Monday, December 31, 2007

A Look Back at 2007

1. Stock markets in the US and Canada were up this year.

The gains were small enough that some would call this a “sideways” market where only stock-pickers can make money. Of course, stock pickers can only make more money by taking it from each other. For every extra dollar that one stock picker made above this year’s average market return, some other stock picker made a dollar less than the average.

2. Apple stock more than doubled.

Technical analysts who study patterns in stock price charts could no doubt show you how this could have been predicted by their methods. Personally, I think it has more to do with those little iPod things that everyone is buying.

3. The Canadian dollar overtook the US dollar.

Only a few years ago the Canadian dollar was the butt of jokes. (What’s another name for the Canadian twonie? A US dollar.) I think Canadians told these jokes more often than Americans did. The higher Canadian dollar should have caused the price of goods imported into Canada to drop, but that hasn’t happened much yet. It will be interesting to see whether the Canadian dollar stays up long enough that market pressures force Canadian retailers to lower prices.

Have a fun and safe New Year’s Eve.

Friday, December 28, 2007

Does Typical Asset Allocation Advice Make Sense?

Typical advice on asset allocation is that you should put fixed percentages of your savings into each of stocks, bonds, and cash. Usually, the advice is that the percentage in stocks should go down as you get older. I’ve never understood this rigid approach to investing. It makes no sense to me.

The theory is that this approach will reduce risk, particularly as you get older and closer to needing the money for retirement. I think the use of the work “risk” here is misleading. We are really talking about volatility. The asset allocation advice is designed to reduce the volatility of your year-to-year returns. But, you pay for this lower volatility with lower long-term returns.

To illustrate what I mean, consider the following example. Suppose you win a raffle, and your prize is that you get to grab a fistful of cash out of one of two large buckets with your eyes closed. One bucket has just twenty-dollar bills, and the other has half tens and half hundreds. If we say that you could hold about 100 bills in one hand, then the first bucket will give you a predictable roughly $2000. The second bucket will give you between $1000 and $10,000, a much more uncertain or “risky” choice. It’s not too hard to see that the second bucket is worth the added risk.

Over the long term, stocks have been a much better investment than bonds or cash, and there is every reason to believe that this will continue. Why should I put any money in bonds for the long term if the odds are overwhelming that the stock market will give me a higher return?

My Approach

Here is how I see things. Cash is for short term needs, say for the next 6 months. I keep cash as an emergency fund as well. The size of your emergency fund is a personal choice, but it should be higher if your income is variable or at risk in some way.

Bonds are for known big expenses coming up in the next 3 years (or 5 years if you want to be more conservative). The taxes you owe next April and the down payment on the house you plan to buy in 2 years shouldn’t be in stocks; bonds that are timed to come due when you need the money are a better choice. I prefer to buy actual bonds (or other government debt) rather than paying the MER on a bond fund.

All money I don’t need for at least 3 years goes into stocks. This can be individual stocks if you are skilled at analyzing businesses, or it can be a low cost index fund for those who want to put their stock investments on autopilot.

With this approach, you could be 90% in stocks if you have no big financial obligations coming up. Or you could be 75% in bonds if you are planning to buy the other half of the family cottage from your sister soon. The financial realities of your life dictate the appropriate mix of stocks, bonds, and cash rather than some pronouncement from a supposed financial guru.

Thursday, December 27, 2007

Beware Long-Term Care Insurance

Many people will need long term care at some point usually late in their lives, and this care is expensive. The insurance industry offers long-term care insurance to pay for this care. However, you have to be aware of the many possible abuses with this type of insurance.

This Consumer Law Page article provides an excellent explanation of long-term care insurance and the types of abuse and fraud that are possible (the web page with this article has disappeared since the time of writing). Disclaimer: I have no affiliation with the law firm associated with this article.

The abuses include such things as loopholes that allow the insurance company to deny benefits, lack of inflation protection, and targeting seniors by getting them to churn their policies. Churning refers to the practice of getting someone to buy a “new and improved” policy every year to boost premiums and boost the salesperson’s commissions.

There is another problem that probably would never have occurred to me, but seems obvious once you hear about it. Let me quote directly from the article:
“When buying long-term care coverage, the consumer should anticipate that premiums will increase to levels that in all probability will severely strain a fixed-income budget, resulting in cancellation, just prior to the time when coverage is needed. All insurance companies know this because their records confirm an increasing level of cancellations as premiums increase with aging policies and aging policyholders. The customer does not. The end result is a system that is rich with the potential for fraud. Add to this situation the fact that sales agents are driven by high commissions and the potential for fraud can readily become a reality.”
It makes sense that premiums have to be high at some point. Long-term care is expensive, and the premiums you pay have to cover the expected benefits you receive plus the costs and profits of the insurance company.

I don’t know whether long-term care insurance is a good idea or not, but it pays to look into the details of any plan you buy to make sure that the coverage will be there when you need it.

Wednesday, December 26, 2007

When Did Boxing Day Become Boxing Week?

My wife isn’t much of a shopper, and I shop even less. So, maybe retailers have been talking about “Boxing Week sales” for some time without me noticing. Until recently, I thought it was just “Boxing Day.”

We seem to get whipped into a frenzy about post-Christmas sales. We also get very excited about trying to find certain toys (particularly video games) that are scarce. I can’t say that I’m an expert on the methods used to get people to shop, but it seems that this scarcity is created intentionally to generate excitement and keep prices up.

The rise in the Canadian dollar relative to the US dollar has created a sharp rise in Canadians crossing the border looking for bargains. There is no doubt that US prices are usually lower, and the trip can be worthwhile when buying expensive items. However, most people seem to just buy a few small things. I hope they are enjoying the trip because not much money is saved, if any at all, once you factor in travel costs and time spent. On the other hand, a benefit of cross-border shopping is that it puts pressure on Canadian retailers to lower prices.

Unless you have a particular item you need and plan to buy at a sale price, your finances might be better served by avoiding the big Boxing Week sales crowds and staying at home.

Monday, December 24, 2007

Analyzing Cramer’s Stock Picks

Jim Cramer has a show called Mad Money on CNBC where he makes (or screams) numerous stock recommendations amid strange sound effects while jumping around. This can be entertaining for a while, but a more serious thought comes to mind. Can we make money from Cramer’s picks?

Bill Alpert analyzed Cramer’s results in an interesting short article on page 34 of the December 2007 issue of “R News”. The main result of Alpert’s analysis is that Cramer’s stock picks jump quickly the day after his show, and then tend to trail off over the course of the next month.

The earliest opportunity for the average investor to buy these stocks is the day after the show, and so it is clear that buying right away is not a good strategy. Alpert looked at various other strategies such as waiting an extra day or two or five, but none of these gave good results.

I haven’t watched Mad Money enough to know whether Cramer’s picks are intended to make money in the short or long term, but it is clear from Alpert’s analysis that things don’t look good for making money in the first month.

But what happens to Cramer’s picks over the longer term? I don’t bother to try to make money from short-term trading because I don’t believe that I can do it. There is only a limited amount of money available that short-term traders are fighting for, and because of trading commissions, it is necessarily the case that most short-term traders lose money.

I would prefer to know how Cramer’s picks do over say 3 years. Maybe we could start a mutual fund that buys each of Cramer’s picks and holds them for exactly 3 years. The important question is whether this fund would do better than the overall stock market. Cramer might like this analysis too, because he could keep his show going for a few years before the results come in.

Friday, December 21, 2007

Four Days Left Until Christmas

Christmas is approaching fast. You have only four days left to overspend your budget and run up credit card bills that will take months to pay off. Okay, okay, I’m sorry to sound so negative about the whole thing. It’s just that so much money is spent at this time of year, and it’s not clear that we really get our money’s worth.

I’m all for buying gifts for children. I get a bigger kick out of watching a child open a gift than I do opening one myself. That’s not to say that I don’t want to receive gifts. I would be disappointed if I didn’t get anything. But, I would be happy to receive a thoughtful, low-cost gift rather than an expensive gift if it meant that the giver would have less financial stress when the credit card bills start arriving in January.

I suppose that I’m not the first person to call for changes in the way we approach the holidays, but I’m not going to complain about commercialization and the lost meaning of Christmas. In fact, my advice applies even if you don’t celebrate Christmas. I urge you to think about what you and your family really enjoy about this time of year and try not to spend time, effort, and money on things that don’t contribute to your happiness.

Thursday, December 20, 2007

Succeeding Financially Because Others Fail?

I don’t waste a lot of time feeling guilty about things, but it wouldn’t be too hard to feel guilty about succeeding financially because others make poor financial decisions. Let me explain.

I have saved my money and have put some of it into bank stocks. Many people get second jobs to pay the interest on their credit card balances, and some of these interest payments flow back to me in the form of bank stock dividends. Similarly, the value of my shares in retail stocks goes up because other people shop compulsively.

