Friday, February 27, 2009

Short Takes: CEO Pay and Mutual Fund Returns and Fees

1. Larry MacDonald pointed to some interesting articles including a brilliant piece by Eliot Spitzer on CEO pay. Companies are supposed to be controlled by their shareholders. CEOs are employees. A company’s board of directors is supposed to represent the interests of the shareholders. However, CEOs have too much control over who serves on their boards of directors, and they also have too much control over the choice of compensation consultants who make recommendations on CEO pay. It’s time that we fixed the system to represent shareholder interest rather than continue to complain about unethical CEOs. Who among us wouldn’t line our own pockets with millions of dollars if we could do so legally? This doesn't excuse CEOs, but the solution is to take away their opportunity to line their pockets unfairly.

2. A guest post by Neal Frankle explains why the 10-year returns of mutual funds are going to start looking very bad. Obviously, recent poor stock market returns are a big factor, but some past good returns are about to drop off the 10-year record as well. Even if you’re smart enough to find funds with low expenses, your mutual funds’ return history will make you look foolish in the eyes of those who pay attention to past performance.

3. Rob Carrick discusses the possibility that mutual funds will increase their fees to make up for having less money to manage. Now that they have lost so much investor money, mutual funds will collect smaller fees if the MER percentage remains the same. MERs would have to rise for the funds to maintain their revenues.

4. Patrick has some strong opinions about the auto bailout plans.

5. Canadian Capitalist draws some lessons from Japanese stocks. It sounds like he is making a case for market timing in special circumstances where a bubble causes valuations to get out of control. Of course, the existence of a bubble depends on most people not recognizing that it is a bubble. Nobody said that investing is easy.

6. Big Cajun Man points us to an amusing cartoon about the Mississippi bubble. It seems that financial bubbles aren’t just a modern phenomenon.

7. Million Dollar Journey had a guest post by Kathryn on the cost of dog ownership. This should be an eye-opener for anyone whose ideas of pet costs are a decade or more old.

8. Preet explains the advantages and disadvantages of a dividend capture strategy.

Thursday, February 26, 2009

Momentum Caused the Credit Crisis

Wired magazine had a great article explaining the causes behind our credit problems. Unfortunately, they blamed math as the root cause of the problem, which is silly. It’s like blaming a hammer for smashing your thumb.

A decade ago, most investors didn’t like to put their money into mortgage pools (unless they were backed by the US federal government) because they couldn’t quantify the risk. Then along came a clever guy named David Li who developed a formula to measure the amount of risk.

This formula came to be used in finance all over the world to measure the risk of baskets of mortgages and other types of debt. The main problem before Li came along was that although financial markets could measure the risk of an individual mortgage, they couldn’t measure correlation: the degree to which debtors tend to default at the same time. Li had a solution.

However, Li didn’t really work out the correlation himself. He examined the movement in prices of individual debts (in the credit default swap market) to estimate what the market thought the correlation was. Li just trusted the market to get the correlation right.

Li’s formula just assumed that the recent history of actual prices gave a good measure of the likelihood that multiple debtors would default at the same time. So, as long as markets ticked along well and had few defaults, Li’s formula predicted that the world would continue to move along smoothly.

This is essentially the same as believing that the future will always be the same as recent history. If it hasn’t rained for a month, then it’s safe to set up priceless paintings outside because it’s never going to rain, right? When the credit crisis finally hit, it became obvious that Li’s formula hopelessly underestimated the correlation of debt defaults.

I see little reason to blame Li for all this. No doubt his formula is useful in some areas and less useful in others. Those who use a formula without understanding its limitations should blame themselves for a bad outcome.

Of course there were people who understood the limitations of Li’s formula, but it was hard to get the attention of bankers who were raking in millions of dollars. They were guilty of momentum-based thinking as well. They had been using Li’s formula and making money consistently. Why would they want to stop? Picking up coins on a highway is profitable until that terrible road kill moment.

Wednesday, February 25, 2009

It’s Different this Time

Looking at history we have a tendency to see certain events as inevitable, but they didn’t seem inevitable at the time. We can agree now that the tech boom of the late 1990s was destined to crash, but the crash didn’t seem inevitable to most of us while we were living through the boom. This provides a lesson for our present difficulties.

As is often the case, the truth is somewhere in the middle. We are too confident in our ability to see the reasons behind past events. But we also have too great a tendency to believe that our present situation will persist.

Many believed that the tech boom would continue indefinitely taking us to a glorious new future. This turned out to be very wrong. On the other hand, many of us now see the tech crash as inevitable. However, another plausible outcome could have been for tech stocks to remain flat for 20 years while their value caught up with their prices. The markets have more than one way to get back in line.

History tells us that the stock market runs in cycles and that good times and bad times don’t last forever. However, while we live through events, there is a tendency to believe that “it’s different this time.”

