Monday, June 30, 2008

The Lazy Investor

Derek Foster who claims to be Canada’s youngest retiree wrote an interesting book called The Lazy Investor. Before I read the book, I thought the “lazy” part referred to the effort required to handle investments, but it actually refers to being lazy by quitting your job once your investments produce enough income.

What sets this book apart from most other investment books is that he recommends specific investments and gives detailed instructions on how open accounts and acquire shares as cheaply as possible.

I tend to agree with most of his general advice: minimize fees, buy stocks rather than bonds, and minimize personal spending in areas that aren’t improving your life. I don’t think it’s necessary to focus exclusively on dividend-paying stocks, but following Foster’s advice would be a big improvement over how the average person invests.

The book gives detailed advice on how to get started with very small amounts of money to invest without wasting too much of it on fees by using dividend reinvestment plans (DRIPs) and stock purchase plans (SPPs). This information is useful for beginning investors.

The second half of the book is about educating kids about money. He advocates buying dividend-paying stock to provide your children with an allowance and give them lessons on stock ownership at the same time. This is what I did with my own kids and it worked out quite well.

I can’t say that I agree with everything Foster says, but the book is well written and came at certain subjects from a fresh point of view, which making me think. It’s a quick read, and I recommend it for the beginning investor.

Other reviews of “The Lazy Investor”:

Canadian Dream: Free at 45
Million Dollar Journey

Friday, June 27, 2008

Nortel Pension Cuts

The Big Cajun Man over at Canadian Personal Finance wrote an interesting post about Nortel’s recent pension cuts. He puts it into historical context and captures the employees’ feelings of betrayal. I would add that whether Nortel’s actions were legal or ethical, they were predictable.

Complicating this story is the switch from a defined benefit pension plan to a defined contribution plan. A defined benefit plan guarantees employees a certain amount of money per month after they retire. With a defined contribution plan, the company sets aside a fixed amount of money per pay period for each employee, and the ultimate retirement benefits will be determined by how well the money is invested.

It would be easy to misinterpret Nortel’s actions as simply changing to a new system. Make no mistake that this is a significant pension cut. Nortel expects to save $100 million per year in the first four years with the new system.

Could we have seen this coming? With defined benefit plans, the company must set aside money in the pension plan to cover future expected pension payouts. But Nortel, like many other companies hasn’t been setting aside enough money.

Nortel's underfunding of pension obligations has grown over the years. It currently stands at about a billion dollars. If a company isn't setting enough money aside in the pension plan, you have to expect that they won't be paying all of the promised pension benefits. This doesn't make it right; it is just predictable. What’s worse is that the large shortfall in Nortel’s pension plan points to further cuts in the future.

Thursday, June 26, 2008

Alignment of Interests

In yesterday’s post, I showed that the interests of homeowners and the real estate agents who work for them are poorly-aligned. The concept of alignment of interests is an important one for understanding why people do the things they do. It can also be useful for predicting how others will surprise you or disappoint you, or maybe try to take advantage of you financially.

I used to play on a softball team that was sponsored by a sports restaurant/bar. We were young and took our commitment to our sponsor seriously. We would sometimes show up after a game with more than 20 people including players, friends, and family. We were developing a great relationship with this sports bar, or so I thought.

After the third or fourth time we arrived at this sports bar on a Monday or Wednesday around 9:30 pm, it became clear that they weren’t very happy to see us. They would tell us we couldn’t sit in one section or another, and would try to hustle us out quickly. We weren’t rowdy, and the place was never particularly full. They just didn’t seem to want our money.

It took me quite a while to figure out what was going on. This sports bar was part of a chain, and all the people working there were paid by the hour. The owners who cared the most about the success of the business were rarely there. This bar wasn’t doing very well, and there was very little business through the week after about 8:00 pm. The workers were used to a quiet evening shift, and we were messing that up!

Let’s look at this from the point of view of Will, one of the workers at the bar. When we showed up, Will got pulled away from socializing with the other workers to do extra work, and he would end up leaving his shift later than normal. As for the tip that we would leave, these were pooled across the employees, and his share of our tip would be very small. Overall, our presence made Will’s life worse.

Of course the owners of the bar would have wanted five groups like ours to show up every night. This shows that the owners and workers did not have their interests aligned. The workers were happiest when the bar just limped along without ever being too busy.

