Friday, October 31, 2008

Short Takes #3

1. For some Halloween fright, Clever Dude shows us what a billion-dollar restaurant bill looks like.

2. Million Dollar Journey gives us a handy summary of planned TFSA (Tax-Free Savings Account) offerings from the major Canadian banks and brokerages.

3. Have you ever heard of a carry trade, but didn’t know what it was? Preet explains carry trades and the possible ramifications of Yen carry trades.

4. Blunt Money has some useful suggestions for getting out of cell phone contracts.

5. Canadian Capitalist reports on John Bogle’s stock market predictions. Don’t worry, though; they haven’t both lost their minds and started making predictions about short-term stock market movements. Now that stock prices have dropped significantly, Bogle thinks that returns over the next decade are likely to average 10% per year.

Thursday, October 30, 2008

Property Tax Assessments

This week I got my notice from the government about how much they think my house is worth. They clearly didn’t spend much time on my house because my assessment went up by exactly the average amount in my area, 13%.

Fortunately, this doesn’t mean that my property taxes will go up by 13%. City governments don’t collect more taxes when property values rise and less when property values fall. What actually happens is the city decides on the total amount they will collect from homeowners, and then divides that amount among homeowners in proportion to assessed property values.

For example, if the city needs $1 billion from us, and the total value of all houses is $80 billion, then the tax rate is set at 1/80=1.25%. A house worth $320,000 would pay $4000 in property taxes. If property values had plummeted to a total of $50 billion, then the tax rate would have been set at 1/50=2%. The house that was worth $320,000 in good times is probably worth only $200,000 in bad times, but would still pay $4000 in property taxes (2% of $200,000).

With this type of system, what really matters to your property taxes is how much the value of your house rises compared to everyone else. Suppose that the city increases taxes by an average of 5% from last year to this year. My house’s assessed value went up by exactly the average amount, 13%. So, my tax increase will be 5%. If my assessment had gone up by 17%, then my taxes would have gone up by about 4% more than average, or about 9%.

One other wrinkle for my area is that new property values will be phased in over four years. This was done to reduce the shock for homeowners whose assessments changed dramatically. If no new assessments are done in the next four years, then I can look forward to paying exactly the average tax increase each year. If my assessment had gone up by 17% instead of the average 13%, then I could look forward to seeing my property taxes increase by about 1% more than the average for each of the next four years.

Wednesday, October 29, 2008

Good News for Ontario Senior Homeowners

Seniors who pay property taxes in Ontario can look forward to a tax break starting next year. The maximum amount of the tax break for 2009 is $250, and for subsequent years it is $500.

The tax reduction won’t come off the city tax bill directly, though. This program is part of the Ontario Tax Credits. Seniors who qualify and submit form ON479 at income tax time will get a tax deduction or rebate on their income taxes.

In 2009, a senior couple with a combined income under $45,000 will get the whole $250, and the amount of deduction drops off to zero for combined incomes over $60,000. Single seniors in 2009 whose income is under $35,000 will get the whole $250, and the amount of deduction drops off to zero for incomes over $50,000.

It’s hard to disagree with a policy like this when you imagine an elderly widow living in near poverty being forced from her home because she can’t afford the property taxes. However, this does shift the tax burden slightly from seniors to younger people, and it’s not difficult for seniors with substantial savings to keep their incomes low enough to qualify for this tax break.

As the proportion of seniors in the population increases, there will be increasing pressure on governments to shift more of the tax burden away from seniors onto young people. I’ll probably be less concerned about this once I become a senior myself.

Tuesday, October 28, 2008

New Rules for Mutual Fund Disclosure

A group of regulators of the Canadian mutual fund industry have come up with a proposed new set of rules for disclosing information to potential investors (pdf). Just in case the details don’t interest you, you can skip down to the end of the document where there are two example mutual fund fact sheets. Thanks to Preet Banerjee at Where Does All My Money Go for pointing me to this report.

Don’t look for any big differences to help investors understand what is going on. These fact sheets don’t even have to include a fund’s trading costs. As explained in an Ontario Securities Commission article Understanding Mutual Fund Fees, “brokerage charges, which are the fund’s cost of buying and selling securities in its investment portfolio, are paid by the fund but are not included in the MER.” These costs are buried in other disclosure documents as a Trading Expense Ratio (TER).

To those of us who have an interest in financial details, the disclosures about fees in the fact sheets seem clear enough. But, I doubt that the average investor could make a meaningful connection between this information and actual fees paid. When friends and family show me their account statements, they are usually shocked when I tell them how much they pay in fees.

