Thursday, July 31, 2008

No More Car Leasing

As the Big Cajun Man at Canadian Personal Finance pointed out, car companies are shying away from leasing cars. This may seem puzzling, but will make sense after looking at the true nature of car leases.

The term “car lease” was great marketing. It gives the illusion that the dealership takes the risk, and you just rent the car for a while and get a new one when it suits you. The truth is that with a car lease you take much the same risks as if you buy the car.

If something happens during the term of a car lease that makes the car worth less than expected at the end of the lease, you’re on the hook and will have to make up the difference. The best way to think of it is that you own the car, but owe a lump sum at the end of the lease. If the car happens to be worth as much as this lump sum owed, then you’re okay. If not, dig into your wallet.

When leasing a car you have lower payments than if you took out a loan, but this just means that you’re paying it off more slowly. In fact, during the early part of the lease, often you aren’t even keeping up with the depreciation on the car.

So, for the first part of the lease, you may actually owe more than the car is worth. This is a risk for the car company. With the recent credit crunch, car companies are smart to avoid such risks. So, it’s no wonder that some car companies don’t want to lease cars these days.

Wednesday, July 30, 2008

Lacking a Sense of Scale Can Hurt Financially

The sensitivity range of our senses is quite amazing. We can hear a whisper, and a scream that is a million times louder doesn’t overwhelm us. The scream may not seem a million times louder, but that is the magic of our sense of hearing. This sensitivity range works well for hearing, but in financial matters, it can get us in trouble.

If we hear a sequence of sounds with each sound ten times louder than the previous one, we perceive the volume as growing in equal size steps. It’s hard to believe that the energy in the last sound is about nine times more than the total energy in all the other sounds combined.

When it comes to spending, we can sometimes see similar things happening. “I haven’t bought any coffee or donuts for a week now; so, I’ll treat myself to a new iPod.” If you don’t have a good sense of scale, saving small amounts several times may seem to balance with one large purchase. But the savings on coffee and donuts may be only $20, and the iPod may cost $200.

Another way we can lose our sense of scale is in the context of a larger purchase. When you lift a 50-pound weight, you won’t notice if it is an ounce heavier than normal. In the same way, when you are negotiating the price of a $30,000 car, spending an extra $500 on rust-proofing may not seem like a big deal. But it’s a mistake to let the larger figure throw you off.

There are many ways that others can fool you into overpaying for add-ons. And there are even more ways that you can fool yourself into overspending.

Tuesday, July 29, 2008

Fee-Only Financial Planners

I’ve always thought that if you need a financial planner, a fee-only arrangement is better than commission-based; you’ll likely pay less in fees, and the planner won’t have the glaring conflict of interest pushing him to select investments that pay the highest commissions.

Canadian Capitalist contacted two fee-based financial planners. Both charged $100 per hour and would take 10 or 15 hours to create a comprehensive financial plan. This sounds reasonable enough. Investors can easily pay much more than this in commissions on mutual funds.

But then I started thinking. What if I insist that the financial planner do all his work with me present? I'll bring all my relevant records in and answer questions, and the planner will work out a plan in front of me. I won’t object if he takes 5 or 10 minutes a few times to look up information in books or on the internet.

The planner shouldn't object to this because I'm paying by the hour, and the process should take longer with me present, in theory. But, I can't imagine why this would take two working days. In fact, I would be surprised if this took even 4 hours for an average client. Sure, there are people with complex financial situations, but I’m not one of them.

I do some short-term (non-financial) consulting myself, and I understand the problem of spending more time finding clients than I spend working for them and getting paid. I deal with this by charging a high hourly rate and just living with the fact that most of the time I spend on consulting is unpaid.

I do know consultants who charge lower rates, but pad the hours. They don’t think of it this way, but I do. Essentially each client pays for the work they get plus they pay for some of the time the consultant spends looking for the next client.

I won’t say that this is what the fee-only planners are doing, but I can say that for myself as a client, I would not be interested in paying for the planner’s time spent without me being present. I wouldn’t care about nice reports with pretty charts. I would just want some advice that I could write down myself and act on.

