Monday, November 30, 2009
While eliminating fraud is a worthwhile goal, outright fraud is not the major problem we have today among financial advisors. The real problem is systemic. Conflict of interest rules this industry. Until the system is fixed, neither self-regulation nor government-imposed regulation is likely to help.
To defend these claims, let’s start with a small story about a couple in my extended family who changed their lives by uprooting themselves and moving to a warm country with nice scuba diving. I prefer not to name the country, but it has been declared the most corrupt nation on earth in the past.
Among the many amusing stories of life in a different country, this couple explained how all services seem to require bribes. Opening a bank account, arranging for telephone service, and just about anything else requires a bribe for the clerk. Bribes are so deeply ingrained in the culture that the bribe amounts are standardized and posted on the walls. At some point, they stop seeming like bribes and seem more like service fees.
In the same way, for those of us who understand how most financial advisors are paid, the system seems normal. But if we take this system to a new context, the problem becomes evident. When a politician awards a $25 million contract to a firm that then kicks back $250,000 to the politician, we are properly outraged. But when a financial advisor recommends mutual funds to a client who doesn’t understand that the advisor will collect a substantial commission and possibly yearly trailing commissions, it all seems normal. One big difference between the politician and the financial advisor is that the politician’s actions are illegal, but beyond that, they look very similar.
Some may argue that commission-based models for salespeople are a way of life. This is true, but financial advisors don’t look like salespeople to most of their clients. We expect the guy at the electronics store to push us to buy a big-screen television because he wants his commission. But, financial advisors look more like lawyers or accountants to their clients. These clients have a right to expect objective advice. Instead, our current system encourages financial advisors to recommend whatever investments pay the greatest commissions. What’s worse is that many of their clients have no idea this is going on.
One step in the right direction would be proper disclosure of fees to clients. Currently, fees are disclosed in percentage terms with confusing language. Better disclosure would be for the advisor to take the amount of money the client will be investing and show the client how much money (in dollars) he or she expects to pay in fees over the upcoming decade based on the investments the advisor is recommending.
Wilkinson says that the relationship between advisor and client should be based on trust. I agree wholeheartedly. Unfortunately, the current system does not encourage advisors to act in a way that is worthy of this trust.
These problems don’t mean that all financial advisors are dishonest. In fact, a great many advisors work very hard to do what they think is best for their clients. These honest advisors are no doubt discouraged by the actions of their less honourable colleagues. Good advisors do their job well despite the system not because of it.
Sunday, November 29, 2009
All mutual funds have a management expense ratio (MER) that covers the costs of running the fund. In addition to the MER, some mutual funds charge “loads”. Loads are fees paid either when you buy into a fund (front-end load) or sell out of a fund (back-end load). Back-end loads are also called deferred sales charges.
The purpose of a front-end load is simple enough. The financial advisor who sells you a mutual fund is paid out of front-end loads. But what about funds that have deferred sales charges? Does the financial advisor have to wait until you sell to get his money?
Things look even worse for the financial advisor when the deferred sales charges are “contingent”. This means that the sales charge declines over time. In a typical arrangement, if you sell in the first year, you get charged 5% of your initial investment, but only 4% if you sell in the second year, and so on until it drops to zero in the sixth year.
Does this mean that if you hold on for more than 5 years your financial advisor doesn’t get paid? No, it doesn’t. The financial advisor gets paid up front regardless of whether the load is up front or deferred. This is easier to understand if you look at deferred charges another way.
Suppose that you invest $100,000 into a mutual fund with a 2% MER with a declining deferred sales charge starting at 5%. A better way to think of this is that you pay $5000 up front and get a $1000 rebate on the MER for the first 5 years. After the fifth year, you pay the normal MER. While your account won’t actually be docked $5000 up front, you are committed to paying a minimum total amount of fees either through several years of MERs or the deferred sales charge.
With this view, the only difference between front and back-end loads is the MER rebate. It is easy to see now how the financial advisor can get paid up front either way.
If two funds have the same MER, then a deferred sales charge is preferable to a front-end load, but both types of load are equally painful for the investor who wakes up to the fact that mutual funds have high fees in the first year or two and wants out. Deferred sales charges ensure that when you enter a fund you are committed to paying a minimum total amount of fees regardless of how long you stay invested. In this sense they aren’t much different from front-end loads.
Friday, November 27, 2009
1. Rob Carrick explains why you can save money by paying explicitly for financial advice rather than taking seemingly free advice.
2. The Canadian Capitalist blog has been going strong for 5 years and is giving away $500 to celebrate. Congratulations on 5 years of sound information and analysis.
3. Mr. Cheap has experience as a landlord, and he explains some of the problems with hiring property management companies.
4. Jonathan Chevreau notes that the recent bear market has motivated financial advisors to recommend more alternative investments. I think this characterization is too charitable for financial advisors. Clients are more inclined to buy alternative investments because of the perception that standard investments don’t work any more. Financial advisors are willing to sell whatever the client will buy as long as the advisors make money from it. My characterization may be a little too uncharitable, but I bet it’s closer to the truth.
5. Canadian Financial DIY reports on research into how long it takes for stocks to give positive real returns. This should resonate with investors who have little stomach for volatility.
6. Preet has a guest writer, Ken Kivenko, to explain how you can get hit with tax distributions from mutual funds even if you didn’t own the mutual fund when it earned the income.
7. Larry MacDonald looks at the issue of whether to go with a bond ETF or a bond ladder. I think he’s overdoing it by having 10 bonds in the bond ladder, but seeking to minimize costs is definitely the right approach.
8. If you enjoy a good rant, check out the latter half of Potato’s discussion of searching for housing and dealing with real estate agents.
9. For more ranting, have a look at the Big Cajun Man’s thoughts on gifts to charity in lieu of presents and battling with Bell. You may or may not agree with him, but he is funny.
10. Do you make a lot of transactions in your bank account and want to minimize fees? Guest writer Kathryn at Million Dollar Journey has information on unlimited banking packages and how to get the fees waived at major Canadian banks.
Thursday, November 26, 2009
When Canadians draw money from a registered plan (RRSP, RRIF, or a registered annuity), the payment counts as income for tax purposes. Low-income seniors who collect the GIS may end up keeping only a small fraction of their registered plan withdrawals. I have looked at some test cases to try to come up with a strategy to keep more of the money.
