much cash/not invested enough. As cited yesterday, too much choice tends to lead to investors not investing at all.

In summary, what can too much choice do to your asset allocation? You end up in the same position as many investors in late 2008; one wakes up to find out their portfolio has drifted into much greater risk and with higher fees than desired.

What is a poor investor to do?

First and foremost, as mentioned yesterday, always go in with an investment goal and investment plan first. If you do not have one, think long and hard about what you want out of your life and money. Stick to the plan through thick and thin (assuming it is reasonable and realistic) and always put product in a lower priority than the plan.

To state this another way, the question is not “what product will make me a lot of money with little risk?” but “what strategy most aligns with what I want out of life?”

Second, you cannot avoid choice being pushed upon you these days, the point is to filter out as much as possible as quickly as possible. I read many excellent blogs and financial columnists but tend to gloss over any post or column about new product issues. There is no magic bullet solution to life. Why would there be one for your portfolio? If there is a product that fits within my goals and strategy, I will actively seek it out rather than being sold on it.

Third, eliminate the niche products from your radar screen. When experts are asked how to increase employee participation in company sponsored plans, one of the first suggestions is to eliminate the sector or niche products. The holdings are so specialized and sometimes risky that most average investors are better off not even contemplating them. An ETF focusing on a single developing country or sector is not going to make or break most portfolios.

Finally, embracing too much choice, by adding new products to an existing portfolio, is not going to solve the problem. Most under-performing portfolios suffer from overlap, high fee product and trendy products of yesteryear. Running towards more choice is often not the solution. It is tantamount to continuing to dig to get out of a hole (“no, no, dig up stupid!”-Chief Wiggum). The solution to too much choice may be to narrow down your holdings and your choices.

When I first took up running, I went into the store, looked at a wall of specialty shoes- stability, control, neutral cushioned, performance etc. etc.- and just blanked out. Were my feet so screwed up that I needed a special shoe? What if I bought these specialized shoes, at a whooping cost of $200, and didn’t like it? Why did I even need special shoes having run most of my life in “normal” footwear? Suffice to say, my feet may not have needed special shoes but my psyche just added a complex.

The conventional wisdom is that choice is good. It is empowering and gives the consumer a sense of control. But, in a universe where there are more mutual funds and exchange traded funds than publicly listed companies, can too much product choice actually be ruining our finances?

I tackle this issue in two separate posts. Today’s post deals with the larger issues with too many choices. Tomorrow’s post will deal with the result from an asset allocation and portfolio management perspective.

The study of the psychological effects of choice came to popular attention at the height of the dot com boom. In 2000, Barry Schwartz coined the term the paradox of choice (which he subsequently turned into the title of his 2004 book). In essence, the more choice a customer is given, the greater the expectation of return and the anticipation of regret that return will not meet expectations. If given more choice, the consumer has a more difficult time making a choice and such difficulty results in anxiety, sadness and, in some cases, depression. In other words, the opposite effect of what freedom of choice is supposed to give you.

Too much choice typically manifests itself in several ways. The first is analysis paralysis: the sheer amount of information overwhelms one’s ability to make a decision. A second is regret by focusing too much on missed opportunities rather than a focus on the potential of the choice made. The third is anxiety; being forced to make a decision is stressful for some.

In the personal finance realm, too much product choice tends to display itself in several behaviors:

1. Not investing at all. There has been a lot of criticism about the retail investor missing the rise of equities in 2009. Some of this inaction is attributed to fear but how much of this can be attributed to too much choice? In a 24-7 world of business news- all with their own experts touting their own hot investment product- how is any average investor to decipher all of this noise? The natural reaction may be to simply turtle- climb in one’s shell and do nothing.
2. Choice leads to declining participation rates. Vanguard Group found that 75% of employees participated in a 401(k) plan when 2 fund choices were presented. When the number rose to 10 choices, participation slipped to 70%. At over 60 fund choices, participation rates begin to decline steadily (if you think 60 fund choices is too much, consider that Ford Motor Company had over 120 fund choices in its 401(k) program at one point in time).
3. Poor execution of an investment strategy. I will address this issue tomorrow.

If too little choice and too much choice is bad, what exactly is the optimal amount of choice a person should have? A Dutch research paper suggested anywhere between 12- 24 choices produced the optimal balance between variety and happiness.

How does the average investor cope with an industry that works in quantity if not necessarily quality?