Monday, July 28, 2008

Investing Lessons from Baseball

I coach youth baseball, and we’re in the middle of the provincial championships. Last night we fell behind 4-1 late in the game. Things were looking grim, but not hopeless. As a coach, it was tempting to try to take some chances to “make something happen”.

Fortunately, we stuck with the game plan and asked each of our hitters to relax and approach the game the same way they had all season. We were lucky enough to score 13 runs in the last inning to win 14-4.

What has this got to do with investing? Well, just as we resisted the temptation to throw away our game plan when things weren’t going well, investors need to stick with their plan when investment returns are lower than they hope for.

Many investors abandon a sound plan and sell out when prices are lowest. This can be a very expensive mistake. The most compelling reason I’ve heard for holding bonds for the long term is to lower portfolio volatility so that investors won’t panic at the wrong time and sell everything.

Personally, I’m able to resist panic even while fully invested in stocks. This way I get the advantage of the long-term higher returns from stocks than from bonds or a blend of the two.

No matter what mix of investments you choose, if you’re convinced that your plan works for you, stick with it through thick and thin. You never know when your portfolio will make a big comeback.

Friday, July 25, 2008

The Importance of Individually Tailoring Investments is Overstated

The marketing for financial planning companies stresses that you need to have your investments specially tailored to your financial situation. There is a certain amount of truth to this, but it is overstated.

Deciding how much of your savings should go into long-term and short-term investments will of course depend on your individual needs and tax situation. But, once you have chosen to invest a sum of money for the long term, there isn’t much need to take into account your special situation to select investments.

If you choose a stock or fund for very smart reasons, you will get exactly the same return as someone who chooses it because it has a nice name. I’m not advocating choosing investments for trivial reasons, but your investments won’t perform any better for you just because you are somehow special.

Investment advisors will take a different view of all this because their primary concern is that you stick with whatever plan they choose for you. They need to take into account your biases when choosing investments so that you won’t switch to another advisor.

Most investors would do quite well to invest long-term money in a few low-cost index exchange-traded funds (ETFs). This isn’t a very individual approach, but it doesn’t need to be.

Thursday, July 24, 2008

The Dangers of Extrapolation

With oil dropping down below $125 per barrel, we get a lesson on the dangers of extrapolating from recent history to predict the future. No trend continues forever.

We’ve heard many predictions about oil prices over the last several months. Commentators have told us when they think a barrel of oil will reach $200, $250, and higher prices. However, these predictions are often based on little more than blindly extrapolating from recent price movements.

Just because oil may have gone up $20 per barrel one month doesn’t mean that it will go up by $20 in each of the next 12 months. Such a prediction has to be justified by some sound reasoning to be worth anything.

Oil prices may yet climb sharply again, but you can’t tell this by studying an oil price chart. If oil rises from $120 per barrel to $140 over the course of a month, it may be reasonable to guess that the price was close to $130 mid-month, but it isn’t reasonable to guess that it will be $160 at the end of next month. This is the difference between interpolation and extrapolation.

Wednesday, July 23, 2008

Survival of Wealth Across Generations

Many people include inherited money in their plans for retirement. In my limited experience, the amounts inherited are often much smaller than people expect. But, when great wealth is concentrated in one family, what stops that family from staying wealthy for many generations to come?

Here are a couple of explanations I’ve heard:

1. When people inherit money without having to work for it, they waste it all.
2. A person may create enormous wealth in business, but the next generation may have little business skill, and they will run the business into the ground.

I’ve never heard what I think is the most powerful explanation: when population levels are stable, the average couple has two children, and the family fortune gets cut in half each generation. So, a family may start with enormous wealth, but 5 generations later, 32 families are sharing this wealth.

So, this gives a partial explanation why you will likely inherit less money than you expect. Don’t count on the lottery either. Most people will have to save money for themselves.

Tuesday, July 22, 2008

New Executive Compensation Approach

Preet Banerjee wrote an interesting article about Sub-Prime CEO compensation. It seems that during 2007 many CEOs were richly compensated for presiding over orgies of loans that would never be paid back. Stockholders of financial companies have been very poorly served.

