Friday, December 19, 2014

Short Takes: $72 million Hoax, Reforming Wall Street, and more

Here are my posts for this week:

Money Rules

Seeking a Reason to Own Bonds for the Long Run

Wealthing Like Rabbits

Here are some short takes and some weekend reading:

The story about some teenager making $72 million day-trading is now confirmed to have been made up. It would be interesting to know how many people believed this story when they first read it. I didn’t. I know it’s easy to use 20/20 hindsight to convince yourself you knew it all along, but I made a point of saying I didn’t believe this story when it first hit. Balancing the likelihood of a publication making such a big fact-checking mistake against the likelihood of some teenager crushing the markets in such an extreme way, I went with the publication screwing up as much more likely.

Michael Lewis has some entertaining ideas for reforming Wall Street.

Canadian Couch Potato explains that the real value of limit orders is protection from wild markets rather than price haggling. He also did a good job of explaining ECN fees.

Big Cajun Man reports that the older you are the less likely you will follow through on your New Year’s resolutions.

SquawkFox explains that she maintains a low-cost diversified portfolio and doesn’t really care about all the stock market gyrations in 2014.

My Own Advisor says you need to save more than 10% of your income. This generated quite a stream of comments.

Robb Engen at Boomer and Echo has pushed his estimate of when he’ll reach financial independence from age 40 to age 45. For his sake, I hope this estimate is more accurate. If every 5 years you have to push your estimate out another 5 years, the projection doesn’t look good.

Thursday, December 18, 2014

Wealthing Like Rabbits

Few people believe they’re digging themselves a financial hole and making their lives worse while they’re in the middle of doing just that. Robert R. Brown’s book Wealthing Like Rabbits uses an engaging story-telling style to persuade readers to avoid the most common ways that they can set back their personal finances.

The main areas Brown covers are homes, credit cards, lines of credit, vehicles, weddings, home renovations, vacations, and Christmas. The approach he takes is to paint a picture of two families in similar circumstances except that one made more expensive choices. An extended analogy between credit cards and smoking was particularly amusing. In the end, the more modest family’s disadvantages are minor but their advantages in greater freedom to make life choices are huge. This style is persuasive.

Brown manages to slip in the usual information about RRSPs, TFSAs, etc., but this is all just secondary to the stories designed to persuade readers that a modest home and an inexpensive car are the pathway to a happy life.

What few criticisms I have are relatively minor. They’re included in the comments on specific parts of the book that follow.

Exercise bikes

“Behind a bunch of crap was an exercise bicycle that was both brand new and eight years old.” A perfect description.

RRSP and TFSA room

Maxing out RRSPs and TFSAs “would make for a world-class retirement ... and if you earn a 7-digit salary, live in a tent, and really like Kraft Dinner that’s the way to go. However, most of us have to choose one, the other, or possibly a combination of both.” Of course, it’s nowhere near this difficult to max out both, but the real message here is to help people who don’t max out both get over the guilt. What matters is how much you save, not how much room remains. We can’t let unused RRSP and TFSA room that keeps building up discourage us from saving money. Brown’s quote is likely more effective at reducing guilt than my explanation.

RRSP vs. TFSA

Even though the math might say that younger, low-income savers are better off with a TFSA than an RRSP, Brown still prefers RRSPs because “with RRSPs they get the tax savings now, when they are younger, lower income earners and they likely need it more.”

This isn’t good logic. Suppose a saver has a marginal tax rate of 20%. So, saving $5000 in an RRSP will generate a $1000 tax refund that the saver likely needs. Why not just save only $4000 in a TFSA to free up that needed $1000 right now? It may seem like the young saver is saving less money in this case, but this isn’t true. Future taxes when the money comes out of the RRSP will balance this out. If the saver’s marginal tax rate is higher than 20% in the future, then saving $4000 in the TFSA is actually better than saving $5000 in the RRSP and both still free up that same $1000 right now.

Brown also prefers RRSPs over TFSAs because people are less likely to withdraw from RRSPs before retirement. This may be true, but his preference for RRSPs will have to stand on this argument and not the one about getting tax refunds.

