Friday, February 29, 2008

My Grandmother’s Thoughts on TFSAs

Sometimes my grandmother surprises me. She is always up to date on the latest news, but I didn’t expect her to analyze the latest Canadian federal budget as carefully as she has. Here are her thoughts on what the tax-free savings accounts (TFSAs) mean to her.

Unlike RRSPs that cannot be used past the age of 71, she is allowed use a TFSA. (I won’t give away her age, but her eldest daughter is on the verge of not being able to contribute to an RRSP either.)

For my grandmother, investing means GICs at a bank, which is sensible at her age. I used to wonder if the bank took advantage of her by offering poor interest rates, but at the latest update, she left one bank to move to another where she negotiated a better rate than the best I was able to find with my discount broker.

In one way the TFSA is good for her because it lets her shelter interest income that is usually highly taxed. However, the $5000 limit is a problem for her. The great interest rates she gets are partly due to the fact that she is negotiating a rate for all of her savings rather than just $5000.

She worked out the after-tax interest rate she gets on her savings and found that it isn’t much different from the pre-tax rate she would get on $5000. The whole TFSA business would be a lot of trouble for no benefit.

So, she will have to wait a few years for the $5000 per year to build up before it is worthwhile for her. I guess there is no reason to worry about my grandmother having Alzheimer’s at this point.

Thursday, February 28, 2008

Tax-Free Savings Accounts (TFSAs) and Income Splitting

The Big Cajun Man over at Canadian Personal Finance has been calling for tax relief for single-income families for some time now. One way the government could do this would be to permit income splitting.

Consider a hypothetical couple, Carol and Dan. Carol earns $80,000 per year as a software developer, and Dan stays home with the kids earning no income. Most people publicly praise Dan for taking on a non-traditional nurturing role while privately wondering what’s wrong with him. It takes a long time for attitudes to change, but that’s another story.

Carol gets some tax breaks for supporting a spouse, but she still pays a lot in income taxes. If the Canadian government permitted income splitting, she and Dan could each declare $40,000 per year in income, and their overall tax bill would be quite a bit lower.

We’ve heard that the Canadian government’s new tax-free savings accounts (TFSAs) provide income splitting opportunities. However, you will not get the same immediate benefit as real income splitting as in the example of Carol and Dan.

Carol can put money into Dan’s TFSA, and he can take it out sometime in the future tax-free. Of course, she can take money out of her own TFSA tax-free as well. Any lowering of taxes will happen in the future, unlike real income splitting which gives tax benefits right away. This strategy is similar to using spousal RRSPs.

A better way of thinking of this is that Carol is able to shelter $10,000 of her savings per year because she is married to Dan. If she were single, she could only shelter $5000 of her savings per year. Of course, this only matters if she and Dan are able to save $10,000 per year on top of their RRSP contributions.

Most families will not be able to make the maximum contribution to both their RRSPs and TFSAs. This means that they will not get any additional income splitting benefit from TFSAs. Don’t let this sour you on TFSAs, though. They will be of great benefit to people who save for the long term.

Wednesday, February 27, 2008

Tax-Free Savings Accounts (TFSAs) vs. RRSPs

The Canadian Federal Government introduced the tax-free savings account (TFSA) in yesterday’s budget. This is the Canadian equivalent of the Roth IRA in the US. Canadians will be able to put up to $5000 per year into a TFSA. Any gains on investments inside a TFSA are tax-free.

For details on the TFSA, see comments from the Canadian Capitalist and Jonathan Chevreau.

The TFSA is similar to an RRSP in that the income from investments within the account are tax-sheltered. The main differences are as follows.

1. TFSA contributions do not give you a tax deduction. RRSP contributions are deducted from your income to reduce taxes.

2. TFSA withdrawals are not taxed. With RRSPs, any withdrawal is treated as regular income and is taxed.

A natural question is should you contribute to an RRSP or a TFSA? The answer depends on your tax rates. If your tax rate when you contribute money is higher than it will be when you withdraw money, then an RRSP is better. If your tax rate when you contribute money is lower than it will be when you withdraw money, then the TFSA is better.

Both RRSPs and TFSAs are better than investing in a regular account where any gains are taxed. So, if you are able to save enough, contributing to both RRSPs and TFSAs is the best option over the long term. Not paying taxes each year on investment gains is a huge advantage of both types of accounts.

An interesting difference between RRSPs and TFSAs is the perception of how much money you have. If you are in a 50% tax bracket, you will only get to spend half of the money in your RRSP. However, all of the money in a TFSA is yours to spend.

So, having $200,000 in an RRSP may feel better than having $150,000 in a TFSA, but it isn’t better (if you are in a 50% tax bracket). This psychological difference may make people happier with bigger dollar amounts in an RRSP even if they are better off with a TFSA.

As more details come out about TFSAs it will be interesting to see what kind of strategies become possible such as income splitting between spouses. If the TFSA is here to stay, it will provide big benefits for people who save money and invest wisely.

Tuesday, February 26, 2008

Debt Problems and the Dangers of Consolidation Loans

When people get into trouble with their debts, they usually have several different debts including credit cards, car loans, line of credit, and possibly student loans. The debts usually have different interest rates and different required monthly payments. Some debts are scheduled to be paid of quickly and others over a long period of time.

