Friday, August 29, 2014

Short Takes: Closet Indexing, Rent vs. Buy Calculators, and more

Here are my posts for this week:

Leverage Quiz

When Genius Failed

Here are some short takes and some weekend reading:

Jason Zweig give a clear explanation of why fund managers tend to make their portfolios match the index fairly closely even if their investors would prefer bolder moves.

Potato reviews several rent vs. buy calculators. He takes a much deeper look than writers of most such review posts and actually explains what’s wrong with some of them.

Tim Stobbs explains his approach to early retirement in an interesting interview. His approach sounds very sensible. The one thing that concerns me in declaring my own financial independence is the possibility that when my health eventually declines somewhat, my expenses will rise. I might need to pay someone to mow my lawn, shovel snow, or clean eavestroughs. I may have more direct expenses such as physiotherapy. For this reason, I think early retirement enthusiasts should add a buffer to their current spending to account for possibly needing to spend a little more in their 60s than they do in their 40s. There will obviously be increased spending due to inflation, but I’m talking about more spending in real terms (after accounting for inflation). The dream of early retirement can still be very real, but it might be sensible to delay it by a year or two to create a buffer.

My Own Advisor lists some Canadian dividend stocks to buy and mostly forget. While I don’t believe any investor with a concentrated portfolio can afford to just forget about a stock, it can be okay to not pay much attention if you’re sufficiently diversified.

Big Cajun Man complains that he thought public education was free. Back to school costs prove otherwise.

Million Dollar Journey has begun net worth updates for Sean Cooper. Sean’s frugality and drive for income should put most readers to shame.

Tuesday, August 26, 2014

When Genius Failed

What happens when smart guys including some Nobel Prize winners borrow $125 billion to invest with huge leverage, gain further leverage from derivative contracts, and rely on markets remaining rational and investments remaining mostly uncorrelated to avoid blowing up? This is the story of the hedge fund Long-Term Capital Management (LTCM). Spoiler alert: they blew up.

Roger Lowenstein’s book When Genius Failed is an interesting account of LTCM’s seeming wild success starting in 1994 followed by its spectacular failure that threatened to take down the U.S. banking system in 1998. Apparently, “long term” is 4 years. Lowenstein does a good job of blending financial events with the personal interactions that were important to this story.

In its first four years, LTCM total returns were a staggering 311%! Even after deducting stiff management fees, investors were up 185%. Unfortunately, when trades started going against LTCM’s huge leveraged portfolio, it took only 5 months to erase all those gains and leave the fund’s total return at underwater at -67% before fees and -77% after fees.

“There wasn’t any risk—if the world had behaved as it did in the past.” At one point traders were shocked to see swap spreads surge as high as they did. Surges like this had “happened in 1987 and again in 1992,” but LTCM’s “models didn’t go back that far.”

You may wonder whether LTCM’s partners were evil geniuses who risked investor money and collected fat fees without risking their own money. This wasn’t the case. The partners believed so strongly in their methods that they left all their fees in the fund. They even found ways to add extra leverage to their personal stakes in the fund.

At one point not long before the blow-up, many outside investors were forced to take much of their money back. “The forced redemption of their money would come to seem a godsend.” The partners did this to increase their own stakes in the fund, a decision they came to regret.

One bad day showed the failure of LTCM’s models. LTCM, “which had calculated with such mathematical certainty that it was unlikely to lose more than $35 million on any single day, had just dropped $553 million” in one day.

George Soros had an opinion on LTCM’s methods: “The idea that you have a bell-shape curve is false. You have outlying phenomena that you can’t anticipate on the basis of previous experience.”

LTCM’s “employees, like most at Wall Street firms, had gotten most of their pay in the form of year-end bonus money. Most of those bonuses had been invested in the fund and went down the drain.” A bond trader said, “we ended up working for nothing.”

In the book’s epilogue, Lowenstein asks a good question. Regulators limit lending so that “loans do not exceed a certain ratio of capital. ... Why, then, does Greenspan endorse a system in which banks can rack up any amount of exposure they choose—as long as that exposure is in the form of derivatives?”

I found this book to be an interesting read, and it is instructive for anyone who doesn’t already have a healthy fear of leverage.