We have all heard the sound financial advice to save some of your income and invest in stocks for the long term to get rich slowly. Once you have enough money, you can stop working if you like. But this advice only works because most people don’t follow it. If everyone saved and invested for 20 years, we couldn’t all quit working. There aren’t enough young people to do the jobs that keep our society functioning.

If we all saved and invested, stock market returns would have to drop, and the advice on how to get rich wouldn’t work very well any longer. My investment success depends on other people handling their money poorly.

Would we all be better off in the long run if everyone handled their money better? I’m convinced that those who handle their money well now would be worse off for a while if the poor money handlers suddenly wised up. But in the very long term, would greater efficiency cause everyone to benefit?

Of course, this is an academic question because it is extremely unlikely that everyone will suddenly smarten up financially. I’m not even sure who I would trust to answer this question accurately – maybe Warren Buffett, Chairman of Berkshire Hathaway and considered by many to be the greatest investor of our time. I suppose the chances are slim that he would find this question interesting enough to answer, and even slimmer that one could get his attention to ask the question.

If you have credit card debt, do your best to pay it off, even if it hurts me financially.

Wednesday, December 19, 2007

Tax Loss Selling

Do you still have some tech stocks lying around in your investment account from the boom days? Some of your stock positions might even be worth less than $100. What good could they possibly be now? The answer is that they might help out on your taxes.

When you sell an investment for more than you paid for it, you have made a capital gain, and you will have to declare this gain on your taxes if it is not in a tax-sheltered account, like an IRA in the US or an RRSP in Canada. If you sell an investment for less than you paid for it, you have a capital loss. Fortunately, each year you pay taxes on your net capital gain, which means that you get to subtract all your losses from your gains.

So, if you are going to have a net capital gain this year, you might consider selling one of those high-tech stinkers to create a capital loss to offset your capital gain. Take some time to think through all the relevant tax implications, though. For example, if your income is unusually low this year, you might be better off to pay taxes on your capital gains at a lower tax rate and save your capital losses for another year.

Don't forget to take into account all costs when deciding on the best course of action. Most people correctly take into account commissions, but not spreads. See this essay about apreads for details.

To take advantage of this idea for the 2007 taxation year, you need to sell the losing stock before the end of the year. To put it more precisely, the transaction has to take place before the end of the year. When you make a stock trade, the actual swap of stock for money doesn’t take place until 3 business days later. It is this day that has to fall in 2007 for your tax loss selling to work for this year.

According to the Times Colonist, the last day for 2007 tax loss selling in the US is Dec. 26, and in Canada Dec. 24. Because I prefer not to cut things too close, I usually do my tax loss selling well before the deadline. Update: An alert reader (Tom) found contradinctory information about tax filing in the US at Fairmark (see his comment below). According to Fairmark, stock sales can take place on 2007 Dec. 31 and still qualify for capital losses in 2007. To be safe, I'll stick to doing my tax loss selling before Christmas.

Although tax considerations are an important part of investing, don’t let taxes drive all of your decisions. It’s important to take a long-term view of your investment success and not be overly influenced by short-term tax considerations. That said, it seems sensible to save money on your taxes by getting rid of a $100 position in a stock you’ve tried to forget about.

Tuesday, December 18, 2007

RESPs: The Quality of Investments Matters

An RESP is a Canadian tax-advantaged savings vehicle for funding a child’s education. I’ll leave most of the details of RESPs to others and focus on one aspect: the actual investments bought with RESP money.

Back when my children were very young, I looked into RESPs and was disappointed to find that there were severe restrictions on how the money could be invested and what the money could ultimately be used for. For the plans I investigated, investments were restricted to mutual funds with MERs over 2%, and the rules for how the money could be used were more restrictive than was required by law.

When the Canada Education Savings Grant (CESG) came along, things were looking up. The government was going to match 20% of RESP contributions (up to a maximum amount). Surely this would make up for the high fees charged by the mutual funds, right? Not so fast.

Costs due to MERs accumulate year after year, but the 20% CESG is only added to each RESP contribution once. So each dollar that goes into an RESP becomes $1.20 because of the CESG, but then gets multiplied by 98% each year because of the 2% MER. At this rate, it takes 9 years for the MER to eat up the entire CESG. This is a problem for a child who won’t need the money for more than 9 years.

RESP rules and the available plans have changed significantly over the years. As you try to understand all of the rules and tax implications, don’t lose sight of the fact that the actual investments are important. Good investments outside an RESP are likely to generate more money for your child’s education than bad investments inside an RESP. The best results would come with good investments inside an RESP.

Monday, December 17, 2007

Who Wins on Stock Spreads?

In an earlier post, I explained that stock trading costs consist of the visible commissions and the less visible costs due to stock spreads. In the case of commissions, it is obvious who gets the money – the brokerage. In the case of stock spreads, it is less obvious where the money goes. If traders lose money due to spreads, who gets this money?

You could imagine a stock trading system where potential buyers and sellers each submit a price and a number of shares, and a computer tries to match them up. This sort of system might work well for a very liquid stock that trades millions of shares each day, but it wouldn’t work as well for thinly-traded stocks.

Suppose that you are looking to sell 100 shares of little known XYZ stock, and for three days running there haven’t been any reasonable bids to buy the stock. You would be quite unhappy. To make the system run more smoothly, each stock has one or more market makers whose job is to create a market in that stock. Market makers are always willing to buy or sell the stock at prices they specify. Each stock market imposes different rules on market makers to prevent abuses, such as maintaining an unfairly large spread between bid and ask prices.

To answer the question asked at the beginning of this post, the money lost by traders on spreads goes to market makers. But this doesn’t mean that market makers make money on every trade. Market makers constantly have to guess what prices to quote for their stock, although they have the advantage of seeing the bids made by traders.

In the example where you wanted to sell your 100 shares of XYZ stock when no traders were bidding, it is the market maker who would buy the stock from you. This means that market makers at various times own some stock or are short some stock.

If a market maker isn’t doing his job well, it is possible for a day trader to trade against him and make money. In this case, the day trader is acting like a market maker. (Warning: for every day trader who succeeds at this, a great many day traders lose all their money trying. Day traders have to pay commissions, and don’t have access to all the information the market maker has.)

A market maker’s income from trading will be variable, but over time, the market maker will earn the money stock traders lose from stock spreads.

Friday, December 14, 2007

Ex-Dividend Date

Why are there so many different dates associated with dividends? Most companies that pay dividends do so every 3 months on a fixed schedule. They don’t have to do it this way, but shareholders like predictability, and companies want to keep their shareholders happy.

You might think that the only important date is when you get your dividend money, but you would do well to understand a few more dates, the most important one being the ex-dividend date.

Declaration Date. Just because a company has paid its dividend every 3 months for years, and they are highly motivated to keep the shareholders happy by continuing to pay dividends, there are no guarantees. On the declaration date, the company announces whether it will pay a dividend and whether there will be any change to the dividend amount.

Ex-Dividend Date. When buying or selling a stock around the time that the company will be paying a dividend, you may wonder who will get the dividend, the old owner or the new owner. The ex-dividend date is the first day that a stock trades without the current dividend payment. Suppose that the ex-dividend date lands on a Tuesday. Then for stock trades on Monday, the buyer will get the dividend, and for stock trades on Tuesday or later, the seller will retain the dividend. In theory, the stock price should drop by the amount of the dividend between close of trading on Monday and opening of trading on Tuesday. In practice, stock prices are not that predictable.

Record Date. The records of who owns stock in the company on this date are used to determine who gets the dividends. You might think that this would be the day before the ex-dividend date, but this isn’t the case. When you make a stock trade, the trade isn’t finalized until 3 business days later. Going back to the example where the ex-dividend date falls on a Tuesday, the last day where buyers get the dividend is Monday, but the Monday trades won’t be finalized until Thursday. So, the record date is Thursday, two business days after the ex-dividend date.

Payment Date. The payment date is the date when the company sends out the dividends, and shareholders should get their money a few days later.

While you hold a stock, the important things related to dividends are the payment amount and when you get your money. When it comes to buying or selling a dividend-paying stock, you need to pay attention to the ex-dividend date to know which dividend payments you will receive.

Thursday, December 13, 2007

Gas Marketer Phone Harassment

Me: “Hello.”
Unknown Caller: “Can I speak to whoever handles the gas bill?”

Huh? This really threw me off guard the first time, but not the second or tenth times. I guess this saves them the trouble of trying to pronounce people’s names. These calls from 623-238-6131 have been quite persistent.

When I was young, I used to talk to telephone solicitors as though they were people, but this took a lot of time, and it was hard to get off the phone. My next strategy was to yell at them, but by acting angry, it left me feeling angry for a while. Yelling at them didn’t help much anyway. The person on the phone is stuck in a low wage job and is not a decision maker with the telemarketer.

