Thursday, December 29, 2011

A Vivid Illustration of an Over-Priced Extended Warranty

One of the computers in my house came to the end of its useful life recently. In my house, that means ordering a new computer from Dell. Since I’m a tech guy and have techie friends, I’ve heard time and again how I can save money by buying cheap components and putting the PC together myself. But I’d rather leave it to Dell to put the system together and pay a little extra, but not too much extra.

I prefer to buy online, but the Dell web site didn’t allow me to make all the choices I wanted. This meant having to make a call to Dell. This also meant having to turn down all the high-margin items available as add-ons.

I was pleasantly surprised when the salesperson didn’t press me on an extended warranty after I turned it down; she just went on with the list of other choices. However, when we came to the end, she began a script: “You know sir, you’re buying an expensive computer...”.

For a mere $119 I could extend the standard warranty from 1 year to 2 years. After I turned down this offer a miracle happened and the extra year of warranty dropped to $79 in 10 seconds. After I refused again, it took only 10 more seconds for it to drop to $60. Yet another refusal by me didn’t create any further drops in price.

I don’t know what an extra year of warranty costs Dell, but I’m guessing that it’s much less than $60. This makes the original price of $119 seem like a big gouge.

Tuesday, December 27, 2011

Train Your Brain to Get Rich (or not)

I’m a victim of marketing. The title of the book Train Your Brain to Get Rich by Aubele, Freeman, Hausner, and Reynolds caught my eye, but the title is misleading. The additional words on the cover, “the simple program that primes your gray cells for WEALTH, PROSPERITY, and FINANCIAL SECURITY,” just add to the misdirection. This book isn’t really about money.

As I read through the first quarter of the book, I kept waiting for the financial aspects to begin, but by the hundredth page I suspected that they never would begin, and as I finished the last page, my suspicion was confirmed.

This book is really about brain health and the benefits of such things as a positive attitude, meditating, exercise, sleep, and healthy eating. The superficial financial parts of the book could just as easily be replaced with “train your brain to play better tennis.”

The financial references actually seem as though as though they were added after the fact by a different writer. It’s as though someone took a completed book and added variants of “to get rich” and “your way to wealth” to all the chapter titles. The financial references inside the book are equally superficial.

There are many examples of this financial superficiality within the book, but I’ll give just one. A section that discusses the brain benefits of dreaming is titled “Dream Yourself Rich”. I would have preferred “Dream Yourself to Killer Abs”.

In an effort to say something positive, I found two things. In one section the authors recommend a focus on buying experiences rather than material things, which seems like very good advice. They also quoted studies showing that while caffeine boosts simple mental processes, it does not seem to help with creative pursuits or “thinking beyond the basics.”

Don’t get too positive about what you might learn, though. The reader is also treated to the following claim: “When you’ve identified an intention, focused on it, and made a clear, committed decision to act upon your intention, your mind will open up the universal floodgates, bringing all the resources you need, sometimes in seemingly mysterious or impossible ways.” Thanks for that.

I can imagine a whole series of books about different subjects: “train your brain to make people like you,” or “train your brain to find a girlfriend.” The great thing is that it would probably take only 15 minutes to replace the financial buzzwords to create each new book.

Friday, December 23, 2011

Short Takes: Long-Term Effect of Fees, Cutting Back, and more

This will be the last regular post until next year. I may write one or two before then if the mood strikes. To all my readers, I wish you happy holidays and all the best in the new year.

Where Does All My Money Go? breaks down the effect of mutual fund fees on a 25-year investment. Check out the spreadsheet that lets you enter your own inputs to see how much of your money goes to your advisor, the dealer, and the fund company.

Gail Vaz-Oxlade conducted a poll to find out how much people could reduce their monthly expenses if they had to. The most striking thing about this poll is that the highest category is “15% or more”. I could reduce my expenses by 50%. If I absolutely had to, I could go further by moving my family somewhere cheaper. I think people have a misguided sense of the distinction between necessities and wants. Necessities are food, simple clothing, shelter, education, and not much more.

Canadian Couch Potato interviews Vanguard representatives about their entry into Canadian ETFs and what new ETFs may come in a second wave. I’m particularly interested in U.S. and foreign stock ETFs without currency hedging. See part 2 of the interview as well.

The Blunt Bean Counter shows that there is no advantage to earning income in a corporation because of the way that dividend taxation is integrated with personal taxes. I wonder if maybe there are certain narrow situations where using a corporation can be used to smooth personal income between years. One strange situation would be two people who run a company by each working every other year. They would prefer to declare $75,000 every year rather than $150,000 every other year.

Retire Happy Blog reviews Andrew Hallam's book, Millionaire Teacher.

Tom Bradley takes on the claims that the world's financial troubles are “different this time”. Ironically, one of the ways that things remain the same is that people tend to think that present conditions are different from the past.

My Own Advisor had some fun making a financial version of Christmas poetry.

Larry MacDonald (this web page has disappeared) reviewed Dan Bortolotti’s book MoneySense Guide to the Perfect Portfolio.

Million Dollar Journey says that cash is king. Many readers weighed in on how much cash they keep around for emergencies and opportunities.

Big Cajun Man makes the case for giving cash as a Christmas present.

Thursday, December 22, 2011

Looking Forward to a January 1st Raise

Come January, I’m expecting a huge raise. Most workers get a huge raise at the start of a new year, but they don’t realize it. In the last days of the year, you are taxed at your top marginal rate, but in January the slate is clean and your income is untaxed for a while.

You won’t see any of this on your pay stub, though. Payroll taxes are designed to smooth out the effect I’m talking about by predicting your final taxable income and taking equal amounts of tax off each pay. But your real taxes are based on your actual income using progressive percentages.

For a person earning $100,000 per year in Ontario, after-tax pay at the end of this year is $28.92 per hour, but will rise to $51.11 per hour starting in January (based on 37.5 hours per week and 365.25 days per year). Of course, it will then drop off over the course of 2012.

For most of us who collect a regular income for the whole year, none of this makes much difference, but for those who work irregularly of for irregular pay rates, this effect can be important.

For example, if you’re planning to quit your job to live off your savings for a few years and see the world, it’s better to wait until March than to quit in December. This way you’ll get paid during the high-income period at the start of the year.

If you’re planning to do something that will cause a big change in your income, it pays to understand our progressive tax system and how it affects your final tax bill.

Wednesday, December 21, 2011

The War on Loyal Customers

A friend I’ll call Jerry recently complained about his Maclean’s magazine subscription:
"I see via your magazine insert I can order a year's subscription for Ontario for $53.62 (tax included) whereas I just recently paid $70.86 to renew mine! While I can understand the ‘bonus gift’ difference, I am quite upset that you are gouging (over 30 %!) a long time subscribing customer (over 30 years)."
Jerry went on to demand a refund of the difference, and Maclean’s promised he would get it in 4 to 6 weeks. Of course, the other loyal customers who don’t bother to complain won’t get this refund. Most people believe that loyal customers deserve to be well-treated, but companies seek profits. Apparently, Maclean’s magazine has decided that the most profitable approach is to draw people in with low prices and hope they keep subscribing at higher prices. My guess is that they are right.

This doesn’t mean that I think loyal customers deserve poor treatment; I just don’t think that discussions of what we deserve are relevant (except as a way to extract a refund). Businesses must seek profits to survive. If enough Maclean’s customers stop subscribing because they don’t like paying more than new customers, then Maclean’s will change its practices. The same is true of Maclean’s parent company, Rogers. However, my guess is that more people are willing to give up a magazine for a principle than are willing to give up their television and internet.

Unless more people start to vote with their wallets, expect loyal customers of most businesses to continue to pay higher prices than fickle customers who pay attention to prices. In the mean time, people like Jerry can get lower prices by complaining.

Tuesday, December 20, 2011

Pay Parity

We often hear of unions seeking pay parity with other workers. Invariably, a pay raise and possibly some back pay are required to right the supposed unfairness. No doubt there are legitimate cases, but I suspect that most are not.

My direct experience is mostly with programmers. Organizations have different philosophies when it comes to paying programmers. Some seek the best talent they can find and give them above-average pay. Most offer average pay and get average talent, and still others offer low pay and try to get by with whoever will work for them.

It is too easy for programmers at one company to look at another company’s pay scales and complain. The truth is that most complainers would be rejected if they tried to get a job with the higher-paying company. Superficially, all programmers do similar work, but when we get down to details it is normal for one company’s programmers to be far superior to another company’s programmers. When this is true, demands for pay parity make little sense.

