Friday, May 30, 2008

Low-Stress Moving

Among the many benefits of amassing savings, one of them is lower-stress moves. The last time I moved, my wife and I deliberately chose closing dates to create an overlap period where we owned both houses. This was only possible because we had enough savings that we didn’t need the proceeds from the old house as a down payment on the new house.

An overlap period gives time for cleaning, painting, changing carpets, etc., at a leisurely pace. Other benefits are directly related to the problems Larry MacDonald described.

On same-day closings, if the delivery of keys for the new house is delayed by a few hours, you might be paying professional movers $100 per hour while they wait. With an overlap period, any delay in getting the keys may be a little disappointing, but it won’t affect a move of belongings, because the move is still a few weeks away.

If you choose to move yourself (with the help of friends and family), delays in getting moving vans can be accommodated more easily if you are able to simply delay the move by a day or two.

Now, you may be thinking that this last point makes little sense because people with significant savings wouldn’t bother to move their own stuff. But, this isn’t how savers think. People get to have savings by making choices that cost less.

Few people can afford to own two houses at once, even for just a week or two, but if you think you can handle the finances comfortably (even if something scuttles the closing of your old house), then it is a great way to reduce the stress of moving.

Thursday, May 29, 2008

Understanding the BCE Mess

It seems that the BCE takeover bid may force the Supreme Court of Canada to make a decision that will set an important precedent for future acquisitions of companies. It took an interesting set of events to get us where we are now.

To understand what is going on, you need to know the various players and their motivations. As they say, “you can’t tell the players without a program.”

Shareholders. These people own BCE, and the majority of them would be thrilled to receive the $42.75 per share of BCE stock promised in the buyout.

Buyers. This is the consortium of players led by the Ontario Teachers’ Pension plan that wants to buy BCE for $42.75 per share. Presumably, they think BCE will be a good investment over time. However, they don’t have enough money to buy all of BCE. So, they need to borrow billions of dollars. This is why it’s called a leveraged buyout. After the takeover, BCE would be saddled with much more debt than it has now.

Bankers. These are the companies lending money to the buyers to complete the deal. They must have liked the deal when they first agreed to it, but everything has changed since then. The subprime meltdown in the US has completely changed conditions for lending and borrowing money. The bankers now hate the BCE deal and want it to die or change drastically.

Bondholders. These are people who had lent money to BCE before the buyout announcement. When the bondholders bought BCE bonds, they paid a price consistent with BCE’s ability to pay the money back plus the promised interest. However, after the buyout, BCE would be saddled with much more debt and the likelihood of not paying the money back would be much higher. This makes the bonds worth less. The bondholders have seen the value of their bonds drop significantly, and they are very upset.

If it weren’t for the bankers wanting the deal to die, all the players might have come together to make a deal to compensate the bondholders for at least some of their losses. But, the bankers have no motivation to do this right now. They are better off to either stick rigidly to the original plan in the hopes that it fails, or demand big changes to make the deal more palatable.

This unique set of circumstances is what has led to the bondholder court case. The bondholders have won the latest round of court battles in Quebec. The case is now being appealed to the Supreme Court of Canada.

If the Supreme Court rules on this case, it will set an important precedent for how bondholders must be treated in future buyouts.

Wednesday, May 28, 2008

The Futility of Saving Revisited

The book “Free Parking” by Alan Dickson makes the contrarian case that for low-income Canadians, saving in an RRSP is futile. All it does is boost your income after retirement and cut into the various income supplements available to seniors.

After factoring in the lost income supplements, some seniors will get to keep very little of their RRSP withdrawals each year. There are also other types of benefits based on income that make the situation worse.

But, things are likely to change with the new Tax-Free Savings Accounts (TFSAs). If the TFSA rules end up as advertised, even low-income Canadians will benefit from saving in a TFSA. It’s not clear that this will actually change people’s money saving behaviour, but at least the incentives are better.

But, this will only last as long as TFSA withdrawals aren’t used to reduce income supplements and other means-tested benefits for seniors as I argued here.