Be warned that my analysis is based on a number of assumptions that may prove to be false. At the end of this post I outline some of the reasons why this analysis may have to be modified.
Annie is a single 71-year old living in Ontario collecting Old-Age Security (OAS) of $6203.52 per year. She has additional income from the Canada Pension Plan (CPP) and other sources (we’ll look at scenarios for additional income of $0, $5000, and $10,000). She has $100,000 in an RRIF and has to withdraw at least $7380 next year (according to the minimum RRIF withdrawal rate rules).
Case 1: Non-OAS income of $0
The entire $7380 withdrawal will cause GIS clawback. Annie’s tax rate on this amount is 71.05% and she gets to keep only $2136.51 of the withdrawal.
Case 2: Non-OAS income of $5000
Once again the entire $7380 withdrawal will cause GIS clawback. Annie’s tax rate on this amount is 71.05% and she gets to keep only $2136.51 of the withdrawal.
Case 3: Non-OAS income of $10,000
Only $5660 of the $7380 withdrawal will cause GIS clawback. Annie’s tax rate on the first $5660 is 71.05% and is 21.05% on the rest. She gets to keep $2996.51 of the withdrawal.
None of these scenarios is very appealing because Annie is losing too much of her savings to taxes and the clawback. A possible strategy for Annie is to withdraw more than the minimum and put the excess in a TFSA. The idea is that most of the excess wouldn’t cause any clawback and she would keep a higher percentage of it. In future years when Annie’s RRIF is drained, she can live on her TFSA.
It seems unlikely that Annie should withdraw the whole $100,000 in one year. For one thing she won’t have enough TFSA room. Other problems are the higher marginal tax rates for such a high income and the 15% OAS clawback that begins at income $66,325. So, I looked for the withdrawal amount that leads to the lowest percentage of tax plus clawback.
Here are the results based on Ontario marginal tax rates:
Case 1: Non-OAS income of $0
If Annie withdraws $60,132 per year from her RRIF her percentage of taxes plus clawback will be 38.6%.
Case 2: Non-OAS income of $5000
If Annie withdraws $55,132 per year from her RRIF her percentage of taxes plus clawback will be 35.7%.
Case 3: Non-OAS income of $10,000
If Annie withdraws $48,679 per year from her RRIF her percentage of taxes plus clawback will be 32.1%.
In cases 1 and 2, the optimum withdrawal amount was just short of the start of the OAS clawback. In case 3, the optimum point was just a little less than this. Once the RRIF is drained, she can collect the GIS and live on the money transferred to her TFSA (assuming she has sufficient TFSA room by the time she begins draining the RRIF).
There are a number of reasons why this analysis may give the wrong answer for you:
1. I may have overlooked some important considerations.
2. You are not single or don’t live in Ontario.
3. Tax rules may change in the future (such as TFSA income contributing to GIS clawback).
4. You may not have enough TFSA room for excess withdrawals and end up having GIS clawed away by income from non-registered savings.
5. Other age-tested benefits actually make the total clawback higher than 50%.
6. I have assumed that a large income would eliminate GIS payments for only one year. If they actually cause the loss of GIS payments for more or less than one year, then the analysis changes.
This whole issue is complex enough that it seems unlikely that many low-income Canadians will succeed in minimizing the taxes on their registered savings.
Wednesday, November 25, 2009
I’ll use the same example that Frugal Trader used:
– Honda CRV: MSRP + freight + PDI: $29,880
– Residual Value after 3 years: $15,276.60
– Depreciation (price minus residual): $14,603.40
– Depreciation per month: $405.65
So, if the interest rate were 0%, then the payments should be just this $405.65 per month. But interest is a fact of life and we need to figure that out too. The accurate way to calculate interest involves present value calculations. I’ll leave the details of this accurate method to the end of this post for those who are interested.
At the beginning of the lease the customer owes the entire value of the car. At the end of the 3-year lease, the customer will owe only the residual value. On average over the 3 years, the balance owing by the customer will be about halfway in between these two values:
– Approximate average balance owing:
($29,880 + $15,276.60)/2 = $22,578.30
– Annual lease rate: 4.9% (1/12 of this per month)
– Monthly interest = $22,578.30 x 4.9%/12 = $92.19
– Total Lease Payment:
$405.65 + $92.19 = $497.84 per month plus sales tax
Typically, the interest part of the payment isn’t explained the way I did. The official method begins with a mysterious money factor which is the annual interest rate divided by 24 (0.049/24). This is then multiplied by (purchase price + residual value) to get the “lease fee”. This lease fee calculation amounts to exactly the same thing as the estimated interest calculation I did.
How good is this interest estimate?
Many readers are no doubt suspicious of this method of estimating the lease payment. Using the proper calculation for this example gives a lease payment of $499.40. So, the estimation method actually gives slightly lower payments.
However, dividing the yearly interest rate by 12 to get the monthly rate isn’t really correct because the yearly rate becomes larger when the monthly rate is compounded 12 times. If we adjust the monthly rate to give a true yearly rate of 4.9%, then the payments should be $497.34, which is 50 cents less than the estimated payment. So, it’s a matter of taste whether the estimated payment is too high or too low, but either way it is very close.
The truth is that there is nothing sinister going on with the “money factor” and “lease fee”. There are no extra profits hidden in the math. The real problem is the advertised price. Few cars are worth as much as their MSRP (manufacturer suggested retail price). An error of a dollar or two on the lease payment is small potatoes compared to thousands of dollars added to the MSRP.
Exact Lease Payment Calculation
M – price of car (MSRP + freight + PDI)
r – interest rate
n – lease duration in months
V – residual value
P’ – estimated payment (without sales taxes)
P – exact payment (without sales taxes)
The estimated payment is
P’ = (M-v)/n + (M+V)r/24
To get the exact value of the payment, the price should be equal to the present value of the payments and residual value:
M = V/y + (P/(r/12))(1-1/y), where y = (1+r/12)^n.
With some algebra we get
P = (r/12)(M + (M-V)/(y-1)).
If we treat y as an unknown variable and set P = P’, we get
y = (24 + rn)/(24 – rn).
