Wednesday, May 17, 2017

Bad Surveys

Yet another survey concludes that people are pretty dull when it comes to finances. This time it’s the Teachers Insurance and Annuity Association (TIAA) Institute who asked just over a thousand Americans 28 financial questions. The respondents didn’t do very well. But sometimes, it’s the designers of the study who are dull.

A Wall Street Journal article quotes one of the survey’s 28 questions:

There’s a 50/50 chance that Malik’s car will need engine repairs within the next six months which would cost $1,000. At the same time, there is a 10% chance that he will need to replace the air conditioning unit in his house, which would cost $4,000. Which poses the greater financial risk for Malik?

Anyone mathematically inclined sees instantly that the expected cost is $500 for the engine and $400 for the air conditioner. But the question is which potential repair “poses the greater financial risk for Malik?”

In the field of assessing threats and vulnerabilities, “risk” is defined as the product of probability and the amount of loss. This is the same as the expected value of the loss. Based on this definition, we would choose the engine as the greater risk.

In finance, we usually use standard deviation as the measure of “risk.” For the engine the standard deviation is $500, and for the air conditioner the standard deviation is $1200. Few people would do this exact calculation, but they may understand it intuitively. A 10% chance of a $4000 cost seems riskier than a 50% chance of a $1000 cost, and the math backs up this feeling. Based on this definition we would choose the air conditioner as the greater risk.

In case the argument based on standard deviation isn’t compelling enough, imagine that we replace the potential air conditioner cost with a 0.1% chance of losing $400,000. This is still an expected loss of $400. However, faced with a 50% chance of losing $1000 and a 0.1% chance of losing $400,000, reasonable people would focus more on the potential huge loss.

But the word “risk” isn’t owned by any one technical field. The everyday use of “risk” is imprecise and doesn’t conform exactly to either of the technical definitions.

Some people might look at this question and decide that it’s reasonable to be able to absorb a $1000 loss into their short-term finances, but $4000 would put them into a cycle of high-interest debt and digging out would take time. In this scenario, the air conditioner is the greater risk.

Another way of looking at this question is that engines will cost $1000 per year in repairs and air conditioners will cost $4000 every 5 years or so. So, engines are more expensive, and even though the word “risk” isn’t a good fit, a person who thinks about the question this way would choose the engine as more risky.

As it turns out, the survey designers think the correct answer is that the engine is riskier because its expected cost is higher. I wonder how many knowledgeable respondents understood expected cost but chose the air conditioner anyway because of their view of what “risk” means. I could easily have chosen the air conditioner had I participated in the study.

I agree that most people know too little about personal finances, but in this case, the study designers seem unable to ask clear questions.

Tuesday, May 16, 2017

Replying to Emails I Usually Ignore

I enjoy feedback from my readers discussing the topics covered in my posts, even when they’re critical of my ideas. However, I get other email as well. Here is another installment of replies to emails that I usually ignore.

Dear Andrew,

Thank you for kind words about my “content related to money.” You remind me of book publishers who see their jobs as trying to sell white bricks. I see you have quite a list of different ways to connect your client to topics that appear to be of interest to readers. If I ever decide it would be funny to subject my readers to dreck, I’ll contact you.




Dear Julia,

Thanks you for yet another chance to share in the profits of duping people into losing their money in forex trading. After careful investigation, I’ve determined that I still have a conscience. Better luck next time.




Dear Jessica,

Thank you for your offer to place sponsored guest advertorials on my website along with your requirements that they not be labeled as “sponsored”, “guest”, or “advertorial”. Your offer to cover administration fees of posting sounds generous. You’ll find that my administration costs are somewhat lower than those of the City of Toronto.



Friday, May 12, 2017

Short Takes: Bogus Research, Dumb Things We Do, and more

Here are my posts for the past two weeks:


Becoming a Millionaire

Should You Invest or Pay Down Your Mortgage?

Here are some short takes and some weekend reading:

Kewei Hou, Chen Xue, and Lu Zhang say that “The anomalies literature is infested with widespread p-hacking.” In plain English, they investigated hundreds of claimed ways to beat the market and found that almost everyone was full of it. For those who know a little bit about statistical testing, the one-paragraph abstract of their paper is worth a read. If correct, the paper is devastating to a huge area of investment research into market-beating anomalies.

Meir Statman says it’s possible to make better investment decisions if we recognize that our tendencies sometimes push us in the wrong direction. It’s interesting that he says “Normal people are not irrational.” I’ve seen this statement elsewhere from other thoughtful writers. I can say with certainty that I am sometimes irrational, and I see others act irrationally as well. Perhaps experts use a different definition of “irrational” than I use. Another possibility is that they are simply avoiding the term because people react badly to being told they are irrational. The language Statman uses is gentle and much more likely to help people make positive changes.

Canadian Couch Potato explains why you should probably own some bonds, even though bond yields are very low right now. Curiously, I found myself nodding in agreement as I read, even though I don’t follow this advice myself. Keep in mind that I lived through the dot-com bust and the 2008-2009 financial meltdown with an all-stock portfolio without flinching.

Andrew Hallam reproduces an excellent article by Mark Dowie, “The Best Investment Advice You’ll Never Get.”

Preet Banerjee had an interesting discussion with Dan Hallett, Vice-President and Principal at HighView Financial Group. The big news is that Preet seems to have changed his name to Preset.

Big Cajun Man explains that some low-income families don’t bother applying for the Disability Tax Credit mistakenly thinking it won’t help them. But it leads to being able to open an RDSP and getting some free government money.

Boomer and Echo explains how CDIC would protect deposits if Home Capital goes bankrupt. It seems that once CDIC steps in, depositors get access to their money in a few days. What’s not clear is how long depositors could be left without access to their money prior to CDIC stepping in. I’m interested in how long depositors have been left without access to their deposits in past bankruptcies, but haven’t found any useful information yet.