There are many reasons we can give to explain why the current stock market drop really is different this time. China and other emerging markets will eat our lunch. We’re running out of oil. Global warming will change everything. Crushing debt will kill the US economy. Canada is tethered to the US and will be dragged down as well.

I just don’t buy into the idea that stock market underperformance will be a permanent part of our future. I look to the past and see that things will eventually turn around. I can’t say when, though.

A few years after the economy improves, we’ll have many reasons why it was inevitable that the turnaround happened when it did. We’ll just as wrong then as we are now in thinking that the decline is permanent.

Tuesday, February 24, 2009

Reverse Health Insurance Coverage

The basic idea of insurance is that you pay a premium to an insurance company who agrees to cover you for a low probability large loss. For example, you might pay $500 per year for house insurance, and the insurance company agrees to rebuild your house if it burns down. For some reason, typical health insurance plans have this basic idea of insurance backwards.

To illustrate what I mean, I’ll look at Sun Life’s basic personal health insurance plan. I don’t intend to promote or criticize Sun Life in particular; other insurance companies have very similar plans.

Sun Life’s basic plan has fairly low yearly dollar limits:

- Prescription drugs: max $750/year
- Dental: max $500/year
- Alternative treatments: max $25/visit and $250/practitioner
- Hearing Aids: max $400 per 5 years
- Dental accidents: max $2000/injury
- Medical equipment and in-home nursing: combined max $2500/year and max $20,000 lifetime

To run a profitable business, an insurance company has to charge more than it expects to pay out in claims. This means that the yearly premium you pay is likely to be more than the amount you claim in a year. This can still be a good deal for you if you are being protected against a large, devastating loss. But, most people could afford to pay the maximum amounts in the list above.

Even worse, if you get a serious condition requiring $10,000 worth of drugs each year, you’ll pay $9250 of that out of your own pocket in addition to the health insurance premium. This health insurance plan offers no protection against serious loss.

These health insurance plans would make more sense if they were reversed to pay for everything above some limit instead of paying for amounts below the limit. Of course, there would have to be some upper limit; insurance companies shouldn’t be expected to take on unlimited risk, but these upper limits would be high. Think of the roughly $1 million liability limit in most car insurance policies.

Many employers offer health insurance plans with similar low caps on claims. These plans aren’t really a form of insurance because they offer little protection against serious loss. They are really just extra income.

Monday, February 23, 2009

Canadian Auto Bailout

General Motors and Chrysler are asking for $10 billion in aid from Canada. This sounds like a big number, but it’s hard to put into context without some analysis. Millions, billions, and trillions can all sound the same until you think it through.

This aid package amounts to about $300 for every Canadian, including children. If the government agrees to this bailout, you can imagine $300 flying out of your pocket and going to GM and Chrysler. This money would be transferred from all of us to benefit the auto workers.

According to the Canadian Auto Workers (CAW), 33,000 of their members work for GM, Chrysler, and Ford. Out of these, about 12,000 work for GM, and 11,000 work for Chrysler. So, the GM and Chrysler bailout would support 23,000 employees.

This amounts to about $430,000 per employee! This doesn’t tell the whole story, though. There are other jobs that depend on the auto sector. The CAW claims that “there are approximately 7 jobs created for every one job in the auto sector.”

If we take this figure at face value, the $430,000 must feed a total of 8 people. Let’s say that the auto worker’s share is $150,000, and the other 7 workers’ shares are $40,000 each. This is a lot of money, and it’s just this round of bailouts. The auto companies will eventually be back for more. As I’ve demonstrated before, North American auto makers make inferior cars, which makes them uncompetitive.

Rather than pay for this enormous bailout, it would be less expensive for the Canadian government to give auto workers (and workers dependent on the auto industry) enhanced employment insurance (EI) benefits. This would make some room for new auto companies that might actually try to be competitive in the industry.

Friday, February 20, 2009

Short Takes: Free HDTV, Audit Defence, and Emotional Investors

1. Million Dollar Journey tells us how to get free HDTV in Canada legally.

2. Thicken My Wallet did a thorough analysis of the QuickTax Audit Defence product. You can also get my take and Canadian Capitalist’s take on this product.

3. Larry MacDonald brings us Professor Richard Deaves’ thoughts on investing. Deaves believes we should be using passive indexing to avoid behavioural traps like overconfidence and performance chasing.

4. Gail Vaz-Oxlade tells us the difference between living within your means and doing without. The distinction is crucial. We need to find a way to enjoy life within our means. If we think in terms of doing without we’ll eventually break down and spend. The same applies to the food we eat. It’s important to find a way to eat that is satisfying and doesn’t have us gain weight. Doing without enough food isn’t sustainable.

5. Canadian Capitalist shows that CIBC has a good selection of index funds with low MERs if your portfolio is large enough.