I’m guessing that the owners of the bar were not aware of what was going on. If they were, they could have tried to do something about it. They could have paid the workers more when business was good, or they could have monitored the bar more carefully and fired the workers who didn’t encourage business. Either of these solutions would have more closely aligned the interests of the owners and workers.

By carefully looking at what is best for each party in any endeavour, you can check how well their interests are aligned, and predict whether they will tend to work towards a common goal, or will work against each other.

Wednesday, June 25, 2008

Improving Incentives for Real Estate Agents

The fundamental problem with incentives for real estate agents is that the extra commission on a higher price is too small to be worth the extra effort.  Agents have little incentive to work hard to sell a house for the highest price possible.  The interests of the agent and homeowner are poorly aligned.

Let’s look at an example. Suppose that a fair price for Hanna’s house is $375,000, and that her current mortgage principal is $275,000. After she pays off her mortgage and pays the real estate fees, legal costs, and other costs, she’ll have about $75,000 left over. If the sale price is $25,000 higher or lower, it would make a big difference in how much money Hanna gets.

Let’s say that Rick, the real estate agent, gets to keep 2% of the sale price of the house for himself. Of course, the full cost to Hanna is much higher than this, but Rick only gets a fraction of what Hanna pays. This works out to $7500 for Rick. If the sale price is different by $25,000, it only makes a difference of $500 to Rick. He cares more about a fast sale than an extra $500 on a $7500 commission.

The way that real estate contracts are usually structured, Rick gets a percentage of the entire sale price, but he doesn’t really deserve anything for most of the price. After all, Hanna could just stick a sign on her lawn saying “For sale: $300,000,” and she is likely to close a deal quickly for only 80% of the fair price of her house.

Suppose that Rick were to get 10% of the portion of the sale price above $300,000 instead of 2% of the whole price. Now a $25,000 difference in the sale price makes a $2500 difference in Rick’s commission. This more closely aligns Rick’s interests with Hanna’s interests.

The big problem with this idea is that it supposes that all parties have a good idea of a fair sale price. With this type of commission structure, Rick is strongly incented to convince Hanna that her house is worth less, say $350,000, and that way the deal will give him 10% of the sale price above $280,000. If Rick then sells the house for $375,000, he gets a $9500 commission instead of $7500.

I have no good ideas of how to prevent this type of abuse. It seems that the idea of offering an “end-weighted” commission of the type I have described will only work for knowledgeable homeowners who have a good sense of the value of their homes.

Tuesday, June 24, 2008

GM Extending No-Interest Car Loans to 6 Years

According to this Bloomberg article, General Motors will begin offering no-interest car loans on certain pickup trucks and SUVs for as long as 6 years. I suppose that this indicates a certain amount of desperation to sell these gas-guzzlers, but what strikes me is the “no-interest” part of this story.

Surely most people understand that they’re not really getting a no-interest loan. In reality, they are paying an inflated price that includes the real vehicle price plus the loan interest amount. For loans extended to 6 years, the advertised price is just inflated by more. Even worse, no-interest loans are often only available on fully-equipped vehicles with many overpriced options.

When it comes to paying cash versus financing a vehicle, Phil Edmonston’s Lemon-Aid Guide explains the dealers’ preference for financing:

“Let’s clear up one myth right away: Dealers won’t treat you better if you pay cash. They want you to buy a fully-loaded vehicle and finance the whole deal. Paying cash is not advantageous to the dealer, since kickbacks on finance contracts represent an important part of the F&I division’s profits. Actually, barely 8 percent of new car buyers pay cash.”

Edmonston goes on to list hidden loan costs and an interesting scam. This scam begins after you purchase a car and leave your trade in. Then you’re told that your loan was rejected and your trade-in has been sold. You’re then forced accept higher payments to get the loan. This shows the importance of getting a signed agreement saying that financing has been approved. Or better still, save up and pay cash for your car.

Monday, June 23, 2008

BCE Lessons on Fixed Income Investing

Canada’s Supreme Court has decided that the planned BCE takeover does not violate any agreement with bondholders, and that the bondholders are not due any consideration beyond the contents of their contract. Like the Asset-Backed Commercial Paper fiasco, the BCE battle illustrates the risks of fixed-income investing.

