Tuesday, August 31, 2010

Tapping Into Investment Sentiment from Millionaires

Tom Bradley at the Steadyhand blog wrote a piece pointing out that millionaires are bearish right now according to one measure. It turns out that Spectrem Group maintains an index of investment sentiment among millionaires by doing 250 interviews each month. So, do these millionaires know something we don't know?

Bradley wasn’t endorsing this index in any way, but it got me thinking. If there is any group that may know something about investing, maybe it is millionaires. Perhaps that’s how many of them came to be millionaires. Perhaps this index has some predictive value.

The scale of the index is -100 to +100. Five years ago it was hovering around +20. However, in late 2007 it went negative. This was nearly a year before the market meltdown. This seems like a vote in favour of millionaires having useful insight into short-term stock market moves.

The next test is whether this index predicted the huge stock market rebound in 2009. Unfortunately, millionaires were bearish through all of 2008 and 2009. This index completely missed one of the biggest single-year stock market surges in history. So, it seems that millionaires aren't infallible.

This millionaire index may be useful for something, but there seems to be little evidence that it is useful for predicting stock market moves. I suspect it is more useful for financial advisors to know what sorts of investments to pitch to wealthy people.

Monday, August 30, 2010

More Realistic RRSP Contribution Expectations

Last week’s post Unrealistic RRSP Contribution Expectations generated quite a few comments. We explored the issue quite thoroughly, and it makes sense to lay out a more realistic plan.

The main problem with examples that assume constant contributions for a lifetime is that they ignore inflation. It makes little sense to assume that the typical young person will make considerably larger contributions (taking into account inflation) than that same person will make later in life. There may be a few people who will follow such a path, but the majority will make large contributions in mid-life.

So, let’s try a different scenario. As some commenters suggested, let’s assume that the contributions increase in size with inflation. Let’s say that a 25-year old starts contributing $500 per month and increases this amount with inflation for 40 years. As before, we’ll assume that inflation is 4% and investment returns are 8%.

The total in the RRSP after 40 years will be about $2.7 million, but it will only have purchasing power of about $560,000 in today’s dollars. The question now is what will happen if we wait until age 35 to begin contributing? The final total in today’s dollars would be about $330,000. So, the first of 4 decades of contributions accounts for a little over 40% of the total.

Even if the contributions from age 25 to 35 are half-sized, the final RRSP holdings of about $445,000 are substantially higher than the $330,000 that would result from making no contributions in the first decade. So, saving when you are young makes a difference.

Friday, August 27, 2010

Short Takes: RESP Catch-22 and more

Big Cajun Man finds that the rules for RESP withdrawals force him to pay for his children’s schooling before he can get the money out of the RESP. I can see that this could be a problem for people with cash-flow difficulties.

Canadian Capitalist makes his personal Adjusted Cost Base and Capital Gains tracker in Excel available to his readers.

Preet Banerjee has some cell-phone deals for his readers. I don’t need as many features as most people want, and so I’ll stick with my $7 per month cell phone.

Money Smarts says that Canadians should be invested in oil stocks.

Thicken My Wallet gives his take on the value of financial (and legal) advice.

Thursday, August 26, 2010

Unrealistic RRSP Contribution Expectations

We hear frequently that young people should start contributing to an RRSP early in life. Recently, I encountered yet another of these arguments. However, there are some unrealistic expectations buried in the assumptions used.

Here is a typical version. If you start contributing $500 per month to an RRSP at age 25 and make an 8% return each year, you'll have about $1.7 million by the time you're 65. But, if you delay making contributions until you're 35, you'll only have about $800,000 at age 65. This is less than half as much.

The math is right. The contributions during the first decade really do count for more than the remaining three decades because of the magic of compound interest. However, there is a serious problem with the built-in assumptions.

Let's look at this from the point of view of a 65-year old who is just making his last $500 RRSP contribution and is about to retire with $1.7 million. Supposedly, he made $500 RRSP contributions each month starting 40 years ago. But what about inflation?