It would be interesting to see an updated version of “Free Parking” to see how the author thinks the TFSA changes his recommended strategies.

Tuesday, May 27, 2008

Edelman Financial’s Fees

Edelman Financial is an investment management firm run by Ric Edelman who has authored several books. I have reviewed two of these books: “Building Wealth” and “The Lies About Money”.

From one book to the other, Edelman went from being a fan of the mutual fund industry to a passionate critic. He explains in great detail all the costs associated with typical mutual funds and how investors don’t get anywhere near their money’s worth.

Until now, I hadn’t looked at Edelman Financial’s fees. Thanks to an anonymous reader who sent a link to the fee schedule, we can take a look. Here are the yearly fees based on total assets:

First $150,000: 2.00%
Next $250,000: 1.65%
Next $350,000: 1.25%
Next $250,000: 1.00%
Next $2 million: 0.75%
Next $7 million: 0.60%
Next $15 million: 0.50%

As it turns out, this does not include fund expense ratios and other charges which add about 0.4% per year.

None of these percentages look particularly big, but they add up. Over 25 years of investing, how much would an investor pay in fees? Let’s assume that the thresholds for the different percentages rise with inflation, and that the investments make 5% above inflation before fees.

Then a starting portfolio of $100,000 would pay 45% of assets to Edelman Financial in fees over 25 years! Even a richer investor who starts with $1 million would end up paying 33% in fees over 25 years. This is a huge price to pay to not have to choose your own index ETFs.

Edelman Financial makes the case here that the industry average fees are much higher, and this is true. But, if the typical financial advisor chooses investments that cost you 10 times the cost of an index ETF strategy, are you content to choose Edelman Financial just because it charges only 5 times the index ETF cost?

Monday, May 26, 2008

An Experiment on Mutual Fund Fees

Apparently, the message that mutual fund fees matter is not getting through. In a recent paper (pdf here), researchers describe an experiment where they give index mutual fund prospectuses to subjects and ask them to create a portfolio with $10,000.

The experiment was carefully controlled so that the only variable was the fees charged by each of four fund choices. Each of the funds was designed to mirror the S&P 500 index, and the subjects were offered incentives to maximize future returns. Some subjects were offered one month worth of upside on their $10,000 portfolio. Others were offered more modest rewards for good performance.

Before describing how the subjects performed, let me say a little about who participated. The subjects were Harvard staff members, Harvard students, and MBA students from Wharton. The students had SAT scores placing them in the top 2% of the population. So, you’d think that they would get above average results in this experiment.

However, the results were dismal. The best strategy was to put 100% of the money into whichever fund had the lowest fees. For subjects who were given just the prospectuses to read to make their decision, the mean fees they chose were more than 1% above the minimum. One group chose portfolios that averaged more than 2% above the minimum.

Even MBA students who understand the importance of fees chose portfolios with only 0.1% lower fees than other participants.

Some of the participants were given fee summary sheets explaining loads and expense ratios to make the comparison between funds easier. Even then, fewer than 20% of subjects chose the best portfolio.

It appears that mutual fund companies don’t have to work very hard to distract investors from their excessive fees.

Friday, May 23, 2008

Economic Predictions

I don’t normally pay much attention to economic predictions mainly because I don’t believe the person offering the prediction actually knows what is likely to happen. However, when Warren Buffett makes a prediction, I usually think about it at the very least.

Buffett’s latest prediction is some doom and gloom mixed with a small amount of hope. He says that the pain from the current global financial crisis will last longer than most people think, and that financial institutions haven’t been hit this hard since the Second World War.

If I hadn’t heard any more than this, I would have thought that his recommendation would be to sell bank stocks. But, Buffett goes on to say that the pain in the financial sector has already been recognized and felt. Now, I’m confused.

It seems that Buffett’s prediction is that we’re in for a long recession, but that bank stocks have already been beaten up enough to reflect this fact. So, what am I supposed to do then?

