Friday, October 13, 2017

Short Takes: Income Swings, Buy vs. Rent, and more

Here are my posts for the past two weeks:

Stock-Picking Skill

Liberating Your Losers

The Success Equation

Here are some short takes and some weekend reading:

A new C.D. Howe Institute study concludes that Canadians whose incomes vary from year to year face an unfair tax penalty and that reforms are needed. I agree. My income is highly variable, and it seems unreasonable that during good years I’m incented to delay new work until January.

John Robertson gives a thoughtful and balanced discussion of whether to buy or rent a home.

Canadian Couch Potato interviews Mike Foy to discuss J.D. Power’s research into investor satisfaction with Canadian online brokerages. He also explains why the latest attack on index funds is just more nonsense.

Robb Engen at Boomer and Echo explains why he doesn’t hold bonds in his portfolio.

Big Cajun Man liked Doug Hoyes’ book enough to lift a few ideas from it.

Thursday, October 12, 2017

The Success Equation

Success in most endeavours is a combination of skill and luck. As Michael L. Mauboussin explains in his book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, we have a tendency to decide we were skillful when we succeed and unlucky when we fail. We make many other mistakes as well when it comes to recognizing the role of luck in our lives. Mauboussin teaches methods of measuring skill and luck.

Some activities involve little or no luck, such as chess or checkers. If a chess master beats me soundly at one game of chess, he or she is likely to beat me another 10 times in a row. Other activities involve to skill at all, such as roulette and lotteries, unless you count not paying as a skill. A test of “whether an activity involves skill: ask whether you can lose on purpose.” If you can lose on purpose, there must be some skill involved. Most activities, like sports, business, and investing, combine luck and skill.

It turns out that there are statistical techniques to measure the contributions of skill and luck to success. For example, using such methods we can measure the amount of luck involved in single-season records of sports teams. From most skill to least skill we have the following ranking: basketball, soccer, baseball, football, and hockey.

Even though there is so much luck in sports outcomes, fans are quick to blame their heroes for the loss of a single game. But even if you don’t make that mistake, don’t be too smug. We also attribute way to much skill to CEOs who often just get lucky, and we definitely attribute too much skill to investors who get lucky in the markets.

One study found that skill at handling day-to-day finances increases to age 53, on average, and declines thereafter. I guess that means I can expect a low, slow descent that ends with an inability to tell door-knockers to get off my property.

With activities that involve a lot of luck, like investing, “the focus must be on process” rather than on outcomes. Reinforcing poor choices just because they work out well isn’t a good path to success. A challenge with focusing on process is that you have to know a good process. Mauboussin summarizes Benjamin Graham’s approach to value investing as an example of a good process. This approach worked well in Graham’s day, but even he was no longer an advocate of his methods back in 1976. Since then, the stock market has become much more competitive requiring ever more sophisticated means of outsmarting other investors.

Not many books leave me pondering their contents after I’ve finished reading them, but this is one such book. If you want to compete in a complex area where feedback is clouded by luck, such as active investing, it pays to understand the lessons Mauboussin teaches.

Tuesday, October 10, 2017

Liberating Your Losers

Recently, Jonathan Chevreau wrote about a way to try to save money on taxes called “liberating your losers” from your RRSP. It’s no fun owning a losing investment, and when it’s in your RRSP, you don’t even get a capital loss for your taxes. Chevreau offers a way to reduce the sting. Unfortunately, it doesn’t work.

The idea is to withdraw a losing investment from your RRSP so that when it rebounds, you’ll only pay capital gains taxes on 50% of the increase. If you leave the investment in your RRSP you’d end up paying taxes on 100% of the increase when you eventually withdraw the assets from your RRSP/RRIF.

According to Chevreau’s broker friend, this makes sense “when you have had bad timing in your RRSP/RRIF investment choices; when you're confident your investment will return to its previous higher value; and if you prefer to pay tax on 50 per cent of a capital gain rather than 100 per cent of income.” The first condition just means you’ve made an investment that lost money, and the third condition is that you’d rather pay less tax.

