Wednesday, December 31, 2008

Countdown to the New Year

From an investment point of view, most of us say good riddance to 2008. The economy for 2009 is shaping up to have a rocky start, but I’m optimistic that stocks will rebound at some point. Don’t take that as a prediction, though. I don’t want to be just another commentator whose predictions are wrong half the time.

Tuesday, December 30, 2008

The Snowball – Warren Buffett Biography

For anyone fascinated by Warren Buffett and his extraordinary investing career, Alice Schroeder’s The Snowball: Warren Buffett and the Business of Life is a must read. At over 800 pages, it adds much detail to the scattering of facts that most people have about Buffett’s life.

Any attempt to summarize this book in a few paragraphs would be hopelessly superficial: he was young, then middle aged, and then old. So, I’ll focus on one aspect: the perception that he is a simple folksy person who doesn’t know much about newfangled things like computers and the internet.

In some ways this perception is accurate. He does tend to live simply, except for flying around in private jets to meet the rich and famous. He also has the ability to explain things simply and briefly. However, the work he puts into his investing is neither simple nor brief.

He has spent most of his life consuming and analyzing financial data. He is well-known for avoiding technology stocks. He explains that he doesn’t understand them and has to stay within his circle of competence. I think that many people misunderstand this explanation.

Given the time that Buffett puts into his investing work, it is inconceivable that he hasn’t examined technology companies. It may not be a big fraction of his time, but the total amount of analysis would be considered high for other people. It’s not so much that Buffett can’t understand what these companies do; it’s more that he can’t understand why any of these companies have any durable competitive advantage.

Maybe the reason he can’t understand this is because none of these companies really has a durable competitive advantage. It seems very likely that Coke will continue to earn profits for the next 20 years. But how confident can we be that the same will be true of Microsoft, Intel, IBM, Google, or any other technology company?

I’m not saying that technology companies are necessarily bad investments. They just don’t fit Buffett’s search for a margin of safety. Although Buffett’s public remarks contribute to the impression that he is a simple guy who doesn’t understand technology, the truth is more subtle.

Monday, December 29, 2008

Mutual Funds Paint over the Rust

At the close of financial markets for 2008, mutual funds must take a snapshot of themselves and disclose it publicly. Here is a short list of the main information that they will disclose:

1. 2008 return (or loss in most cases).
2. Main investments held.
3. Comparison to a benchmark.

You might not think that there is much that mutual funds could do to paint a rosier picture, but as Jason Zweig explains in a Wall Street Journal article, mutual funds have a few ways to paint over the rust.

1. Painting the tape.

Mutual funds inflate returns by buying more shares of stocks they already own at the end of the last day of trading. The extra demand drives up the price that gets reported for the end of the year. The price usually drops back down on the first trading day of the new year so that the fund actually loses some money doing this, but it has the desired effect; the reported 2008 returns will be slightly higher.

2. Window Dressing

Who wants to find out that their mutual fund bought a bunch of bad investments? Some mutual funds sell their losing investments and buy others that performed better during 2008. This would be fine if the fund manager believes that the new investments will do better than the old ones in 2009, but that’s not the goal here. The manager wants to list investments that performed well during 2008 in the public disclosures.

3. Benchmark Hopping

The great thing about benchmarks is that there are so many to choose from. There are benchmarks of small companies, big companies, value stocks, growth stocks, bonds, and blends of all these things. The best way to make a mutual fund’s dismal return look a little better is to compare it to the worst-performing benchmark. Mutual funds are supposed to compare themselves to benchmarks that match their investing style, but as Zweig explains, a “study by finance scholar Berk Sensoy shows that 31% of U.S. stock funds pick a benchmark that doesn't closely reflect what they own.” I can’t break the world record for pole vault, but I could probably pole vault over the record high jump bar.

Not all mutual funds do these things, but many have in the past. It’s hard to understand why anyone would knowingly invest in funds that use these tactics.

Friday, December 26, 2008

Short Takes: Real Estate, Ponzi Schemes, and Geniuses

The blogs were fairly quiet this week, but there were a few interesting posts:

1. Million Dollar Journey had a guest post by Julie Broad busting myths about investing in real estate. This is one of the more sensible articles about real estate investing that I’ve read.

2. Larry MacDonald examined Bernard Madoff’s $50 billion Ponzi scheme and noted that given how little information Warren Buffett gave his early investing partners, they could not have known whether he was running a Ponzi scheme. It seems that judging a money manager’s honesty is as important as judging his competence.

3. Canadian Financial DIY found a web site that tries to measure the reading level required to understand a given blog. He had mixed feelings about his blog being judged to require a genius reading level. My blog got the same rating, and I have the same mixed feelings. I’d like to think that my readers are all geniuses, but I doubt that you have to be a genius to understand what I have to say.

Thursday, December 25, 2008

Profiting From the Rapture

If you have a sense of humour about religion, you might want to check out Armageddon Cable News by the authors of the book How to Profit from the Coming Rapture. Apparently it’s possible to plan for being left behind at the rapture.

Merry Christmas!

Wednesday, December 24, 2008

Scott Adams Talks Finance

I’ve been a fan of Scott Adams’ Dilbert cartoons for many years. I spent most of my career in a small cubicle lined with cloth, and his cartoons captured the essence of my work-related frustrations and fears with humour. Many of his cartoon-based comments on financial crises over the years have been right on the mark. However, Adams’ latest blog post misses the mark by a wide margin.

To be fair, Adams doesn’t always believe the things he says on his blog. He likes to throw out half-baked ideas and stir the pot. Consider my pot to be stirred.

Here is the essence of Adams’ argument about stocks:

1. People aren’t smart enough to pick their own stocks.

2. People should be limited to investing in indexes or special regulated funds run by experts. He also wants stock prices to be set by “some sort of regulating board.”

To borrow from a well-known quote about democracy, capitalism is the worst way to run an economy except for all the other ways. One of the core benefits of democracy and capitalism is the lack of concentration of power. Capitalism works well until one market participant begins to dominate and has to be regulated. Unfortunately, Adams is suggesting that we round up much of the spread out power of our capitalist system and concentrate it in official funds and regulating boards. This is a bad idea. Power corrupts.

I agree with Adams that most people would be better off investing in index funds rather than buying individual stocks. But, I think it is crucial that people retain the choice to invest as they please.

One sign of a reasonable person who argues fairly is that he considers arguments against his position. Adams definitely passes this test by raising the Warren Buffett argument. Buffett has been a spectacularly successful investor, and wouldn’t it be unfair to prevent the next Buffett who comes along from succeeding in the same way?

Adams counters this argument with two points:

1. “Warren Buffett buys companies, not stocks.”

2. “If every investor picked stocks entirely randomly, you would still produce a good number of Warren Buffetts entirely by chance.”

Adams is wrong on both points. Buffet’s most successful investing years happened early on before he had enough capital to buy entire businesses. He bought stocks.

If we stopped Buffett’s career early on, we could reasonably say that a few investors would be expected to have results as good as his by chance. However, Buffett continued to outperform for decades. The probability that any one person would succeed as Buffett has by random chance is far less than one in a billion. Buffett has proven that he is the real deal and not some monkey throwing darts at a stock page.

Tuesday, December 23, 2008

Bell Comes Through

I haven’t had much luck with Bell’s customer service until recently. I’ve had some crazy battles with Bell including being made to pay the same bill twice many years ago and a more recent running battle to get their internet service to work. A problem with my telephone sent me back to Bell’s customer service.

It all started Friday when I started getting calls where the caller would hang up after one ring. My first thought that some kid was just having fun proved wrong when a friend sent an email asking what was wrong with my phone. It turned out that callers got one ring followed by static. My strategy at this point was to “hope the problem goes away.” By Sunday, it was clear that I would have to try another solution.

Ever since Bell “gave” every customer the wiring inside their homes, we have to pay for any repairs. I had visions of having a Bell technician in to mess with the wiring for $100 and not fix the problem. This is what happened the last time a Bell technician came to “fix” my internet connection.

After some Google searches, I learnt that there is a demarcation point on the side of my house that separates the Bell side from my side. I decided that I wanted to know whether the problem was mine or Bell’s before calling them.

I cut open one of my many spare phone wires, did a little soldering, and added some alligator clips to rig up a phone that could be attached to bare wires. Then I disconnected the Bell cable coming to the demarcation point and connected my rigged up phone directly to the Bell cable. At this point, my whole house was disconnected from Bell.

I then phoned my home number from a cell phone and the call went to static after one ring. So it was clear that the problem was on the Bell side and not in my house. Whew.

Next was the dreaded call to Bell’s customer service. I was prepared for a long wait, but was connected to an actual human in less than 15 minutes. Maybe my expectations were too low, but this was better than I had hoped.

A friendly guy with an Indian accent took the information from me including the details of my test at the demarcation point. I certainly wasn’t expecting the person answering the phone to understand anything technical, but he seemed quite knowledgeable.