Simple New Type of Disclosure

A problem with the fact sheets is that they are disconnected from the purchase of units in a fund. Whenever an investor buys units of a mutual fund, there is some piece of paper or browser screen that shows how much the investor pays for the units in the fund. I’d like to see two additional numbers related to fees written beside the transaction information: assuming that the units are held for 10 years, what will be the total amount charged in fees, and how much of this goes to the advisor.

Let’s try an example. An investor decides to move his $50,000 RRSP into the biggest Canadian mutual fund that will take an investment of this size, Investors Dividend-A. This fund’s MER plus its trading expense ratio comes to 2.70% per year. According to the fund’s prospectus, advisors get 4.10% of the sale plus an additional trailer of 0.63% per year.

To avoid the problem of assuming rates of return and calculating present values, we’ll calculate fees assuming that the investment stays at a constant $50,000. Here is what our investor would see if this idea were adopted:

Investors Dividend-A fund unit price: $18.60
Units purchased: 2688.17
Total Cost: $50,000
Estimated total fees charged during 10 years in this fund: $13,500
Out of these total fees, estimated payments going to your advisor: $5200

This type of disclosure concerning mutual fund fees would be much easier for investors to understand than the information in fact sheets. It might cause investors to ask questions about fees and even do some comparison shopping.

Monday, October 27, 2008

Greenspan’s Remedy for the Credit Crisis

Former Federal Reserve Chairman Alan Greenspan was grilled by a US House oversight committee about his role in creating the rules for the banking system that failed. All the bickering about who is at fault was less interesting than Greenspan’s suggested fix: “I see no choice but to require that all securitizers retain a meaningful part of the securities they issue.”

In case that didn’t make much sense to the average reader, let’s break it down. A securitizer is an organization that collects loans into a big pile and then sells fractions of this pile to others. This doesn’t mean that they sell off each loan individually. If someone buys 1% of the pile of loans, that person will own 1% of every loan in the pile.

Greenspan is suggesting that the securitizer should not be allowed to sell the whole pile of loans, but should have to keep some fraction of it. This leaves the securitizer with some meaningful fraction of every loan.

How would this help? Well, the assumption is that at least some of the securitizers knew that the loans were bad, and that they were selling bad investments to others. But, they didn’t care because they were able to sell off all of the bundled loans for an immediate profit. If the securitizer had to keep a fraction of the pile of loans, it might think twice about buying too many really bad loans.

During the bubble, there were many securitizers playing a game of hot potato. They made money by buying overpriced products and then selling them for an even higher price to a bigger fool. If all securitizers had to hold on to a fraction of the bad loans they buy, they would be pickier about which products they buy. This would severely reduce the demand for potential mortgage holders who have little hope of keeping up their payments.

Greenspan’s rule would force middlemen to take a more long-term view. Instead of making an immediate buck by passing on the hot potato to a bigger fool, the middlemen would have to make some of their money by actually collecting on loans.

Friday, October 24, 2008

Short Takes #2

1. Rogue Clients

Falling stock prices mean that financial advisors need to beware of lawsuits from “rogue clients” according to Gowlings’ Ellen Bessner in her interview with the Wealthy Boomer (the web page with this article has disappeared since the time of writing). She defines a rogue client as an investor who claims to have a high capacity for risk but says something different when markets decline. I prefer “insurgent clients” or “terrorist clients” to really drive home the imagery. Perhaps the real reason these clients are angry is because various marketing efforts gave them unrealistic expectations about the advisor’s ability to beat the market and protect their portfolios from loss. Just a thought.

2. Bank Prime Rate

The Big Cajun Man added his voice to the many others observing that reductions in the central bank rate are not being fully passed on to borrowers. On one level this makes sense because the banks are recovering from a period where they lent money to borrowers with poor credit at unprofitable interest rates. However, adding a fixed amount to everyone’s interest rate isn’t the answer. Banks need to raise interest rates for borrowers in proportion to how likely they are to default.

3. Bankers’ Bonuses

Larry MacDonald reported that the New York Attorney General told AIG to recover executive bonuses (the web page with this article has disappeared since the time of writing). I agree with Larry that this is a good move. The problem here is that top executives are supposed to run a company for long-term success, but they are compensated for very short-term results. This creates a conflict of interest. We tend to think that these executives must have a weak moral character. But few of us could resist millions of dollars for just doing what everyone else seems to be doing. Perhaps an executive’s bonus for a given year should be paid three years later when the company has a better idea of the value of that executive’s efforts.