6. Preet’s continued discussion of fee-only versus fee-based financial planners generated quite a few comments.

7. The Big Cajun Man hosted the Carnival of Personal Finance that included my article Teenager Jobs that Pay Well.

Thursday, February 19, 2009

Cell Phone Obsolescence

I try to avoid making predictions because as Niels Bohr once said “prediction is very difficult, especially about the future.” However, I see the world on the verge of a long, slow decline in cell phone use.

Am I predicting that people will no longer feel the need to have a phone with them at all times? Absolutely not. As a matter of fact, I think that the percentage of people who carry communications devices is likely to increase in the future.

Cell phones are going to be replaced. Roaming calls will eventually be carried over the internet rather than a separate cell phone network. Many of us have wireless internet set up in our homes with a data rate many times higher than is needed to carry a phone call. In fact, if you used a cell phone continuously day and night for a month, the total amount of voice data transmitted would be less than the 60 Gigabyte monthly cap on typical home high-speed internet plans.

Technology to carry phone calls over the internet (called voice over internet protocol (VOIP)) exists today, but has many problems. It tends to be somewhat flaky, and some approaches have you talking into your computer rather than a regular handset. However, technical problems will be overcome.

Imagine your home phone connecting wirelessly to your internet modem instead of connecting to a base station that you plugged into one of your phone jacks. Imagine further that this internet phone can connect to the internet at any other wireless hot spot. Some of us have become accustomed to finding hot spots for using a laptop; why not use them for phone calls too?

None of this would work very well right now, but it will get better with time. Ubiquitous wireless internet access will come eventually, and it will be used for voice communications as well. This will eliminate the need for a costly cell phone “plan”. You won’t need a plan for your phone any more than you’ll need a plan for your laptop.

All this will change the market for makers of devices like the BlackBerry. They will no longer need to sell them through companies that offer cell network connection plans. They will be able to sell these devices directly to the public in whatever way is most desirable. This may lead to increased competition for them.

Operators of cell phone networks are looking at a future of declining business. This doesn’t necessarily mean that they won’t be profitable, but if you’re an investor, don’t count on growth unless the company has plans to move into some new business.

Wednesday, February 18, 2009

Maximum Pessimism may not be here yet

Some say that the best time to invest is at the point of maximum pessimism. The theory is that just at the point when the most people are sure that the world of stocks is collapsing, prices should be lowest, and this makes it the best time to buy stocks.

Money usually flows into mutual funds during RRSP season, and so far this year is no different. January saw $1.17 billion more money flow into mutual funds than was withdrawn. However, this applies to all types of mutual funds collectively. It turns out that money market funds and bond funds were popular. Equity funds had net withdrawals of $376 million.

So, despite the fact that this is RRSP season, money is still flowing out of stock funds. Even though stock prices are low, there continue to be more pessimists than optimists. If you’re waiting for a sign that the point of maximum pessimism has been reached, this data suggests that we haven’t reached it.

However, I’m no fan of trying to predict the perfect time to jump into stocks. No bell will ring to let you know when the bottom has been reached. Many who try to time their entry will wait well past the bottom and buy at higher prices.

Tuesday, February 17, 2009

Stepper GICs are Great Marketing

I recently saw an ad for TD Bank’s 5-year “Stepper” Guaranteed Investment Certificate (GIC). The ad made the product seem quite attractive. A sign of great marketing is turning a negative into a positive.

A Stepper GIC offers a low interest rate in the first year with an increase in the interest rate paid each year. It’s like getting a raise each year. Who wouldn’t want a raise? All the major Canadian banks have GICs like this with different names:

Royal Bank - RateAdvantage GIC
Scotiabank - Accelerated Rate GIC
BMO - RateRiser GIC
CIBC - Escalating Rate GIC
TD Canada Trust - Stepper GIC

In TD’s ad, the most prominent part of the picture showing the interest rates is “8.0% In the 5th Year.” Where else can you get 8% on your savings? Here are the advertised interest rates for each year of this Stepper GIC:

Year 1: 1.5%
Year 2: 3.0%
Year 3: 3.5%
Year 4: 4.0%
Year 5: 8.0%

The average compound interest rate works out to 3.98%. Suppose that this GIC were marketed differently. Imagine that TD offered a 5-year GIC at 3.98% interest with the following penalties for early redemption:

After year 1: 2.38%
After year 2: 3.30%
After year 3: 3.75%
After year 4: 3.72%

This is exactly the same GIC as the Stepper. Through the magic of marketing, the disadvantage of scary-looking early redemption penalties has been turned into a rising interest rate with no mention of penalties. In my description, the highest interest rate you hear about is 3.98%, but TD’s version gets to trumpet 8% in the final year.

I’m not saying one way or the other whether this GIC is a good deal for you. But we should all see it for what it is: a fixed-rate GIC with early redemption penalties.

Monday, February 16, 2009

Is Warren Buffett’s Record a Fluke?