I think I’ll just go on following my financial plan and pretend that I never heard any predictions, even though they came from Warren Buffett.

Thursday, May 22, 2008

Credit Card Arbitrage

Madison over at My Dollar Plan runs an interesting credit card arbitrage scheme (described here). She basically flips a large number of credit cards from one 0% interest introductory period to another.

As of December last year, she owed $223,000 on her credit cards, but she pays less than $1000 per year in transfer fees. She once got hit with an interest charge, but it turned out to be a mistake that she got fixed.

She puts most of this money against her mortgage and into high-yield savings. After factoring in the balance transfer fees, she comes out ahead about $11,000 per year!

One of the many questions that come to mind when thinking about this scheme is where do you find so many credit cards with 0% introductory rates that put up with your game? Well, here is Madison’s list.

Before reading about this scheme, I would never have thought it was possible. Surely the credit card companies protect themselves against this sort of thing, right? Well, my guess is that almost everyone who tries credit card arbitrage would slip up. From what I can tell, Madison belongs to a very small group of people who could pull this off without mistakes.

It’s not hard to come up with ways that this scheme could go wrong. The most serious of them boil down to some change in the rules set by the credit card companies making it impossible to continue getting 0% interest. If this happens, Madison would have to come up with a large sum of money quickly.

Madison is well prepared for this with large cash savings and room on her home equity line of credit (HELOC). But how many people could resist the temptation to spend at least some of the money? Even if the money is invested in the stocks, a stock market drop could make it impossible to cover the entire credit card debt.

Suddenly having to pay 20% interest on a 6-figure sum would be devastating for most people. So, I can’t recommend that anyone try credit card arbitrage. But, I’m impressed that Madison makes it work.

Wednesday, May 21, 2008

BCE Takeover

The latest news on the planned takeover of Bell Canada Enterprises by a group headed by the Ontario Teachers’ Pension Plan is that the deal is in trouble. Every few days the deal seems to swing between going ahead as planned and falling apart.

The main possible outcomes are

1. The deal goes ahead as planned at $42.75 per share.
2. The deal goes ahead at some lower price.
3. The deal gets delayed (perhaps permanently).

What amazes me is the number of people who believe they know which outcome will occur. I guess it’s normal for people to form opinions on matters they can only guess at, but it’s another thing to commit real dollars to these guesses.

I suppose that someone with detailed knowledge about banking as it relates to financing acquisitions might have a better shot than the rest of us at guessing the outcome here. But, this isn’t the case with the investors I know who have bought (and in one case shorted) BCE lately.

I count myself among those who don’t know what will happen. For me, buying a block of BCE shares wouldn’t be much different from dropping several thousand dollars on red and waiting for the roulette wheel to spin.

Far too many people who see themselves as stock-pickers are really just gamblers. As long as they only remember the good picks, they can maintain positive thoughts about their abilities. They’d better not gather all the information and work out how they’ve really performed over several years, though. Most stock pickers won’t like the answer they get.

Tuesday, May 20, 2008

Combining Your Mortgage with Other Accounts

Some lenders offer mortgage accounts that include features of chequing and savings accounts as well. The idea is that you can save money by combining all your bank accounts into a single flexible low-interest mortgage. To pick (or pick on) an example, see the Manulife One mortgage account. Thanks to a friend, Susan, for suggesting this topic.

On the surface, this seems like a great idea. The money in your savings and chequing accounts goes on your mortgage so that they are effectively earning tax-free interest at your mortgage rate rather than the pathetic interest rate those accounts used to get. Your line of credit and car loan move to the mortgage at a lower interest rate. Even your high-interest credit card debt moves to the mortgage.

Manulife illustrates their account benefits with a fictitious case study. Our heroes are Mike and Sarah who start with a mortgage, car loan, line of credit, credit card debt, and savings and chequing accounts. They save $46,980 in interest over the life of their mortgage by consolidating everything into a Manulife One account.