Unless you’re Warren Buffett, the middle condition (that you’re confident the investment will rebound) requires you to hallucinate that you have investment skill that makes your judgment of the investment’s value better than the collective judgment of all other investors. If this is true, why not invest more in this investment that’s sure to rebound? The truth is that this investment is no more likely to generate future profits than any other investment you might choose in the same class. However, even if you’re right about the investment rebounding, the strategy of liberating your losers doesn’t make sense, as I’ll show.

To avoid making mistakes analyzing investments inside and outside RRSPs, it helps to think of part of your RRSP belonging to the government. If you expect to pay 40% tax on RRSP/RRIF withdrawals, then think of your RRSP as only 60% yours. Whatever gains your investments make in the future, the government will get 40%, so you might as well think of 60% of the money belonging to you and growing for you, and 40% for the government. The government bought this slice of your RRSP back when you got a tax refund on your contribution.

Thinking about the government owning a chunk of your RRSP isn’t pleasant, but it can keep you from making mistakes when thinking about different strategies. A silver lining is that the 60% of your RRSP that’s yours is completely tax-free. All the taxes you owe are taken into account by allocating 40% of your RRSP to the government.

Getting back to the strategy of liberating your losers, let’s consider an example. Suppose you invested $25,000 in XYZ stock within your RRSP a few years ago and its value has dropped to $5000. Now you’re considering liberating your losers and hoping to save on taxes. The truth is that only $15,000 of that initial investment was yours, and only $3000 is currently yours. If you withdraw your XYZ stock from your RRSP, you’ll have to pay $2000 in income taxes.

By doing this you’re actually increasing your stake in XYZ stock. Before the withdrawal, you really only owned $3000 worth of XYZ stock, and afterward you owned $5000 worth. This suggests an alternative strategy: leave the XYZ stock in your RRSP and buy $2000 worth of XYZ outside your RRSP.

Let’s name these strategies “liberate” and “buy more.”

Liberate: Withdraw $5000 worth of XYZ stock from your RRSP and pay $2000 in taxes.

Buy more: Leave the XYZ stock in your RRSP and buy $2000 more XYZ for you non-registered account.

Suppose XYZ stock doubles. Which strategy is better? In the liberate case, you own $10,000 worth of XYZ stock in your non-registered account, and you have a $5000 capital gain that will generate $1000 in taxes when you sell.

For the buy more strategy, you have $10,000 worth of XYZ in your RRSP (of which only $6000 is really yours), and you have $4000 of XYZ in your non-registered account for a total of $10,000 worth of stock. You have a $2000 capital gain that will generate $400 in taxes when you sell.

One difference between these two strategies is that you’ll pay more capital gains taxes with the liberate strategy. Another is that further gains will generate more capital gains taxes with the liberate strategy. This is what I assume Jamie Golombeck meant when Chevreau quoted him as saying “But you then lose your tax-free compounding indefinitely, which is why I don't like it.” It’s clear that the buy more strategy is superior.

But what about all the extra tax you’ll pay when you ultimately sell your XYZ stock and withdraw the money from your RRSP/RRIF? It’s true that the government will get more tax with the liberate strategy. But that’s because you invested $2000 in XYZ stock on the government’s behalf in your RRSP and it doubled. With the buy more strategy, both you and the government came out ahead. Unless you hate the government so much that you’d rather both lose than both win, I suggest just focusing on your own after-tax gains.

Does liberating your losers make sense if you’re forced to make a RRIF withdrawal, but you don’t need the money to live on? The short answer is no. In this case, the “buy more” strategy changes but is still superior to the liberate strategy if XYZ stock is going to perform better than your other investments.

The alternative to liberating XYZ stock begins by choosing $8333 worth of some other investment(s) within your RRIF that you think will perform worse than XYZ. Sell 40% of these investment(s) and buy XYZ stock with the resulting $3333. Use the remaining $5000 of the investment(s) to make an in-kind withdrawal from the RRIF. If XYZ outperforms the other investment(s), then after working through the details, you’ll find that this strategy works out better than liberating your losers.

In summary, liberating your losers is a bad idea. It only seems good when your understanding of RRSP/RRIF taxation is muddled.

