Tuesday, September 30, 2008

Who will be protected by a Bailout?

Reporters are running out of words to describe the drop in stock prices yesterday after the US House of Representatives voted down the $700 billion bailout of the financial system: crash, plunge, carnage, bloodbath. Supporters of the plan said that the bailout is necessary to prevent further financial collapse. Others fear that even $700 billion would not be enough.

What is usually left unstated in these discussions is what will happen if government doesn’t act. This part is usually left to our imaginations. In a more fearful moment, I tend to recall images I’ve seen of the homeless and hungry in the swirling dust of the great depression. Maybe others imagine burning buildings and widespread panic.

The truth is that supporters of a bailout probably get more mileage out of leaving the consequences unsaid. We imagine much worse outcomes than most commentators would predict.

I have little doubt that the US government will ultimately have to do something fairly costly to limit the damage, but it sickens me to think that public money may be used to protect the jobs of executives at financial institutions whose greed is largely responsible for the current mess.

If there was a plan designed to protect the economy, but not protect the businesses and individuals most responsible for the current crisis, this plan would likely get strong public support.

Monday, September 29, 2008

An Invitation to Become a Financial Consultant

According to a sheet of paper stuffed in my mail slot, it’s “time to think about being paid what you’re worth.” Investors Group is taking on twelve new “consultants” in my area. This prompted me to poke around the Investors Group web site to look at their investment products. I didn’t much like what I saw.

Presumably, Investors Group (IG) consultants would sell IG mutual funds among other things. The fund selector on IG’s web site showed 84 funds designated as “aggressive growth,” which seems to mean stock funds. The dollar-weighted average management expense ratio (MER) was 2.65% per year!

This is staggeringly high. Most forecasters consider an estimate for the long-term compound return from stocks of 6% above inflation to be optimistic. IG stock funds take away nearly half of this return in MERs.

Actually, it’s worse than the 2.65% I calculated. This percentage is for the back-end loaded version of the funds, where you pay a percentage upon leaving the fund if you leave too soon. Typically, a back-end load starts at 5% or 6% and declines to zero over 5-7 years. The unloaded version of IG’s funds typically had an MER about 0.15% higher than the loaded versions.

What about Canadian money market funds? These are supposed to be ultra-safe funds that give very modest returns. They typically have low MERs. IG has three Canadian money market funds. The only no-load fund has a painfully high MER of 1.13%. The loaded funds have MERs of 0.66% and a whopping 1.27%!

This was enough for me. I have moments where I think it might be fun to be a financial advisor, but I certainly wouldn’t want to do it having to sell mutual funds with such painfully high expenses.

Friday, September 26, 2008

Why Pundits Can’t Predict Short-Term Stock Movements

There is no shortage of pundits who offer predictions of what will happen to particular stocks or the stock market in general. You’ll find them on television, radio, and innumerable blogs. I’m open to the possibility that some investors can guess the long-term success of a particular business, but I simply don’t believe any short-term predictions that I hear.

Here is why: if these pundits actually get it right a significant fraction of the time, then they could make much more money investing based on their predictions instead of wasting their time as pundits. To prove this, I decided to run some Monte Carlo simulations.

Suppose that our pundit Peter predicts whether the S&P 500 will beat inflation each month, and he gets it right 80% of the time. So, 20% of the time when he picks stocks to win, he is wrong, and 20% of the time when he picks inflation to win, he is wrong. This may seem like only a mildly impressive record, but I’ll show how Peter can make himself fabulously wealthy.

Let’s say Peter decides to give up his life of wearing a bow tie on inane financial television shows and starts trading based on his insight. He starts by taking a $100,000 second mortgage on his home. (Fortunately, Peter bought well before the housing bubble began and has been conservative with his money until now.)

Each month, Peter will make his prediction and do one of two things:

1. If he thinks stocks will not beat inflation, he just keeps his money in cash for the month. In this case, we’ll assume that the interest he collects just keeps up with inflation.