The next strategy I tried was to say “just a minute” and set the phone down for a few minutes before hanging it up. This was amusing for a while, but sometimes I’d forget to hang up, and if my wife wanted to make a phone call, she would have to run around the house to find the off-hook phone.

Now I just listen long enough to be sure that it is a telemarketer, and I say “I’m not interested, thanks” and hang up without listening for a reply. For very persistent telemarketers, I tend to remember their numbers, and I just don’t answer. This seems to minimize the disruption in my life, but maybe I’ll find a better strategy at some point.

I’m used to the gas bill people showing up at my door pretending to be with my current gas supplier and asking to see my gas bill. Their goal is to get an account number from my gas bill and switch me over to their service (without my knowledge). I don’t know how widespread this problem is, but it is quite prevalent around my area. Maybe the company behind the annoying calls I’ve been getting is trying to do the same thing. Who knows?

What has all this got to do with personal finance? Natural gas marketers who use these tactics often have rate structures that will cost you more money than your current gas provider. The important thing to remember is that if you give these people the slightest bit of encouragement in person or over the phone, you might get switched to their service. It won’t be until later that you find out what terms you “agreed” to for payment.

Wednesday, December 12, 2007

Smith Manoeuvre

The first things you’re going to need are six pillows and a waterbed. Oh, wait a minute, that’s something completely different. The Smith Manoeuvre is actually a method of deducting interest payments on your taxes. The Canadian Capitalist has had some interesting discussion of this manoeuvre.

In case you’ve heard about this, but can’t make any sense out of it, let me try to simplify things. In the US, homeowners can deduct their mortgage interest on their income taxes. However, Canadians can’t. The Canadian Capitalist describes the Smith Manoeuvre accurately, but in other places it is sometimes presented as a method of deducting mortgage interest for Canadians. This description is somewhat misleading. Let me explain.

Ordinarily, Canadians can’t deduct any interest payments on their taxes unless the loan was taken out specifically for investing with the intent to earn investment income. Borrowing to invest is called using leverage and can turn out badly if the investments don’t do well. In an earlier post, I explained how some financial advisors like to recommend using leverage because it increases the amount their clients invest and increases their commissions.

So what does any of this have to do with a mortgage? Well, you can usually get a lower interest rate on an investment loan if it is secured by the equity in your home. The size of this loan is limited by the amount of equity you have in your home. Now we get to the slightly misleading part of some descriptions of the Smith Manoeuvre. You can deduct the interest on the investment loan (that is secured against your home), but you can’t deduct the mortgage interest on your income taxes.

The last part of the manoeuvre that complicates its description and analysis is the suggestion that you take out a loan that can be automatically increased by the amount of the principal part of each mortgage payment. Normally, with each mortgage payment you pay some interest and some of the loan principal so that your debt gets reduced. With the manoeuvre, your investment loan keeps increasing so that the total amount you owe (mortgage plus investment loan) stays the same. In a variant of the manoeuvre, you can increase the size of the investment loan if the value of your home rises.

As long as the value of your home doesn’t drop, and your investments do well, everything should be fine, right? If things don’t go well, how do you feel about getting a second job to pay all the interest on your investment loan and mortgage?

I suspect that the Smith Manoeuvre is too risky unless your income is high enough to pull you out of any problems with your investments or a drop in the value of your home. But, if your income is high, why not just go for the low risk strategy of paying down your mortgage and investing some of your excess earnings?

Tuesday, December 11, 2007

Protect Yourself from Thinly-Traded Stocks

In an earlier post I discussed how using a limit order to beat the spread doesn’t really reduce spread-related trading costs. Does this mean that investors should always use market orders when buying or selling stocks? Definitely not.

Let’s continue with the example of SPNS that had a quote of bid $1.45x200 and ask $1.60x2500, and we wanted to buy 6000 shares. In the earlier post we put in a limit order at $1.52. But there is a significant risk that this order won’t be filled. Maybe we really want to own this stock. (Please note that I don’t own SPNS, and I don’t know anything about it other than its quote worked well for my example.)

We could just put in a market order and see what happens. One possible result is that we get 2500 shares at $1.60, and the rest at $1.61. Great. We get all the shares we want at a reasonable price. But what if we get the first 2500 shares at $1.60 and then 500 at $1.70, 1000 at $1.95, and 2000 at $2.40? This works out to $11,600 when we expected to pay $9600 (plus commission).

One way to protect yourself when you really want the stock is to make a limit order at the current quote. So, if you placed a limit order to buy 6000 shares at $1.60 or lower, the first 2500 would be filled right away, and you could wait a while to see what happens. If the ask price rises to $1.61, you can change your order for the remaining shares to $1.61. But, if the ask price spikes up, you can just leave your order alone and be happy with the shares you did get.

When you are trading in a very liquid stock (where spreads are low and bid volumes are high compared to your order size), it's reasonable to make an order at the market. When buying a thinly-traded stock (with high spreads and low bid volumes), it’s a good idea to protect yourself with limit orders.

Monday, December 10, 2007

Trading Big Blocks of Stock Increases the Spread

In my post about trying to use limit orders to beat the spread, I mentioned that the spread between a stock’s bid and ask prices can be worse when you are trading large blocks of stock. What we mean by large here depends on the stock you are buying or selling.

When you get a quote on a stock, you get not only the bid and ask prices, but volume information as well. In our SPNS example in a previous post, the quote was bid $1.45x200 and ask $1.60x2500. This means that there were orders to buy 200 shares at $1.45 and sell 2500 shares at $1.60. If we had bought 6000 shares with a market order, the first 2500 shares would have cost $1.60 each, and the remaining shares would have cost more.

So, in the case of SPNS, a $10,000 trade qualifies as a large trade that increases the spread cost. In a quick look at Microsoft stock (ticker MSFT) as I write this, the price is a little under $34, and the bid and ask volumes are both above 3000 shares. So, even a $100,000 trade in MSFT is small enough to get the minimum spread.

This expanding spread is actually a disadvantage for rich people (although it is a problem that most of us would like to have). This is also a disadvantage for mutual funds because they are investing very large sums of money. They can’t invest in small companies without causing big increases in the stock price as they buy, and big drops in the stock price as they sell.

Smaller companies tend to have fewer people trading their shares, and these companies are difficult to make large investments in without having problems with the spread. Mutual funds are forced to stick with investing in larger companies. The larger the mutual fund, the smaller its universe of available stocks.

In the next post I will discuss how to protect yourself when you are making a trade that is large in relation to the quote volumes.

Saturday, December 8, 2007

Stock Option Tax Amnesty

In my last post, I explained what is going on with the tax amnesty granted to former JDS Uniphase employees who ran afoul of the rules for taxing stock options. I continue to read articles that are sharply critical of the government, but don’t accurately portray what happened.

The main point that people I speak to about this situation don’t believe even when I explain it is that taxes are being charged on income never received. It is possible for employees with stock option plans to put $10,000 into their plans, later take $10,000 out of their plans, and then be expected to declare $500,000 in income on their taxes. See here for a full explanation.

I disagree with those who say that these are high-tech high rollers who deserve what they got. I worked with people who were caught by these tax rules for smaller amounts. My colleagues were not high rollers or even particularly savvy with their money. Like most people they did their best to understand the benefits offered by their employer, and somehow managed to mess it up.

I do agree that the government is wrong to give special treatment to this small group of people. What should be done is to change the tax rules to allow stock option gains to be written off against capital losses (for everyone).

If no stock options were involved, there would be no problem. Suppose that you put $10,000 into stock A, and it goes up to $500,000. You then sell that stock and use the proceeds to buy stock B. The value of your stock B drops down to $10,000, and you sell. On your taxes you will declare a $490,000 gain on stock A, and a $490,000 loss on stock B. The gain and loss offset, and you don’t declare any extra income. Why shouldn’t it be the same with stock options?

Now I know that the government employs some smart tax people, and it is possible that they know of ways to abuse the tax system if the change I’m suggesting is made. If this is true, then they should find some other way to prevent the abuses without pointlessly ruining the financial lives of people who have no intention of abusing our tax system.

Friday, December 7, 2007

Government Forgives JDS Employee Tax Bills

Here is a bonus post on some recent news. If you were looking for my promised post on trying to beat stock spreads, click here.

The Canadian government has decided to forgive the tax bills of some JDS Uniphase employees who got caught by tax rules on employee stock options. The articles I have read on this so far haven’t explained things very well. I understand what is going on because I was caught by these same tax rules.

When employees get stocks options, what they have is the right to buy a certain number of company shares at a certain price. This is different from owning stock. If employee Ed has 5000 stock options struck at $2, it means that he has the right to buy 5000 shares in his company for $2 each. When he exercises this right, the company comes up with the shares (usually by just creating new shares) and gives them to Ed in return for $10,000. At this point, Ed is holding 5000 shares in his company, and he can sell these shares if he wants to.

