Thursday, June 23, 2016


Some say that comparing your portfolio’s returns to an appropriate benchmark isn’t important as long as you’re meeting your financial goals. This sounds very reasonable, but whether or not it makes sense depends on the situation.

Situation 1: An investor saves all of her money in GICs. She could be making more over the long term by owning some stocks, but she is saving enough that she is meeting her financial goals. Is this sensible?

With a couple of caveats, I’d say yes. Many investors, particularly GIC investors, don’t think enough about inflation. If you’re about to retire and your GIC portfolio is producing the amount of interest income you’d like to spend, then you could be disappointed in future years as inflation erodes your savings and your income. As long as our hypothetical investor takes into account inflation and possible interest rate changes, she should be fine ignoring the stock market. I prefer to go for the near certainty of an earlier retirement from decades of investing in stocks, but to each her own.

Situation 2: An investor has all his savings in the IG AGF Canadian Balanced Fund, paying total fund fees of 2.89% each year. He prefers not to compare his returns to a blended benchmark of Canadian stocks and bonds because his portfolio seems to be progressing acceptable well.

This investor’s reasoning doesn’t make sense. He is giving away a substantial amount of money each year. If he doesn’t need high returns, he could have a much less risky portfolio that gives more stable returns. With a DIY approach, he might be able to get the same expected returns without any stocks at all. By finding another advisor who chooses funds charging 2% or less each year, he could significantly lower his stock allocation. His current path has him taking equity risk but giving away much of the equity premium. His future returns are expected to be low, but his retirement hopes could still be dashed by a stock market crash. He’d be better off to compare his returns to a benchmark, see the problem, and either go for a less risky portfolio or choose to keep more of the equity premium.

Situation 3: A stock picker prefers not to compare his returns to a benchmark. He says the benchmark isn’t relevant in his case.

This investor’s reasoning doesn’t make sense. He needs to know whether there is something wrong with his stock selection process. It’s true that comparing his returns to the wrong benchmark gives no useful information. For example, an investor who chooses Canadian stocks learns little by comparing his returns to the S&P 500. A Canadian dividend investor would do well to compare his returns to that of a Canadian dividend ETF. Consistently underperforming this ETF could be a sign of making poor stock selections. The challenge for each investor is to honestly seek out an appropriate benchmark. It’s always possible to find a benchmark that had a bad year to make personal portfolio returns look better. It’s best to choose the benchmark beforehand and try to make an honest assessment of whether your stock selections are really doing you any good.

It’s true that past returns are no guarantee of future returns. However, we are looking at the gap between our returns and that of a benchmark. When the benchmark is chosen well, this gap has some predictive value. The investor with his money in the expensive balanced fund has past underperformance that is likely to persist into the future. A poor stock picker is likely to remain a poor stock picker, particularly if he isn’t aware that his efforts are losing him money.

For stock pickers who prefer to protect their egos from an objective measure of their real skill level, I have a checklist of best practices.

Tuesday, June 21, 2016

Misbehaving: The Making of Behavioral Economics

Richard Thaler’s book, Misbehaving: The Making of Behavioral Economics, is both a fascinating look at the way humans make economic decisions and an interesting account of the history of this field within economics. Despite being an easy read, this book teaches important lessons.

I had no idea that claiming humans are not completely rational was once controversial in the field of economics. The term used for a person who makes perfectly rational financial decisions is “Econ.” The entire field of economics was built on the notion that we are all Econs. Of course, we aren’t. Economists used to deny that our irrationality had any serious impact on markets, but Thaler devoted his career to showing how our mistakes are an important part of economics.

One interesting finding is that “people who are threatened with big losses and have a chance to break even will be unusually willing to take risks, even if they are normally quite risk averse.” Perhaps this is the source of the common offer of “double or nothing.”

One part of the book was particularly tough on dividend investors. Thaler says that “in a rational world,” preferring dividends to capital gains “makes no sense.” “A retired Econ could buy shares in companies that do not pay dividends, sell off a portion of the stock holdings periodically, and live off those proceeds while paying less in taxes.” He goes on to describe a preference for stocks paying high dividends as “silly.”