This turns out to be a reasonably close approximation to the true value y = (1+r/12)^n. This can be verified by examining the power series of each expression. Aren’t you sorry you asked?
Tuesday, November 24, 2009
Knowledgeable investors won’t find it worthwhile to pay anyone 1% of their assets for financial advice every year. Poor financial advisors aren’t worth 1% each year no matter how little the investors know about investing. But what about the combination of investors with medium to low knowledge and advisors who are middling to very good?
People differ on this question, and I don’t have the data to answer it definitively. However, I can examine my own experience. When I first began investing in more than bank GICs, I turned to a financial advisor who gave a presentation at my workplace.
For about 5 years I owned mutual funds recommended by this advisor. For two years during this period I owned more mutual funds sold to me by another advisor. If we assume that these advisors collected 1% of my savings each year, then they got a total of $2781 (in present-day dollars) from me. Of course, I paid more than double this in MERs, commissions, and deferred sales charges, but let’s assume that just 1% went to the advisor.
For this $2781, I estimate that over the 5 years I took up about 5 hours of these advisors’ time either speaking to them in person or on the telephone. No doubt these advisors spent more time doing things not visible to me behind the scenes related to my accounts.
About half of this time was spent on a brief initial interview to collect information about me and a few brief meetings where I handed over more money to place in my accounts. The other half was spent in a few meetings where they tried to convince me to borrow money to invest more.
One advisor convinced me to borrow enough to use up all my available RRSP room. The other failed to convince me to take out a big mortgage on my nearly-paid-for home. The RRSP loan worked out well because I managed to pay it off in one year. Taking out a mortgage would have been a disaster because the stock market tanked shortly afterward.
Throughout this period, I was pretty naive about investing (but was learning on my own). I should have been a good candidate for getting help from a financial advisor, but it seems clear to me that the “help” I got was not worth the $2781 I paid.
My experience is just one data point. I’ve met investors who are happy with their advisors and others who are unhappy. However, I’d like to see investors figure out how much they’ve paid their advisors and then decide if the money was worth it.
Monday, November 23, 2009
Before I go any further, I should mention that this idea hasn’t worked for anyone else who has played craps with me. It requires patience that the typical gambler doesn’t have. So, I don’t recommend trying this.
I start by finding a craps table that allows bets as small as $5. Some casinos don’t have any tables with bets this small. Then I only bet what is called the pass line. It is the most boring possible bet, but it has very close to fair odds. Out of 495 bets, the casino expects the player to win 244 times and lose 251 times, a net loss of 7 bets. Out of 495 bets, I expect to lose $35, which works out to just over 7 cents per bet.
It takes about 3.2 rolls of the dice, on average, to decide each bet. So, my loss per dice roll averages about 2.2 cents. In a very unscientific experiment, I timed the rolls at one table and found that each one took about 40 seconds. That’s 90 rolls per hour for an average loss of just under $2 per hour for me.
So far, all this sounds like losing money: where does the beating the house come in? They bring free drinks while you play. I wander over to a craps table and play for an hour before dinner and (statistically) lose $2, but have a couple of drinks while playing. The way I see it I come out ahead.
Of course, I could actually win or lose money each time I do this, but the long-term average will be losing roughly $2 per hour. And I enjoy the fun of being part of a group of excited people who tend to all win and lose together.
A few friends who have tried this with me couldn’t resist making bigger bets and making some of the other more exciting bets on the table that have worse odds. So, be warned: if you try this, it is likely to work out badly for you.
Sunday, November 22, 2009
A strategy is said to be dominated if it is guaranteed to give the same or worse results than some other strategy. This term is usually used in game theory, but it can apply equally well to investing.
Most of the time when we have a choice between two alternatives, we don’t know for certain which choice will lead to a better outcome. Should you buy stocks or bonds? In a given year, stocks might give better returns or bonds might give better returns.
In some cases, the choice turns out to be clearer. Suppose that I offer you a bet: we’ll toss a coin, and the winner gets $100 from the loser. I see you hesitate, and I make a second offer: I’ll give you $10, and then we’ll toss the coin for $100.
No matter which way the coin comes up, you’ll be ahead $10 taking the second offer rather than the first. This means that the first choice is dominated by the second.
This doesn’t necessarily mean that you should go for the second offer. Depending on your circumstances (and whether you think I have some sort of trick coin), it may be sensible for you to reject both offers. But one thing is certain: it makes no sense to accept the first offer.
How well does an index fund track its index?
How does all this relate to index funds? If two companies both offer equity index funds based on the same index, then the funds should hold exactly the same stocks in the same proportions. The only difference between the two funds is how well their returns track the returns of the index.
The main reason for a fund lagging an index is its Management Expense Ratio (MER). If an index fund charges a 1% MER each year, then the fund must return 1% less to investors than the stocks produce.
Another contributor to index funds lagging their index is cash holdings. Funds vary in the amount of cash they keep around. Because stocks tend to give better returns than cash, over the long term, more cash means lower returns. Similar to this case is the possibility that the shares held by the index fund do not accurately mirror the index for whatever reason.
Another possibility is that the price of an index fund’s units does not accurately reflect the value of the underlying stocks. This is called a premium or a discount depending on whether the price is too high or too low.
Yet another reason for two index funds to track their index differently is securities lending. Many index funds lend shares to short sellers for profit. How much of this profit gets retained by the management company can affect returns on the index units.
The right choice of index fund is usually clear.
Suppose that we have two index funds A and B that hold the proper mix of stocks, do not sell at a discount or premium, hold very little cash, and return about the same amount of securities lending profits to unit-holders. The only thing left to distinguish them is the MER. Fund A has a 0.2% MER, and fund B has a 1% MER.
This means that no matter what happens in the stock market, fund A will always give a 0.8% higher return than fund B. As an investing strategy, fund B is dominated by fund A. So why would anyone invest in fund B?
The only reasons I can see why anyone might invest in fund B come down to ignorance. Maybe fund B manages to market itself without focusing on the MER. Maybe people aren’t aware of fund A.
In theory, all index funds that track a particular index can be evaluated, and everyone should invest in the one that lags the index by the least. In practice, things don’t always work out this way.