If we assume inflation has averaged 4% per year over those 40 years, that first $500 contribution when our retiree was 25 years old is the equivalent of $2400 today! How many 25-year olds do you know who can contribute $2400 per month (or $28,800 per year) to their RRSPs?

I'm a believer in saving money from a young age, but the typical justification of the type I described here is hopelessly flawed. Your early years of saving are important, but not quite as important as they can be made to seem.

Wednesday, August 25, 2010

Freedomnomics: Defense of Freedom or Fox News Rant?

The book Freedomnomics: Why the Free Market Works and Other Half-Baked Theories Don’t by John R. Lott, is a mixed bag. It makes a strong case for free markets and democracy, but contains a healthy measure of partisan politics that undermines the reader’s confidence in various analyses.

In part, this book is a rebuttal to Freakonomics, by Dubner and Levitt whom Lott likens to Michael Moore. Whatever you think of Dubner and Levitt’s ideas, they are a far cry from Moore’s populist (but entertaining) rants. In the end I found the criticisms of Freakonomics unconvincing, although Lott may be right on some points – it’s hard to separate his sound analysis from the apparent political bias.

Lott makes a convincing argument for free markets working much better than having governments run industries. The role of governments should be to keep free markets working properly and not to interfere overly. However, free markets tend not to work properly in two situations:

1) When consumers lack necessary information.

2) When a company or group of companies monopolize a market.

Lott would keep the government out of everything, but I would have governments mandate effective disclosure and either break up monopolies or regulate them. Lott argues against regulating monopolies with the example of granting a monopoly on a drug to its inventor. However, this is very different from a monopoly over an entire industry, such as cable television or local telephone service where regulation is necessary to protect consumers.

People seem to believe that gasoline prices should be controlled by governments, but Lott argues convincingly that this would simply lead to shortages. The free market does a better job of balancing price and availability of gasoline.

The most surprising part of the book for me was the assertion that concealed handguns give a “clear social benefit”. The idea is that criminals will think twice before committing a crime if they think the people around them might be armed. I find it hard to believe that this benefit outweighs the negative of having otherwise inconsequential everyday conflicts potentially escalate to shootings.

Lott argues that licensing of professionals has little to do with guaranteeing competence and is mainly done to keep new entrants out and protect the incomes of existing professionals. Lott asks why there are extensive training requirements instead of just rigorous testing. The answer, of course, is that mandatory extensive training keeps people out of the profession.

Lott thinks that the government should not ban smoking in bars and restaurants and let the free market decide. I can’t agree with this one. Tobacco may be legal, but it is clearly harmful. There is a major benefit to everyone if we can go about our days without breathing second-hand smoke. Without a government ban, this would not be possible.

Levitt and Dubner argued that abortion reduces the number of unwanted children. Lott argues that abortion leads to more women raising children out of wedlock. I had a hard time following the logic on this one.

In general, this book started as a defense of free markets and slowly turned into partisan politics denouncing all sorts of things including car safety devices and gun locks. If you like to have your views challenged in an intelligent way, this book may do it for you.

Tuesday, August 24, 2010

Only 6% of Bogus Credit Card Charges Challenged

Larry MacDonald wrote an interesting piece about scammers who made about $10 million by duping banks and credit-card customers with bogus charges of $9 and $0.20 (the web page with this article has disappeared since the time of writing). The most surprising part of this is that only 6% of all charges were contested.

I didn’t realize how far out of the norm my credit card habits are. I keep all my receipts until the end of the month and match them to my statement. Anything on my statement I can’t account for triggers a call to the credit card company. I don’t care if the mistake is for $1000 or for a dime; I still call and get it fixed.

Apparently, for each person like me who tries to catch mistakes, there are 15 other people who don’t bother. I find this staggering. Apparently most of us can’t be pulled away from the television or video game long enough to check whether we’ve been cheated. It’s no wonder that fraud can be profitable for clever con artists.