Given a chance to take a fair coin flip to win $200 or lose $100, many people who would not do this once say they’d be happy to do it 100 times. Thaler explains why this is irrational, but notes that people think this way anyway.

Other research shows that people become less willing to take on risk if they see frequent losses. Combining this fact with the up-and-down nature of the stock market, we find “that the more often people look at their portfolios, the less willing they are to take on risk, because if you look more often, you will see more losses.”

Thaler explains a number of problems with strong forms of the efficient markets hypothesis, but notes that despite mispricings, “investors who attempt to make money by timing market turns are rarely successful.” This seems to be a common theme in the stock market. We can find anomalies, but it’s hard to profit from them.

The book contains humour as well. In a section analyzing the value of NFL draft picks, Thaler tells the story of the Redskins trading away several picks over multiple years to the Rams to get quarterback RG3. At the beginning of a game between the two teams, “the Ram’s coach sent out all the players they had chosen with the bonus picks to serve as team captains for the coin toss that began the game. The Rams won the game 24-0 and RG3 was sitting on the bench due to poor play.”

Thaler discusses the importance of “nudges,” which are ways to make it easier for people to do the right thing. Translating to the Canadian tax system, he suggests that RRSP contributions would increase if people could direct their tax refunds to their RRSPs and have the contribution count “for the return being filed (for the previous year’s income).”

Another amusing and likely effective nudge is when people need to “leave for higher ground before a storm strikes ... offer those who opt to stay a permanent marker and suggest they use it to write their Social Security number on their body, to aid in the identification of victims after the storm.”

It’s tempting to laugh at the kinds of mistakes people make and feel confident that we don’t make such mistakes. Of course, this isn’t true. It makes sense to try to make the choices an Econ would make, but we are doomed to fail sometimes. Hopefully, by pointing out the ways we make mistakes, Thaler is helping us make better choices.

Saturday, June 18, 2016

Visa Response to Walmart is Unconvincing

By now most people have heard that Walmart Canada announced it will soon stop accepting Visa credit cards. The reason they cite is that “the fees applied to Visa credit card purchases remain unacceptably high.” Visa now has a public response, but it is not at all convincing.

Visa accuses Walmart of believing “that their cost to accept Visa cards should be much lower than all other merchants – lower than local grocery stores, pharmacies, convenience stores – and yes, charities and schools too.” Walmart’s announcement didn’t include a demand for lower costs than other retailers. All Walmart said was that Visa’s costs were too high for Walmart. Visa could reduce costs for all retailers if they want. This just looks like an attempt by Visa to pit Walmart against other retailers and portray them as greedy. Walmart doesn’t control what Visa charges charities and schools.

Visa accuses Walmart of “unfairly dragging millions of Canadian consumers into the middle of a business disagreement that can and should be resolved between our companies.” This is nonsense. If Walmart is not willing to stop accepting Visa cards under any circumstances, then there is nothing to stop Visa from continuing to increase fees indefinitely. There is clearly a maximum fee level beyond which Walmart is more profitable not accepting Visa cards. It’s Walmart’s responsibility to their shareholders to reject Visa if it makes them more profitable.

The claim that Walmart is “using their size and scale to give themselves an unfair advantage” is amusing. This may be true, but it is also common practice by Visa. Smaller retailers know that when it comes to Visa’s terms, they have to take it or leave it.

It’s common for large businesses to squabble over money. In this case the battle escalated to the point where it became public. These companies are driven by self-interest. The attempt by Visa to stake out a moral high ground is a joke. Neither company’s motives are influenced much by morality. If consumers look at their own self-interest, they will be on Walmart’s side to keep extra costs down.

Friday, June 17, 2016

Short Takes: George Soros’ Short, Cash-Back Scams, and more

Here are my posts for the past two weeks:

A (U.S.) Penny for Your Thoughts

How Not to be Wrong

Building a Tolerance for Debt

“The Foundation of Financial Independence is a Paid-for Home”

Here are some short takes and some weekend reading:

The Reformed Broker has a very sensible take on the news that George Soros is betting against global stocks. No doubt Mr. Soros has high moral character, but if he were acting purely in his own self-interest, he would be best served by leaking this story shortly before buying out his short position and going long.