Thursday, October 5, 2017

Stock-Picking Skill

When researchers talk about someone having skill at stock-picking, they are using the word “skill” differently than we’re used to. I might be impressed that a stock-picker seems very smart and knows far more than I do, but this is far from having skill in the technical sense.

To illustrate what we typically mean by “skill,” let’s consider golf. Over the years, I’ve golfed with many people whose abilities impressed me. There are dozens I’ve played with who I’d say have golf skills. Worldwide, there are millions of people who I would judge to be skillful at golf if I saw them play.

But what if we define “golf skill” differently? What if we decided that only those who have an expectation to earn more in prize money and endorsements than they spend on travel and equipment count as being skilled at golf? By this definition, I’ve never golfed with a skillful player. Worldwide, there are perhaps a few thousand players who have skill in this sense.

Does this strict definition of golf skill make sense? I suppose it makes sense for someone considering making a living at golf. But the vast majority of golfers play for fun, and there is nothing wrong with deciding that a player is skillful, even if they have no chance of making a living at it.

Getting back to stock-picking, does it make sense to call someone skilled just because I’m impressed with their knowledge and insight about stocks? The answer is no because the purpose of stock-picking is profits. I’ve never met anyone who admits that their stock-picking efforts tend to lose money but they do it anyway because it’s fun. A few such people may exist, but the vast majority of stock-pickers believe their efforts are likely to be profitable; they wouldn’t pick their own stocks otherwise.

Roughly speaking, the definition of stock-picking skill is the expectation of earning higher compound returns (after factoring in costs) than an appropriate benchmark. The word “compound” is important here because it implies a rational level of risk aversion. This is similar to the concept of risk-adjusted returns. (The way the math works out, the expected compound return is approximately equal to the median return rather than the arithmetic average return.)

A major challenge with this definition of stock-picking skill is that there is so much luck involved. Even Legg Mason Value Trust’s record of beating the S&P 500 every year for 15 years seemed certain to be skill before 3 years of substantially underperforming the market. It’s very difficult to say with any confidence that a particular stock picker has skill. Another challenge is that stock pickers can shop around for a benchmark they look good against.

A paradox of skill at stock picking is that the better everyone gets at it, the less skill there is in the world. The definition of skill at stock picking involves beating the market, which implies beating the average returns of other investors. So, you can only have skill if you’re enough better than other stock pickers.

As more and more talented stock pickers enter the field, the talent threshold for having skill rises. With each passing decade, market professionals increase their domination of trading in stock markets. Retail stock pickers are no longer much of a factor. To have skill, you need to be substantially better than the typical professional stock picker, a tall order.

There is even some doubt in the case of the great Warren Buffett. I’m satisfied that Buffett demonstrated skill over his long and hugely successful career. But does he have stock picking skill today? He has two huge forces working against him. The first is that his competition has been getting better over the decades. The second is that he’s investing so much money that he’s forced to focus on the stocks of only the largest businesses that already attract a huge amount of attention. He may still have skill, but it’s hard to be certain.

I’m satisfied that stock-picking skill must be very rare. Among professional stock pickers, skill is, at best, uncommon. Among retail investors, skill is so rare that you can safely assume that anyone you meet almost certainly doesn’t have skill, regardless of any claims they make.

Friday, September 29, 2017

Short Takes: Pension Changes, the Middle Class, and more

Here are my posts for the past two weeks:

The Wealthy Renter

What We Need on Credit Card Statements

Straight Talk on Your Money

Here are some short takes and some weekend reading:

Frederick Vettese makes the case for changing federal civil servants’ pensions to a target-benefit plan to save taxpayers a lot of money. The government could save even more money by eliminating employees they don’t need.

Andrew Coyne does some clear thinking about taxes and the middle class. He shows that when there is a raging debate, it’s possible for both sides to be very wrong.

Larry Swedroe summarizes Vanguard research that debunks dividend myths.

Squawkfox explains the steps necessary to open a Registered Disability Savings Plan (RDSP). It’s work, but the substantial free government money available makes it worth the effort.

Big Cajun Man was on his best behaviour for a podcast with Doug Hoyes. He even explained how he got his nickname (but left out the profanity).