An hour or so later (on a Sunday!) an actual technician called to say he was coming over. He trudged through the snow to the demarcation point and quickly established that there was a problem with the Bell cable coming to my house.

After an hour or so of trudging around to my neighbours’ houses and driving back and forth to the other end of the cables for our area, he found a spare line that we could use until things get sorted out in the spring. Now I have a cable running across the snow between houses, and my telephone line has never been this clear. I’m guessing that the old cable has had problems since the day I bought my house 15 years ago.

So, thank you to Bell and in particular to technician Todd who worked bare handed while it snowed at 15 degrees below freezing. I’m sure he appreciated the hot pack I gave him to hold while he explained the work he had done before running off to his next job.

Monday, December 22, 2008

New Credit Card Issuer Rules in the US

The US Office of Thrift Supervision has developed new rules to put a stop to some nasty practices of credit card issuers. The fact sheet they put out describes the major changes. This is good news not only for consumers but also for the credit card issuers who were already following these rules because their competition will be forced to play on a more level playing field.

Most of the new rules are self-explanatory. Interest rate increases must take place at defined times with adequate notice for card holders. Consumers must be given at least 21 days to make a payment.

A fairly substantial change is the rule ending double-cycle billing where the average balance over two months is used to calculate interest. This practice causes interest to continue for another month after you pay your bill in full. Now interest will be based on just the current month.

The last new rule places restrictions on predatory high-fee subprime cards. These are high-fee, low-limit credit cards given to people who are poor credit risks. In some cases the fees chew up most of the consumer’s borrowing limit right away. The new rule says that if fees exceed 25% of the available credit limit, then they have to be spread out over at least 6 months.

Friday, December 19, 2008

Short Takes: TSX Glitch, Newlyweds, and Mutual Fund Redemptions

1. A technical glitch kept the TSX closed on Wednesday. This is a big deal for those who make money from stock trading, but it shouldn’t matter much to investors who aren’t hyperactive. I’d be happy if stock markets were only open one day per week.

2. Larry MacDonald takes the Canadian Real Estate Association and the media that reports their figures to task for misleading the public about movements in house prices.

3. Moneygardener has a newlywed guest writer figuring out how to merge finances with a new spouse.

4. Million Dollar Journey turns the advice to spend less than you earn on its head and suggests that you could try to earn more than you spend.

5. The Big Cajun Man wonders whether assets under management in mutual funds have dropped more due to investor redemptions or dropping stock prices.

Thursday, December 18, 2008

DIY Isn’t All or Nothing

There are many times when you have to choose whether to “do it yourself” (DIY) or hire someone to do a job. This choice comes up with house repairs, investing, landscaping, to name a few instances. We tend to think of the choice as binary: either DIY or hire someone. However, there is a middle ground.

Let me use an example to illustrate my middle ground approach. I have a large natural gas pool heater that became flaky after about two years. I have no training with these heaters and had little choice but to call a repair person.

It turns out that fixing natural gas heaters is specialized work and calling in the repair person wasn’t cheap. I always had to pay for some minimum time plus the cost of some expensive part that had to be replaced. The repair person would get the heater working, but the flakiness never went away.

During the fourth service call in two years I did my usual thing of watching the repair guy and asking questions. This guy happened to mention that the controls on my model of heater had a tendency to get corroded. In addition to charging me for some part that didn’t really need replacing, the repair guy jiggled some connectors. The heater worked fine for two years after that.

So, I paid over $1000 in repair bills before I finally learnt that the problem had been flaky connections the whole time. Ever since then I routinely undo a few screws, pull off the connectors and reconnect them. All the flakiness is gone.

What has all this got to do with a middle ground between DIY and hiring an expert? Even when you pay an expert, you should learn something about the work being done. This will make you a more informed user of the expert’s service and may allow you to do it yourself the next time if you choose.

Experts I hire differ in how they deal with having me pepper them with questions. Some like it and some don’t, but I do it anyway. I prefer to learn a little. I don’t like to be the one paying experts for something I can easily handle myself. When it’s not so easy to do myself, I keep hiring the experts.

Wednesday, December 17, 2008

Buffett’s Market Timing

Alice Schroeder’s fascinating biography The Snowball: Warren Buffet and the Business of Life makes it clear that Buffett engages in market timing in the sense that he varies his allocation to stocks over time. If he does it, why shouldn’t we?

Of course, Buffett’s market timing is different from the investor who makes short-term bets on whether stocks will go up or down. Buffett looks for attractively-priced stocks, and during some time periods he finds them and sometimes he doesn’t. This is still a form of market timing, though.

It’s easy to show that market timers as a whole must make less money than buy-and-hold investors, on average. It’s simple mathematics that the extra trading costs along with investing in inferior asset classes like cash and bonds must hurt the average market timer’s returns. This doesn’t mean that all of them lose to the market averages, though. Buffett is a remarkable example of someone who has beaten the odds so convincingly that he must have talent that almost all of the rest of us lack.

In some ways the situation is similar to playing poker. Because the house takes a slice of every pot, it is simple mathematics that the average poker player must lose money. But, this doesn’t mean that all poker players lose money. The big poker stars seem to win reliably enough that they have skills that most of us don’t have.

So, if you’re going to play poker or try to beat the stock market averages through some form of market timing, you should convince yourself that you’re not just above average, but well above average. But be warned that the majority of people who convince themselves that they are well above average will be wrong.

Tuesday, December 16, 2008

Rogers Cable Makes Me an Offer

My family uses Rogers Cable for TV and internet, but we still use Bell for our telephone. Both companies work hard to get us to bundle all three services together. I’ve discussed the offers from Bell here and here, and now it’s Rogers’ turn.

The mailing we received from Rogers isn’t just a generic mailing; it is addressed to us and contains specific details of which services we already pay for. Apparently, we can bundle Rogers telephone service in with everything else for $149/month, “all monthly service fees included.”

This is only $5.27/month more than we pay right now which makes it seem like a great deal. There must be a catch, right? After reading further it turns out that there is more than one catch.

I’m guessing that the $149 figure doesn’t include sales taxes. This makes the added cost of phone service close to $20/month. The list of services we currently have seems to be missing a service that costs close to $20, and so we’re up to about $40/month extra for the phone service. This is still a savings over what we’re paying Bell, but I have little confidence that $40 is actually the final figure.

Maybe if I spent the time to check on all these details, I’d find that I really can save some money switching to Rogers phone service. And maybe if I chase rainbows, I’d find a pot of gold. If anyone has investigated these offers more carefully, I’m interested in hearing about it.

Monday, December 15, 2008

BCE Share Buyback

With the BCE takeover officially dead, BCE has announced that they will resume their dividend and start buying back shares. Just about everyone knows what a dividend is, but many investors may not understand what it means to buy back shares. After all, what sense does it make for a company to buy itself?

For the uninitiated, it may be disturbing to learn that the number of shares in a company does not remain constant. Many companies issue new shares over time, and this dilutes each shareholder’s ownership in the company.

There are many reasons why a company would issue new shares and they all have to do with paying for something. Stock options, when exercised, usually cause the company to issue new shares. A company might choose to raise money by making a secondary offering of new shares to the public. Corporate takeovers of other companies are often financed by issuing new shares.

All of these things dilute the ownership of existing shareholders. Is this a bad thing? Well, that depends on what the company gets in return for the shares. If they get more value than they give up, then this dilution actually helps shareholders. Otherwise, it hurts them.

It’s also possible for the number of outstanding shares to shrink. When a company thinks that its shares are undervalued, it can help its shareholders by buying its own shares on the open market and retiring them. So, if BCE buys back 5% of its outstanding shares, shareholders who hold on to their shares will see their fraction of ownership of BCE rise by about 5%.

Is this a good thing? Again the answer comes down to whether the company gives up more than it gets. If the shares truly are undervalued, then this helps the shareholders who keep their shares. Otherwise, it hurts them.

Let’s illustrate this with the traditional lemonade stand example. Suppose that there are 100 shares in a lemonade stand that has $500 in cash and expects $1500 in future profits. Then each share is worth $20. Suppose that some shareholders are pessimistic about future earnings and are willing to part with their shares for $10.

If the lemonade stand uses the $500 cash to buy back 50 shares and retire them, then there will be only 50 shares remaining to divide up the $1500 in future earnings. So, shareholders who don’t sell get to watch their shares rise in value from $20 to $30 each.

But what if the weather is about to turn bad and future earning are destined to be only $100? Before buying back shares, the business had $500 plus $100 in future earnings, or $6 per share. After the buyback there are only 50 shares to divide up the $100 of future earnings, or $2 per share. So, we see that whether a stock buyback is good or bad depends on whether the stock is under- or over-valued.