Monday, August 25, 2014

Leverage Quiz

When you borrow to invest, it is called using leverage. I’ll explain the basics of leverage and then hit you with a one-question quiz to see how well you understand its effects.

If you have $100,000 and borrow $100,000 more so you can invest a total of $200,000, it’s called using 2:1 leverage. If you borrowed $200,000 to invest a total of $300,000, that’s 3:1 leverage.

Once you’ve leveraged your portfolio, there are two ways basic approaches to maintaining that leverage. One is to rebalance periodically so that you maintain the same level of leverage. This means that if you’re leveraged 2:1 and stocks go up, you borrow to buy more shares to maintain the 2:1 leverage. If stocks go down, you sell shares and pay off some debt to get back down to 2:1. The other basic approach is to treat the debt and investments separately, just paying the loan interest. Your leverage ratio goes up and down as your investments go down and up.

If you had invested in the exchange-traded fund of Canadian stocks called XIU over the past 10 years reinvesting dividends along the way, your total return would have been +143%. With that background, here’s the question:

Q: If you had invested in XIU over the past 10 years with 5:1 leverage, rebalanced weekly and paying 4% per year interest on the loan, what would your total return have been (ignoring trading costs)?

a) +715%
b) +582%
c) +103%
d) -48%

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I grabbed some historical prices for XIU, did some spreadsheet calculations, and found the correct answer to be d) -48%. This can be hard to understand on an intuitive level. If you invest 5 times as much, why don’t you make 5 times more money? If XIU returns were so much higher than the loan interest, how could you lose money? There are many ways to answer these questions. A simple answer is that when rebalancing you are always buying more stocks when their price is up and selling when their price drops. This buying high and selling low creates a drag on returns that grows with the amount of leverage.

Another way to explain the poor results with high leverage is by explaining volatility drag. If you make 0% twice, your total return is 0%. But if you make 10% then lose 10%, you end up down 1%. Your average return is the same in each case, but the second case has a drag on returns due to volatility.

Volatility drag grows as half the square of the standard deviation of returns (per year). With no leverage, volatility drag for a stock index is usually somewhere close to 2% per year. When you leverage 5:1, you’re growing your return by a factor of 5, but you’re growing the volatility drag by a factor of 25. This makes it close to 50% per year! This huge drag overwhelms the 5 times higher returns.

You could choose not to rebalance your leverage ratio and just treat the debt separate from the investments. However, this just trades volatility drag for the possibility of a complete blow-up. If you start with $100,000 and borrow $400,000 more and invest the whole half-million, all it takes is a 20% investment loss to completely wipe out you original capital. If the lender demands his money back while you’re under water, you’ve lost everything and more.

All this is why leveraged hedge funds are so risky and why brokerages generally don’t permit you use more than 2:1 leverage for stocks. If you plan to borrow to invest, do so with great care.

Friday, August 22, 2014

Short Takes: Bad Financial Ads, Executive Pay Abuses, and more

Here are my posts for this week:

TFSA Penalties Poised to Rise

Test Driving Financial Rules of Thumb

Here are some short takes and some weekend reading:

Dan Hallett uses his expertise to pick apart the misleading aspects of a few ads for investments. The rule seems to be “if it’s misleading but legal, run it.”

Eric Reguly does a great job of explaining executive pay abuses. Stock options do a terrible job of aligning the interests of shareholders and company executives.

Tom Bradley at Steadyhand is advising retired clients to rebalance by topping up their cash reserves. He says “the general range used by our clients is 12 to 24 months” worth of spending in cash reserves. When I started looking at retirement income strategies, I chose 5 years of spending as a cash buffer. I think the difference is that Steadyhand’s client’s portfolios generally contain a significant allocation to bonds that reduces risk. My strategy was based on the cash buffer being the only safe component; the rest of the portfolio is stocks.

Million Dollar Journey provides a complete set of resources for those considering the Smith Manoeuvre. Take some time to understand the risks well before jumping in. In my opinion, leveraged investing is only appropriate for a small minority of investors.

My Own Advisor gave his take on several financial rules of thumb which prompted me to do the same.

Big Cajun Man found that even Cosmopolitan Magazine had some financial advice he needed to heed.