The safest bonds are offered by the government. If the government doesn’t pay on its bond obligations, then money probably isn’t worth much either. On the down side, government bonds pay the lowest interest rate among available bonds.

Corporate bonds pay higher interest rates to compensate the bondholder for the risk that the corporation won’t be able to meet its obligations. It can be tempting to buy corporate bonds to get the higher interest, but there is always a slim chance that something will go wrong.

In the case of the Bell Canada bonds, the promise to pay the bond principal and interest has not changed. But the huge amount of added debt to be taken on by BCE in the takeover will lower the chances that the bond obligations will be paid. So, the bonds have dropped in value.

Bondholders could choose to simply hang on and hope that they get all the promised interest and principal in the fullness of time, but this won’t work for people who want to sell bonds now because they need the money.

Many investors choose bonds over stocks for safety reasons. By this logic, they probably would prefer government bonds over corporate bonds if they understood the risks involved with corporate bonds.

Another lesson here is the need for diversification. Most investors understand the need to diversify stock investments, but fewer understand the need to diversify corporate bond investments. If Bell Canada bonds make up 2% of your portfolio, then the planned takeover has just been an annoying blip. But if they are 20% or more of your portfolio, the past several months have been stressful.

Whether you own stocks, bonds, real estate, commodities, or anything else, understand the risks of what you own and be appropriately diversified.

Friday, June 20, 2008

The Green Shift

St├ęphane Dion’s Liberals have released their Green Shift plan that would make big changes in our tax system. For a good summary, see this post by the Canadian Capitalist. Dion plans to shift some of the broad-based tax burden on all individuals and companies to just those who pollute.

So, the final price of goods and services that cause pollution would go up. Whether you support this type of taxation or not, it is clear to me that this is the only way to cause people to change. Begging people to be green is mostly ineffective. But taxing people less and making some items expensive may cause people to make different choices.

There are a number of big ifs in this plan. It will work

if the Liberals get elected (does not seem likely right now),

if there are no loopholes for polluters to get around the new legislation, and

if the government doesn’t cave to pressure to make exceptions for certain polluting industries.

It may not seem like it makes any difference to tax you $250 less and simultaneously make your living costs for the year $250 higher. But, prices won’t be uniformly higher, and this will cause you to make different choices.

I’m always suspicious when politicians tell me that some plan is revenue neutral. Even if it is revenue neutral based on current patterns of consumption, it may not be after spending patterns change.

Whether this is the right plan or not, I’m convinced that the only way to change our day-to-day choices and reduce greenhouse gas emissions is with financial incentives; basically making desirable choices cheaper and undesirable choices more expensive. The same approach is needed to reduce our garbage production.

Thursday, June 19, 2008

Leverage Always Has a Cost

In yesterday’s post, I explained that Horizon BetaPro’s double exposure ETFs don’t give double the return of the index they are based on. One reason for this is the daily rebalancing of the doubled exposure as explained by Preet Banerjee in this post. Even without this daily rebalancing, the return would not be exactly double because leverage always comes with a cost.

The simplest way to get leverage is to borrow money. Instead of investing $10,000 in an index, you could borrow an additional $10,000, and invest $20,000 in the index. This way, you double your returns. Well, not quite double your returns. You have to pay interest on the borrowed $10,000.

This begs the question, is there any way to truly double your returns without paying any additional costs? We can show that the answer is no because it would create an arbitrage opportunity.

Arbitrage basically means a risk-free way to make money. Suppose that an investment exists that gives double the returns of an index. Then you could put just half your money in this investment to get the full return of the index. The other half of your money could collect interest in short-term government debt. Overall, you’re guaranteed to get better returns than the index whether the index goes up or down. If you simultaneously short the index, then you’re making free money by arbitrage.

So, whether you double your market exposure with borrowed money, stock options, or futures contracts, there will never be a way to guarantee double the return of the index.

Wednesday, June 18, 2008

The Dangers of Horizons BetaPro ETFs

The Million Dollar Journey had an article yesterday about Horizons BetaPro ETFs. These Exchange-Traded Funds (ETFs) are designed to give investors double exposure to certain indexes.