The idea of a consolidation loan is to borrow one large amount to pay off all of the other debts. For this to make sense, this loan would have to be at a low interest rate and amortised over many years to make the payments low enough for the debtor to handle.

To qualify for this type of loan at a low interest rate, the debtor might have to put up some collateral, and this collateral is usually a house. The consolidation loan then turns into a home equity line of credit (HELOC).

On the surface, this seems like a good strategy. A lower interest rate means that you pay less interest. What other considerations could there be? I can’t say that I ever thought about this much, but a HELOC seemed to make sense if you are in debt trouble.

I was reading Suze Orman’s latest book “Women & Money” and she is dead set against this strategy saying “never use home equity to get rid of credit card debt.” Her reasoning is that if you got into trouble once, then you are likely to run up your credit cards again. Then you will have credit card debt and the HELOC to pay off. And if you can’t pay them off you will lose your house.

My first thought was that I disagreed with Orman. A rational person would consolidate the loans and then bring spending under control. But a rational person probably wouldn’t have had debt problems in the first place.

It is possible for someone who manages his money well to have some big expensive event occur that throws him into more debt than he can handle. But this is infrequent compared to the number of people who make poor choices that result in having debts spinning out of control.

So, I think Orman is right. Most people with debt problems probably should not consolidate their debts into a HELOC.

Monday, February 25, 2008

Predatory Lenders and Students

It turns out that banks consider students to be great customers for their credit cards. I learnt this from James D. Scurlock’s book “Maxed Out: Hard Times, Easy Credit and the Era of Predatory Lenders,” which gives a fascinating look into the world of lenders and their hapless customers.

The part of the book about students hit home with me. I have one son in university, and another will hopefully be going in a couple of years.

So why are students good customers? When you think of the old style bank that only lends to people with steady income to pay off a loan, lending to students makes no sense. Students usually have little income, and many of them will run up bills on their cards that they can’t pay off.

It turns out that students have something else that makes them great customers: parents. According to Scurlock, parents will almost always bail their children out of debt problems. And the attitude of banks has changed dramatically over the years.

Students run up debts and pay interest for as long as they can. When things finally fall apart, their parents pay off the debts. The situation is perfect for the bank: they charge high interest rates with very little risk of default.

Other great customers are people who can’t handle money properly, but have a valuable asset such as a home. The strategy here is to offer this person some unsecured credit, and when they become unable to make payments on the debts they run up, get them to reorganize the debt with the home as collateral. As the debt continues to grow, and the borrower can’t make the payments, the bank can seize the home.

In this scenario, the bank’s goal isn’t so much to seize the home as it is to collect interest on its loans. The home serves as protection against default making the loan safe. Profitability comes from maximizing interest rates and minimizing the risk of default.

When you think in generalities about debt, it is hard to argue with the idea that people should be responsible for their debts and should pay them back. But, when confronted with the particular case of an illiterate woman being forced from her modest trailer home over a snowballing small debt combined with some papers she signed, but didn’t understand, things become less clear.

I’ve done my best to educate my sons about the problems with debt. I’ve also tried to convince them to talk to me before the first time they get a credit card or borrow money in any other way. But, I don’t have any particular insight into the best way to protect young people from the debt trap.

Friday, February 22, 2008

To Win with Stock Options, Someone Has to Lose

Not to be too philosophical, but my experience has taught me that I’m best off to conduct myself as though there exists a single objective reality that applies to all of us rather than each of us having our own separate realities.

What does this mean for the investing world? If several people all buy 100 shares of ABC stock at the same time for the same price, then they will all get the same return over a given period of time. Some of these people bought ABC stock for very smart reasons, and some might have bought it because they have the initials ABC. Some of the investors are smart, some dumb, some nice, and some mean, but they will all get the same return.

This all seems obvious enough, but you have to keep it in mind when you read the come-ons for businesses that want to set you up with an account to trade stock options.

Stock options are side bets between two parties on whether a stock will go up or down. A bet that the stock will go up is called a call option, and a bet that the stock will go down is called a put option.

Descriptions of stock option strategies usually go something like this:

“If you think ABC stock is poised for a big move upward, buy call options. When ABC stock rises, you will make a lot more money than if you just bought the stock instead of the options.”

Statements like this are true because they start with “if”. But what happens if ABC stock doesn’t go up? You’ll lose your money, that’s what. For every bet you make with stock options, there is someone on the other side betting the opposite way. You can’t both win; the stock can’t go up for you, but down for the other guy.

One of you will win the bet and the other will lose. This is what is called a zero-sum game. Across everyone who plays, the total wins and losses add up to zero. Actually, it’s worse than this because of trading commissions when you buy or sell options. So, in reality, the average person involved in stock options loses money.

When you trade in options you are making bets ON the stock market, but you’re not invested IN the stock market. Because of this, you’re not taking advantage of the fact that the average stock market investor makes money over time. This means that stock option trading has a built-in disadvantage when compared to investing in stocks.

Before trading stock options, you should ask yourself a tough question: am I so good at predicting stock prices that I can overcome the disadvantage of trading in options rather than investing in stock directly? For the vast majority of people (including me), the answer is no.

Thursday, February 21, 2008

When is the Right Time to Buy a Stock?