Robert McLister warns us about a mortgage broker scam where the broker offers cash-back to effectively lower your interest rate but gives too little cash for the claimed reduction in interest rate. This is closely related to cash-back mortgages that I analyzed years ago and created a calculator to compute the effective interest rate for a given amount of cash back.

Larry Swedroe explains why using collar strategies to limit portfolio downside puts a drag on returns.

The Blunt Bean Counter explains the tax implications of divorce when you own both a home and a cottage. Without proper planning, you could end up in a race to see who can use the capital gains exemption for principal residences. The stakes can be quite high.

Boomer and Echo compares Boomer’s family’s spending to that of Mr. Money Mustache, who is known to be very frugal.

Big Cajun Man says you should check on your automatic withdrawals and deposits periodically. He had a case where a bank mysteriously stopped moving his money.

My Own Advisor takes a peek into Kyle Prevost’s portfolio. It’s quite close to mine.

Million Dollar Journey has an update on Frugal Trader’s push to financial independence. As many people have found, being a millionaire doesn’t provide the same lifestyle it once did.

Thursday, June 16, 2016

“The Foundation of Financial Independence is a Paid-for Home”

This article’s title is a frequent quote from journalist Jonathan Chevreau (see here for one among many examples). He is a baby boomer and this advice has worked out spectacularly well for most baby boomers who have followed it. However, today, this advice is likely to lead young people astray.

In much of Canada, house prices have become—pardon the technical term—stupid. My first mortgage was less than one-and-a-half times my family’s yearly gross income. Even cheaper fully-detached homes on nice lots were available at the time. Today I see families getting mortgages for four to five times their gross incomes. The multiple on their take-home pay is even higher. This creates enormous multi-decade financial burdens at a time when secure long-term employment is becoming scarcer.

Getting back to baby boomers, buying a home had many advantages. One such advantage was that in the period shortly after buying a home, mortgage payments forced a family to control spending and save indirectly by increasing home equity. Then as inflation eroded the value of the owed payments, the pressure eased off. Falling interest rates caused mortgage payments to drop even further.

However, today’s home buyers can expect a different experience. Rather than creating a sensible level of forced savings, many families have mortgage payments that are a huge burden eating up a big chunk of their take-home pay. Low inflation takes away the hope that future mortgage payments will be more affordable. There is very little room for interest rates to decrease and they may increase. Even a modest interest rate increase will drive up mortgage payments significantly.

Baby boomers enjoyed huge increases in the values of their homes. In most cases, these increases exceeded inflation by a wide margin. Today’s home buyers can’t expect the same outcome. For house prices to increase by as much in the coming decades as they did in the past few decades, there would have to be a flood of rich people to pay the astronomical prices. It’s possible that house prices will manage to increase with inflation, but another possibility is a substantial drop in prices at some point.

Young people face too much marketing and parental advice to take on huge financial commitments such as expensive houses and cars. A much safer path is to pay as you go by renting and buying modest used cars. The trick with this path is to save a significant fraction of your income along the way. I usually recommend 20% of take-home pay.

The purpose of such saving isn’t just a very far off thing like retirement. Maybe you’ll decide to buy a house when you can better afford it. Or maybe you’ll go back to school. Or maybe you’ll need a cash buffer while you change careers. If this doesn’t motivate you, then just think about the reality of working for several years and having nothing to show for it. You should have some savings in return for the work you put in.

A big benefit that baby boomers got from owning their own homes was ending up with a paid-for home 20 to 30 years later. Those who rent are certainly at risk of having nothing to show for their years of working if they don’t save any money. However, home ownership has its risks as well. Many people today have over-extended themselves and are destined to repeatedly re-expand their mortgages or lose their homes entirely. This risk would become much worse with job loss or if interest rates rise.

Baby boomers who bought homes when they were starting out did well, but this strategy is much less likely to work out well today. Now it’s definitely a bad idea to borrow as much as a bank is willing to lend you for a house. You’re likely better off taking a lower risk path that includes renting a home and saving some of your income as a foundation for financial independence.