Now that we know that these CEOs did not deserve their 8-digit compensation during 2007, shareholders would like to get the money back. But, it is too late. Just like the lowly salesman who gets an immediate commission for selling a mortgage whose profitability won’t be known for years, CEOs get their compensation long before we can know for sure that they deserve it.

I have a fix for this problem to suggest to the board of directors of these firms: spread executive compensation out over 5 years. So, each year the CEO would be paid one-fifth of the money earned over each of the last 5 years, continuing after the CEO leaves the company. If a major CEO blunder from a given year comes to light, the compensation tap on that year could be turned off.

For most of the sub-prime CEOs, we know now that they haven’t earned their compensation for years now. They permitted their companies to make massive numbers of unreasonably risky loans. So, if this delayed compensation plan were in place, companies could save 80% of the CEO’s 2007 compensation, 60% from 2006, etc.

Of course, CEOs and other top executives wouldn’t like such a plan, but it is in the interests of shareholders. Decisions about CEO compensation are made by the company’s board of directors who are supposed to represent shareholders. Sadly, many boards just rubber-stamp whatever the CEO wants.

If these sub-prime CEOs knew that the compensation tap would have been turned off if they continued to abdicate their responsibilities, they may have acted differently. This would have slowed the rise of housing prices and softened the fall.

Monday, July 21, 2008

Bad Investment Advice

The Big Cajun Man wrote about the worst financial advice he had ever given, and he challenged other bloggers to admit to bad advice they have given. I had to think about this one for a while.

The truth is that while I have opinions on just about every financial subject, I don’t advise people directly very often. For example, although I often say that trading stock options is a very bad idea for most people, it could be right for a particular person. Then again, most of the people who think it is right for them are mistaken.

There was one period of time where I suggested a way of thinking about investing that didn’t work out the way I thought it would. During the high-tech boom, I worked for a company that had given almost all employees stock options. The stock rocketed skyward making these options very valuable. Employees spent a lot of time discussing when to sell and how much.

I suggested to several coworkers that they imagine that the options were exercised and the stock sold with all the money sitting in their bank accounts. Then I asked them, would you be willing to invest all this money back into our employer’s stock? I expected the answer to be an emphatic no, and that people would decide to sell a substantial block of their holdings based on this little mind game.

But, it didn’t work out that way. To my knowledge this mental exercise caused only one of my coworkers to sell off most of his options. Other employees seemed to get a feeling of bravado and renewed confidence that our company’s stock would rise even higher. I was baffled by this reaction. My best guess is that nobody wanted to be the one who sold out and watched his friends continue to make more money.

Sadly, many employees were millionaires on paper briefly, but sold very little before the crash came. A few people never made a dime from their options. One employee who never made a dime spent wildly on a big new house and car with the plan of selling a few options each month to make the payments. Obviously, this worked out quite badly.

In retrospect it should have been obvious to people that they shouldn’t have 80% or more of their net worth tied up in a high tech start-up company. These things are much easier to see after the fact.

Friday, July 18, 2008

Staying Around for Sudden Stock Market Jumps

Yesterday I saw the biggest one-day jump in my portfolio value in some time. Days like this are comforting. These gains may drain away in the coming days, but right now it feels good to be fully invested.

By “fully invested” I mean that all the money I won’t need for at least 3 years is in the stock market. I only use cash and fixed-income investments for money I will need to spend in less than 3 years (including university costs for both of my sons).

Most commentators recommend holding a fraction of your long-term portfolio in bonds so that you won’t panic during market declines. However, market advances outnumber market declines, and I’m more likely to panic if I don’t take full advantage of market advances.

Of course, there are worse things than investing a quarter of your retirement funds in bonds. One such bad idea is market timing. There are plenty of people who have pulled their money out of the stock market and are waiting for the right time to get back in. All these people missed out on yesterday’s advance.

Of course, missing one good day of rising prices isn’t the end of the world. But, eventually we will have a sustained period of rising stock prices and most market timers will miss out.