Friday, November 20, 2009
2. Rob Carrick collected together several proposals for improving TFSAs. Most of them amount to increasing the amount that Canadians can contribute to a TFSA, in some cases favouring older people. These sound great for old rich people (something I aspire to be one day).
3. Canadian Capitalist wonders what are homeowners thinking when they take on 35-year mortgages that they can barely afford when it seems that interest rates (and payments) can only rise in the future? This one generated quite a barrage of comments.
4. Gail Vaz-Oxlade explains how minimum payments on credit cards actually decrease the amount that people pay towards their credit card debt each month due to a phenomenon called anchoring.
5. Making a claim on your insurance is often something you have to do at a traumatic time in your life. MoneyNing explains the four things you shouldn’t say to your insurance agent if you want you claim approved.
6. Canadian Financial DIY reports on rule changes with Locked-in Retirement Accounts making it possible to shift money to a regular RRSP.
7. Big Cajun Man likens the choice between a fixed or variable rate mortgage to the choice for New England to punt or go for it on fourth down in a recent football game against Indianapolis. He’s right that fixed rate mortgages are the more conservative choice, but this doesn’t apply to the football game. Football games don’t have intermediate outcomes; the only possibilities are win, loss, or tie. New England coach Belichick made the right choice.
8. Guest writer at Million Dollar Journey, Ed Rempel, thinks that faith is an important part of successful investing. I should add that he doesn’t mean the religious kind of faith, but rather optimism in the future of humanity. If this is what it takes to avoid selling out when prices are lowest and news reports are darkest, then it sounds good to me.
9. Mr. Cheap thinks it’s OK not to save for retirement in your 20s and 30s. This is another one of those cases where a message will resonate with the wrong people. Mr. Cheap wants to reach people who save every penny and fail to enjoy life. He’s more likely to reach spendthrift fools who are happy to have another excuse to speed towards a painful bankruptcy. This is often the way it goes with giving out advice as Jason Zweig explains.
10. Jonathan Chevreau has an amusing story of people showing real interest in a fictional 100-times leveraged ETF.
Thursday, November 19, 2009
Leaving the value of such reports aside, are they true? Well, recent stories announced that gold had reached US$1150 per ounce. Back in 1980, gold peaked at US$850 per ounce, which is obviously a smaller number than US$1150, but what about inflation?
This US consumer price index calculator says that US$850 in 1980 had the same buying power as US$2230 has today. So, an ounce of gold today has a little over half the buying power it had at gold’s peak in 1980. I’d say that this is a much more reasonable way to judge the price of gold, but it makes for less exciting headlines.
If we look at everything in absolute dollars, we can pump out headlines for record prices of many items every time inflation nudges up another 0.1%. Alarmist stories are great for reporters, but not much good for readers.
Wake me up if gold punches through US$2230.
Wednesday, November 18, 2009
MoneyNing wrote about a variant of the 0% credit card balance transfer that I hadn’t seen before. Usually, the deal is that the debt transferred to the new card is charged no interest for a few months, and then the interest rate shoots way up.
There are two main ways people get caught with this deal. The first is that they are unable to pay the balance off before the interest rate shoots up and they have to pay excessive interest. The second catch is that if they use the card for new purchases, payments go toward the 0% balance and the new purchases start collecting high interest right away (although there is pending legislation to force credit card companies to apply payments more favourably for cardholders).
With a 0% for life balance transfer, we could beat the credit card company by just never using the card for new purchases. But that’s where the catch comes in. When credit card issuers offer 0% for life transfers, they require cardholders to make at least two purchases per month or else the interest rate would shoot up.
This could still be a good deal if the cardholder pays off the balance fast enough that the new purchases don’t accrue high interest for too long. To test this, I looked at the following scenario. Andy owes $5000 on a credit card. He is considering one of two approaches:
1. Use the 0% for life balance transfer. Andy will make two $20 purchases each month and make a $150 credit card payment each month until the card is fully paid off. We’ll assume that the interest rate on new purchases is 1.5% per month. (This is what the credit card companies would call 18% per year, but is actually 19.56% per year.)
2. Take out a line of credit for $5000. With the $150 available each month, Andy will make the two $20 purchases with cash and use the remaining $110 as a payment on the line of credit.
The question is what interest rate on the line of credit would cause the two debts to be fully paid off in the same number of months? It turns out that the credit card balance would be wiped out after 4.5 years. The equivalent interest rate on the line of credit that gets paid off after the same length of time is 5.7%. So, if the best rate Andy can get on a line of credit is more than 5.7%, he’s better off with the 0% transfer deal.
However, this analysis is very sensitive to the initial assumptions. What if Andy spends $100 per month and makes $200 payments? Then the credit card debt takes 5.5 years to pay off, and the equivalent line of credit interest rate is 10.6%. In this case, Andy is very likely better off with the line of credit.
Almost every special credit card offer is a potential trap to get you paying high interest on debt. Be wary.
Tuesday, November 17, 2009
As Jonathan Chevreau reports, many investors demand ETFs from their advisors, and now Invesco Trimark is offering “hybrids” of ETFs and mutual funds to meet the demand. We should be suspicious about calling these products ETFs when they can be sold by advisors who are only licensed to sell mutual funds.
As Rudy Luukko of Morningstar explains, most of these new products are actually regular mutual funds that invest in a single ETF. These new funds pay a trailer fee of 1% per year to advisors who sell the funds to their clients. Hapless clients, who can now be told they are buying ETFs, will pay a management fee that includes the 1% trailer plus the management fee of the underlying ETF for a total between 1.65% and 1.9% each year.
This solves financial advisors’ problems nicely. If clients want ETFs – no problem – they can have ETFs. Never mind that the underlying reason why clients want ETFs is to pay lower fees. These new products are hybrids only in the marketing realm. In reality, they walk and talk like mutual funds, but advisors can call them ETFs.
Until investors seek lower fees and demand to be told what their investments cost, they can expect more marketing efforts like this to keep them paying high fees.
Monday, November 16, 2009
When the City of Ottawa reversed their decision to limit student bus passes to students under the age of 27, I decided to buy a bus pass and take the bus to school every day instead of just the two days a week I start at 8:00 am.