Monday, August 23, 2010

Airline Customer Service Games

I had an interesting experience recently where I got better service from an airline by threatening to abandon my travel plans. I didn’t intend for this to be a bargaining technique, but it seemed to work out that way.

I was scheduled to fly 3 legs to a US destination on a Sunday on United Airlines. We were an hour late leaving which made me miss my first connection. There weren’t any actual airline employees nearby to help me get a new connection and I ended up calling United Airlines customer service.

US air carriers use various techniques to keep their flights quite full, and I was told that they couldn’t get me to my destination until Tuesday (two days later)! The agent tried to convince me to just take a flight to a city nearer my destination and hope to get on another flight to my destination by getting on a standby list.

However, I insisted that if I couldn’t be scheduled with guaranteed seats the whole way, I wanted to turn around and go back home. I’ve had experience with the extreme over-booking of the last leg of the routing the agent wanted me to take. This strategy would surely have left me stranded overnight.

The agent on the phone insisted that she couldn’t make such a change for me and that I’d have to find a customer service agent in person in the airport. This is silly of course. Why couldn’t an agent book me on a flight back home? I gave up and started wandering around the airport trying to find a United Airlines customer service desk.

The second such desk I found had actual agents at it. The agent I spoke to gave me the same story initially – I’d have to just fly somewhere else and hope to get a spot on a flight for my last leg. When I told her that I wanted to go back home, her attitude changed. Suddenly, she had several other things she could try. Eventually, I had a routing through a new city with guaranteed spots on each leg, or so she told me.

After the second leg, I wandered over to the gate for my last leg and inquired about switching to an earlier flight. After tapping on her computer for a bit, the agent told me that I wasn’t actually assigned a seat on the later flight, and that I’d have to pay a $50 change fee to get on a flight whose doors would close in just a couple of minutes.

So, now I was faced with either paying $50 extra or have the possibility of missing my meetings and staying overnight in some random city if I couldn’t get on the later flight. It may have been that I still had a guaranteed spot on the later flight, but I couldn’t take a chance. I don’t think it was right to extract $50 in this way, but I had little choice.

In the end I got where I was going on time. However, if I had accepted the first answer I got, I would certainly have ended up arriving for my meetings at least a day late. United Airlines seems motivated to keep their customers from abandoning their travel plans. Some possible reasons are the loss of revenue from refunding part of the flight costs, the likelihood of the customer flying a different airline next time, and the bad word of mouth that would result.

I’d be interested to hear from any readers who have been forced to abandon travel plans after completing at least one leg. How hard did the airline try to keep you from turning around and heading back home?

Friday, August 20, 2010

Short Takes: Mutual Fund Marketing Nonsense, Free Chequing Accounts, and more

Canadian Capitalist points out a gaping flaw in the analysis of a recent report from the Investment Funds Institute of Canada (IFIC).

Million Dollar Journey compares two free chequing accounts in detail: ING Direct vs. PC Financial.

Preet Banerjee gives his take on his interview with Martin Horvath about a tax-saving scheme.

How to Invest Online gives a primer on investor protection in case a business connected to your investments goes belly up.

Canadian Financial DIY does an interesting financial case study of installing a geothermal home heating system.

Big Cajun Man rants about places that accept Mastrercard or Visa, but not both.

Money Smarts continues the series on information for landlords with useful information on lease agreement and repairs.

Gail Vaz-Oxlade has a fun TFSA quiz that you should get 12 out of 12 on before contributing to a TFSA.

Thursday, August 19, 2010

The Costs of an In-Ground Pool

Eleven years ago I took the plunge (pardon the pun) and put an in-ground pool in my back yard. I’ve always known that it was expensive to buy and is expensive to maintain, but I didn’t know how expensive the maintenance is until I added up the costs. Anyone considering an in-ground pool may be interested in the costs that await.