So, for others like me who remain fully invested, enjoy days like yesterday. There will be more of them in the future.

Thursday, July 17, 2008

Simplifying Compound Options

Preet over at Where Does All My Money Go? wrote an interesting post about compound options. It shows that the financial world has become very complex, but I think I can simplify it a little.

A stock option is a side bet on stock performance. We can also think of it as a form of insurance. To get a call option you pay a small amount of money (say $2) called a premium to buy the right, but not the obligation, to purchase stock at a certain strike price (say $50) at some time in the future.

If the stock goes above $50, then you will exercise your option to buy the stock at $50 and then sell it for the higher price. If the stock stays below $50, then your option will expire worthless.

Now that we have call options figured out, what happens if we have options to buy other options? These are called compound options. This may seem far-fetched, but our financial world has all sorts of such side bets.

So, we can buy a compound option for, say $1, which gives us the right to buy a call option for $2, which in turn gives us the right to buy the stock for $50. Whew! Are you still with me? Maybe there can even be options on compound options.

However, for the case where the compound option has the same expiry date as the call option, we can show that the following two investments are exactly the same (except possibly for small differences in commissions):

A: A compound option with $1 premium for the right to pay $2 for a call option at $50.

B: A regular call option with $1 premium struck at $52.

To show that these investments are the same, let’s look at a few different cases to see what happens. Each case will have a different stock price when the options expire.

Stock Price $49:

A: The compound option expires worthless. The $1 premium is lost.

B: The $52 call option expires worthless. The $1 premium is lost.

Stock Price $51:

A: We’re above $50, but it will cost $2 to buy the call option. This isn’t worthwhile because we’ll only make $1 on the stock. The $1 premium on the compound option is lost.

B: The $52 call option expires worthless. The $1 premium is lost.

Stock Price $52.50:

A: We exercise the compound option and pay $2 to get the call option at $50. We then exercise the call option by paying $50 to get the stock, and sell the stock for $52.50. We paid $53 in total and have lost fifty cents.

B: We exercise the call option by paying $52 to get the stock, and sell the stock for $52.50. Taking into account the $1 premium, we have lost fifty cents.

Stock Price $55:

A: We exercise the compound option and pay $2 to get the call option at $50. We then exercise the call option by paying $50 to get the stock, and sell the stock for $55. We paid $53 in total and have made $2.

B: We exercise the call option by paying $52 to get the stock, and sell the stock for $55. Taking into account the $1 premium, we made $2.

In every case, the investments gave the same return. So, instead of buying compound options, you can just buy an option at a different strike price. Having said all this, though, I think it’s a bad idea for the average investor to use stock options. They only make sense in specialized circumstances as a form of insurance.

Wednesday, July 16, 2008

The Phases of Stock Talk

The performance of the stock market affects the way people talk about stocks in interesting ways. In my roughly 20-year investing career, I’ve seen the kinds of discussions the average person has about stocks go through several phases.

During the bull run of the latter 90’s, everyone was a stock picker. Even if they didn’t actually invest any money, they had strong opinions about which stocks were the right ones to buy. Few people looked at anything other than recent stock performance, but they had opinions on the future of stock prices anyway.

After the bubble burst, people still talked about stocks, but discussions centered on the question of when the stock market would start going back up. Many people had unjustified confidence in their guess of how long it would take.

The next phase was where people didn’t talk about their investments at all. When their account statements came in the mail, many people didn’t even open them. We are getting into this phase again now that the stock market has continued to drop.

Curiously, for someone who is a stock picker, now is exactly the right time to be examining stocks to find some good companies that have been beaten down unfairly. I still think that most people are better off indexing, but if you are ever going to pick individual stocks, now is the time, right when most people would rather think about anything else.

Whether it takes a year or ten years, stocks will eventually have another bull run. When this happens and just about all stocks become overpriced, we’ll all become stock pickers again.

Tuesday, July 15, 2008

Financial Motivation for Conservation

Let’s face it. It’s hard for most people to understand why they should care about conserving species. It’s not politically correct to say it out loud, but most people don’t care whether the world loses yet another species.

