Friday, April 30, 2010

Short Takes: Currency Conversion Shopping Trap, Lowering Utility Bills, and more

1. MoneyNing warns of a currency-conversion catch while shopping in a foreign country.

2. Big Cajun Man politely asks for a break on his Roger’s bill and gets it.

3. Jason Zweig reports on a research finding that people often can’t make good decisions even with full and clear disclosure.

4. Have you ever bought the wrong stock or bought the wrong amount? Preet explains the phrase “fat-finger trade”. Another good post from Preet is some advice he and his girlfriend are learning the hard way: don’t sign contracts at your door.

5. Canadian Capitalist takes the Fraser Institute to task for perpetuating the myth that taxes have risen steadily over time.

6. Larry MacDonald generated quite a stream of comments with his discussion of the sustainability of the retirement system and flat taxes.

7. Patrick makes a case for renting rather than buying a home.

8. Gail Vaz-Oxlade has an excellent rant making the case that debt isn’t normal.

9. Scott Ronalds outlines the problems with Canada’s mutual fund industry and describes the UK’s solution.

10. Frugal Trader does a detailed comparison of Smartphone/iPhone plans.

11. Madison is still able to keep up with her 0% balance transfer credit card arbitrage. You had better be disciplined and organized if you want to try this one.

Thursday, April 29, 2010

A Nearly Sure 6% Return?

In these days of low fixed-income returns, preferred shares of Canadian banks are offering impressively high rates. In some case the dividend yield is above 6% per year. What gives?

Let’s take Bank of Nova Scotia series 12 preferred shares (ticker: BNS.PR.J) as an example. As I write, these preferred shares are trading for $21.65 and pay a dividend of $1.52 per year (actually a half-cent more than this). This is a dividend yield of 6.08%.

According to the prospectus, Bank of Nova Scotia can redeem these shares any time after 2013 October 29 for $25 each. So, you either get to keep collecting your 6.08% each year or they take the shares off your hands for a capital gain of $3.35 per share. This sounds like heads I win and tails I win.

Lenders are still offering rates on 3-year closed mortgages below 4%. So, there is a spread of over 2% between what you could pay for a mortgage and what you could collect on these preferred shares.

There is always the possibility that Bank of Nova Scotia could default on its obligations, but how likely is that? This all seems too good to be true. What am I missing?

Wednesday, April 28, 2010

EcoENERGY Program Update

Nearly 8 months ago, I bought a new furnace and took advantage of the ecoENERGY program to reduce my total cost. After only 34 weeks (!) the last cheque from the provincial government arrived. The process definitely hasn’t been speedy, but I did actually get all the money I was promised.

I must admit that the whole thing felt a little like a scam in the beginning. The salesman wanted me to buy a furnace and pay for an ecoENERGY audit up front with the promise that I’d get lots of money back down the road. This doesn’t sound much different from being asked to send in a fee so that some supposed huge lottery win can be released.

Counting sales taxes, I paid $4209 for the furnace and another $420 for the energy audits. Then very slowly over time I got the following rebates:

$790 federal furnace grant
$790 provincial furnace grant
$150 provincial energy audit grant
$125 provincial power authority grant
$150 gas supplier grant
$145 furnace seller rebate
$481 home improvement income tax deduction (15% of $4209 minus $1000)

Net Savings: $2211 (after deducting the $420 for the energy audits)

The final cost of the furnace to me is $1998, which is less than half of the starting price. I even got an extra $389 in rebates and income tax savings for replacing a patio door. Unfortunately, the somewhat confusing message at the ecoENERGY site seems to indicate that the program is now closed to people who haven’t already started the process.

So, I can confirm that the process that used to exist worked as advertised in my case. If the rebates hadn’t taken so long to come in that the program expired in the interim, this message may have been more useful to readers.

Tuesday, April 27, 2010

An Unflattering Thousand-Foot View of Hedge Funds

Hedge funds are a murky area of investing for me. They are often characterized as only being suitable for sophisticated investors with large portfolios. This gives the impression that hedge fund investors are having a party making lots of money while the rest of us are going to work every day and making little on our savings.