Inflation

Like many books trying to persuade people to save, there is the obligatory example of saving some fixed amount of money each month and ending up with millions in 40 years. Of course, inflation will make these millions worth a lot less in 40 years than they would be worth right now. Brown does the same thing with examples of huge future interest costs on long-term mortgages.

These little white lies are mostly harmless because they are intended to steer readers in the correct direction. Saving is a good idea and interest costs on mortgages are bad, even if this book overstates the case by ignoring inflation.

Tax reductions from RRSP contributions

“If you contribute $50 a week to your RRSP, you can reduce your taxes by $50 a week.” Not quite. You’re reducing your taxable income by $50 a week. How much your taxes are reduced depends on your marginal tax rate. This same slip occurred a second time a page later.

Investing

How to invest your savings isn’t a main theme of this book, but Brown does say “you should invest in a low-cost index fund.” He goes on to explain the higher costs and general lack of greater performance from actively-managed funds.

Banks

In a story of two brothers who each buy new homes, Brown hammers home the point that banks will lend you more than enough money to drown your finances. People have to figure out for themselves what their borrowing limit should be.

Tracking spending

The usual reason given to track your spending is to be able to see where your money is going and make sensible changes. Brown adds another. “Just like the dieter who finds himself eating less as soon as he starts monitoring his calorie intake, you will find yourself spending less of your money as soon as you start tracking what you are spending it on.”

Car Leasing

“Leasing basically means that you rent the car.” I was prepared to disagree because I’ve heard people liken leasing to renting as a benefit because it’s a way to avoid the cost and hassle of actually owning a car. But Brown means it as a negative because you still end up not owning a car at the end of the lease.

I’d say that leasing gives you the worst of owning and renting. Leasing resembles owning in the sense that you’re still on the hook for maintenance costs. But leasing resembles renting in the sense that you have nothing to show for all your payments when the lease is up.

Car-buying advice

“Consumer Reports is a great place to find comparative data and objective information” on vehicles. Consumer Reports is certainly better than most publications when it comes to car information. But Phil Edmonston’s Lemon-Aid Guides that come out every year are an even better antidote to the barrage of car articles in newspapers, magazines, and online that are little more than extended advertisements.

Vacation Traveling

In adding up the expenses of driving versus flying to a sunny destination, Brown includes the cost of gas but neglects other car-related costs. This is a common mistake. In my own case, I found the total variable costs of driving (including fractions of maintenance, insurance, and initial purchase price) were about triple the cost of gas. So, in the book’s example, the $500 for gas jumps to about $1500. You may prefer to drive anyway, but at least you should do it knowing the real costs of driving.

Saving while in debt

There can be good reasons for starting to save while still in debt. People need emergency savings. Some people need the feeling of making progress on savings at the same time as paying down debt. RRSP tax breaks for high-income earners are valuable even while you have a mortgage. I have no problem with those who choose to eliminate all debts aggressively before starting to save, but saving while still in debt can make sense too.

However, Brown offers a strange additional reason to save while in debt: “the interest on your savings will be compounding for a much longer period of time than the interest on your debt will be, which makes the math favour the savings plan.” This isn’t true. If paying off debt gives a higher return than adding to savings one year, this advantage will carry forward indefinitely. The only thing I can think of that would work against this would be a behavioural issue where someone would just run their debts back up with foolish purchases.

Mortgage default insurance

Given how hard it is for young people to build enough savings for a down payment on a house, Brown asks whether we should change the rules so that “first-time home buyers only need 10% down to buy their first homes without purchasing mortgage default insurance.” My answer is an emphatic no. Mortgage insurance costs should be driven by the actual risk of default and not some political goal.

Living within your means

Some criticize personal finance books for asking “you to reduce the quality of your life today so that you can save for tomorrow.” Brown says this “is a great big load of crap.” He follows this with an excellent explanation of how your life will become better immediately if you get control of your finances.