2. If he likes stocks for the month, he leverages his money by a factor of 3 and buys an S&P 500 index fund. By “leverage” here, I mean that if he has $100,000, he borrows an additional two times this amount ($200,000), and invests the whole $300,000 in the index fund.

Before I can run the simulations to see what happens to Peter’s money, we need to factor in some assumptions about real-world stock performance and costs:

- The expected compound return of the S&P 500 will be 6% above inflation each year, with a 20% standard deviation.

- The cost of borrowing money is 5% above inflation.

- The cost of trading in and out of the index fund is 0.5% each time.

- Peter must pay 40% tax on his gains each year.

- Inflation is 4%. (This is only needed for the tax calculation. You have to pay tax on all gains, even the gains needed to keep pace with inflation.)

All of these costs are a huge burden for Peter to overcome with his market timing strategy. The simulations will tell us whether Peter’s 80% prediction rate can win out.

I piled all this data into my program and ran millions of possible futures for Peter’s money. After 20 years, there is a 90% chance that Peter will have between $1.6 million and a whopping $69 million! The median outcome was $10.3 million. These figures are in present day dollars taking into account inflation.

So, why would Peter bother being a pundit and give away his valuable insight? The answer is that he wouldn’t. I don’t pay attention to pundits who make short-term stock market predictions because I don’t believe they can get it right significantly more often than someone who tosses a coin.

Thursday, September 25, 2008

The Perils of Short Selling

In his article about the new ban on short selling 800 US financial stocks, Larry MacDonald discussed some of the pitfalls of short selling. This reminded me of one of the more interesting ways that short sellers can come out on the losing end.

Short selling is the practice of borrowing stock and selling it so that you effectively own a negative number of shares. Short sellers hope that the stock drops so that they can later buy the stock back at a lower price, pocket the difference, and return the borrowed shares. Until recently, this practice was perfectly legal. Now, short selling is banned on certain beleaguered financial stocks.

As Larry said, the biggest reason why short selling is a difficult game is that stocks tend to go up. When you pick a stock to short, you have to have far better insight into the stock’s future than other investors just to break even. Using short sales to make more money than you could have made by simply owning an index is very difficult. Some might say that it’s a fool’s game.

Even when you are right about a business being overvalued, you may not make money. Government interference to prop up stock prices or ban short selling are possibilities. Another possibility is the stock remaining overvalued for years until the business value finally catches up to the stock price.

One of the more interesting ways that overvalued businesses cheat short sellers occurred during the tech boom. Suppose that ABC stock trades for $100, but ABC’s business is really worth less than $1 per share. This would seem like a perfect situation for a short seller.

But, what happens if ABC makes an acquisition? Suppose that ABC doubles the number of outstanding shares to acquire another business that is fairly valued. Now the true value of ABC’s shares has jumped to about $50 each (that is $100 of value in the acquired business spread across twice as many ABC shares). In the mania of a bubble, this might cause ABC shares to jump to $300 each.

Now ABC repeats the process by finding another larger business to acquire that matches ABC’s new larger market capitalization. Again, ABC doubles its share count. The new business value is $50 from the first acquisition plus $300 from the new acquisition diluted across twice as many ABC shares. Now ABC shares have a fair value of (50+300)/2 = $175.

ABC has successfully used its overvalued stock to increase its real value by over two orders of magnitude. Imagine the poor short seller who sold ABC stock for $100 before the two acquisitions. He thought he had a sure thing because ABC was overvalued by a factor of more than 100. Now ABC stock is worth at least $175 per share, and the stock is likely to trade much higher than this because of the mania. Short selling is a difficult game.

Wednesday, September 24, 2008

The World’s Oil Reserves

In his book, Twilight in the Desert, Matthew R. Simmons makes the case that Saudi Arabia’s oil production will soon peak as the most easily recovered oil is depleted. His extremely detailed analysis contrasts sharply with the Saudi assertion that they can satisfy world demand for another 50 years. Much of his technical information comes from Saudi technical papers that seem to contradict their public statements.