4. Active Share

Preet explains the concept of active share, which is a measure of how much a mutual fund differs from its benchmark index. Many mutual funds are “closet indexers” that differ little from the index. Preet goes on to show you how to calculate the effective MER on the active part of a mutual fund.

5. Warren Buffett a Market Timer?

Canadian Capitalist observes that Warren Buffett has had some very good timing with his stock market advice. Although Buffett is careful to say that he has no idea what direction the stock market will take in the short term, the timing of some of his public statements has been remarkable.

Thursday, October 23, 2008

When Will We Get Back to Normal?

We’ve watched as credit markets have seized up and world governments have pumped trillions of dollars into the banking system. Many of us want to know whether these efforts are working, and when we’ll get back to normal.

According to Business Week, bank-to-bank lending rates in the US have dropped eight straight days (the web page with this article has disappeared since the time of writing). This doesn’t mean that the problem is solved, but we are headed in the right direction. This is as close as I can get to answering the question of whether government intervention is working.

As for question of when we’ll get back to normal, I don’t think we will get back to normal. For many years, “normal” was to lend money to people who couldn’t pay it back. It was normal for investors to buy packaged loans for much more than they were worth. Until we have another bubble that leads once again to lending madness, we won’t go back to the way things were before.

There is nothing sustainable about making unprofitable loans. When banks lend money to a collection of borrowers at interest rates too low to compensate them for the ultimate default rate, someone has to lose money eventually.

Hopefully we will be creating a new normal where the credit worthiness of borrowers matters. People with the best credit should be able to borrow at rates similar to those rates available to them before this crisis. Those with mediocre credit should see an increase in the interest rates they pay, and those with the worst credit should not be able to get loans at all.

Wednesday, October 22, 2008

Canada is Number 1

At least in a few areas Canada was declared number 1 in the 2008-2009 Global Competitiveness Report from the World Economic Forum. Overall, Canada was 10th out of 134 countries, up from 13th last year.

And now let’s see the areas where Canada is number 1. Drum roll, please:

1. Soundness of banks

This is a big one. We often complain about our banks for good reason. Their wide array of fees catches us coming and going. But, at least we don’t have to worry about whether our money will be there when we want it. Canadian banks are much less likely to go bankrupt than banks in most of the rest of the world.

2. Number of procedures required to start a business

This one surprised me. Although I recall that starting my own business was a fairly easy exercise, I just don’t think of Canada as being business-friendly. I guess our fairly high tax levels are a separate matter from the amount of paperwork needed to register a new business.

3. Personal Computers

Apparently, Canada has a high level of technological readiness. Again, I would not have guessed that Canada would outdo the US on this one, but the US is only 6th.

4. Malaria incidence

One of the advantages of a cold northern climate is a lack of malaria. The toll taken by malaria in tropical areas is enormous. This is one area where I would be happy to see the rest of the world catch up to Canada.

Tuesday, October 21, 2008

Surprise Eco Fees Not Helping

I got my first introduction to Eco Fees when I bought some paint at Canadian Tire on the weekend. Standing third in line at the cash, I decided to work out the final price. Let’s see ... $4.27 plus 13% sales tax ... works out to about $4.83. So, I was standing there with $4.85 in my hand and preparing to refuse the two pennies change.

Cheerful Cashier: “That’ll be $4.86 please.”

Me: “Oops. Here’s another nickel.”

At this point I looked at the cashier’s screen to see where I messed up and saw a line that read “ECOFEE $0.03.”

Me: “What’s an ECOFEE?”

Cashier: “It’s for stuff that’s bad for the environment.”

Poking around online I discovered that this Eco Fee has something to do with Stewardship Ontario and an organization called EcoFee.org. From the EcoFee web site:

“The EcoFee is an ENVIRONMENTAL RECYCLING & RECOVERY FEE that businesses may add to invoices, billing statements, reminders, receipts, and document processing to help cover the costs that businesses incur for recycling, processing, printing, sorting, mailing, ink cartridge recycling, toner cartridge recycling, etc. This helps businesses keep the environment healthy.”

So, it seems that the fee I paid isn’t really a tax and will be kept by Canadian Tire. I found various angry opinions about Eco Fees that expressed doubt that it is anything more than extra profits. However, even if we assume that the money really will go towards environmental efforts, I have a problem with how it is being collected.