The first thing to observe is that our couple’s finances start in a sorry (but sadly typical) state. Any time you carry credit card debt at typical interest rates, your financial life is swirling the bowl. Mike and Sarah could save a lot of money by just paying off the credit card debt with their cash savings.

The calculation that our couple will save $46,980 is based on the assumption that their spending levels will remain stable. But, Mike and Sarah were foolish enough to build up all this debt in the first place. Now that they have tens of thousands of dollars of room on their flexible mortgage, a paid off line of credit, and paid off credit cards, what is going to happen?

Mike and Sarah need to find a way to get their spending under control. If they can’t do this, then the Manulife One account would be a devastating financial mistake. In an earlier post, I discussed the strategy of creating artificial scarcity to control your spending. The all-in-one mortgage takes away some of the signs of overspending that people use to control themselves.

If Mike and Sarah can’t pay off their credit cards one month, they get a strong signal that they are overspending. With their pay flowing onto the mortgage, and then all expenses coming out, they can blissfully ignore their financial problems until Manulife tells them that they have reached the maximum mortgage size based on the value of their house.

Another consideration is what happens if Mike or Sarah gets laid off. One of the purposes of cash reserves is to see you through temporary tough times. What happens if your lender refuses to let you expand your flexible mortgage because you no longer qualify based on your income?

A single mortgage account isn’t always a bad idea. If you are careful to live within your means then it could be a good way to simplify your banking. But, if you have any doubts about your ability to control your spending, then think twice.

Monday, May 19, 2008

Victoria Day and the Cost of the Monarchy

Today is Victoria Day in Canada celebrating Queen Victoria’s birthday. The cost of the monarchy can be a lively subject in Britain, but to be honest, I’m not sure what it costs Canadians.

The Queen’s representative in Canada is the Governor General. This position is largely ceremonial, but it does cost us money. The amounts are not terribly large when spread out across all Canadians, but it is many millions of dollars.

Our previous Governor General, Adrienne Clarkson, went on many trips with a few dozen of her favourite artists costing Canadian taxpayers millions. I was never too clear on what value this brought to Canada, but perhaps there were some diplomatic benefits.

What are the benefits to Canada of the role played by the Governor General and the rest of the monarchy?

Friday, May 16, 2008

Taxing Phantom Income

Imagine working for a company for years, participating in the company savings plan, taking $2000 out of the plan, and then getting hit with a tax bill for $50,000! This actually happened to a woman who worked for $14 per hour for JDS Uniphase. Sadly for her and her husband, she wasn’t one of the JDS Uniphase employees who had their tax bills forgiven late last year.

There is an organization growing to fight to change Canadian tax law to stop the taxing of money that people never received. This organization is called Canadians for Fair and Equitable Taxation (CFET).

I explained the problem first here and here. It’s hard to understand why the government would want to tax people on money they never actually received.

The problem is related to how employee stock options are taxed. The gain in the value of the options can’t be offset against any losses on the stock acquired with the options even though both are taxed at the same rate. Many company savings plans are structured using stock options, and so there can be problems here as well.

This problem affects me as well. I will be hit with a 6-figure tax bill if I ever sell stock in my former employer, even though I will get only one-third of this amount from selling the stock. One solution is to never sell, but there is a deemed sale if I leave Canada to live elsewhere or if the company is bought out. So, I don’t control my fate.

A perverse aspect of the tax law is that you can offset stock option gains with capital losses on the acquired stock in the year that you die. I will be able to handle the tax bill if the company is bought out, but not everyone facing this problem is this fortunate. What a sickening situation to have to die before the end of the year to avoid financial devastation for your family.

Thursday, May 15, 2008

Globe and Mail’s Best of Blogs Poll

The Globe and Mail ran a poll to see which financial blogs their readers liked. My pick was the Canadian Capitalist, but the winner was The Fly.

According to the Globe and Mail results article (no longer online), The Fly is “George (The Fly) Hamilton, a professional money manager who provides a hilarious running commentary to his trading day.” And sure enough, it’s a profanity laden commentary displaying supreme confidence in his opinions on stocks.