Back when we were in the high-tech bubble, share prices rose to crazy levels. Suppose that the shares in Ed’s company rise to $100. For $10,000, Ed can exercise his options, and then sell the resulting 5000 shares for $500,000!

But what if Ed decided to exercise his stock options and hold on to the stock for a while to see if it goes up more? By the tax rules, Ed has made a gain of $500,000 minus $10,000, even though he hasn’t sold the shares yet. This $490,000 paper gain is considered to be employment income that will be taxed at the same rate as capital gains, but is not the same as a capital gain. By the rules as they were changed in 1997, Ed won’t have to pay tax on this income until he sells the shares.

Ed‘s luck runs out, the stock drops back to $2 before he can sell. He decides to cut his losses and sell at $2 to get his $10,000 back. So now he’s even right? Not so fast. From the government’s point of view, Ed has an employment gain of $490,000 and a capital loss of $490,000. They want their taxes on the employment gain now, even though Ed never got that money. Ed can use his capital loss to offset future capital gains, but that isn’t much consolation as he loses his house to pay his tax bill now.

In my case, I did make money when my employer’s stock rose, but I’m still holding most of the last block of stock I got from exercising options. If I were to sell the rest, I would have to declare a big employment gain on money I never received. So, I sit on these shares hoping that my employer doesn’t go out of business triggering a deemed sale.

Each year where I have a capital gain on other investments, I sell a little of my former employer’s stock to create a corresponding capital loss. This effectively turns the capital gain into an employment gain. I should be finished leaking out all my shares this way in about 40 years.

As I see it, the fundamental problem is that the government treats stock option gains as employment gains rather than capital gains. What is the point of this given that they are taxed at the same rate? If both types of gains were capital gains, then Ed could offset them against each other, and his problems would be over. He wouldn’t be getting away with anything. After all, he put in $10,000 and took out $10,000; why should he pay any taxes on this? He didn’t make any money.

I wrote a letter to Paul Martin about this after he delivered his budget in 1997. I explained how an unsuspecting person could be ruined financially without even realizing the risks. Unfortunately, all I got back was an off-topic form letter. I also got a local high-tech lobby group interested, but they couldn’t get the government to make any changes.

This all sounds like tax games for the rich and famous, but these problems have affected many people of modest means who never really understood what stocks options are or how they are taxed.

For smaller amounts, none of this makes much of a difference. If you have to declare an employment gain, you end up being able to reduce your capital gains by the same amount, and the tax bill isn’t affected. The only time it makes a difference is for larger amounts that can break someone financially.

What is the point of forcing someone into bankruptcy for income he never received?

This is continued here.

Trying to Beat the Spread

In my last post, I was explaining that the spread is the difference between the bid and ask prices on a stock, and that the spread contributes to the cost of trading stocks. Is there anything we can do to reduce the trading costs due to spreads? You can try to do this with what is called a limit order (rather than the simpler market order), but results are not guaranteed.

A market order is an order to trade stock where you are saying, “just give me the best available price right now.” So, for a buy order you will get the ask price, and for a sell order you will get the bid price. Things get a little more complicated if you buy enough shares to exhaust the shares available at the current bid or ask price, but this is a subject for the next post.

A limit order is an order to trade stock where you are saying, “give me the best available price as long as it is $X or better,” where $X is a price you specify. If there is no stock available at your price, then the order is held until the stock price reaches your price. Limit orders usually expire at the end of the day if they are not filled by then.

An Example

Suppose that you want to put about $10,000 into Sapiens International Corp (ticker SPNS). As I write this, the current quote is bid $1.45 and ask $1.60, for a spread of 15 cents. You decide that you want 6000 shares. Using the same method as in my last post, you can expect your trading cost to be the commission plus a spread cost of

(6000 shares) x (1/2) x (15 cents) = $450.

Ouch! In reality, the spread cost is even higher than this because the current quote shows that there are only 2500 shares available at $1.60 (for more on this, go here). You will buy the remaining 3500 shares at a higher price. What can you do about this?

You could try a limit order to get the price in the middle of the spread. Suppose that you place an order to buy 6000 shares of SPNS at $1.52 or lower. And then you wait. Maybe your order will get filled for all 6000 shares at $1.52. Great! You have saved the spread cost. You get to feel clever for a while.

But what happens if your order is never filled? Maybe you were right that this is a good company, and no other trader is willing to sell shares at your limit price. The stock price rises a little before the end of the day, and rises a little more the next day. So, now you either abandon this stock or buy it at an even higher price than the $1.60 you could have had originally.

So your attempt to save on the spread either works or ends up costing you more than the initial spread. This doesn’t mean that there is anything wrong with limit orders. It’s just that they are not a guaranteed way to avoid trading costs caused by the spread.

Thursday, December 6, 2007

Stock Spreads

The buying and selling of stocks is a kind of auction. At any given moment, people are offering to buy a given stock at various prices, and others are offering to sell that stock at various prices. If a buyer and seller have the same price, then they get matched up, a trade occurs, and they leave the system. What is left is a list of buyers who are offering less than what the list of sellers are willing to accept.

The highest price offered by the buyers is called the bid price, and the lowest price asked for by the sellers is called the ask price. The word “price” is often dropped, and people talk about the bid and ask on a stock. The difference between these two prices is called the spread.

Let’s look at a real life example. As I write this, Microsoft (ticker MSFT) has a bid of $33.49 and an ask of $33.50. The spread is quite low at 1 cent. Such a small spread is typical of stocks that are traded a lot. So, if you want to buy Microsoft stock, someone is out there who will sell it to you for $33.50 per share. If you have Microsoft stock you want to sell, there is a ready buyer at $33.49.

Suppose that someone is crazy enough to simultaneously buy and sell shares in the same company at the price the market is currently offering. Then this person would lose the amount of the spread, or 1 cent per share (plus commissions). Another way to think of this is that on each trade you are losing an amount of money equal to half of the spread.

So, if I buy 100 shares of Microsoft, I should think of my trading costs as the $10 commission (this is what my brokerage charges me) plus

(100 shares) x (1/2) x (1 cent) = 50 cents for the spread.

For heavily traded stocks, the cost of the spread is not too painful, but this changes for more obscure shares. The current quote on Oxford Bank Corp (ticker OXBC.OB) is bid $34.30 and ask $34.70 for a spread of 40 cents. So, on a buy of 100 shares, the cost is a $10 commission plus

(100 shares) x (1/2) x (40 cents) = $20 for the spread.

This shows that the cost of the spread can easily exceed the commission cost, especially if you are trading more than 100 shares. Things are even worse when trading stock options where spreads are often more than 10% of the ask price.

Some people try to beat the spreads by making what is called a “limit order”. I’ll have more to say about this in the next post.

Wednesday, December 5, 2007

Stock Trade Commissions

As I mentioned in my last post on the cost of trading stocks, I pay a $10 commission for each stock trade. In most years I make between 5 and 20 trades. If I average one trade per month for 25 years, the commissions will add up to $3000 (ignoring inflation). This is low enough that it won’t have a serious impact on my returns.

My strategy for buying stocks is to guess at the future prospects of the business, determine a fair price for the stock, and compare this to the current stock price. If I buy a stock one day believing that the business will be successful, it is unlikely that something significant will happen in the first week or month that changes everything. This is why I tend to trade infrequently.

What happens if you trade more frequently than this? Suppose that day-trader Dave is playing with $10,000 and makes 2 trades a day, 5 days a week, for 50 weeks a year. (Even day traders need 2 weeks off, don’t they?) The commissions add up to $5000 per year. So, Dave needs to make a 50% return on his money just to pay the commissions and break even. I know I’m not smart enough to do this consistently. Most likely Dave will be just about out of money in a couple of years.

Some people might object to this analysis because day traders often get discounted trades. This is true. However, day traders often make more than 2 trades a day. No matter how you slice it, commissions are a huge hurdle for day traders to overcome. This explains why the majority of day traders lose their money. See this SEC article for more useful information about day trading.

All of this discussion didn’t even take into account the cost of stock spreads, which I discuss further in my next post.

Tuesday, December 4, 2007

The Costs of Trading Stocks

In my own portfolio, I choose to own several individual stocks. Even though I think that most people would be better off in index funds, I’m not against direct ownership of stocks. I happen enjoy tracking the progress of the businesses that I own, and I’m hopeful that I will prove to be slightly above average at stock picking.

If you are not interested in analyzing businesses, and the time you spend following stocks consists mainly of checking current prices, then owning individual stocks probably isn’t for you. Over the long term it is the sales and profits of the business that determine your profits. Predicting the long-term future of a stock is best done by trying to predict the future success of the business rather than looking at wiggles in the chart of stock prices.

Just as it is important to understand the cost of owning mutual funds (loads and the Management Expense Ratio, MER), it is also important to understand the costs of owning stocks. These costs come mainly from buying and selling stocks. Other possible costs are account opening and closing fees and yearly maintenance fees. Many brokerages offer accounts without these additional fees.