However, I don’t see why it takes much sophistication to hand over a fat cheque to a hedge fund manager. Combine that with the fact that hedge funds as a whole don’t seem to outperform the market generally, I don’t think that hedge funds deserve their reputation.

From what I learned about a few different hedge funds, here is my own (possibly flawed) view of the typical hedge fund:

1. Some very clever guy develops a trading strategy with a good chance of outperforming the market and a small chance of going bust.

2. This clever guy doesn’t want to risk his own money because of the possibility of going bust.

3. He has the bright idea to start a hedge fund to use his strategy and collect fat performance fees if the fund does well.

The great thing about this approach is that the hedge fund manager doesn’t lose any of his own money if the fund goes bust. The manager takes a big slice of the upside and leaves all of the downside for the chumps investors.

This model works well for the manager even if the fund’s expected return taking into account all possibilities is less than the market’s expected return. Even if the fund blows up after a few years, the manager will get his fees up to that point.

No doubt this isn’t a fair characterization of all hedge funds, but I certainly wouldn’t invest in a hedge fund until I was fully satisfied that it didn’t match this general description.

Monday, April 26, 2010

Portfolio Alternatives

Last week we analyzed the mutual fund holdings of an investor named Tim. Now we’ll look at ways to replace his mutual funds with alternatives that don’t cost as much. The goal will be to construct a portfolio with the same asset allocation but lower costs. The two approaches I’ll look at are TD e-series index funds and exchange-traded funds.

Tim’s asset allocation is as follows:

56% Canadian stocks
16% foreign stocks (including US)
28% bonds

The blended MER of his holdings is 2.45% per year.

I won’t address the question of whether this is an appropriate allocation for Tim. I believe that it is within a reasonable range, but this discussion is a distraction for the question of whether Tim’s advisor is worth the extra costs. The starting point is to see how cheaply Tim can get essentially the same portfolio as he has now.


TD e-series approach

To match this allocation with TD e-series funds, Tim could get the following:

56% TD Canadian Index Fund (MER 0.31%)
8% TD US Index Fund (MER 0.33%)
8% TD International Index Fund (MER 0.48%)
28% TD Canadian Bond Index Fund (MER 0.48%)

The blended MER of these holdings is 0.37% per year. This is a savings of 2.08% per year over Tim’s current mutual fund holdings. For a $100,000 portfolio, the savings are $2080 per year.

ETF approach

Another approach is to buy exchange-traded funds (ETFs) that trade like stocks on stock exchanges. The main advantage of this approach is that the MERs are even lower. Here is a possible ETF allocation to roughly match Tim’s current allocation:

40% iShares S&P/TSX 60 Index Fund (ticker: XIU, MER 0.17%)
16% iShares S&P/TSX SmallCap Index Fund (ticker: XCS, MER 0.55%)
28% iShares DEX Universe Bond Index Fund (ticker: XBB, MER 0.30%)
16% Vanguard Total World Stock ETF (ticker: VT, MER 0.30%)

The blended MER of these holdings is 0.29%. Tim would save $2160 per year less trading costs based on a $100,000 portfolio. Trading costs include trading commissions (often $10 per trade) plus half of the bid-ask spread on each trade. These spreads tend to be very low on the ETFs chosen here.

Comparison

The choice of whether to go with TD e-series funds or ETFs is mainly based on costs. Trading costs will depend on how often money is added to the portfolio and how many different accounts the portfolio is split into. Combining this with the MER costs, the TD e-series funds will look better below a certain portfolio size, and the ETFs will look better for larger portfolios.

Conclusion

The alternatives presented here are not exactly the same as Tim’s current holdings, but they are fairly close. The main advantages are that the approaches described here are

1. Much cheaper
2. Better diversified
3. Free of punitive deferred sales charges (TD only charges up to 2% for selling within 90 days of purchase)
4. Under Tim’s personal control

Having greater control over his portfolio is also a potential disadvantage for Tim. There would be no advisor to hold his hand and possibly stop him from panicking the next time the market drops. Only Tim can decide if the advice he gets is worth the added cost of his mutual funds. The important thing is to understand what these costs are to make an informed decision.

