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.