Friday, August 29, 2008

A Few Good Quotes

Here is some lighter fare for a Friday. The first quote is this article referencing itself. Unfortunately, it probably applies to some of my other articles (and some articles by other financial bloggers as well).
“When ideas fail, words come in very handy.” – Johann Wolfgang von Goethe

This next quote from Warren Buffett explains more clearly than I ever have why most professional money managers don’t really try to beat the index.
“Most managers have very little incentive to make the intelligent-but-with-some-chance-of-looking-like-an-idiot decision. Their personal gain/loss ratio is all too obvious: if an unconventional decision works out well, they get a pat on the back and, if it works out poorly, they get a pink slip. (Failing conventionally is the route to go; as a group, lemmings may have a rotten image, but no individual lemming has ever received bad press.)”

The last bit makes me think of someone watching a video of hundreds of lemmings going over a cliff, pausing the video, and pointing and screaming “THAT ONE RIGHT THERE! WHAT AN IDIOT!”

And finally, we have one of my favourite investing-related quotes with a slight temporal challenge:
“Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.” – Will Rogers

Thursday, August 28, 2008

Are Modern Conditions Tougher for Money Managers?

Some commentators say that while professional money managers used to provide value because stock markets were inefficient, modern markets are too efficient for money managers to make up for the fees they charge. I agree with the latter part of this claim, but I haven’t thought much about the former part.

The idea is that in the “old days” there was little information available to the little guy, and professionals supposedly had a huge advantage. But, with the instantaneous spread of information on the internet, professionals no longer have an edge.

For the claim about the past to be true, money managers had to be buying when stock prices were low, and selling when they were high. After all, the only way to outperform in the stock market is to sell stock for more than you pay for it.

I came across a 30-year old quote from Warren Buffet showing that money managers in the past weren’t doing their job very well for at least one time period:
“An irresistible footnote: in 1971, pension fund managers invested a record 122% of net funds available in equities – at full prices they couldn’t buy enough of them. In 1974, after the bottom had fallen out, they committed a then record low of 21% to stocks.”
These pension fund managers made a huge error of record buying at high prices followed by record selling at low prices. Buffett continues:
“In 1978 pension managers, a group that logically should maintain the longest of investment perspectives, put only 9% of net available funds into equities – breaking the record low figure set in 1974 and tied in 1977.”
The evidence says that during this period, pension fund managers behaved like momentum investors following the herd. So, I’m sceptical that professional money managers as a group ever provided value.

Wednesday, August 27, 2008

The Limits of Asset Allocation

The idea behind asset allocation is that by carefully choosing how much of each asset class (like cash, bonds, and stocks) to own, you can get higher returns without taking on more risk. Any sub-optimal portfolio can replaced with an optimized portfolio with higher expected return or lower risk.

This mantra has been preached by many commentators to the point where thoughtful investors devote so much attention to their asset allocations that they lose sight of other important considerations. But, optimizing your asset allocation gives less benefit than you might realize.

An Example

Suppose that Jen has a retirement portfolio made up of 40% bonds and 60% stocks. We’ll assume that the stock and bond money is invested in low-cost index exchange-traded funds (ETFs) to minimize fees. Using the figures from John Norstad’s paper on portfolio optimization, Jen can expect a compound return of 5.23% per year above inflation.

What happens if we allow Jen to include cash in her portfolio? It turns out that the optimal portfolio with the same risk as Jen’s portfolio is 8% cash, 30% bonds, and 62% stocks. What difference does this make? The expected return above inflation goes from 5.23% to 5.24%. Whoop-de-do. Investing $10,000 over 25 years, Jen could make an extra $70.

Another Example

Maybe Jen was just lucky and had a nearly optimal portfolio to begin with. Suppose that Jim’s portfolio is 30% cash and 70% stocks. Surely we can improve on this. The optimal portfolio with the same risk as Jim’s portfolio is no cash, 35% bonds, and 65% stocks. The expected return above inflation goes from Jim’s 5.35% to an optimized 5.46%. This is a much bigger difference, but 0.11% is still not huge. Investing $10,000 over 25 years, Jim could make an extra $1000.

It’s possible that larger differences could be found by mixing in other asset classes like real estate, commodities, and international stocks, but optimal asset allocation is not going to have the same benefit as a 1% lower management expense ratio (MER).