For the conservation movement to improve its chances of success, it needs to stop preaching to itself and start appealing to the average person’s self interest. Only committed conservationists care very much about saving exotic frogs; the average person wants to know what’s in it for him.

Consider the following two arguments against continuing to pollute the river flowing through the fictitious town of Birdville.

1. We need to stop polluting the river to maintain biodiversity in and around Birdville.

2. Pollution in the river is killing the species that our more exotic natural birds eat. The traditional bird-watching tourism to Birdville is way down because of the loss of birds. At this pace, we’ll lose another 400 jobs this year. We need to stop polluting the river to turn this around and save our jobs.

People need to see a clear link between conservation efforts and their self interest. No amount of consciousness raising will get the average person to care very much about animals for their own sake. I’m not opposed to such consciousness-raising efforts, but they are not enough by themselves.

For more information on this topic, see “Conservation for the People”, Scientific American, October 2007, pp. 50-57.

Monday, July 14, 2008

Am I Going to be OK?

Most people would rather not think about money. They’d like to have more of it, but failing that, they would just like to know if they will be OK financially. Francis D’Andrade’s book Am I Going to be OK? deals with this emotional side of money.

Apart from a few commercials for some high-priced financial products, the book does a good job of explaining our fears. Unlike financial books that preach advice that just makes most people feel worse about how they handle their money, many readers will feel that the author understands their fears.

The book offers no real magic for a better financial life. If it’s possible for a book to listen to the reader without leaping to solutions, this book does it. D’Andrade steers readers to the standard sensible money strategy of spending less and saving more, but with a much gentler approach than you’ll find elsewhere. If other money books make you want to stick you head in the sand, then this might be the book for you.

The best part of the book is the discussion of ten mistaken beliefs that many of us share. Among these are:

The government will look after me.
My kids will look after me.
My kids will get a scholarship.
I’m going to win the lottery.

On the negative side, this book has a few paragraphs here and there that seem out of place. They remind me of the mandatory nude scene that adds nothing to the plot in some movies. These paragraphs speak positively about critical illness and disability insurance, life annuities, and investment wrap accounts.

I don’t have anything in particular against the insurance and annuities discussed, but they do pay salespeople nice commissions. If costs are reasonable, then critical illness and disability insurance and life annuities carefully matched to your needs can be good to have.

The investment wrap accounts mentioned are another matter altogether. Wrap accounts add an extra layer of fees on top of the already very high fees charged by most mutual funds. All told, some wrap accounts charge as much as 3%, which may not sound high until you realize that this gets charged on all your money every year. After 25 years, fees will eat up more than half of your money! Fees can be 10 times lower with some well-chosen index exchange-traded funds.

An amusing bit of logic was the explanation that because you can’t tickle yourself, you need a financial advisor. Huh? The author gets full marks for creativity, though.

Another section claimed that differences in product costs are slight and don’t matter. This is clearly not true. Sometimes the fee differences among financial products are huge. Only someone who collects such fees would advise people to ignore them.

The commercials for high priced financial products and services definitely dampened my enthusiasm for this book, but as long as the reader is wary, the rest of the book is worth a read.

Friday, July 11, 2008

The Trap of Trying to be Normal

When we’re uncertain, we tend to look at what others are doing to guide our choices. Most of the time this works well, but it can get us into trouble when it comes to finances.

If you’re at a banquet and you’re not sure whether to eat the strange orange stuff on the side of your plate, looking at what others are doing can be helpful. But, deciding to buy a hot stock because everybody else is buying it is usually a very bad idea.

Advertising tries to exploit our tendency to follow the crowd by giving us the sense that “everyone is doing it.” If it looks like all the beautiful people are drinking a certain beer and driving a certain pickup truck, then we’ll want these products.

When it comes to retirement, most people will have only a modest amount of money to live on. This is because there simply isn’t enough wealth to go around. I can’t say for sure who will retire in style and who won’t, but I can say for certain that the majority of people will have little savings and low income during retirement.

