Friday, January 19, 2018

Short Takes: Minimum Wage, Index Investing, and more

Here are my posts for the past two weeks:

Dollars and Sense

Measuring Stock-Picking Skill

Underfunded Pensions

My Investment Return for 2017 

Here are some short takes and some weekend reading:

The Blunt Bean Counter brings us a thoughtful and balanced discussion of the minimum wage hike. He also discusses the importance of executors advertising for creditors.

Robb Engen at Boomer and Echo switched to index investing 3 years ago, and he explains how this has affected his life in terms of time, stress, and portfolio returns.

Canadian Couch Potato gives the Couch Potato portfolio returns for 2017. He also has a new podcast out where he interviews Shannon Lee Simmons, a fee-only financial planner and author of Worry-Free Money. During the podcast he explains that while cryptocurrencies may take over the world eventually, there is no guarantee that Bitcoin will be the winner. I’d say it’s not even likely.

Gail Vaz-Oxlade gives step-by-step instructions for getting out of debt in just 40 lines.

John Robertson compares the costs of Robo-advisors and DIY investing approaches. His comparison is relevant to those who could handle any of the choices but are looking for the right personal cost/hassle trade-off.

Big Cajun Man anticipates the day when we’ll interact with large businesses through chatbots. I’m not sure how widespread their use is right now.

Thursday, January 18, 2018

My Investment Return for 2017

Stock markets gave us above-average returns again this year, even measured in Canadian dollars that rose in value relative to U.S. dollars during 2017. My internal rate of return (IRR) that takes into account cash flows was 12.17%.

A big change for me this year is that at mid-year I retired from my job. It was a tough decision to walk away from a comfortable income, but the family portfolio sits at about 35% above what I calculate we’ll need to make it to age 100. This is a pretty healthy margin in case the stock market crashes, perhaps even healthy enough by my wife’s standards.

I don’t know if I’ll stay retired, but I seriously doubt I’ll ever work full-time again. I may do consulting work if the mood strikes and the work is interesting.

With retirement comes some fixed-income investments. I’ve written before about my intention to keep 5 years’ worth of family spending in safe investments. So, my portfolio that used to be 100% stocks now contains cash and GICs. The percentage in cash will grow with my age according to my spreadsheet calculations.

My benchmark changed for this year as well. In addition to fixed allocations to exchange-traded funds VCN, VTI, VBR, and VXUS, my benchmark has an allocation to cash. My benchmark return for 2017 was 10.60%. My actual return was higher primarily because I was slow in selling stocks to create cash. My returns were boosted by the ever-rising stock markets. If stocks had crashed, I could have lost out by not filling my cash allocation immediately.

I have a spreadsheet set up that dictates all my actions with the ETFs in my portfolio. I do this to eliminate making my own foolish choices in the moment. I haven’t yet automated the cash part of my portfolio. This happened to work out well for me this year, but I prefer to automate everything and wait for my spreadsheet to tell me what to do.

Here’s my cumulative real return history (subtracting out inflation) on a log chart:


I had a spectacularly lucky 1999 where I took a wild chance and won. For the next decade I gave away some of these gains, and for the last several years my indexed portfolio’s actual returns haven’t deviated much from my benchmark returns. It’s good to know that the money I had invested in 1994 has grown to the point where it can buy 7 times as many loaves of bread.

Over my investing history, my compound real return (which factors out inflation) has been 8.72% annually. I have outperformed my benchmark by a compound average of 3.02% annually. Both figures are almost certain to drop in the coming years. For planning purposes, I assume that my stocks will average 4% above inflation, and that cash will just match inflation.

It’s inevitable that your portfolio actions won’t exactly match your investment plan, even if you’re an indexer. In part, I do these calculations to see whether the deviations from my plan are costing me money. When you think you’re being clever, it’s important to see if in reality you’re being dumb, unless protecting your ego is more important to you than money.