Borrowing to invest

“Do not allow anyone to talk you into borrowing money to invest.” He goes on to say that borrowing to invest is “a worse idea as you approach retirement” and a “terrible idea during retirement.” This is good advice for almost all people. It reminds me of the story of a 75-year old widow who was talked into borrowing to invest.

Conclusion

This book is mainly aimed at young adults. It uses an easy-to-read storytelling style that drives home important points about avoiding the biggest personal finance mistakes. I’m considering trying to persuade my own children to read it.

Tuesday, December 16, 2014

Seeking a Reason to Own Bonds for the Long Run

We tend to look at investment returns one year at a time. Most investment models treat each year’s returns as independent of previous years. But this isn’t actually true. A decade of returns in the real world doesn’t look the same as 10 independent single years strung together. Here I look at 10- and 20-year returns of different stock/bond mixes based on historical data.

As usual, it is easiest to get U.S. returns data. I found S&P 500 returns and 10-year Treasury bond returns from 1928 to 2013 at NYU Stern. I got historical CPI figures from Robert Shiller. This gave me 86 years of U.S. stock and bond real (inflation-adjusted) returns.

From these returns I created 5 portfolios with different stock/bond mixes: 0/100, 25/75, 50/50, 75/25, and 100/0. With the mixed portfolios, I rebalanced to the target percentages once per year. Then I calculated rolling 10- and 20-year returns. For each period, I calculated the compounded average annual real return.

Everything I’ve described so far is fairly standard, but the next bit isn’t. I took the 77 rolling 10-year annual returns and sorted them from lowest return to highest. I did the same for the 67 rolling 20-year periods. I did this independently for each of the 5 portfolio mixes.

This allows us to compare the worst outcomes for each portfolio against each other. These worst cases for the 5 different stock/bond mixes didn’t necessarily occur during the same time periods. We can also compare the best outcomes and everything in between.

Here are the results for 10-year periods:


Comparing the all stock portfolio to the all bond portfolio, it’s hard to see any reason to choose bonds. One might like the look of the 75% stock portfolio because in the bottom one-third of outcomes it looks better than the 100% stock portfolio, and isn’t too much worse for the top two-thirds of cases. It’s hard to see much justification for any of the portfolios with 50% or more bonds.

Here are the results for 20-year periods:


In this case it’s hard to make a case for anything but the all-stock portfolio over a 20-year period. More than half the time stocks beat even the very best bond return. It’s interesting to note that there isn’t much difference in slopes among the portfolios. The slope roughly corresponds to volatility. We’re used to thinking that stocks are much more volatile than bonds, but this isn’t true for 20-year periods.

The only remaining justifications I can see for having bond allocations for very long periods are related to behavioural problems and investing skill. By behavioural problems I mean that many people can’t stay invested in a volatile portfolio for 20 years without selling at a bad time. This is a real problem. I think people should try to educate themselves as much as possible to avoid such problems, but in the end, most people need bonds for a feeling of safety.

The other justification is investing skill. An investor who believes he or she can pick above-average bonds or bond funds will have reason to own bonds over the long run. Of course, the vast majority of such confident people are wrong and will get worse results due to following their own ideas. But there will be some who get good results by luck and possibly some who have genuine skill.

For the rational investor who is neither skittish nor overconfident, how should we use these results? I look at my own portfolio as made up of different investment horizons. I will spend some of my money the first year I retire. I’ll spend another slice the next year, and so on.

Each slice of my portfolio needs a different allocation. Only by adding up all of these individual allocations do I obtain my overall portfolio split between stocks and fixed income. The result is a heavy overall allocation to stocks, even when I first enter retirement. Because I managed to stay invested through the 2000-2001 crash of the tech bubble and the 2008 financial crisis, I have some confidence that I won’t sell at a bad time in the future. So, I can reasonably focus on returns over 10 or 20 years rather than single-year returns.

For investors who can stay calm through short-term fluctuations in stock prices, I still can’t see much justification in owning bonds in a portion of portfolios that they won’t touch for 10 or more years.