Simmons provides mountains of technical information that amounts to circumstantial evidence that oil supplies are dwindling. However, as he points out, it is up to the Saudis to prove their claims about how much oil is still in the ground and how quickly it can be supplied to the world.

Assessing the nature of oil fields and how much oil they contain is very difficult. As much as anything this could account for the seeming lack of reliable information about oil reserves.

Even if we knew how much oil is in the ground, it’s not clear how much of it can be recovered economically. And even if we could tell how much oil can be recovered, the Saudis and western oil companies seem to have an interest in projecting a message of stable oil supplies into the future. All this leaves little hope for the average person to know when oil supplies will begin to dry up.

The main way that this book has changed my thinking is that I no longer believe any reports of the size of oil fields. It’s not that I necessarily think that the report writer is lying; I just think that they likely don’t really know. In this sense, I put them in the same category as pundits who make short-term stock market predictions.

Tuesday, September 23, 2008

Obscene MERs

Preet over at Where Does All My Money Go recently discussed the importance of paying attention to investment fees. In a lighter moment, he had some fun with a fund screener and listed funds with yearly MERs above 8%! To appreciate how ridiculously high this is, you need to see the effect over a long period of time.

As I have discussed before, MERs are paid every year, and investors have to be cautious about comparing them to one-time costs. After one year in a fund charging an 8% MER you would still have 92% of your money. The next year, though, the fund would take 8% of your remaining 92% leaving you with 84.64% of your money.

Over 25 years, an 8% MER would chew up 87.5% of your money. Suppose that your initial investment grows to $250,000 after 25 years. If you didn’t have to pay the 8% MER, you would have finished with $2 million!

Things get even sillier with the worst fund Preet listed: “Dynamic Power Hedge Fund-F” with an MER of 13.94%. I’m not sure what this name means, but it does a better job of distracting us from its high fees than something like “Stodgy Limp Noodle Fund-Z.” After 25 years in this fund, 97.6% of your money is gone. If the fund’s managers were to re-invest the MER they collect from you back into the fund for 25 years, for every dollar of your money left in the fund, the fund’s managers would have over $40.

Don’t let these high MERs desensitize you, though. Anything over 2% looks outrageous to me. Even a 1% MER takes away 22% of your money after 25 years.

I would like to see funds have to report their MER25, which is 25 years worth of expenses rather than just the one-year MER. When comparing a 2% MER actively-managed mutual fund to a 0.2% MER index fund, both percentages seem trivially low. But their MER25s are 40% and 4.9%. This gives a better picture of the damaging effect of fees.

Monday, September 22, 2008

Experiments in Assessing Risk

Suppose you’re given a chance to bet on the toss of a coin. If it comes up heads you win $20, and if tails you lose $10. Would you take this bet? Given a chance to do it 100 times in a row would you do it? This experiment was actually performed in a coffee shop in Westwood, Los Angeles, as explained by Jason Zweig in his book, Your Money & Your Brain.

The average outcome is to win $5 every time you take this bet. But, if you do it only once, you could lose $10 instead of winning $20. What about doing it 100 times? The expected outcome is to win $500. The odds that you’ll actually lose money are less than 1 in 2000. The odds of losing $200 or more are less than one in a million. The odds of winning more than $200 are over 97%. This is an incredibly good bet.

Amazingly, two out of three people accepted the one-time bet, but only 43% said they would be willing to repeat the bet 100 times. What are the possible explanations for the 57% of people who turned this down?

1. People are spectacularly bad at assessing which risks are worth taking.

2. Some people believed it was a trick, and that the gamble wouldn’t be fair.

3. Some people have philosophical objections to gambling. (However, because almost everything in life involves some type of gamble, it must be difficult to draw the line on this one.)

4. A few of the subjects were compulsive gamblers, and they knew that if they accepted the bet, they’d go out and lose it all and more in a casino.

5. A few of the subjects were so wealthy that winning only $5 per coin toss was a waste of their time.

I suspect that the dominant explanations of the experiments’ results are reasons 1 and 2. It’s no wonder that so many people make poor investing choices given that they would turn down a near sure thing.