Friday, April 23, 2010

Short Takes: Cheaper Generic Drugs, House-Buying Advice, and more

1. The Ontario government is taking on the pharmacy industry to reduce the cost of generic drugs.

2. Buying a house is an emotionally-charged decision. Seth has some advice on how to think about buying a house. I recommend this article as a good way to put your choices in perspective. Thanks to frequent commenter Gene who pointed me to this piece.

3. Apparently 62% mortgage-holders plan to carry their mortgage into retirement. Jonathan Chevreau sensibly tells them to give their heads a shake.

4. Canadian Capitalist explains that US estate taxes are set to rise and that this can affect Canadians. From what little I’ve seen, the calculations are complex.

5. Rachelle at Million Dollar Journey gives a clear and detailed account of the issues in the battle between CREA and the Competition Commissioner over the Multiple Listing Service.

6. The world of ETFs isn’t so simple any more as Tom Bradley explains. Instead of “ETFs are a great low-cost method of index investing,” we now have to say “some ETFs are a great low-cost method of index investing”.

7. See Larry MacDonald’s latest thoughts on the cost of currency conversions between the Canadian and US dollar in an RRSP.

8. The Big Cajun Man gets the nod for best headline related to the Icelandic volcano.

9. Preet warns that travel insurance will no longer cover interruptions due to the Icelandic volcano now that it is a known problem.

Thursday, April 22, 2010

Portfolio Analysis

Most people are insecure about their investments. Others seem so confident, and we’re afraid of being ridiculed for our pathetic investment choices. An acquaintance I’ll call Tim was brave enough to show me his holdings for some analysis. Tim has been working full time for about 5 years and has managed to build up some savings in mutual funds.

Tim’s holdings are concentrated enough that I’ll try taking a more detailed look than usual. Keep in mind that I don't do this professionally. I like to give people information so that they can make their own choices.

To keep Tim's personal information mostly private, he has scaled his holdings so that the total is $100,000. His real portfolio may be larger or smaller than this. Here are his mutual fund holdings:

$5000: AGF Global Value - FE
$38,000: AIC Canadian Balanced - DSC
$27,000: AIC Diversified Canada - DSC
$11,000: AIC Global Premium Dividend Income - DSC
$19,000: Fidelity Canadian Balanced - ISC

$100,000 Total

For me, the first step is to figure out what Tim has. My sources of information are Globefund, Morningstar, and the company prospectuses (AGF, AIC, and Fidelity).

Here is my best effort to figure out the key data about these funds. The accuracy of this information depends on the accuracy of my sources and my ability to ferret out the information correctly. I make no promises.

AGF Global Value - FE
-- 100% foreign stocks
-- MER 2.81%
-- Front-end load negotiable to maximum of 6%
-- Trailer commission 1% per year

AIC Canadian Balanced - DSC
-- 50% Canadian stocks
-- 50% Bonds
-- MER 2.50%
-- Deferred sales charge 6% first year, declines by 0.5% each year to 3% in 7th year, then zero after 7 years
-- Trailer commission starts at 0.5% increasing to 1% after 8 years

AIC Diversified Canada - DSC
-- 100% Canadian stocks
-- MER 2.53%
-- Deferred sales charge and trailers same as AIC Canadian Balanced

AIC Global Premium Dividend Income - DSC
-- 100% foreign stocks
-- MER 2.63%
-- Deferred sales charge and trailers same as AIC Canadian Balanced

Fidelity Canadian Balanced - ISC
-- 50% Canadian stocks
-- 50% Bonds
-- MER 2.03%
-- Initial sales charge (front-end load) negotiable to maximum of 5%
-- Trailer commission 1% per year

All the funds are actively managed, which means that they attempt to beat market averages by strategically buying and selling equities, despite the strong evidence that such efforts are fruitless for the majority of fund managers.

Because Tim was unaware that he was paying any front-end loads, I'll assume that he paid the maximum in each case.

The MER is the Management Expense Ratio which is the fees paid by Tim each year to the funds. Because funds tend to underperform market averages by the amount of the MER, Tim can think of the MER as a rough estimate of the cost he pays each year for the privilege of owning the fund and receiving advice from his advisor.

The trailer fees are paid to the dealer (the advisor who sold Tim his funds) and come out of the MER. So, this isn't an extra expense, but it does give some idea of the advisor's motivations.