ABC stock has been rising steadily lately – is this a good time to buy? XYZ stock has fallen steadily lately – is this a good time to buy? Sadly, the answer in both cases is maybe.

It turns out that you just can’t tell what is going to happen to a stock by just looking at what has happened in its price history. ABC might go up and it might go down. The same is true of XYZ.

To understand this better, let’s look at an example that is much easier to understand: bananas. Suppose that bananas have been selling for a dollar per pound. Sometimes you buy a few and sometimes you don’t.

Suddenly, banana prices jump to $1.50 per pound – should you buy them now? If the bananas seem the same as usual then probably not. But what if the bananas look unusually good, and you ate one and found it to be much better than the usual bananas? Then you’d probably buy them at the higher price.

The next month, banana prices drop to 50 cents per pound – should you buy them now? If the bananas seem to be about the same quality as you’re accustomed to, then you’d probably buy more of them than usual. But what if they are overripe and bruised? Then you probably wouldn’t buy any at the lower price.

In both the price rising and price falling cases, we couldn’t say for sure whether we’d buy bananas until we knew more about their quality. The same is true of stocks. You must have an opinion about the prospects of ABC company’s future success to decide whether to buy the stock. This is true regardless of what has happened to the stock price lately.

If you don’t know how to go about forming an opinion on the future prospects of a business, then you are a good candidate for investing in a low-cost equity index fund. This way, you’ll get the market average instead of being like most investors who get less than the market average because they pay high fees or try to time the market.

Wednesday, February 20, 2008

Hidden Mutual Fund Fees?

Many people don’t like to talk about money, and so I try not to discuss money unless others show an interest. On a few occasions when the subject came up, I’ve encountered people who think that they don’t pay fees on their mutual fund investments.

In a recent case, an acquaintance who I’ll call Rosie offered her reason for believing this. Rosie said that she knew that some people paid fees, but she checked her statements regularly, and she had never seen any fees listed.

Of course she does pay Management Expense Ratios (MERs) and possibly front or back-end loads. I decided to have a look at some of my old statements from back in the days when I owned mutual funds. Sure enough, there weren’t any references to fees even though I know I paid them.

How widespread is the mistaken belief that investors don’t pay any fees on their mutual funds? I’d be very interested in the results of a poll. Among those who know they pay fees, it would be interesting to find out how much they think they pay.

Disclosure rules are supposed to prevent this sort of confusion. Each mutual fund has a document called a prospectus that discloses fees, and investors have to be given a copy of the prospectus. However, I suspect that people read the prospectus about as often as they read the 16-page manual that comes with a new toaster. (Do not use in bathtub. Do not sue us ...)

Maybe the disclosure rules need to be changed to require fees to be shown prominently on statements. This would be similar to the way that credit card statements have to include information about the amount of interest charged and the interest rate.

Because MERs are so high in Canada, let’s take a Canadian example. Suppose that Howard and Cindy are in the early fifties and have been saving in their retirement savings plans (RRSPs). As of a year ago, between them they had $200,000 split across the three biggest actively-managed Canadian equity mutual funds. (The following figures are based on real fund results.)

Here is the summary part of their collective investments including a fee disclosure that doesn’t normally appear on statements:

Total Assets one year ago:
$200,000

Total Assets now:
$197,247

Total investment return over the past year:
-$2753

This investment return takes into account the following MER fees paid:
$4647

Howard and Cindy would definitely pay more attention to the exorbitant fees charged by mutual funds if they were disclosed this way. Switching to index funds would save Howard and Cindy about $4000 per year in MER fees.

Don’t hold your breath waiting for this kind of disclosure. There would be huge opposition to it from the mutual fund industry.

Tuesday, February 19, 2008

When Can I Retire?

A major concern for many people is how old they will be when they can retire. This depends on a number of factors such as how much you save, how well your investments perform, how much you spend during retirement, and how long you live.

Retirement calculators can figure this out for you based on a number of assumptions. However, most of them don’t give you a feel for how the final answer would change if your investment returns are volatile instead of perfectly steady.

There was a good post over at the Canadian Financial DIY blog about using Monte Carlo analysis for financial planning. Monte Carlo analysis just means simulating possible outcomes many times to see how the final answer changes.

I decided to use Monte Carlo to see how the mix of stocks and bonds in a portfolio affects when you can retire. I had to make some assumptions:

- Stocks and bonds will have the returns and volatility as reported in a paper by John Norstad.
- Retirement money has to last until you are 90 years old.
- After retirement you will invest conservatively and get steady returns 3% above inflation.

The simulations were based on the following saving and spending rates:

- You save $600 per month (rising with inflation) in a retirement account while working.
- You will spend $4000 per month (in today’s dollars) during retirement.

I ran each simulation until there was enough money to retire. After a million runs, I found the median retirement age as well as the age range that covered 90% of the simulations.

Here are the results if you start saving at age 25:

StocksBondsRetirement Age
Median (Range)
0%100%75 (65-82)
50% 50%66 (56-76)
100%0%57 (47-72)

The width of these age ranges shows that there is quite a bit of uncertainty. There isn’t much doubt that historically stocks have been better than bonds at giving investors a chance to retire early.