1. Set your goals first before looking at product. Choice selection is made easy if you set a goal. If your financial goal is not to lose money and to be conservative, you have automatically eliminated all high risk/high reward products.
2. Limit the information given to you based on your goal. It is easy to get off-track on your goals given the amount of information coming at you. In marketing lingo, every good marketer has a “call to action” to every marketing piece. Most calls to action are to buy (watch the “I buy your gold” commercials; despite the high cheese factor, they are brilliant at manipulating us).  By limiting calls to action, you limit the industry’s ability to reach out and distract you from your goal.
3. Pick the product sub-set that aligns with your goals the best. This is pretty self-explanatory.

Tomorrow, I will tackle asset allocation in a world with too much choice.

Life has little absolutes- death, taxes and change come to mind- but, yet, the discussion between active management vs. passive management assumes that one absolutely has to be in one corner or the other. Either one is an active portfolio manager in an attempt to outperform the market or one makes as little decisions as possible by tracking broad based equity and fixed income indexes.

However, life is not that simple. Few investors start with a combination of a blank slate and adequate cash to begin an purely active and passive management approach (and how lucky are you if you have both). Others, like me, have to wait out early redemption penalties before selling mutual funds, leading to an in-transition portfolio.

As Rob Carrick pointed out recently, institutional investors do engage in both active and passive management strategies as a way to mitigate against the downside risks of both approaches.  Carrick suggests that retail investors adopt a similar strategy by dividing their assets 50/50 between both approaches.

For institutional investors employing a mixture of both strategies, what are they actually doing? A recent surveys reveals that pension funds were passively managed when it came to U.S. equities but  active managers on non-U.S. equities (up to 75%).

This suggest when it comes to broad based equity markets, such as the S & P 500, where there is depth in quantity and quality of publicly listed companies, it is a fool’s errand to believe one can pick a winner from a loser.  One may be better off picking them all via a broad based index.

In smaller exchanges, with relatively less transparency, lack of shareholder rights and lack of quality on any given exchange, institutional investors may be trying to separate the wheat from the chaff.

What does this all mean for you and I?

1. Start from the assumption there is no objectively absolute “right” way to invest. I agree with passive investors and active investors- if it works for them. The concept of a “right” way to invest comes down to life-style, skill, experience (in life and investing) and comfort level. Know yourself well and decide accordingly.  It can be passive, active or both.
2. Having said that, the smaller your portfolio, the greater you should think about passive investing. This is where I disagree with Carrick- a 50/50 split between passive and active investing is too aggressive with a small portfolio. With a smaller portfolios, loss and costs are magnified on a relative basis which suggests an emphasis towards passive management.
3. The less knowledgeable you are, the greater you should think about passive investing. Active managing is not about picking the right stock per se. It is about understanding business. If you know little about how business works, have yet to mastered reading a financial statement or have no interest in doing either, passive management may be for you.
4. Passive management can become stupid management in a hurry. Exchange traded funds (ETFs) have become short-hand for passive management and there is some belief, promoted by the financial industry, that all you have to do is pick a bunch of ETFs and you are a successful passive manager of your money. The problem is that the excesses of the mutual fund industry have slipped into the ETF industry- bad product, rising fees, duplication to name a few. Remember the lesson of the institutional investors- passive management is based upon investing in BROAD based indexes and not niches. Do not equate passive management with no thinking management. One is still required to think about asset allocation, reallocation and product purchases to align with the foregoing. The number of decisions one has to make is less but you still have to think.
5. Finally… stick with a strategy. There is no harm in combining a mixed strategy as long (i) see number 1 and; (ii) stick with the strategy (I am going to defer to Carrick about product choices).  The same applies if you are moving from one strategy to another- don’t stop. If you allocate 30% of your portfolio in active management, stick with it. Don’t abandon it at the first sign of trouble and vice versa for passive management. Performance, for either approach, does rely in part on hold periods. Time is your friend in investing so don’t turn your back on your friend.

Nouriel Roubini, arguably next to Ben Bernanke, is the world’s foremost media darling economist (to the extent any economist is appealing to the masses). It was Roubini who predicted the end of the global real estate bubble in 2006 and continues to believe that the worst is yet to come.  In March 2009 he predicated that the Dow Jones Industrial Average would fall below 7,800. It ended 2009 at 10,300.

Harry Dent predicated Japan’s economic fall and America’s boom in the 1990’s. Since then, he has sold a lot of books making widely inaccurate predictions based on his research. In 2006, Dent predicted the Dow Jones Industrial Average would hit 40,000 by the end of 2009 (it hovers around 10,000). After the bubble burst, he changed his tune and called for a great depression ahead.