Warren Buffett’s investment record has been very impressive for decades. It seems a virtual certainty that his success is due to skill. However, there are some who say that it may be just luck. They argue that out of billions of people, you’d expect at least one investor to perform as well as Buffett. Let’s take a stab at figuring out which side is right.

From the first table in Buffett’s 2007 letter to shareholders we see that over the 43 years from 1965 to the end of 2007, the S&P 500 (including dividends) returned 6840% and Buffett’s Berkshire Hathaway returned 400,863%. An investment in Berkshire over this period would have made you 57.8 times richer.

This is an impressive record, but we want to know if it could have happened by chance. This depends greatly on how Buffett approached investing. To see this, consider the following scenario.

Suppose that in January of 1965, a few hundred people took $1000 each to gamble on blackjack. They all used the same strategy. They bet everything on 6 consecutive hands hoping to double their money 6 times. Odds are that at least one of these people would succeed. Let’s call him lucky Eddy.

Eddy was lucky enough to turn his $1000 into $64,000 at the blackjack table. Suppose that Eddy then invested all this money in the S&P 500 and left it there until the end of 2007. With his factor of 64 head start, Eddy would have more money than someone who invested $1000 in Berkshire starting in 1965. We see from this little thought experiment that it’s possible for an investor who takes wild chances to beat Buffett’s record.

But Buffett didn’t amass his wealth by taking wild chances. The question is whether a random stock picker who takes an approach superficially similar to Buffett’s could reasonably perform as well or better. To answer this question we’ll have to make several assumptions, any of which could be challenged.

For those not interested in the math, here is the spoiler on the math section below. I worked out that the odds of a random investor matching Buffett’s record by chance are about 0.00000000000000000000007. Even if every person alive right now were to choose stocks randomly in an effort to match Buffett, the odds of at least one of them succeeding are less than one in two trillion. However, let me stress that this is based on several assumptions (see below). Changing these assumptions would give a very different answer.

Based on this analysis, I conclude that it is very likely that Buffett has skill and isn’t just lucky. However, skill at picking stocks seems to be quite rare. Most investors would be better off to just own low-cost index funds rather than try to beat the index by picking individual stocks.

If any readers have others ideas about how to assess Buffett’s record, I’m interested in hearing them.

The Math

The variance of US stocks over the last century has been about 0.04 per year, which corresponds to a standard deviation of 20% per year. Roughly speaking, this means that about 70% of the time, the yearly return from the stock market is within plus or minus 20% of the average return.

Suppose that Buffett was choosing among stocks and whole businesses whose individual variance is about 0.12 (3 times that of the stock market as a whole). This means that each stock or whole business has a non-market specific variance of 0.08. This is consistent with some of the data shown in Table 6.2 of the book The Intelligent Portfolio by Christopher L. Jones.

Suppose further that, on average, Berkshire owned 20 businesses at a time. This cuts the non-market specific variance by a factor of 20 to 0.004 per year. Over 43 years, the total non-stock market specific variance is then 0.172, which corresponds to a standard deviation of 41.5% (square root of the variance).

To take us from the lognormal distribution of investment returns to the normal distribution we take the natural logarithm of Buffett’s outperformance factor of 57.8 to get 406%. Dividing the 41.5% standard deviation into Buffett’s 406% outperformance gives 9.8 standard deviations. This corresponds to an event probability of 0.00000000000000000000007.

If we multiply this probability by the number of people alive, we find that the odds of even one person matching Buffett’s performance by chance are less than one in two trillion. Although I find these assumptions reasonable, others may not, and changing them would give a very different answer.

Sunday, February 15, 2009

Book Giveaway Winner

After a draw that gave all entries an equal chance, the winner of a copy of Gail Bebee’s book No Hype: The Straight Goods on Investing Your Money is Kelsi! It is quite a coincidence that Kelsi won. I was prepared to mention her entry anyway because she included a colourful love poem for Valentine’s Day:

Roses are RED
YOUR blog is the best
Please send me Gail’s book
To help me INVEST!

Thanks for the poem and thanks to everyone who entered the draw!

Friday, February 13, 2009

Short Takes: Book Giveaway, Expensive ETFs, and How Couples Handle Finances

1. If you want a chance to win a copy of Gail Bebee’s book No Hype: The Straight Goods on Investing Your Money, send an email to me with the subject “Book” at the email address in the upper right corner of my blog before noon on Sunday. The original announcement of the draw has my review of this book.

2. Thicken My Wallet observed that expense ratios of some new ETFs are awfully high. If you’re looking for low cost ETFs, don’t forget the “low cost” part.

3. Million Dollar Journey had a guest post on the different ways that couples can share their finances. Predictably, my wife and I don’t exactly fit into any of the options. Option D with one joint account for everything where there is no yours and mine (just ours) comes closest. However, we don’t use joint accounts. We just freely give each other money as necessary.

4. Canadian Capitalist crunches the numbers to show that paying down a lump sum on your mortgage will have a much bigger financial benefit than spending money to take advantage of the Renovation Tax Credit program announced in the latest Canadian federal budget.