A monthly student express bus pass costs $76.60 compared to the full adult express rate of $106. If you are paying with cash or tickets, there is no discount for being a student. A monthly parking pass at school in the cheapest lot would cost me $71. Of course, there are 700 people on a waiting list to get one of these coveted spots and the college doesn't guarantee that even with a parking pass you will actually have a parking spot when you get there with your car. It doesn't seem like that good a deal to me.
Now I'm not as good at analyzing financial matters as my dear husband but I'm going to go out on a limb and say the gas, depreciation and wear and tear on my car would cost me more than the difference of $5.60 per month.
It took awhile to figure out that the bus schedule is more of a suggestion than something written in stone and that when coming home in the evening with the thousands of public servants returning to the suburbs, any bus in the 70 range that has room will get me closer to home where I can transfer onto the proper bus once said public servants have gotten off the bus and into their cars that they left at the park and ride that morning. And it has been fun trying to figure out who is going to give me H1N1, but I will diligently continue to not touch my face and wash my hands when I get to my destination.
Time-wise taking the bus in the morning is more convenient than taking the car because of the transitway and dedicated bus lanes. I almost feel sorry for all the people in traffic as we zip by them. The off peak trips take a bit longer and are more unpredictable but it's not a big enough hassle to get me back in my car at this point.
The interesting pricing even makes it more economical for me to purchase a student monthly pass in December when I am only in school for 3 weeks instead of paying full adult fare with tickets. And next year the city is going to make it even cheaper to buy a semester pass. I don't see using public transit for grocery shopping but for back and forth to school, it is working out pretty well.
Sunday, November 15, 2009
Many Canadians are confused about whether they should be saving money in Tax-Free Savings Accounts (TFSAs) or in RRSPs. In some situations this can be a complex question. Let’s look at the basic differences between TFSAs and RRSPs.
The TFSA is similar to an RRSP in that the income from investments within the account are tax-sheltered. The main differences are as follows.
1. TFSA contributions do not give you a tax deduction. RRSP contributions are deducted from your income to reduce taxes.
2. TFSA withdrawals are not taxed. With RRSPs, any withdrawal is treated as regular income and is taxed.
3. TFSA contribution room accumulates at $5000 per year. RRSP contribution room calculations are more complex.
4. Any amount withdrawn from a TFSA becomes new contribution room for the future. Regular withdrawals from an RRSP don’t increase future contribution room.
A natural question is should you contribute to an RRSP or a TFSA? The answer depends on your tax rates. If your tax rate when you contribute money is higher than it will be when you withdraw money, then an RRSP is better. If your tax rate when you contribute money is lower than it will be when you withdraw money, then the TFSA is better.
Both RRSPs and TFSAs are better than investing in a regular account where any gains are taxed. So, if you are able to save enough, contributing to both RRSPs and TFSAs is the best option over the long term. Not paying taxes each year on investment gains is a huge advantage of both types of accounts.
An interesting difference between RRSPs and TFSAs is the perception of how much money you have. If you are in a 50% tax bracket, you will only get to spend half the money in your RRSP. However, all of the money in a TFSA is yours to spend.
So, having $200,000 in an RRSP may feel better than having $150,000 in a TFSA, but it isn’t better (if you are in a 50% tax bracket). This psychological difference may make people happier with bigger dollar amounts in an RRSP even if they are better off with a TFSA.
Friday, November 13, 2009
2. Canadian Capitalist shows that a technicality in how Nortel’s Long-Term Disability plan was set up has had devastating consequences from those who depend on it.
3. Larry MacDonald pulled some great quotes from books on passive investing. If you like the first set of quotes, he has a second and third set as well.
4. Canadian Financial DIY can’t find any advantage to foreign diversification in 22 years of investing returns.
5. Big Cajun Man has a story about the worst investment advice he ever gave a friend.
6. Preet explains how high-frequency traders make money. This is definitely not a system for the average overconfident day trader.
7. Mike at Four Pillars looks at the pros and cons of various potential ways to prevent future pension plan failures.
8. Gail Vaz-Oxlade has an entertaining rundown of the 8 reasons why you don’t save.
9. Frugal Trader lost his wallet and has some advice for making life easier if you happen to lose your own wallet.
Thursday, November 12, 2009
Fairly arbitrarily, I decided to divide the portfolio into half Canadian and half US stocks. Each half consists of one individual stock and two index ETFs (one large cap ETF and one small cap ETF). The starting portfolio contains equal values of 6 different equities:
BMO – Bank of Montreal stock
XIU – iShares Canadian Large Cap ETF
XCS – iShares Canadian Small Cap ETF
BRKB – Berkshire Hathaway stock
VV – Vanguard US Large Cap ETF
VB – Vanguard US Small Cap ETF
The starting portfolio size for the experiment is $400,000 (Canadian). Because XCS began trading 2007 May 18, the experiment begins on that day with money divided equally among the 6 equities, rounded to the nearest 100 shares, except for BRKB which is rounded to the nearest share (because of its high price). Two different portfolios start this way: one is buy-and-hold and the other uses rebalancing.
The following costs are assumed:
– Trades cost $9.95 (Canadian or US depending on the shares bought or sold).
– Bid-ask spreads are two cents, except for BRKB whose spreads are one dollar.
– Currency conversion costs 0.5% on top of the exchange rate in each direction.
– Funds are in a tax-sheltered account so that no capital gains taxes are paid.
The buy-and-hold portfolio does no trading for the roughly 2.5 years from portfolio inception to the present. The other portfolio rebalances whenever the allocations drift too far from equal allocations in the 6 equities. It was surprisingly difficult to settle on a set of rules for how to do the rebalancing.
To minimize currency conversion costs, I wanted to rebalance from one Canadian equity to another or one US equity to another, where possible. I settled on the following rules to trigger a trade:
– If the total Canadian side gets outside the range 45% to 55%, then rebalance.
– If one of the Canadian equity’s proportion of the Canadian side is outside the range 33.3% plus or minus 5%, then rebalance the Canadian side. Handle the US side similarly.
For the actual rebalancing, I usually sold one overweight stock and bought one underweight stock. All trades were in multiples of 100 shares (except BRKB).
The initial portfolio size and rebalancing rules are set so that the typical trade size is about $10,000. In cases where two equities were roughly equally underweight or overweight, the buy or sell was split into two separate trades. I used my judgement rather than trying to define all the rules completely precisely.