This means that if you are invested in their S&P/TSX 60 ETF and the index goes up by 1% one day, the ETF should go up by 2%. They also offer a bear version of each ETF where a 1% rise in the index gives a 2% drop in the bear ETF. Obviously, the owners of the bear ETFs are hoping for the index to drop.

Let’s focus on the ETF based on the S&P/TSX 60 index, which is based on the biggest companies in Canada. If the TSX 60 goes up by 10% one year, you’d expect the corresponding Horizons BetaPro ETF (ticker symbol HXU) to go up by 20% that year. But, that’s not how it works. For example, this fact sheet shows that in its first year, HXU returned 13.28% and the TSX 60 rose 9.19%. If we double the TSX 60 return, we find that there is a 5.1% gap.

What causes this 5.1% gap? I tried reading the prospectus, but like most such documents, clarity doesn’t seem to have been a priority. Page 36 outlines a number of fees including 1.15% management fees, operating expenses, and various expenses attached to forward contracts.

In addition to fees, the method used to achieve double exposure contributes to the 5.1% gap. This can be interest on borrowed money or built-in bias of stock options (called forward contracts in this case). When you trade in stock options, the expected rise of the underlying stock (the TSX 60 in this case) is built in to the option prices.

If this explanation of the 5.1% gap makes no sense to you, don’t worry. Just accept that it exists for what follows.

It might seem like we just need the TSX 60 to return at least 5.1%, and then HXU will perform better than the TSX 60. This works for one year, but doesn’t take into account the effect of volatility on long-term compounded returns.

Based on historical data, the long-term compounded return will be lower than the expected one-year return by about 2%. However, HXU’s doubled volatility increases this penalty by a factor of 4 to about 8% per year.

Combining all this together with the 5.1% gap we observed earlier, the TSX 60 would have to have a long-term compounded return of 9.1% for HXU to break even with the TSX 60. Suddenly, HXU doesn’t look as appealing as it did before.

(Math interlude that can be ignored: If the expected one-year return of the TSX 60 is x, then its long-term compounded return will be x-2%. HXU’s one-year return will be 2x-5.1%, and its long-term compounded return will be 2x-5.1%-8%. Equating the two compounded return gives x=11.1%, or a long-term compounded return for the TSX 60 of 9.1%.)

The bear versions of the ETFs are much easier to argue against. Investors and pundits cannot reliably predict when the stock market will drop. The bear ETF corresponding to HXU is HXD and it had a one-year return of -19.85%. An investor who chose the bear for this year would be in a very deep hole trying to catch up to investors who just bought the TSX 60.

Tuesday, June 17, 2008

How to Get Rich

In yesterday’s post on the economics of windfalls, I showed how difficult it can be to maintain wealth once you have it. We tend to think that the best way to get rich is to win the money somehow such as in a lottery. But, lottery winners usually burn through their money quickly.

So, this begs the question, how do people get rich, then? This is the question that was tackled by Thomas Stanley and William Danko and led to their excellent book, “The Millionaire Next Door”. These marketing guys wanted to find rich people and figure out how to sell them stuff.

They started by looking in upscale neighbourhoods, but soon found that the people living there weren’t rich. When they did find wealthy people, they tended not to live in upscale neighbourhoods.

Wealthy people tend to live more modestly than most people would guess. The path to wealth is hard work and the self-discipline to spend less than you make for a long time. The book gives a profile of typical millionaires as a frugal couple in their late 50s who continue to save despite their wealth.

This contradicts our mental image of the big-spending millionaire, but it makes sense once you hear it; if you spend less, then you’ll have more. Big spending obviously leads to having less money.

Now that I’ve broken the bad news about the difficult path to wealth, another question is how much money you need to consider yourself wealthy. This depends greatly on how you plan to live. If you want enough to live modestly without having to work, then two or three million dollars is likely enough if invested well. However, if you long for a life of flashy excesses, you may need as much as $50 million to avoid the risk of running out of money.

Monday, June 16, 2008

The Economics of Windfalls

Watching the US Open Golf Championship and its top prize of $1.26 million made me think about windfalls. Many of us dream of coming into a large sum of money whether it is by winning a sporting event, a lottery, or getting an inheritance.