So, if you’re content to be forced to work after age 65 or to live very frugally, then just look around you to see what others are doing and follow suit. On the other hand, if you want an early retirement with a comfortable income, you’ll have to think for yourself. Gathering ideas from others is a good idea, but blindly following other people’s financial choices is dangerous.

Thursday, July 10, 2008

Implied Odds of BCE Takeover

Recent news about the BCE takeover seems good for those who want the buyout to take place. However, Larry MacDonald gives the contrarian view explaining the difference between a Definitive Agreement and an Agreement for Purchase and Sale (the web page with this article has disappeared since the time of writing).

So, the deal is still up in the air. We might wonder what the odds are that the deal will finally take place. We can’t know this for sure, but we can look at what the market thinks the odds are.

The expected deal price is $42.75 per share in 5 months. However, BCE stock closed at only $39.09 on July 9. At a risk-free interest rate of say 5% per year, this works out to $39.89 in December. The gap between this amount and the deal price of $42.75 indicates that the market doesn’t think that this deal is a sure thing.

It’s time for some more assumptions. Let’s say that there are only two possibilities: either the deal will go ahead as planned, or the deal will die and BCE stock will drop to $30 per share in December. The current price plus 5 months of interest ($39.89) is 78% of the way from $30 to $42.75. So, the market puts the odds of completing the deal at 78%.

In reality, there are more than two possible outcomes, but this analysis gives us a sense that the market thinks that a successful outcome is likely. If you have good reason to believe that this probability is too high or too low, then you might consider trading in BCE stock for a short-term gain.

However, a gut feel and pointless overconfidence are not good reasons for having an opinion one way or the other. I have no idea whether the market is right in this case, and so I’m not going to gamble on BCE.

Wednesday, July 9, 2008

Bell’s Pointless Persistence

I used to be a customer of Bell’s Sympatico internet service. For some reason, Bell is trying much harder to get me back as a customer than they ever worked to keep me as a customer.

My most recent mailing from Bell trumpets a very low monthly price of $22.95. Of course, the fine print says that this is for a level of service far below what I used to have with Bell. The real cost to me would be about double this figure.

However, I’m actually not very price sensitive when it comes to internet service. I just want it to work. I haven’t really noticed my Rogers’ internet service because it works and is fast; just the way I like it. I know that other people have had trouble with Rogers, but I’m one of the lucky ones so far.

I know a little about the technology Bell uses, and the quality and speed of service depends greatly on the length and quality of the phone line connection into the home. So, some people will have no trouble, and others will have no end of trouble. Unfortunately, I was in the latter camp after a forced upgrade to a “faster” modem.

My repeated complaints to Bell about having to reset the modem several times per hour got no reaction for a long time. Finally, a technician came out and ran around the house with some equipment. Between smokes he at one point decided that the chain holding one of my lamps was somehow connected to the phone line. This idea was then abandoned for another theory that led to the technician installing a length of phone wire on the side of my house.

None of this solved the problem, but Bell hit me with a surprise charge of $100. Nice. I wanted to talk to a competent person on the phone to try to narrow down the problem rather than jump straight to the $100 non-solution.

Even cancelling Bell’s internet service was painful. They claimed that some fine print in a contract obligated me to keep paying for another month after the current month. Even the process of mailing back the modem and various filters, etc. required a few phone calls to get everything straight.

So now Bell repeatedly invites me to “switch to a better online experience” and they claim to have “the most powerful internet”. Thanks, but no thanks.

Tuesday, July 8, 2008

Charges Laid in Mortgage Scam

The part of the subprime mortgage crisis that is hardest to understand is how so many people were able to get mortgages for amounts that they couldn’t possibly pay back. One case in Massachusetts sheds some light.

Kenneth Garabedian, a mortgage broker, is charged with selling fraudulent “verification of deposit” documents to make it seem like mortgage applicants had more assets than they really had. The purchasers of these documents knew they were committing fraud, and the mortgage applicants were either incredibly naive or they knew they were breaking laws as well.