When it comes to trading stocks, most people are aware that they have to pay a commission on each trade. The first time I ever bought some stock I was charged a commission of $186.07. This seems outrageously high by today’s discount brokerage standards, but it is typical of the commissions charged by full service brokers even today. These brokers would be better named “full cost brokers.” Today I can make trades with my discount broker for $10.

Another cost in trading stocks that most people don’t think about is the spread. Each stock has a bid price and an ask price. The bid price is the highest price that someone is currently willing to pay for the stock, and the ask price is the lowest price someone is currently willing to accept for a stock. The difference between these two prices is called the spread. When you place an order “at the market”, you buy at the higher (ask) price, or sell at the lower (bid) price.

In the coming posts, I’ll have more to say about commissions and spreads.

Monday, December 3, 2007

Transferring Investments to a New Account

The first time that I wanted to close an investment account with one company and move the contents to a new account with another company, I went about it in entirely the wrong way. You may have heard the expression “you can’t push a rope.” Well, the same seems to be true for money. Let me explain.

I started by talking to my old investment advisor and giving him the bad news about my plans to make a change. He spent some time trying to change my mind, but gave up after it was apparent that my mind was made up. I asked him what I had to do to get the investments moved, and he told me that I had to contact some administrative person whose telephone number he didn’t have handy.

After several telephone calls and some broken promises over the course of more than a month, I was getting quite frustrated. I didn’t realize it at the time, but my problem was that I was trying to push the money rather than pull it.

When I spoke to the new company that would be handling my investments about my problems, I was told to just come in and fill out a short form, and they would handle everything. It all became clear to me at that moment. The new company is motivated to get the money moved, and the old company isn’t. I never even had to speak to anyone at the old company again.

If you are planning to change investment accounts, you might want to ask the new company about what costs you will get hit with when closing the old account (and maybe ask if the new company will absorb some of these costs). There might be brokerage costs for selling stocks or mutual fund units, account closing fees, or transfer fees. You could also contact the old company to confirm what fees you will be changed, and who knows, they might even give you a good reason for not making the change.

Another thing to consider is moving investments “in kind.” Suppose that you hold 100 shares of Microsoft. If they are moved “in kind,” then the shares are moved directly to the new account rather than selling them first and then sending money to the new account. This isn’t always possible because some companies put their clients into private investments that can’t be held in the new account.

It turns out that pulling money into a new account is far easier than pushing money out of an old account.

Friday, November 30, 2007

Life insurance on Children

Another example of a bad deal is life insurance on children. In rare cases where a child actually has a substantial income that others depend on, it can make sense to take out life insurance on the child. But, in most cases, insuring a child’s life makes no sense; remember that the insurance offers no protection from death!

I have had insurance agents try to talk me into insuring my children by arguing that I would need to cover funeral expenses, and that buying the insurance would guarantee future insurability. This was all nonsense. I can afford a funeral without the help of insurance, and if I couldn’t, I would choose something less costly than the standard funeral.

The future insurability argument requires more explanation. When you buy term life insurance for, say, 10 years, it comes with or without the guaranteed right to renew the insurance at a particular price after the 10 years are up. If your insurance is renewable, then even if you develop a terminal illness in the tenth year, the insurance company has to let you renew.

When it came to renewal in my case, the guaranteed price was about double what I was able to get after they checked out my health again. So, the renewal price would only have applied if I was at high risk of dying.

To get guaranteed insurability in case your child gets terminally ill later in life, you have to pay for life insurance for decades before it is really needed. This is a high price to pay the questionable benefit of continued insurability.

The final pitch that one insurance agent tried on me was “don’t you love your son?” This one caught me off guard, and I mumbled some sort of reply, but I wish I had said “get out of my house.” Prove you love your children by feeding them well, playing games with them and reading to them, not by buying pointless life insurance.

For more detail on the arguments for and against life insurance for children, see this CNNMoney article and this post on My Dollar Plan.

Overall it pays to figure out whether the insurance you buy is actually eliminating any serious risk to your finances.

Thursday, November 29, 2007

When Can Insurance be a Bad Deal?

How you ever been to see a doctor who is obviously upset about something that has nothing to do with you? This has happened to me a couple of times where a doctor was complaining about something and I had little choice but to sympathize even though I was much more concerned about my own problems. Otherwise, why would I be seeing a doctor?

One of these times the doctor was having a problem with her extended health coverage for topping up the basic Ontario government medical coverage. Her partners wanted her to go in with them on a plan that cost $400 per month for each doctor, but she saw in the fine print that the plan had a lifetime cap on all benefits of $25,000. She correctly figured out that she would pay $25,000 in premiums in just a little over 5 years.

I asked her if she could afford to pay $25,000 right now if she had some sort of medical problem, and she said yes, which isn’t too surprising for someone with the income of a successful doctor. So, this means that the insurance company wouldn’t be reducing her financial risk very much.

From the discussion of utility of money in my last post, both the doctor and the insurance company qualify as rich for the amounts of money at stake here. It must be that one of the two parties was getting a bad deal, and in this case, it was the doctor.

The doctor would have been better off with a plan that only paid for treatment costs above some amount, like $5000 per year. She could easily afford the first $5000 each year, and the premiums for this type of insurance would be much less than $400 per month. Such a plan would actually protect her against real financial risk instead of only covering an amount she could easily afford anyway.

The various medical insurance plans I have had through employers had similar problems. There were yearly caps on all types of coverage: $500 for physiotherapy, $200 for glasses, etc. These plans were nice to have, but they weren’t really insurance because they didn’t reduce my risk of financial ruin. I just thought of them as a little extra income. If any expensive medical problem came up, I was on my own.

In the next post, we continue with bad insurance deals.

Wednesday, November 28, 2007

The Utility of Money

Some financial decisions, particularly about insurance, must take into account what is called the utility of money to get the right answer. Normally the concept of utility is explained in very mathematical terms, but it doesn’t have to be. Let’s take a fun example straight from a game show.

You’re standing beside Howie Mandel playing a super-sized version of Deal or No Deal. You’re down to just two amounts left, 1 cent and $3,000,000! You get the following offer: take $1,000,000 now, or take a 50/50 chance at the $3,000,000. What should you do?

If you got to do this many times, then on average, taking the chance you would win half the time and get an average return of $1,500,000. This is more than the million dollars you were offered, and so you should take the chance, right? Not so fast.

Most people would correctly figure out that they should just take the million dollars. The reason is that the first million would make a huge difference in their lives, and an additional two million doesn’t have the same impact. This is exactly what we mean by the utility of money: how useful the money is to you. The more you have, the less useful the next dollar is to you.

So, if you are already rich, the first million isn’t as big a deal, and you should probably take a chance on getting the full three million. But, if you aren’t rich, and that first million would completely change your life for the better, then you should just take the million that was offered.

One simple model for the utility of money is to view things in percentage terms. Suppose that everything you have in the world, including future earnings above the amount you need to live, adds up to $250,000. Then a million dollars increases your net worth by 400% to $1.25 million. Adding another two million dollars to this is a 160% increase, which is less than the first 400%. So, the extra benefit of taking a chance in the game isn’t worth the risk. For a rich person who starts with a net worth of $4 million, the first million adds 25% to make $5 million, and the next two million adds 40% more. For this person, the risk is worth it.

All this explains why a car insurance company with deep pockets is willing to take on risk, but individual drivers are better off paying a little extra to reduce risk. In the next post, I’ll show how the utility of money can be used to make decisions about other types of insurance.

Tuesday, November 27, 2007

How Can Insurance be Good for Both Sides?

In my last post, I discussed how insurance is a financial matter and doesn’t do anything to prevent accidents. So, if insurance is just about trading money back and forth, how can it be a good deal for both the insurance company and the person buying the insurance?

When it comes to buying goods like food, it is easy to see why an apple is more valuable to a person buying one than it is to the farmer who owns an orchard full of apples. I’m quite happy to part with 50 cents for an apple when I’m hungry, and farmers are willing to take less than 50 cents for each of their apples. So, in this case, it is possible for both sides to win. When it comes to insurance, it isn’t as obvious that both sides can benefit.

To keep things simple, imagine that a car insurance company has worked out that they will have to pay out an average of $600 per driver in claims for car accidents next year. If they charge each driver $1000 for the insurance, then they will make a $400 profit on each driver minus administrative costs. But, doesn’t this mean that each driver is making a bad deal and is wasting $400? Not exactly.

If we knew that each driver would claim exactly $600 for accidents during the year, then it would be a bad deal for the drivers. But, the majority of drivers will make no claims, and a small number will make large claims. If two cars are totalled, the claim could be $50,000 or more, and if people are injured, the claim could be $1,000,000 or more. Losses like this for the average person can be devastating financially. It is worth paying a little extra to avoid a small chance of losing everything you have.

