Tuesday, November 14, 2017

The Dividend Puzzle

The strong preference many investors have for dividends over capital gains is known among economists as the “dividend puzzle.” Meir Statman offers a solution to this puzzle in his book Finance for Normal People.

Statman syas that many investors incorrectly “frame the capital of a stock as a fruit tree and dividends as its fruit. In that frame, collecting dividends and spending them does not diminish the capital of the stock any more than picking fruits off a tree and consuming them diminishes its size.”

“Rational investors know the correct frame for dividends and capital. They know that $1,000 in ‘homemade’ dividends from the sale of shares is identical in substance to $1,000 from a cashed dividend check, even if different in form, and they care about their total wealth, not its form.” Because the “price of shares of a company declines when a company pays dividends,” “payments of dividends do not affect the total wealth of investors.”

All that said, dividends do offer some advantages when we consider “expressive and emotional benefits” rather than just utilitarian benefits.


“Young investors bolster their self-control by setting separate mental accounts for income, including salary and dividends, and capital, including stocks. They add a rule—‘spend income but don’t dip into capital.’” Investors who create homemade dividends are more likely to succumb to temptation and “turn a 3 percent homemade dividend into a 30 percent homemade dividend.”

Sticking to a rule of not spending capital “also benefits older investors who draw money from their portfolios for retirement expenses and worry that self-control lapses would turn” their intended 3% home dividend into larger withdrawals.

Mental prohibitions against spending capital are so strong that when a company is forced to suspend its dividend, some shareholders living off dividends do “not even contemplate creating homemade dividends by selling [some] shares.”

Hindsight, Regret, and Pride

“Compare John, who buys a laptop computer for $1,399 with dividends received today from shares of his stock, to Jane, who buys the same laptop today with $1,399 homemade dividends from the sale of shares of the same stock.”

If the stock later goes up, Jane will feel regret for not having waited to sell, but John won’t feel this regret. Of course, if the stock later drops, Jane would feel pride for selling when she did, and John won’t feel this pride. “Consistent with loss aversion in prospect theory,” Jane would feel regret stronger than she would feel pride. So, on balance, John comes out ahead.


There is another emotional advantage to dividends that comes from the way that capital gains are framed with and without an associated dividend. This topic is somewhat technical, and so I’ll leave it to those who choose to read Statman’s book.

So, even though rational investors focus on total returns rather than over-valuing dividends, normal investors get some expressive and emotional advantages from dividends.

Friday, November 10, 2017

Short Takes: Amazon Nonsense, Extended Warranties, and more

I managed only one post in the past two weeks, a review of two books:

The Smartest Investment Book and Portfolio

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand is almost as cynical as I am about Amazon’s long, drawn-out “search” for a second headquarters location. I hope this whole PR event backfires for Amazon. In another article he discusses the elements of academic behavioural economics that he sees in practice.

Squawkfox has some sensible advice about extended warranties.

Gordon Pape shares important things you should know about traveling to Florida for the winter. His advice on this subject is far superior to his investment advice.

Big Cajun Man clarifies some of the rules surrounding Registered Disability Savings Plans (RDSPs).

Friday, November 3, 2017

The Smartest Investment Book and Portfolio

There is little doubt that the vast majority of investors would be better off investing in low-cost diversified index funds than attempting to beat the market. However, the best writers explaining this fact, like Charles D. Ellis, tend to be calm and reasonable, while the loudest proponents of expensive active management say silly alarmist things like “index funds will destroy capitalism.”

One voice on the index fund side that can take on hysterical active management proponents is Daniel R. Solin. His books The Smartest Investment Book You’ll Ever Read (Canadian Edition) and The Smartest Portfolio You’ll Ever Own pull no punches. While I prefer Ellis’s style, I like Solin’s chances of holding his own in a public debate.

Solin refers to active portfolio selection as “hyperactive management.” He says “The securities industry adds costs. It subtracts value.” He devotes many pages to the numerous failings of the investment industry. While he overstates some of his points (e.g., “Nobody Can Consistently Beat The Market”), most investors would do well to assume his absolutes are correct.

The 2006 book, The Smartest Investment Book You’ll Ever Read (Canadian Edition), is starting to get a little dated, but is still very useful. Many Management Expense Ratios (MERs) for index funds are now much lower, and there are more Exchange-Traded Fund (ETF) choices than there were back then. On the positive side, this Canadian edition really does have meaningful Canadian content.