With this experience as a backdrop, I tend to be skeptical of any claim that one group of workers does the same work as another and deserve pay parity. If this were true, why aren’t members of the lower-paying group leaving to get jobs with the higher-paying group? The answer is often that the better workers actually do this and thus create a meaningful difference in talent between the two groups.

Monday, December 19, 2011

The Mythical Volatility Drag of Dollar-Cost Averaging

Dan Hallett at The Wealth Steward accused mutual fund critics of missing the big picture when they focus their criticism on high MER costs. His main point is not so much that MERs are not a problem but that there are other important ways that investors lose money. He claims that one of these ways that investors lose money is due to a volatility drag that comes with periodic investments or dollar-cost averaging (DCA). I’ve done a couple of experiments and can’t find any evidence that this volatility drag exists. In fact, DCA has a slight edge over lump-sum investing.

Hallett explains volatility drag as follows:
“You’ve no doubt scratched your head at why a portfolio’s long-term performance hasn’t quite lived up to expectations. It’s likely that volatility drag is one of the big culprits. ... If a mutual fund reports a 7 percent 10-year rate of return, for example, the only way to have achieved that precise result was to invest at the beginning of that period, hold for the full decade and have no buys or sells in between. ... The investment industry has long preached the benefits of investing a regular dollar amount so that you buy more units of a fund when the price goes down and fewer when it’s up. This intuitive argument just doesn’t hold. ... Stock fund investors, however, might see returns that are 150 basis points (or 1.5 percentage points) less than published performance just from the fact that there are regular transactions over time.”
This contradicted my understanding of the effect of dollar-cost averaging (DCA), but Hallett is a smart guy, and so I set out to investigate. I started with investment return data from a spreadsheet provided by Libra Investments. I focused on the real returns of the TSX from 1970 to 2010.

Experiment 1

In the first experiment, I looked at rolling 15-year periods. For each period, I calculated the average compound return from investing a lump sum at the beginning of the period and holding it for the full 15 years. The average compound return across all periods was 6.19%.

Then for each period, I considered the case where an investor makes an equal size investment at the start of each year for 15 years. For each period I calculated the internal rate of return (IRR). With this method of calculating return, we don’t penalize DCA for having less money invested in the early years. Across all of the 15-year periods, the average return was 6.52%, which is more than the average lump-sum return.

Of course, this victory for DCA may be just a quirk of the particular set of returns I used. While the DCA approach edged out the lump-sum approach on average, the results for individual 15-year periods varied. The full range was from DCA winning by 3.07% from 1973 to 1987 (inclusive) to DCA losing by 2.38% from 1978 to 1992 (inclusive).

The reason why DCA performs differently from lump-sum investing is that with DCA there isn’t much money invested in the early years. If the early years have better returns than later years, then lump-sum investing will win, and if the early years have lower returns than later years, then DCA will win. The fact that the TSX was down nearly 40% in 1973-74 and up nearly 60% in 1978-79 tells us why DCA beat lump-sum starting in 1973, but lost starting in 1978.

Experiment 2

To factor out this dependence on the order of returns, I did a second experiment. I used 12 years of TSX return data from 1999 to 2010 inclusive. For every possible reordering of the 12 years of returns I calculated the DCA return. (There are nearly half a billion cases and it took a program 12 minutes to check them all. To do the same for 15 years of returns would have taken about 3 weeks, and I’m not that patient.)

The DCA return results ranged from -1.81% to 15.82% with an average of 6.55%. The lump sum compound return is the same in every case: 6.27% per year. So we see that DCA returns can differ from lump-sum returns by quite a bit, but on average, the DCA returns are slightly better. In fact, the DCA return was higher than the lump-sum return in 52.3% of the cases.


I can’t find any evidence that Hallett’s volatility drag exists. Either one of us is wrong, or we are calculating different things. There is another type of volatility drag that comes from compounding, but this applies to both lump-sum investing and dollar-cost averaging.

For investors who are enthusiastic about dollar-cost averaging, these results do not apply to the case where you have a lump sum and choose to invest it slowly over a period of time. This is because of the opportunity cost of the lost returns on money waiting to be invested.

Saturday, December 17, 2011

How to Spot Investment Scams in 6 Simple Steps

It pays to be wary of investment scams. The well-done 3-minute video below hits the high points for how to protect yourself. It was created by the (deep breath) U.S. Financial Industry Regulatory Authority (FINRA) Investor Education Foundation.

Bloggers for Charity Results are in

Glenn Cooke of InsureCan Inc. was our top bidder of $100 in the Blogger’s for Charity auction. Glenn will be contributing a guest post on this blog on 2012 Jan. 17. Thanks to all the bidders. Hopefully, they will contribute their bid amounts to their favourite charities anyway – winter is a tough time for those in need.

Friday, December 16, 2011

Short Takes: Expensive Trading Glitches, Cooperating Monopolies, and more

The highest bid so far in the bloggers for charity auction for a post on this blog (see here for details) is $100. Bidding will close tonight at 11:59 pm EST. I will update this note with further bids.

Jason Zweig has some examples of small investors being harmed by strange results when trading stocks. He gives some suggestions for protecting yourself against these infrequent but costly problems.

Ellen Roseman thinks that the Rogers-Bell collaboration to buy a majority stake in Maple Leaf Sports and Entertainment is bad for Canada. I agree with her. These companies' near monopoly status allows them to treat their customers poorly to increase profit. If anything we should be looking at breaking up these companies to improve competition.

Canadian Mortgage Trends says that 6.5% of Canadian mortgagors currently pay more than 40% of their income to service debts, but that increasing interest rates would drive that percentage higher.

Money Smarts finds that Canadian Tire's "1% rewards" card actually gives a much lower reward than advertised due to truncating purchase prices. Maybe they don’t have any computers and don't like working with too many digits. The next time you're there to buy something for $129.99, try offering them $100 just to keep things simple.

Wealthy Boomer weighs in on the 2-page Fund Facts that Canada's fund companies now provide for each fund.

Canadian Capitalist says that if you're unhappy with high MERs, you should vote with your wallet.

Gail Vaz-Oxlade explains a retailer trick that gets us to pay more. I think this one has worked on me many times.

Potato gives a thorough and convincing explanation of why the solar electricity MicroFIT program exists despite the fact that it loses the government money.

Big Cajun Man has some snappy answers to (stupid) financial questions modeled after Mad Magazine. A couple of them had me laughing out loud.

Million Dollar Journey edges ever closer to his goal of a million-dollar net worth. Will he shut down his blog when he gets there? I hope not.

Preet Banerjee says to hold on to your long-term investing strategy even when it hasn't performed well lately.

Larry MacDonald says that the European Central bank could end the EU crisis right now by announcing that they will print enough Euros to keep indebted EU members' borrowing costs down. However, the central bank is using the crisis to try to get indebted EU members to stop borrowing wildly.

The Blunt Bean Counter wades into the crowded space of advice on how to track expenses.

Retire Happy Blog explains why investors need to pay attention to investment fees.

Thursday, December 15, 2011

Modernizing Library and Archives Canada

My employer recently moved to a hoteling system where nobody has a fixed desk. We just take our laptops out of a locker and pick a desk each day. This has its advantages and disadvantages, but one side effect is that it is much more difficult to have great piles of paper. I've had to throw away unimportant papers and scan the important ones. This elimination of paper has been very freeing for me, and it occurred to me that this way of thinking would be good for Library and Archives Canada as well.

Certain documents are of such great historical significance that they it makes sense for taxpayers to pay to preserve them. However, many documents held by Library and Archives Canada could simply be scanned, the electronic copies be made available to Canadians free on the internet (assuming their copyrights have run out), and then the original documents could be sold to collectors.

I wouldn't want to lose great works of fiction written by Canadians, but all I need is an electronic copy. Then anyone who wants it on paper could simply print it themselves. I don't see why taxpayers should pay to house the physical books in an expensive building. Library and Archives Canada has a service making it possible to get electronic copies of documents now, but you have to pay between 20 and 80 cents per page (the web page explaining these charges has disappeared since this article was written). Why not just scan everything once and be done with it?

I used to want paper copies of documents to truly feel like I possessed them. I'm over that now. Data on the internet has a permanence that physical objects like paper can't match. Combine this with the fact that electronic copies would be far more accessible to all Canadians, and the idea of scanning all historical documents is obviously the right direction.

Wednesday, December 14, 2011

A Better Way to Explain Investing Costs

The typical person will invest for many years, but we express investment costs with yearly percentages that are misleadingly low. I propose that for recurrent costs that accumulate, we use an investing horizon of 25 years to express these figures.