My pool costs may be higher than typical because I put in a large (20x43 feet) pool with a longer and deeper deep end than is typical. So, some costs may be lower for other pool owners.

My costs are laid out below. Most are actual figures including taxes. I estimated the costs for natural gas based on an average of the last couple of years. Hydro is a little more difficult. I based this cost on the power draw stamped on the pump. The figure I came up with seems consistent with the increased hydro cost we see in summer months. The repair cost is an average over the many years I’ve had the pool.

Initial Costs

$27,862 – pool + installation + heater
$2009 – running a 70-foot natural gas line
$500 – extra cement not part of contract
$75 – pool enclosure permit
$215 – water
$396 – parts needed for winter closing

$31,057 – total in 1999

$38,846 – total adjusted for inflation in 2010 dollars

Yearly Costs

$320 – chemicals (chlorine, algaecide, alkalinity, muriatic acid, conditioner)
$341 – pool opening in spring
$369 – pool closing in fall
$300 – natural gas
$560 – hydro for pump
$300 – repairs, replacement parts

$2190 – total per year

As you can see, owning an in-ground pool is expensive. I don’t regret my decision because I have really enjoyed the pool over the years. However, some people may hesitate when they see the size of these numbers. The costs go down for smaller pools and you can save if you’re willing to do the opening and closing work yourself. However, costs will shoot back up if you close it for the winter improperly and you get freezing damage.

I know a few people who got a pool without a heater, but they ended up buying one later. Without a heater, you just won’t get much use of the pool in the Canadian climate.

If you want a pool, make sure your eyes are open to the costs before diving in.

Wednesday, August 18, 2010

Your Money Milestones

Moshe Milevsky’s book, Your Money Milestones brought up so many interesting topics that I chose to write about four of them in earlier posts:

Smooth Consumption over a Lifetime
Owning a Home vs. Renting
Human Capital
Portfolio Construction Taking into Account Employment

This very thoughtful book is worth reading. Its ideas are deep, yet the text is understandable. I didn’t agree with everything written, but the ideas were worth thinking about. To add to the points made in the four earlier posts, I include a few interesting tidbits below.

Choosing a Career

It turns out that not all university degrees are a good deal from a financial point of view. Some types of degrees won’t increase your expected lifetime earnings by more than the cost of acquiring the degree. This is reasonable as far as it goes, but may mislead kids coming out of high school.

Engineering may pay better than Fine Arts, on average, but this isn’t helpful to most individual students.  A given student might be destined to be in the top 1% of his or her class in Fine Arts, but would expect to just barely scrape by in Engineering. I’ve spent my career doing Engineering and Mathematics, but I recognize that it isn’t for everyone. Too many students fail to think about the job prospects for their degrees, but jumping into fields they don’t like and have no aptitude for is no solution.

Men vs. Women and Risk-Taking

Men choose riskier portfolios than women do, and married women choose riskier portfolios than single women do, according to a study of Italian women. Milevsky attributes this to the married women taking into account the stability their marriage provides that allows them to take greater financial chances. I think it’s more likely that some husbands tell their wives which investments to buy.

Income Tax Refunds

We’ve heard that we’re better off reducing income tax taken off at source rather than getting a big income tax refund. After all, why give the government an interest-free loan? However, many people prefer to get a big refund, even when they show they understand that it means having a lower pay cheque through the year.

It turns out that people like the forced savings, even though it collects no interest. Curiously, some of these people even choose to take their refunds early (for a substantial fee) from an income tax preparer.

Mutual Fund Reported Returns

I wasn’t aware that US mutual funds must report after-tax returns assuming the highest individual tax rate. So, mutual funds that distribute dividend, interest, and capital gains income to unit-holders must take these distributions into account in the after-tax reported returns. Canadian mutual funds don’t have to do this.