If only you could win a million dollars; you’d be set for life, right? Not so fast. A little analysis will show that with a million dollars, you’re nowhere near as rich as you might think. Just ask the 8 lottery winners in this article who won millions and lost it all in a few years.

Let’s assume that our lottery winner, Leon, starts out with a lump sum of one million dollars. His winnings aren’t being spread out over many years, and if he has to pay US taxes on lottery winnings, the prize was large enough that he is left with a million dollars after taxes.

If Leon wants to be set for life, he has to grow his windfall by at least enough each year to cover inflation. He can only spend the investment gains that exceed inflation. Otherwise he is dipping into his capital and will eventually run out of money.

Let’s start by assuming that Leon invests the whole million in a few low-cost stock index ETFs. A rule of thumb that many people use is that you can draw 4% from a stock index each year and have the principal still grow enough, on average, to cover inflation. Leon can draw $40,000 in the first year.

Of course, he will have to pay taxes on this money. Let’s say that given the mix of capital gains, dividends, and return of capital, Leon pays 20% taxes on this income. This leaves Leon with about $2700 per month to spend on top of whatever he makes from the job that he isn’t able to quit.

This is a lot less spending money than most people would have guessed. And this is a very optimistic scenario. What if Leon can’t handle the volatility of an all-stock portfolio and puts 40% of his money in bonds? The bond returns will only average about 2% above inflation, and the tax rate on this income will be higher, say 40%. Now Leon draws an income of $24,000 from stocks, $8000 from bonds, and after taxes, he can spend $2000 per month.

Even this scenario is too optimistic. What if Leon hires a financial advisor who puts him into stock and bond mutual funds that cost Leon 2% more in fees each year than he would have spent in commissions and spreads from trading ETFs? Now Leon can’t draw any income at all from the bonds, and only a 2% income from the stocks. His income is $12,000 from the stocks, or about $800 per month after taxes.

You guessed it. Even this scenario is too optimistic. A few times over the years when the stock market drops, Leon will become dissatisfied with his financial advisor and switch to a new one incurring deferred sales charges or front-end fees on a new set of mutual funds. This will drive Leon’s returns below inflation. It is now inevitable that Leon will run out of money at some point.

A windfall of $3 million is enough to produce an after-tax income of about $8000 per month indefinitely, growing with inflation, if handled properly. This is enough to provide a very comfortable life without having to work, but it isn’t enough for extravagant spending. It’s no wonder that many lottery winners go broke quickly.

Friday, June 13, 2008

New Copyright Bill Will Not Work

The Canadian government has tabled new copyright legislation that is similar in many ways to the US Digital Millennium Copyright Act. If the intent is to stop online piracy, then it will fail.

Intimidating-sounding fines like $20,000 for trying to get around copy protection on CDs might stop many people who would otherwise have done it. It might even stop 90% of these people. But, it only takes one person to break the protection and put a copy online for the world to have access.

It will never be possible to stop every single person from breaking protections. Even if the best protection technology in the world is used on some music, somebody will buy the music legitimately, and then record it while it is playing and throw a copy on the internet.

I’m not arguing that any of this is right, because it isn’t. I’m arguing that it is inevitable. This legislation will make criminals out of people who copy a CD to their iPods for personal use, but it won’t stop piracy.

Laws and law enforcement would do better to focus on stopping illegal enterprises from selling illegal copies of copyrighted works. Trying to stop the masses from getting access to music and movies for free is doomed to failure.

The fundamental problem for copyright holders is technology. It is easy now to copy data the size of digitized music. The only reason that piracy of movies has been less of a problem so far is that movies are about a thousand times bigger than a song. As technology advances, movie piracy will flourish.

The real money to be made now is in distribution of content. If a business can make music and movies available to the public for a reasonable price in a way that is more convenient than downloading pirated versions, then that business will succeed. Short of making our society a high-surveillance police state, no amount of legislation will turn back the clock to the good old days for media companies.

Thursday, June 12, 2008

The Imperceptible, but Relentless Drain of Investment Fees

In yesterday’s post I showed how the stock market’s tendency to rise steadily gets lost in the day-to-day volatility of the market. In a similar way, the drain of investment fees on a portfolio can get lost in the daily choices made by money managers.

Let’s suppose that Sam has his money in mutual funds with an average Management Expense Ratio (MER) of 2.5% per year. This works out to about 0.01% per trading day throughout the year, a seemingly trivial amount.