For example, instead of talking about a fund's MER, we would talk about its MERQ (Management Expense Ratio per Quarter century). This would give investors a better feel for the effect of recurring costs. In another example, if an investor's portfolio concentration creates a drag on returns, we should look at the effect over 25 years rather than just one year.

In a recent article, Jonathan Chevreau observed that Investors Dividend A Fund has an MER over 2% higher than that of iShares Dow Jones Canada Select Dividend Index Fund (XDV/TSX) despite the fact that they have substantially the same holdings. Even if we add 1% to the MER of the iShares ETF to account for the cost of advice as Canadian Capitalist suggests, the percentages are 2.69% vs. 1.53%. The difference in these percentages doesn't seem like much, but if we look at MERQ (plus the cost of advice for XDV), we get 49% vs. 32%. This is a more meaningful comparison. Would you rather give away half of your money to Investors Group or one-third of your money to iShares and an advisor?

If you can handle your own investments, then you only have to give iShares 12.4% of your money over 25 years. Going even further, the MERQ of Vanguard's Total Stock Market ETF (VTI) is only 1.73%. Seeing cost figures ranging from under 2% up to 49% ought to make investors think.

In another example, I recently concluded that a portfolio of 20 randomly-selected stocks would underperform the index by 0.51% per year based on a paper by Meir Statman. If the stocks owned by dividend investors are no better than random, then a 20-stock portfolio would lose 0.51% per year to the index due to increased volatility. Based on some of the comments on that article, it seems that investors are unconcerned about such a small percentage of drag. But, if we say that the drag (dragQ?) is 12% over 25 years, it seems more troubling. Of course, most dividend investors don't believe that their stocks are no better than random, but that's a discussion for another day.

Even if the world doesn't like the idea of adding a "Q" to the end of MER and other measures, I think the fundamental idea of taking a longer view would help investors.

Tuesday, December 13, 2011

What do “Black Swans” Mean for Investors?

Big economic events, popularized as “black swans”, are known to happen more often than standard economic theory predicts. However, it’s not easy for most investors to figure out what they should do with this information other than to be vaguely worried. One important implication is that leverage is more dangerous than it appears.

Leverage just means borrowing to invest. If you invest $50,000 and it goes up 10%, you make $5000. But if you had borrowed another $50,000 at 4% interest, you’d have made $10,000 less $2000 in interest for a profit of $8000. When investments are rising, leverage is a wonderful thing. However, when investments are dropping, leverage magnifies losses. There is even the possibility of going completely broke if the value of your investments drops below the amount you owe.

In most cases where investors use leverage, they can weather minor storms by paying off the leverage loan with employment income. This way they can wait out stock market tumbles until prices rebound. However, a big enough stock market crash might knock a leveraged investor out of the market completely leaving huge losses. It’s tough enough to watch a portfolio half in stocks get hammered, but it’s another thing to be 200% in stocks and watch them plummet.

Proponents of leverage often talk of Sharpe Ratios and the optimal amount of leverage. These formulas are based on the standard Bell curve and do not give results that are useful for most investors. Be very wary of leverage.

Monday, December 12, 2011

Will the Retailer Battle with Credit Card Companies Help Consumers?

Right now in Canada you usually pay the same price to a retailer for goods and services whether you pay by cash, debit, or credit. On the surface this seems like a good thing. However, when we scratch the surface, we see inefficiencies that boost prices. Planned changes to these price rules could create different pricing for different payment methods, but whether consumers will benefit is still unclear.

When you pay with a credit card, the retailer has to pay between 1.5% and 3% of the transaction amount to the credit card company. The cost of all the wonderful credit card reward schemes we enjoy comes out of these fees charged to retailers.

Retailers have to raise their prices to compensate for the fees they pay to credit card companies. The catch is that everyone has to pay these higher prices, even those who pay with cash. In effect, people who pay cash are subsidizing the credit card rewards and cash-back schemes. But only some of the retailer fees flow back to consumers as rewards; the rest goes to banks and credit card companies.

Retailers are upset about new credit cards that require them to pay ever-higher fees. These higher fees pay for the increasingly generous credit card rewards consumers enjoy. But more of these fees are kept by banks and credit card companies, which causes the prices of goods and services to rise.

So, there are two problems. One is cash-paying consumers unfairly having to subsidize credit card users. The other is the growing fraction of transactions that get retained by banks and credit card companies that must lead to higher prices for consumers.

Retailers argue that they should be able charge consumers extra for credit card purchases. On the surface this would seem to solve both problems. Retailers in competitive markets would advertise slightly lower prices. This would end the subsidy by cash-payers, and credit card users would pay for the credit card fees. The high-fee credit cards would suddenly be less desirable to consumers if they had to pay 3% extra for each transaction. Cash, debit, and lower-fee credit cards would suddenly look much better.

However, why should we think that retailers would pass on just their actual costs for credit card fees? Why wouldn’t they charge much higher fees if they could get away with it? Consumers are driven by advertised prices and may not be as sensitive to extra charges at the point of sale. In the absence of rules to prevent this kind of abuse, particularly by monopolies and near-monopolies, there is no reason to believe that consumers would be any better off if retailers could charge extra fees for credit card transactions.

The Competition Bureau is challenging the rules credit card companies impose on retailers preventing them from charging extra fees for using credit cards. There is a lot at stake and it isn’t clear how much freedom retailers might get to charge extra fees. If retailer freedom is limited, consumers are likely to benefit, but the situation is less clear if retailers are free to add surcharges as they please.

Friday, December 9, 2011

Short Takes: Buffett Embraces Analysts, Debit Card Trap, and more

To answer a question about the charity auction for a guest post (see here for more details), yes I am willing to read your post before you make a bid to confirm that I’m willing to publish it.

For the first time Warren Buffett is inviting Wall Street analysts to the Berkshire Hathaway annual meeting. Some commentators see this as a sign that Buffett believes Berkshire is undervalued.

Boomer and Echo describes how debit cards draw people into high banking fees.

Canadian Couch Potato has a vivid illustration of how investment marketers could paint very different pictures by just taking the window in time for quoting investment returns and shifting it by 3 months.

Thicken My Wallet has an amusing little story that links Bobby Bonilla and the New York Mets with Bernie Madoff. You won't be surprised to learn that this story involves a poor investment decision.

Canadian Capitalist tries to sort out whether giving your online banking passwords to violates your agreement with your bank.

Larry MacDonald (this web page has disappeared) says that the new PRPP won't benefit Canadians much.

Big Cajun Man stumbled onto a way to improve security for his ATM card.

Preet Banerjee answers a reader question about whether MERs are tax deductible.

Million Dollar Journey is 5 years old and to celebrate is having a big set of giveaways.

The Blunt Bean Counter explains how to have a tax-free corporate divorce using a "butterfly" transaction.

Retire Happy Blog says it's important to develop a strategy for charitable giving.

Thursday, December 8, 2011

Confirmation that Mandelbrot Beats Standard Economic Theories

Nassim Taleb gets much credit for popularizing the idea that big economic events, so-called “black swans,” occur more frequently than standard economic theory predicts. The initial work was actually done by the “father of fractals,” Benoit Mandelbrot.
Physicists have studied detailed market data and have now concluded that Mandelbrot was right. (Hat tip to the Stingy Investor for pointing me to this article.)

The bigger the market move we contemplate, the lower the chances that it will happen. However, these probabilities shrink much more slowly than standard economic theory predicts. In standard economic theory based on the normal distribution, if a move has a 1 in 1000 chance of happening, a move twice as large has less than a 1 in a billion chance of happening. In Mandelbrot’s model as confirmed by the physicists, the bigger move has about a 1 in 8000 chance; each doubling in move size reduces the odds by 8 times.

For conditions of low market volatility, standard theory and Mandelbrot’s model agree fairly well, but when it comes to the possibility of big upheavals, standard theory is just plain wrong.

Wednesday, December 7, 2011

Loyalty Points as Currency

Credit card companies, retailers, and other businesses have jumped on the loyalty points bandwagon. We accumulate all sorts of different points, and some of us manage to redeem points for various goods and services. I tend to look at these points as a kind of currency.

Businesses are issuing their own brand of currency that they give their customers in return for making purchases with actual money. The problem for consumers is that these businesses control the rules for this currency and can devalue it at any time by adding various restrictions and changing the number of points needed to redeem a “reward”.

Viewed this way, it becomes apparent that many reward points systems aren’t worth the bother, but this isn’t likely to change consumer behaviour. The innumerate masses love their points. It’s true that some points systems have real value and are worth the trouble, but this is the exception rather than the rule.