However, I did not use any discretion in deciding when to rebalance. Whenever the portfolio was out of balance, I brought it back into balance that day.
The following chart shows how the rebalanced portfolio fared against the buy-and-hold portfolio. The red triangles mark the 8 rebalancing days that were needed over the 2.5 years.
In the end, the rebalanced portfolio won out by 3.95% (about 1.6% per year), but it wasn’t a smooth ride. For the first year and a half, rebalancing lost money. Rebalancing seemed to do a good job of exploiting the high volatility earlier this year.
Overall, this experiment doesn’t prove one way or the other whether this strategy will profit over buy-and-hold. If a basket of equities each rise at about the same average rate of a long period of time, then rebalancing can capture extra profits from the relative volatility. However, if one or more of the equities’ average growth rate is significantly lower than the others, then continually rebalancing into the underperforming equity will hurt returns.
Wednesday, November 11, 2009
According to this Veterans Affairs Disability Pension Program document, a soldier wounded during war time who is considered to be 100% disabled gets a disability pension of $2322.14 per month. Soldiers who are judged to be only 50% disabled would get half of this amount.
This figure is smaller than I was expecting. I suppose it doesn’t make sense to turn war heroes into millionaires, but it’s hard to imagine $2322.14 per month stretching very far for someone who is completely disabled.
Tuesday, November 10, 2009
For example, consider the following two very general opinions:
1. Investors should be careful with their money.
2. You have to take some investment risk to get rewarded.
These opinions are somewhat contradictory, yet both true. They are also vague enough that people will read into them what they want. Let’s look at a couple of extreme examples to illustrate how this advice affects two investors.
Action Andy has his investment account leveraged to the maximum and owns just two stocks. He reads the first piece of advice about being cautious and rejects it because it sounds like his mother talking. The second piece of advice prompts him to re-mortgage his house and buy into the latest hot Initial Public Offering (IPO).
Fearful Frank has all his savings stuffed into his mattress. He rejects the advice about taking some risk because he can vividly remember all the bad things that have ever happened to him when he took a chance. The advice about being careful prompted Frank to get rid of his dog so that the money in his mattress wouldn’t get chewed up.
In these extreme examples, Andy and Frank rejected the piece of advice they most needed to follow. Most of us tend to reject ideas that don’t already fit into our beliefs. However, it can be a good idea to think about new ideas sometimes, even if you end up rejecting most of them. The odd idea that doesn’t sound right at first may be beneficial.
Some advice I encountered recently that will likely reach the wrong people came from Larry Swedroe who advises you to reassess your investment strategy in light of the recent bear market. The idea is to lighten up on stocks if you couldn’t stomach the paper losses.
The investors Swedroe has in mind are the overconfident stock pickers who take on far too much risk. For these people, Swedroe is spot on. Unfortunately, his message isn’t likely to resonate with these investors.
However, consider the investor who had a conservative 50/50 split between a stock index and a bond index and sold all the stocks near the market lows. This investor is likely to see Swedroe’s advice as supporting the stock index sale. Well into the next bull market this investor may decide to reassess his risk tolerance again and buy back in.
So, this hypothetical investor has used Swedroe’s perfectly good advice to justify a terrible strategy of selling low and buying high. Giving advice is a difficult game (when you genuinely want to help people) because often the wrong people take it.
Monday, November 9, 2009
As Larry MacDonald points out, some ETF companies generate extra revenue through a practice called securities lending. This is the practice of lending stock to short sellers for a fee.
Some commentators are speculating that Schwab is keeping the proceeds from securities lending to augment the MER. The Schwab prospectus doesn’t seem to clear up the matter:
“When the fund lends portfolio securities ... the fund will also receive a fee or interest on the collateral. ... The fund will also bear the risk of any decline in value of securities acquired with cash collateral.”
So the fund gets a fee and the fund bears the risk. What do they mean by “fund” in this context? Is it the unit-holders or the management company?
In my opinion, because unit-holders own the securities they should keep the proceeds of securities lending (net of reasonable costs). If a management company keeps some or all of the proceeds, then they are essentially understating the fund costs.
Until Schwab makes it clear who gets the securities lending proceeds, I’ll stick with Vanguard. Vanguard has a clear policy:
“Unlike other firms that allocate a significant portion of lending revenues to their management companies, Vanguard returns all lending revenues, net of broker rebates, program costs, and agent fees, to the funds. Other securities lenders may divert up to 50% of the revenues derived from their securities lending programs.”
Sunday, November 8, 2009
When people get into trouble with their debts, they usually have several different debts including credit cards, car loans, line of credit, and possibly student loans. The debts usually have different interest rates and different required monthly payments. Some debts are scheduled to be paid of quickly and others over a long period of time.
The idea of a consolidation loan is to borrow one large amount to pay off all of the other debts. For this to make sense, this loan would have to be at a low interest rate and amortised over many years to make the payments low enough for the debtor to handle.
To qualify for this type of loan at a low interest rate, the debtor might have to put up some collateral, and this collateral is usually a house. The consolidation loan then turns into a home equity line of credit (HELOC).
On the surface, this seems like a good strategy. A lower interest rate means that you pay less interest. What other considerations could there be? I can’t say that I ever thought about this much, but a HELOC seemed to make sense if you are in debt trouble.
However, Suze Orman is dead set against this strategy saying in her book Women & Money “never use home equity to get rid of credit card debt.” Her reasoning is that if you got into trouble once, then you are likely to run up your credit cards again. Then you will have credit card debt and the HELOC to pay off. And if you can’t pay them off you will lose your house.
My first thought was that I disagreed with Orman. A rational person would consolidate the loans and then bring spending under control. But a rational person probably wouldn’t have had debt problems in the first place.
It is possible for someone who manages money well to have some big expensive event occur that throws him into more debt than he can handle. But this is infrequent compared to the number of people who make poor choices that result in having debts spinning out of control.
So, Orman is right. Most people with debt problems probably should not consolidate their debts into a HELOC.
Friday, November 6, 2009
Okay, you caught me. I’m pleased because Rob included my article comparing bond ETFs to directly purchasing bonds in his roundup. I suppose it’s too unprofessional to put “Rob Carrick has heard of me” on a business card. Rob has done a great job explaining financial matters clearly and I’m happy to be included.