Here are some fee totals taking into account the dollar amounts in each fund:

Front-end charge:
$1250 (The advisor actually received $5050 with the added $3800 paid by the DSC finds. The funds will recover this money from Tim through MERs or deferred sales charges if Tim sells before 7 years.)

MER paid each year:
$2449

Trailer fee for advisor (paid out of the MER):
$610 to start and growing to $1000 per year

The MER and trailer fees will actually grow (or shrink) as Tim's portfolio grows (or shrinks).

Each of these funds holds various stocks and bonds. Overall, here is Tim's asset allocation:

56% Canadian stocks
16% foreign stocks
28% bonds

The stocks are primarily large cap stocks.

Note that I haven't looked at the performance of these funds at all. Whether stocks and bonds go up or down, these funds are likely underperform the market averages by about the amount of the fees they charge.

Asset allocation is a personal choice, but I'd say that Tim's is in a reasonable range for a young guy. My choice is always for more stock ownership, but this isn't for everyone. Sleeping at night matters. Selling at market lows out of fear is a disaster.

Overall, I'd say that the MER that Tim is paying (2.45%) is quite high. For a $100,000 portfolio he is paying $2449 per year. If his portfolio is actually $20,000, then this is only $490 per year, and if it is $500,000, the MER is a whopping $12,245 per year. It is up to Tim to decide if the advice he is getting from his advisor is worth the amount he is paying in fees.

For comparison purposes, the next step (in a future post) is to try to build a portfolio with a similar mix of investments using lower cost products.

Wednesday, April 21, 2010

A Proposed Break on RRIF Withdrawal Taxes

Andrew Dunn of Deloitte Canada has some ideas quoted at the Wealthy Boomer on changing the way RRIF withdrawals are taxed. On the surface these ideas seem to make a lot of sense, but on analysis, the reasoning breaks down.

As things stand now, when you pull money out of an RRSP or RRIF, the amount gets included in your income for the year. Over the years this tax-sheltered money grows through capital gains, dividends, and interest, but none of that matters when filing your taxes; all withdrawals become regular income that is taxed at your top rate.

Dunn suggests that the type of returns should be tracked so that when you withdraw the money, it gets taxed as capital gains, dividends, and interest so that some of it will be taxed at lower rates.

This seems reasonable at first, but it ignores the real nature of RRSPs. An RRSP is a vehicle for deferring taxes. Your contributions are untaxed in the year you make them and get taxed when you withdraw them.

Let's consider an example to illustrate why the current system makes sense. Sally opened a new RRSP with a $10,000 contribution. Her marginal tax rate is 40%. If she hadn't made the RRSP contribution, she would have kept $6000 and paid $4000 in additional income taxes.

Sally should think of the $10,000 sitting in her RRSP as being $6000 for her and $4000 for the government. In this sense, $6000 in a TFSA has about the same value to Sally as $10,000 in an RRSP (assuming her tax rate is also 40% when she pulls money out of the RRSP).

Fast-forward 25 years. Sally's $10,000 has grown to $100,000, and her marginal tax rate is still 40%. This money is still only 60% hers. The whole amount grew by a factor of 10, and her portion grew by a factor of 10 from $6000 to $60,000.

If we focus on Sally's portion, it has grown completely tax-free. The growth of the government's portion will cover the taxes owing. So she will get all of her portion over time without having to pay any additional taxes on its growth.

Any further tax breaks Sally might get along the lines of Dunn's proposal are outside the intent of RRSPs. Additionally, the complexity of tracking the nature of all the gains would be a burden.

If the government wants to give additional tax breaks to people making withdrawals from RRSPs and RRIFs, something simple like making the first $3000 withdrawn each year tax-free is preferable to Dunn's proposal that would require significant accounting information to be retained for decades.

Tuesday, April 20, 2010

Income Tax Myths

I don’t normally do much with the many marketing emails I receive, but UFile sent a good list of common myths about income taxes. Enjoy.

If I make a mistake on my tax return, the CRA will correct it for me.

FALSE. The Canada Revenue Agency will correct mathematical errors and add income that you may have missed on your return. However, if you miss credits or deductions, or if you do not transfer amounts to your best advantage, the CRA is not obliged to correct the return.