I’m not saying that asset allocation is unimportant. It matters, but it doesn’t make as big a difference as many people might think. Fortunately it isn’t necessary to choose between proper asset allocation and low investing fees. There are so many low-cost ETFs of different types available that you can have your cake and eat it too.

Tuesday, August 26, 2008

Asset Allocation isn’t Everything

Back in 1986, a study by researchers Brinson, Hood, and Beebower concluded that over 90% of the variance in pension fund returns was determined by their asset allocation decisions rather than the individual equities they chose. Investment advisors like to abuse this statistic for their own gain.

What the researchers did was to replace the pension funds’ individual equities with appropriate indexes and see how much the returns changed. It turned out that they didn’t change much. When a pension fund allocated a fraction of its money to mid-cap stocks, it tended to choose a broad mix of mid-cap stocks that performed very close to the average of all mid-cap stocks. The same thing happened for other asset classes. This isn’t very surprising.

Christopher L. Jones observed in his book, The Intelligent Portfolio, that investment advisors abuse this 90% statistic to steer investors toward investments that are profitable for the advisor. I didn’t recognize it at the time, but I had an investment advisor use this approach on me early in my investing life.

Many investment advisors use a hierarchical approach where they first choose an asset allocation, and then choose individual investments (usually mutual funds) that satisfy the required asset allocation. The implication is that the asset allocation is much more important than the individual investments.

However, choosing a set of mutual funds with high expense ratios is going to hurt the investor’s returns seriously and pay the advisor handsomely no matter what asset allocation is used. Investors need to pay attention to both asset allocation and the expected returns of the individual investment choices.

Monday, August 25, 2008

Small Amounts add up, but Pennies Don’t

A friend observed a contradiction between two of my articles. In one I point out that it’s important to pay attention to small amounts because they can add up. In another I argued that pennies are a waste of time. In fact, I routinely refuse pennies in change from cash transactions.

So, which is it? Do small amounts matter or don’t they? It depends on how small the amount is. If you spend $10 on fancy coffee and donuts, that is wasting the equivalent of a thousand pennies. The difference between a penny and a ten-dollar bill is the same as the difference between running to first base and running a marathon.

The average cash transaction will produce about two pennies in change. I average 2 or 3 cash transaction per week. So, I’m refusing about $3 per year in pennies. It would take me more than 3 years for this to add up to spending $10 on coffee and donuts once.

Thirty years worth of pennies invested at 8% interest with 3% inflation would have a present value of about $150. I’m willing to forego $150 once for the privilege of never having to handle pennies for the next 30 years.

So, small amounts matter, but pennies are too tiny to qualify as even a small amount. It's important to maintain a sense of scale when it comes to your finances. You'd need to save a thousand pennies to make up for wasting $10 on a snack, and you'd need to avoid a thousand snacks to make up for spending $10,000 too much on a car.

Friday, August 22, 2008

Small Effects Add Up

I enjoy playing low stakes poker for fun. I’ve even tried it in casinos in Las Vegas. Part of the ritual in casino poker games is that the dealer takes a cut of a few dollars out of each pot, and the winner of each hand often gives the dealer a tip of a dollar or two. This gives a good illustration of how small things can really add up.

In low stakes games the players are often very impatient. I found that I could make about $20 per hour by simply being patient and disciplined. Playing this way is boring, but slightly profitable.

To win this $20 each hour, I actually lose about $180 and win $200. Of course, the winning and losing occur randomly, and it took many hours of play before I considered these average figures to be fairly reliable.

The problem is that the casino’s cut and the dealer’s tip come out of the $200 rather than just the $20. My “gross earnings” are actually more like $40 per hour. Even though the cut and tip are just a small fraction of each pot, they eat up about half of my winnings.

Similarly, a 2% management expense ratio (MER) on your mutual funds will eat up about half of your retirement savings after 35 years. Small amounts add up.

The next time you decide to spend $10 on expensive coffee and something to munch on, just remember that the cumulative effects of this spending may be the reason why your finances are keeping you awake at night.

Thursday, August 21, 2008

Many People Would Rather Feel than Think

According to CNN, a Ponzi scheme run by Andres Pimstein fell apart recently in Miami, Florida. A Ponzi scheme is a fraudulent investing scheme where investors are paid returns out of other investors’ principal instead of being paid from the returns of a legitimate business.

Ponzi schemes fall apart when there aren’t enough new investors to pay the existing investors. The fraud grows exponentially until the pool of suckers runs out.