Tuesday, December 6, 2011

Vanguard's Canadian ETFs Begin Trading Today

Vanguard's first 6 Canadian ETFs begin trading today (see the list below).  Note that the MERs consist of slightly more than the management fees listed.  The most interesting of these to me is VCE as a potential replacement for XIU for Canadian stocks.  However, I plan to wait and see that all goes smoothly in the first few months of trading.  I have little interest in the bleeding edge when it comes to new securities.

VCE (Mgmt fee 0.09%) Vanguard MSCI Canada Index ETF

VUS (Mgmt fee 0.15%) Vanguard MSCI U.S. Broad Market Index ETF (CAD-hedged)

VEF (Mgmt fee 0.37%) Vanguard MSCI EAFE Index ETF (CAD-hedged)

VEE (Mgmt fee 0.49%) Vanguard MSCI Emerging Markets Index ETF

VAB (Mgmt fee 0.20%) Vanguard Canadian Aggregate Bond Index ETF

VSB (Mgmt fee 0.15%) Vanguard Canadian Short-Term Bond Index ETF

Monday, December 5, 2011

Analyzing Dividend Investing

A very popular method of investing is to build a portfolio of individual stocks with a solid history of dividend payments. Dividend investors tend to believe that this approach will beat index investing, and index investors believe that dividend investors have sub-optimal portfolios.

Although dividend investing tends to be quite passive in the sense that it involves infrequent trading, it is at least a little bit active in the sense that dividend investors choose individual stocks. Any time you choose an active investing strategy, it makes sense to know how much your strategy is likely to underperform the market averages in the event that your strategy is little better than random.

So, if we begin with the premise that index investors are right and that dividend investors are likely to underperform, how much lower are their returns expected to be? To answer this question, I dug up an old paper by Meir Statman: How Many Stocks Make a Diversified Portfolio? In it he reprints a table of the number of stocks in a portfolio and its expected standard deviation from a book by Elton and Gruber. Here are a few lines from this table:

1 stock: 49.236%
10 stocks: 23.932%
20 stocks: 21.677%
All stocks: 19.158%

The volatility drag on compound returns is half the square of the standard deviation. So, here are the volatility drag numbers:

1 stock: 12.12%
10 stocks: 2.86%
20 stocks: 2.35%
All stocks: 1.84%

Compared to index investing where portfolios contain all stocks, smaller portfolios have the following excess volatility penalties on compound returns:

1 stock: 10.16%
10 stocks: 1.02%
20 stocks: 0.51%
All stocks: 0%

So, if a dividend investor owns 10 stocks and they are essentially randomly-selected, the investor is giving up 1.02% per year in returns. At 20 stocks, the penalty is only 0.51%.

Of course, dividend investors don’t believe that their stock choices are random. But even if they are wrong, a portfolio of 20 dividend-paying stocks from a wide range of different industries is only giving up about 0.5% per year compared to index investing (not counting taxes). Giving away returns is never a good idea, but many active investing approaches have higher expected losses to the index than just 0.5%.

Friday, December 2, 2011

Short Takes: Slamming Investors Group, Family Financial Planning, and more

Wealthy Boomer takes off the gloves in an exchange with Investors Group over sky-high mutual fund MERs and a questionable commitment to Canadians’ financial literacy. The truth is that Investors Group profits greatly from their clients’ lack of understanding of important investing facts.

Big Cajun Man created an amusing flowchart of financial planning in families. I fear that many people follow this flowchart.

The Blunt Bean Counter explains that while he is moving to passive investing, he plans to be a stock-picker for a small fraction of his portfolio for the excitement.

Canadian Capitalist likes Ally's high savings account interest rates and wonders why it isn't more popular.

Retire Happy Blog explains some model investment portfolios. He gives a range from conservative to aggressive. There are higher levels, though. If you borrow to invest, such as with the Smith Manoeuvre, you are moving into the hyper-aggressive range. I think leveraged schemes might be less popular if people understood how risky they are.

Larry MacDonald reviews David Trahair's new book Crushing Debt: Why Canadians Should Drop Everything and Pay Off Debt. The Wealthy Boomer reviewed this book as well.

Million Dollar Journey reviewed Derek Foster's new book The Worried Boomer.

Preet Banerjee gave us a look into the complex world of interest rate swap dealers.

Thursday, December 1, 2011

Calculating Returns Can Be Tricky

Calculating the total return of a collection of investments is a simple matter of adding up or averaging the returns of the individual investments, right? In reality, the right way to "add" or "average" returns depends on the context.

Suppose that investment A stayed flat for two years (0% return each year), and investment B fared much better returning 20% each year for both years. Suppose further an investor splits $1000 between A and B in the first year, then rebalances and again splits his money between A and B in the second year:

To start:

A $500
B $500

After year 1:

A $500
B $600

The total is $1100 for a 10% return. So we see that correct overall return is the average of 0% and 20%, namely 10%. This investor will get another 10% return in the second year and will end up with $1210 for a total return of 21% after two years.

Note that the total return is not just 10% + 10% = 20%. In this case we have to "add" the returns using compounding: 1.10 x 1.10 - 1 = 21%.

Consider a second investor who owns only investment A for one year and then only investment B for the second year. We might think that this investor will get an average return of (0% + 20%)/2 = 10%, but he does not. This investor will be left with $1200 for an overall return of 20%. But this doesn't work out to the 10% per year that the first investor got. The second investor's average return is 9.54% per year. When you compound this return for two years, you get his 20% total return for the two years.

This isn't just an academic exercise. Lenders use this against us all the time. If you get a monthly car loan at 6% per year, the actual rate is 0.5% per month. They call this "simple interest". In reality they calculate the monthly rate as though they were going to use simple interest (divide by 12), but then they compound it. If you multiply 1.005 by itself 12 times you get the real yearly rate that you’re paying: 6.17%. The difference isn't huge, but it's still extra money out of your pocket.

Understanding when to add returns and when to compound them is at the core of why higher portfolio volatility leads to lower long-term investment returns. Any time you hear someone talk about the average return of some type of investment you should ask what kind of average was used.

Wednesday, November 30, 2011

Why Do People Buy on Black Friday and Cyber Monday?

There are a couple of obvious explanations for why people buy more stuff on Black Friday and Cyber Monday:

1. Retailers offer better prices enticing people who have been thinking about buying to finally pull the trigger.

2. People are helpless victims of mass advertising and are deluded into thinking that they are acting along with their many friends.

I have one more possible reason to add to this list: people look for excuses to follow their desires rather than use restraint. We see a similar effect with people who try to eat healthily. Even people with good salaries who can afford to eat anything they want will get overly excited about free donuts or pizza. They can afford to buy junk food, but they usually show restraint and eat healthy food. The free junk food is an excuse to indulge.

So, for people who have a desire to shop, Black Friday and Cyber Monday are a great excuse for going off their "diets".

Tuesday, November 29, 2011

Past GIC Returns Not as Good as They Appeared

Many GIC investors long for the days double-digit returns 30 years ago. In a post warning of misconceptions about guaranteed income funds, Jim Yih at the Retire Happy Blog observed that today's low GIC rates are “not very appealing to a lot of people.” He’s right that people feel this way, but the truth is that today’s GIC rates aren’t too far out of line with past rates when you properly take into account inflation and taxes.

Most investors understand the idea of spending interest and leaving their principal alone. The problem with this approach over the long term is that inflation erodes principal. A better approach is to avoid spending part of the interest to account for inflation. This way the principal maintains its purchasing power over time. GIC investors should be focusing on real returns, which is the GIC return minus inflation. For example, if a GIC pays 3% interest and inflation is 2% per year, then the real return is only about 1%.

Using inflation data from Statistics Canada and 5-year GIC return data from the Bank of Canada, I found that from 1969 to 2009, the average GIC return was 2.35% per year above inflation. This is better than today’s GIC rates, but not by as much as most people think.

Historical GIC rates look worse for investors whose interest is taxable. The average real GIC return from 1969 to 2009 at a 25% tax rate is only 0.71%, and at a 40% tax rate it drops to -0.28%! So, for GIC investors who pay taxes, current GIC returns aren’t much different from what they have averaged over the past 40 years. Inflation is the silent killer of wealth.

Monday, November 28, 2011


Some companies are moving to a system of seating for employees where the workspaces are not assigned to anyone in particular. Each employee can just pick any spot when they arrive at work. This system is called hoteling (but according to Wikipedia if reservations aren’t necessary, it should be called “hot-desking”).

The benefits from a company point-of-view are obvious: saving costs. If employees are in the office 75% of the time on average, then the company only needs to offer 75% as many work stations. And with people having to store their work items in lockers, they typically don’t accumulate as much paper and other items so that the work stations can be smaller.