Friday, September 19, 2008

Understanding the Current Financial Mess

I stumbled across an excellent radio program that puts a human face on all the players in the current mortgage crisis. To listen to the program, follow this link to This American Life and click on the “Full Episode” link under the picture of curled US dollar bills.

During the radio program we hear from borrowers who didn’t have to show any credit worthiness, a broker who aggressively sought out borrowers without caring whether they could pay back loans, and other players up the food chain packaging mortgages into investments for the $70 trillion world-wide fixed income market that hungered for higher returns than US treasuries.

Over the course of many steps, a half-million dollar loan to someone with low income was merged with other bad loans and transformed into an AAA-rated investment. This story is part stupidity and part greed. Unfortunately, both parts are extremely large.

It’s easy to listen to this radio program and get discouraged. Are we all just greedy idiots? On the other hand, we still have too much food to go around and far more clothing for sale than we could possibly wear out. Life is pretty good whether we’re greedy idiots or not. For most of us, unhappiness is driven by envy of our neighbours rather than actual need.

Thursday, September 18, 2008

Life Insurance from my Alma Mater

Yet another mailing from the university I attended years ago arrived. It’s life insurance this time. In a burst of optimism, I think, maybe this will be a good deal because my alma mater will have trimmed the rates down as low as possible. I’ll get the benefits of a low cost group plan, and maybe university grads have slightly lower mortality rates.

I decide to take a look. The first thing I see is a big picture of a smiling young woman. This is not a good sign. Advertisers know that men get looser with their money when they see smiling attractive women. I skip all the other mumbo jumbo and get right to the numbers. I’m a male non-smoker. I look up my age and desired coverage amount and find that the cost with the discount available to me is $67.50 per month.

Is this good? I’m not sure. I could hunt through some paper files, but Google is right here at my fingertips. It took less than a minute online to get 12 quotes from the major insurers in Canada ranging from $46.40 to $60.73 per month.

Hmm. That’s 10% to over 30% better than the quote from my former university. Maybe the fine print is different. No, they’re all 10-year renewable and convertible. What gives?

Obviously, I knew that the university was getting a slice of the insurance premiums. But, I’d hoped that they had negotiated a great deal and had split the difference with me. Instead, they’re trying to gouge me and split the proceeds with the insurance company.

I guess my alma mater doesn’t love me as much as I’d hoped. Oh well, at least my wife, kids, and my neighbour’s dog still care about me.

Wednesday, September 17, 2008

20/20 Hindsight

Most of us have heard the phrase 20/20 hindsight. It refers to the fact that we tend to view past events as inevitable even though we didn’t see them coming in advance. Another name for this is hindsight bias.

In his book, Your Money & Your Brain, Jason Zweig describes brain-scanning experiments that look for the biological basis for some of our human quirks. One of these quirks is hindsight bias.

When we learn something new, we have a tendency to begin to believe that we’ve known it all along. When we buy a stock that later rises, we tend to think that we knew the stock would go up. We come to think that we bought the stock confidently knowing it would go up when the truth was that we were probably very uncertain and almost made a different choice.

This tendency to believe that we were able to predict past events before they happened is very dangerous for investors. It makes us believe that the future is much more predictable than it really is.

Hindsight bias can even kick in on missed opportunities. Even if you just considered buying a stock, but didn’t buy it before it shot up can make you say “I knew it.” This feeling that you knew the stock would go up makes you more likely to throw money at the next stock that looks like it might rise.

The next time you think about some past event as having been inevitable, try to remember what you really thought before the event occurred. If you’re honest with yourself, you’ll likely remember that you really didn’t know what was going to happen.

Tuesday, September 16, 2008

Lehman Brothers and a Healthy Economy

The banking crisis continues as Lehman Brothers files for bankruptcy. Most people seem to view banks failing as a sign that the financial crisis is deepening. You won’t be too surprised to learn that I see this differently.