Friday, December 12, 2008

Short Takes: Corruption, House Prices, and Tax Evasion

1. The state of Illinois will stop doing business with the Bank of America. Governor Blagojevich is upset that the bank received $25 billion of taxpayer money in a bailout, but refuses to restore credit to a Chicago business. Is it possible that this type of political interference had something to do with the bad loans that caused the credit crisis? Amusingly, a couple of days later Blagojevich was arrested for a “political corruption crime spree” that included trying to sell Obama’s recently vacated Senate seat. Then he decided to ignore Obama’s call for his resignation. Sounds like a soap opera.

2. Larry MacDonald kicks the tires on a new way to measure house prices that promises to be more accurate than the old method of just averaging recent sale prices.

3. Million Dollar Journey discusses an important lesson in real frugality. For items you need for the long-term it’s important to focus on dollars per unit of time rather than just one-time cost.

4. MoneyGardener has some interesting graphs that show a strong correlation between oil prices and the value of the Canadian dollar.

5. Jonathan Chevreau reports that electronic sales suppression software is available for sale (the web page with this article has disappeared since the time of writing). This software helps businesses cheat on their taxes by eliminating records of a fraction of point-of-sale transactions. CRA’s strategy to catch those who sell this software seems to be to get honest businesses that are approached to contact law enforcement.

6. The Big Cajun Man discusses the perfect storm of snowfall and a transit strike causing major traffic snarls. He’s happy that at least gas prices are low, but that contributes to the traffic problem.

Thursday, December 11, 2008

The Stock Market and the Economy Aren’t the Same Thing

It may seem obvious when you think about it, but the stock market and the economy aren’t exactly the same thing. Some commentators seem to confuse the two. There is no doubt that they are related to each other, but they don’t always move in the same direction.

The stock market reflects the going price for businesses that are at least partially owned by the public. The economy includes these businesses plus privately-owned businesses, bond markets, currency markets, governments, jobs, etc.

Stock prices are a consensus view of the expected future profitability of public businesses. This makes the stock market forward-looking. Sometimes the crystal ball is cloudy and stock market participants get it wrong, but stock price movements tend to precede changes in the economy.

We have seen this lately in media stories. As stock prices dropped, we heard story after story of gloom and doom about the stock market. This has largely given way now to gloom and doom about the economy. Apparently we’re all going to lose our jobs and have to start flipping burgers for a meagre living. Unfortunately, this really will happen to some of us.

If past patterns repeat, we can expect stock prices to rise before we pull out of recession. But don’t take this as a prediction from me. Short-term stock market movements have a way of surprising us.

Wednesday, December 10, 2008

Joint or Separate Bank Accounts?

My wife and I have always maintained separate bank accounts. It never really occurred to us to do all of our banking with joint accounts. I’ve often wondered what it says about a couple when they make one choice or the other.

It’s not that I have my money and my wife has hers. Since we were married it’s all been our money. If I happen to be short on cash, she’ll just give me $100 from her wallet without keeping track. If her bank account gets low for some reason, I’ll just write her a cheque.

Sharing a bank account feels sort of like sharing a toothbrush to me. It can be done, but you’d have to be in quite a romantic mood to think that sharing a toothbrush is a good idea. It just seems like a pointless hassle to balance a chequebook when two people are making withdrawals. Misunderstandings with joint accounts must lead to the occasional bounced cheque.

It’s possible that having separate accounts but not really keeping our money separate is only possible because we both tend to be frugal. Maybe other couples have to keep track of each other’s spending. A joint account might help with monitoring each other. Alternatively, having “her money” and “his money” is probably more easily done with separate accounts.

Perhaps getting a joint bank account shortly after getting married is a symbolic gesture of commitment like wedding rings. If you’re not sure what to do and you want to be like other people, a joint bank account seems like the right choice.

There are probably some good reasons to have joint accounts. My wife and I actually have one joint account for a technical reason to do with transferring money years ago, but I think of it as hers and never touch it. Does anyone have any thoughts in support of joint accounts?

Tuesday, December 9, 2008

Lifecycle Investing vs. Going for Broke

Experts differ on which is the best approach to investing throughout your life. Some say to maintain a fixed percentage allocation in stocks, bonds, and cash regardless of your age. Others advise a lifecycle approach where you invest heavily in stocks while you’re young and shift to bonds and cash as you get older.

Larry MacDonald reported on a recent study by researchers Basu, Byrne, and Drew titled Dynamic Lifecycle Strategies for Target Date Retirement Funds (full text of the study is available free). The title hints at a market-timing strategy which piqued my interest.

The study compares fixed allocation strategies, lifecycle approaches, and a dynamic strategy the researchers devised. It turns out that the dynamic strategy doesn’t really involve market timing in the sense of trying to anticipate bull and bear markets. The dynamic strategy begins with a target yearly compound return expectation of 10% and makes the following choice each year:

- If your compound average lifetime return so far is less than 10%, then invest 100% in stocks.

- If your lifetime return exceeds 10% per year, then use the allocation dictated by a lifecycle strategy (more stocks if young and less if old).

So, this dynamic strategy has a built-in sense of how much the investor needs at retirement. The strategy gets conservative when returns are on track, and goes for broke with all money in stocks when lifetime returns are under par.

One finding from the study is that this dynamic strategy tends to beat the lifecycle strategy. This is hardly surprising because, on average, the dynamic strategy will have more money invested in stocks over the years, and we know that stocks tend to beat bonds and cash over the long run.

One aspect of the dynamic strategy that concerns me is that if the portfolio gets behind on its target return, it stays 100% in stocks right into retirement. This tendency to go for broke assumes that if you miss your target retirement dollar figure, it doesn’t matter how much you miss it by. However, if you were hoping for $2 million, you’re still better off with $1.5 million than just $1 million.

Apart from this problem with the dynamic strategy, there is a lot to like here. For investors who are behind in the amount they have saved, it makes sense to invest more in stocks to catch up. For those whose savings are well on track to give them as much as they need, it makes sense to get more conservative, sacrificing excess returns for greater safety.

In the never-ending search for the best investment approach, I suspect that including some amount of this dynamic strategy is better than just sticking with a pure fixed allocation or a pure lifecycle strategy.

Monday, December 8, 2008

Attitudes Toward Experts

Listening to financial experts can be both good and bad. Most of what I know about money has come from one financial expert or another. On the other hand, we need to be initially skeptical of anything new some supposed expert says. Evaluate new information before accepting it.

For example, recent research suggests a link between poverty and brain function in children. The researchers believe that poverty is causing brain impairments. My first thought is that maybe some people have brain impairments which prevent them from making much money, and they pass these impairments along to their children genetically. I may be wrong about this, but I won’t accept the researchers’ theory until I see evidence, and I don’t care enough to pay $10 to see the full text of the study.

I extend this way of thinking to all experts. Some people take anything their doctor says as gospel. My thinking is that like any other field, doctors have wildly-varying skill levels, and it pays to be skeptical of their advice. This doesn’t mean that all advice should be rejected. It means that you should seek second opinions, especially when treatments don’t seem to work.

I like to tell people that “50% of all doctors finished in the bottom half of their class.” This way of thinking pushes me to find the best expert and not just any expert. Three areas where I think I’ve done particularly well are my doctor, car mechanic, and athletic therapist. In other areas, I’m still searching.

Clearly some people don’t see the world of experts as I do. A recent experience illustrates this. A friend I’ll call Jim had a nagging sports injury and wanted advice. I directed him to my athletic therapist explaining that I had seen about 15 different athletic therapists and physiotherapists over the years, and this guy was clearly the best.

I saw Jim a couple of weeks later still complaining about his injury. He said he had gone to a physiotherapist (not the guy I recommended), but it seemed to make things worse. In Jim’s mind, he had followed my advice. From my point of view, Jim ignored my advice. Jim seems to think that all therapists are interchangeable.

People who keep going back to experts who fail them seem to be showing the same attitude as Jim did. If your car needs fixing, you have to take it to some mechanic. If all mechanics are the same, then you might as well go back to the same one who messed up your car last time. But, if you believe that mechanics differ in their skills and honesty, then you’ll keep trying new mechanics until you find one you like.

Whether you’re looking for a financial advisor, or some other type of expert, it pays to put in some effort to be knowledgeable yourself and to seek multiple opinions.

Friday, December 5, 2008

Short Takes: Investing Time Horizon, Tax-Loss Selling, and Leverage

1. Some algorithm at Google thinks this blog might be spam. This is silly of course, but it’s hard to argue with binary code. By contesting this, I’m now in a penalty box where to make a post I have to solve a CAPTCHA (one of those twisted up words you type into a box to prove you’re a person). I’m on some list to be checked out by an actual person at Google. If this blog ever disappears completely, you’ll know that something went completely wrong.

2. Canadian Capitalist has an excellent guest post from ABCs of Investing explaining investment time horizon. I tend to be less conservative about my asset allocation, but the basic idea that how you invest money is determined by how long until you need it is absolutely right.