Milevsky isn’t a fan of all-or-nothing retirement. Neither am I. It makes much more sense to ease out of working life by dropping to 4 days per week, then 3, and so on.


Milevsky is clearly a smart guy who is able to express his ideas clearly. This book is definitely worth a read.

Tuesday, August 17, 2010

Portfolio Construction Taking into Account Employment

Taking into account the nature of your employment when constructing your investment portfolio makes sense. Stock brokers may not want to expose their portfolios to too much stock market risk because their wages depend on the stock market performing well. However, paying too much attention to risk at the expense of expected returns can lead to problems.

In his book, Your Money Milestones, Moshe Milevsky quotes a study saying that MBA students interested in a Wall Street career should consider shorting the stock market upon entering school.

This is a good example of focusing on risk at the expense of expected returns. It is definitely true that these MBA students are exposed to stock market risk. If the markets perform poorly while they study, their job prospects upon graduating may be grim. Shorting the stock market would yield profits in this case and reduce their overall financial risk.

However, stocks have a built-in tendency to go up. We may disagree on how large the risk premium is, but it does exist. Another point is that those who short stocks are charged a form of interest on the borrowed stocks. This interest would build up over the course of a few years.

If the stock market remained exactly flat while the MBA student studied, he or she would lose money on the short position and would probably run into a tough job market.

It is dangerous to focus on expected returns and ignore risk. But it is also dangerous to focus entirely on risk and ignore expected returns. Constructing a sensible portfolio requires taking into account both factors.

Monday, August 16, 2010

Do Investors Need Advice?

We often hear the following two seemingly contradictory claims:

1. Most investors need financial advice.

2. Most investors should get rid of their financial advisors.

How could these both be true? The answer boils down to what we mean by advice. If you imagine the advice coming from a savvy investor who has your best interests at heart, then you would do well to listen. In this case, even experienced do-it-yourself investors could benefit.

Investors need good advice, not just any advice. If someone suggests that you borrow $100,000 and bet on red at the roulette table $1000 at a time until the money doubles or is gone, this qualifies as advice, but not good advice. (By the way, your chances of doubling your money this way are less than 1 in 30,000!)

Unfortunately, in the mutual fund world, “advice” means whatever tactics a mutual fund salesperson uses to get your money into a set of funds. Typically, the clients pay about 1% of their assets each year for this so-called advice.

So, if you’re in a debate about the value of financial advisors, you should happily concede that most investors need advice. Just be clear that this doesn’t mean that most investors need to pay 1% of their assets each year to a salesperson. There are cheaper ways to get advice of higher quality, such as paying a competent expert for a couple of hours of his or her time.

Friday, August 13, 2010

Short Takes: Warren Buffett as Poster Child, Worsening Credit Card US Dollar Exchange Rates, and more

1. Preet thinks that Warren Buffett is not a poster child for active management. I agree that Buffett’s approach doesn’t bear much resemblance to the typical actively-managed mutual fund. However, Buffett is an active manager in the broad sense that he doesn’t own the index. I think Buffett’s approach is the only one that has a hope of consistently outperforming. I don’t have the skill, but it is conceivable that some investors can see that a given company has above-average long-term prospects. This seems more plausible than believing that some people can anticipate short-term moves without inside information.

2. Canadian Capitalist explains changes to credit card agreements that give us worse US dollar exchange rates.

3. Potato wrote an excellent review of Benoit Mandelbrot’s book, The Misbehavior of Markets.

4. Thicken My Wallet explains the latest changes to car insurance in Ontario.

5. Mike at Money Smarts thinks that now is a good time to start leveraged investing. What if it isn’t a good time?

6. Ever wondered how an expensive restaurant menu item can affect you even if you don’t order it? The story of the $69 hot dog explains it. Hat tip to the Stingy Investor for pointing me to this one.

7. Big Cajun Man’s Registered Disability Savings Plan (RDSP) saga continues. It seems that bank and government systems are not overly prepared for the RDSP.