5. WhereDoesAllMyMoneyGo discussed where to find a fee-only financial planner.

6. The Big Cajun Man is put off by a picture of a store front combining cigarettes and a free lottery ticket with each payday loan and cheque cashed.

Thursday, February 12, 2009

Book Giveaway

Gail Bebee, author of No Hype: The Straight Goods on Investing Your Money was kind enough to send me a review copy of her book. In addition to reviewing it, I will be having a draw to give away this gently-used book.

The Draw

Parts of the book are specific to Canada, and so the draw will be limited to Canadian addresses. To enter, send an email with the subject “Book” to the address shown on the upper right corner of this blog. The draw will close Sunday Feb. 15 at noon. I will contact the winner to get a (Canadian) postal address.

Book Review

On the whole, this book lives up to its “no hype” title. Bebee covers many important subjects for investors giving clear explanations of advantages and disadvantages of different investment products and approaches. A common theme throughout the book is “think for yourself,” which is very important if you don’t want others to take advantage of you financially.

Bebee is not a financial industry insider, which is a plus. She tells it as she sees it rather than showing bias for products she sells. My biggest criticisms are the tendency to steer readers past index investing to individual stock picking and the treatment of technical analysis.

Chapter 5 gives an extensive list of information sources you should read, and pages 184 and 185 list the work that you should do to monitor your investments. Bebee is correct that all this work should be done by stock pickers, but if most people are honest with themselves, they know that they won’t do one-tenth this amount of work. Index investors can eliminate the need for most of this work. Bebee does discuss index investing, but I would prefer to see the frightening amount of work required to monitor investments broken down into what must be done by the different types of investors, i.e., index investors versus stock pickers.

Chapter 20 deals with market timing and technical analysis. Bebee believes that “investors can improve investment returns by market timing.” It’s simple mathematics that the average market timer must lose out to the index. Good market timers can only take money away from bad market timers, and they all pay more in trading fees and taxes than index investors. To keep up with the index, you must be an above average market timer.

Technical analysis is a form of market timing where one studies charts of stock prices and trading volumes to try to guess whether to buy or sell a stock. Bebee’s treatment of this subject is far too flattering in my opinion. I see no reason why a stock’s movement in the near future should have anything to do with the shape of its chart. Even if there is a slight correlation, any advantage would have to overcome trading costs and taxes. An investor who is considering using technical analysis might want to consider horoscopes as well.

Getting back to the many positives of this book, here are some of its important messages:

- Think for yourself.
- Focus on low-cost investments. Fees matter.
- Educate yourself at least enough to evaluate the advice from a financial advisor.
- Avoid momentum investing and day trading.
- Financial advisors may steer you toward investments that pay them the highest fees.
- Buying stocks on margin is risky.
- A good exercise for mutual fund investors is to add up all the fees they pay each year.
- Be wary of hedge funds, resource limited partnerships, and stock options.

Overall, this is a good book for the beginner to learn the basics of investing. For another review of this book, see Canadian Capitalist's review.

Wednesday, February 11, 2009

Don’t Invest Based on Emotional Accounting

We’re often told that we feel losses twice as strongly as gains. This tends to make us risk averse, which is a good thing when crossing the road, but may not work out so well for long-term investing. I tried a little experiment with Walmart stock to see how emotional accounting would affect the perception of this stock.

Walmart has been one of the greatest success stories in business. A $10,000 investment at the start of 1975 would be worth over $25 million today even ignoring dividends! This is an average compound return of over 25% per year for just over 34 years.

Imagine that our hero, Dave, invested his $10,000 savings in Walmart stock at the start of 1975. He then checked the previous day’s percentage change in stock price each morning. We’re assuming that all he looks at is the percentage change each day and not his portfolio value.

I downloaded a spreadsheet of daily Walmart closing prices (ignoring dividends, but incorporating stock splits) and calculated the daily percentage returns. To gauge how Dave feels about Walmart stock, I doubled the percentage on negative days.

So, a day with a 1% return would give Dave 1 unit of happiness, but a day with a 1% loss would give Dave 2 units of unhappiness. To capture this, the 1% loss is treated like a 2% emotional loss.

Because we know that Walmart had such phenomenal returns since 1975, we might think that even doubling the negative days to produce the “emotional return” would still leave the stock with a healthy return. Let’s look at the results.

It turns out that the average daily unemotional return was 0.11%, but the average daily emotional return was a 0.55% loss! Compounding the daily emotional returns for a year gave an average yearly emotional loss of 77%. Even the best one-year period had an emotional loss of 30%. If Dave never looked at anything but daily returns, he must be near suicidal even though he’s a multimillionaire now.

It’s clear that how we feel about short-term stock market moves can have little correlation with reality. It’s very important to work out the numbers rationally and not succumb to emotions when investing.