I should get a tax refund every year.

FALSE. Getting a tax refund means that you have been effectively lending the government your money. This is especially true when your refund is a result of year-long RRSP contributions or childcare expenses. These are items that can be taken into consideration by your employer when calculating deductions at source. Some of us prefer this kind of "forced savings" with a payoff in the spring, but it is important to understand the source of these funds.

Once I get my refund, I am free and clear.

FALSE. The Canada Revenue Agency will initially assess your return without receipts or supporting documents. However, they have the right to review your return, ask for documents and look for errors such as unreported income or miscalculated transfers. If you are asked for supporting documents, do not delay sending them to the CRA to avoid re-assessment.

If I make a mistake or forget something on my return, I should file a new one.

FALSE. If you have made a mistake on your tax return, the best way to inform the CRA is by using a T1 Adjustment (T1-ADJ). It is easy to prepare in UFile. Simply select it from the Interview setup section and complete the form, which shows which line needs to be adjusted, the previous amount and the corrected amount. Add a handwritten explanation for the change and print and mail in the form.

All NETFILE-certified tax software is of the same quality.


This is FALSE. The CRA testing for NETFILE does not grade the quality of the software but rather its ability to create a .tax file that can be read by its systems. Certain criteria must be met, but these do not apply to user-friendliness or the ability to find deductions to get the best possible result.

Monday, April 19, 2010

Saving Money on Appliance Repairs

One of the many benefits of the internet is the availability of information on how to fix appliances. Over the years I’ve managed to save money by fixing a washing machine, a vacuum cleaner, a heater, and most recently, a dishwasher with the help of online information.

Some repairs are simple enough that I am able to figure them out myself, but I was out of my league with the dishwasher. The water was just dribbling around inside instead of firing around, and the dishes were staying dirty. After staring at the dishwasher’s innards for a while, I would certainly have given up without some online help. It didn’t help that this dishwasher didn’t come with a user’s manual. It only had an installation manual.

Past experience with calling repair people tells me that the minimum charge is about $100 plus the obligatory replaced part. Add in taxes and it’s hard to see how the total could be less than $200. Not only did I not want to spend $200, but I wasn’t sure whether I would be throwing good money after bad on a dishwasher that should be replaced.

After poking around online for a while, my wife found a web page whose instructions on cleaning out the food filter seemed to match our dishwasher. I wouldn’t have guessed how to remove the parts necessary to get at the filter without these instructions.

A half-hour later (with some moaning from me about a sore back from working awkwardly) we had a functioning dishwasher again thanks to some kind person who posted useful information.

I’m probably just being paranoid, but I wonder if the lack of a user’s manual for my dishwasher (a Kenmore made by Whirlpool sold by Sears) is an attempt to increase repair calls. It’s not that I lost the manual; from online searching, it doesn’t seem to exist. Fortunately for me, useful online information is cutting into the incomes of repair people.

Friday, April 16, 2010

Short Takes: Rising House Insurance Premiums, US Dollars in RBC RRSPs, and more

1. Rob Carrick says that house insurance rates are going up.

2. Canadian Capitalist reports that RBC will start letting clients hold US dollars in their RRSPs and TFSAs. This may not sound like a big deal, but it can save big dollars on currency conversion when buying and selling US securities in your registered account.

3. Big Cajun Man outlines the rules for rolling registered accounts over to disabled children.

4. Larry MacDonald doesn’t like tax thresholds that don’t automatically rise with inflation. I don’t blame him. Hidden tax increases don’t sit well with me either.

5. Preet reviews the Apple iPad with action pictures. A good quote: “It’s definitely a winner. But you don’t NEED it.”

6. Million Dollar Journey has some advice for those interested in buying a car at an auction.

Thursday, April 15, 2010

A Sign of Imminent Personal Financial Disaster

On a recent golfing trip in the Orlando area, I was in line waiting to pay for groceries. Finally, the young family ahead of me reached the point where they were paying for their food, but there seemed to be some sort of credit card problem. The problem turned out to be of a different sort than I first thought.