The goal of shifting costs to those products that harm the environment is to change people’s choices. Given a choice between two equally desirable options, most people will choose the one with the lower price. Thus, products with higher Eco Fees will be chosen less often. But, this can’t work if the Eco Fees are hidden until they get added to the final bill. For all I know, I’ve been paying Eco Fees for some time and never noticed before.

These Eco Fees need to be obvious at the time people make their product selections inside the store. This means that the displayed price should either just include the Eco Fee, or both the base price and Eco Fee should be displayed.

It’s not hard to see why a business would rather add these fees at the cash. They get to advertise a low price to attract buyers and then collect more money. However, this isn’t the right approach to shift people to more environmentally-friendly choices.

Monday, October 20, 2008

Life Insurance that Doesn’t Pay

How much are you willing to pay for life insurance that most likely won’t be paid if you die? Probably not much, if you know that your family won’t collect. I’ve always been suspicious of life insurance offered by employer benefits plans, and now I have a friend whose situation has confirmed my suspicions in at least one case.

If you die suddenly in some way, there is no problem with life insurance from an employee benefit plan (apart from the fact that you’re dead!). The scenario that always worried me was what if I become terminally ill with cancer or some other horrible disease, and I’m unwilling or unable to continue working? Or maybe I develop a condition that prevents me from passing a physical to get life insurance, and then I get laid off.

A friend of mine is in this last situation, laid off and unable to qualify for life insurance. Years ago, I asked about scenarios like this and was told by my employer that the life insurance is renewable. This means that employees are able to get an individual policy without have to take a physical to prove that they are insurable. Another employer told me the same thing year later.

Jim’s story

To protect my friend’s privacy, I’ll call him Jim. For years Jim paid for about half a million dollars of life insurance through his employer’s benefits plan. Around the time he was laid off, Jim also got some bad news from his doctor. Knowing that he couldn’t qualify for new life insurance, Jim tried to take advantage of the renewability feature of his employer’s plan.

The insurance company that runs the benefits plan for Jim’s employer told Jim that only $200,000 of his life insurance was renewable. This was shocking news. This sounds like a lot of money, but it is far less than the half million he paid for and that his family would need to carry on without him.

Had Jim known years ago that most of his life insurance wasn’t renewable, he would have bought a half million dollar renewable policy on his own instead of using his employer’s plan. Jim lost the opportunity to properly protect his family.

Jim continued on thinking that coverage of $200,000 was better than nothing. The insurance company gave Jim a hard sell on forgetting about renewing his policy and just going for a physical to get the lowest possible premium. Of course, this would actually mean that he would be rejected. Jim stuck to his guns and was told that the renewed $200,000 policy would cost him $50 per month. This isn’t a very competitive rate, but it’s not unusual for the guaranteed renewal rate to be somewhat higher than the going rate.

For Jim, paying a slightly higher rate would be better than no life insurance at all. The insurance company hit him with another hard sell to forget about renewal. When they finally gave up, they then told Jim that his policy would cost $225 per month and that he must have dreamt the $50 figure.

So, now Jim is looking at paying about 7 times as much per unit of coverage than he was paying before, and he only has about 40% as much coverage. It is fair to say that Jim’s life insurance was not truly renewable in any reasonable sense.

What about the rest of us?

You may think that Jim’s case is unusual somehow, but he worked for a large Canadian company whose benefits plan is run by a large Canadian insurance company. There is every reason to believe that a great many Canadians who rely on life insurance through their employers are at risk.

How can you tell if you are at risk?

If you have life insurance through your employer, you need to know whether it is renewable, how much of the insurance is renewable, and what the guaranteed premiums will be. These things should be in writing. If your employer is unable to provide this information in writing, then you have good reason to believe that you may be at risk.

If you are told that insurance companies don’t put this sort of thing in writing, don’t believe it. When I bought my first individual term life insurance policy, the contract contained a table that outlines exactly how much I would pay each year to continue the policy. I had the option to cancel any time if I found a better deal, but the insurance company was obligated to continue my coverage as long as I paid the premiums.

I’d be pleased to hear from anyone with information on how widespread this problem is and if there is anything Jim can do to improve his situation.

Friday, October 17, 2008

Short Takes

I don’t normally do a Friday round-up of interesting articles from other blogs, mainly because mine is still one of the newer blogs, but I found a few articles from yesterday particularly interesting.