Here are the results if you waited until age 40 to start saving:

StocksBondsRetirement Age
Median (Range)
0%100%80 (74-84)
50% 50%75 (68-81)
100%0%69 (60-80)

The advantage of stocks is evident here as well. The other thing to note is the power of starting to save earlier. In the all-stock case, the 15-year head start in saving led to retirement about a decade earlier.

It makes sense to use short-term bonds for money that you will need to spend within the next 3 years or so, but I haven’t found a good reason to own bonds for the long term.

Monday, February 18, 2008

What I Want My Children to Know About Money

Part of my motivation for writing this blog is to pass on what I know to my children before they are on their own making financial decisions. Even though I make my choices carefully and put time into understanding how things work, I have made some financial mistakes and other people have taken advantage of me financially from time to time.

People like to say that money isn’t everything, and this is true. Relationships, fun, interesting activities, and challenging pursuits lead to a full life. Money can’t give you these things, but it can give you more freedom to pursue them.

Most of us trade our time for money by taking jobs. The jobs we have vary in how fulfilling they are, but very few of us can honestly say that we would do our jobs for nothing. Even the best jobs have unpleasant parts, and almost all of us do some fraction of our jobs only for the money. So, for most of us, to say that money isn’t important is to say that our time isn’t important, and this is wrong.

Money represents your hard work and your time. You could have spent this time with friends and family, travelling, or any of a number of other pursuits that would have been more enjoyable than your current job. Handling your money wisely will contribute to your future happiness.

Young People Have a Financial Advantage

Children tend to look at the money that adults have and think that the adults are better off. This is only superficially true. Adults usually have more money, but they have obligations that use up their money. Most adults settle into a lifestyle whose costs consume all of their incomes. Each small raise at a job is met with increased spending.

Changing careers often means at least a temporary drop in pay, and starting your own venture may mean no pay at all for a while. Most adults are unwilling or unable to change their lifestyles to accommodate such changes. These people are trapped in their jobs whether they like them or not, and losing their jobs can be traumatic. But, it’s not all doom and gloom; just a modest amount of savings can serve as a buffer allowing people to make the career changes they want.

One advantage young people have is that they are less set in their ways. They may want expensive things, but they can more easily make do with less. Taking the bus isn’t too painful if you have never owned a car. Young people can more easily choose to live frugally, build up some savings, and invest those savings for big long term gains.

The big opportunity for young people is the chance to begin their financial life by saving some money and avoiding debt. If you get into debt early, you are setting yourself up for a life of financial insecurity and limited choices. If you save and invest, you will have a secure financial base that will give you choices in how you live your life.

Friday, February 15, 2008

Hot Stock Tip

I don’t normally go for hot tips on stocks, but I can’t help myself because I’ve come across a scorcher! Before I reveal the name of the stock, let me just say that this tip is a little different from most tips because it comes with a strategy that you have to follow to make money on this stock.

The company is Questcor Pharmaceutical Corporation, trading under the symbol QSC in the US. This stock has been red hot. On Aug. 18th last year, QSC closed at 35 cents per share. Now it trades at about $4.70, a 1243% increase!

With just three of these opportunities in a row, you could turn $1000 into over $2 million. The catch is that all this stock appreciation for QSC is in the past. So, to make money, you’ll have to travel back in time to Aug. 18th to buy this stock and then sell it now.

The reason for the time travel is that I have no idea what Questcor Corporation does or what will happen to its stock price in the future. I’m not buying even a single share because I haven’t perfected my time machine yet.

I think I’ve milked this long enough. Obviously, I have no real stock tip. What difference does it make if a stock has done well in the past if you have no insight into its future? The same is true of mutual funds, but for some reason many people jump back and forth between mutual funds based on their past results.

There are a staggering number of online services available to help you sift through mutual funds to find the ones that performed well in the past. They seem to admit the futility of this approach with the disclaimer “past results are no guarantee of future returns.”

When an advertisement trumpets ABC fund’s category leading one-year returns, the correct response is “So what? What reason is there to believe that this fund will perform well again next year?” There might actually be a good reason to expect good future returns, but don’t bet on it.

Here are some posts that explain why you might be concerned that ABC fund could perform poorly after you buy into it:

A Mutual Fund Too Successful to Succeed?
The Illusion of Mutual Fund Returns

Index Funds Beat Most Mutual Funds

Always be sceptical when it comes to hot stock tips and top performing mutual funds.

Thursday, February 14, 2008

How the World Works Financially

People can be split into two groups: 1) those who spend carefully, save money, and invest wisely, and 2) those who, to varying degrees, do not do these things well. For convenience, let’s call these two groups savers and spenders.

Some of the spenders’ wages get transferred to the savers, primarily in the form of interest on debts. Most interest paid by spenders becomes the profits of banks and other companies, which then gets distributed to shareholders who happen to be savers.

Of course, people don’t really fit into just two groups. Most people fall somewhere between the best of savers and the worst of spenders. You can think of people being lined up the side of a mountain based on how well they handle money with the worst spender at the top of the mountain. Now imagine money rolling downhill from the spenders to the savers.

Although I have called the two groups savers and spenders, limiting spending is not enough to make someone a saver. A saver must invest wisely as well. Imagine someone who never takes on any debt, but keeps all savings in a low interest bank account that fails to keep up with inflation. This will increase the bank’s profit and benefit the bank’s shareholders who are savers.