This blog certainly has some entertainment value. The Fly actually says which stocks he is buying and selling, including price and number of shares. This comes with a generous helping of disdain for anyone who might disagree with his judgment. Does anyone actually trade based on what The Fly says?

I was unable to find out what money George Hamilton manages. It certainly would be interesting to see his track record. I’d like to know whether he is a talented stock picker or just an entertaining blowhard. Either way, his blog is likely to remain popular.

If any readers have information about where The Fly does his professional money managing, I’d like to hear about it.

Wednesday, May 14, 2008

Market Averages Aren’t Average

We’ve all heard about market averages. In the US, the big ones are the Dow-Jones Industrial Average, the S&P 500, and in Canada, we have the TSX. There are many other stock market averages as well.

However, most investors get significantly worse results than these averages. There are many reasons for this: paying higher brokerage fees, paying high fees to investment advisors, paying high taxes due to overtrading, etc.

Even when investors buy index funds that are designed to track a market average, they often underperform the average because of failed attempts to time the market; in trying to avoid market drops, they miss market increases.

For these reasons, I think that “market averages” are misnamed. If you buy a stock index and hold on for two decades, you will get much higher than average results.

Another problem with the word “average” here is that it turns off investors. Who wants to be average? Who doesn’t think he can do better than average? Maybe we should call the returns of indexes the “index high bar”.

Some people would still try to beat the high bar, but most could comfortably say at a party “I decided to take the market high bar and devote my free time to other pursuits rather than evaluating stocks all the time.”

Tuesday, May 13, 2008

The Folly of Stop-Loss Orders

A stop-loss order is an order with a broker to sell stock at a certain price. If you own 100 shares of ABC stock that is trading at $10 per share, you might place a stop-loss order to sell if it goes down to $9 per share. This limits how much you can lose on the stock.

If the stock never goes down to $9, then the stop-loss order is never triggered. But, if something happens that causes ABC stock to fall very quickly, your stop-loss order may get triggered at a price below $9. But, most of the time the sale occurs at roughly the price level you pick.

On the surface, this seems like a good idea. You are limiting your losses to 10%, and there is unlimited upside. Would a competent stock picker use stop-loss orders? I’ll show that the answer is no.

A competent stock-picker is someone who is able to evaluate companies and identify one or more businesses whose future prospects indicate the stock is underpriced. Suppose that Carl is a competent stock picker and he has identified ABC Company as a business whose stock is underpriced at $10. He expects a significant stock price increase over the next 3-5 years.

If ABC stock drops to $9, Carl wouldn’t be concerned because he believes that the business is doing well and that the market just hasn’t caught on yet. Rather than selling his stock, Carl is more likely to buy more at the lower price.

Stop-loss orders simply make no sense for Carl. He buys and sells based on the attributes of the business relative to its current price. Why would he sell at a price that he judges to be too low? Carl is more likely to sell if ABC stock runs up to $30 without any real justification.

Does this mean that you should always buy more when your stock goes down? Absolutely not. Sometimes a stock drops because of very bad news. Carl may choose to sell ABC after a price drop if he thinks the news seriously affects ABC Company’s long-term prospects as a business.

Few people fall into the category of competent stock pickers. If you still like the idea of stop-loss orders, then this is a good sign that you’re not in this category.

Monday, May 12, 2008

MER: the Gift that Keeps on Giving

Mutual fund fees are very different from many of the other types of fees that we encounter in our financial lives. It’s important to understand the difference.

Mutual funds charge investors yearly fees that are disclosed to the public as a percentage called the Management Expense Ratio (MER). To see the difference between MERs and, say, real estate fees, imagine the following exchange after the doorbell gets you out of bed on a Saturday morning:

Agent: “I’m here to collect my $15,000.”
You: “What!?”
Agent: “My $15,000. The fee for selling your old house.”
You: “But, that was last year. I already paid you.”
Agent: “Right, but we’re into a new year. Your old house is worth $250,000. At 6%, that’s $15,000 this year. My fees are yearly. How do you intend to pay?”