1. Canadian Capitalist observed that yields in real return bonds show that investors are worried about deflation. His observation makes sense to me, but why investors are worried about deflation doesn’t make sense to me. I’m no economist, but I would have thought that the prospect of the US government printing trillions of new dollars to cover debts would make inflation more likely. Maybe deflation is more of a short-term worry. Maybe this is a difference between Canada and the US. Maybe I need someone to explain this one to me.

2. Preet explained that the usual measures of liquidity don’t apply very well to ETFs. Normally, if a stock has very few trades each day, a single trade can cause a large change in the stock’s price. So, if you place a market order to buy shares in a low-liquidity stock, you may end up paying much more than the quoted price at the time you placed your order. See Preet’s explanation of why this doesn’t apply as much to ETFs even if they have low liquidity.

3. Gail Vaz-Oxlade had a guest post by a woman named Alicia who has learned financial lessons the hard way. I tend to be a numbers guy who isn’t much moved by articles with artistic content, but this is an exception. Alicia manages to capture the frustration of being steered the wrong way financially by parents, peers, and finally a credit card company.

Thursday, October 16, 2008

Election Results and Coalitions

To understand the significance of the Canadian federal election results, a good method is to look at which coalitions form majorities. The biggest difference between this election and the last election is that this time the NDP is relevant.

When we have a minority government, for a party to win a vote in the House of Commons, they must form a coalition with other parties to control more than half of the votes. To get a picture of where power lies among the parties, we can look at the possible coalitions that make a majority.

The results from the 2006 election were as follows:

Conservatives: 124
Liberals: 103
BQ: 51
NDP: 29
Others: 1

The only coalitions that the Conservatives could form to make a majority were

Conservatives + Liberals: 227
Conservatives + BQ: 175

The NDP were useless to the ruling Conservatives and this made the NDP mostly irrelevant until the numbers changed in later by-elections. Fortunately for the NDP, the riding counts changed so that the Conservatives could make a majority by working with the NDP.

The results from the latest election are

Conservatives: 143
Liberals: 76
BQ: 50
NDP: 37
Others: 2

This time, the Conservatives can make a coalition with any one of the Liberals, BQ, and NDP, and it would take all three of these parties to block the Conservatives. This means that the NDP have the same power to control votes as the Liberals and BQ.

It may seem unlikely for there to be any alliance between the Conservatives and the NDP, but it could happen. If the Conservatives have a piece of legislation opposed by the other three parties, they might try to buy NDP support by offering to support some NDP policy. Such bargaining is common, and if the NDP demands are more palatable to the Conservatives than the demands of the Liberals and BQ, we could easily see a temporary alliance between the Conservatives and NDP.

Analyzing the numbers of Members of Parliament for each party in this way can help to explain some of the deals that get made to pass legislation.

Wednesday, October 15, 2008

On to the Next Bubble

As we pick up the pieces from the end of the housing bubble, many investors who left the stock market are trying to figure out when to get back in. If they want to outsmart the market, maybe they should really be trying to anticipate the next bubble.

We had a bubble in internet-related companies about a decade ago and then the recent housing bubble; another bubble of some type is sure to come along. The real money will be made by anyone who can anticipate the next bubble, buy in early, and sell at the height of the mania.

Apart from the timing issues, a big challenge is to figure out where the bubble will be. Here are a couple of possibilities:

Water. As global warming continues, fresh water may become scarce. Companies that buy up water rights or make grand plans to float giant icebergs through the ocean could attract crazy valuations.

Alternative Energy. As China’s demand for oil continues to rise, supplies will be pushed to the limit, and prices are destined to rise much more than we’ve already seen. Politicians are already saying that we need to develop alternative sources of energy. As oil prices rise to the point where alternative energy technologies become profitable, we may fall in love with any company that can spell “solar” or “wind”.

Recently, I’ve seen two others suggest that alternative energy may be perceived as the next big thing. Canadian Financial DIY asks if the cynical investor should gamble on alternative energy as the next bubble, and Scott Adams captured this idea in three Dilbert cartoons (first, second, and third).

I have so much confidence in these predictions that I’m allocating 0% of my portfolio to them.

Tuesday, October 14, 2008

Half of Last Week’s Losses Erased

If last week’s stock performance was a “meltdown,” then Monday saw an “explosion” that erased half of last week’s losses as measured by the S&P 500 index. With Canadian markets closed on Monday, it will be interesting to see how they react in today’s opening.