3. BluntMoney observes that it’s harder to spend money you’ve saved up. This is quite true. Found money often gets wasted quickly.

4. I had some plumbing problems this week and so did the Big Cajun Man. Fixing leaks yourself only saves money if you don’t end up calling a plumber anyway.

5. Now is the time of year to think about your capital gains and losses. FrugalTrader explains tax-loss selling.

6. A carnivals this week: Investing Carnival

Thursday, December 4, 2008

Is Half-Price Meat Safe?

My wife is quite frugal and often comes home from grocery shopping with a cut of meat sold at half price that has to be cooked within a day. We don’t seem to have had any problems eating these cuts of meat, but they leave me a little uneasy.

I presume that the reason for the price discount is that these cuts are older than the full-price cuts. Presumably this means that the odds of getting sick from eating discounted meat are higher. I’m wondering how much higher.

I’d like to say that we’ve never had a problem eating discounted meat, but it’s hard to know for sure. We don’t seem to have had any serious incidents of food poisoning, but minor bouts of stomach upset are common and hard to attribute to any particular cause.

Most likely the risk from eating discounted meat pales in comparison to the risk of driving a car. I’ll probably continue to have a flicker of uneasiness when I’m told that dinner includes half-price meat, but only a flicker, and then I’ll dive in.

Wednesday, December 3, 2008

Enbridge TAPS Program Mishap

My natural gas supplier, Enbridge, has a program in place called TAPS where they give away some hot-water pipe insulation and efficient showerheads and kitchen and bathroom faucet aerators. My savings each year are supposed to be $45 on natural gas and $113 on water. But, plumbing often doesn’t work out very well for me.

I started with the kitchen faucet. Swapping an aerator is easy, right? Unfortunately, our house is 19 years old and the parts were nicely fused. I got them apart, but a piece of the faucet broke. A consult with a plumbing expert confirmed the bad news: we needed a new faucet. Am I saving any money yet?

Two more trips to the store for another consult and more parts plus a couple of hours on my back under the sink solved the problem. I think it will take a while to recover the total cost of $115.72 with my savings on natural gas and water. I’m afraid to try to install the other parts.

This experience reminds me of the time my father-in-law got serious about saving on heating his house. He had an array of pamphlets with energy-saving ideas and he tried almost all of them. After adding up all of the savings he was supposed to get, the total exceeded his heating costs! He liked to joke that he expected to make money heating his house.

Tuesday, December 2, 2008

Root Cause of Emergency Room Wait Times

My personal experience with trips to hospital emergency rooms is that wait times have increased over the last 25 years. Numerous newspaper articles on the subject seem to indicate that the trend to longer waits exists across Canada.

My latest data point came when my son broke a finger playing basketball. He made a nice play stealing a pass and drawing a foul and was rewarded with a finger not quite pointing in the right direction. My wife and I took a deep breath at the thought of a long wait at the hospital, but we had little choice. At least only one of us would have to wait with our son. Sadly, I couldn’t find my two-headed coin when we were deciding who would stay.

The wait to see a doctor was less than I feared at just over 5 hours. However, I can recall trips to the hospital for my own injuries decades ago when I waited less than an hour to see a doctor. What has changed?

In thinking about the root cause, I see the problem at ultimately coming from government debt. The Canadian government ran deficits through the 70s, 80s, and into the 90s. Turning this around in the mid-90s required cuts in government spending.

While there may be individual people, organizations, and political parties to blame for particular aspects of our current health care problems, once the debt had been built, funding pressure on our health care system was inevitable.

Monday, December 1, 2008

Stocks Cause Psychological Pain

How bad have stocks been lately? Regardless of what the numbers say, what matters to people is how they feel about stocks. Two people can feel very differently about the same events. Here we have a couple disagreeing about stocks:

Sue: “After all this excitement in the stock market, the last two weeks have been good.”

Andy: “Are you nuts? Stocks have been brutal lately. Worrying about our savings is keeping me awake at night.”

Sue: “But I’m talking about just the last two weeks. Look at this chart.”

Andy: “That proves my point. The TSX went down below 8000. At this rate, we’ll never be able to retire.”

Sue: “But we’re up 2.4% in these two weeks. That’s good for such a short period of time.”

Andy’s reaction is more typical than Sue’s. The pink region in the chart measures Andy’s psychological pain of watching stock prices sit well below where he hoped they would be. It’s like watching your favourite sports team when they’re way down. Even if they close the gap somewhat, fans suffer psychologically while their team trails badly.

Andy isn’t wrong. After all, he knows his own feelings. But, the way he perceives the stock market may cause him to make choices that hurt his long-term returns, such as selling at a low point. The truth is that the past two weeks have been good for investors’ returns (as long as they didn’t sell), even if it made many of them ill.

Sue’s temperament is better suited to investing success. She ignores the pattern of prices during a period where she didn’t trade stocks. In a month, she won’t care what prices are like today.

Although individual stocks can fall to zero permanently, you’ll have much bigger things to worry about than money if the entire stock market goes to zero. Sue remained calm and trusted that stock prices would rebound eventually. Stocks may drop again in the short term, but it won’t be permanent.

Friday, November 28, 2008

Short Takes: BCE, Free Books, and Hazardous Waste

1. After the BCE share price plunge on news that KPMG might not approve the buyout, Larry MacDonald thinks BCE might be a good buy for the short term even if the buyout really is dead.

2. BluntMoney argues that we need to cover more than the bare minimum of expenses in our emergency funds because we will find it difficult to give up our lifestyle-related spending in a financial emergency.

3. Canadian Capitalist is celebrating his blog’s fourth birthday by giving away 10 copies of Jonathan Chevreau’s book Findependence Day. Today is the last day to enter by leaving a comment on his article.

4. Frugal Trader explains how to use a Cash Flow Dam to turn a debt with non-tax deductible interest into a debt whose interest is tax-deductible.

5. Big Cajun Man doubts that most people are willing to pay fees to dispose of hazardous waste.

6. Preet explains different ways of weighting stocks in an index with some clear examples: cap-weighting and fair-value weighting part I and part II.

7. My article on a sense of scale about money made it onto MoneyGardener’s list of must-read blog posts.

8. The blog Disciplined Approach to Investing hosted the Investing Carnival.

Thursday, November 27, 2008

Wedding Gift Registries: Efficient or Wasteful?

When I’m invited to a wedding, I usually buy the happy couple a gift from their wedding gift registry. Until recently, I just assumed that the list contained items the couple really want at prices they consider reasonable. Recent discussions with two couples cast doubt on my assumptions.

In both cases, the couples’ attitude seemed to be “we might as well put everything on the list and see if someone pays for it.” It was clear that they didn’t concern themselves much with whether they really want the items, and they certainly didn’t care about price.

In the case of one of the couples, I had a chance to continue the discussion a little further, and it became clear that the salesperson helping them create their list definitely encouraged the “put it on the list and see what happens” attitude.

It seems obvious enough that this approach is bad for both gift buyers and the couple getting married. Gift-buying guests have a limited amount of money to spend. If the registry contains expensive things that the couple don’t really want, then money gets diverted away from the things they do want.

It isn’t surprising that some couples compile their gift registries carefully and some foolishly. But which is more common? I would have bet on “carefully” before listening to these two couples. I can’t say that I’ve discussed wedding gift registries with very many people, and so these two couples represent a fairly high proportion of my very limited sample space.

I’m interested in reader experiences on this subject. It seems doubtful that anyone has collected data on the thoughtfulness of gift registry lists, but if anyone has, I’d like to hear about that too.

Wednesday, November 26, 2008

Manulife IncomePlus Reader Comments

A reader had some thoughtful comments and questions about my analysis of the Manulife IncomePlus annuity. Here are his comments (edited for brevity) followed by my thoughts.

1. You describe the worst case scenario in which an investor makes withdrawals beginning in the first year. The product is best suited to the investor who leaves cash in the investment for at least 15 years so that the guaranteed income grows at 5% per year (albeit simple rather than compounded) for that period.

An example will help here. Our investor Ida puts $400,000 into IncomePlus. In my earlier analysis of IncomePlus, I focused on the case where Ida draws a guaranteed income of 5% or $20,000 per year for the rest of her life. But, suppose that Ida is only 50 years old and doesn’t need any extra income until she is 65.

IncomePlus rules permit Ida to defer payments for 15 years and then collect a guaranteed $35,000 per year for the rest of her life. This figure came from increasing the $20,000 by 5% (not compounded) for each year Ida deferred payments.

On the surface, $35,000 per year sounds not too bad. But this ignores inflation. Even if inflation averages only 3%, Ida will only get $22,500 in today’s dollars in the year she turns 65. By age 90, this drops to $10,700. If inflation averages 5%, this is $16,800 at age 65 and less than $5000 at age 90. Pass the cat food.