Tuesday, February 10, 2009

Teenager Jobs that Pay Well

When we think of jobs for teenagers we tend to think of minimum wage jobs at fast food joints. Back when my older son was first refereeing house league basketball, he dreamed of getting a “real” job in fast food to make more money. What he didn’t realize was that his refereeing gig paid more per hour.

My younger son is now refereeing house league basketball and gets $60 to referee four 45-minute games on Saturdays. There are 45-minute gaps between games for the teams to run a practice, and so he has to be there for a total of 5 hours 15 minutes.

You can think of this as either $20/hour during the time he actually works or $11.43/hour for the full time he has to be there. Even $11.43/hour looks pretty good when you get three 45-minute paid breaks. And running up and down a basketball court is a whole lot more enjoyable than flipping burgers.

I’m interested to hear from readers if they have other ideas for good jobs for teenagers that pay better than a “real” job.

Monday, February 9, 2009

Carnival

This is a quick note to say that my article Financial Lessons From Poker made it into the Carnival of Personal Finance. For those not familiar with the idea of a blog carnival, here’s the short version: bloggers submit articles and the best ones are chosen to become part of the carnival. If you’re interested in personal finance, you might want to check out this carnival.

Financial Slavery

Visa has a booklet of financial advice available online called Practical Money Skills: A Guide to help you manage your money. It contains a fair bit of very basic, but useful information. The advice on how to allocate your income is consistent with other sources of financial rules of thumb, but it struck me how useless this advice is for anyone who wants to develop some financial independence.

The first page of content after the mandatory giant pictures of smiling families contains the following chart in large font:

Guideline for after-tax expenses:
30%: shelter
10%: fixed expenses
10%: loan payments
10%: personal spending
10%: savings

Presumably, the missing 30% is income taxes. On the surface, these percentages seem sensible enough. The truth is that staying within these guidelines will work fine if your goal is to be like everyone else and trudge off to work each day for most of the rest of your life to a job you will come to hate but can’t afford to leave.

If you’re hoping for more out of life, you’ll want to aim for something better than Visa’s percentages. The first thing to observe is that the guidelines have you saving and borrowing at the same time. A certain amount of this can be unavoidable, but it serves the interests of banks nicely. Banks make much of their money from the interest rate spread between savings and loans. Customers who have both are profitable and low-risk for banks.

To see how the guidelines don’t do much to get people ahead, let’s consider a hypothetical young couple, the Smiths, who have a modest combined income of $75,000 per year. The monthly spending guidelines for the Smiths are then

$1875: shelter
$625: fixed expenses
$625: loan payments
$625: personal spending
$625: savings

The Smiths rent a nice house for $1875/month and manage to save $625/month. They make the following debt payments each month:

$450 - Line of credit balance $15,000
$175 - Credit cards total balance $8750
Total debt: $23,750

So, they are matching the guidelines exactly. Suppose that the Smiths get a combination of raises that increases their income by $5000/year for the next 5 years, and that they continue to follow the guidelines exactly. After 5 years, their combined income is $100,000. Their new monthly spending breakdown is

$2500: shelter
$833: fixed expenses
$833: loan payments
$833: personal spending
$833: savings

They rent a nicer house now, still save 10% of their income, and their debt payments are now

$600 - Line of credit balance $20,000
$233 - Credit cards total balance $11,650
Total debt: $31,650

If the Smiths’ savings grew at 7% per year, their total savings after 5 years works out to $50,030. This is more than their total debt which puts them in a better position than many people. But the Smiths have made little progress toward enough financial independence to make some different choices.

If the Smiths want to buy their own home, their savings could make a down payment, but they would still have $31,650 in consumer debt, and they’d have nothing left saved for retirement. They can’t afford to have one of them quit working to stay home with children. If they are unhappy with their jobs, they can’t afford pay cuts while they ramp up in a new career.

The fundamental problem is that constructing a lifestyle that consumes almost all of your income locks you into a rut. During a 5-year period where the Smiths’ total income was $425,000, their financial situation improved by only a small amount. The job that you love at first may not seem so exciting 5 years from now.

The truth is that to have enough financial independence to make choices later in life, you need to eliminate consumer debt and save more than 10% of your income. Some debt is very difficult to avoid, such as a mortgage or student loans. However, car loans and credit card debt are almost always completely avoidable.

We tend to look to others to see what is normal. Unfortunately, “normal” for most people is to be indebted enough that they are locked into a path in life. If you want more out of life, aim much higher than Visa’s income breakdown guidelines. Debt takes away choices.

Friday, February 6, 2009

Short Takes: International Trade, Bank Executive Pay, and Mutual Funds

1. We had some good news about the “buy American” part of the US stimulus package. US legislation has been changed to include “a requirement that the US not violate its international trade agreements” (the web page with the article quoted has disappeared since the time of writing). It’s not clear whether this will be enough to protect Canadian exports, but it’s a step in the right direction.