For some reason, the 11.6% recovery in the S&P 500 has not generated much excitement. Even if the rest of this week sees stocks prices fully recover from last week’s losses, it seems that many investors will still feel the stinging pain of loss.

We’re wired to feel losses more strongly than gains. Our instincts often do not serve us very well when it comes to making investment decisions. We’re prone to being overly confident during good times and overly fearful during bad times like we’ve had lately.

Do you really believe that our financial system and our way of life will crumble away? It’s time to tune out the hysterical ranting on pseudo-news channels and think for ourselves.

Monday, October 13, 2008

Thanksgiving in Canada

Today is Thanksgiving Day in Canada, and the main thing I’m thankful for is that the stock markets in Canada are closed. Unfortunately, our American friends won’t be celebrating Thanksgiving for a few more weeks and their stock markets will be open today. So, we won’t get a complete break from the barrage of panicky reports about stock prices.

Maybe we would be better off if stock markets were only open one day per week. This might reduce panic and cause more investors to take a long-term view. In his 1993 letter to shareholders, Warren Buffett said “after we buy a stock ..., we would not be disturbed if markets closed for a year or two.”

I’m not as confident an investor as Buffett, but I understand the idea. I own my current set of investments because I believe they will do well in the long term. I’m not gambling on short-term moves.

Friday, October 10, 2008

Do You Have the Nerve to Rebalance Right Now?

I’ve never been one to maintain a particular percentage balance between stocks and bonds like 70/30 or 60/40. However, many people do this on the theory that they are rebalancing buy selling something whose price is high to buy something whose price is low.

The advantage of this approach is that it’s a disciplined way to buy low and sell high. On the negative side, it has investors holding low-return bonds for the long-term. However, for investors who can’t stomach an all-stock portfolio, the fixed ratio approach isn’t a bad one.

Larry MacDonald wrote an interesting and amusing article titled the stock market hates you that does a good job of capturing our fears right now. We’re so nervous that many of us are abandoning our financial plans.

Recent price drops in the stock market has thrown the stock/bond balance of investors’ portfolios out of whack. The percentage in stocks has dropped and the percentage in bonds has risen. So, my question is do you have the nerve to rebalance right now?

Thursday, October 9, 2008

Financial Side Effects of Election Promises

Canadian Financial DIY gave us a great summary of the Canadian political party platforms. As usual, the NDP have the most entertaining promises. The Green Party are a close second with their promises to raise the GST and legalize marijuana.

Whenever I hear political promises, I tend to think about the side effects that will be caused. Charlie Munger, long-time business partner of Warren Buffett, illustrated the concept of second-order effects nicely in a speech at UCSB (pdf):
"A truck trailer business had a plant in Texas whose workman’s comp costs were 30% of payroll. This means that for every ten people working at the plant, the equivalent of three more were at home getting paid because they were supposedly unable to work. Workman’s comp is important for legitimate health problems, but 30% is ridiculous. When legislators created the workman’s comp rules, did they project costs based on existing sick-day rates, or did they anticipate the secondary effects of soaring numbers of workers taking advantage of an easily-gamed workman’s comp system?"

Credit Card Interest Rate Promise

The NDP promises to limit interest rates on credit cards to 5% over prime. With this policy, many people who currently have credit cards would no longer qualify for them or would only qualify for a drastically reduced spending limit. An interest rate 5% over prime roughly compensates the bank for a 5% chance that you won’t pay back the money you borrow. If the bank judges your odds of default to be above 5%, then you won’t get a credit card.

This may actually be a good thing; I’m no fan of the aggressive tactics used by banks to ensnare the unwary into debt. But, I wonder how many people with below-average credit scores agree with this policy not realizing that they would lose their own credit cards.

Promise to Forgive Doctors’ Student Loans

The NDP promises to forgive doctors’ student loans if they devote the first ten years of their practices to family medicine. I don’t have a strong opinion on whether this is a good idea or not, but I do have a strong opinion about assessing its cost. The wrong way to assess cost would be to use the average student loan size among currently graduating doctors.

Many doctors in training who would otherwise have paid their way without taking student loans would seek student loans under such a policy. People prefer free money to a loan. Without any change in the rules governing qualifying for loans, the average student loan size would increase.

Part of the reason why each party’s estimates of the costs of their promises tends to be too low is that they ignore secondary effects.

Wednesday, October 8, 2008

Two Bad Stock Market Days in a Row

Lots of red ink has been flowing two days in a row now. According to Jason Zweig in his book Your Money and Your Brain, “after two repetitions of a stimulus ... the human brain automatically, unconsciously, and uncontrollably expects a third repetition.”