If Ida lives to age 90, her guaranteed $35,000 per year amounts to a 3.03% per year return on her original $400,000 investment. If she dies younger than this, her return is even worse. This investment has all the inflation risk of a long-term government bond, but with lower returns than a bond.

2. You describe scenarios where the market performs poorly for 20 years.

It’s true that I’ve focused on the income guarantees. The point is that the guaranteed income is very low because of decades of inflation. However, it is possible for the guaranteed level of income to rise if our investor Ida’s mutual funds within IncomePlus perform well. Unfortunately, they have to perform very well to overcome the very high fees charged. The market could perform reasonably well and still not trigger any increases in Ida’s payments.

3. Some of the funds available to IncomePlus investors charge lower MERs than you quoted.

The funds with lower total fees are the ones containing a lower percentage of stocks. The only way to have a chance at doing significantly better than the minimum guaranteed payments is to have as much exposure to stocks as possible.

4. The product might enable some investors, who would otherwise be too skittish, to buy into today's markets or to feel comfortable maintaining some exposure to markets during volatile times.

It is true that this product’s guarantees may draw in nervous investors. However, IncomePlus behaves more like a bond than like stocks. The high fees charged prevent investors from participating in very much of the market’s upside. In the future, IncomePlus investors are likely to see positive news about stocks, but see their payments increase minimally or not at all.

5. The fact that Manulife had to inject new capital partly to boost its reserves for products of this kind suggests the product is not as one-sided as you suggest.

Let’s try an analogy here. Suppose that I offer people a $1000 bet on the flip of a coin. But, they don’t realize that I’ve rigged the coin to come up my way 90% of the time. If I happen to lose the first flip and scramble to raise the $1000 I owe, is this evidence that the bet wasn’t one-sided? Manulife lost one round of a bet stacked in their favour. I like their chances in future rounds.

6. Those who bought earlier this year may be glad they did that rather than investing directly in mutual funds or equities.

You are right that these people are probably glad, particularly those who need money right now. However, if our 50-year old investor Ida, who doesn’t need income until she is 65, just stays invested in a low-cost stock index and waits out the current downturn, she is likely to be better off than investors who bought into IncomePlus early this year.

Despite our differences, I appreciate comments from readers. I’m more interested in learning the truth than I am in trying to argue than I’m right.

Tuesday, November 25, 2008

Hedge Fund Conflict of Interest

Before the recent financial crisis, hedge funds were generally known as mysterious investments that make outsized returns. Now they have a reputation for flaming out. The reason why so many hedge funds have failed is easier to understand once we see that hedge fund managers maximize their expected returns by taking more chances than are good for investors.

The main differences between hedge funds and regular mutual funds are

Types of investments. Hedge funds are less closely regulated and tend to make riskier investments than mutual funds make, such as shorting stocks and using leverage.

Fees. In addition to a yearly management fee, hedge funds charge a performance fee, which is a percentage of any returns over a certain threshold. A “2 and 20” hedge fund would charge 2% of the full amount invested plus 20% of all returns above the threshold.

The performance fee is supposed to align the interests of the money manager and the investors, but it does this quite poorly. On the surface it seems that both parties make money together, but there are important differences that I’ll show with an example.

Suppose that High-power Growth Hedge fund (HGH) uses a simple leverage-based strategy: it buys stocks on margin. For a concrete example, we’ll assume that HGH can borrow money at 5% interest, the expected return on stocks each year is 10%, and the volatility of stocks measured by standard deviation is 20%, a figure that is close to the long-term average for US stocks. HGH’s fees are a 2% management fee plus a performance fee of 20% of returns above 5%.

What is best for investors?

Based on these assumptions, investors maximize their expected compound returns if no leverage at all is used. Without the performance fee, the optimum amount of leverage is only 16%. The performance fee clips the upside enough that it isn’t worth it to take on the higher risk of borrowing some money to invest. But the optimal amount of leverage is quite low even without the performance fee.

What is best for hedge fund managers?

It turns out that using leverage increases the money manager’s fees considerably. I ran billions of 3-year Monte Carlo simulations of HGH fund with different amounts of leverage, and the money manager’s highest expected compound return came with leverage at 249%! This means that if investors contribute $10 million to HGH, the fund would borrow an extra $24.9 million and invest the whole $34.9 million in stocks.

Using 249% leverage, investors’ expected compound return is reduced to -3% per year due to the high volatility. Don’t think of this as a steady -3% each year. HGH would have wildly swinging yearly returns like +70%, -60%, and +30%, with a significant risk of losing everything in a very bad period for stocks like the one we’re in right now.

These results show that hedge fund managers do not have their interests aligned with investors. In fact, their interests are so poorly aligned that hedge fund managers are effectively in a conflict of interest.

Monday, November 24, 2008

Lotteries, Millionaires, and a Sense of Scale about Money

Most of us dream of living the life of a millionaire. Many of us regularly buy lottery tickets, and more of us buy them when jackpots get larger than normal. However, few of us have a good sense of what is truly a large amount of money.

Imagine a young guy named Jack who is 25 years old and starting a new job. We look into a crystal ball and see that Jack will average an inflation-adjusted income of $50,000 per year for the next 40 years. If you’ve never done the math, it can be surprising to realize that this amounts to two million of today’s dollars.

Now if Jack were to win $1 million in a lottery, this would be only half as much as his total 40-year income. Even with investment returns, Jack would risk running out of money if he were to quit his job and spend $50,000 per year. Even if he kept his job, he would risk running out of money if he spent $100,000 per year.

So, unless Jack spends his winnings quite modestly, his good fortune will be temporary, and the money will be gone in a few years. We see this fate befall many lottery winners. Sadly, many end up spending themselves into huge debts after the money runs out. They simply didn’t understand that their big prize wasn’t so big compared to the length of a human lifetime.

For the average person to be able to quit working and live large, a lottery win of about $5 million or more is needed. Even then caution is required. A sequence of poor choices, such as buying a money-losing dream bar or restaurant, can easily wipe out $5 million in a few years.

The truth is that most millionaires accumulated their money while living frugally. Their financial habits are an important part of what has made them wealthy. Ironically, most real millionaires don’t live like millionaires.

The next time you encounter found money, whether it is a large sum or small, try figuring out how much it represents per day over 50 years of life. So, a $50,000 inheritance divided by 50 is $1000 per year, and divided by 365 is $2.74 per day. Doing this might make you hesitate before wasting “found money.”

Some may find this “dollars per day” idea depressing, but I don’t see it that way. It comforts me to realize how long my expected lifetime will be.

Friday, November 21, 2008

Short Takes: Bonds, Wrap ETFs, Small Caps, and a Boot to the Head

1. Preet explains why bond returns have been strong for the last 28 years and why the next 28 years are highly unlikely to have such high bond returns.

2. Canadian Capitalist discusses wrap ETFs available from iShares and Claymore. These wrap ETFs hold other ETFs to create a portfolio. For the extra costs charged for these wraps, you get the convenience of buying only one ETF instead of two or more, as long as you’re happy with the particular allocations the wrap ETFs use.

3. Larry MacDonald makes a case for owning small cap stocks. The ride with small caps is even bumpier than the overall stock market, but over the long term, average compounded returns have been better with small cap stocks.

4. Jonathan Chevreau reports on a survey showing that Canadians are delaying retirement plans. I had more fun with the joke definitions at the end of this article. I particularly like the redefinition of “P/E Ratio.”

5. The Big Cajun Man discusses some Canadian bank woes along with a funny “boot to the head” video clip by The Frantics.

6. I’m fairly new to the idea of blog carnivals, but my article Time for the Smith Manoeuvre? appeared in the Nov. 18 Investing Carnival.

Thursday, November 20, 2008

Auto Bailout: Throwing Good Money After Bad

There is a big difference between the financial crisis and the plight of US automakers. The financial crisis affected all financial institutions everywhere. US automakers are being crushed by foreign competition. The financial crisis is definitely making things far worse for US car companies, but the fundamental problem is that Asian companies make better cars.

I’m not necessarily arguing against some sort of assistance for the US auto sector, but it has to be with an eye toward becoming competitive. Unless GM, Ford, and Chrysler start making better cars, they will keep coming back to government looking for more handouts.

Some people dispute the fact that Asian cars are generally better than American cars. This is largely patriotism rather than reason, but let’s examine it anyway.

It is actually quite challenging to find unbiased information about car quality. Almost everything written in magazines and newspapers about cars is heavily influenced by the auto industry. The best source of real information I’m aware of is Phil Edmonston’s Lemon-Aid books that come out each year. (Disclosure: I have no affiliation with Edmonston other than having bought a few of his books.)

The Lemon-Aid guides rate all cars on a scale from one to five stars. I have the 2002 and 2007 editions for new cars and minivans, and I collected the ratings for all American and Asian cars. Here are the results:

This is a huge edge for Asian cars over American cars. Unless a bailout comes with a realistic plan to become competitive in car quality, the US government is just throwing good money after bad.