What I find interesting about this story is the way that people are tricked into these schemes. Potential investors are offered guaranteed big returns in a short time. If this were a legitimate business, why wouldn’t the pitch man just borrow some money from a bank and keep the huge profits himself?

The usual explanation for why people get caught in these frauds is that greed overcomes reason. I think that is just a partial explanation. My guess is that the people, like Pimstein, who run Ponzi schemes are charismatic. Potential investors probably liked Pimstein as a person and felt good about investing with him. Reason and logic took a back seat.

It’s interesting to think about the usual advice on finding a financial advisor with this Ponzi scheme story in mind. We are told to find an advisor we like and feel comfortable with. My guess is that Pimstein would meet this test nicely.

When it comes to large dollar amounts, it is very important to think instead of feel. Big money decisions don’t come up very frequently. You can spend the rest of your time enjoying art, family, and good friends.

Wednesday, August 20, 2008

The Limits of Risk Premium

In a previous article we discussed how increasing a portfolio’s risk level can increase expected returns. This risk premium is most dramatic for long-term returns. You might ask can we keep increasing the risk level indefinitely to get ever higher expected returns?

The short answer is no. Starting from a low-risk portfolio of fixed-income investments, we can increase risk and return by adding a diversified mix of equities. However, once we get to the all-stock portfolio, the party is pretty much over.

Unless you have very unusual stock-picking skills, choosing individual stocks increases risk without increasing the expected return. There are many ways to increase risk, but most of them give lower returns, such as casino gambling and lottery tickets.

To get higher expected returns along with the higher risk requires leverage. This means borrowing money to invest. Unfortunately, the interest on borrowed money cuts into the expected returns.

Many analyses of leverage assume that we can borrow money at the same interest rate that we are paid on cash savings. This just isn’t true. The interest rates on my loans are higher than the interest rate I can get on my cash savings. And as I borrow more money, my financial state becomes more precarious, and lenders will demand even higher interest rates.

Even a small gap between the interest rate on debt and the interest rate on savings can prevent leverage from giving any added expected return. For the average person, it doesn’t make sense to seek higher risk than an all-stock low-cost diversified portfolio.

Tuesday, August 19, 2008

Risk versus Long-Term Return

There is a tendency for higher investing returns to come with higher risks. The difference in expected return between safe and risky investments is called the risk premium. It’s obvious that once you choose a risk level, you should go for the highest returns possible. The challenge is to choose an appropriate risk level.

One barrier to understanding risk is the way it is usually expressed. Saying that the S&P 500 has a 20% standard deviation means little to most people. In his book, The Intelligent Portfolio, Christopher L. Jones offers a good solution to this problem. Jones first assigns a risk level of 1.0 to the market portfolio, which is an average portfolio consisting of all asset classes in the proportions that exist in the marketplace. All other portfolios then have their risk level expressed relative to the market portfolio’s risk.

So, an all cash portfolio has a risk level of about 0.2, and a single large-cap stock has a risk level of about 3.0. This seems like a much more intuitive way to express risk than talking about standard deviations.

Armed with this metric, Jones works out several optimal portfolios at different risk levels. By “optimal” I mean that the portfolios have the highest possible expected return (based on a number of assumptions) without exceeding the chosen risk level.

Each of the optimal portfolios has a mix of cash, bonds, large-cap stocks, international stocks, and small- and mid-cap stocks. Jones analyzes three of these portfolios in detail:

Risk level 0.4: Safe portfolio (90% cash and bonds, 10% stocks)
Risk level 1.0: Market portfolio
Risk level 1.4: All stock portfolio

For each of these portfolios, Jones uses Monte Carlo analysis to compute the range of possible real returns. By “real returns” I mean the returns after subtracting out inflation. Here are the 30-year median returns:

Safe portfolio: 119%
Market portfolio: 326%
All stock portfolio: 444%

For money that I don’t expect to need for 30 years, the all stock portfolio looks like a significant improvement over the market portfolio. It certainly makes sense to look at the range of possible outcomes for each portfolio, but for me the added return outweighs the added risk.

Monday, August 18, 2008

The Market Portfolio

In his book, The Intelligent Portfolio, Christopher L. Jones discusses the average portfolio at great length. This average portfolio is also called the “market portfolio,” and it consists of every class of asset in the proportion that it exists in the marketplace. Jones attributes many qualities to this portfolio, but it has its limitations.