The damage to the economy was done when financial institutions made poor choices chasing short-term profits at the expense of the long-term health of their businesses. Lending money to people who can’t pay it back has to cause problems eventually. That banks are failing now is a logical consequence of their actions rather than a sign that things are getting even worse.

To maintain a healthy economy, some businesses must fail. Everything would become stagnant if we were to prop up unprofitable businesses. Well-run businesses should see their market share increase as their poorly-run competitors fail.

This doesn’t mean that government intervention is always wrong. However, the important test of whether government should step in is whether it is in the public interest to do so. Having the government prop up a business just for the sake of that business is a mistake.

So, when you hear about a company failing, don’t automatically take it as a sign that the sky is falling and we’re doomed to a dark future. The remaining companies in the same industry are likely to be better run and more likely to succeed at offering products or services that make our lives better.

Monday, September 15, 2008

Life Annuities and Longevity Risk

Unlike most investing products, life annuities actually solve a problem that do-it-yourself investors have difficulty handling on their own: longevity risk. By controlling my own investments with low-cost index ETFs, I can beat most professionally-managed mutual funds. However, when it comes to my retirement years, it will be hard to decide how much money it’s safe to spend because I don’t know how long I’ll live.

If you control your own investments, the only practical approach in your retirement years is to spend little enough that your money will last to the end of a very long life. Just because the odds are only, say, 50% that you’ll make it to age 80, that doesn’t mean that you can get away with saving only half a year’s worth of spending money for your eighty-first year. If you make it to age 80, you’ll need a whole year’s worth of money.

Life annuities are an insurance product designed to solve this problem. The insurance company takes a lump sum of money from you and pays you a monthly amount for the rest of your life, no matter how short or long your life turns out to be. This transfers the longevity risk from you to the insurance company. It also eliminates any inheritance.

The insurance company reduces risk by selling many life annuities. They can predict with reasonable certainty how many people will live to each age. So, if only half the people will make it to age 80, the insurance company will only have to pay half as much by then. The savings the insurance company expects over time allows them to increase the monthly payments everyone gets right from the first month.

So, with the longevity risk significantly reduced and with everything else being equal, a life annuity allows you to spend more each month than if you handled your own investments. Unfortunately, everything else isn’t equal. Insurance companies have to pay executive salaries and salespeople’s commissions somehow. These costs come out of the lump sum you hand over to the insurance company when you buy the life annuity.

Another factor is that the insurance company might not invest the money the same way that you would. If they are conservative and use mostly fixed-income investments, then you’re very likely to get less than if the money were invested in stocks.

Overall, I don’t have an answer to the question of whether a life annuity is better than investing on your own throughout retirement. But, I tried to come up with a way to have your cake and eat it too. By this I mean can we reduce longevity risk and cut out all the hefty fees and commissions?

One possibility is to pool retirement funds with other individuals to spread out longevity risk. Suppose that 20 people pool their money. At first withdrawals are split 20 ways, but as the participants die off, the withdrawals get split 19 ways, then 18 ways, and so on. The idea is that after you die, your share goes to the survivors.

It’s all a bit morbid, but it could work out well if there aren’t any serious conflicts. Draining the money to pay lawyers over a squabble would be a problem. Another problem that might make an interesting movie is that each person would have a financial incentive to bump off the others.

Despite what many people seem to believe, individual investors with a little knowledge can usually get better returns than the professionals. Reducing longevity risk is one of the few significant ways that professionals handling big piles of money have an edge over the little guy.

Friday, September 12, 2008

The Dangers of Web-Based Trading

One of the concerns I have about my investing future is my own emotions. One day I may become bold or fearful and make some rash decisions. The resulting trades would probably work out badly.

I consider my online trading account to be one of the things that increases my risk of doing something impulsive. Some people say that the solution is to work through a financial advisor who performs the trades for you. I have a much cheaper solution: I avoid logging in to my trading account unless it is necessary.