Monday, December 15, 2014

Money Rules

In her book, Money Rules, Gail Vaz-Oxlade shows her very effective and unique style for helping people get out of debt and handle their money properly. We all know we should spend less than we make, but Vaz-Oxlade uses her keen insights into people’s thinking and habits to offer helpful strategies. This book is useful for those who need help with money and those looking to help others with their finances.

I’ve already reviewed parts of the book related to life insurance and investing. These parts weren’t as good as the rest of the book that I review here.

Amusing Quotes

Vaz-Oxlade goes back and forth between tough love and gentle understanding in a way that makes a compelling read. Here are a few amusing quotes:

“If you are under the impression that the folks you deal with at the bank are there to ‘help’ you, you’re a sap.”

“The credit scoring system is a racket designed by lenders for self-serving purposes.”

“Overdraft protection should really be called ‘Too Lazy to Keep Track Protection.’”

“If you think a job is below you, but you’re prepared to spend the money you haven’t earned by using credit, you’re a jackass.”

“About 5% of Canadians—that’s over a million dopes—plan to use a lottery windfall to finance retirement.”

“Never mind what some moron lender tells you about paying just the minimum to have a better credit score ... that advice is designed to make you pay interest. And paying interest is dumb. Don’t do it.”

Some things I learned

I always thought you couldn’t pledge RRSP assets as collateral, but you can. “If you borrow against your RRSP, the fair market value of the RRSP assets pledged are included in your income for tax purposes at the end of that year. When the plan’s assets are no longer pledged, you may deduct the amount previously included in your income, minus any loss resulting from using the plan’s assets as collateral.” It sounds like this could be abused for income smoothing.

“Your RESPs may not be covered by CDIC. ... The CDIC Act makes no provision for separate coverage of eligible deposits held in a RESP.”

“A preapproved mortgage does not mean you’re guaranteed financing.” Lenders have outs.

If you don’t name a contingent subscriber on the RESP you set up, and if you die intestate, “the plan will likely be terminated and all the contributions and income earned put into your estate.” So, money you intended to be for your kids’ education might not go to them.

More good advice

“Renting is not a waste of money.”

“No, a line of credit is not an emergency fund. It’s debt waiting to happen.”

“Don’t let your lender decide how much home you should buy.” Banks will let you overextend yourself.

“Never buy mortgage life insurance.”

“A consolidation loan does not pay off debt.” This is an interesting insight into the mind of someone who handles money poorly. I think of a mortgage as debt, but apparently some people don’t.

“Get in the habit of paying all your bills at least three business days before the due date.”

Making insurance claims raises your premiums, and “you wouldn’t make a claim for less than $1000, so raise your deductible.”

Budgeting

“Only people who are LAZY and can’t be bothered think a budget is a waste of time.” I don’t think they’re a waste of time for most people, but I don’t think I need one for my money personality. But I suspect that still puts me in the “LAZY” camp.

Maybe “you make a whack of cash and you live the simple life, but that is no reason not to have a budget.” Now it feels like she’s writing about me. In my defense, I do know how much I spend in an average month, but I don’t have a budget.

“If you think you can do better without a budget ... pass this book to someone who is smarter than you.” Now it’s starting to feel personal, but at least it’s funny. I’m still not going to create a budget, but I appreciate that budgeting is a critical tool for many people to get out of debt and stay that way. No doubt most people who think they don’t need a budget are wrong. Who knows – maybe I’m one of them.

Tithing

We even have a section for believers in debt. “Are you in debt and tithing or giving money to charity? That’s not your money to give, so stop.” Young people who get talked into giving $25 a month to some charity should heed this advice.

Money set point

The idea here is that each of us has a cash level or “money set point” where we feel normal. For me, it’s about $5000 in a chequing account. But others have set points at $1000, zero, or even $2000 into overdraft.

Vaz-Oxlade recommends taking a spending holiday where you cut way back on spending to pull yourself out of overdraft and build up a cash buffer. But if you can’t change your mental money set point to a higher level of cash, she suggests splitting your money across multiple savings accounts. That way no one account has enough to make you feel rich and in a mood to spend.