It may seem like being a saver is not much of a life, but in truth, it is only necessary to spend less than your wages for a while. Once you have some savings built up and invested wisely, the investments generate returns in the form of interest or capital gains. When these returns are large enough, they can be your new savings, and you can spend all of your wages. Later, you can begin to spend all your wages plus some of your investment returns. The best of savers can ultimately quit their jobs and live on their savings.

If you are a saver, one way to think of it is that spenders go to work to benefit you. If you are a spender, then you go to work to benefit savers, at least partially. No amount of claiming that money isn’t the most important thing in life changes the basic fact that spenders work for savers.

Wednesday, February 13, 2008

Roger Gibson’s Asset Allocations

Most commentators agree that we should include some bonds in our long-term investments. My quest for a reasonable analysis to support this conclusion continues. Previously, I have discussed the ideas of Gordon Pape and Morningstar on this subject.

I’m starting to feel like I’m in some sort of boxing match. So, let’s do it right:

“In this corner ... Roger C. Gibson, esteemed author of ‘Asset Allocation: Balancing Financial Risk’ now in its fourth edition. He’s a well-respected expert whose ideas have been endorsed by Sir John M. Templeton and Don Philips, Managing Director, Morningstar.”

“And in this corner ... some guy who figured out how to use Blogger.”

Oh well. I lose on the credibility meter. My only chance is that people actually think about the arguments.

Gibson does an impressive amount of analysis and explains many important concepts clearly. When it finally comes time to figure out an optimal asset allocation, he tosses in an interesting assumption about our tolerance for risk. Here goes:

Suppose that our only investment choices are US Treasury Bills or stock in large US companies. Gibson assumes that for us to be willing to have a portfolio equally split between these two choices, the expected return from stocks would have to be 10% higher than the Treasury Bill return.

To understand the implications of this assumption, let’s assume that we have access to an investment that will either return 0% or 1000% on the flip of a coin. (Heads and you get your money back. Tails and you get 11 times your money back.)

Gibson’s assumption means that we would rather have a guaranteed 11% return than take a 50/50 chance on getting a 1000% return! This is a ridiculous level of aversion to risk.

In a previous post I explained that on Morningstar’s risk-aversion scale, I rate about a zero and Morningstar thinks that the average investor rates about a 2. Gibson’s assumption is that we rate a 7.1!

Despite all his analysis, in the end Gibson actually ignores most of it and focuses on investor psychology. He bases his portfolios on what the investor will tolerate rather than an analysis of what asset allocation has the best characteristics.

I understand that a major concern of investment advisors is whether their clients will stick with a plan. According to Gibson, it seems that investor psychology trumps the pursuit of investment returns.

However, this is not my concern. I seek a plan for myself that finds a rational balance between volatility and returns. I trust that I can control myself if I start having irrational feelings.

Tuesday, February 12, 2008

Gordon Pape’s Portfolios

Well-known financial author Gordon Pape seems to agree with Morningstar that investors tend to be very conservative. (See this post for a discussion of Morningstar’s views on investor conservatism.)

For example, in his book “Sleep-Easy Investing”, Pape recommends against owning stock index ETFs. He observes that by early 2003 stocks had declined, and “many people would have bolted at that point, thus defeating the basic strategy of owning ETFs.”

He is right that it is a bad idea to sell low and miss out on a subsequent run-up in stock prices. But stock index ETFs have given good returns for people who have stuck with them calmly through declines. The good times with stocks more than make up for the declines.

Pape’s book is one of the best financial books I’ve read. It includes useful information and practical advice explained clearly, but I’m not the least bit interested in his model portfolios. They are filled with fixed income products, and the target returns are far too low. It seemed strange to agree with almost all of his points throughout the book, but then disagree with many of his conclusions.

As a side note related to Pape’s credibility, he tells a story of extending himself too far when he and his wife bought a winter home in Florida. He says that if it the Canadian dollar had not started to rise in 2003, “we probably would have had no choice but to sell.” Maybe the story is written with a modest spin, but he seems to be saying that he isn’t rich. I’m not sure I want to take financial advice from someone who has had so much career success, but isn’t wealthy.

Pape’s portfolios may well be a good match for the way most investors think, but they’re not for me. I have cash reserves and safe investments for any money I will need in the next 3 years. Everything else is in stocks. The sleep-easy portfolios would keep me up at night worrying about the higher returns I could be getting.

If Pape is right and most investors would worry terribly and sell after a big decline if they invested the way I do, then those investors may be better off with one of the sleep-easy portfolios. I’m hardly a seasoned investor, but I’ve been through enough ups and downs that I stay calm through both.

During one 3-year period when my stocks doubled, I didn’t start planning which private jet I’d use during my retirement. When my stocks lost a third of their value over a couple of years, I didn’t sell, and I didn’t start preparing for my future by taste-testing cat food.

I believe in the long-term success of the Canadian and US economies and know that stock market prices will reflect this success over the long run. I prefer to go for the historically higher returns of stocks. I accept that the value of my portfolio will have ups and downs, and I sleep well.

Monday, February 11, 2008

How Conservative Are Investors?

Everything I read about asset allocation says that investors are very conservative and must put a significant fraction of their money into fixed income investments like bonds even though stocks have historically given much higher returns.