This type of reasoning takes the “utility of money” into account, which we’ll discuss further in the next post.

Monday, November 26, 2007

Insurance is not the Same as Protection

A while ago during a temporary gap in my house insurance, some of my friends joked about coming over to my place and “having an accident” to make some big money. Of course they weren’t serious, and we all had a good laugh.

Later on I thought about what had made the joke funny. If you think about it, a fraudster would have better luck getting a big settlement from an insurance company than from me. So, for a short while my house was probably the worst place to target for faking an accident. But my friends and I all got the joke instantly, even though it doesn’t seem to make much sense after some thought. What is going on?

To answer this you need to look at how house insurance is marketed and sold. The best example is one insurance company that shows the image of a giant protective blanket enveloping your house. As long as you don’t think about it too much, you have the feeling that house insurance actually helps prevent accidents. The marketing promotes this subconscious idea. Of course, if you think about it, it’s clear that all the insurance does is give you money if something bad happens (that is covered). This is valuable enough, but accidents are just as likely to happen whether you have insurance or not. So, my friends’ jokes depended on our false sense that insurance somehow prevents bad things from happening.

When making decisions about what insurance to buy, it is important to keep in mind that insurance is essentially a financial matter. You are not buying protection from calamity so much as you are buying financial compensation when accidents happen.

Friday, November 23, 2007

More on Why Stock Prices Rise

In my last post, I discussed how stock price increases over the long term are possible. A reader, Steve, asks “If the value of stocks keeps on rising at a greater rate than inflation, wouldn't that mean that less and less people could buy stocks in the future due to lack of necessary funds?” This is a good question that points to the seeming paradox of the stock market creating value out of nothing.

Let’s start with understanding inflation. Inflation is a measure of the increase in prices of the things we buy, like food, gas, and clothes. At the beginning of the year, a particular basket of items is selected as the typical things that people need, and the price of this basket of items is added up over the course of the year to measure the cost of living. If inflation is 3% one year, then the cost of this basket of items has risen 3%. Another way to view this is that the things we buy have constant value, and the value of money has dropped.

Now, just because inflation is 3% doesn’t mean that we all have 3% more income to spend. Some of us will have more than 3% more income over the course of the year, and some less. The fact that over the long term the stock market rises faster than inflation means that our overall buying power rises faster than inflation. So the question becomes, how is it that we can afford to buy more and better stuff today than we could 50 or 100 years ago?

The answer is that we can produce most items like food and clothing with much less human effort than was possible in the past. Better processes make it possible to produce goods with less effort, which frees people up to do other things and make other goods. This ability to do more with less means that the sum total of all the things we can produce rises over the years, and this is reflected in stock market prices.

So, stock market prices cannot indefinitely run away from the amount of money people have to spend. In fact, over the long term, stock market prices exactly reflect the total value of all the goods and services we produce. Over the short term, the stock market can fluctuate wildly, but over the long term, it can’t get away from the sum total of the value of our efforts.

Thursday, November 22, 2007

What Makes the Stock Market Go Up?

Over the last 100 years, the Dow Jones Industrial Average has gone from about 65 to 13,000, a factor of 200. But this is only about half of the return because it doesn't include dividends. So you can multiply this by another large factor to get the full returns. Of course stocks have had some major blips in the last 100 years, but this represents a relentless rise in stock prices. Even factoring out inflation, stocks have made an impressive long-term run. In the short term stocks rise because there are more buyers than sellers, and when demand outpaces supply, prices must go up.

Over the long term it seems like the stock market creates wealth out of nothing. Science teaches us the law of conservation of energy, we often hear that there is no free lunch, and we talk of zero-sum games, but the stock market doesn’t seem to be bound by any such law. Over the long term, almost everybody who stays in the game seems to win.

What makes stock prices rise over the long term? The short answer is innovation and hard work. The increasing number of people is a factor too, but the main driver of stock market prices is the continuous improvements in our lives due to better ways of doing things, better tools, and better toys. When a company hits the market with a better product at a lower price, the average person’s life improves a little, and this ultimately translates into more overall value in the stock market.

If you still believe in continued innovation in our society, then you should be comfortable with the long-term prospects of stocks as a whole.

See more on this in the next post.

Wednesday, November 21, 2007

More Fund Manager Arguments Against Indexing

This is the third post examining the arguments given by fund managers against leaving their funds and investing in an index.

Argument #4: Over such and such a time period active funds beat index funds.

It is true that over some periods of time, actively managed mutual funds give higher returns than index funds. When making this kind of argument, the fund manager has to select the time period carefully, because most of the time, index funds win out. Where actively managed funds tend to win is in periods where the stock market performs poorly. This is because most funds have to hold some cash (often around 10% of the money in the fund) to deal with the volatility of investors entering and leaving the fund. So over a period of time where stocks don’t do as well as interest on cash, a fund with 90% of its money in stocks and 10% in cash will beat an index fund with nearly 100% in stocks.

However, stocks have been much better long-term performers than cash. The cash component of actively managed funds is actually a factor in their long-term underperformance compared to index funds. For the investor who prefers to buffer bad times in the stock market by holding cash, a solution with lower fees than owning actively managed mutual funds is to own index funds along with some cash.

Argument #5: Some index funds do not have low costs.

This is certainly true. There are fund companies who have tried to jump on the indexing bandwagon and offer index funds, but with high costs to trap the unwary. This is a nice job if you can get it – charging high management fees without having to do much management.

This argument is like saying that medicine is bad because some people sell bad medicine. Investors in index funds just need to pay attention to management expense ratios (MERs) and avoid funds with high expenses.

In summary, I’m not against active stock picking. What I am wary of is paying a high price in the form of management expenses and other fees for the services of an active fund manager.

Tuesday, November 20, 2007

Fund Managers Argue Against Indexing

In the previous post, I started to examine some of the reasons fund managers give against leaving their funds and investing in an index. Here are a couple more.

Argument #2: Our gains are more intelligent.

Some of the arguments given by active stock pickers amount to saying that their returns are somehow better than the returns on an index fund because of some vague attribute like intelligence, precision, or global-mindedness. This raises an important question: would you rather make a 10% return intelligently or 12% mindlessly? I’m not advocating investing without thinking, but what matters ultimately to your financial future are results, not the process.

Argument #3: Some people need their hands held.

The argument here is that some people need advice, and if they try to manage their own money they might get nervous and sell at a bad time. There is a lot of truth to this. Many people do panic and sell near a market bottom when they would have been better off just holding on. However, there are two problems with this argument.

How much should people pay for this “steady hand”? If you have $200,000 invested in mutual funds with an average management expense ratio (MER) of 1.5%, then you are paying $3000 every year to have your hand held. You might consider finding some cheaper way to avoid getting panicky and making poor decisions.

Just because you are invested in actively managed mutual funds does not mean that you automatically have someone there to stop you from making rash decisions. Many people own mutual funds in a self-directed account and are able to trade in an out of funds without the benefit of a friendly expert to calm their nerves. Fund managers may try to hold on to stocks that have dropped in price, but some of the fund’s investors will sell out of the fund forcing the manager to raise cash by selling stocks.

I will continue with more of these arguments used against indexing in the next post.

Monday, November 19, 2007

Fund Managers Running Scared

The investing strategy of indexing is a major threat to the mutual fund industry. (See some of my previous posts for an explanation of indexing, examples, and how to get into an index.) When you put your money in a low cost index fund, you are no longer paying the high fees charged by actively managed funds. Each investor with $100,000 in a mutual fund with a Management Expense Ratio (MER) of 1% pays $1000 per year in fees. Up that to the $500,000 you’re hoping to have one day and a 2% MER, and the fees are $10,000 per year. It is no wonder that the managers of these high cost funds are highly motivated to fight against indexing.

Try typing “the case against index funds” into Google. You’ll get plenty of hits. The most amusing hit I saw was called “How to Market Against Index Funds.” At least the title makes the motivation very clear. I read through several of the articles I found while keeping an open mind about the possibility of learning about some real problems with indexing. After all, nothing is completely good or completely bad. In the rest of this post and some following posts, I will go through the main points in the case against indexing and give my thoughts.

Argument #1: Some index funds aren’t very diversified.

This is true to a point. For example the Vanguard Energy ETF is an exchange-traded fund that tracks an index of energy stocks. This fund is for investors who like energy stocks, not for those looking for diversification. The implication of this criticism is that all index funds lack diversification, and that you need an active portfolio manager to be safe from having all your eggs in one basket. This is simply not true.

S&P 500 index funds invest in 500 of the biggest U.S. companies. If you are concerned owning only large companies, then there is the Vanguard Total Market ETF that holds 1200 of the largest U.S. companies plus a representative sample of the remaining stocks. If you are concerned with owning only U.S. companies, then there are international index funds. Some of your money could go into low cost bond funds as well, or you could buy a bond directly. There is no reason to pay high management fees to get diversification.