Tuesday, January 16, 2018

Underfunded Pensions

The plight of Sears Canada pensioners has been in the news lately. After reading about the hardships created by pension cuts, it’s natural to think about what we should do to prevent this in the future.

Some, like Jen Gerson, question whether pension plans should have higher priority than they do now when divvying up the assets of a bankrupt business like Sears Canada. However, the side effect of doing this is that suppliers would be less willing to extend credit to any business with an underfunded pension, and this would drive struggling businesses into bankruptcy sooner. This is a difficult choice to make when you’re still hoping that a weak business can get back on its feet.

However, the Sears Canada case looks far different from a plucky business doing all it can to survive. “While Sears’ shareholders pocketed payouts of $3.5 billion, the chain’s pension plans remained underfunded to the tune of $270 million.” Why are owners allowed to pull assets out of a business that owes money to its pension plan?

I can see where a company with a regular modest-sized dividend might be harmed if it’s forced to suspend the dividend. However, in this case, Sears Canada paid special large dividends. It seems appropriate to me to limit a company’s ability to pay dividends while its pension plan is underfunded. By itself this won’t prevent all cases of pension cuts, but it would make it harder to drain assets from a business at the expense of pensioners.

Friday, January 12, 2018

Measuring Stock-Picking Skill

Deciding whether someone has skill in picking stocks that will give higher than average returns is a tricky business. You’d think that having a long-term track record of beating the market would be proof. However, some have found ways to argue that such records aren’t proof at all. I have my doubts about the arguments.

When investment managers have the ability to pick superior stocks, we call this alpha. If they beat the market averages by 2% per year, we say that they have an alpha of 2%. When we just invest in market index funds, we call the source of these returns beta. These returns come from putting your money at risk, but they don’t come from investment skill.

Complicating the situation is the existence of types of stocks that give superior returns. It’s well known that stock in small businesses and low-priced businesses have given superior returns over the long run. Such categories of stocks are called factors. These two examples are called the size factor and value factor. There are other lesser-known factors (e.g., momentum). Researchers are finding new possible factors all the time.

In the first chapter of their book The Incredible Shrinking Alpha, Larry Swedroe and Andrew Berkin argue that if we invest in factor stocks rather than just a regular index, the outperformance we get isn’t really alpha; it’s just another kind of beta. By this they mean that we’re not showing stock-picking skill; we’re just invested in a category of stocks know to perform better than others.

Swedroe and Berkin go on to use factors to show that investors with strong long-term investment records did it with various types of factor-based beta rather than using alpha. I have concerns about this type of argument.

My main concern is best illustrated by taking factors to an extreme. Suppose we invent so many fine-grained factors that each factor actually represents just a single stock instead of a broad class of stocks. Then by definition, alpha is impossible. Whatever stocks you pick, there are corresponding factors saying your returns are the due to beta rather than alpha.

Now, I’m not saying that factor research has gone this far, but there is no guarantee that any given factor will persist into the future. Suppose that in the next 50 years a given factor disappears because we were guilty of data mining or for some other reason. Past investors should be given credit for alpha when they recognized stocks covered by this phantom factor as undervalued.

Factor researchers work hard to avoid data-mining. They look for sensible reasons why a factor should exist in addition to just observing it’s outperformance in returns data. However, even 100 years of stock returns is only a modest amount of data. We can’t eliminate the possibility of data mining. There are a few factors that seem fairly solid, but a great many others are not.

When we examine investment records during periods of time long before the existence of a given factor was widely-known, declaring an investor’s performance to be “merely beta” seems like 20/20 hindsight. On the other hand, if a modern era investment manager used well-known factors to increase returns, we’re justified in saying any outperformance is the result of beta, not alpha.

Of course, the main point of the book that it’s not worth it to pursue alpha still stands. Alpha is scarce and trying to get it can be very expensive. I’m not a fan of venturing too far into the world of factors either. Pursuing factors increases investment costs. If the factors don’t outperform by as much as we hope, the net effect may be lower returns.