All of these commentators may be right about their assessment of investor psychology. Of course, this says nothing about what would be best for investors; it is just a reflection of how investors think.

Morningstar has formalized this view of investors in a formula for assessing investments. This formula calculates what they call the Morningstar Risk-Adjusted Return (MRAR). I spoke about this somewhat in a previous post. Morningstar describes it in more detail in a 4-page write-up that is no longer available online, but that's okay because all the math in their expanation tends to obscure what is going on.

Let’s look at a simple example. Suppose that each year a particular investment returns either 50% or -20% with equal probability.

A simple view of this investment is that its average return is (50% + (-20%))/2 = 15%. Morningstar’s MRAR calculation can handle different degrees of conservatism, and this simple kind of average corresponds to MRAR(-1).

Another way to look at this investment is that after two years you will probably get 50% once and -20% once. So, $1 would grow by 50 cents to $1.50, and then lose 20% of $1.50 (30 cents), leaving $1.20. The two-year return is 20%. This corresponds to an annual compound rate of 9.5%. After many years, the odds are about 50/50 whether your long-term annual return would be above or below 9.5%. This kind of average corresponds to MRAR(0).

You can think of the drop from 15% to 9.5% as a penalty for volatility. And this high penalty is appropriate. This is a very volatile investment.

But Morningstar thinks that the volatility penalty should be much higher than this to match the “risk tolerances of typical retail investors”. I’m not sure, but I think “retail investors” is a reference to dolts like you and me. Presumably, professional money managers have different risk tolerances.

Morningstar says that the typical investor is so conservative that we should use MRAR(2), which gives a risk-adjusted return of minus 0.2%! If Morningstar and other commentators are right, investors would rather stick their money in a zero-interest bank account than try this investment.

Maybe most investors really are this conservative, but I’m not. I make sure that I have adequate cash reserves, and have safe investments for any money I will need in the next three years. After that everything is invested for the long term, and my risk tolerance is consistent with MRAR(0).

Friday, February 8, 2008

Unlocking the Value of Your Home

What a great sounding idea: unlocking the value of your home. Whenever I hear this phrase, I picture piles of cash stored in my walls. What could be more reasonable than taking some of this cash out to make my life better?

I usually hear advice about unlocking my home’s value from a bank that wants to sell me a loan or a financial advisor who wants to sell me mutual funds. But, so what? Do I really need to have so much of my money tied up in real estate?

Some financial advisors even talk about the dangers of investing too heavily in just one asset class: real estate. For the sake of safety and diversification, do we need to take some money out of our houses and buy some stocks and bonds?

To begin with, the idea that you can take some money out of your home without selling it is just a trick. You own 100% of your home regardless of how much you owe on your mortgage. If your house drops in value, the loss is yours, and the bank will still want the same mortgage payments.

So, “using home equity to invest” is just a fancy way of saying that you are borrowing money to buy stocks and bonds. And “using home equity to travel” is just a fancy way of saying that you are borrowing money to go on vacation.

Somehow, it doesn’t sound like such a good idea when you phrase it differently. Don’t be fooled by marketing language designed to get you into debt. If you decide to borrow anyway, at least you’ve done it with your eyes open.

Thursday, February 7, 2008

“Worry-Free Investing” Book Review, Last Part

This is the last part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here.

On the positive side, this book contains a wealth of useful and unbiased information about investing and saving for such things as college and retirement. The authors are thorough and knowledgeable. Not counting differences of opinion, I found only one error in the book: at the top of page 113, the return in the example is actually 43.4% rather than 24.9%.

On the negative side, the book heavily stresses investing in I Bonds, which are safe, but give low investment returns. I fear that most people will not be able to save enough money each year to meet their goals if they stick to I Bonds. These people need to take some calculated risks to get what they want. It’s better to have a 90% chance of achieving your goals with stocks than having a 0% chance with I Bonds.

Even though I disagree with the authors’ main point that stocks are too risky, it’s a good idea to seek different points of view that challenge your assumptions. The authors do make good points about people exposing their finances to too much risk. For these reasons, I recommend this book.

Wednesday, February 6, 2008

“Worry-Free Investing” Book Review, Part 6

This is the sixth part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here.

Chapter 1 of this book begins with the sad story of John and Joan Parker who in March 2000 were planning to retire when John turned 62 at the end of 2002. Their retirement savings were in stocks and the recent big stock market gains made it look like they would have a comfortable retirement soon.

Sadly, stock prices dropped, and this couple had to plan on working longer to make enough money to retire. If only they had their money invested in safe investments, right?

What if they had put their retirement savings entirely into regular bonds and I Bonds for the past 30 years? Then the Parkers would not have participated in the long bull market that ended in the early 2000’s. As we saw back in part 4 of this review, stocks have beaten the I Bond strategy in all 30-year periods since 1926.

Had the Parkers invested in bonds, their savings would have been much lower by March 2000. Even by the end of 2002, stocks for the entire 30 years would have beaten bonds over that period. The remaining problem is that they had their hopes dashed; the uncertainty of stocks made planning difficult.

The solution to this problem comes from recognizing that money should not be in stocks if it will be needed soon, say 3 to 5 years. (See this essay for more about this approach to stock investing.) If the Parkers had begun selling stock 5 years before the planned retirement date, they would have locked in some of their big gains.