On any given day, a money manager could make a choice that makes a 5% difference to Sam’s portfolio. This is 500 times bigger than the day’s MER. This is like worrying about an extra nickel on the price of a case of beer.

The problem is that this 5% difference the money manager makes could be either up 5% or down 5%. Over the course of a year, the good and bad choices tend to balance out somewhat, and the 2.5% MER starts to look significant compared to the money manager’s performance.

Over 30 years, the MER has consumed more than half of Sam’s portfolio, and it is highly doubtful that the money managers have consistently performed well enough to justify taking half of Sam’s money. He would almost certainly have been better off investing in low-cost index funds.

Let’s leave the world of percentages and talk about dollars. Suppose that Sam’s portfolio is worth $500,000. Most investors don’t have this much, but they hope to have this much or more before they retire.

The MER Sam pays works out to over $1000 per month. Are Sam’s investment advisor and the managers of his mutual funds really earning $1000 per month working for Sam? It seems doubtful. For this price, Sam could pay a top-notch financial advisor by the hour for half a day each month, not that he should need this much help. Sam could reduce his costs to about $100 per month with low-cost index funds.

Wednesday, June 11, 2008

Steady Market Rise Lost in the Noise

It’s hard to see the steady rise of the stock market on a day-to-day basis because of the volatility of prices. Whether you focus on the long-term increase in prices or the short-term volatility determines whether you are an investor or a trader.

Let’s suppose that the stock market is expected to rise 10% per year with volatility of 20%. The volatility (or standard deviation) has a precise mathematical meaning, but let’s just say that it creates a return range of 10% plus or minus 20%, or from -10% to +30%. In most years the market return will be in this range.

Because there are about 250 trading days per year, you’d think that we could divide these numbers by 250 to get a range for each day of -0.04% to +0.12%, but volatility doesn’t work this way. From experience we know that daily market movements are very often outside this range.

The problem with this thinking is that volatility partially cancels out over time. A big rise followed by a big drop may leave the stock price unchanged. The stock market’s tendency to rise by 10% per year means that it tends to rise by about 10%/250 = 0.04% per day, but the volatility calculation is a little more complex.

Volatility grows by the square root of the number of days. So, the 20% volatility per year works out to about 1.26% per day. This makes the daily range about -1.22% to +1.30%, which is much closer to what we actually see in the market each day.

A side effect of all this is that the market’s tendency to rise by an average of 0.04% per day is swamped by the volatility that is about 30 times larger. It’s easy to lose sight of the slow, but relentless rise of stock prices with all the ups and downs.

It’s easier to see the market’s tendency to rise by looking at longer periods of time. Over 25 years, the range of returns works out to stock prices increasing by a factor of between 4 and 30. There is no guarantee that all 25-year periods will have returns in this range, but most will.

Long-term investors focus on the 25-year results and let traders fight over the 1.26% swings each day. The long-term investors will spend much less time on investing and will spend less on commissions, spreads, and taxes.

Tuesday, June 10, 2008

Buffett Bets Against Money Management

This New York Times article describes how Warren Buffet bet Protege Partners, a money manager that invests in hedge funds, that they can’t beat the S&P 500 index over the next 10 years.

Both sides are putting their money where their mouths are. They are each risking enough that the whole pot is expected to be worth a million dollars in 10 years. The winner will get to contribute the wagered money to the charity of their choice.

Protege Partners manage money by choosing among hedge funds. A hedge fund is basically like a mutual fund with less regulation. To beat the S&P 500, the money invested will have to overcome the hedge fund management fees in addition to Protege Partners’ fees.

Buffett has been a consistent critic of the high fees charged by money managers, and now at least one money manager is being put to a very public test. Of course, you can’t conclude much no matter which way this bet goes. The fact that the average money manager loses to the index because of fees doesn’t change because of the results for any one money manager.

The 10-year duration of the bet underscores how long it takes to determine whether an investment strategy is sound. Too many unsophisticated investors are taken in by proponents of financial strategies with high management fees. If these investors ever figure out their mistakes, it usually isn’t until after they have been taken for a lot of money.