Many people choose to read stock quotes and other investing news through their online accounts. When you do this, making trades is always just a few clicks away. I do my day-to-day financial news gathering anywhere but through my trading account. This small extra barrier of trying to remember my password and figuring out how to make a trade gives me a little more protection against impulsiveness.

Usually, the people I mention this to think I’m a little crazy. Is anyone else concerned about their emotions getting out of control resulting in dumb trading? What methods do you use to stop yourself?

Thursday, September 11, 2008

Million-Dollar Pennies

A recent article at My Dollar Plan caught my eye: A Penny Saved is ... $6,977.03! This article points to the essay Every Penny Counts by Scott Bilker.

Bilker shows that if you increase payments on a long-term high interest debt by just a penny each month, big savings result. Starting with a $10,000 loan at 1.5% per month, the interest is $150 per month. The minimum you can pay and still have the loan paid off eventually is $150.01. But this will take about 54 years. Increasing the payment to $150.02 saves you $6977.03 over the life of the loan. Just a penny per month makes a big difference.

Now I understand the point these authors are making: small amounts can add up. Ignoring small amounts each day can seriously hurt your finances over the long run. I’ve made the same argument myself in Small Amounts Add Up, but Pennies Don’t. As you can guess from this article’s title, I argue that small amounts add up, but pennies are just too small to amount to anything important.

But, doesn’t Bilker’s example prove the opposite? No, because it is too contrived. It just shows that you should avoid high-interest loans.

Let’s take Bilker’s argument to the next level. Suppose that you have a department-store credit card that charges 2.4% per month. You build it up a $10,000 balance, and then pay the exact amount of the interest, $240, each month. Your balance should stay at $10,000 indefinitely.

But, you didn’t notice a short paragraph in the fine print. There is a one-penny service charge each month. At first your balance goes up by a penny each month, but interest begins to compound over time. After 60 years, you finally notice that something is wrong. How much do you owe at this point? Drum roll, please ... $10,868,192.14!

Of course, this whole example was silly. Bilker’s example was less silly, but silly nonetheless. It’s about time that we eliminate the penny. The pennies that we hand back and forth in cash transactions can never amount to much. We would be just fine if all cash transactions were rounded to the nearest nickel, or even quarter.

Wednesday, September 10, 2008

The Cost of a Free Dinner

Let’s say you’re in a casino gambling and an employee walks up and says “I see you’re not having a good day. Here’s a voucher for you and your wife to have a free steak dinner. You can go right now. Enjoy.” This is a real possibility at Harrah’s casino in Las Vegas. This is a very kind gesture, but what is behind it?

Yale law professor and economist Ian Ayres answers this question in his book, Super Crunchers. The ability of computers to gather vast amounts of data about our actions and choices has given rise to decision-making based on data analysis, called super crunching by Ayres.

To see how super crunching works, let’s look at the case of Harrah’s casino. Like any business, Harrah’s would like to maximize profits. To use super crunching, Harrah’s began by collecting data about the gambling patterns of their “total rewards customers” who use swipeable electronic cards to identify themselves while gambling. Then Harrah’s used a method called regression on the data to see what factors lead to higher revenue per person over time.

There is no need to guess which factors are most important for profitability; the data analysis figures this out. Harrah’s determined that people tend to have a “pain point.” If they lose too much money in a weekend, then they don’t have fun and may not come back.

This pain point depends on income and other factors, and the regression analysis allows Harrah’s to guess each customer’s pain point from personal information collected when the customer card is created. When a customer approaches the predicted pain point, Harrah’s intervenes in some way, such as offering a free steak dinner. So, the free dinner is all about increasing the odds that you’ll come back and lose more money in the future.

So, what is your reaction to all this? Is Harrah’s making people’s lives better or worse? Some people have no problem with this sort of personal data collection, and others are horrified by the invasion of privacy.

Tuesday, September 9, 2008

Chasing Bad Stocks is Your Brain’s Fault

According to Jason Zweig in his very interesting book, Your Money & Your Brain, the wiring of our brains is responsible for some of the mistakes we make in our approach to investing. Zwieg covers a number of human tendencies that can be traced to brain activity, but I will focus here on what makes us want to keep chasing stocks that ultimately disappoint us. For a complete reviews, see the Canadian Capitalist's review.