This brings us to the reason for American car companies being uncompetitive. One guess is that US car companies have ploughed money into advertising at the expense of designing better cars. This may be a symptom rather than the underlying problem. Some commentators blame the unions for high costs and low productivity. I don’t know if this is true or not. If it is true, then lawmakers should make some tough decisions and solve the problem before giving out money to failing companies.

There is no doubt that if any of the big three US automakers fail it will cause huge problems for the economy. However, a bailout without a plan to become competitive is a step toward a planned economy where subsidies suppress innovation.

Wednesday, November 19, 2008

Courses on Gambling with Stock Options

I’ve been getting a lot of requests lately to place advertising on my blog. Unfortunately, most of it is completely inconsistent with my message about how to handle money. Many are from payday loan companies. It’s sad that some people have got their finances into such bad shape that they feel the need to take loans from these companies at such exorbitant interest rates.

The latest advertising request came from a web site (that I won’t name) devoted to strategies for gambling with stock options. There are some sensible uses for options, but this web site was not promoting sensible strategies.

The strategies were a long-winded version of the following:

“If you think a stock will go up, buy a call option.”
“If you think a stock will go down, buy a put option.”
“If you think a stock will have a big move, but don’t know which direction, ...”
And so on.

There are dozens of option strategies for ever more specialized situations. The problem is that you can’t predict the future to tell which option strategy to use. If you buy a call option, but the stock doesn’t go up, then you lose your money. If you split your money among several guesses, you will lose money, on average, due to the commissions and spreads on the option purchases.

Much of the promotional material on the web site focused on “success stories” that give no information about how the typical person has fared trading options with this web site’s advice. One promotional video included the following breathless come on:

“All these people, people just like you, found a simple, easy way to make the kind of money they never thought possible. They found the key that unlocks the unlimited potential wealth created by the stock market. And best of all, they found out how to do it risk free through the free [company name] expo coming to your area.”

Saying “risk free” here makes it sound like the option strategies have no risk and that you’re guaranteed to make money. In fact, the “it” that is “risk free” is the expo that you can attend without paying any money. The option strategies are definitely risky.

Let me reiterate that there are specialized circumstances where stock options can be part of a sensible investing strategy as a form of insurance to reduce risk. I’ve never had the need to trade in options myself, but it could come up. However, if anyone is telling you to use options to get rich, you should be very suspicious.

Tuesday, November 18, 2008

MER: Death by a Thousand Cuts

It’s time to bring out the heavy artillery (by which I mean pictures) to explain the effects of the Management Expense Ratio (MER) charged by mutual funds. Fees charged to manage your money are a good example of a death by a thousand cuts. They are barely noticeable over short periods, but are devastating over long periods.

For the charts we’ll use a MER of 2% per year. This figure is on the low side for actively-managed funds in Canada, and on the high side for funds in the US. I collected some data from 1950 to the present on the S&P 500 index, the 500 biggest businesses in the US. Any other index, including Canadian stocks, would have worked equally well and would give similar results.

Our hypothetical investor, Harry, has $100,000 in a tax-sheltered account. He puts it all in stock funds that we’ll assume perform as well as the S&P 500 (including reinvested dividends) less the 2% MER each year. All returns in the examples below will be real returns, meaning that we account for inflation.

Harry likes to check his returns each day; so let’s see what a typical day looks like. The S&P 500 data from 1950 to the present show that 90% of the time, daily returns are between $1400 down and $1408 up. Let’s call these a bad day and a good day. The 2% MER on $100,000 is $2000 per year, which works out to a little less than $8 per trading day. The following chart sums this up:

The MER in red is barely noticeable. Why should Harry care about eight bucks when his portfolio is swinging up and down by hundreds or thousands of dollars each day? It turns out that the daily ups and downs partially cancel out, but the daily MER costs all point in the same direction: down.

Suppose that Harry takes a month-long vacation without checking on his portfolio. What kind of change can he expect when he gets back? To answer this, I found all the one-month returns of the S&P 500 since 1950 including reinvested dividends and removing inflation. Finding the return values that bracket 90% of the cases gives us a “good month” and a “bad month” for the following chart:

The MER is still quite small compared to the possible swings in return over a month. However, the MER is growing. Now let’s see how the MER compares to the possible returns over a year:

Over a year, the MER is noticeable, even on a bad year. This is like watching the height of Harry’s daughter Hanna. Her growth isn’t noticeable to people who see her every day or month, but her grandparents who only see her once a year sure notice the difference.

Let’s see what happens over 25 years:

Now the MER really begins to dominate, consuming 44% of the returns in the good scenario and 73% of the returns in the bad scenario. This should make it clear how much damage a “little” 2% MER can do.

Monday, November 17, 2008

Bond Trading Fees

Whenever I buy bonds through my discount broker, the commissions they charge me are hidden. When I want to buy a particular bond, they just quote me a price, and when I decide to sell the bond, they just quote me another price. There is never any mention of commissions.

Of course, discount brokers don’t let you trade bonds out of the goodness of their hearts; they make money somewhere. With stocks it is more obvious. You pay commissions and lose some money on the spread between bid and ask prices.

Right now I only have one bond. It is a British Columbia coupon for $14,000 coming due 2010 June 18. A “coupon” is a bond that is bought for a discount to the face value and pays no interest until the coupon comes due. So, I paid less than $14,000 for it, and will get $14,000 in June of 2010.

To figure out the fees I’m charged for trading this bond I first checked what I could get for it if I sold it: $13,438.14. The cost of buying another identical bond is $13,532.82. So, the total fees charged for buying and selling this bond are $94.68. I’ve actually done this calculation twice about a week apart to see how stable these costs are. The total fees the first time were $96.01. Based on just two data points, the total cost of a buy and sell is about 0.7% for this bond.

Let’s compare this to the costs of trading $14,000 worth of XIU, an index ETF of the S&P/TSX 60. I would pay $9.95 for each trade, and based on 1000 shares and a bid-ask spread of $0.02, the total spread cost of a buy and a sell is about $20. So, the total fees are $39.90. Based on this example, trading the bond is nearly 2.5 times more expensive than trading the index ETF.

If any readers would care to check on their costs of trading bonds with their brokers, I’d like to try to get a picture of bond trading costs.

Friday, November 14, 2008

Short Takes #5: Market Bottom, Nortel, and Carpooling

1. I think it’s funny that the day after CIBC predicted a market bottom (the web page with this article has disappeared since the time of writing), stock markets in Canada and the US dropped 4-5%. It seems to be human nature to listen to these predictions when all evidence shows that nobody knows what will happen to stocks in the short term. I believe those who say that current stock prices will seem low looking back 5 or 10 years from now, but that doesn’t preclude the possibility of another 20% drop in the short term.

2. Larry MacDonald makes a sensible argument that the government should not bail out auto companies. The banking system is having a short-term liquidity problem. North American auto companies have been losing the competitive battle for decades.

3. Just when the markets have just about beaten us to a pulp, Canadian Capitalist warns us to watch out for higher discount broker fees. If your accounts drop below threshold amounts, you could be charged administration fees and higher commissions on trades.

4. The Big Cajun Man asks if Nortel is a dinosaur, and discusses its prospects and planned reorganization.

5. Ellen Roseman asks who will be responsible for credit card fraud when credit card companies start giving us “chip and PIN” cards. Credit card companies would love to make consumers responsible for fraud based on the reasoning that the system is secure and the customer must have done something wrong. However, it is impossible to use even a chip and PIN card safely. Consumers are expected to insert their cards and type their PINs into a device supplied by a stranger. The consumer can’t control the risk in this situation. The risk should continue to be borne by credit card companies and banks. If the new technology is more secure, then the credit card companies and banks can look forward to lower losses due to fraud.

6. When negotiating, Thicken My Wallet advises: never throw out the first number. I’m left with the image of two people sitting silently staring at each other. It’s amazing how few people can withstand long pauses in a conversation.

7. Preet starts a new job, and plans to explain in his blog how the financial industry works from an insider’s point of view. He also plans to create financial products with lower fees to benefit investors.

Thursday, November 13, 2008

Money for Nothing and Your Stocks for Free

In his book Money for Nothing and Your Stocks for Free, author Derek Foster offers two strategies for boosting investment returns: selling put options and leveraging your house. Let’s examine these strategies.

1. Selling Put Options

Foster suggests finding a good dividend-paying stock that you’d like to own. However, instead of just buying the stock, he wants you to sell put options on the stock. How this works is best explained with an example. I’ll use some actual (approximate) figures for Royal Bank stock (ticker: RY).

Let’s say you’d like to own 200 shares of RY that are currently trading for about $46 each. You could just buy the stock for about $9200 right now, or you could sell put options on 200 shares. Royal Bank December put options at $44 have a premium of about $3.50. This means that someone is willing to pay you $3.50 for the option to sell you a share of RY for $44 any time between now and the third Friday in December.