In talking to employees about this system, I was surprised to learn that the most common concern is the lack of a space to call one’s own. I would have thought that other concerns would be greater such as the time it takes to bring work items from a locker and set up each morning, and more time to tear down each evening.

Another possible concern is the inevitable distraction that comes with denser seating. But, in informal polling, I’ve found that the biggest concern is not having a feeling of ownership over some space that can be filled with family pictures and other personal items.

While some employees grumble, the prospect of large savings will drive more employers to adopt some form of hoteling.

Saturday, November 26, 2011

Contacting Me by Email

The main reason I write this blog is to interact with other people interested in learning about how to invest well and handle personal finances well. So, I’m always happy to hear from people who have questions or have something interesting to contribute.

However, the truth is that I ignore 99% of the emails I receive. This is because they mostly fall into one of two categories:

1. “How much does it cost to put a link on your site in a place nobody will notice in order to boost my web site’s PageRank?” I don’t do this.

2. “Instead of having to write your own posts, would you like us to write some for you with embedded links to our payday loan web site?” I don’t do this, either.

If I have ignored your email, it is likely because I suspect that your message falls into one of these two categories. I’m not opposed to placing advertising on my site or taking a guest post, but I don’t try to trick my readers into thinking that a post is real content when it is really advertising.

The best way to interact with me is to make a relevant comment on one of my posts. For readers of my feed and email subscribers, this means that you have to click through to my web site to view the post and make a comment at the bottom of the page. I happily accept questions from beginners as well as feedback from experts.

Let’s continue our journey of learning about money!

Friday, November 25, 2011

Short Takes: Reverse Mortgages, Getting Married on the Cheap, and more

The highest bid so far in the bloggers for charity auction for a post on this blog (see here for details) is now at $100. Keep those bids coming!

Rob Carrick explains why reverse mortgages aren't a very good idea but are likely to become more popular.

Squawkfox explains how she got married on the cheap (part 1 and part 2).

Jeremy Cato at the Globe and Mail rants about taxes on drivers and how Ontario may be adding a carbon tax. I'm no fan of taxes, but we need higher taxes on gasoline consumption. This will stimulate private-sector green energy solutions that we desperately need. There could be offsetting income tax deductions to make the change revenue-neutral.

Wealthy Boomer interviews Charles Ellis about the high cost of mutual funds in Canada.

Larry MacDonald makes the case that our public-sector unions are doing us great harm.

Canadian Capitalist says that institutional investors still get access to information from companies before the rest of us despite rules against this practice.

Million Dollar Journey generated quite a list of comments by asking whether it is possible to earn a $90,000 salary by age 30.

Big Cajun Man has a picture showing how he is keeping critters out of his attic.

The Blunt Bean Counter asks whether Steve Jobs or Bill Gates is more deserving of being placed on a pedestal.

Preet Banerjee has found a no cost ETF.

Retire Happy Blog doesn't think the new PRPPs are necessary.

Scott Ronalds at Steadyhand catches Investors Group sweeping some bad mutual fund results under the rug.

Thursday, November 24, 2011

Gaming Mortgage-Breaking Costs

Trying to break a mortgage before your term is up can be a bewildering experience. If interest rates have gone down since you took a fixed term, the bank will ask for an "interest rate differential" (IRD), which is a mortgage-breaking fee. Few people understand how this IRD is calculated and the banks don't make it easy to find out. There is an interesting way for banks to game the IRD calculations as I'll explain, but I have no idea if any of them actually do it.

Most people know that a bank's posted mortgage rates are just a starting point for negotiations; borrowers usually qualify for a discounted rate depending on their credit record. The size of these discounts is controlled by the bank. A bank could raise its posted rate by a half-point and then give larger discounts without affecting the rates on the mortgages they write. By playing with posted rates and the size of this discount, I’ll show how a bank could affect the size of IRD penalties.

The basic principle behind an IRD is that you have to honour your obligation. If you promise to pay 6% interest for 5 years and rates go down after 2 years, you can't just get a mortgage at a lower rate without paying the bank an IRD to compensate them for not getting the larger payments for 3 more years. The bank can't renege on its promised rate for the term you choose and you can't either.

Continuing with this example, suppose that right now you would qualify for a 4% mortgage for a 3-year fixed term. Then the bank takes your future 3 years of payments and the lump sum that would be owing at the end of the 3 years, finds their present value (at 4%), and calls the difference between this amount and your outstanding mortgage balance the IRD. So, when you pay the IRD plus your outstanding mortgage balance, you are effectively paying the present value of the future obligations of your existing mortgage (at 4%).

An important wrinkle here is how the bank came up with your initial rate of 6% and how they chose the 4% rate for the IRD calculation. Suppose that the posted rate for your initial 5-year term was 8%. Then you got a 2% discount. Some banks reason that to choose the rate for the IRD calculation, they should take 2% off the current posted 3-year rate. (Keep in mind that the lower the rate used for IRD, the larger the IRD fee will be.)

This approach has potential problems. Perhaps discounts on shorter terms tend to be smaller than those on longer-term mortgages. If this were true, then the IRD rate would be artificially low making the IRD fee unfairly high.

Another potential problem is that the banks control the amount of mortgage rate discounts. Competitive pressures limit the ability of banks to control the rates at which they write mortgages, but they do control their posted rates. This means that they control the typical rate discount.

So, suppose that the typical discount is 2% during a period of higher interest rates and then rates drop. This creates conditions where homeowners will want to break their mortgages. If the bank then changes their advertised rates to be only 0.5% higher than the typical mortgage they write, then when someone breaks a mortgage, the IRD rate used will be 2% less than the posted rate, which is 1.5% lower than the actual rate the homeowner could get. This artificially increases the IRD significantly.

I have no idea if banks actually do this, but it would surely be tempting. To check whether this sort of thing goes on, I'd need some information that I don't currently have:

- What is the exact method each bank uses for IRD calculation?
- How do they arrive at the rate to compute the IRD?
- How does the typical mortgage rate discount vary with length of term?
- How has the typical mortgage rate discount varied with interest rate levels?

TD has some online IRD information, but of the 4 questions above, the only one that is answered is how they compute the IRD interest rate. They give a calculator for estimating your IRD, but not an exact calculation. Royal Bank has some IRD information as well, but it isn’t any more helpful than the TD link. BMO has similar IRD information, CIBC’s is no better, and neither is Scotiabank’s.

Wednesday, November 23, 2011

Investing Like the Rich

How often do we see articles on how to invest the way rich people invest? For yet another example, see this Wall Street Journal article. The not so subtle implication is that you can become rich yourself if you act the way rich people act. Unfortunately, this can be like trying to become a surgeon by wandering around in scrubs.

No doubt some rich people made their money by investing well. However, the people I know who are wealthy made their money in business, and they don't know any more than the rest of us about successful investing. One tried day trading with disastrous results, a few lost their money to a small-time advisor who skipped the country, and several just pay little attention to investing after handing their money over to a high-fee advisor.

Imitating the actions of successful people may or may not be a good idea depending on particular actions you are imitating. To know what traits to imitate requires deeper understanding. Learn more and think for yourself.

Tuesday, November 22, 2011

Bloggers for Charity

The Blunt Bean Counter has rounded up some bloggers to support charities by auctioning off the opportunity to write guest posts on our blogs. I have no idea how this will work out, but I’m happy to give it a shot for a good cause. The first announcement about this blogger charity effort came out yesterday.

I won’t repeat all the information in The Blunt Bean Counter’s announcement, but I will lay out some rules:

– Send bids to the email address on the upper right corner of my blog. (If you’re reading the feed or an email, you’ll have to click through to the web site. This is also a great way to see the comments people leave on blog posts.)

– The auction will close on 2011 Dec. 16. I will publish periodic updates of the highest bid and will notify the winner after the auction closes.

– The winning bidder must send me (by email) a scanned copy of a donation receipt, dated between Dec. 17 and Dec. 31 to confirm that the donation has been made. Please block out any personal information; I only want to check the amount and that it seems to be a legitimate charity receipt. You may choose your favourite charity.

– The “blogger for a day” post will appear on 2012 Jan. 17. I must approve the post contents. I will be very liberal with a genuine attempt to contribute an interesting article and will be very harsh with an obvious marketing piece. At the bottom of the post, the guest blogger can provide their name, name of their company and a brief description of their company and its products. Alternatively, the guest blogger can remain anonymous.

I’d like to call out a few other bloggers to give charity blog day a try:

Big Cajun Man at Canadian Personal Finance Blog

Preet Banerjee at Where Does All My Money Go?