Of course, real estate fees don’t work this way, but MERs do because they are charged every year. In the case of income taxes, you only pay tax on new money you earn during the year. Your savings aren’t taxed. But MERs get charged on the same money year after year taking bite after bite out of the same pot of money.

MER percentages seem harmlessly small, but they add up. For example, if the MER is 2.5% per year, this leaves 97.5% of your money in your account after the first year. In the second year, the MER is 2.5% of your remaining money. Now you’re left with about 95.1% of your money.

The following chart illustrates how much of your money gets consumed by the MER over the years. We assume a starting value of $100,000 and that the investments held by the fund return 4% per year above inflation, which leaves about 1.5% after the MER is charged.


After 25 years, the MER has consumed 47% of your money. This shows why it is important to pay attention to the MER when investing in mutual funds. There are index funds that charge less than 0.5% per year. These funds tend to outperform high-MER funds mainly because of the lower fees.

Friday, May 9, 2008

Safety Margin Beats Insurance

In many aspects of personal finance, you have a choice of whether to protect yourself with a safety margin or with some form of insurance. This won’t make much sense until we look at some examples.

Mortgages

Many homeowners worry that interest rates will rise and make their payments unaffordable. This can make long mortgage terms with fixed interest rates seem more attractive. However, long-term fixed rates are higher than variable interest rates. As Jim Somerville explains in this post, the extra interest is a form of insurance against future interest rate increases.

Suppose that your bank says that you can get a mortgage for up to $300,000. If you get a mortgage this big, then you may need to lock it in for a long term because a spike in interest rates might ruin you. But, if you get a smaller house with a $200,000 mortgage, you’ll have a margin of safety that makes it possible to save interest costs by taking a variable-rate mortgage.

If mortgage rates remain steady, then the interest savings go into your pocket making your financial life better. The safety margin makes you essentially self-insured.

Retirement Investing

When you retire, you’ll have to live off your savings (plus any pension income you might have). It can be tempting to go for high returns when investing your money during retirement, but the variability of returns can be scary.

There are two basic ways of dealing with this problem. One is to reduce the risk by investing in short-term government bonds or by using stock options to lower downside risk. This approach is essentially a form of insurance. You expect to get lower returns, but they will be more predictable.

The second solution is to use a safety margin. You may be expecting stock returns of 6% above inflation, but you choose a lifestyle that requires returns of only 4% above inflation. If you actually get the higher returns, then you can increase your spending later on.

What Insurance is for

Insurance is a way to reduce risk. But, costs can be high. It always makes sense to see whether you can get the financial protection you need with a safety margin rather than insurance.

Almost all of us need insurance to protect ourselves against the possibility of a million-dollar settlement over a car accident. You would have to be wealthy to be able to handle this with a safety margin.

But, choosing the deductible on your car insurance is a different story. With some modest cash savings as a safety margin, you could afford to take a small chance with a $500 deductible rather than a $50 deductible. Over time the savings on your car insurance premiums would add up.

Thursday, May 8, 2008

The Effects of Higher Gas Prices

While driving for about 11 hours to bring my son home from university, I was struck by the fact that high gas prices don’t seem to have reduced the number of cars on the road very noticeably. You can’t tell much from one day, but I haven’t noticed much difference in day-to-day driving either.

Gas prices have risen about 50% in my area over the last year and a half. Some days I imagine that there are fewer cars on the road, but other days I’m not so sure. It’s likely that more people are taking the bus, but the difference hasn’t been enough to shorten the duration of my commutes perceptibly.

Either demand for gasoline is less elastic than I would have guessed, or the effect is delayed. Perhaps, even if gas prices were to stabilize at current levels, demand would continue to drop as people feel the cumulative pain of paying high prices for a long time.

I had hoped that a small benefit of rising gas prices would be less congested roads. Has anyone else noticed a difference?