Wednesday, August 20, 2014

Test Driving Financial Rules of Thumb

Taking a close look at some financial rules of thumb began with a post at Brighter Life and jumped to My Own Advisor. Here I give my take on some very common rules of thumb.

Your retirement income needs to be 70% of your working income.

This is obviously just an average or typical case. You should really look at you spending needs, including saving up for bigger items like replacing a car, windows, furnace, flooring, or roof. My family’s spending is currently about 40% of the combined take-home pay for my wife and me. It makes no sense for us to target a retirement income almost double what we need right now. Retirement needs are driven by your spending, not your income.

Keep an emergency fund equal to six months’ income.

I’m a big believer in liquidity. Access to credit may seem like adequate protection, but lenders may take away access to credit in tough financial times. If you lose your job when the biggest employer in town goes bankrupt, banks may not be in a hurry to lend to you. If you can borrow, the rates may be painful.

Exactly how much you need in emergency savings depends greatly on your flexibility. How much can you reduce spending? Are you able to take a job that you could get quickly but may pay less? Are you able to move to find new work? I tend to have 4 to 5 months of spending in cash. Very flexible people may need less than this and others may need more.

Don’t pay more than 3.5 times your gross annual income for your house.

This seems far too high to me. I’d much sooner rent than spend this much for a house. At current prices, it’s certainly possible to rent a nice house for much less than it would cost to own the house. As long as you’re saving the difference, renting can be much less risky.

Don’t invest more than 5% of your savings in any one stock or bond.

This is sensible for stocks and for bonds that have risk, but makes little sense for Canadian government bonds. I actually violate this rule in my own portfolio. I still have about 10% of my savings in Berkshire Hathaway stock. The large built-up capital gains make me hesitant to sell and pay the taxes.

Accumulate 20 times your gross annual income, then retire.

I don’t see the logic of basing retirement goals on my current income. They should be based on my spending. Using this rule, I get further from retirement every time I get a raise. I can just imagine a worker flying into his boss’s office in a rage: “what’s this raise garbage? My savings were up to 19.5 times my pay. I was going to retire in 6 months. Now I’m down to 18 times. I’ll have to work another 2 years!”

Never touch your retirement savings, except for retirement.

Apart from extreme circumstances, this is a sensible goal.

In retirement, you can sustainably live off of 4% of your starting nest egg, rising with inflation.

There is research that supports this rule of thumb. However, it is based on the assumption that you pay no investment fees. If you’re like most Canadians who own mutual funds and (often unwittingly) pay substantial MERs, the safe withdrawal rate is much lower – more like 3% as I showed when I repeated the research to include the effect of fees.

If your employer matches your contributions to a workplace savings plan, go for it.

This is good advice. One thing to watch out for is that if you are forced to invest in company stock with all or part of the money, you should sell out of that stock and buy something else when possible. There are so many examples of companies going bankrupt and employees losing both their jobs and their savings. Like those employees, you may think that your company can’t go out of business. Those companies went out of business and so can yours.

The percentage of your portfolio in bonds and fixed-income investments should be equal to your age.

This is safe enough, but I find it too simplistic. I prefer to put all savings I won’t need within 5 years into stocks. But this isn’t for everyone. A huge potential risk for all investors is the possibility that they’ll lose their cool during a stock market crash and sell low. The 2008-2009 crash was a good test of your ability to stay invested. If you sold stocks back then, even if you think it was for a smart-sounding reason, you may need to keep your stock allocation lower. Even if you just failed to rebalance from bonds to stocks during the crash, your stock allocation may be higher than you can really handle.

Total home ownership costs shouldn’t exceed 30% of your gross income.

This sounds too high to me. As I wrote above, renting is not a bad option when house prices are high.

Your total debt servicing costs shouldn’t exceed 40% of your income.

Again, this sounds far too high to me.

Don’t plan to retire with debt.

Yes.

You need to have x times your annual income in life insurance.

This is far too simplistic. As your savings grow, your need for life insurance tends to drop. I have far less life insurance now than I did 15 years ago even though my income is higher now.


If there’s one theme running through my reactions to these rules of thumb, it’s that you should think. This shouldn’t be too hard for my readership, but too many people prefer to be told what to do.