Frugal Trader at Million Dollar Journey

Bid early and bid often!

Monday, November 21, 2011

How Many Stocks Are Enough to be Diversified?

Most commentators agree that the stock portion of our portfolios should consist of many stocks in order to reduce volatility. Where they disagree is on how many stocks are needed to be adequately diversified. Over the years, the trend has been for the recommended minimum number of stocks to rise. I have an explanation for this trend.

In 2009 Tom Bradley wrote "While a portfolio of 20 stocks and a few government bonds were just fine for our parents a generation ago, it’s probably not enough today." Why would the minimum number of stocks we should own change over time?

With each stock you add to a portfolio, the volatility tends to decrease. However, the amount of benefit drops off as the number of stocks rises. Adding a second stock gives a big reduction in volatility, but adding a 101st stock doesn't reduce volatility much.

For indexers, there is no such thing as too much diversification as long as the cost of ownership (fund MERs) stays low. So, an index investor is happy to get the benefit of reduced volatility by owning all the stocks in an index.

Stock pickers see things differently. Suppose that they rank their stock picks from most to least confident. From the stock picker’s point of view, the expected return is highest for the first stock and decreases as we move down the list.

The expected compound return of a portfolio is a combination of the expected return minus a penalty for the amount of volatility. As the stock picker adds each stock on the list to a portfolio, volatility drops giving a boost to expected compound return. However, a lower confidence pick (with lower expected return) is diluting the expected return of the stocks already in the portfolio. One effect raises expected compound return and the other lowers it.

After some number of stock picks, the volatility benefit isn't enough to offset the dilution penalty of a lower confidence stock pick. It can be difficult to put exact numbers on these things, but this is the reason why a stock picker wants to own enough stocks, but not too many.

The better a stock picker is at outperforming the market, the fewer stocks he or she will buy before the dilution effect outweighs the volatility benefit. So, better stock pickers should want to own fewer stocks than weaker stock pickers.

Some commentators, including Benjamin Graham, have said that picking good stocks has been getting more difficult over the years. If this is true, then a given stock picker whose skill level remains constant will find that as the years pass, his or her returns in excess of the market averages erodes. This should lead to the optimal number of stocks to own to rise over time.

For index investors who don't believe they can beat the market net of costs, the optimal number of stocks to own is all of them.

Friday, November 18, 2011

Short Takes: New Discount Broker Rankings, Mistrusting Banks, and more

Globe and Mail's annual rankings of discount brokers is out. TD Waterhouse dropped 3 positions in part because they don't offer U.S. dollars in RRSPs yet.

Scott Adams has some good reasons for never trusting banks.

Big Cajun Man explains why flooding in Thailand may cause computer prices to rise in time for the holidays.

Preet Banerjee (this particular web page is now gone) shares some of his industry knowledge explaining why some advisors switch firms frequently.

Million Dollar Journey explains how to calculate U.S. capital gains in a non-registered account.

Canadian Capitalist takes TD Waterhouse to task for not allowing U.S. dollars in RRSP accounts.

The Blunt Bean Counter says that starting in 2013 in Ontario, executors will have to be more careful about justifying the value of assets for probate fees.

Money Smarts says you should take business media with a grain of salt. I liked the bit about an elevator with "Soar!" and "Plunge!" buttons.

Thicken My Wallet says that you should consider liquidity risk along with fees and other factors when choosing ETFs.

Wednesday, November 16, 2011

Currency Trading Should be More like Stock Trading

A constant irritant of mine is the high cost of converting between U.S. and Canadian dollars at my discount brokerage. Canadian Capitalist has a good way to reduce these currency-conversion costs, but it involves several steps. I wish that my discount brokerage would offer a more sensible option.

When I trade stocks or ETFs, I have to contend with commissions and spreads. Most people understand commissions, but spreads are less familiar. Consider the ETF XIU. As I write this, it is trading at a bid price of $17.51 and an ask price of $17.52. This means that the price per unit is different by one cent depending on whether I'm buying or selling. For $100,000 worth of XIU, this difference is $57. Each time I make a trade, I lose half of this spread, or about $28.50. Add in the trading commission of $10, and the cost to me is $38.50.

Things are very different when buying or selling U.S. dollars. If I don't do anything special to avoid high costs, the spread at my discount brokerage on large amounts is 1%. This means that if the Canadian and U.S. dollars were at par with each other, I'd have to pay C$100,500 to buy US$100,000 but would only get C$99,500 if I sold US$100,000. There is no explicit commission, but the spread costs me $500 on each conversion! Compare this to only $38.50 when trading the same dollar amount of XIU.

Something much more sensible for converting between Canadian and U.S. dollars would be a much lower spread and an explicit commission. With a $10 commission and a spread of say 0.05%, the cost of converting $100,000 would be only $35, which is much more reasonable. For $10,000, the cost would be $12.50. I may not have chosen exactly the right commission and spread amounts, but this model of an explicit commission plus a greatly reduced spread much more fairly reflects a brokerage's costs of performing currency conversions.

Tuesday, November 15, 2011

Getting Started with Index Investing

A common problem for young investors who get excited about index investing is that they try to over-think their portfolios in their early saving years. Your asset mix is much more important when your portfolio is much larger than your new contributions than it is when you're just starting out. I'll go through a fictitious example to illustrate a pattern I've seen with novice index investors.

Amy is a responsible woman in her mid-twenties with a good job who wants to start building savings for her future. She has read about index investing and is excited to learn that she doesn't have to be an expert on stock picking to be a successful investor. After some study she has settled on the following asset mix:

35% Canadian stocks
30% U.S. stocks
20% International stocks
15% Canadian bonds

She has picked the 4 ETFs she plans to use for these asset classes, and she has RRSP and TFSA accounts opened with a discount brokerage. Right now she has $2000 in her RRSP and $2500 in her TFSA. This leads her to the following allocations:


$700 Canadian stocks
$600 U.S. stocks
$400 International stocks
$300 Canadian bonds


$875 Canadian stocks
$750 U.S. stocks
$500 International stocks
$375 Canadian bonds

The problem here is that it will cost her $80 in commissions plus a smaller amount in spreads to make these 8 purchases. This represents about 2% of her portfolio right now. It just doesn't make sense to spend this much right now.

However, Amy has set up some automatic withdrawals from her pay to add $400 per month to her TFSA and $600 per month to her RRSP. In just 5 months her savings will more than double. But what should she do right now?

One approach is to set a minimum dollar amount, such as $2000, and wait until each account has this minimum in cash before making a purchase of whichever asset class is furthest below its allocation (in dollars). So right now her accounts hold a total of $4500 in cash. The asset class that is furthest below its target allocation is Canadian stocks which are supposed to have $1575. But Amy just buys the Canadian stock ETF with her entire TFSA ($2500). After this purchase, the U.S. stock ETF is furthest below its intended allocation. So, she buys the U.S. stock ETF with the entire contents of her RRSP. In the coming months, her accounts will build cash until she is able to make purchases of ETFs in her other asset classes.

There are a few potential issues with this approach. One related to tax efficiency, and the others are mostly psychological.

Tax Efficiency

U.S. stocks are better held in an RRSP than a TFSA because there won't be a 15% withholding tax on U.S. dividends for U.S. assets held in an RRSP. So Amy should arrange things so that she tends to buy the U.S. stock ETF (and possibly the international stock ETF) in her RRSP.


With cash just sitting around for a few months in her RRSP and TFSA, Amy may be tempted to take a vacation rather than buy ETFs once the cash builds up to $2000. Each investor has to assess his or her personality when making a plan. If cash in a retirement account feels like cash burning a hole in your pocket, then maybe you have to pay a little extra in commissions by making smaller trades.


It's hard to start anything new without a good dose of enthusiasm. Unfortunately, Amy has just done the work to figure out her preferred asset allocation, and she now realizes that she won't get anywhere close to that allocation for a couple of years when she has saved more money. This is somewhat deflating. If Amy follows the plan described above she will be fine, but it doesn't feel very satisfying right now. Paying the extra commissions to get to the right allocation (and maintaining it thereafter) is an expensive way to feel satisfied.

Some observers will say that Amy is better off with TD e-series mutual funds because her account is small and will stay fairly small for a few years. However, she may not want the hassle of switching approaches in 5 years. If she follows the plan laid out above, she will not pay excessive fees; an ETF approach will work nicely.

My personal rule is that I don't make an ETF purchase until I have $3000 in cash, and I often wait until I have $5000 or more. This can lead to fairly large amounts of cash sitting in the 9 accounts my wife and I have. However, this cash (in the non-RRSP accounts) serves as part of my emergency cash reserve.