Roubini and Dent are but two of the industry predicting our imminent economic doom. Not to be outdone, the U.S. government warned in 2001 that if 5 nuclear reactors were not built every year for the rest of the decade, the country would experience rolling brown outs. Yet the U.S. Energy Information Administration of the U.S. Department of Energy reports electricity prices are falling which contradicts price movement of a supposedly scare resource (not to mention the small detail that it takes many years to build a plant).

The fact of the matter is that even a broken clock is right twice a day. This is not to downplay the fact there are serious economic issues which need to be faced and the immediate future does not look so rosy as the not so pre-2008 past. However, lest one forgot, people do not attract media attention because they are right per se but because they are outrageous in their claim.

Underlying all these claims meant to attract headlines and stoke our fears is a call to action to do something. Typically, that something has to with the self-interest of the person predicating doom. We will run out of energy! Build nuclear plants cries the politician in the nuclear power’s pocket. The world is ending! Buy gold (oh, by the way, this television show is sponsored by a gold producing company). The demographics say bad things will happen! Here’s a mutual fund sponsored by me which will make you rich.

And, therein, lies the problem. The dooms day predictors either give terrible financial advice or are peddling product which enriches them at the expense of the investor. Roubini has been quoted as saying he is 95% in cash and 5% equity. He gets paid in USD as a professor at NYU. Assuming his cash holdings are in USD, and one of thesis is the American economy is shrinking, it seems like a strange asset allocation to concentrate holdings in a depreciating currency. Even if he is not substantially all in USD, this is a strange allocation for a 50 year old man.

Dent has a very spotty record peddling products associated with his research. In 1999, the AIM Dent Demographic Trends mutual fund was launched to great fanfare. Its investment philosophy would be based on Dent’s demographic trending and analysis (Dent acted as sub-advisor to the fund). Five years later, the fund was merged out of existence, partially due to poor performance.

Since we have short memories, Dent has launched an actively managed ETF (a walking misnomer) with a total expense ratio of 1.65%- well above many ETFs; one can only conclude that Dent’s research found that investors are suckers. True to form as a inaccurate predictor, the sucker/investor did not bite.  Its trading volume is so small (3,882 shares traded yesterday) that, barring a major turn-around, the ETF will likely be closed.

Sprott Asset Management may be one of the exceptions to the rule. But, even then, some of its mutual funds are charging management fees of 2.5%.

If the fundamental thesis of the doomsday industry is the economic system will collapse upon itself, why exactly do they need to make all this money?

If money has no value upon collapse,  what exactly are they accumulating it for? If our economic world was to end tomorrow, I am not sure I would be listening to the person telling me to buy gold or their mutual fund. Instead, I would be listening to the person telling me to find my family and friends and to cherish and protect them now and in the future. But I guess no one ever made money giving that advice.

Many of my friends and colleagues have young children. Since the parenting industry looks at all new parents as walking dollar signs, they are often sold the latest magic bullet solution to raise perfectly well-adjusted, intelligent and healthy children; after all, if you buy the wrong thing for junior, he’ll grow up to be a juvenile delinquent or, worst, never move out of your house!

But, instead of buying Baby Einstein DVD’s, how about spending time with the kids? I am not a parent, and do not presume to give parenting advice, but, as a general observation, the most well adjusted people I know did not grow up in the most affluent of households but received the riches of time with family.

A similar argument can be made for personal finance. Personal finance is not a black box where you input magic bullet products and it outputs above market returns. Instead, it is a process of spending time thinking about your life desires and planning your financial decisions accordingly.

In fact, one could argue that the magic bullet product in personal finance is actually spending time on personal finance. Specifically, there appears to be a positive correlation between the amount of time spent on planning personal finance and household net worth.

The time spent is not substantial. Instead, it appears that the bar for what an average investor spends thinking about personal finance is shockingly low. In a 1997 paper, two researchers surveyed the habits of staff employees at the University of Southern California (USC) who were enrolling in its defined pension plan. 75% of employees did NOT answer the background questions. Nearly 60% of the respondents spent less than an hour on picking asset allocations in their plan (their plan allowed participants to allocate funds based on risk tolerance).

One would assume that employees at USC  are moderately well-educated. Thus, you cannot cite lack of education as a factor. Perhaps they are too busy, have too much responsibility or they do not want to think about money because of some negative connotation it provokes.