2. President Obama has capped executive pay at $500,000 per year at companies that accept government money. This Wall Street Journal video explains some of the other measures designed to prevent executive excess.

3. Canadian Capitalist and I were of the same opinion about the news that a slight majority of actively-managed Canadian equity mutual funds beat the TSX composite index in the fourth quarter of 2008.

4. Preet gives a good explanation of why the average active money manager must lose out to the index.

5. Larry MacDonald brings us a scary picture of what happened to the top marginal income tax rate after the depression.

6. FrugalTrader explains how Canadians’ investments are protected by CDIC and CIPF.

7. The Big Cajun Man sees the interest rate on his line of credit increase. It makes sense that the credit crunch would lead to higher interest rates, but it’s no fun when it happens to you.

Thursday, February 5, 2009

More Lottery Troubles

Lotteries were in the news a while back because of problems with insiders claiming many of the prizes. It turns out that the problem is worse than we thought according to CTV.

The Ontario Lottery and Gaming (Gambling?) corporation (OLG) has studied lottery wins over the last 13 years. Originally, they said that 1.7% of the money went to insiders, but they have now revised this to 3.4%. Of course, this should be viewed as a minimum because they can only report insider wins that they know about, and they couldn’t possibly know about all of them.

The suspicion is that not all of these insiders bought these winning tickets. No doubt the fraud took many forms, but the classic example given is the lottery player who hands a winning ticket to a convenience store clerk who either says the ticket didn’t win or says a prize amount that is smaller than the real prize.

It’s amazing that people get so worked up about insiders skimming 3.4% of the prizes but are unconcerned about the incredibly low prize payout of lottery tickets. Lotto 6/49 is designed to pay out only 45% of the take in prizes. With the lottery skimming 55% of the money, an extra percent or two for insiders doesn’t seem like such a big deal.

Compare the 55% skim in lotto 6/49 to the 1.4% skim in the dice game craps. Don’t take this as an endorsement of craps, though. You’ll lose your money if you play.

If numbers held any sway in the minds of lottery players, I suppose that they wouldn’t buy tickets. It’s the thought of some insider stealing their prize that has lottery players upset. In an attempt to rectify this perception problem, the OLG has announced a series of measures designed to prevent insider fraud.

So, now the poorest members of our society can safely continue to donate a disproportionate fraction of their income to lotteries without fear of an insider stealing the big prize that they will never win.

Wednesday, February 4, 2009

Mutual Fund Scorecard

Standard & Poor’s Indices Versus Active Funds Scorecard (SPIVA) is out. For the fourth quarter of 2008, 53.2% of actively-managed Canadian equity mutual funds beat the TSX composite index.

Some will tout this as a sign that you need active fund management for protection during down markets. We need to dig a little deeper to see the truth. To begin with, 53.2% is such a narrow victory that it is better to think of it as a tie.

The next thing to look at is how this slim majority of actively-managed mutual funds beat the index. The fund industry would like to have you believe that managers cleverly move your money around from one stock to another to avoid losses.

The truth is that every mutual fund must keep a certain percentage of its money in cash or cash equivalents to deal with the constant inflow and outflow of investor money. During the fourth quarter of 2008, the TSX composite dropped about 23%. This means that cash in your mattress outperformed stocks by a wide margin.

So, mutual funds got a return “bump” because they held cash. This bump was more or less offset by the fees charged by the funds leaving us with roughly a tie between the funds and the index. If you had 10% of your money in cash and 90% in the TSX composite index, you would have outperformed the majority of active Canadian equity mutual funds.

Of course, it makes little sense to judge any investing strategy over only three months of returns. Fortunately, the SPIVA scorecard gave results for longer periods. Over the last year, 58.1% of active funds underperformed. For the last 3 years, 79.0% of active funds underperformed, and over 5 years, 88.8% underperformed. These damning figures should make any sane person think twice before investing in actively-managed mutual funds.

Tuesday, February 3, 2009

Financial Lessons from Poker

Common advice about controlling spending is to track all your purchases and add them up each week or month. I believe that this is effective, but have been fuzzy on why it seems to work so well. Why can’t people just spend less without the constant reminder of how well they are doing? I got some insight on this question from, of all places, poker.

For poker players there is a certain thrill to dragging in a pot of chips. The thrill is there whether it is a $1 pot or a $10 pot. The $10 pot gives a bigger thrill, but not 10 times bigger. Similarly, losing a $10 pot feels worse than losing a $1 pot, but not 10 times worse.

This leads to some players playing in such a way that they maximize happiness by taking in many small pots, but losing some big ones. As long as they don’t count their dwindling chips, they can actually be happy playing this way.

Counting your chips is a lot like adding up your spending at the end of the month to see what happened. You may feel good about having saved small amounts of money several times, but if you wasted a big amount just once, you’ve had a bad month. If you don’t add up your spending you might actually feel good about all the times you saved money even though you’ve had a bad month overall.