8. Canadian Mortgage Trends is tracking efforts to standardize mortgage penalties.

Thursday, August 12, 2010

Rule of 72 Revisited

Most of us have heard of the rule of 72. If you are paid an interest rate of say 6%, then it takes about 12 years to double your money. The “rule of 72” part comes from 6 times 12 equals 72. Similarly, it would take only about 8 years at 9% interest. However, this so-called rule is just an approximation.

When you multiply an interest rate in % by the number of years it takes to double your money, you get the following chart:

The rule of 72 turns out to be exactly accurate at about 7.85%. But up at around 26%, it should be called the rule of 78. Down around 1% or 2%, it should be called the rule of 70.

Blindly applying the rule of 72 for interest rates of 1% and 2% gives answers that are slightly off. The real times to double your money are about 70 and 35 years rather than 72 and 36 years.

This kind of error certainly isn’t a big deal when doing back-of-the-envelope calculations, but I prefer to know when rules are accurate and when they are just approximations.

Wednesday, August 11, 2010

Human Capital

The concept of human capital is an interesting one. A young person may have no significant assets other than the potential to earn money over his or her lifetime. This potential is called human capital. Over time, we turn our human capital into actual assets.

Moshe Milevsky does a good job explaining the idea of human capital in his book, Your Money Milestones. He gets his students to create a personal balance sheet. The first versions they produce are usually depressing; they are full of student loans and few assets. Then he teaches them about human capital. They work out their expected income over their working lives and add that to the balance sheet. Presto! Now they are millionaires.

Human capital is definitely a worthwhile concept in personal financial decisions. However, it is misleading to include future income without considering future needs. We all need water, food, clothing, and shelter. Even the most basic versions of these things have a cost. Nobody wants to end up old and alone eating cat food.

A lifetime of these basic costs should be included in any balance sheet that includes human capital. Without considering lifetime basic costs and the consequences of not having enough money to maintain a minimum standard of living, people may be enticed into taking too much risk.

An example of taking too much risk is Milevsky’s smoothing of consumption over a lifetime. By considering human capital without thinking about future basic human needs, young people may be enticed into excessive consumption that risks their futures. Most young people don’t need more reasons to spend money.

Tuesday, August 10, 2010


The abbreviation ETF stands for exchange-traded fund. It used to mean a basket of equities making up some broad index where the annual fees charged were very low. As investors came to understand that ETFs were good, the name “ETF” began to be used for just about any type of investment.

At first it was very narrowly-focused exchange-traded funds that got in on the ETF name. It’s hard to argue that this was really an abuse of the name, though, because these funds were, in fact, exchange-traded. But they were different from the original ETFs in important ways. Firstly, they had higher fees, and secondly, they did not represent a broad index (as Preet observed recently).

For a while I tried to use the cumbersome term “low-cost broad-index ETF” to get at the original meaning of ETF, but that’s not a very catchy name.

Lately, the name ETF has been attached to index mutual funds as well. Because mutual funds aren’t exchange-traded, this is hard to justify other than with the we-will-make-more-money-using-this-misleading-name justification. As long as the general public thinks ETF=good, we can expect the use of “ETF” to expand further to apply to ever more expensive investments.

I’m officially declaring the name “ETF” dead for having any specific useful meaning. To be precise, you’ll have to use some long list of qualifiers along with “ETF” to avoid its various marketing uses.

Monday, August 9, 2010

Owning a Home vs. Renting

Moshe Milevsky thinks that many homeowners should have rented. In his book, Your Money Milestones, he makes many good points to support his conclusion. However, there is a compromise choice that may be better than either typical home ownership or renting.

One of Milevsky’s arguments comes down to a correlation between wage risk and the investment risk in owning a house. If a big local employer leaves town, people lose their jobs and at the same time see the value of their houses drop.