2. Big Cajun Man isn’t too happy about the city of Ottawa’s plans to more than double garbage collection fees and charge for them separately. With the trend toward cities charging fees for services, eventually property taxes will pay for nothing but the bloated administration that adds nothing to the actual services delivered.
3. Ellen Roseman is concerned about the use of verbal contracts by telecommunications companies.
4. Rob Carrick reports that the Ontario government plans to start teaching money management to kids in grades 4 to 12. Hopefully, the government will be able to limit the influence of the mutual fund industry who will want to steer the curriculum in a favourable direction.
5. Apparently Warren Buffett and Larry MacDonald think alike in at least one respect: Burlington Northern railroad.
6. Gail Vaz-Oxlade has a collection of stories about parents and their spendthrift children. It’s heartbreaking to watch young people make terrible mistakes and not be able to convince them to change their ways.
7. Frugal Trader feels conservative for using excess cash to invest instead of increasing leverage. In my books that’s somewhat aggressive; using excess cash to pay off the leverage loan would be conservative.
8. Thicken My Wallet looks at “being nice” as a negotiation tactic.
9. Jonathan Chevreau reports that Visa has revised its financial literacy web site. Apparently, Visa thinks the 20-10 rule makes sense: “never borrow more than 20% of your yearly net income” and “monthly payments should not exceed 10% of your monthly net income.” I have a better idea: never borrow more on your credit card than you can pay off at the end of the month.
Thursday, November 5, 2009
Official sources paint overly-rosy pictures of the amount of oil still available. The biggest reserves are controlled by Saudi Arabia, but the Saudis severely limit access to scientific information about these reserves. The authors painstakingly go through available scientific evidence and conclude that peak oil production world-wide is near despite official claims that at least 50 years of oil remain.
Part of the problem with oil production is that as an oil field matures it gets progressively harder to extract oil, and the extracted oil has more impurities that take energy to remove. At some point, even if a field still has oil, it becomes unprofitable to extract any more oil. So, estimates of the amount of oil remaining are misleading; what matters is how much oil can be extracted.
This book is filled with detailed information about not only oil, but almost every other current and foreseeable source of energy. Here are some of the major conclusions:
– Oil production has peaked or will do so in the next three years.
– Natural gas and coal will peak some time in the next 13 years.
– Nuclear energy will peak in the next 10 years because we are running out of high-grade uranium.
– Wind energy is already competitive with coal and nuclear at 4 to 6 cents per kilowatt-hour.
– A hydrogen-based economy is highly impractical.
– In the future we will have an electric energy infrastructure with distributed electricity production and storage.
Another fact that puts Warren Buffett’s recent acquisition of a rail company in perspective: moving goods by rail is about 8 times more energy-efficient than trucking.
I give this book an A+ for technical content and clarity of explanations. However, investors are interested in profits. Interspersed throughout the book are “Investment Opportunities” sections that basically list companies involved in various energy-related ventures.
Despite the quality of information in the book, I can’t see how to profit. No doubt some of the companies mentioned will be wildly successful and many will fail. I can’t tell them apart. Even if I could guess which new energy source will prevail, such as wind or solar, there are so many companies working in these areas that I can’t predict which ones will dominate.
Wednesday, November 4, 2009
Until now CREA has kept commissions on the sale of homes in Canada at artificial levels (usually 5-6% of the house’s sale price) by refusing access to MLS to any broker offering lower commissions. Because most homes for sale are listed in MLS, being denied access is a serious impediment for discount brokers.
For now CREA is sticking to its guns saying that they don’t plan to grant greater access to MLS. This may ultimately lead to a showdown before the Competition Tribunal. It seems that we can eventually look forward to lower real estate commissions driven by market forces rather than a monopoly.
Tuesday, November 3, 2009
Tharp paints a picture where profitable trading strategies are a dime a dozen, but the discipline to follow a system is the real key to success. A lack of discipline can certainly be harmful to investors’ returns, but Tharp offers no evidence that the consistently profitable trading strategies that he repeatedly refers to actually exist.
The book anticipates this criticism by ridiculing a “gentleman from England” who took one of Tharp’s courses and complained that it didn’t give him a profitable trading strategy. Tharp’s reply is that the course wasn’t designed to give a methodology; “it is about how to become a peak performance trader/investor,” and “psychology is far more important than methodology.” I’m with the English gentleman on this one.
Any failure to make 25%, 50%, or 100% return each year can be traced back to investor error, according to the author. This could easily be self-fulfilling; unless a trading strategy is described extremely precisely, a trader could look over the losing trades for a year and decide that many of them were mistakes.
Some of the subject matter of this book seems more suitable for athletes. Maintaining a positive attitude is good in most endeavours and feeling confident may help with tennis, but I’m not sure how it helps much with trading. Tharp takes this a step further by saying “it is time to open up the spiritual basis of trading.” Does this mean that we should pray for our stocks to go up?
More along these lines: “The opposite of joy is not necessarily sorrow; it’s unbelief in the true nature of your soul or the essence of God.” Thanks. Now my next trade is sure to be profitable.
The author attempts to link his ideas to Einstein a couple of times. Apparently, the techniques for looking at things from multiple perspectives are “part of how he [Einstein] formed his great ideas about relativity.” I guess the idea is that disagreeing with the author is like disagreeing with Einstein.
Defusing More Potential Criticism
It’s simple math that the average trader gets the same returns as buy-and-hold investors, except that they pay more in trading costs. For very active traders these trading costs can be substantial. Tharp attempts to defuse this criticism of trading with a little story and a reader exercise:
Bill’s wife says “Trading is nothing but gambling. It’s a waste of time and has no redeeming value.” Bill then uses one of Tharp’s techniques aimed at solving the problem. It begins with Bill writing down some “statements” including “I married the wrong woman” and “She’s an idiot.” Of course, the real substance of the criticism is left unaddressed.
“I’d recommend a good hedge fund over T-bills because you can get a much better rate of return.” You can also get a much worse rate of return as we’ve seen from recent hedge fund implosions.