Jones gives a table of how much money is in each type of asset (e.g., cash, various types of bonds, different classes of stock, etc.). If you believe in the market portfolio, then you should buy into each asset class in these proportions.

Jones justifies this saying “when it comes to predicting the future, the market is usually smarter than any one person.” However, he exposes the problem with his reasoning when he says that the market portfolio “represents an efficient allocation of asset classes for an investor with an average tolerance for risk.” What if your tolerance for risk isn’t average?

The perfect airplane seat is only perfect for the average size person. No matter how hard you try to make this seat perfect, it still won’t work well for the shortest gymnast or the tallest basketball player. Few of us have exactly the average tolerance for risk, and therefore few of us would find the market portfolio to be optimal.

For next week’s grocery money, you should stick with cash because the market portfolio is far too risky. But, is the market portfolio suitable for long-term savings? No, because it is too conservative.

The market portfolio consists of all assets including people’s grocery money, retirement savings, and everything in between. Even much of the retirement savings is controlled by pension plans that give strong incentives to their managers to be conservative. A money manager who gets modest, but steady results gets to keep his job.

Overall, the market portfolio is more conservative than necessary for retirement savings. It’s conceivable that given your mix of short-term and long-term investing needs, the market portfolio fits you well. But, it is best to make sensible choices with your grocery money and retirement savings separately instead of blindly following the pack.

Friday, August 15, 2008

When is “The Price” the Real Price?

I was on the Air Canada web site considering booking a flight when some “special offers” caught my eye. Apparently there is a flight to Las Vegas available for only $94. I wasn’t planning to go to Las Vegas, but I decided to click a few buttons while I daydreamed about a fun weekend.

After selecting some dates, I was dumped into a screen with the final price of $423.79. Apparently, the $94 was a one-way price. And a flurry of surcharges added another $235.79. I particularly liked the fuel surcharge. Is fuel optional?

The sad thing is that I was expecting worse. I doubt that very many readers are surprised at these numbers. How did we get to a place where we expect advertised prices to have nothing to do with the actual amount we have to pay?

I think it is a side effect of visible sales taxes. We’ve been conditioned from a young age that everything costs more than the advertised price. At first it was just a little bit more, but creative businesses have been pushing the envelope a little at a time until we have Air Canada showing me a final price more than four times the advertised price.

There are disadvantages of hidden sales taxes as well. It is common in Europe for prices to include any taxes. This makes it too easy for governments to raise sales taxes without too much fuss from voters. We’ve opted for the different evil of fantasy prices in advertising.

Maybe burger chains will start offering one-cent burgers with added fees for meat transportation, onion chopping, and hairnets. As long as they introduced these fees slowly enough, we’d probably just accept it.

Thursday, August 14, 2008

Tolerance for Risk

Many commentators tell us that we each have a certain level of tolerance for investing risk and that we should make choices that work for us. As long as we are all true to our feelings about risk, we can all be right, even if we make different choices. This is bunk.

Betting next week’s grocery money on a horse is dumb whether you have a risk-taking personality or not. Buying stocks with the house down payment that you’ll need in 6 months doesn’t make sense even if you’re comfortable with it.

The appropriate way to invest money depends mainly on when you’ll need it and for what purpose. How much of a risk-taker you are may determine what choice you make, but it shouldn’t. The larger the sum of money, the more important it is to be driven by rationality rather than feelings.

The examples involving crazy risks are easy to agree with, but the mistakes of being too conservative can be harder to accept. Investing retirement money you won’t need for many years in bonds just doesn’t make sense even if you’re a nervous investor.

Keeping emergency savings in cash in case of job loss or other financial emergency makes sense. Safe investments for money that you will need in the next few years make sense. Even designating a small slice of retirement savings to be in bonds in case of a huge financial emergency may be sensible.

But, once these things are taken care of, it is appropriate to invest long-term savings in riskier investments that have higher expected rewards. I would prefer to see people try to overcome irrational fears before giving up and accepting a future with very modest savings.

Wednesday, August 13, 2008

Bell Internet Update

A while ago I described my experience with Bell’s internet service. Since I switched providers, Bell has made numerous pointless efforts to get me back as a customer.

The latest offer has a picture of a beaver inviting me to “get a lot of internet for a very little price.” The offer says that I will pay $9.95 per month. Wait a minute, there’s some fine print. That’s just for 6 months. Then the price then goes up to $22.95 per month. And I have to sign up for two years.