If Zweig is right, then we must all be anticipating the end of the world. Stocks will keep dropping every day until there is nothing left. Things really are different this time. The sky is falling.

All kidding aside, I do find myself looking for someone authoritative to explain that the world’s financial problems are now under control. I’m not sure who qualifies as sufficiently authoritative. President Bush does not. Warren Buffett might be good enough, but he’s too busy buying up businesses at fire-sale prices.

For now, the financial system is still in surgery, and we’re in the waiting room hoping to hear from the surgeon soon.

Tuesday, October 7, 2008

Bears are Smiling for Now

Even after the US government settled on its $700 billion bailout plan, markets continue to drop on Monday. Investors who sold out of the market before this latest drop are congratulating themselves. Unfortunately for them, they still need to make another right guess to come out ahead.

Because I don’t believe we’re headed for anarchy, I expect recent stock market losses to reverse sometime in the future. It may not be for months or years, but I expect the sun to shine again. If I’m right about this, then any bears who sold before recent price drops will have to guess when to jump back into stocks. I suspect that most of them will buy back in at a higher price than their selling price.

A curious thing about human nature is that many of those investors who end up paying more than their selling price to buy back in will be happy with themselves anyway. Even though they have lost on their market-timing gamble, these investors will cheerfully tell others about how they got out of stocks before the big fall.

In the same way that most people claim to have above-average driving skills and have made money on their lottery ticket purchases, most market timers will claim to have made money. They aren’t necessarily lying, though. Many of the investors who lose money through market timing will actually believe that they are ahead.

The cold, hard facts about the futility of market timing are no match for human illusions. In the same way that someone has to win the lottery, some people will come out ahead by selling all their stocks and re-buying them at the right time. Maybe you could be one of these people, but probably not.

Monday, October 6, 2008

Extended Warranties are getting out of control

We’re used to getting the hard sell for extended warranties on many of the things we buy. When I bought my latest television, I had to say no three times before the salesman finally gave up. It was the usual deal: the manufacturer warranty lasts for a while and I was offered a two-year extension for “only” $149. This magically dropped to $79 in less than 30 seconds.

None of this is very surprising, but I did get a surprise while buying a replacement battery after my car key finally died. At first I could unlock my car from 50 feet away. This distance began to shrink until final the battery in the key died completely.

This is actually my second car key battery replacement, and I confidently got out a tiny screwdriver to remove some tiny screws to get at the battery. The guy at the electronics store had no problem finding a replacement battery after I handed him the old one.

Store guy: “How long did your battery last?”

Me: “What? Oh. Uh, 2 or 3 years.”

Store guy: “That’ll be $5.67, and we can guarantee your battery for 3 years for a dollar fifty.”

Me: “Huh? I’m sure I won’t remember where or when I bought it.”

To his credit the store guy was slightly embarrassed at this point and muttered something about how the warranty didn’t really make much sense. I guess the training he got from his employer didn’t strip him of all common sense.

I’d be interested in hearing other people’s experiences with extended warranties:

Did the warranty offered make any sense to buy?
Did the salesperson hit you with an unpleasant hard sell?
When your item broke, were you able to collect on your extended warranty?

Friday, October 3, 2008

Lessons from the Great Depression

Whenever times are turbulent, we are tempted to say that “things are different this time.” While there are aspects of the current financial crisis that are unique, they also have much in common with past recessions and the great depression.

In a moment of fear, we can begin to imagine that the current crisis won’t end and that we should all be buying bonds and gold in preparation for the breakdown of civilization. However, as the Canadian Capitalist explained with a 1932 Dean Witter quote, we should keep the faith in stocks. Our economy will either recover or there will be chaos. If there is chaos, then nothing will maintain its value. Even real estate will be worthless because titles will be insecure. The only sensible course of action is to plan for a recovery.

Another lesson from the great depression comes from the fact that the government of the time did not attempt a bailout of the type that US lawmakers are currently working on. It’s easy to argue against a bailout. Why should we use public money to help rich bankers?

As banks fail, the other institutions they owe money to will fail and there will be a cascading effect throughout the economy. As the Canadian Capitalist explained in Why Bailout Wall Street?, the first businesses to fail may be those most deserving of bankruptcy, but the pain will eventually spread to other businesses that had little or nothing to do with sub-prime mortgages.