Thursday, May 11, 2017

Fintech in Canada

“It is not from the benevolence of the butcher, the brewer, or the baker that we expect our dinner, but from their regard to their own interest.” ― Adam Smith
Fintech holds the promise of greatly reducing the cost of financial services for Canadians. Our big banks have little choice but to keep costs high because they have a lot of capital tied up in real estate, they have a lot of employees to pay, and most importantly, they have shareholders demanding ever-growing profits. Operating primarily online, lean fintech companies give us the hope of reduced banking fees, better interest rates, and other benefits. But it’s important to understand the motivations of fintech companies.

People like John Bogle who founded Vanguard are rare. Instead of enriching himself, he created an investment company that serves the interests of its customers. He even had the foresight to create a legal structure that created strong incentives to benefit customers instead of pitting them against Vanguard’s management.

Fintech companies are not structured this way. They seek to make money. The best way to make money fast in fintech is to attract as many customers as possible and then sell the company to one of the big banks. Not all fintech companies have this plan, but many do. After acquiring a fintech firm, the big bank will do its best to squeeze more profits from its newly purchased customers without losing their loyalty to the original fintech firm. It’s a tricky balancing act but make no mistake: this is why big banks buy fintech firms.

A longer fintech plan is to actually operate the fintech company and make money from its profits over time. Even here, though, the company’s long-term dreams would be to get closer to the kind of profitability that the big banks enjoy. The path to these profits is to start off with very customer-friendly practices to get a loyal customer base, and later try to squeeze more profits from these customers. Whether or not a fintech company seeks to get sold to a big bank, the endgame is similar: whoever owns the fintech company will try to extract more money from customers.

None of this is really different from the rest of our economy; companies seek profits. But bank customers who understand what is going on can predict how to get less expensive banking. You have to be willing to change banks. It’s not enough to jump once from a big bank to a fintech firm. You need to be prepared to leave one fintech firm for another that makes a better offer.

I’ve gone through this myself first leaving a big bank for Tangerine. Since then Tangerine has been whittling away at credit card rewards and the interest rate they pay. They have even resorted to teaser interest rates to try to compete using advertising without actually paying competitive interest rates on deposits. This has driven me over to EQ Bank.

It’s not my intention to promote one financial firm over another here. Every time I see a good deal at an online bank, I expect to have to pay attention to whether they make negative changes. I expect to have to change banks yet again. I won’t be more loyal to a bank than it is to me.

My hope is that more and more fintech firms will keep popping up to the point where the big banks can’t keep buying them all. If the marketplace becomes diverse enough that there is meaningful competition, maybe some new banks will actually decide that treating customers well is in their long-term interests. Until then, expect to have to change banks whenever your current bank’s offerings deteriorate.

Should You Invest or Pay Down Your Mortgage?

“It is better to be vaguely right than exactly wrong.” ― Carveth Read.
In a good example of how you should be careful where you go for financial advice on the internet, the blog Money After Graduation attempted to tackle a reader question about whether to save money or pay down a mortgage. The analysis and conclusion are not useful.

Ordinarily I applaud those who pull out their math skills to answer questions, but in this case, crucial factors were missed. The article simplified the reader’s question by assuming that TFSA investments would provide a tax-free return of exactly 5% each year, that the mortgage interest rate would stay less than 3%, and that nothing bad would happen in the reader’s life.

With these assumptions, there is no need for the article’s detailed calculations. We can see that 5% is more than 3%, so investing will beat paying down the mortgage. No need for any further analysis, unless there are problems with the assumptions, like the possibility of stock market crashes, poor health, and lost jobs.

I would hope that most people already know that investing in stocks and bonds is likely to give higher returns than a mortgage interest rate. The other factors to consider have to do with risk. Mortgage debt is a form of leverage. There are limits to how much leverage it makes sense to take on.

If there were no uncertainty in life, we could all get rich borrowing as much as possible at a modest interest rate and earning a higher return in the stock market. Market returns would cover the interest on the debt and more. But the stock market is volatile, and people get sick and lose their jobs.

If you have too much leverage, losing your job during a stock market crash could ultimately lead to losing your house too. This may sound unlikely, but losing your home would be so devastating that it’s a more important consideration than whether investments usually earn higher returns than mortgage interest rates.

The exact amount of leverage that makes sense for you depends on several factors including your age, health, income, job security, and how easily you could find another job. Unfortunately, people often overestimate their job security. One reason seems to be that the thought of losing our jobs is so scary that the only way to get through the day is to believe that our jobs are secure.

Most people understand these things to some degree. Big debts make people nervous, and they feel better when they can pay down their debts. We may not be able to figure out our optimum leverage level, but we often recognize too much leverage when we see it.

Not to pile on, but the Mortgage After Graduation article also contains the following quote: “Even at 1%, cash in the bank is better for your net worth than mortgage pre-payments simply because cash will earn a compounding return and mortgage pre-payments won’t.” This is wrong. Pre-payments on your mortgage have a compounding effect on your net worth. Cash earning 1% interest will not outperform a mortgage pre-payment. Of course, this doesn’t mean we shouldn’t hold some cash. The purpose of holding cash is to prepare for an emergency or other cash needs that arise, not to act as a better investment than paying down your mortgage.

Getting back to the question of what to do with some savings, I see 4 main possibilities: invest, add to an emergency fund, pay down the mortgage, or pay down some other debt. Which one is correct depends on the details of the person’s financial life. The general order is to eliminate high interest debt, build an emergency fund, pay down the mortgage until you get to a sensible level of leverage, and finally invest. Deciding what to do can be difficult, but thinking in this way offers a chance to be vaguely right instead of exactly wrong.