In the coming posts, I’ll look at some of the other arguments against indexing.

Friday, November 16, 2007

A Third Investing Pitfall: Overconfidence

So you’ve been investing for a while, know some buzz-words, and now you’re a financial whiz. It’s time to start trading in and out of speculative stocks and stock options to make big money.

Hold it right there! This could be a disaster. You could lose most of your money very quickly. There is nothing wrong with investing in individual stocks if you are truly knowledgeable and willing to put in the time to follow the companies you own. Following a stock price is not the same as following the company. If you own an individual stock you should have an informed opinion about the company’s prospects and whether the current stock price is high or low relative to those prospects. This is not true of the average investor. Be wary of overconfidence. You may be better off sticking with the unexciting and low-action index fund strategy.

Overconfidence can creep in slowly. It might begin with thinking that you can predict a period of dropping stock market prices, and so you sell some of your index fund and put it in a bond with the plan to switch back later. It is true that there are some people who do this successfully. Some of these people might actually be skilled rather than just lucky. However, there is strong evidence that most investors do not make good market-timing choices, and the result is higher trading costs and poorer investment performance than if they had just left things alone.

If you can avoid the potential pitfalls of taking control of your investments and buying index funds, you will get better returns than most people who invest in high cost mutual funds with financial advisors.

Thursday, November 15, 2007

Another Investing Pitfall: Losing Your Nerve

Pundits, friends, and acquaintances confidently drone on about interest rates, the balance of trade, commodity prices, and the impending doom in the stock market. History tells us that when stock prices have been falling, the negative predictions increase. There is no reason to believe that these people know any better than anyone else whether stocks will go up or down in the short term. Anyone who could actually predict where the stock market was going in the short term could easily make a fortune fast.

Some successful investors say that one of the best times to buy is when the masses agree that stocks are doomed. This barrage of negative news about the stock market leads to a common problem for nervous investors: selling when prices are low. If the stock market then rallies, these investors lose out. I’m not advocating waiting with your cash until the world seems to be crashing down and then buying in either. This kind of market timing works for few people.

If your investments are keeping you up at night, it could mean that you are listening to too many predictors of doom, or that you have too much of your money in stocks rather than bonds. As long as you don’t need the money for a few years, there is no reason to be nervous about short-term market fluctuations.

For another investing pitfall, see the next post.

Wednesday, November 14, 2007

Investing Pitfall: Quick Decisions

The idea of indexing is to put money that you won’t need soon into one or more low cost index funds for a long time. There are pitfalls with handling your own investments that might cause you to deviate from your strategy. One such pitfall is making quick decisions about your investments.

It is very easy to place stock market trades with a web browser. While connected to your broker’s web site to look at your investments, the trade button is sitting right there on the screen. In a moment of weakness, you might make some trades you later regret. Fortunately, North American markets are only open from 9:30 am to 4:00 pm eastern time, and not too many people are making trades after a beer or two.

When you pay the fees to work with a financial advisor, the advisor usually has to be contacted to make investment changes. One of the good things that most financial advisors do is to talk people out of doing anything rash.

In the coming posts, I will discuss other potential pitfalls of striking out on your own to invest.

Bonus: A Question About Index Funds and ETFs

In a comment a reader asked “I have some index funds, but now I'm wondering about ETFs; when would they be preferable to index funds?”

An Exchange-Traded Fund (ETF) is a fund whose units trade like stocks on the stock market. You can place an order to buy them the same way that you would buy shares of Microsoft. The fact that a fund is exchange-traded does not tell you anything about the type of investments held by the fund. There are index ETFs, actively-managed stock fund ETFs, bond ETFs, and so on.

An index fund is a fund that invests in the stocks that make up a particular index, such as the S&P 500 in the U.S. or the S&P TSX in Canada. Index funds require little management because they just hold the stocks in the index rather than actively buying and selling stocks. Some index funds are ETFs and some are not.

How well an index fund matches its index is more important than whether it is an ETF or not. The main cause of index funds underperforming the index they are trying to match is the Management Expense Ratio (MER). If two funds both mirror the S&P 500, the one with the lower MER is preferable (all else being equal), regardless of whether they are ETFs or not.

Tuesday, November 13, 2007

How Can an Investor Get Into Index Funds?

To those who have opened a self-directed brokerage account and have bought and sold stocks, this might seem like a trivial question. However, this whole business can be quite bewildering to the uninitiated. To start with, you need to choose a broker. I won’t recommend any particular broker, but the following surveys may help.

U.S. Brokers. In a survey by SmartMoney, the top brokers in the premium category were E*Trade, Fidelity, and Charles Schwab. The top brokers in the discount category were TradeKing, Scottrade, and Firstrade.

Canadian Brokers. In a survey by the Globe and Mail, the top Canadian online brokers were Qtrade Investor, E*Trade Canada, TD Waterhouse, and BMO Investorline.

Opening an account. After choosing a broker, follow the instructions on the broker’s web site for opening an account. This process is similar to opening a regular bank account except that the brokerage account can hold stocks, bonds, and mutual funds in addition to cash. There are several types of brokerage accounts, and the main choice is whether or not the account is tax-sheltered for retirement (IRA in the U.S. and RRSP in Canada). For non-retirement accounts, you can choose a cash account or a margin account. The difference here is that margin accounts permit the risky practice of borrowing money to invest.

Buying the index fund units. Once the account is open and full of cash, you need to decide what fraction of your portfolio that you want in index funds, bonds, and possibly other investments. For the index fund portion, choose one or more of the many available index funds. Two that I discussed in my last post were Vanguard Total Stock Market (U.S., ticker VTI) and iShares Canadian Large Cap 60 Index (Canada, ticker XIU). When placing buy or sell orders, the ticker symbol is used to identify what you are trading. I chose these two funds as examples because they are large, popular, and have low fees; I have no financial interest in these fund companies.

For the average person, an advantage of indexing is that there is no need to follow individual stocks. You are betting on the continued success of the companies making up the index, which is an entire country in the case of the two example index funds discussed above.

In the next post, I will discuss some of the potential pitfalls of going it alone that must be avoided to be a successful investor.

Monday, November 12, 2007

Index Fund Examples

Low-cost index funds are a great way to own a very broad range of stocks without paying high fees. Of the many index funds to choose from, two are described in the table below. If some of the table entries don’t mean much to you, don’t worry because I’ll explain them.

CountryU.S.Canada
Fund Name

Vanguard Total Stock Market

iShares Canadian Large Cap 60 Index
Stock TickerVTIXIU
Description 1200 largest U.S. public companies60 of the largest Canadian companies
MER0.07%0.17%
MER251.7%4.2%


These two mutual funds are called Exchange-Traded Funds (ETFs) meaning that they can be bought and sold like stocks in the stock market. Other mutual funds are bought directly from the mutual fund company or through an intermediary like a financial advisor who deals with the fund company. The stock ticker listed in the table above is the symbol that is used to identify the stock (or ETF) when making a buy or sell order.

Low MER

An important attribute of these funds is that they have very low Management Expense Ratios (MERs). Calculating the expense ratio over 25 years, which I abbreviate MER25 in the table, gives a better idea of how low the fees are with these funds. A typical mutual fund in the U.S. might have an MER of 1%. After 25 years, this eats up 22% of your money, but the Vanguard Total Stock Market Fund only takes 1.7% of your money after 25 years. A typical Canadian fund is closer to a 2% MER, which corresponds to a 40% MER25, compared to only 4.2% after 25 years with the iShares Canadian Large Cap 60 Index Fund.

If you haven’t heard of these mutual funds before, it might be because your financial advisor makes his money from commissions, and these funds don’t pay any commissions. Beware of funds that are called index funds, but charge high commissions anyway. By definition, index funds don’t require a manager who makes decisions about which stocks to buy, and charging high management expenses cannot be justified.

Low Taxes

There are experts who decide which companies belong in a given index, and these experts make infrequent changes as necessary. A low rate of change means that the fund does not often buy or sell stocks. This is important for investments that are not tax-sheltered in an IRA (U.S.) or an RRSP (Canada). Less change means lower capital gains taxes that investors have to pay each year that they own the fund. However, these index funds are fine for tax-sheltered accounts as well.

In the next post, I will discuss how to go about investing in index funds for those who have not worked without a financial advisor.

Friday, November 9, 2007

Alternative to High Fees: Indexing

I have been talking about the dangers and high costs of investing in typical mutual funds, which is useful to a point, but you may ask “well then, what should I do with my savings?” Of course, this is a question that everyone has to answer for themselves, but one possibility to consider is a strategy called indexing.