Whatever the reason, the less time one spends on personal finance, the more likely such indifference will be costly in the long run. The book the Millionaire Next Door found that financially prudent households spend 8.4 hours a month, or 100 hours a year, planning their investment decisions.  The under-achieving households spent only4.6 hours a month planning their investment decisions. As a result, those households that spent more time planning investment decisions had over 5 times the net worth of their under-achieving counterparts.

8.4 hours a month may seem like a lot of time for most young families. However, consider this is 1.2% of the number of hours in a year. Compare 8.4 hours a month with how much time spent watching television, mindlessly surfing the internet or playing video games.

If planning investment decisions is daunting, I would suggest three tips:

1. Set aside a designated time every week to review your bank statements, portfolio summary etc. with your spouse and kids (if they are old enough to participate).  Decentralized decision making is often a cause for unnecessary spending.
2. Budget. If you feel you are too busy to budget then I suggest the Seymour Schulich’s approach to budgeting: is there more cash in the bank this month than last? If so, you are on the right track. If not, you best to start making decisions on what to cut back.
3. If it feels bad emotionally to talk about money, remember that feeling. If you never want to feel that again, then do something about it as opposed to sticking one’s head in the sand.

A special thank you to the Globe and Mail for naming this blog one of the five sensible yet entertaining blogs to help build wealth. The other blogs are thoroughly entertaining reads and readers should take time to explore them. If you are reading this blog for the first time, please browse around and, if entertained, please subscribe to my RSS feed. Thanks.

Everyone is gunning for the investment advisor. There are now articles on whether to sue investment advisors, how to leave them and whether they provide any value. Some investment advisors have even turned on their own.  I am not much for overly broad generalization. Like any other industry, there are good, bad and indifferent members and timing makes a real difference. A good investment advisor hired in August 2008 could have only minimized damage but, without the benefit of context, a loss is a loss in the rear view mirror.

Assuming you have an investment advisor, how long should you give them before deciding to dump them for another or to walk down the DIY road? I am not sure there is a definitive answer but let’s assume that a relationship with an investment advisor is like any other relationship.

If communication issues occur immediately- for example, their advice is not geared towards your stated risk tolerance levels-it may be a sign that perhaps, to using the dating analogy, it is not worth getting past the third date. One hopes in this situation, your entire portfolio has not been handed over to them. Just like dating, one should always keep some secrets.

If clearly stated goals and intentions are communicated and a plan put in place, it would be imprudent to pull the plug quickly on the investment advisor (assuming she is following an agreed upon and reasonable strategy). Study after study shows that low investor return is caused by, among other things, switching strategies quickly. As Jason Zweig commented recently, discount brokerage customers with higher trading volume tend to do worse than their low trading counterparts. With the investment advisor, throw in possibly higher transaction costs and a quick trigger finger initiated by the client may actually not be a reason to dump the investment advisor. Perhaps it is the clients own sense of impatience which is to blame.

Assuming a reasonable strategy is put in place and neither party gets impatient, one would have to give at least 3-4 years to assess the true value of an advisor. Three to four years may seem like a long time but remember my assumptions: (i) a reasonable strategy is in place (built into my assumption of what is reasonable is low cost so the advisor is not eating 3-4 of unreasonable fees); and (ii) neither side gets impatient. I would add one more point, the parties have to agree to meet at least once a year to review and adjust, and not gut, a reasonable plan.

Having sat on the other side of the advisory table, it is a little unfair to criticize the advisor if the client never communicates clearly what they want, the client rarely communicates except when things turn badly and the client has unrealistic expectations. Now, if communication is quite clear and the advisor acts in their own self interest to the harm of the client, the advisor should be punished accordingly. But if a plan and communication is clear, one has to give enough time for a strategy to fully mature.

But, to return to the dating analogy, one cannot be passive aggressive about what you want. The other party are not mind readers and, in a vacuum, will act in their own self-interest. If the investor has no idea what they what then perhaps no advisor should be hired at all and time spent on a little soul searching.

Professional investors or bloggers often say  or write that the stock market or the real estate market is over-valued or under-valued.  What exactly are they basing this analysis on? How do you know if you paid to0 much for stocks or real estate or whether you got a deal?

Share prices are an expectation of future return. If a share price is high, this means the market believes the future is bright. If the share price is low, and sometimes the share price can drop below the value of the assets of the company, the market has low expectations of the future growth of the company.