Hold on, there’s more. I’ll be charged an extra $2 per month for modem rental and there are extra charges for using more than 2 Gigabytes per month. Something else is wrong. This offer is for a much lower speed of service than I had before I made the switch.

So there you have it. If I switch back to the same service I used to have with Bell, I’ll pay some amount that has nothing to do with all the numbers in this offer. Clear as mud. Maybe it will all be worth it to get “the most powerful internet,” whatever that means.

Apart from trumpeting a price that is about one-fifth of what I would really pay, the problem is that Bell’s service doesn’t seem to work at my house because of the nature of my phone line. We seemed to establish this fact during my numerous calls to Bell while I was an internet customer of theirs.

I know several people who have no problem with Bell’s service, and that’s great for them. It seems that I’m destined to get internet access over cable and continue to receive “very special” offers to “come back to Bell”.

Tuesday, August 12, 2008

Investing Skill or Luck?

Investing contests are often won by someone who puts all of his hypothetical money into a few risky stocks whose share prices double or better over a short time. Is this skill or luck? The truth is that we can’t tell. If the same person wins several contests in a row, then we may be forced to believe that the good results come from skill.

Any time you have thousands of people picking stocks, it’s inevitable that a few will have outstanding results. How can we tell if the winners were skillful or lucky? In his book, The Intelligent Portfolio, Christopher L. Jones discusses methods of distinguishing skill from luck.

Jones chose the example of the Legg Mason Value Trust fund as an example. This fund beat the S&P 500 each and every year from 1991-2005 by an average of 7%! To get a handle on whether this is an unusual result, Jones uses simulations.

He simulated 10,000 funds with similar investing styles, but making random stock selections, and checked how they performed compared to Legg Mason. It turned out that about 1 out of 30 simulations beat Legg Mason. Based on this, Jones concluded that Legg Mason’s results were not unusual and could easily have simply been luck.

If you think you smell something fishy here, it’s because something is fishy. If 1 out of 30 simulated funds beat Legg Mason, then why didn’t any real funds beat Legg Mason? This seems like a very unusual result, and it made me suspicious of Jones’ analysis.

Unfortunately, Jones didn’t give much detail in how he did the simulations. One correct way to do the simulations is to have funds select stocks at random according to the same distribution as Legg Mason, and assign returns equal to the actual returns of those stocks in the relevant time period.

An incorrect way to do the simulations would be to randomly generate entirely new stock market histories. This would be answering the question “what are the odds that some 15-year period will produce better returns than Legg Mason produced?” This is entirely different from the question “what are the odds that a random stock picker could have done better than Legg Mason from 1991-2005?”

While I agree with Jones that strong returns could easily be just luck, I’d like to know more about how he did the Legg Mason analysis. If he got this wrong, then it casts doubt on the correctness of other analyses in his book.

I found it curious that Jones didn’t tackle the best long-term track record available: Berkshire Hathaway. Berkshire’s results have been so strong for so long that it seems inconceivable that it is just luck. But, I haven’t attempted to analyze this case.

Monday, August 11, 2008

Too Many Safety Margins

I’m a big fan of safety margins. When I drive over a bridge, I’m glad it has been designed for several times the weight of the cars on it. Investing strategies should be designed so that you’ll be okay financially even if your returns are lower than you hope. But, we can sometimes make the mistake of layering too many safety margins and lose track of likely outcomes.

In his Book, The Intelligent Portfolio, Christopher L. Jones does some computer simulations to show that even though the S&P 500 returned an average compound rate of 6% above inflation for the past 40 years, there was a 1 out of 20 chance that the return could have been as low as 1.2% above inflation.

This analysis is based on a strong version of the efficient market hypothesis that includes assumptions about the distributions of stock market returns. What happens if we take a look at actual returns over the past century?

According to this chart produced by Crestmont Research, in the 58 rolling 40-year periods since 1910, the S&P 500 compound average return has ranged from inflation plus 3% to inflation plus 8%. This is the average compound rate taking into account transaction costs such as bid-ask spreads, commissions, and other fees (but not taxes).

So, even taking into account transaction costs, there has never been a 40-year period in the past century with returns as low as inflation plus 1.2%. Either we have been lucky, or Jones’ model is wrong.

It’s amazing what many people choose to worry about: very poor stock market returns for more than a generation, terrorist attacks, and meteors. If you want something real to worry about, then think about cancer and heart disease. I’m much more likely to die in the next 40 years than I am to see stocks lose out to inflation.