On the surface, it might seem that the lenders were innocent victims of this fraud, but I don’t think this passes the sniff test. By allowing low-documentation and no-documentation loans, these lenders were essentially inviting fraud.

The fundamental problem comes down to how people are compensated for mortgages. Each mortgage is presumed to produce a certain amount of profit over its lifetime. The amount of this profit depends on the mortgage amount, interest rate and terms, the borrower’s likelihood of defaulting, and other factors.

The profit from each mortgage is realized over a long period of time, but the various salespeople and other facilitators are paid a fraction of this presumed profit immediately. This creates a strong incentive for salespeople to ignore the credit-worthiness of borrowers. So, lenders must check each borrower’s ability to pay carefully.

Unfortunately, lenders weren’t doing this job well. As long as house prices kept going up, this lack of oversight wasn’t exposed, and regulation continued to become more lax. Now that the bubble has burst, weak oversight by lenders has become obvious.

Maybe a portion of the commissions paid to salespeople on mortgages needs to be deferred and made conditional on the mortgage not going into default. Such a system might have made the current financial crisis a little less painful.

Monday, July 7, 2008

BCE Buyout at a Slightly Lower Effective Price: Still Time to Gamble

After all the legal turmoil, the buyout of BCE is proceeding nominally at the original price: $42.75 per share. However, the real buyout price has actually been reduced by about $1.50 to $2.00 depending on how you do the accounting.

The big changes are that BCE won’t be making any more dividend payments, and the deal closing is delayed until December. Between the dividend amounts and the interest on the delayed payment of $42.75 per share, the deal is worth about $1.50 to $2.00 less per share than the original terms.

However, BCE closed at $39.64 on Friday, which is below what you would expect if this was a sure thing. So, there is room for more gambling. Just as it was gambling to trade in BCE back in May, it’s still just gambling to trade in BCE now. The probabilities have changed since then, but I still don’t know for certain that the deal will happen, and I doubt that any other non-insider knows either.

If you’re tempted to buy now and pocket the $3 profit in December, you probably should keep the bet modest: you won’t be happy if the deal falls apart.

Friday, July 4, 2008

Alignment of Interests with Stock Options

During the tech boom, employee incentive stock options were widely used by companies to provide extra income to employees. Management justified stock options by saying that they aligned the interests of employees and shareholders.

Aligning the interests of a company’s owners and employees is very important to the survival of the company as I explained in this post about alignment of interests. On the surface, it would seem that stock options can do the job. After all, if the company’s stock price goes up, it benefits both the shareholders and the employees holding options.

Unfortunately, closer examination will show that stock options do a very poor job of aligning interests. To begin with, most employees do not have enough influence within a company to affect the stock price perceptibly. From middle management down to the workers, stock options are just lottery tickets whose payoff is unrelated to the employee’s performance. Stock options do almost nothing as an incentive for these employees to do what the company’s owners want.

This leaves the top management of the company. These people do have enough influence to affect the value of the company. They are usually given a large block of stock options as a strong incentive to run the company well. In fact, the potential value of the stock options is usually so large that it dwarfs salary, bonuses, and other benefits.

The lure of a huge stock option payday is so strong that top management becomes completely focused on finding some way to drive the stock price up quickly. This can lead to taking wild chances that are not in the interests of shareholders. Consider the following example.

ABC Company’s stock currently trades at $20, and management’s stock options are struck at $20 (meaning that they will be able to buy shares for $20 each at some future time). Management at ABC is considering a bold new plan. There are three equally likely possible outcomes from implementing this plan. One of them results in the stock price jumping to $35, and the other two will result in the stock dropping to $5.

Let’s look at this from both the shareholder and management points of view:

Shareholders: The average outcome is (35+5+5)/3=$15, a loss of $5 per share. This is clearly a bad plan.

Management: If the stock drops to $5, then the stock options become essentially worthless, but employees won’t lose any money. If the stock jumps to $35, then the stock options will be worth $15 each. For the CEO who might have 2 million stock options, this would be a $30 million payday. The average outcome is (15+0+0)/3=$5 per stock option. This is a great plan.