It’s much more important for Amy to focus on saving regularly than it is for her to have the perfect asset allocation right now.

Monday, November 14, 2011

MoneySense Guide to the Perfect Portfolio

Dan Bortolotti’s MoneySense Guide to the Perfect Portfolio is the most accessible explanation of the merits and mechanics of index investing I’ve seen to date. He takes a topic that is often explained in a technical manner and makes it understandable for non-specialists. At 128 pages of easy-reading, it’s not painful to get through, either. I expect to be lending out my copy to friends and family.

This book is actually a cross between a book and a magazine. It contains 10 pages of ads and has a fair bit of interesting artwork. Readers can decide for themselves what they think of a book with ads, but presumably the ads helped to get its cost down to $9.95 + $3 for shipping + taxes.

The book begins by explaining how “Couch Potato” investing with indexes is a different way of thinking about investing. It then goes on to look at how to decide what should go in your portfolio and how to set up accounts to buy the chosen investments. Even investors who feel intimidated by financial jargon should find the discussions clear.

In some ways this guide is deceptively simple. Bortolotti takes a subject that goes counter to most people’s instincts about investing and makes it seem natural. Overall, the content is top-notch, but there are always some nits to pick. The remainder of this review is my take on some details in the book.

Challenging Fund-Pickers

I laughed out loud at Bortolotti’s suggestion to challenge advisors who believe they can pick the best mutual funds by asking “them to show you a list of the funds they were recommending 10 years ago.” I’m guessing that this would usually generate a very sour look.


“One of the laws of nature is that it is impossible for two asset classes with positive expected returns to have perfect negative correlation.” I’m not sure what point the author was trying to make here, but this statement is not literally true. Two investments can have positive returns and 100% negative correlation if the average of their returns does not exceed the risk-free rate. See one of my past posts for an explanation of a common misunderstanding about correlation.

Market Timing

“You shouldn’t keep changing your overall asset allocation to respond to market moves.” This is a great message. This “responding” is really just market timing and it gives more sophisticated investors a chance to take advantage of your mistakes.

The author also says that “it’s fine to change your asset allocation if you realize you overestimated your risk tolerance.” That’s fine as long as you don’t bump up your allocation of risky assets when they feel safe to you again. If you yo-yo your allocation this way, you’re just buying high and selling low.

Online Security

Bortolotti says that we don’t need to be concerned about the security of online investing. I agree that people don’t need to lose sleep over online security, but they do have to follow sensible precautions such as protecting their passwords, running anti-malware programs, and other precautions listed in their agreements with their online brokerage.


“You can withdraw funds from a TFSA any time, and you get the contribution room back at the beginning of the next calendar year.” Enough Canadians have been caught returning money to TFSAs too early that I think an extra sentence of warning about penalties is warranted here.

Transferring Assets to a New Account

In the discussions of leaving an advisor and moving assets to a new account, I think it makes sense to explain that it is best to fill out paperwork with the brokerage handling the new account to make the transfer. I’ve heard of too many people who try to initiate a transfer by talking to their advisors. Whether or not you choose to talk to your advisor about leaving him or her, when the time comes to transfer assets, you do it by signing papers with the new brokerage.

Stop-Loss Orders

“Stop loss orders ... just ensure that you’ll sell low.” This is a good warning for couch potato investors.


“The hardest part of Couch Potato investing is sticking to your plan when your instincts tell you to bail out.” Bear markets in stocks are a difficult test for long-term index investors.

Cost of Investing Advice

“Good quality, unbiased advice is worth 1% to 1.5%.” I think this is dependent on portfolio size. It makes sense to pay more for good advice if your portfolio is 10 times larger, but it doesn’t make sense to pay 10 times more.

Sample Portfolios

Bortolotti gives 7 different sample portfolios for different portfolio sizes and goals. Five of them look reasonable to me, but the “Yield-Hungry Couch Potato” and the “Über-Tuber” are aimed at fairly large portfolios and seem expensive with MERs of 0.50% and 0.45%, respectively.

Friday, November 11, 2011

Short Takes: Vanguard's Canadian ETFs, Record Earnings in the U.S., and more

Canadian Capitalist and Canadian Couch Potato give their takes on Vanguard's announcement that their new ETFs will have lower management fees than other comparable ETFs in Canada.

Preet Banerjee says that amid the doom and gloom about the stock market there is a bright note: the S&P 500 earnings per share hit a new record.

How to Invest Online has some tips on when borrowing to invest makes sense and when it doesn't.

The Blunt Bean Counter tackles a tricky question: should you set up your new business as a proprietorship or a corporation?

Big Cajun Man says you should change your bank if you're not being treated well.

Retire Happy Blog explains how to get organized for estate planning. If a friend or family member has asked you to be an executor, you might want to send them this information to make your job easier when the time comes.

Million Dollar Journey has lists of the most and least expensive MBA programs.

Thursday, November 10, 2011

A Strategy with Vanguard ETFs

Vanguard's entry into the Canadian ETF market with very low management fees has many ETF investors considering making a switch. However, it costs commissions and spreads to switch over to Vanguard ETFs. This leaves investors weighing the costs to decide whether to change or not. However, there is a middle ground.

The most interesting of Vanguard's new ETFs to me is VCE which tracks the MSCI Canada stock index. This is a potential replacement for iShare's XIU which tracks the S&P/TSX 60. The management fees are 0.09% for VCE and 0.15% for XIU. These figures are not the complete MER, but we can assume that the difference in MERs will be close to 0.06%.

So, an investor with $20,000 in XIU could save $12 per year by switching to VCE. This isn't exactly a huge savings. It's hard to justify the trading commissions and spreads to make the change. But, there is a simple compromise: just buy VCE whenever you're adding new money or rebalancing toward stocks and sell XIU when you're withdrawing money or rebalancing away from stocks.

Personally, I'll be waiting a while with VCE to avoid the "bleeding edge", but I expect to be using this compromise strategy to avoid unnecessary costs.

Wednesday, November 9, 2011

Misleading Insurance Advertising

Yesterday I got a letter that had the feel of a government mailing. The envelope had a Canadian flag in the top left corner like many government letters. The contents talked about the Canada Pension Plan, shortfalls, and how I’m eligible for benefits of the Purple Shield Plan if I register now.

This letter turned out to be a come-on for life insurance that covers any expenses not covered by the CPP $2500 funeral benefit. But, there is no mention of having to pay any premiums. The form of this advertising is very likely to confuse some people enough that they will send in the “information request” thinking that they might be missing out on a free government program. This kind of thing just makes me more cynical about anything I read from my mailbox.

Tuesday, November 8, 2011

Steadyhand vs. Indexing with ETFs

Tom Bradley at Steadyhand invited me to comment on their comparison of Steadyhand Funds versus indexing with ETFs. The piece is clear, balanced, and worth a read. (Disclaimer: I have no financial relationship with Steadyhand other than the fact that they’ve bought me lunch a couple of times. It would take a lot more than that to stop me from saying what I really think!)

The summary on fees in their example of two investors with $250,000 portfolios is that Steadyhand funds charge about 0.55% per year more than the total costs of running an ETF portfolio. The burning question is whether Steadyhand offers enough benefits to make up for this additional cost of $1375 per year.

Here are some of the ways that Steadyhand might earn their extra fees:

– ease of getting started
– investing advice on asset allocation
– calming influence when you’re about to do something foolish and expensive out of greed or fear (a steady hand)
– possible higher returns

Although I wish them well, I’ve cast my vote with my own money on the side that says nobody has the expectation to produce excess returns over the market return. So, even though beating the market is important to Steadyhand, I will ignore this as a possibility.

Making it easier to get started has some value, but not on an ongoing basis. This leaves advice on asset allocation and a calming influence when investors are inclined to make expensive mistakes. This is where I think Steadyhand likely adds value for the typical investor. The reason most investors trail market returns so badly is that they make big mistakes even though they think they’re doing smart things.

Knowledgeable investors would prefer to pocket the extra 0.55% per year, but many people who are overly influenced by media reports of financial boom and bust would likely benefit from Steadyhand’s advice by enough to justify the extra 0.55% per year. Investing with ETFs seems simple enough, but staying calm in a storm can be difficult. I still think that people should learn enough to invest on their own, but realistically only a fraction of investors will do this properly.

One concern I have about Steadyhand’s comparison is that any other mutual fund could produce a similar-looking document that paints them in a favourable light. As it turns out, Steadyhand’s comparison is very fair, but you have to be knowledgeable about investing to come to this conclusion. Uninformed investors who stumble onto Steadhand are likely to do well, but they could just as easily end up with someone else who sets them up with a portfolio full of funds with 3% MERs and 7-year DSCs.