Net worth

“Track your net worth,” but “don’t compare your net worth to anyone else’s.” This reminds me of a Warren Buffett quote: “It’s not greed that drives the world; it’s envy.”

A call to arms on paying with cash

“We should encourage small retailers to discount for cash. ... I want to see a flurry of signs in stores: ‘We give a 1% discount for cash purchases.’ If retailers don’t twig to this, then they’ve got to stop whining about how much credit card fees are costing them. They can’t expect consumers to switch to cash with no incentive.” I’d love to see more discounting for cash payments.

Hitched to a money moron

I can’t imagine what my life would be like if my wife handled money poorly, but many people have a “money moron” spouse. Vaz-Oxlade gives a set of concrete steps you can take to isolate your finances from a partner who is irresponsible with money.

Collateral mortgages

The problems with collateral mortgages can get quite technical. Vaz-Oxlade gives the best explanation I’ve seen of the problems with this type of mortgage. Few mortgagors have any idea of what type of mortgage they have.

Conclusion

Overall, this is a very wide-ranging book on many different aspects of personal finance. It contains a lot of solid advice. The best parts are where the author demonstrates her skill at helping people change their habits to get out of debt and generally handle their day-to-day finances better. Not so good were the parts related to investing. What I got out of it was better insight into the minds of those who handle their finances poorly.

Friday, December 12, 2014

Short Takes: All-Weather Portfolio, Credit Card Problems, and more

Here are my posts for this week:

Which Group RRSP Costs are Worth Paying?

Life Insurance: Permanent vs. Term

Money Rules for Investing

Here are some short takes and some weekend reading:

Barry Ritholtz says the “All-weather portfolio” from Anthony Robbins is based on the peculiarities of investment returns over the last few decades. Ritholtz believes his portfolio would be better over the next 20 years and offers Robbins a $100,000 bet based on whose portfolio gets higher returns. I have to agree with Ritholtz. The all-weather portfolio is very heavy in bonds, gold, and other commodities. It’s a very backward looking portfolio.

Ralph Nader explains why he doesn’t have a credit card. This thoughtful piece takes a 1000-foot view and puts the problems with credit cards into perspective.

Canadian Couch Potato explains why three funds following the MSCI EAFE index show very different returns.

Tom Bradley gives his take on the coming new mutual fund disclosure rules known as CRM2. It should be interesting to see what will happen when investors start seeing how much they pay for investment advice.

Justin Bender says that the benefits of Dividend Re-Investment Plans (DRIPs) is mostly a myth. There may be behavioural advantages from not letting cash accumulate and tempt people to spend, but there isn’t much difference between DRIPing and periodically investing cash. Personally, I treat accumulating cash as part of my emergency savings that I’d have anyway.

Jason Zweig explains very clearly how some professional money managers use different forms of “window dressing” to make their performance look better than it really is.

Robb Engen at Boomer and Echo has decided to switch from dividend investing to indexing. Among his reasons is his understanding of behavioural biases.

Mr. Money Mustache does a case study of a two-income family trapped in a high-cost life with full-time jobs they don’t want. I didn’t think the obvious improvements that occurred to me would make a big impact, but Mr. Money Mustache showed how to transform their lives.

Preet Banerjee starts up his podcasting again with an interview with Frank Wiginton who specializes in educating employees of various companies about finances and investing.

SquawkFox says impulse buying is the Achilles heel of saving money. She has a prescription for recognizing your weaknesses and dealing with them.

Big Cajun Man tweeted out a vintage post taking pot shots at financial bloggers. Here ‘s my addition: “Blogger process = navel gaze, extrapolate own experience to world.”

My Own Advisor gave a dividend income update that included the following quote: “Part of being an investor is making sure you do what you can to stay out of your own way.” This is so true, but I only understand it now looking back on past mistakes. I wasn’t at all aware that I was getting in my own way while I made the mistakes.

Potato (a.k.a. John Robertson) announced the official launch of his new financial book The Value of Simple. See my review here (but the associated draw is now over).