The typical (although not a perfect) manner of measuring this expectation is the price to earnings ratio (p/e ratio). The p/e ratio is calculated by price per share/annual earnings per share. In plain English, it measure how many years it would take for an investor to get back their money (removing the time value of money). For example, a p/e ratio of 20 means that a $1 invested today would take 20 years to return.

Is there such a thing as an ideal p/e ratio? On an individual basis, an ideal p/e ratio is a relative measure. For example, the p/e ratio for a consumer staple stocks tends to be relatively modest (typically under the mid-teens). A supermarket trading for less than the industry standard may indicate that it is in trouble or has little growth potential left. Conversely, a supermarket trading for well above the industry p/e ratio may be a market darling but will eventually come back down as it reverts to the mean.

The S&P 500, arguably a good sample of how the stock market is doing as a whole, is often a good gauge of whether one may have overpaid for a stock (or an index fund if you are an ETF investor) and whether the market as a whole is too hot, cold or just about right.

The p/e ratio of the S & P 500 is approximately 14 at this point which most experts believe is a reasonable valuation, bearing in mind that perception of risk is subjective. The typical rule is that a p/e ratio of over 20 means the market is over-valued (the p/e ratio of the S & P 500 during the tech boom reached 24 at times) whereas a p/e under 10 may mean there are bargains to be had (the p/e ratio before 1985 was in single digits).

My rule of thumb is that if a stock or an index has a p/e ratio over 16, I tend to shy away from buying (I am not a small-cap investors and, hence, the ceiling of my p/e ratio tolerance is relatively low).

Real estate valuations tend to influenced by more subjective factors. For example, a young couple with kids may pay a premium to live close to their parents. However, stripped of these subjective factors, what is a fair price to pay for real estate?

William Bernstein formula probably pleases no real estate agent.  Taking as an assumption that the opportunity costs of investing in real estate would be a 6.7% nominal return on stocks and bonds, Bernstein determined that no homeowner should ever pay more than 15 years worth of fair rental value for any residence. For example, a 3 bedroom house which rents out at $2,000/month should not be purchased for more than $360,000.

To state this another way, Bernstein has placed a p/e ratio of 15 on real estate; in the abstract, a fair valuation if you believe real estate is an investment (which it is not for your principal residence).

The other way of looking at real estate valuations is not if you paid too much but can you afford what you paid for your home?  The rule of thumb tends to be never take out a mortgage which is twice your salary. Last time I wrote this rule, there were several comments about how unrealistic this was. Since no one can tell the future, it remains to be seen whether this is an out of date rule or we continue to  live well beyond our means as real estate consumers.

Retailers tell you that retail is a brutal business. Trends shift. Consumers are bargain hunters. Expenses are high. Several years ago, retailers began to shift into the credit card business to pursue higher margin lines of business.  The rationale being that traditional retail was making so little money but, with such high traffic into the store, the retailer might as well sell something a little less labor intensive and with higher margins. Hence, Walmart attempting to obtain a banking license and retailers like Canadian Tire and J. Crew issued credit cards.

Yet, you hear about Nike shoes being manufactured for under $10 and selling for over $150 and wonder if the retailers are pulling your leg. Are they making a bundle but crying poor?

I took a look at a completely random sample of public traded retailers to see who is zooming whom.

Walmart is the largest retailer in the United States.  As a discount retailer, its margins should be low since it works on volume and not margin. For the quarter ending January 31, 2009, its operating income (which is earnings before interest and taxes so think of how much the store itself brings in) was 5.6%.

The Gap Inc. consists of a mixture of low end (Old Navy), mid-market (the flagship Gap store) and higher end (Banana Republic) clothing stores. I could consider this a middle-class retailer since it has a little bit of everything thrown in- low, medium and high. When you mix it all together, the Gap reported operating income of 13.9% in Q3 2009.

Lulu Lemon Athletica has convinced all of us that paying $90.00 for track pants (albeit stretchy ones) is not only acceptable but trendy. Most would consider Lulu Lemon on the high end of the retail market and, unlike the Gap Inc., is not dragged down by any lower end lines. For the quarter ending November, 2009, its operating income was 18.5%.

For mature businesses, a profit margin in the high teens is respectable. However, this is a far cry from the belief that retailers have a huge mark-up on their product. Is this an urban myth or is there truth to this?

