Wednesday, November 22, 2017

The High Cost of Paying Property Insurance Monthly

Recently, I was helping a family member switch property insurance companies. The last thing to arrange was paying the premium. The insurance agent was steering us toward monthly payments instead of paying for the full year in advance. I was shocked when I found out why.

At first I was just going to dismiss the idea of paying monthly, but I decided to ask the agent what interest rate they charged. I think his exact words were “there is a 4% service fee.”

For the purposes of this article, I’ll scale all the numbers to an annual insurance premium of $1200 to keep the math simple. I took the insurance agent to mean that they take the $1200 premium, add 4% to get $1248, and divide by 12 to get $104 as the monthly premium. This turns out to be only partially correct.

In addition to the monthly charges, the insurance company wanted a $200 “down payment.” So, the $1200 premium led to a total of $1448 in payments if paid monthly. After doing some figuring, I said “that service fee of 4% is more like 4% per month.” The agent’s reply was a simple “yes.” Needless to say, we just paid the full annual amount of $1200.

Later on when I had time for more accurate calculations, I worked out the internal rate of return on these payments to be 3.58% per month, which compounds to 52.6% per year! At least the insurance company was careful to stay below the 60% usury level.

At this interest rate, getting people to pay monthly is a big source of profits for the insurance company. If your insurance company is doing the same thing to you, you can get a big discount by choosing to pay annually.

Tuesday, November 21, 2017

The Annuity Puzzle

A big challenge in retirement is spending enough to be happy without running out of money. The main problem is not knowing how long you’ll live. This is called “longevity risk.” We are forced to plan for a long life whether we’ll live long or not.

One way to eliminate longevity risk is with an annuity. The idea is to hand your money over to an insurance company, who then promises to pay you monthly, even if you live much longer than they expect.

According to Meir Statman in his book Finance for Normal People, “people are reluctant to annuitize, a reluctance we know as the ‘annuity puzzle.’” Statman identifies a number of “behavioral impediments to annuitization.”

We are averse to “transparent dips in capital.” Seeing your portfolio take a big drop hurts, even knowing that you’ll get lifetime income in return. Also, the “money illusion” makes “a lump sum of $100,000 seem larger than its equivalent as a $500 monthly annuity payment.”

“Availability errors deter people from annuitizing further because images of outliving life expectancy are not as readily available to people as images of many kinds of death that might befall them soon after they sign an annuity contract.” Regret aversion is also involved because of the possibility “their heirs would receive only pennies on the annuity dollar.”

Finally, we get to the easiest-to-understand reason for avoiding annuities: they have a “smell of death.”

All these behavioural reasons that people avoid annuities sound perfectly plausible. However, there are also rational utilitarian reasons for avoiding the annuities available to people.

First, let’s consider a simple fixed payout life annuity. The return on such annuities is a mixture of long-term bond rates, mortality credits, and embedded fees. This forces people who prefer the higher expected returns of stock investments to give them up to get mortality credits. One good solution might be to take just your bond allocation and buy an annuity if the embedded fees aren’t too high. But, it can be quite reasonable to prefer to keep a significant allocation to stocks.

There are annuities available whose variable payouts are related to stock investments. However, the investment fees buried inside these products are extremely high.

If we had an annuity option that resembled a well-run shared-risk pension plan, then it would certainly make sense for people to use it to get the advantage of mortality credits. Until this is available, expect this annuity puzzle to persist.

Monday, November 20, 2017

Portfolio Optimization

Deciding what percentage of your portfolio to allocate to bonds, domestic stocks, foreign stocks, etc. can be challenging. Any attempt to optimize this allocation is necessarily based on assumptions. It’s dangerous to blindly follow optimized allocation percentages without examining the assumptions built into the optimization process.

In his book Finance for Normal People, Meir Statman tells the story of investment consultants choosing asset allocation percentages for a large U.S. public pension fund. The consultants used Harry Markowitz’s mean-variance portfolio theory to calculate an optimal portfolio for the pension fund. But then they modified all the percentages.

Statman’s explanation for why the consultants changed the percentages is that the managers of the pension fund wanted more than the “utilitarian benefits of higher expected return”; they wanted “expressive and emotional benefits, including the benefits of conformity to the portfolio conventions of this pension fund and similar pension funds.”