Wednesday, May 7, 2008

Berkshire Bets on Stock Market Increases

Warren Buffett’s company, Berkshire Hathaway, has sold put options on four stock indexes including the US S&P 500 (reported at the end of this Forbes article). These are essentially bets that the value of the stocks in the indexes will go up.

This is curious considering that Buffett was quoted in the rest of the article saying that stock market returns will be less than people think. This isn’t necessarily contradictory, though. The put option prices may have simply been too good for Berkshire to pass up.

In these transactions, Berkshire is providing insurance to stock investors. Berkshire has collected option premiums from the investors and has promised to cover these investors if their stock doesn’t rise to agreed upon prices at some point in the future (between 2019 and 2027).

Given Buffett’s lifetime investment record, it seems safe to assume that these put options were mispriced and that Berkshire collected large enough premiums that these transactions are expected to be profitable for Berkshire.

I wonder if this has anything to do with the fact that the best-known method of pricing options, Black-Scholes, has a serious flaw that gets worse the longer the duration of the option. This flaw is not serious for options that last for just a few months, but Black-Scholes gives wildly wrong answers for options lasting decades like the ones sold by Berkshire.

The cause of the flaw is the silly assumption that all investments have the same expected rate of return. I’d be willing to make a big bet that stocks will outperform government bonds over the next 50 years. Apparently, Berkshire has already made this bet.

Tuesday, May 6, 2008

Controlling Spending with Artificial Scarcity

The Big Cajun Man over at the Canadian Personal Financial Blog asked for insights into his spending habits in this post. Like many people, he’d like to spend less and save more, but reality is not exactly matching his wishes.

The best way I know of to do this is to shorten the time from spending money to when you realize that you’ve spent too much. Most of us know the futility of yelling at a dog hours after it misbehaves. Controlling the way a dog behaves requires that rewards and punishments come right away.

People are more sophisticated than dogs, but similar principles apply. When using credit cards, people can overspend for about a month before the statement arrives giving feedback on what they’ve done wrong. Even then, the minimum payment is manageable and the real problem can be ignored.

Many young people go for years overspending until various interest payments build up to the point where they can’t keep up. Most people need negative feedback about their overspending much sooner than this.

In extreme cases on television shows, part of the solution is to get rid of credit cards and deal in cash. A month of cash is split up into piles for gas, food, entertainment, etc. The main effect of this drastic step is to give people feedback right away that they are spending too much. If $50 is allocated to entertainment each month, it will be obvious immediately that spending $40 on the first day of the month is a problem.

So, for the Big Cajun Man and others who aren’t meeting their financial goals, one approach to solving the problem is to find a way to create scarcity. This usually involves creating rules for yourself that are essentially mind games.

Someone who overspends on clothes might have a personal rule to only pay cash for clothes. Other people might split income into different bank accounts for different types of spending. The effect of these rules is to stop you from spending when you have no cash or a bank account runs low.

No one solution works for everyone, but each approach achieves the same thing: creating a feeling of scarcity. I’m interested in hearing about techniques that others have used to introduce artificial scarcity to control spending.

Monday, May 5, 2008

Is the US in a Recession?

The question of whether the economy is in recession always seems to be more confusing than it should be. Can’t someone just add up all the right numbers and tell us?

According to Wikipedia’s Recession page, the standard definition of a recession is when a country’s gross domestic product declines for two or more successive quarters. This means that we can’t say for certain whether we are in a recession until 6 months after the recession starts.

This gives pundits and experts at least 6 months to speculate on whether we are in a recession before the matter is settled. This is like having 9 innings to argue about which team is going to win a baseball game. No amount of careful study can say for certain who will win the game until it is over. Similarly, no amount of careful accounting can say for certain that the economy is in recession until the 6 months of decline have happened.

The US Commerce Department says that the economy grew by 0.6% (annualized) in the first quarter. This means that the US hasn’t been in recession, and we won’t be able to say for certain that the economy has fallen into recession until at least October.