Whether the market went up or down from March 2000, steady selling starting from 1997 would have given the Parkers more certainty for their retirement. The money from the stock sales could have been put into safe I Bonds until needed.

The last part of this book review is next.

Tuesday, February 5, 2008

Risk Aversion and Morningstar

Here is a bonus post today in case you’re not following the book review.

Your reaction to a game show scenario can reveal important information about your attitudes as an investor. It can even tell you what mix of investments are appropriate for your portfolio.

Let’s get right to it. You are playing Deal or No Deal and you are down to two amounts: one penny and a million dollars! What is the minimum offer you would accept from the banker?

For those not familiar with this game show, here is the situation. You are about to toss a coin. If it comes up tails, you get nothing (and lose nothing). If it comes up heads, you get a million dollars. Just before you toss, someone offers you a sum of money to give up your chance to toss for the million dollars. What is the minimum such offer you would accept?

It turns out that your answer depends on how rich you are. Bill Gates would likely accept an offer of half a million dollars, but not much less. However, someone in a desperately poor country might accept an offer of $5000.

To make a proper apples-to-apples comparison, we need to take into account your wealth. So, let’s look at how much money is in your portfolio. I’m not talking about your house, cars, and emergency stash of cash. Just consider the value of your investments that you are trying to grow for the long term.

Instead of tossing for a million dollars, imagine that you are tossing for 10 times your current portfolio size. I’ll continue this discussion as though your portfolio size is $100,000, but you will have to multiply or divide all the numbers I use by some appropriate factor.

If you are an investor who seeks to maximize the long-term compounded return on your portfolio, then the lowest offer you accept to give up your chance at the million dollars is $230,000. In the language of portfolio optimization (see this paper by John Norstad), you have a “coefficient of relative risk aversion” of A=1.

If the thought of coming away with nothing after the coin flip scares you enough that you would accept an even lower offer, then your value of this risk-aversion number A is higher. At A=2, the lowest offer you would accept is $83,000.

At A=3, the lowest offer you would accept is $41,000. It might seem ridiculous that someone who has $100,000 in his portfolio would accept only $41,000 and pass up a 50/50 chance at a million dollars, and I agree. So why am I talking about this silly A=3 case?

Morningstar uses A=3 in their risk-adjusted return calculation to rate mutual funds. Morningstar provides detailed information about both US and Canadian mutual funds. When you hear that some fund has a 4- or 5-star rating, this is based on Morningstar’s formula for comparing mutual funds.

From the notes with Morningstar’s formula, “γ=2 [which corresponds to A=3] results in fund rankings that are consistent with the risk tolerances of typical retail investors.” I can’t speak for other investors, but this definitely doesn’t apply to me.

This formula gives strong preference to funds with low predictable returns. Funds with higher returns but more volatility are punished severely.

Everyone has different thoughts about how much risk is acceptable. Personally, I’m in the A=1 camp trying to maximize the long-term compounded return on my investments. This makes Morningstar’s ratings completely irrelevant to me.

“Worry-Free Investing” Book Review, Part 5

This is the fifth part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here.

In Chapter 7, the authors outline a strategy for investing primarily in inflation-protected bonds (I Bonds) along with a small amount in stock options. Before discussing this strategy any further, let me give a brief primer on stock options.

The simplest kind of stock option is a call option. When you buy a call option, you are buying the right to purchase stock at a particular price. Suppose that Microsoft currently trades at $34 per share, and you decide to buy 1000 call options for $1 each that give you the right to buy Microsoft shares for $40 each sometime in the next 6 months.

If Microsoft stock never gets to $40 per share within 6 months, then you lose the $1000 you spent. If the stock goes to $45 per share, then you can exercise your right to buy 1000 shares for $40 each and then sell them for $45 each. In this case you make a profit of $5 per share minus $1 for the cost of each option. You make a total of $4000.

With options, you can make a lot of money or lose a lot of money fast. All the arguments about stock markets rising and everybody winning don’t apply to options. Call options are essentially a bet where the option buyer gambles that stocks will go up, and the option seller gambles that stocks won’t go up. It is a zero-sum game except for the costs of commissions and spreads. The average participant in stock options loses money.

Given $100,000 to invest, the authors’ suggest buying enough (I Bonds) to get back the $100,000 plus inflation after 3 years, and put the small amount that is left over into call options on the whole stock market. With this strategy, you won’t lose money, but you are combining a low-return investment (I Bonds) with an investment whose expected return is negative. If this sounds bad, it’s because it is bad.

In rolling 3-year periods between 1926 and 2000, buying stocks was better than this strategy 79% of the time. On average, stocks were better by $12,800. Now let’s consider repeating this strategy 10 times over a 30-year period. In rolling 30-year periods from 1926 to 2000, stocks were better than this strategy 100% of the time by an average margin of $409,000!

It turns out that safety can have a very high cost.

We continue with part 6 of this book review next.

Monday, February 4, 2008

“Worry-Free Investing” Book Review, Part 4

This is the fourth part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here.

In part 3 of this review I showed that the authors’ justification for disliking stocks based on simulations is misleading. Instead of doing 30-year simulations, what about looking at actual 30-year returns in the data we have from 1926 to 2000?