The stock options have created a very strong incentive for management to focus on the short term and take wild chances. This is clearly not in the interests of shareholders. Carefully crafted bonus schemes that measure desirable employee behaviour are a far better than stock options for aligning the interests of employees and shareholders.

Thursday, July 3, 2008

Dollar-Cost Averaging Truth and Myth

Patrick at A Loonie Saved did an experiment with historical stock data to determine the value of dollar-cost averaging. His results were that spreading investments out over short periods of time seems to make no difference. This is because the usual way of explaining dollar-cost averaging is based on a myth.

Here is the usual way of explaining dollar-cost averaging. Suppose that you spread the investment of $1800 in a stock over three months ($600 per month):

Month 1: Share price $30, 20 shares bought.
Month 2: Share price $60, 10 shares bought.
Month 3: Share price $30, 20 shares bought.

In the end you have 50 shares at an average price of $1800/50=$36. But the average share price over the three months has been (30+60+30)/3=$40. Through the miracle of dollar-cost averaging you have saved $4 per share.

The problem with this reasoning is that the average share price calculation is simply not relevant to anything. If you had spent the $1800 all at once, you would have got either 60 shares in months 1 or 3, or 30 shares in month 2. The average result is (60+30+60)/3=50 shares, the same result as spreading out your investment.

The advantage you do get from dollar-cost averaging is reduced volatility. However, the effect is smaller than the examples often given make it seem. Looking at my example, it’s not very common for a stock to double one month, then get chopped in half the next month.

The main advantage of dollar-cost averaging is that if you’re doing it, then you are saving regularly instead of spending all your money. This is more important than any other supposed benefit.

Some investors have been led to believe that they must invest money every month or even more frequently to avoid missing out on dollar-cost averaging. This is simply not true. There is nothing wrong with letting cash build up for a few months until you have say $1000 or more to invest, as long as you aren’t tempted to waste it before you get a chance to invest.

The advantage of waiting for the money to build up before say buying more of a low-cost index ETF is that you’ll save money on commissions. This saving has to be balanced against the cost of being out of the stock market while the cash builds up.

Wednesday, July 2, 2008

Children’s Allowance With Dividends

At the suggestion of the moneygardener, I’m writing about the method I used to pay my kids an allowance with stock dividends. This method of paying allowances was also suggested in the book The Lazy Investor (see review here).

Back in the year 2000, I decided to stop giving my kids an allowance out of my pocket. I bought 100 shares of the Bank of Montreal for each of them. Initially it paid them $50 every 3 months, a modest allowance.

A nice side effect of this is that instead of having to lecture them about the value of stock ownership, I actually had them coming to me with questions about where the money was coming from, and whether the dividend would increase, and so on. Anything that reduces the number of speeches I have to give to kids who aren’t interested in listening is a good thing.

My kids were always happy to see the account statement when the dividends came in, particularly if the dividend had increased. Fortunately, the Bank of Montreal increased the dividend each year giving my kids a nice raise.

There was even a stock split one year that gave me a chance to explain why this wasn’t really a big deal. There were twice as many shares, but the dividend was only half as much for each share. Stock splits are usually as sign of good past performance, but they mean little for the future.

Now the dividend is up to 70 cents per share ($1.40 per original share that I bought). This is a 180% increase over the last 8 years. The drop in stock value has been a little tough, but this has been a good lesson for the kids as well. At least the dividend hasn’t gone down.

The only down side of this approach as far as I’m aware is the need for capital to buy shares initially. On the plus side are the good lessons and not having to dig money out of my pocket every week.

Tuesday, July 1, 2008

Canada Day

Happy Canada Day! We Canadians tend to be understated about celebrating Canada Day compared to July 4th celebrations south of the border, but we do set off some fireworks.

Each Canada Day I’m reminded of my previous corporate life where I often had to explain to American colleagues who wanted to get a meeting in before July 4th that I wouldn’t meet on July 1st. It often took some effort to explain that our Canada Day is similar to Independence Day and that it matters to us.

Maybe we should consider ourselves citizens of North America and take both days off work. I know I will.