Friday, August 8, 2008

Using Simulations to Compare Stocks and Bonds

Life only follows one path, but we can’t predict which path we will follow into the future. The fact that investments have risk means that we don’t know for sure what returns we will get. What we can do with some analysis is to list possible outcomes and estimate the chances of each outcome.

The company Financial Engines uses a technique called Monte Carlo simulation to generate possible outcomes as part of personalized investment advice to its clients. (Disclosure: I have no connection to Financial Engines or its products.) Monte Carlo methods are well-known in the sciences, and it’s not surprising that they are useful in economics as well.

Christopher L. Jones, who works for Financial Engines, includes examples of their simulations in his book The Intelligent Portfolio. I found the long-term simulations of stocks and bonds particularly interesting.

The way the simulations work is that you start with some portfolio of investments, and the software generates thousands of possible futures for this portfolio based on the expected returns, risk level, and correlations of the various investments. Then the software finds the 5th and 95th percentile of outcomes and calls these the downside and upside. This gives us an idea of the range of possible outcomes.

Jones did this for two different portfolios:

Bonds: 100% invested in long-term US government bonds
Stocks: 100% invested in large-capitalization US stocks

All results are given as real returns, meaning that inflation has been taken into account. The dollar amounts in future years are adjusted so that they will have the same buying power as today’s dollars.

Here are the ranges for the two portfolios after investing $10,000 for 20 years:

Bonds: $8260 to $29,700
Stocks: $8070 to $100,000

Given these results, I can’t see why anyone would hold bonds for 20 years; the downsides are almost identical, and stocks have a huge advantage in upside. For shorter periods I can see why one might shy away from the volatility of stocks, but Jones’ results make it difficult to justify holding bonds for the long term.

Jones goes on to say that “in those scenarios where the equity portfolio underperforms the fixed-income assets, the degree of underperformance can be dramatic.” For some reason he doesn’t say that when stocks outperform bonds, the difference can be far more dramatic.

Thursday, August 7, 2008

The Link Between Risk and Return

We would all like to have investments with high return and low risk. Despite the sales pitches for get-rich-quick schemes, such investments don’t exist. In his book, The Intelligent Portfolio, Christopher L. Jones explains the forces that cause higher-return investments to have higher risk.

Given a choice between two investments with the same expected return, investors would select the one with lower risk. Investors “expect higher returns as compensation for taking on the additional risk.”

Suppose for a moment that a high-return, low-risk investment existed. Investors would immediately start buying this investment and drive its price up to the point where the returns are lower and more consistent with the risk level. Market forces will always act to maintain the relationship between risk and return.

One thing I would add that Jones did not mention is that this relationship is based on our collective guess of the risks and returns of each type of investment. Such market wisdom is sometimes very wrong. Examples of this include tulip mania in the 17th century and all the speculative bubbles since then.

I tend to be sceptical of anyone who claims to have better insight into investments than the “market wisdom,” but markets do get prices spectacularly wrong sometimes. Unfortunately, this only becomes obvious to most of us after the bubble bursts.

Wednesday, August 6, 2008

Why do we have Commission-Based Financial Advisors?

I have already discussed the forces that led to individuals managing their own retirement money. In his book, The Intelligent Portfolio, Christopher L. Jones explains how this led to product-based compensation for financial advice.

For wealthy people, investment advisors traditionally charged a percentage of the total portfolio each year. For this money, advisors were expected to have high levels of expertise over a broad range of financial topics. Investors got personalized attention requiring substantial amounts of the advisor’s time.

Now that there are so many small investors managing their own retirement money, this model doesn’t work well. Advisors simply don’t make enough money on $50,000 portfolios to justify the time and effort. Something had to change.

Enter commissions. When an advisor sells a mutual fund or insurance product, he gets a commission that is often invisible to the client. The result is, in Jones’ words:

“This approach suffers from a big conflict of interest, as some products invariably result in larger commissions for the broker or advisor than others. The result is that the advisor may have a vested interest in selling certain products (such as the funds of their own firm), even if it is not necessarily in your best interests.”

In my opinion, the biggest problem is that the size of the fees is hidden from the average investor. These fees are mostly commissions and management expense ratios (MERs). By law these fees have to be disclosed in a prospectus, but these documents are written to be unintelligible by the average person.