Ignorance can be bliss for a while, but when the debts finally start catching up to you, there won’t be much happiness. The worse your financial trouble, the more often you should be adding up your purchases to take stock of your financial situation.

Some people can get along by assessing their finances monthly, and others have to do it weekly to keep a lid on spending. Then we have the families who appear on Gail Vaz-Oxlade’s television show Til Debt do Us Part who have to assess their financial position with every purchase by abandoning debit and credit cards entirely and using cash.

Monday, February 2, 2009

Analyzing Scotiabank’s “Market Powered” GIC

A while ago I discussed how to build your own market-linked GIC. A friend (who prefers to remain anonymous) mentioned that his market-linked GIC has a maximum return. It turns out that he has what Scotiabank calls its “Market Powered” GIC or MPGIC.

This MPGIC is similar to other market-linked GICs in that its return is linked to a stock index. In this case, it is linked to the TSX 60 index of large Canadian companies. This GIC also returns only a fraction of the index return, called the participation rate or participation factor (PF).

Three differences with the MPGIC compared to other products I’ve looked at are

1. it guarantees a minimum return,
2. it caps the maximum return, and
3. it bases market return on the average index value over the whole time period instead of just an average over the last year of the GIC.

For the 3-year MPGIC, this page shows that currently the guaranteed minimum return is 0.5%/year and the maximum additional market-linked return is 20%. For some reason, this page does not mention the PF, and the detailed explanation on pages 60-64 of this document does not mention the maximum return. As a matter of fact, this document contains an example where the investor gets more than a 20% market return!

Once again, we’ll try to approximate the MPGIC with stock options. Let’s say that we have $100,000 to invest. The minimum return of 0.5%/year means that we are guaranteed to have at least $101,508 after 3 years. The best rate I could find on a 3-year regular GIC is 3.55%. If we invest $91,422 at this rate (leaving $8578), it will return $101,508 after 3 years. This takes care of the minimum guarantee for our self-constructed MPGIC.

The remaining $8578 can be used for stock options to get market exposure. As in the previous post, we can buy call options on the XIU exchange-traded fund (ETF). To simulate the maximum return, we can sell call options at a higher strike price.

To see how this works, imagine a stock trading at $10. We buy call 100 call options struck at $10, and sell 100 call options struck at $12. If the final stock price is under $10, all options expire worthless. If the final stock price is $11, we exercise our $10 options and sell the stock for a $1 per share profit, and the $12 options expire worthless. If the final stock price is $13, we exercise our $10 options, but the resulting stock gets bought from us for $12 per share by the holder of the $12 options. Thus, our return is capped at $2 per share (less commissions).

So, to match the MPGIC we’d like to buy call options struck at XIU’s current market price, and sell call options at a higher price that results in capping the return at $20,000 (20% of our original principal). Unfortunately, options on XIU only come at a few different strike prices. Also, the longest range options available expire in about 26 months instead of 3 years.

Friday’s closing price on XIU was $13.12, and call options in our range of interest had the following bid-ask spreads on the Montreal Exchange:

$12 strike: $3.20 to $3.69
$14 strike: $2.25 to $2.73
$16 strike: $1.27 to $1.97
$17 strike: $0.97 to $1.66

Approach 1

Let’s try buying $12 call options and selling $16 call options. If we get unfavourable prices on each sale we are buying at $3.69 and selling at $1.27 (a difference of $2.42). At these prices, our $8578 can buy (and sell) 35 option contracts (each contract is 100 options) with $108 left over that will more than cover commissions.

Multiplying the 3500 options by XIU’s current market price of $13.12 gives close to $46,000 for a participation factor (PF) of 46%. This is rather low. On the plus side, we actually make money even if the market stays flat because we bought call options at only $12. Our maximum market return is only $14,000, which is less than the $20,000 target.

If we repeat these calculations assuming that we can buy and sell options for prices in the middle of the bid-ask spread, the results are different. The PF would be 62%, and the maximum market-linked return would be $18,800.

Approach 2

This time, let’s try buying $14 options and selling $17 options. This will increase the PF, but we’ll only get a market return if XIU rises to at least $14. If we get unfavourable option prices, the PF is 63%, and the maximum market return is $14,400. If we get option prices in the middle of the bid-ask spreads, the PF is 96%, and the maximum market return is $21,900.

As we can see from these examples, whether we can do better that Scotiabank’s MPGIC depends on the participation factor they offer and the option prices we are able to get. It also depends on how you value the differences like the inexact option strike prices and the difference in relevant market return: MPGIC bases it on the average over the 3 years, and our self-constructed investment has its market return based on the value of XIU at the end of about 26 months.

I should reiterate that I’m not a fan of index-linked GICs for my own investments because I find the cost of the capital guarantee too high. I’d rather go for higher returns at the risk of capital loss.