The worst 30-year period for stocks was from 1965 to 1994 (inclusive), where the average real compounded return was 4.3%. This means that if I Bonds had existed then, and you could get one that paid 4.3% above inflation, then it would have done just as well as stocks. But, I Bonds don’t usually pay this much. In every single 30-year period, stocks beat I Bonds.

But what about the big stock market crash after the year 2000? Even taking the 30-year period ending at the bottom of the crash, average yearly compounded real returns were above 4%, which beats I Bonds.

One of the points that the authors repeat is “the risk of owning stocks does not always decline the longer you hold them.” This depends on how you look at it. You may not know whether stocks will beat I Bonds by a little or a lot, but the odds of beating I Bonds are high over the long term.

From 1926 to 2000, yearly real stock returns ranged from roughly -40% to +60%. But, if we look at all the possible 30-year periods, the range of average yearly compounded returns was 4.3% to 10.3%. Over time, the range of average yearly stock returns declines. In this sense the risk of owning stocks does decline with time.

In part 5 of this book review, we examine the authors’ strategy based on stock options.

Saturday, February 2, 2008

Asset Allocation: Should You Buy Any Bonds?

I’m interrupting my book review to continue an interesting discussion over at Canadian Financial DIY (post 1 and post 2). The posts and follow-up comments make good points about investor psychology, but I’m more interested in getting the right answer for rational investors.

A quick search turned up a useful paper by John Norstad. This paper describes all the math I needed to calculate optimal portfolios, and it provides information about stock and bond returns in the US from 1926 to 1994.

The paper assumes that you can borrow at a rate that is 0.83% above inflation. Based on all this, I worked out the optimal mix of borrowing, stocks, and bonds to maximize the expected compound return. Let’s assume that you have $100,000 to invest.

Drum roll, please! The optimum portfolio has you borrowing $180,000 (for a total of $280,000 to invest now), and investing $196,000 in stocks and $84,000 in bonds. This mix gives you a boost of 2.45% per year over an all-stock portfolio with no borrowing. Wow, that was anticlimactic.

Does this mix of investments sound crazy to you? It seems way too risky to me. How can it make sense to borrow so much money? We’re assuming that you will rebalance your portfolio frequently to maintain the right proportions, but any quick drop in stock prices would really hurt.

The problem with this analysis is the assumed borrowing rate. Who can borrow at less than 1% above the current inflation rate? What happens if we change this to assume that we can borrow at a rate that is 2% above inflation?

I went back to Excel with this new borrowing rate. The result is that you should borrow $70,000, put $170,000 into stocks, and put nothing in bonds. Now you’re getting only a 1.01% per year boost over an all-stock portfolio with no borrowing.

That’s quite a difference from the first portfolio. What happens if the borrowing rate is even higher than 2% above inflation? All that happens is that the amount borrowed drops. The optimal portfolio still has no bonds. When we get to a borrowing rate that is 5% above inflation, there is no borrowing, and the whole $100,000 goes into stocks.

All analyses like this one have built-in assumptions that need to be examined. The main message here is that the interest rate on borrowed money makes a huge difference in how you should invest. A secondary message is that I’m still searching for a rational reason to invest in bonds for the long term.

Friday, February 1, 2008

“Worry-Free Investing” Book Review, Part 3

This is the third part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here.

The main theme of this book is that stocks are too risky for most investors. The authors repeatedly claim that stocks are too risky even in the long run and that most people should avoid them completely or have only a small percentage of their money in stocks. Curiously, the justification for this claim doesn’t come until Chapter 6.

The authors give some useful historical investing information for the period from 1926 to 2000, including the real returns investors received in US stocks, bonds, and treasury bills (Figures 6.1 and 6.2). By “real returns” we mean the investing returns after subtracting inflation. This makes for better comparisons because we are comparing dollar amounts that have equal purchasing power.

This information was then used to simulate possible outcomes of stock investing over 30 years (Figure 6.6). These simulations were based on the assumption that the future will be similar to the past. The book gives results based on an initial investment of $100. I will base my discussion on an initial investment of $10,000 to make the numbers more meaningful. In the authors’ simulations, here is how much the stocks are worth after 30 years:

Simulation 1: $75,000
Simulation 2: $5200
Simulation 3: $200,000

For comparison, an I Bond with a 3% return above inflation would give $24,300 after 30 years. The authors then point to simulation 2 saying “we see that very bad outcomes can occur for long-time horizons.”

The outcome of Simulation 2 seemed very unlikely to me. I decided to run my own simulations based on choosing each year’s return randomly from the historical returns in Figure 6.2. Instead of only doing 3 runs, I let my PC go for a few hours, and it completed a billion runs. This is more than we need, but it gives a good picture of the possible outcomes.

One thing I learnt was that 25-year olds are about 10 times more likely to die before the end of the 30 years than they are to get stock returns as bad as in Simulation 2. In only one out of every 140 simulation runs the stocks were worth less than $5200. In 87% of runs, stocks beat I Bonds. Half the time stocks were above $86,000 compared to I Bonds at $24,300.

If we accept Simulation 2 as a meaningful result even though it happens only once out of 140 times, what about the high end of stock return possibilities? In one out 140 runs, stocks returned more than $1,060,000! The main result here is that the authors’ three simulations do not give an accurate picture of what is likely to happen.

We continue with part 4 of this book review in the next post.