An index is a measure of prices among a particular set of stocks. For example, the Dow Jones Industrial Average (DJIA) measures stock prices of 30 of the largest public companies in the U.S. When you hear that “the Dow is up 100 points today,” the commentator is referring to the index of these 30 stocks. Other familiar indexes in the U.S. are the Nasdaq and the S&P 500. In Canada, the main index is the S&P TSX, often abbreviated as the TSX. Each of these indexes is reported as a number that gives us a sense of whether stock prices have gone up or down. If an index goes from 10,000 to 10,100 one day, then stock prices have risen by an average of 1%.

The investment strategy of indexing means owning all the stocks in a particular index. In the case of the S&P 500, this would mean owning shares in each of the 500 large U.S. companies that make up this index. Without some help, the average small investor could not do this. Starting with $50,000, it would be crazy to try to buy an average of $100 worth of 500 different stocks. Fortunately, there are mutual funds available to help with indexing.

The main advantage of indexing is that there are index funds with extremely low Management Expense Ratios (MERs). In the coming posts, I’ll have more to say about indexing including some examples of index funds and how we can go about investing in them.

Thursday, November 8, 2007

Mutual Fund Scandal

This will be the last discussion of the ugly side of mutual funds for a while. After this post I will be talking about an alternative to the standard mutual fund.

I have always liked Will Rogers’ advice about investing:

“Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.”

There is a slight temporal problem with this strategy, but it is clear that if you could look into the future, investing would be easy. Another way to look at this quote is that you should wait until a stock goes up and then buy it at the old price. But who would be foolish enough to let you do this?

Late Trading

Back in 2003 there was a big scandal where some mutual funds allowed their preferred clients to do what is called late trading. Generally, mutual funds set the day’s price of their units when the stock market closes (4:00 pm eastern) and any trades (buying or selling of mutual fund units) during the day are executed at this price. If a trade order comes in after 4:00 pm, it is supposed to be delayed until the next day’s price. However, some funds were permitting preferred clients to make trades after 4:00 pm and still get that day’s price.

Now this may not seem like a big deal, but let’s dig a little further. Many companies wait until the stock market closes to make big announcements about events that will affect their stock to give everyone a chance to digest the news before any trading begins again. Each trade of stock has a buyer and a seller, and if the company made a positive announcement during the day, someone who heard the news first could buy some stock at a low price from someone who hadn’t heard the news. Overall, the markets run more smoothly and fairly if everyone has a chance to hear the news before trading begins.

Suppose that a mutual fund holds a lot of stock in a company that makes an announcement of unexpected good news. This will cause the mutual fund’s units to rise in value. A late-trading investor places an order at 4:20 to buy mutual fund units at the 4:00 price, and then sells these units the next day. So, the late trader puts a sum of money into the fund one day and takes out more money the next day with very little risk. The profit he makes comes directly out of the assets held by the mutual fund. All of the other investors share a loss exactly corresponding to the late trader’s profit.

Eliot Spitzer summed things up nicely: “Allowing late trading is like allowing betting on a horse race after the horses have crossed the finish line.”

To the best of my knowledge, this particular problem has been eliminated. But the fact that it happened at all illustrates that at least some mutual funds are clearly not being run for the benefit of the investors, as is required by law.

Wednesday, November 7, 2007

A Mutual Fund Too Successful to Succeed?

Suppose that you have found a mutual fund called XYZ with a good track record of strong returns and an honest manager who has not closed and renamed losing funds and has not incubated funds as discussed in my last post. Hurray!

XYZ fund manages $50 million making it small by mutual fund standards. The fund manager is very skilled at investing in small companies that are about to grow big. So, you switch out of your current mutual fund and switch into XYZ. This is going to be good!

The herd is with you.

It turns out that you weren’t the only person with this idea. Literally thousands of other people pile into XYZ chasing those high returns. Assets under management at XYZ swell to $2 billion, a 40-fold increase.

This is great for the fund’s managers; they will collect 40 times the management fees. But, what are they going to do with all that investor money? XYZ fund was successful at finding a handful of small companies that give big returns. These companies aren’t big enough to buy 40 times as much stock in each one. The fund managers worked hard to find 20 good investments, and suddenly they need at least 100 more investments, fast!

Something has to give.

XYZ’s managers quickly find several more small companies along with some larger ones and invest the whole $2 billion. However, these hasty investments turn out to be nowhere near the quality of their picks back when XYZ was small, and a year later, the returns are very disappointing. XYZ has turned into just another mediocre fund. You got into this fund too late to make any money.

This illustrates the danger of chasing high-returning funds – you get mediocre returns and keep paying fees and possibly loads for switching in and out of funds frequently.

Tuesday, November 6, 2007

Mutual Fund Mantra: Focus on Long-Term Returns

My last post discussed how mutual fund managers close, rename, and merge mutual funds with a history of low returns to hide their poor record. To counter this, investors are advised to choose funds with a long history of good returns. Typical advice is to focus on 10-year returns.

Investors do tend to choose funds with a history of high returns. However, they often focus on just the past 1 or 3 years of returns, rather than looking at longer periods. Not surprisingly, mutual fund managers are aware of this.

Because mutual fund managers are paid a percentage of their fund’s assets each year, they are motivated to attract as many investors as possible to the fund to drive up its total assets under management. This has led to an interesting practice among some mutual fund companies to drive up reported returns.

Incubation

Some companies start up several mutual funds with small amounts of private money and run them aggressively. After a while, the poor performers are closed and the strong performers are ready to be advertised to the public. This process is called incubation.

The returns on these incubated funds look great initially, and they attract a lot of investor money. Of course, once the managers have to invest a big pot of new money without the benefit of quietly closing losing investments, the returns tend to be just mediocre.

Incubating funds to get high reported returns is a bit like holding a lit match under a thermometer to warm a room. The thermometer will report a nice high temperature, but the room will be just as cold.

If the management company keeps an incubated fund open to the public after the first year or so, the returns during the incubation period can be dramatic enough to unrealistically influence even the fund’s 5 and 10-year returns.

I have no idea how to find out if a particular fund has inflated its reported returns with incubation. This makes it hard to put much faith in any mutual fund tables full of investment returns.

Monday, November 5, 2007

Why did My Mutual Fund Change its Name?

I used to hold mutual funds in an employee savings plan. The first time that one of the funds I held changed its name, I was puzzled. Was I switched to a different fund? Why was this done?

I asked the representative of the firm that managed our savings plan about this. He said I shouldn’t worry because the name change was inconsequential, and this seemed to be true. The number of units I held and their approximate value didn’t change. What was the point of all this?

After comparing my last two statements, I did find one seemingly small difference. The part of my most recent statement with the 1-year and 5-year performance of my fund was blank. The previous statement listed these returns for the old fund name, and the returns weren’t very good compared to other mutual funds.

Erasing History

The purpose of the name change was to erase an unpleasant history and start over. Because of this little trick, mutual fund lists are purged of their poorest performers. There are definitely funds that do badly, but their records go away after a while.

This leads to what is called survivorship bias. If you calculate the average 5-year return of all mutual funds, you will get a percentage that is higher than the real returns seen by investors, because the bad returns are missing from the average. I guess my investing performance would look a lot better too if I could eliminate all my bad investments.

So, if your mutual fund changes its name, odds are that you’ve lost some money. Erasing the history of this loss will help you forget about it, but the money will still be gone.

Friday, November 2, 2007

Common Investment Traps: Borrowing to Invest

The second financial advisor I actually invested money with was a pleasant woman who used to work at my bank branch handling my mortgage and had moved out on her own. I won’t use her real name; let’s call her Gina.

Initially, my wife and I each invested a small sum with Gina in some mutual funds. We were contemplating moving the rest of our investments over from our first financial advisor, but Gina had an idea for something even bigger.

The Pitch

Based on our income and lack of debt, Gina said that we should be borrowing a large sum of money and investing it. Interest rates were low, and when it came to taxes the interest could be deducted from the big gains we were sure to make on our investments. At the end of 5 years, we would have big profits with “no money down”.

Gina worked on us for quite a while with this pitch. Fortunately, the borrowing made us nervous, and we decided not to go for it. This all took place just before the high-tech bubble burst. We would have lost a lot of money and would have been left paying off a large debt for some time.

Although Gina was surely aware that she was recommending something that would make her a lot of money, I think she believed she was helping us. The training Gina received as a financial advisor with her firm told her that borrowing was the right thing for a couple in our situation. I don’t think she knew any better.

Common Tactic

My wife and I are not alone in getting this pitch. Members of my extended family as well as friends have been hit with higher pressure versions of this “borrow big to invest” strategy from financial advisors. This appears to be a common tactic that financial advisors (or the firms who train them) use to increase mutual fund sales.

Borrowing large amounts of money to invest is called using leverage and is an advanced and risky investing strategy. This does not mean that it is always the wrong thing to do, but if you need a financial advisor to show you how to invest, then it is likely that borrowing to invest is not for you.

This is part 3 of 3 parts. Back to part 1.