The 2011 book, The Smartest Portfolio You’ll Ever Own, covers some of the same ground as the first book, but covers new ground as well. It offers several model portfolios. One ETF-based portfolio is essentially the same as the one recommended in the first book. Another portfolio is based on index mutual funds. A third is based on Vanguard target-date funds.

Solin calls these three model portfolios the “smartest portfolios.” To distinguish a fourth model portfolio from these three, he calls it “The SuperSmart Portfolio.” This portfolio is based on ETFs and is designed to capture size and value factors based on the Fama-French three-factor model. All four portfolios are intended for Americans, so Canadians will have to try to adapt them to investment choices available to us.

Here are a few interesting quotes:

“Wall Street is not completely lacking in skill. It takes considerable skill to convince you it has an expertise that doesn’t exist and that you should pay for this nonexistent skill.”

“Just say no to: Market timing; Buying individual stocks and bonds; Actively managed mutual funds; Alternative investments; Variable annuities; Equity indexed annuities; Private equity deals; Principal-protected notes; Currency trading; Commodities trading.”

“The true secret of giving advice is, after you have honestly given it, to be perfectly indifferent whether it is taken of not and never persist in trying to set people right.—Hannah Whitall Smith”

“If you are using a broker or adviser who claims to be able to beat the market, withdraw your money and close your account.”

Toward the end of the 2011 book, Solin gives somewhat of a commercial for Dimensional Fund Advisors (DFA), and he admits to being an advisor offering their funds. However, this comes after the bulk of the book that offers advice suitable for do-it-yourself investors.

Overall, I find these books useful for giving readers the indexing side of the active vs. indexing debate. Academics might cringe at the repeated absolutes, but the impact on readers is likely to be positive.

Friday, October 27, 2017

Short Takes: Free Trials, Trailer Fees, and more

Here are my posts for the past two weeks:

Cheerleading for Home Ownership

Burn Your Mortgage

Here are some short takes and some weekend reading:

Ellen Roseman calls on credit card companies to do more to prevent “free-trial” credit card fraud. One problem I see here is that while some such offers are clearly deceptive, some aren’t as easy to identify. Another problem is the conflict of interest for credit card companies. My personal rule is that if it’s a free trial, then they don’t need my credit card number.

Tom Bradley at Steadyhand says that even though the battle over banning trailer fees rages on, the writing is on the wall. I hope he’s right that “Trailer fees are going the way of the dodo bird.”

Big Cajun Man isn’t very happy with the amount of his charitable contributions going to overhead.

Robb Engen at Boomer and Echo monitors the progression of his human capital into financial capital.

The Blunt Bean Counter summarizes planned changes to taxing private corporations.

Thursday, October 19, 2017

Burn Your Mortgage

Many people are familiar with Sean Cooper’s story of living extremely frugally for a few years while he saved up a large down payment, bought a home, and paid off his mortgage by age 30. Cooper built on the interest in his story by writing a book called Burn Your Mortgage. I expected to like this book because I believe paying off your mortgage and any other debts is a good idea (I paid off my first mortgage by age 28). However, despite many good parts of the book, there is too much cheerleading for home ownership for me to recommend it.

A common theme throughout this book is treating rising housing prices as a permanent reality. “The last thing you want is to find yourself priced out of the market.” “It’s probably wise, if you’re in the financial position to do so, to buy now while you can still afford to.” Even though this book came out in 2017, it already has a dated feel now that home prices have been dropping in Vancouver and Toronto.

Another part of this theme of rising house prices is the claim that real estate has been a better investment than stocks. See my recent post on cheerleading for home ownership for one example. Another is a chart of home sale prices from 1980 to 2015 with the caption “Canadian real estate prices have been trending upward over the past 25 years. That’s more than we can say about the stock market over this same time.” I can’t do better than John Robertson’s image of the S&P 500 total return superimposed on Cooper’s home price chart.

The early chapters of the book cover advice on basic personal finances building up to how to save up for a down payment. One quote I particularly liked is “It’s not how much you make; it’s how much you save.” The more I see of other people’s finances, the more I realize that overspending can happen at any income level.

One section offers “25 Ways to Save Big.” This is a decent list of things that many people buy mindlessly, but each item includes a suggested amount of annual savings that just seems random. This attempt to quantify savings marred an otherwise interesting list.

Some of the advice is too superficial for readers to follow without a lot more knowledge. One example is “Carefully weigh the pros and cons of a car loan versus leasing to see what makes the most sense.” This ignores the best option: save up and pay cash for a car. Another problem is that those who just compare monthly payments might think they’re following this advice.