Wednesday, January 10, 2018

Dollars and Sense

If you think you spend money rationally and that businesses can’t manipulate you into spending more than you should, you probably haven’t read a recent book by Dan Ariely and Jeff Kreisler, Dollars and Sense: How We Misthink Money and How to Spend Smarter. The authors explain many of our financial “quirks” and offer ways to compensate for or even harness our irrational tendencies.

One of our common errors is to make spending decisions based on irrelevant comparisons. A good example is sale prices. Just because a crappy shirt has a $100 price tag on it and is marked down to $60 doesn’t mean it’s worth $100 or that anyone ever paid that price. It may still be a terrible deal at $60, and you definitely aren’t saving $40 by buying it.

The comparison we really should be making is whether owning the shirt is better than the other things we could buy for $60. But that’s harder than looking at the $100 “regular price” and deciding we’re getting a deal. “When we can’t evaluate something directly, as is often the case, we associate price with value.”

Some other mistakes we make are spending more when the method of payment is easier, overvaluing things because we own them, and giving in to the temptations of the present. The authors explain each of these and more with entertaining examples.

In an example of mental accounting, the authors explain that “people who feel guilty about how they got money will often donate part of it to charity.” This means that “How we spend money depends upon how we feel about the money.” Presumably, donating some of the money somehow cleans the rest of it in our minds.

The authors make an observation that I think applies far more generally than just financial decisions: “There is no limit to the effort people will make just to avoid thinking.”

The genius of credit cards is that because the real payment will be made at some point in the future, “they lessen our current pain of paying.” But then when the credit card bill comes, “we feel like we already paid at the restaurant.”

In an interesting experiment, employees in a company savings program were given the company matching amount up front each month, and then if the employee didn’t make a full contribution, they were given a statement saying “We prefunded the account with $500, you contributed $100, and the company took back $400.” This is an interesting way to harness loss aversion to get people to save more.

Over very short time periods, stocks are down almost as often as they are up. But we feel losses about twice as strongly as gains, so watching your portfolio daily will make you feel bad. The authors’ remedy is to look at your investments infrequently because the longer the time period, the more likely it is that stocks are up. Of course, this works best if you have a portfolio that doesn’t require monitoring, such as indexed investments.

We have a tendency of overvalue effort over experience. We’re happy to pay a tradesperson who takes a long time and seems to work hard. But if a highly skilled person finishes a job quickly and with high quality, we balk at paying what seems like a high price for the (apparently) low effort required.

“If we have a root canal coming in a week, it can ruin every day leading up to it.” Anticipation can multiply the impact of both positive and negative experiences. This is why when my son was having surgery and the hospital called to offer a nearer date, I jumped at the chance to end the family misery sooner.

An unfortunate example of expectations affecting performance is that “When you remind women that they are women, they expect to perform worse on mathematics tasks and they actually do perform worse on those tasks.”

In experiments involving brain scanning, researchers found that “branding doesn’t just make people say they enjoyed things more; it actually makes these things more enjoyable inside their brains.”

In the shake-your-head department, a survey found that “46 percent of financial planners didn’t have financial plans themselves.”

When it comes to big financial decisions, it’s hard to decide based on some big numbers. The authors suggest working out what you’re giving up in non-financial terms. For example, when deciding whether to buy a bigger house, we might think “the bigger house costs me the same as the smaller house plus one yearly vacation, a semester of college for each of my children, and an additional three years of working before retirement.”

On the importance of understanding the issues discussed in this book: “the struggle to improve our financial decision-making isn’t just a struggle against our personal flaws; it’s also against systems designed to exacerbate those flaws and take advantage of our shortcomings.” So, businesses know how to push our buttons and get us to spend more.

In conclusion, this book explains our many decision-making flaws and offers suggestions for making better choices in realistic ways. I find the writing clear and entertaining. It’s definitely worth a read.