Based on 200 shares, you can collect $700 now as long as you are willing to pay $8800 for 200 RY shares. Of course, the option buyer will only force you to buy the shares if RY shares drop below $44 each. If this happens, your net price for 200 RY shares will be $8100 (much better than the $9200 you would have paid if you just bought the shares). If the price of RY doesn’t drop, then you get to pocket the $700 from selling the put options.

According to Foster, whether you are forced to buy the shares or not, you win; it’s a “free lunch.” If this sounds suspicious, it’s because there is a catch. What if RY shares go up to $55? If you had bought the 200 shares for $9200, you’d be ahead $1800 instead of only pocketing the $700 option premium. You are giving up potential upside to take a guaranteed small amount right now.

The only way that Foster’s strategy can be profitable is if put options are routinely overpriced. If Foster thinks this is true, then he needs to justify it. Otherwise I’d have to assume that because stock options are a negative-sum game due to commissions and spreads, his strategy over the long term will prove to be worse than just buying stock.

2. Leveraging Your Home

The dangers of borrowing to invest are well known. While gains get magnified, so do losses, and you have to pay interest on the loan. Foster does a good job of explaining the risks of leverage when buying stocks on margin and concludes “never borrow on margin; it’s simply too risky.”

Foster is much more positive about borrowing against your house to invest. However, leveraging your house has all the same risks as using margin. Foster sees the critical difference as being that there are no margin calls when leveraging your house. This allows you to ride out bad periods for stocks without being forced to sell your stocks.

However, margin calls force an investor to reduce risk. The leveraged homeowner just has more rope to hang himself. Trying to ride out a downturn in stock prices could turn out well, or it could lead to complete disaster if stocks continue to drop.

Overall, this is a clearly-written book requiring little investment knowledge to understand. But readers should think carefully and tread cautiously if they plan to follow Foster’s advice.

Wednesday, November 12, 2008

Do Investors Need to be Good at Mathematics?

In the book “Money for Nothing and Your Stocks for Free,” author Derek Foster asks why we force kids to spend so much time “calculating the hypotenuse of a triangle,” something he can no longer remember how to do, when skills like this “are never used by most people in the real world.” He advocates spending more time teaching kids financial literacy.

I agree that schools could do more to teach financial skills. However, I’m not sure how to keep vested interests from influencing the curriculum. We may end up teaching our children to buy expensive mutual funds, hire expensive real estate agents, and pay transaction fees on all purchases.

The first part of Foster’s argument is that much of the math he was taught wasn’t very important. A curious thing about discussions like this is that people who lack a certain skill are often the ones who assert that the skill isn’t important. For example, I might say that knowledge of Russian literature isn’t important in investing. In reality, I don’t know if this is true or not because I know little about Russian literature.

The reason that few people ever calculate the hypotenuse of a triangle in their daily lives is mainly because they can’t. Further, they wouldn’t recognize a situation where it might be useful. For example, measuring out a 3-4-5 triangle is a way to get a square corner when laying out a football field.

If you have to lay out bases on a baseball diamond, it can be useful to figure out that second base is 127 feet, 3 inches from home plate by calculating the hypotenuse. I once helped a volunteer who had no measuring tape figure out where to put a new pitcher’s plate by figuring out that it should be about 3 feet in front of the line from first to third base. Opportunities to make use of a skill are often impossible to recognize unless you have the skill.

Getting back to investing, I’m not arguing that you need to know calculus to succeed. In fact, people who delve too far into mathematical topics like efficient market theory and modern portfolio theory often get caught up in details and can’t see the forest for the trees. When a writer comes up with incorrect conclusions and baffles his readers with math, don’t blame the math; blame the author.

Any skill is potentially useful when investing. Some are clearly more useful than others. Basic math is obviously important for investing, and I think that more advanced math can be helpful. Common sense, curiosity, and the ability to stay calm are beneficial as well.

Tuesday, November 11, 2008

Time for the Smith Manoeuvre?

Interest in investing in stocks is low right now, and interest in using leverage (borrowing money to invest) is even lower. This also applies to the Smith Manoeuvre, which is a leveraging technique for borrowing against your home’s equity to invest.

I’ve never been a big fan of leverage because it magnifies losses. If your investments do well, then leverage will make them perform even better, but if stock prices have big declines, you can be left with a lot of debt and a shrunken portfolio that won’t cover those debts.

Having said all that, using leverage now is far less risky than it was when stock prices were higher. Paradoxically, the average investor is less interested in using leverage right now. Let me reiterate that I’m not a fan of leverage, but if there ever is an appropriate time for it, now is probably that time.

I give FrugalTrader at Million Dollar Journey credit for continuing his series on his Smith Manoeuvre portfolio after the big stock price declines. It would be easy to just write about other things and return to the Smith Manoeuvre again when stocks have recovered and the subject is more popular. However, it is precisely when stocks are peaking that this topic is most popular and the use of leverage is most dangerous.

Monday, November 10, 2008

Manulife IncomePlus Default Risk

Recent stock market declines forced Manulife Financial to borrow $3 billion from the Canadian banks. This brings to mind one of the risks of buying any type of annuity including IncomePlus: default by the insurance company.

The main drawback of IncomePlus is the high fees and the likelihood of not keeping up with inflation. On the positive side is the protection from a prolonged decline in stock prices. If stocks perform poorly for a long time, customers of IncomePlus will get a steady income eroded by inflation, but at least it wouldn’t drop in absolute terms.

But if this doomsday scenario for stocks plays out, all IncomePlus customers will be leaning on the insurance guarantee all at once. What happens if Manulife runs out of money? Existing regulations require Manulife and other insurance companies to maintain certain financial reserves, and this was the reason for the $3 billion loan.

If stock prices really do decline for a long time, creditors will eventually stop lending Manulife more money. I don’t know how deep the decline would have to be to cause Manulife to default on its promises, but this is something that potential customers should know before handing over their life’s savings.

This doesn’t apply only to Manulife. Any person who considers buying any type of annuity should understand exactly what entities are backing it, and whether they are strong enough financially to make good on their promises.

Friday, November 7, 2008

Short Takes #4

1. Cartoonist Scott Adams of Dilbert fame writes about a conspiracy theory that makes you money even if the theory is wrong.

2. The Wealthy Boomer reports that Canadians are dumping mutual funds but buying ETFs (the web page with this article has disappeared since the time of writing). This is encouraging news if Canadians stick to low-cost ETFs. High-cost ETFs exist, and more are likely to pop up. Much of the financial industry is willing to call their products anything as long as they can continue to collect fat fees.

3. The Big Cajun Man debates what to do with his pension after getting laid off from Nortel. He can either take the lump sum and put it in a retirement account or leave it where it is and draw a pension when he is old enough. An actuary can crunch all the numbers, but this will ignore the most important consideration: will the money still be there to draw a pension? Nortel’s pension plan is hopelessly underfunded right now, and business prospects aren’t good.

4. For fixed-income investors who want higher returns, two possible strategies are to choose higher-risk bonds or to choose longer bond maturities. Preet explains that adding equity exposure gives better returns for the amount of risk compared to higher-risk bonds, and that longer bond maturities don’t give a good risk-return payoff.

5. Larry MacDonald shows that Canadian bank stocks are undervalued based on comparing their dividend yields to Canadian bond yields.

6. As I’ve explained before, Bell’s internet service just doesn’t work at my house. Yet another mailing arrived this week imploring me to “come back to Bell.” For only $17.95/month plus some fine print details that would roughly triple this price, I could get wireless home networking that would then fail to connect anywhere outside my house.

Thursday, November 6, 2008

Manulife IncomePlus Hard Sell

A member of my extended family I’ll call Don has been hit with a hard sell to buy into a Manulife Financial’s IncomePlus annuity. This makes the recent articles from Canadian Capitalist about the cost of IncomePlus, comparing it to an all-bond portfolio, and the importance of stock dividends in the IncomePlus analysis quite timely for me.

IncomePlus is essentially a portfolio of mutual funds with very high MERs combined with an insurance component that adds even more fees. For an overall cost of about 3.5% each year, Don is guaranteed payments each year for the rest of his life of at least 5% of his original investment. For the first 20 years, this is just a guaranteed return of his inflation-ravaged capital.

If Don’s portfolio happens to grow despite the 5% withdrawal and 3.5% fee each year, there are defined times every three years when the portfolio locks in the gains, and Don’s guaranteed yearly income rises to 5% of the new portfolio size. Don would be counting on such gains just so that his income would keep up with inflation.

For Don’s income to match inflation, the mix of investments in his mutual funds would have to grow in value each year by inflation plus the 5% withdrawal plus the 3.5% fees. With a 75/25 mix of stocks and bonds, and if bonds beat inflation by 2% each year, stocks would have to beat inflation by about 11% each year. This is not likely over a long period of time. So, Don is not likely to keep up with inflation unless he dips into his capital and reduces future guaranteed returns.