I wasn't paying much attention initially, but they seemed to be swiping credit cards multiple times. As I watched more closely, the process of swiping multiple cards and punching in codes continued. I thought that maybe the machine wasn't working. Then I thought that maybe their cards were being refused. But they were successfully charging some money to each card.

I think the true explanation was that they were spreading the cost of the groceries across multiple cards, charging less than $100 to each one. I can't say for certain how many cards they swiped, but it seemed to be at least four.

The best theory some of my friends came up with was that the couple were keeping the charges under the threshold where full authorization is required. Presumably, their cards were over the limit or some other similar type of problem.

I can't imagine what it would be like to be in such bad financial shape that I would have to resort to such tactics just to eat.

Wednesday, April 14, 2010

Sticking to a Plan

We often hear the investing advice “have a plan and stick to it.” Unfortunately, these words don’t seem to convey the intended meaning to the investors who most need to hear it.

When I first started DIY investing, if someone gave me this advice, I would have thought “my plan is to invest in things I think will go up and sell the things I think will go down, and I’ll stick to that.” Unfortunately, this has little to do with what people mean by the sticking-to-a-plan advice.

A big problem for many investors is following the herd. They buy the hot stocks at sky-high prices because everyone seems to like those stocks. Later they sell holdings at low prices because everyone seems to think selling is a good idea. Following the herd can cost you a lot of money if you act after the herd has acted.

An example of a plan is to have a particular asset allocation with fixed percentages of your assets in stocks, bonds, etc. Sticking to a plan means not abandoning these percentages when the investing herd is thundering in one direction and you’re tempted to follow them.

I’d like to find some other way to express these ideas other than “have a plan and stick to it” because I don’t think this expression helps novice investors much.

Tuesday, April 13, 2010

Findependence Day

The book Findependence Day is a work of fiction that teaches financial lessons in the style of The Wealthy Barber. The author, Jonathan Chevreau, is a personal finance columnist for the Financial Post and National Post.

Trying to marry compelling fiction with financial lessons isn’t easy. I was curious to see how Chevreau would try to do this. It was obvious from the beginning of the story that the finance parts were going to be central. The first page contains financial lessons. You might think that this means the fiction part took a back seat, but this didn’t turn out to be the case.

By the time I got about a third of the way through the book, I was hooked on the story. It’s not exactly a Stephen King thriller, but I was hooked enough read the latter two-thirds of the book in a single sitting on a lazy Sunday morning.

I won’t give away the story other than to say that it is about a couple who make plenty of typical financial mistakes, but manage to succeed with the help of some expert advice.

There was one point where the marriage of fiction and finance was a little strained. While an expectant father waits to see his wife who is in labour, he coolly discusses financial matter with an expert advisor. In the hours before my first son was born I could barely string words together.

For the rest of this review I’ll focus on a few of the financial lessons.

Qualifying for a Mortgage

In a discussion of whether the young couple would qualify for a mortgage, the expert says “You qualify if you can fog a mirror.” That line cracked me up. Some home buyers seem to think that banks are doing them a favour by granting them a mortgage, but in reality, the banks are hungry for this business.

MERs

One part I couldn’t make much sense of was “If mutual fund Management Expense Ratios or MERs are running between 2% and 3% a year, they’ll cut your investment returns by 20% or 30% over three or four decades.” A 2% MER for 30 years takes away 45% of a portfolio. A 3% MER for 40 years takes away 70% of a portfolio.

Hacking Online Brokerage Accounts

According to one of the book’s characters, online brokerages guarantee the full amount in an account in the event that some cyber-criminal breaks in and transfers all the assets out. It makes sense to me that brokerages should cover losses in this case, but I was never too sure how it would play out. I’d like to see actual documentation of some sort to confirm that customers have this protection.

One of the main themes of the book is that becoming financially independent is best done slowly by making good financial choices through your life rather than going for the big score. Amen to that.

Monday, April 12, 2010

Obsolete Courses

When I was young, I remember hearing debates among adults about whether high school students should take more “practical” courses instead of so many academic courses. The reasoning was that these practical courses would do a better job of preparing students to make a living.

I came across some old papers from high school that contained course descriptions. One thing that struck me is that the academic courses such as algebra and literature haven’t changed much over the years. But, many of the practical courses are now completely obsolete.