It depends on how you look at the numbers. If you looked at net sales minus cost of goods sold- in other words, the retail price minus the direct cost of making the good (the materials and labor to make the good)- the margins tend to be outrageously high. For example, the Gap’s margin is approximately 42% while Lulu Lemon’s is approximately 50%. So, yes, developing country workers are sharing very little based on the profit made at the counter.

But add in operating expenses- the rent, the store employees, the warehouses, transportation etc.- which are not related directly to the cost of the goods and that margin gets reduced significantly. How significant? Try going from 40-50% gross margins to the teens.

Thus, there is some nugget of truth that retailers are making a killing selling us goods.  Alas, they cry, if only we could do it without all that overhead!

Hence, retail e-commerce is hailed as a savior for retail. Now, if only they could sell their goods on-line significantly cheaper than at the store…

There are certain things that do, indeed, go up during economic down times: unemployment rates, welfare rolls, collective insecurity and litigation. Litigation is a boom business during recessions. Suddenly, parties cannot overlook their differences knowing that another pay cheque or deal is coming since they have dried up and Court awards or settlement monies are seen as potential sources of income for litigants.

Litigation rarely, if ever, brings down a publicly traded business. Either the business is too large or the Courts limit damages based on ability to pay. After all, an overly large punitive award means little if the business itself is forced to file bankruptcy. However, what effect, if any, does litigation actually have on stock prices?

Surprisingly, studies suggest that litigation chill is one reason why initial public offers (IPOs) are consistently under-priced. The largest litigation risk in IPOs are fraudulent misrepresentation. If the issue price of the IPO is lower than it should be, it should, theoretically speaking, lower than quantum of damages which have to be paid if the allegations are proven to have merit. Studies show that IPO lawsuits can cost a new issuer up to 20% of the proceeds raised not to mention the undefinable loss of reputation and goodwill.

Perhaps the most interesting development in IPO securities litigation is the rise of class-action lawsuits against issuers of exchange traded funds, particularly of the leveraged variety. Among the allegations of numerous lawsuits against leveraged ETF issuers is that they failed to warn investors of the risk and the leverage component does not work properly since there is not a perfect tracking match. None of the allegations have been proven.

Litigation will not wipe out the leveraged ETF market but Court awards and settlements may put a dent in the earnings of ETF issuers which are  publicly traded companies (for example, iShares is owned by BlackRock, a publicly traded firm). Shareholder discontent or investors thinking twice about investing in the stock of an ETF issuer ending up on the wrong side of too many lawsuits may, in and of itself, force some issuers to be more cautious in issuing products or force regulators to act. This  is what class-action litigation, ideally, is supposed to do; it is a private remedy to drive public policy.

On a non IPO basis, I could not find any resarch that showed a consistent pattern of the effect of litigation on stock price. This is because litigation can be speculative (the ambulance chasers), perhaps have some merit but is a tough case to prove (the effect of a garage dump on a community), has merit but will take years to wind its way through the Court (asbestos related litigation when it first commenced) or the market simply brushes it off as the price of doing business (Nokia suing Apple in October 2009 did little to Apple’s prospects).

To quote Philip Morris’ latest annual report: “we and our subsidiaries record provisions in the consolidated
financial statements for pending litigation when we determine that an unfavorable outcome is probable and the amount of the loss can be reasonably estimated.” And therein lies the problem. In other words,  the effect litigation on the financial statements relies on: (a) the business reasonably believe they will lose; (b) the business can estimate the loss; and (c) the loss is of a material nature to report it to the public market.

This is analogous to financial institutions believing they had sufficient controls in their proprietary trading pre 2007.  Risk is a subjective concept.

The issue is that it is hard for anyone to accurately predict if they can win in Court or, if they lose, what the damages will be. Even the most seasoned of litigators will tell you that if a lawsuit has made it to trial, neither side knows the outcome because both sides believe it has a strong enough case to go before Judge and jury.   Suits with poor merits tend to settle or be abandoned relatively quickly. Cases with merit tend to become unpredictable affairs.

The exception to the rule seemed to be a small window of time when public opinion and shifting regulatory landscape line up against an industry (tobacco, asbestos) and it is clearer that loss may occur. However, given the relative gridlock of government these days, these conditions tend not to exist for most industries.

The end result seems to be that the markets are just as surprised about litigation’s impact on a stock price as the lawyers on the losing end. The knee-jerk reaction would be to attempt to invest in an industry that is not as prone to litigation but today’s markets darlings become tomorrow’s defendants.

Just a quick congrats to Canadian Finance Blog which celebrated its one year anniversary this week. Congrats and keep up the good work.