Imagine the following scenario. Tina the typical investor walks into the office of Frank the financial advisor. Frank works out a mutual fund plan for Tina’s $50,000 retirement savings. Then Frank tells Tina that following his advice will cost her about $8000 in fees over the first 5 years! Tina would likely balk at such a high cost.

But, this is how much Tina would pay if Frank got a 5% commission up front, and Tina paid a 2% MER on the mutual funds each year. The bottom line is that hidden commissions and other fees make it possible to extract a lot of money from small-time investors by exploiting their ignorance.

Tuesday, August 5, 2008

What is Turning Us All into Investors?

In my parents’ generation, most people didn’t need to know how to invest money. They saved modest sums at the bank, but few routinely owned stocks. This question of why we’re all becoming investors is answered on the first page of The Intelligent Portfolio, written by Christopher L. Jones.

You can read reviews of this book at Seeking Alpha, Million Dollar Journey, and the Canadian Capitalist. I found that this book is well written and contains many interesting subjects. However, I don’t always agree with the author. I will be discussing several topics from this book individually over the next while.

It turns out that people are living longer, making retirements much longer. The cost to defined benefit pension plans is skyrocketing. Companies don’t want to pay for these dramatically increasing pension costs. So, pension plans are being replaced with individual retirement accounts.

In Canada these accounts are primarily RRSPs, and in the US they are mostly 401(k) plans. Instead of funding pension plans, many companies now match contributions to individual retirement accounts. Investing the money in these retirement accounts is the responsibility of the individual.

Blaming these changes on the fact that we are living longer is one way to look at things. However, life spans have been increasing for a long time. We have seen this coming. The real problem is that we haven’t made big increases in the retirement age.

Instead of increasing the retirement age from 65 to 75 or 80, we have done very little. In fact, many workers can retire and collect benefits starting at age 60 or 62 if they choose. If the retirement age were 75, pension funds would need much less money and many companies might still have traditional defined benefit plans.

But, increasing the retirement age is very tough politically. How do you tell someone who hates his job and has been planning a move to Florida that he has to work longer? Ultimately it is the voters who are responsible for the fact that we have all become investors.

Monday, August 4, 2008

Forecasting Family Finances

I confess that I’ve never actually created a budget for my family. I’ve started budgets a few times, but never made it even half way through. Patrick over at A Loonie Saved describes an approach to family budgeting that seems less painful than what I tried to do. He begins with what he calls descriptive budgeting and evolves into prescriptive budgeting.

What I have done for my family a few times over the years is some financial forecasting. I looked at our spending patterns, income, and one-time expenditures at a very coarse level to predict how much savings we would have a year or two later. This is similar to Patrick’s descriptive budgeting, but I suspect that my analysis was much less detailed.

If you’re looking at your budget for the purpose of estimating future savings without trying to change your spending habits, you don’t need much detail. If I always take $400 out of a bank machine each month, it doesn’t matter what I spend it on unless I’m trying to reduce this spending.

I definitely recommend starting with forecasting your family’s future savings. If you’re like my wife and me (cheap?), you may find that you’ll be fine in a year or two if you continue spending as you are now. If you’re prone to being vaguely worried about finances, this can be reassuring.

If your predicted future savings aren’t what you’re hoping for, you’ll need to add more detail to your record of spending patterns to get to Patrick’s descriptive budget. This will give you enough information to choose a few areas to reduce spending.

If a few adjustments aren’t enough to save your finances, you may be a candidate to be on Gail Vaz Oxlade’s television show Til Debt Do Us Part. She will have you giving up credit cards and storing cash in jars to control your spending. Overspending has to stop sometime, either with the jars or with bankruptcy.

Friday, August 1, 2008

Can Tax Credits Affect Fertility?

Whenever economic conditions change, there are obvious primary effects and less obvious secondary effects. Rising oil prices have the primary effect of causing people to spend more on gas. Secondary effects include reduced oil use, reduced demand for gas-guzzlers, higher food prices, and increased research into alternative energies.

Asako Ohinata at the University of Warwick did a study of the effect of a working families tax credit on fertility in the UK. The question was whether people would actually have more children if given a modest economic incentive.

The results were mixed. The tax credit did not affect when couples had their first child. But, among couples who had one child, they had a second child sooner as a result of the tax credit.

This speaks to the amazing power of economic incentives. If you want to reduce dependence on foreign oil, then increase gasoline taxes. If you want to reduce garbage output, then tax items at the time of purchase based on the amount of garbage they will ultimately produce. There may be political barriers to such actions, but there is little question that they will work.