Here are abbreviated versions of a couple of funny ones:

Business Machines II 511:

Students will learn to operate mechanical and electronic adding machines and calculators, and spirit and ink duplicators.

Steno IV 531:

Students will increase their stenographic skill to take dictation at 100 words per minute and to transcribe it accurately using a typewriter.

This doesn’t prove one way or another whether students should take more practical courses, but it does illustrate how utterly useless some skills become. In my youth, teaching cursive writing was central in primary years, but some schools don’t teach it at all now.

Friday, April 9, 2010

Very Short Takes

Short Takes will return next week.  For now I'll point to Gordon Pape's advice on how to avoid charity scams brought to us at the Wealthy Boomer.  Pape provides interesting details on how these scams make themselves appear legitimate.

Thursday, April 8, 2010

Annuities and Inflation

The idea of dedicating a portion of your retirement savings to an annuity can be appealing. Imagine that at retirement you buy an annuity guaranteeing payments of $3000 per month for the rest of your life. This would bring some peace of mind. You could then use what is left of your retirement savings for extras.

The big problem that could upset this tranquil scene is inflation. If the first ten years of your retirement are like the period from 1973 to 1983 in Canada, the purchasing power of your $3000 per month will drop to only $1220 per month! Suddenly, the annuity is bringing much less peace of mind.

By not taking into account inflation, retirees with fixed-payment annuities are effectively overspending in the early part of their retirements, possibly without realizing it.

It is possible to get an annuity whose payments rise by some fixed percentage each year (at the cost of much lower starting payments), but this requires guessing at the rate of inflation. If inflation is higher than your guess for several years, the purchasing power of the annuity will still erode.

An ideal solution would be an inflation-indexed annuity. The idea is that each year, payments would rise with the Consumer-Price Index (CPI) the way that Canada Pension Plan payments do. However, my attempts to find an inflation-indexed annuity in Canada have come up dry so far. Perhaps insurance companies don’t want inflation risk any more than retirees do.

Wednesday, April 7, 2010

Missing the Benefits of Asset Allocation

One of the benefits of maintaining a constant asset allocation is that it forces the investor to buy low and sell high. However, this only works if investors actually do the rebalancing when the asset mix is off.

In a few places now I’ve seen comments from an investor who failed to rebalance during the lowest stock prices a year ago, but that “this is okay because my allocation percentages have almost come back in line.” Unfortunately, this investor has missed the opportunity to profit from rebalancing during the period when stocks went on sale.

To illustrate what I mean, let’s consider an example. As of the first trading day in July 2008, two investors, Adam and Beth each had $100,000 in bonds and $100,000 in the Canadian large-cap index exchange-traded fund XIU. Their intent was to maintain this 50/50 split.

However, Adam didn’t do any rebalancing, preferring to think about anything else other than falling stock values. On the other hand, Beth checked prices on the first trading day each week and rebalanced if the allocation got further out of kilter than 55/45.

Let’s compare their results. To simplify the comparison, we’ll assume that the bonds remained flat and ignore the XIU dividends. The idea is to just see what effect the rebalancing would have.

Adam just rode XIU up and down throughout this volatile period from a starting price of $19.94 per unit to $17.88 per unit.

Adam’s portfolio today:

Bonds: $100,000
XIU: $89,700
Total: $189,700

Beth rebalanced three times:

2008 Sep. 29: Bought $10,900 XIU at $15.59
2008 Nov. 17: Bought $10,500 XIU at $11.90
2009 May 4: Sold $11,000 XIU at $15.23

Beth’s Portfolio today:

Bonds: $89,500
XIU: $105,100
Total: $194,600

Trading just 3 days over nearly 2 years, Beth has come out ahead of Adam by about $4900 using a purely mechanical system requiring no judgement. This is more than enough to cover trading costs. Even if the savings were in taxable accounts, Beth would come out ahead.

Some investors choose not to rebalance ever, and this can be a reasonable approach. However, having a rebalancing strategy, but abandoning it when “things look scary” is just another form of following the crowd.

Tuesday, April 6, 2010

Moving Up to a Larger Home, But not Away

It’s not unusual for someone to buy a starter home and fall in love with the neighbourhood enough to want to stay when it comes time to get a bigger home. Moving just down the street is a lot easier when it comes to carting your stuff to the bigger house, but it can present other problems.