Statman may be correct in this assessment, but there is another reason for rejecting the recommended percentages from mean-variance portfolio theory. This reason is based on strictly utilitarian benefits and not expressive or emotional benefits.

The basis for mean-variance portfolio theory is that investment returns follow what is called a lognormal distribution. This model does a decent job for most of the range of possible investment returns, but it vastly underestimates the chances of extreme events. Unfortunately, making sure you can survive extreme events is a very important part of portfolio allocation.

If returns really conformed to mean-variance portfolio theory, then rational investors would be using a lot of leverage (investing with borrowed money). To compensate for the tendency of mean-variance portfolio theory to recommend risky portfolios, we usually choose a low value for the standard deviation of portfolio returns we can tolerate. This helps but isn’t a perfect solution.

There are other stable distributions that do a better job of modeling extreme investment returns. Unfortunately, they are harder to work with. In fact, their standard deviations are infinite.

Statman may be right that the primary reason why people deviate from portfolios optimized by mean-variance portfolio theory is that they seek expressive and emotional benefits. However, trying to protect portfolios against extreme events is another good reason.

Tuesday, November 14, 2017

The Dividend Puzzle

The strong preference many investors have for dividends over capital gains is known among economists as the “dividend puzzle.” Meir Statman offers a solution to this puzzle in his book Finance for Normal People.

Statman syas that many investors incorrectly “frame the capital of a stock as a fruit tree and dividends as its fruit. In that frame, collecting dividends and spending them does not diminish the capital of the stock any more than picking fruits off a tree and consuming them diminishes its size.”

“Rational investors know the correct frame for dividends and capital. They know that $1,000 in ‘homemade’ dividends from the sale of shares is identical in substance to $1,000 from a cashed dividend check, even if different in form, and they care about their total wealth, not its form.” Because the “price of shares of a company declines when a company pays dividends,” “payments of dividends do not affect the total wealth of investors.”

All that said, dividends do offer some advantages when we consider “expressive and emotional benefits” rather than just utilitarian benefits.

Self-Control

“Young investors bolster their self-control by setting separate mental accounts for income, including salary and dividends, and capital, including stocks. They add a rule—‘spend income but don’t dip into capital.’” Investors who create homemade dividends are more likely to succumb to temptation and “turn a 3 percent homemade dividend into a 30 percent homemade dividend.”

Sticking to a rule of not spending capital “also benefits older investors who draw money from their portfolios for retirement expenses and worry that self-control lapses would turn” their intended 3% home dividend into larger withdrawals.

Mental prohibitions against spending capital are so strong that when a company is forced to suspend its dividend, some shareholders living off dividends do “not even contemplate creating homemade dividends by selling [some] shares.”

Hindsight, Regret, and Pride

“Compare John, who buys a laptop computer for $1,399 with dividends received today from shares of his stock, to Jane, who buys the same laptop today with $1,399 homemade dividends from the sale of shares of the same stock.”

If the stock later goes up, Jane will feel regret for not having waited to sell, but John won’t feel this regret. Of course, if the stock later drops, Jane would feel pride for selling when she did, and John won’t feel this pride. “Consistent with loss aversion in prospect theory,” Jane would feel regret stronger than she would feel pride. So, on balance, John comes out ahead.

Framing

There is another emotional advantage to dividends that comes from the way that capital gains are framed with and without an associated dividend. This topic is somewhat technical, and so I’ll leave it to those who choose to read Statman’s book.

So, even though rational investors focus on total returns rather than over-valuing dividends, normal investors get some expressive and emotional advantages from dividends.

Friday, November 10, 2017

Short Takes: Amazon Nonsense, Extended Warranties, and more

I managed only one post in the past two weeks, a review of two books:

The Smartest Investment Book and Portfolio

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand is almost as cynical as I am about Amazon’s long, drawn-out “search” for a second headquarters location. I hope this whole PR event backfires for Amazon. In another article he discusses the elements of academic behavioural economics that he sees in practice.

Squawkfox has some sensible advice about extended warranties.

Gordon Pape shares important things you should know about traveling to Florida for the winter. His advice on this subject is far superior to his investment advice.

Big Cajun Man clarifies some of the rules surrounding Registered Disability Savings Plans (RDSPs).