Another of Milevsky’s arguments is that houses represent too high a percentage of the typical homeowner’s net worth. Having all your money tied up in one house is similar to having your entire portfolio tied up in one stock.

Milevsky does discuss some of the benefits of home ownership. There can be social benefits to having stable neighbours who help each other. To this I would add the benefit of not having to interact with a landlord.

I don’t see this as a binary choice. A compromise that would help many people would be to own a smaller, less costly house. I see too many people who say that they need a bigger house, but their current house is full of junk they don’t use. Amassed stuff is clogging up their lives.

I’m not talking about the extreme cases of clutter dealt with in some television programs. I’m talking about the majority of people who make the parts of their house that others see fairly presentable, but have almost all storage space and maybe a room or two jammed up with useless junk. When baby comes, it may be a better idea to throw away junk instead of buying a bigger house.

If people limited their mortgage payments to say 20% of their income instead of the currently accepted limit of about 30%, they would look much better against Milevsky’s criticisms.

For those whose income is modest compared to the cost of houses in their chosen neighbourhoods, buying a less expensive house might not be an option. For these people, Milevsky makes a strong case for renting. When buying a less expensive house in an option, aspiring homeowners would do well to consider this option seriously.

Friday, August 6, 2010

Short Takes: Warren Buffet’s Mr. Fix-it, Defending DSCs, and more

1. CNN Money Fortune did a very interesting profile of David Sokol who they describe as Warren Buffet’s Mr. Fix-it. Hat tip to the Stingy Investor for pointing me to this one.

2. Dan Richards defends Deferred Sales Charges (DSCs). I’m not swayed by his arguments, but it’s important to study opposing points of view. How else can you tell when you’re wrong?

3. Canadian Capitalist had some harsh words about a web site’s financial tune-up services. The retorts were entertaining, but far from relevant.

4. Preet takes BMO to task for trying to add “ETF” to their index mutual fund names to cash in on the popularity of ETFs.

5. Gail Vaz-Oxlade hates the Credit Score and backs up her strong words with sound reasons why the credit score system has problems.

6. Money Smarts has another funny tenant from hell story.

7. Big Cajun Man is fretting about his huge cash outlays for his kids’ schooling.

8. Planning a trip to Europe? Million Dollar Journey has a list of 8 ways to save money in Europe.

9. Financial Highway explains that while a credit card can be for emergency purchases, it shouldn’t be an emergency fund.

Thursday, August 5, 2010

Wild Portfolio Outcomes

Most investment analysis is based on the assumption that returns follow a Gaussian or Normal distribution. However, examinations of available data show that returns don’t exactly follow this pattern. Benoit Mandelbrot of fractal fame suggested the Cauchy distribution as an alternative that may agree better with real-life investment data.

To illustrate the difference between these two theories, suppose that you invest money over a period of time, and based on historical data, you expect to have $1 million on a certain date. Suppose further that historical data suggests there is a one in ten chance that you'll actually have $750,000 or less. What is the chance that you'll actually end up with $250,000 or less?

The Gaussian distribution says that the odds of this bad outcome are less than one in a billion. However, the Cauchy distribution says that the odds of this bad outcome are just over 2%! This is an enormous difference.

The available evidence shows that real life investing is wilder than the Gaussian distribution, but not as wild as the Cauchy distribution. Beware any investing advice based too strongly on calculations using just one of these distributions.

Wednesday, August 4, 2010

Pet Insurance is Hard to Justify

With the skyrocketing veterinary costs for pets, many insurance companies are offering pet insurance. However, it's hard to find a good reason why pet owners should buy such insurance.

The main idea behind insurance is to reduce risk. Suppose that you are forced to do a random draw of one ball out of 1000 lottery balls. If you pull the one bad ball, you have to pay $100,000. If you pull any of the other 999 balls, you pay nothing.

It would be nice to buy insurance to cover the case where you pull the bad ball. In a simple analysis, this insurance premium should be $100. Out of 1000 people, we expect only one to pull the bad ball, and then the total premiums of $100,000 would exactly cover the required payment of $100,000.