The new science of neuroeconomics involves scanning subjects’ brains while they take part in experiments. By seeing which parts of the brain light up and how intensely they light up, researchers can tell a lot about how we’re wired.

It turns out that we’re more excited during the time leading up to a potential reward than we are to actually receive the reward. So, when a gambler plunks his money down on lucky number 7 at the roulette wheel, he’s more excited watching for the wheel to stop than he is to rake in his chips if he happens to win.

The amount of excitement in the gambler’s brain increases with the size of the potential win. This means that we’re attracted to buying stocks where we can imagine a big payoff. This makes penny stocks much more exciting and rewarding than big bank stocks, at least until the penny stock becomes worthless and the investor gives up hope.

But, things get worse. Our excitement level is dictated by the size of the potential reward and not the odds of collecting that reward. This explains lottery tickets. Watching the numbers being drawn is exciting because of the multi-million dollar payoff even though the odds of winning are negligible. So, even though we lost money on the last ten penny stocks we bought, the next one is just as exciting to own.

Things get even worse than this. The potential for reward is more exciting if the potential for loss is present. So, if your penny stock is a sure thing, it’s less exciting than if you might lose all your money.

If ever there was an activity that requires people to remain calm and unemotional to succeed, it is investing.

Monday, September 8, 2008

Record Earnings

The TD Bank recently announced record earnings for the third quarter this year. This sounds a lot more impressive than it really is.

If I leave some money in a savings account that pays 3% interest every year, I can expect to make “record earnings” every time I get paid interest. By leaving each interest payment in the account, the next interest payment will be larger than all the previous ones. So, a new record is set every time. Warren Buffett explained this in his 1977 letter to shareholders.

Pay raises tend to be very small these days, but by the standard of financial press releases, you can trumpet a new record income even if all you get is a 1% raise.

I’m not making any claims about whether TD Bank had a good quarter or not. But, you shouldn’t be impressed by any announcement of record earnings. It’s always necessary to dig further into the details to find out what is really going on.

Friday, September 5, 2008

Be the First to Order in a Restaurant

I was recently pointed to a fascinating book called Predictably Irrational, by Dan Ariely (see this review by the Canadian Capitalist). Among other things, I learnt that when ordering food in a restaurant, I should try to order first to maximize the odds that I’ll enjoy my meal. Huh?

In a series of experiments, Ariely determined that many of us have a tendency to order something different from everyone else at our table to show our individuality. Other people have a tendency to order the same food as others to show solidarity. Either tendency leads to ordering a sub-optimal choice.

Ariely’s experiments showed that when people write down their orders without knowing what others at their table ordered, they enjoy their meals more. In the ordering out loud case, only the first person to order enjoyed his meal as much as those who wrote their orders down.

This is just one of the many ways that people are consistently irrational in a predictable way. I would say that being too afraid of short-term investing losses is another way that people are predictably irrational. To paraphrase Warren Buffett, I would rather make a lumpy 10% than a smooth 7%.

Thursday, September 4, 2008

Do You Cheer Your Stocks Up or Down?

Most people are happier to see the price of the equities they hold rising rather than falling. But, is this sensible for people who are in a phase of their lives when they are saving money and buying equities? Isn’t it better to buy things at lower prices instead of higher prices? I think that your feelings on this subject say something about you as an investor.

Warren Buffett has consistently said that he would be pleased to have the stocks he holds drop by 50% so that he could buy more cheaply. The reason he thinks this way is that he believes he has a good sense of the intrinsic value of the businesses he owns. You can think of stock prices as estimates of intrinsic value that may or may not be accurate.

Buffett is confident that if a stock price drops way below the intrinsic value of the business, the price will rise to meet the intrinsic value eventually. So, for him, low stock prices are a buying opportunity.