There are advantages and disadvantage to using the Home-Buyer’s Plan (HBP) to use RRSP assets for a down payment, but Cooper’s justification is pure FOMO: “in this crazy real estate market where home prices are rising a lot faster than wages, it’s hard to turn down a 30% risk-free return.” To start with, the HBP allows you to increase the size of your down payment with money you’ll have to pay back later; this is not the same as a 30% return. Further, it’s dangerous to make big financial decisions based on the belief that house prices will keep rising.

The second part of the book contains a lot of useful advice on the details of buying a house. Cooper even allows that “sometimes it makes sense to rent until you’re financially ready to buy a home.” More excellent advice is to “Love They Neighbour.” It’s difficult to understand how important it is to work at getting along with neighbours until you’ve had a bad neighbour. “A good neighbour can make your time at home pleasant; a bad one can make it a living nightmare.”

I was suspicious of a quote Cooper attributes to Warren Buffett: “To build true long-term wealth, you must buy and hold real estate.” This turns out to be from a list of 13 Buffett quotes that were “translated” for real estate investors. The actual Buffett quote is “Our favorite holding period is forever.” But Buffett is referring to the businesses his company owns, not real estate. This is another example of true believers in some investment approach trying to recruit Buffett as one of their own.

In a section listing the pros and cons of buying a home, one of the pros is “forced savings.” There is some truth in the idea that forced savings helps people, but as Rob Carrick once said, a home comes with “forced spending” as well. Curiously, Cooper says forced saving is good because “Most people put their mortgage ahead of all other debts.” If you’re paying off your mortgage and allowing other debts to grow, that’s not forced savings. You’re not saving anything if your net worth isn’t growing.

One section contains some good, detailed advice on choosing a real estate agent. However, along with several good ideas is the advice to “Visit their website to read testimonials.” That’s not a good idea. For some reason humans are wired to be influenced by stories, even when they are deliberately misleading. In Ontario, regulated health professionals aren’t even permitted to publish testimonials.

In a discussion of mortgages and how much you can borrow, Cooper discusses the two main debt ratios. For the gross debt service ratio, he recommends that we “aim for a GDS ratio 30% or below (up to 35% in pricey real estate markets).” For the total debt service ratio, he recommends that we “aim for a TDS ratio of 37% or below (up to 42% in high-cost cities).” This idea that it’s okay to borrow more in hot markets is nonsense. You can’t suddenly handle more debt just because houses are expensive. And hoping to get bailed out by prices continuing to rise after you buy is a bad plan.

In a section discussing the pros and cons of mortgage brokers, Cooper says they have “No cost.” This is just wrong. The broker’s fee is baked into the rate you get. Now, it could be that a mortgage broker can still get a better rate than you could negotiate yourself from a lender, but that doesn’t mean the broker has no cost. Any time it seems like someone is working for you for free, you’re probably missing something.

A good section on breaking a fixed mortgage explains how expensive this can be. Many people would be shocked to learn that it could cost $20,000 or more to break their mortgage. A statistic that surprised me is that “70% of people change their mortgage before the end of its term.” Presumably, this doesn’t always involve a huge penalty, but such penalties are common enough that home-buyers should understand this potential cost.

The book’s last section covers topics that come after you’ve bought your home such as insurance, wills, and becoming a landlord. Becoming a landlord isn’t for everyone, but those who choose this path get some useful advice from Cooper on pitfalls and good practices.

“A rental property is the ultimate solution to building long-term wealth and achieving financial freedom.” I disagree. I’ve known too many people who tried to make money this way and ended up losing a lot of time and money. It takes a certain personality type to be able to deal effectively with tenants and to negotiate with various types of contractors for repairs and upgrades. You also need to develop a keen sense of the value of real estate to buy and sell at good prices. Only a small minority of people seem to do well at being a landlord. It’s much easier to build wealth with passive investments in the stock market.

An appendix lists a number of “side hustles” to make some extra money. This list of ideas can be a good starting point for an energetic person seeking ideas. One that made me cringe, though, is “If you’re healthy, get paid to test out new drugs.” Yikes!

The best parts of the book discuss frugal living and the advice on important details of the house-buying process and becoming a landlord. However, if asked whether I’d recommend this book to my sons, I’d have to say no; they are bombarded with enough messages to buy now while they still can. I think they’re better off using price-to-rent ratios to decide when to rent and when to own.