Whenever you buy a house it always has a few issues. Maybe the garage door gets stuck halfway down or the pipes rattle when you turn on the shower. More major problems are possible as well, but the minor annoyances are much more common.

The sellers should have told you about these problems, but didn’t. Maybe they deliberately kept them from you, but maybe they had just lived with the problems so long that they didn’t think about them any more. Either way, you’re likely to just fix the small problems yourself without trying to contact the seller. After all, hiring lawyers for small issues is likely to work out badly for everyone (except maybe the lawyers).

But what if the people who sold you the house moved just a few doors down? Maybe you see them every day just going on about their business as though it’s okay that they didn’t tell you that the garage door doesn’t work right. You’re much more likely to contact them about your new home’s problems in this case.

Now turn things around and put yourself in the shoes of the seller. You’ve sold your small house and moved to a bigger one a few doors down. As far as you’re concerned, the old house was in pretty good shape and you think the new buyer got a fair deal. But now the buyer is hassling you about some silly problem he should take care of himself.

So do you offer to pay for part of the repairs or offer to help do the repair? Or do you get a head start on a bad long-term relationship with this neighbour by blowing him off? Neither choice is very appealing and one of them will cost you money.

A possible remedy is to avoid ever meeting the buyer and avoid giving him your new address. This would probably work reasonably well if you move to another street, but if you’re just a few doors away, one of the other neighbours may let the cat out of the bag.

Of course, the longer it takes for the buyer to find out that you live very close, the longer he’ll have to work through the house’s issues on his own. So, a modest effort to avoid letting the buyer know that you’re within shouting distance may be enough to avoid any hassles.

Monday, April 5, 2010

Short Takes: Fiduciary Duty for Advisors, Karl Marx Day Trading, and more

1. Rob Carrick looks at the possibility of requiring financial advisors to have a fiduciary duty. I think many investors would be surprised to learn that financial advisors don’t have some duty of care similar to a fiduciary duty.

2. Larry MacDonald quotes a paragraph from Karl Marx’s writing showing that he did some short-term speculative trading similar to modern day-trading.

3. Preet asks whether your broker’s bond desk is making undue profits on your bond trades. The best protection I know of is to get both the buy and sell price to check on the spread. Unfortunately, many brokers don’t make this easy.

4. Thicken My Wallet examines some myths about the battle between the Competition Bureau and the Canadian Real Estate Association.

5. Canadian Capitalist explains some handy Google tools for portfolio tracking in a spreadsheet. I find this far better than using the standard portfolio tracking at various web sites. I always want to do calculations that aren’t offered.

6. Mr. Cheap looks at the distinction between middlemen who add value and those who don’t (the web page with this article has disappeared since the time of writing).  The internet has made life difficult for many middlemen, which is a good thing for the long term, but painful for some in the short term.

7. Big Cajun Man runs down his top 5 investing regrets.

8. Tom Bradley makes an amusing open application for employment at Google.

Thursday, April 1, 2010

Dihydrogen Monoxide = H2O = Water

Here is a translation of today's April Fool post:

Sometime in April, it may get cold enough for it to snow. Snow clearing will cost cities money.

Thanks to all the commenters who played along. I had fun reading your contributions. With the holiday tomorrow, I'll delay the Short Takes post to Monday. Enjoy the long weekend.

Dihydrogen Monoxide De-contamination to be Costly for Municipalities

The fact that our atmosphere contains the chemical dihydrogen monoxide is of little concern to people most of the time. However, there is a good chance that it will become an expensive problem for many municipalities sometime in the next month.

Under the right conditions, atmospheric dihydrogen monoxide solidifies slightly causing it to descend. Scientists believe that the conditions will be right sometime in the next month over much of Canada.

Although this phenomenon has only minimal effect on people’s breathing, it can affect the proper operation of motor vehicles. Municipalities are likely to be forced to spend considerable amounts of money trying to deal with this contamination.

Fortunately, it isn’t necessary to eliminate all traces of the chemical entirely. The cost of a complete clean-up would be prohibitive. Nevertheless, costs are expected to be high.

See this update.