Monday, June 9, 2008

Real Interest Rates

You’d think that a 6% interest rate means that you’d be charged $6 in interest on a $100 loan after one year, but this isn’t true. You’d actually be charged more. The difference has to do with compounding periods. It’s not hard to calculate the real interest rate being charged, but for some reason, banks aren’t required to tell the truth about interest rates.

For loans in the US and non-mortgage loans in Canada, interest is compounded monthly. For most mortgages in Canada, interest is compounded twice a year. I’ll explain Canadian mortgages first because they are a little easier to follow.

If you get a 6% mortgage in Canada, it is really 3% interest every 6 months. This means that without any payments, your outstanding debt is multiplied by 1.03 after 6 months. After a year, it has been multiplied by

1.03 x 1.03 = 1.0609.

This means that the real yearly interest rate being changed is 6.09%, not 6%. So, what? The difference looks small. Well, over the life of a 25-year $200,000 mortgage, you’d pay an extra $3100 in interest because of this small difference.

In the US, things are even worse. A published mortgage rate of 6% per year really means 0.5% per month. After a year, this compounds out to 6.17%. Over the life of a 25-year $200,000 mortgage, you’d pay an extra $5800 in interest because of this difference.

These examples are based on the current low interest rates. What if mortgage rates were at 12%? Over the life of a 25-year $200,000 mortgage, Canadians would pay an extra $14,000 and Americans an extra $27,000 because of the extra compounding.

Monthly compounding is used in both countries for most non-mortgage loans. If you maintain a $10,000 balance on a credit card for 25 years with 20% interest, you’ll pay an extra $4000 in interest because of the extra compounding.

Many department store credit cards claim that the interest rate is 28.8%, but this is really 2.4% per month which compounds to about 33% per year!

I assume that this form of legalized lying is permitted because of historical precedent. I’d like to see it stop, but I won’t hold my breath.

Friday, June 6, 2008

Interest-Free Loans to Utility Companies

As a matter of principle, I try to avoid giving interest-free loans to utility companies. This may sound like a strange thing to say, but I’m willing to bet that many people who read this post are giving out interest-free loans.

When you sign up with an equal-billing plan for gas or hydro, the payments are usually structured so that you’ll pay for more than you use at the beginning of the billing year and less at the end. This means that you’re lending a modest amount of money to the utility company, but they don’t pay you any interest.

I can handle the seasonal variations in my bills, and so I just pay for my consumption each month. In theory then, I’m not lending any money to the utility companies.

Enbridge has a nice solution to the problem of me not going on equal billing: estimated meter readings. In winter my back yard is difficult to access and Enbridge estimates our consumption. And curiously enough, the estimates are usually too high.

Ordinarily, my wife and I look out for this on each bill, but we missed it for the last while. For the 5 months from Dec. 1 to the end of April, Enbridge estimated that we used 2025 cubic meters of gas. Our actual consumption for the last 6 months was 1884 cubic meters.

This difference isn’t huge, but it’s annoying to pay more than we have to. Enbridge has an online system where we can input the current meter reading to get things back on track. We won’t be paying anything on the next gas bill or two.

So, if you’re not on equal billing and you don’t want to pay for more gas than you actually use, just go online once in a while and enter the actual meter reading.

Thursday, June 5, 2008

Income-Generating Assets in Retirement

It seems to be conventional wisdom that once you start drawing from retirement accounts, your investments should be shifted into income generating assets such as bonds and dividend-paying equities. This makes little sense to me.

Let’s consider an example. Suppose that Sam starts retirement with a million dollars in a tax-sheltered account. He invests in dividend-paying stocks and in the first year he makes $40,000 in dividends plus $60,000 in capital gains. He withdraws the cash dividends to live on and leaves the capital gains in the account.

Another new retiree, Linda, invests her million dollars in non-dividend paying equities and makes $100,000 in capital gains in her first year of retirement. She sells $40,000 worth of stock to generate cash to live on.

What’s the difference between these two cases? Not much. What matters are the returns you get and the risk you take to get these returns. In tax-sheltered accounts, the difference between capital gains and dividends isn’t important.

The two cases feel different because Linda seems to be eating into her principal. But, Linda isn’t eating into her principal any more than Sam was.