Just to confuse things more, not everyone defines a recession in the same way. The National Bureau of Economic Research defines a recession as “a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales.”

By Warren Buffet’s definition, the US is in recession (see this Forbes article). Buffett says that “people are doing less well than they were three months, six months or eight months earlier and most businesses find themselves in that position too.”

Buffett’s definition sounds more useful than the standard definition of a recession. I wouldn’t want to accuse Buffett of cheering on a recession, but it should give him a chance to use his mountain of cash to buy some businesses while they’re cheap.

Friday, May 2, 2008

Mortgage Strategy

Yesterday I asked why anyone would get a mortgage with one of Canada’s big 5 banks considering that their advertised interest rates are much higher than other alternatives such as ING Direct and PC Financial. I got some useful responses from readers.

Like most things in life, the price of a mortgage is negotiable. The big banks do give mortgages at rates much lower than their advertised rates, but you have to negotiate to get these low rates. Using the ideas from the reader responses, here is one possible strategy for getting a good interest rate on your mortgage:

1. Go to a financial institution that offers low advertised interest rates and negotiate a mortgage rate. Choose an institution that you would be willing to actually use for your mortgage; you may end up coming back if you can’t get a better deal anywhere else.

2. Armed with a firm offer of a low rate, go to your preferred big bank and try to negotiate a better deal. But, be willing to walk away if you don’t get what you want.

3. If you get confused, walk away temporarily. Banks don’t produce billion-dollar profits by training their people to negotiate poorly. Bank employees have techniques for dealing with people trying to use the strategy I’m describing here. It’s important to expect to have something thrown at you that confuses you.

4. Be prepared for the most effective negotiating strategy of all: likability. We tend to compromise with people we like. There is too much money at stake with your mortgage to let rapport with the bank employee affect the outcome. Stay focused.

Some additional thoughts from Preet who writes the Where Does All My Money Go blog are to exploit bank quotas by negotiating at the end of the month or at the end of October, which is the end of the fiscal year for the big banks.

Mortgages are a major cost for most people and it is worth spending some time to keep costs down. I’m interested in hearing about any other strategies or experiences that might help people get better deals on their mortgages.

Thursday, May 1, 2008

Unsecured Line of Credit Poll Results

Thanks to everyone who commented on yesterday’s post with their unsecured line of credit interest rates. The results are hardly scientific, but I have enough data to give people some idea of how their own interest rate compares to others.

The average interest rate was prime+1.7%. Most of the interest rates were between prime+1.5% and prime+2%. There were outliers at prime+0.5%, 1%, and 2.5%. (I didn’t count the response from the anonymous reader who has a line of credit at prime because it seemed to be connected to a brokerage account and I wasn’t sure if it was for margin.)

I didn’t get any responses pointing me to resources to explain what rates consumers can expect. Maybe such resources don’t exist. I suspect that consumers would get better deals if they had some way to compare lending institutions on the interest rates they charge for unsecured lines of credit.

Mortgages

It’s a different story for mortgage interest rates. CanadaMortgage is one of many sources for advertised mortgage rates in Canada. Based on these rates, it’s hard to understand why anyone would get a mortgage from one of the big 5 banks.

Just to pick two examples, both ING Direct and PC Financial beat the big 5 banks’ mortgage rates by between 1% and 2% for every term from 1 year to 10 years. I can understand why people might prefer to do most of their banking with a big familiar bank, but what does it matter who holds your mortgage?

There were fewer choices back when I had a mortgage, but I was willing to go with just about any institution that offered me a low interest rate. I cared who held my money, but I didn’t care as much who lent me money.

Is there some good reason why people choose one of the big 5 banks for their mortgage? Maybe they are able to negotiate the bank’s interest rate down by more than 1%. Or maybe the newer financial companies offering the low rates have strings attached like having to open bank accounts and get credit cards.

I’d like to hear from anyone who knows of a good reason to get a mortgage from one of the big banks. Without an explanation, it seems that people are simply making uninformed (and expensive) choices.