“I’ve known people with systems that can easily net 100% or more each year.” That’s great. A 30-year old starting with $10,000 could build it up to $10 billion by age 60 and $1 trillion by age 67. If the existence of such a system sounds implausible to you, you’re not alone. This book is filled with references to systems with incredible returns without giving any hint of how they work or any proof that they actually exist.
Advice for Prospective Hedge Fund Managers
“To have large amounts of money under management, you need to produce above-average returns with very little risk.” Most promises of high returns with little risk are scams as we’ve seen with the flurry of exposed Ponzi schemes.
“Deciding on your objectives is about 50% of developing a trading system.” This reminds me of a joke about a clueless CEO. One day he announces that he has a great new idea: the company needs to double revenue while keeping expenses constant. This sounds great to the underlings, and one of them asks “that’s fantastic, what’s the idea?” The CEO stares back blankly and says “I just told you the idea.”
It takes 10 seconds to choose an objective of making at least, say, 40% return each year risk-free. The idea that the work toward meeting this goal is now half done is laughable.
Random Trading is Profitable
Tharp claims that choosing the right equity to trade isn’t important – what matters is the right exit. To prove this he devised a random trading scheme as follows. For each of 10 commodities toss a coin to decide whether to go long or short. Choose an exit point to cut losses equal to 3 times the trading range over the last 20 days. Otherwise, ride profits indefinitely.
After a trade is exited, flip a coin again to start a new position in that commodity. Tharp claims that this strategy made money consistently over a 10-year period. I’ll leave it to others to examine this more closely, but I’ll need a lot of evidence to believe that random trading can be more profitable than buy-and-hold.
An Example Trading System
“Let me present a simple trading system.” This got my attention. Maybe this is finally the part where the reader learns the secret to profitable trading! Sadly, the description doesn’t reveal how the system works. It just describes each trade’s results in terms of a dollar amount R:
– 20% of the time it makes 10R
– 70% of the time it loses 1R
– 10% of the time it loses 5R
On average, each trade makes 0.8R, although there is considerable volatility. The system is assumed to make 80 trades per year. Tharp claims that such a system is “not unrealistic” and that he’s “seen much better systems.” Let’s examine this a little.
If we set R to be 2% of our portfolio, then on each trade the portfolio makes 20%, loses 2%, or loses 10% with varying probabilities (see above). After 80 trades (one year), the average compound return is 156%! At this pace it would take only 20 years to turn $10,000 into over a trillion dollars.
Volatility is a factor here, and so I decided to run some Monte Carlo simulations. Out of a million simulations the starting $10,000 grew to at least $1 million 99.99% of the time.
If Tharp has seen trading systems with this kind of phenomenal potential, why is he wasting time writing books?
A Few Good Parts
There isn’t much I can recommend about this book, but there were a few good points. Tharp criticizes come-ons for trading saying they are designed “so that other people can take your money in fees and commissions.” There is no comment on the irony that this criticism can apply to this book as well.
There is extensive discussion of position sizing which more or less means controlling the size of trades to avoid doing significant damage to your portfolio if a trade works out badly. Tharp gives examples of profitable trading systems that can become money losers if the bets are too big. However the real value of this advice is that it will allow the typical trader with a money-losing strategy to lose money more slowly.
The best part of the book is the third of three biggest lies a cowboy tells:
1. The truck is paid for.
2. I won this belt buckle at the rodeo.
3. I was just helping that sheep over the fence.
Much of this book is self-help advice and exercises that have little to do with trading. For the parts that are related to trading, there is no evidence that they will help anyone trade profitably. This book definitely does not live up to its title.
Monday, November 2, 2009
This means that I don’t get the advantage of rebalancing a portfolio between stocks and bonds. By trading to maintain constant percentages in stocks and bonds, investors are forced to buy low and sell high (as long as they actually do the rebalancing). Too often investors delay rebalancing when an asset class is priced low and the news is full of doomsday stories.
My latest idea is to change my portfolio to include fixed allocations to different stock asset classes. I’m sure that other people have thought of this before, but it’s the first time I have seriously considered committing my money to it.
My first thought is to include low-cost index ETFs for Canadian and US large and small cap stocks as well as possibly a few company stocks. I would define a percentage allocation to each stock class and rebalance whenever the percentages went outside of preset bounds.
All simulations I’ve ever done indicate that rebalancing gives a portfolio a small boost, but not enough to overcome the penalty of including an asset class with low expected returns, like bonds. Thus, I want to stick to stocks. I’m interested in reader feedback on this idea along with suggestions for which ETFs (and possibly individual stocks) make sense to use.
Sunday, November 1, 2009
It turns out that banks consider students to be great customers for their credit cards. I learnt this from James D. Scurlock’s book Maxed Out: Hard Times, Easy Credit and the Era of Predatory Lenders, which gives a fascinating look into the world of lenders and their hapless customers.
So why are students good customers? When you think of the old style bank that only lends to people with steady income to pay off a loan, lending to students makes no sense. Students usually have little income, and many of them will run up bills on their cards that they can’t pay off.
It turns out that students have something else that makes them great customers: parents. According to Scurlock, parents will almost always bail their children out of debt problems. And the attitude of banks has changed dramatically over the years.
Students run up debts and pay interest for as long as they can. When things finally fall apart, their parents pay off the debts. The situation is perfect for the bank: they charge high interest rates with very little risk of default.
Other great customers are people who can’t handle money properly, but have a valuable asset such as a home. The strategy here is to offer this person some unsecured credit, and when they become unable to make payments on the debts they run up, get them to reorganize the debt with the home as collateral. As the debt continues to grow, and the borrower can’t make the payments, the bank can seize the home.
In this scenario, the bank’s goal isn’t so much to seize the home as it is to collect interest on its loans. The home serves as protection against default making the loan safe. Profitability comes from maximizing interest rates and minimizing the risk of default.
When you think in generalities about debt, it is hard to argue with the idea that people should be responsible for their debts and should pay them back. But, when confronted with the particular case of an illiterate woman being forced from her modest trailer home over a snowballing small debt combined with some papers she signed, but didn’t understand, things become less clear.
I’ve done my best to educate my sons about the problems with debt. I’ve also tried to convince them to talk to me before the first time they get a credit card or borrow money in any other way. But, I don’t have any particular insight into the best way to protect young people from the debt trap.