However, insurance companies have overhead and expect to make profits. They are more likely to charge $200 for this coverage. This illustrates an important point. The total of insurance premiums that you pay is expected to be more than the amount the insurance company will pay out for your coverage. If this isn't true, then the insurance company will go out of business quickly.

It may still be worthwhile to buy the insurance for $200 if having to make a payment of $100,000 would be so devastating to your life that you can't take that chance. This is the real benefit of insurance – covering low probability costs that are so large that they would devastate you.

Getting back to pet insurance, would you really agree to life-saving treatment for Fluffy if it would devastate you financially? I don't mean a $3000 operation. I'm talking about an amount so large that it would devastate you. The answer is very likely no. Of course, any reasonable pet insurance wouldn’t cover extremely costly treatment anyway.

Hang, on you might say. I'd still like to be covered for that $3000 operation. After all, who wants to shell out $3000? Keep in mind that the insurance company will charge much more in premiums than what is needed to cover these operations. Having insurance is very likely to be more costly than just paying as you go.

We make an exception for health coverage on people because we are willing to go to great lengths and expense to save people's lives. As much as we love our pets, few people are willing to go to the same lengths (and costs) to save a pet.

There is an emotional aspect to this that actually makes little sense, but does affect pet owners' decisions. Insurance advertising and terminology create the feeling that having insurance will somehow stop bad things from happening. Having insurance "protection" does not stop bad things from happening. It just pays for some of the treatment. Buying pet insurance will not stop Fluffy from getting sick or injured. Buying pet insurance won’t help Fluffy; it allows you to overpay for treatment in return for reduced volatility of payments.

In the end I suspect that many people will buy pet insurance even though it is a poor financial choice. Between the misunderstanding about how premiums exceed expected benefits and having the vague feeling that pets will be safer if covered with insurance, many will likely buy such insurance.

Tuesday, August 3, 2010

In Search of New Money Management

A reader, Bill in Albuquerque, asks the following question (lightly edited):

I have $1 million in a retirement account that I can’t get at yet (and don't need for another 10 years or so—I'm 59).

The equity firm that has this IRA account now (not my employer—I retired 5 years ago) has been doing a lousy job, IMHO, for their 1%/year expense.

Do you have any suggestions as to what other options might be available to me as a place to invest that money?

I've thought of Max Advisor and have talked with the manager. I have also thought of managing an ETF portfolio based on Kiplinger recommendations.


My starting point for financial matters is always personal education. You are unhappy with your current money manager, but why? Perhaps you have good reasons. To assess a money manager, you should make sure you understand your current investments. What is the breakdown of stocks, bonds, real estate and other asset categories? Are the percentages appropriate for you?

Does your portfolio have undue concentration in one asset class or sector or country that unduly raises its riskiness? Is the expense you pay really just 1% per year or are there other hidden expenses? How has your portfolio fared against an appropriate blend of indexes?

If you have learned enough about investing, you should be able to answer these questions and be in a good position to judge whether your current money manager is doing a good job.

As for a new money manager, even the option that costs 0.5% to 0.75% represents $5000 to $7500 of your money each year. You are entitled to know what approach a new money manager would take with your money. If you have learned enough about investing, you should be able to understand the new money manager’s answer. If not, run—I wouldn’t work with someone who sets out to baffle me.

In the end it makes sense to learn investing basics whether you are a do-it-yourself investor or intend to hire a professional. You don’t have to be able to analyze a company’s financial filings, but you should know the difference between stocks and bonds, how to figure out your total expenses, and understand the relationship between risk and reward. With this information you’ll be in a better position to judge whether the pros are doing a good job for you.

Another good thing to understand is that nobody can predict major market moves accurately. If you can’t live with a major stock-price correction, don’t bother trying to find a money manager who can time the market for you because they don’t exist.