So, it seems that the US government has little choice but to bail out Wall Street to try to contain the problem. I see two important questions to address in the aftermath of the bailout:

1. Why was there no effective government regulation to prevent this disaster?

2. Why are the boards of directors of public companies so completely unable to protect shareholders from CEOs who collect huge salaries and bonuses while driving their companies to ruin?

Thursday, October 2, 2008

Returns Reported by Mutual Funds Don’t Tell the Whole Story

You’d think that if a mutual fund reported a 3-year return of over 24% per year, most of its investors would be quite happy. After all, any money kept in the fund over those 3 years would nearly double. Looks can be deceiving. Reported returns aren’t enough information to tell how the investors have fared.

Suppose that ABC Explosive Growth Fund starts out with $10 million of investors’ money. To simplify our example, we’ll only allow money to enter or leave the fund at the start of each year. After one year, another $10 million of new investor money enters the fund. After another year, investors pour an additional $60 million into the fund.

After the end of the third year, suppose that ABC fund holds $80 million. Note that this exactly equals the total amount of money contributed to the fund ($10 million twice and then $60 million). So ABC generated zero net return over those 3 years. Does this mean that their reported 3-year return will be 0%?

Nope. In coming up with this 0% figure, we have calculated what is called the internal rate of return. But this isn’t how mutual funds calculate returns. To work out ABC’s reported 3-year return we need a little more information. Here is some more detail for our example:

Year 1: ABC grows $10 million into $15 million (50% return).

Start of year 2: Investors add $10 million. The fund now holds $25 million.

Year 2: ABC grows $25 million into $40 million (60% return).

Start of year 3: Investors add $60 million. The fund now holds $100 million.

Year 3: ABC has a bad year and loses $20 million (-20% return).

The average compound return of the 50%, 60%, and -20% one-year returns is a little over 24% per year. But, the other method told us that the return was zero. How could the two ways of working out the 3-year return be so different?

The answer comes down to what type of investor you have in mind. If you think of the investor who leaves his money in the fund for the whole 3 years, then you get the 24% figure. However, in our ABC example, very little of the money in the fund was invested this way. If you think of the actual average experience of investors in the fund, then you come up with the 0% return.

Essentially, the way that funds report their returns ignores the total assets of the fund. My example is extreme, but the internal rate of return method that takes into account the actual experience of investors usually gives lower returns than those reported by mutual funds. This is because funds tend to perform better while they are small. As funds get bigger, the managers often run out of good ideas for investing the new money. This isn’t true of all funds, but it does happen with many of them.

All of this begs the question of which method mutual funds should use for reporting their returns. There are advantages and disadvantages to both methods. My preference would be to require that both types of return be reported. This might be confusing, but potential investors would be right to be concerned if the two returns were significantly different.

Wednesday, October 1, 2008

Panicked Investors get Whipsawed

After Monday’s big drop in stock prices over the failed vote on the financial bailout, Tuesday saw prices come most of the way back. Apparently, investors as a whole think that lawmakers will find some way to contain the financial problems. The net effect for diversified investors who sat tight through it all is minimal. Those who panicked and sold at the wrong time are facing real losses.

When stock prices fall quickly and then immediately reverse course, it’s called a whipsaw. The same name is used when stock prices rise quickly and suddenly reverse course. The effect is reminiscent of the action of a saw going back and forth cutting through wood.

Such whipsaws generate a lot of concern and discussion, but they really make little difference if you don’t do any trading. Unfortunately, many investors got caught up in the panic and sold their stock holdings near the low point of the whipsaw and plan to “wait until things calm down.”

Unfortunately, these investors have already missed Tuesday’s huge rebound. Prices may yet fall again, but another possibility is that they will continue to drift upward never to return to the levels at the bottom of the whipsaw.

Sadly, many pundits contribute to the panic. Even some who advise sticking to a plan and taking a long-term view are saying that shifting into safer investments is prudent right now. Somehow this sounds different from saying to sell stocks, but it means the same thing.

If you focus on the value of your holdings in say 5 years, stocks are safer to own now than they were at higher prices a year ago. However, the advice from pundits usually runs counter to this obvious fact. They advise caution when prices drop and express confidence when prices are high. This just feeds into our emotions that sometimes cause us to make poor choices in a panic.

I have no idea whether stock prices will rise or fall in the coming days, but as I explained in an earlier essay, nobody else knows what will happen to stock prices in the short term either. What I do know is that you can’t get whipsawed if you don’t sell in a panic.