Even using investments such as low-cost exchanged-traded funds (ETFs), it is difficult to design portfolios that provide investors with complete peace of mind due to longevity risk, inflation risk, and the risk of declining stock prices. Insurance companies can have a role to play in eliminating longevity risk, but any benefits to investors in the case of IncomePlus are more than offset by the ultra-high fees.

Seeing a bar chart of income stretching on indefinitely without ever going down is comforting only as long as you don’t think about inflation. If these charts were changed to take into account a plausible level of inflation, they would cease to be persuasive.

Canadian Capitalist asked “why then are advisors pushing their clients to buy these products?” I suspect he knows the answer, and it became clear to me after listening to Don. Don is contemplating a last decision about all of his savings. This includes not only the money controlled by the advisor who is pushing IncomePlus, but also his other retirement accounts. This advisor is going for the chance to get control of all of Don’s money for the rest of his life. That would give the advisor a big commission immediately and additional trailer fees indefinitely.

As far as I’m aware, Don hasn’t made a decision yet. I don’t like to tell people what to do with their money, because they know their business better than I do. But, it’s not hard to tell where I stand on IncomePlus.

Wednesday, November 5, 2008

Obama’s Win and the Effect on the Stock Market

A Barack Obama presidency is now confirmed. So, what effect will this have on the stock market? Whatever happens to stocks, we can expect the press to link it to Obama’s victory.

One theory is that Democrats are bad for business, and stocks will drop in value. Another theory is that Republicans are responsible for driving the US debt to dizzying heights, and the stock market should respond positively to a Democrat as President.

Or maybe the market was anticipating an Obama win, and investors will “sell on the news” driving stocks down even though they think Obama will be good for the economy. Or maybe the opposite will happen because of some sort of double-reverse psychology.

I don’t know what will happen to stock prices for the rest of this week, but whatever happens, it will be portrayed as the inevitable effect of Obama’s victory. Surely some stock price movements will come as a result of random buying and selling that has nothing to do with the election.

Short term price movements are mostly unpredictable, and the important thing is what happens in the long term. We can only hope that Democrats will govern in a way that leads to the economic growth that is necessary to have long-term gains in the stock market.

Monday, November 3, 2008

Canadian Scammers Target US Grandparents

The Better Business Bureau reports a scam that has worked on grandparents from California to New Hampshire. The scam is a variant of the loved one in trouble. In this case, a caller claims to be a grandchild travelling in Canada, in trouble, and needing a few thousand dollars.

What makes this scam so effective is a combination of factors. Grandparents are very likely to want to help a grandchild. Voices can be difficult to recognize on the phone, especially if the grandparent hasn’t seen a teenage grandchild in a while. Traveling in Canada is quite plausible for a young American. Lastly, Canadians are far too nice to run a scam like this.

I’m disgusted with these thieves, but somewhat impressed at the same time. This scam is quite clever. If these criminals put their abilities and some hard work into an honest venture, they probably would do well. Some people are willing to work very hard to avoid having to do any work.

Friday, October 31, 2008

Short Takes #3

1. For some Halloween fright, Clever Dude shows us what a billion-dollar restaurant bill looks like.

2. Million Dollar Journey gives us a handy summary of planned TFSA (Tax-Free Savings Account) offerings from the major Canadian banks and brokerages.

3. Have you ever heard of a carry trade, but didn’t know what it was? Preet explains carry trades and the possible ramifications of Yen carry trades.

4. Blunt Money has some useful suggestions for getting out of cell phone contracts.

5. Canadian Capitalist reports on John Bogle’s stock market predictions. Don’t worry, though; they haven’t both lost their minds and started making predictions about short-term stock market movements. Now that stock prices have dropped significantly, Bogle thinks that returns over the next decade are likely to average 10% per year.

Thursday, October 30, 2008

Property Tax Assessments

This week I got my notice from the government about how much they think my house is worth. They clearly didn’t spend much time on my house because my assessment went up by exactly the average amount in my area, 13%.

Fortunately, this doesn’t mean that my property taxes will go up by 13%. City governments don’t collect more taxes when property values rise and less when property values fall. What actually happens is the city decides on the total amount they will collect from homeowners, and then divides that amount among homeowners in proportion to assessed property values.

For example, if the city needs $1 billion from us, and the total value of all houses is $80 billion, then the tax rate is set at 1/80=1.25%. A house worth $320,000 would pay $4000 in property taxes. If property values had plummeted to a total of $50 billion, then the tax rate would have been set at 1/50=2%. The house that was worth $320,000 in good times is probably worth only $200,000 in bad times, but would still pay $4000 in property taxes (2% of $200,000).

With this type of system, what really matters to your property taxes is how much the value of your house rises compared to everyone else. Suppose that the city increases taxes by an average of 5% from last year to this year. My house’s assessed value went up by exactly the average amount, 13%. So, my tax increase will be 5%. If my assessment had gone up by 17%, then my taxes would have gone up by about 4% more than average, or about 9%.

One other wrinkle for my area is that new property values will be phased in over four years. This was done to reduce the shock for homeowners whose assessments changed dramatically. If no new assessments are done in the next four years, then I can look forward to paying exactly the average tax increase each year. If my assessment had gone up by 17% instead of the average 13%, then I could look forward to seeing my property taxes increase by about 1% more than the average for each of the next four years.

Wednesday, October 29, 2008

Good News for Ontario Senior Homeowners

Seniors who pay property taxes in Ontario can look forward to a tax break starting next year. The maximum amount of the tax break for 2009 is $250, and for subsequent years it is $500.

The tax reduction won’t come off the city tax bill directly, though. This program is part of the Ontario Tax Credits. Seniors who qualify and submit form ON479 at income tax time will get a tax deduction or rebate on their income taxes.

In 2009, a senior couple with a combined income under $45,000 will get the whole $250, and the amount of deduction drops off to zero for combined incomes over $60,000. Single seniors in 2009 whose income is under $35,000 will get the whole $250, and the amount of deduction drops off to zero for incomes over $50,000.

It’s hard to disagree with a policy like this when you imagine an elderly widow living in near poverty being forced from her home because she can’t afford the property taxes. However, this does shift the tax burden slightly from seniors to younger people, and it’s not difficult for seniors with substantial savings to keep their incomes low enough to qualify for this tax break.

As the proportion of seniors in the population increases, there will be increasing pressure on governments to shift more of the tax burden away from seniors onto young people. I’ll probably be less concerned about this once I become a senior myself.

Tuesday, October 28, 2008

New Rules for Mutual Fund Disclosure

A group of regulators of the Canadian mutual fund industry have come up with a proposed new set of rules for disclosing information to potential investors (pdf). Just in case the details don’t interest you, you can skip down to the end of the document where there are two example mutual fund fact sheets. Thanks to Preet Banerjee at Where Does All My Money Go for pointing me to this report.

Don’t look for any big differences to help investors understand what is going on. These fact sheets don’t even have to include a fund’s trading costs. As explained in an Ontario Securities Commission article Understanding Mutual Fund Fees, “brokerage charges, which are the fund’s cost of buying and selling securities in its investment portfolio, are paid by the fund but are not included in the MER.” These costs are buried in other disclosure documents as a Trading Expense Ratio (TER).

To those of us who have an interest in financial details, the disclosures about fees in the fact sheets seem clear enough. But, I doubt that the average investor could make a meaningful connection between this information and actual fees paid. When friends and family show me their account statements, they are usually shocked when I tell them how much they pay in fees.

Simple New Type of Disclosure

A problem with the fact sheets is that they are disconnected from the purchase of units in a fund. Whenever an investor buys units of a mutual fund, there is some piece of paper or browser screen that shows how much the investor pays for the units in the fund. I’d like to see two additional numbers related to fees written beside the transaction information: assuming that the units are held for 10 years, what will be the total amount charged in fees, and how much of this goes to the advisor.

Let’s try an example. An investor decides to move his $50,000 RRSP into the biggest Canadian mutual fund that will take an investment of this size, Investors Dividend-A. This fund’s MER plus its trading expense ratio comes to 2.70% per year. According to the fund’s prospectus, advisors get 4.10% of the sale plus an additional trailer of 0.63% per year.

To avoid the problem of assuming rates of return and calculating present values, we’ll calculate fees assuming that the investment stays at a constant $50,000. Here is what our investor would see if this idea were adopted:

Investors Dividend-A fund unit price: $18.60
Units purchased: 2688.17
Total Cost: $50,000
Estimated total fees charged during 10 years in this fund: $13,500
Out of these total fees, estimated payments going to your advisor: $5200

This type of disclosure concerning mutual fund fees would be much easier for investors to understand than the information in fact sheets. It might cause investors to ask questions about fees and even do some comparison shopping.