Some would argue that income-generating assets are less volatile and therefore safer. I counter that the bulk of retirement savings should go into a broad index of stocks that are likely to give the best return, rather than limiting investment to dividend-paying stocks. You can create safety by investing enough to live on for 3 or so years in short-term bonds.

Wednesday, June 4, 2008

Choosing an Investment Advisor

The Canadian Capitalist’s recent Friday roundup pointed to an article by Rob Carrick in the Globe and Mail about choosing an investment advisor. The conclusion is that a good advisor has the following 4 attributes:

1. Is comfortable speaking about fees and commissions.
2. Communicates clearly in everyday language.
3. Asks detailed question about clients’ situations.
4. Makes time for clients.

These make sense, but they aren’t enough to avoid being taken in by a good salesman. The article acknowledges this saying that people “have to be at least a little involved in the running of their portfolios.”

The problem I have at this point is that if you are knowledgeable enough to be involved in the running of your portfolio, then you probably know enough to pick a few ETFs yourself and forget the advisor. For the more complex financial planning activities (that many advisors don’t really do), investors can pay a fee-based advisor by the hour periodically.

In my limited experience of listening to people talk about their financial advisors, they tend to pick them based on rapport. Of course, rapport is important, but should you really hand over all your money to someone just because he or she knows how to act friendly?

Given the various low-cost index ETFs that exist today, mapping out your own financial plan isn’t very difficult. People who can’t handle this on their own are forced to take the risky path of trying to find a trustworthy financial advisor. I fear that the list of four desirable attributes of a financial advisor won’t be enough help.

Tuesday, June 3, 2008

ETF Does Not Always Mean Low Cost

Many sensible investors like index Exchange-Traded Funds (ETFs) because of the low fees charged. However, just because an investment is ETF-based doesn’t automatically mean that it is low cost.

The Wealthy Boomer posted about some new AIM Trimark ETF-based funds (the web page with this article has disappeared since the time of writing) that underscore this point. These new funds have MERs of around 2% (the management and advisory fees are 1.8%, but I wasn’t able to find out the cost of the other expenses included in MER).

The marketing for these new ETFs include “GlidePath”, “PowerShares”, “Retirement Payout Portfolios”, and other impressive-sounding phrases. But, do you really want to pay $5000 per year in fees when your portfolio gets to $250,000?

Any time a financial product becomes popular, you can count on fund companies to jump on the bandwagon. You can have products with any name you like as long as the fees are high. Just because a financial product’s description talks about indexes or ETFs doesn’t necessarily mean that its fees are low.

In my view, “low MER” means under 0.25%, and anything over 0.5% is a “high MER”. I realize that this puts almost all products into the high MER category, but that’s just the way it is. There may be good reasons for choosing to pay high MERs in some cases, but this doesn’t change the fact that the fees are high.

Monday, June 2, 2008

Borrowers Who Lie

Amir Efrati of the Wall Street Journal asks the question “Are Borrowers Free to Lie?” in an article about a court case in California. A bank sued Cecelia and Norman Hill for lying on a mortgage application. What makes the case unusual is that the Hills have already been through bankruptcy.

Even though the Hills’ debts had already been dealt with during the bankruptcy, the bank argued that the Hills should still be responsible for their mortgage because they lied on their application.

This case illustrates the abuses that went on during the housing bubble. No matter which party you focus on, they deserve to lose.

The Hills deserve to lose for lying. However, they have already faced the significant financial pain that comes with bankruptcy. Anything more would seem to be piling on.

The bank deserves to lose because they ignored their own rules about checking the accuracy of loan applications. The application listed the Hills’ occupations as a delivery driver and an employee for an auto-parts distributor with a combined income of $191,000. Someone wasn’t trying very hard to find fraudulent applications.

The Hills claim that the inflated incomes were filled in by their mortgage broker and the bank. If this is true, then the mortgage broker deserves to lose as well.

In the end, the court did the only reasonable thing which was to say that the Hills don’t have to pay anything to the bank beyond what was awarded during the bankruptcy. But, it would have been nice to see all parties lose, including anyone who made a commission or bonus from the mortgage.

To answer the question asked in the article “Are Borrowers Free to Lie?”: yes, they are if the bank is stupid, the mortgage broker corrupt, and the borrowers are content to go through bankruptcy after their financial lives blow up.