However, most people can’t estimate the intrinsic value of a business better than the stock market does. These people cheer their stocks up even when they plan to buy more. This makes sense if you see stock prices as the best available indication of the health of the business. In contrast, Buffett sees price changes as random gyrations taking the price closer to or further from intrinsic value.

Cheering price increases isn’t irrational; it’s just a sign that the investor belongs to the large majority who can’t do what Buffett does. Perhaps this could be used as a test of whether an investor should be a stock-picker. If you are in a phase of your life where you are saving and buying stocks and you cheer rising stock prices, maybe you should switch to index investing.

Wednesday, September 3, 2008

To Index or Not to Index

Last week, Frugal Trader over at Million Dollar Journey wrote a provocative article about 4 reasons why index investing may not be for you. This article generated a lot of interesting discussion. Instead of giving my own opinion on the subject, I thought I’d search out views from a recognized expert.

Enter Warren Buffett, or at least a 15-year younger version of him. In his 1993 letter to shareholders, Buffett wrote
“[A] situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb.

“On the other hand, if you are a know-something investor, able to understand business economics and to find five to ten sensibly-priced companies that possess important long-term competitive advantages, conventional diversification makes no sense for you. It is apt simply to hurt your results and increase your risk. I cannot understand why an investor of that sort elects to put money into a business that is his 20th favorite rather than simply adding that money to his top choices - the businesses he understands best and that present the least risk, along with the greatest profit potential. In the words of the prophet Mae West: ‘Too much of a good thing can be wonderful.’”

You might think that by Buffett’s definition, the investing world is divided into 50% “know-something” investors and 50% “know-nothing” investors, but this isn’t right. Because of the cost of commissions, spreads, increased volatility, increased capital gains taxes, and losses due to market timing attempts, the proportion of investors who beat the index is way below 50%. So, there’s a good chance that you and I are both “know-nothing” investors by Buffett’s definition.

The good news is that even if you can’t evaluate the prospects of individual businesses effectively enough to beat the index, you can still beat most other investors by buying the index.

Tuesday, September 2, 2008

The ebay Effect

One of the quirks of human behaviour is that we value things more highly if we own them. When selling your house, you remember the good times, but prospective buyers notice the cracks in the walls. One of the places where this effect can give you trouble is on ebay.

Suppose that you are searching for an item on ebay and are pleased to find it. You then make a bid. But the bidding won’t close for another three days. Two days later you see that there aren’t any higher bids. At this point, you begin to mentally treat the item as partially in your possession.

The rest of this story is familiar to frequent users of ebay. In the last minutes of the auction, a higher bid will come in and anger you. This newcomer has a lot of nerve! After all, this item has been nearly yours for three days. Now you’re tempted to enter bids higher than the upper limit you decided upon three days earlier.

I don’t have any grand ideas for how to combat this tendency. Maybe just being aware of it can help us save some money in this type of situation.

Monday, September 1, 2008

No Recession in Canada

Canada’s Gross Domestic Product (GDP) rose 0.3% in the second quarter of this year, which means that we’re not in a recession. This should be good news, but it’s actually mildly annoying.

We all know that the economy hasn’t been great lately. Even if unemployment is low, we know people who have lost jobs and have been forced into lower paying jobs or part-time work. Stock prices are dropping. Housing prices are dropping. To say that we’re not in a recession is like denying that there are any problems with the economy.

But the numbers don’t lie. GDP shrank in the first quarter and rose in the second quarter. The definition of a recession requires two consecutive quarters of dropping GDP. So, we’re not in a recession.

The emotional response to this news was captured nicely in the headline “Canada skirts recession on a technicality.” The implication is that we all know that things have been rough and we should be calling it a recession, but some number cruncher found some way around it on a technicality.

Curiously, the article going with this headline does not have this tone. It’s as though the article and headline were written by two different people. I’m told that this is fairly common in the newspaper business.

Hopefully, all this is a sign of continuing improvements in the economy, but I’m not making any predictions. I don’t believe other people’s short-term economic predictions, and I definitely know that I have no worthwhile insight.