So, even investors who intend to get financial advice should learn about investing enough to be able to tell if they’re being treated well or taken for a ride.

Monday, November 7, 2011

Exploiting Stock Market Anomalies

Much time and effort goes into searching for stock market inefficiencies that can be exploited for profit. Former string theorists work together developing algorithms to comb through historical data looking for persistent patterns. The problem is that once we find a strategy to exploit an anomaly and it becomes widely-known, it stops working. There is one pattern that I bank on, though.

There are those who try to make money from momentum effects and others who believe in “sell in May and go away” until November because stocks have performed poorly in summer. I don’t trust these approaches because they seem like just the sort of thing that would stop working if too many people used them.

If everyone believed in “sell in May and go away” then we could anticipate a big sell-off in May and a rise in November. So the right thing to do would be to sell before May and buy before November. But if too many people did this, the right strategy would change again.

There is one stock market pattern that I bank on, and that is the tendency for people to be conservative. To entice investors, risky investments have to offer significantly higher expected returns than safe investments. This makes sense to a degree, but I think investors are generally too conservative. This makes riskier investments look better to me.

So, I am content to invest in the stock market and hope to get higher returns than I could get with safer investments. I have my limits, though. I don’t use leverage, and I stick to indexes for broad diversification. And I avoid getting drawn into attempts to beat the market with interesting strategies.

Friday, November 4, 2011

Short Takes: Cheap Gas at Costco, Variable Rate Mortgages Now Less Attractive, and more

Big Cajun Man reports that Costco is selling gas for about 5 cents less per litre than other stations.

Rob Carrick says that recent action by banks has made fixed mortgages much more attractive than variable mortgages.

Larry Swedroe says that the U.S. Department of Labor made a mistake in abandoning a fiduciary standard for financial advisors.

Preet Banerjee has a warning about how you can pay triple for your life insurance if you're not paying attention when you renew.

Canadian Capitalist found an interesting anomaly in the pricing of the U.S. Dollar Currency ETF called DLR that affects his method of converting between Canadian and U.S. dollars cheaply.

Canadian Financial DIY thinks very highly of the book Financial Statement Analysis. I'm not a fan of trying to beat the market by selecting stocks, but if you're going to try you must be able to read financial statements.

The Blunt Bean Counter has some first-hand experience observing how people react to big cash windfalls.

Canadian Couch Potato reviews the book Millionaire Teacher.

Financial Highway runs through the factors that affect the interest rate on your loan.

Retire Happy Blog outlines the 3 basic steps to creating a retirement plan.

Money Smarts says that buying an annuity is like creating a gold-plated government pension for yourself and wonders why annuities aren't more popular. I suspect the answer has to do with a lack of forced savings leading to not having a big enough lump sum to buy a sizable annuity.

Thursday, November 3, 2011

The Best-Kept Secret about Successful Investing

A widely-held belief is that the world contains a small number of financial geniuses who know what is going to happen in the stock markets and who make obscene amounts of money with their trading. With this world-view, the goal for the rest of us is to become a financial genius or hand over the reins of our investments to someone who is a financial genius.

When I first started getting serious about investing, I began by trying to pick the right financial genius running some mutual fund to invest my money. When this didn't work out, I set out to read every book I could find about investing and become a financial genius myself. In the end I discovered I was heading in the wrong direction.

The secret to successful investing is not making brilliant moves, but failing to make serious mistakes. Rather than trying to outdo other investors, the best strategy for most of us is to avoid doing anything stupid.

Almost all of us are best off just trying to match the stock and bond market indexes rather than trying to beat them. Investors who try to be smarter than the next guy try many strategies to beat the indexes, but most of the time they end up making dumb mistakes and paying lots of fees and taxes along the way.

Admittedly, this message is not exactly a secret; it is in many books and in many blogs. But the fact remains that the average person believes in the idea of financial geniuses whose advice they need for insights into the future of stock markets.

When people find out that I write a financial blog, a typical reaction is to ask me about what will happen in the market or with interest rates. I usually respond saying that nobody knows these things with any useful degree of certainty and that they shouldn't bother seeking someone who does know. This message usually falls flat. The world seems to believe in financial prophets despite the mountain of evidence to the contrary.

Wednesday, November 2, 2011

Confusion about Correlation of Investments

Most of us have heard that it is good to hold asset classes with low or negative correlation. The informal explanation for this is that risk is lower because when one asset class, such as stocks, is going down, another asset class, such as bonds, is going up. However, this explanation is misleading.

It is possible for two investments to both be going up over a period of time, but have negative correlation. Consider the following example:

Investment A earns either 2% or 20% each year based on a 50/50 coin toss. Investments B, C, and D do the same. Investment B's return is based on the same coin as A uses. Investment C uses its own independent coin. Investment D does the opposite of A's coin. All 4 investments have an expected compound return of 10.63% (for math geeks, this is 1 less than the square root of 1.02 x 1.20).

Even though the investments all look the same based on their returns, their correlations are different:

A and B are +100% correlated (perfect correlation).
A and C are 0% correlated (uncorrelated)
A and D are -100% correlated (perfect negative correlation).

We can see the effect of correlation by looking at the expected compound return of investing strategies that use half investment A and half of each of investments B, C, and D (assuming yearly rebalancing):

Half A, half B: 10.63%
Half A, half C: 10.82%
Half A, half D: 11%

Because A and B are exactly the same, it's not surprising that a 50/50 mix looks the same as either investment on its own. The expected compound return goes up when we mix independent investments A and C. The return is highest for perfectly negatively correlated investments A and D. In this case, every year one investment returns 2% and the other returns 20% for a blend of 11%. Of course, investments like A and D don't exist in the real world or else you could get a certain return of 11% without any risk.

Getting back to the informal explanation of correlation, it's not the case that when one investment goes up, a negatively-correlated investment must go down. The real explanation relates to how the investments perform relative to their average returns.

When one of the investments returns only 2%, this is a downside surprise, and when it returns 20% we have an upside surprise. Investments A and B always have upside surprises together and downside surprises together. Investments A and C have surprises in the same direction half the time, and A and D always have surprises in opposite directions.

So, correlation has nothing directly to do with whether investments go up or down; it has to do with whether they tend to have surprises in the same direction. If an investment has an expected return of -10% and one year it returns -5%, this is an upside surprise. If another investment has an expected return of 10% and returns 5% one year, this is a downside surprise. Correlation measures the extent to which two investments tend to have surprises in the same direction.

Tuesday, November 1, 2011

Can Leveraged ETFs Cause Market Instability?

Canadian Couch Potato took a detailed look at whether leveraged ETFs can cause market instability including links to other opinions on the subject. Missing in the various articles I read was a clear and simple explanation of the forces that can cause leveraged ETFs to add to market volatility.

2X Bull ETF

Consider first an ETF that seeks to give double the daily return of a given stock index. Suppose that investors have invested a total of $100 million. There are many ways for an ETF to gain double exposure, but we'll look at a simple method: the ETF borrows another $100 million and buys $200 million worth of index stocks.

At the start of the day the ETF holdings are

Stock: $200M
Cash: -$100M

The ETF's goal is to maintain a 2:1 ratio between stocks and borrowed cash. Let's now look at what happens on a volatile day. If stocks go up 5%, the holdings are now

Stock: $210M
Cash: -$100M

At the end of the day, the ETF has to borrow another $10 million to buy stock to get back to a 2:1 ratio:

Stock: $220M
Cash: -$110M

Suppose that instead of going up 5%, the market had dropped 5%. Then the ETF holdings are

Stock: $190M
Cash: -$100M

At the end of the day, the ETF has to sell $10 million worth of stock to get back to a 2:1 ratio:

Stock: $180M
Cash: -$90M

Note that no matter which way the market moves, the ETF trading pushes the market further in the same direction. If the market goes up, the ETF starts buying stocks to drive it higher. If the market goes down, the ETF sells stocks to drive it lower.

2X Bear ETF

We might hope that an inverse ETF would have the opposite effect, but this isn't the case. Suppose that investors have invested a total of $100 million in a double inverse ETF. Again, there are many ways to gain double inverse exposure, but we'll look at the direct method: the ETF borrows $200 million worth of stock and sells it.

At the start of the day the ETF holdings are

Stock: -$200M
Cash: $300M

The ETF's goal is to maintain a 2:3 ratio between stock debt and cash. If stocks go up 5%, the holdings are now

Stock: -$210M
Cash: $300M

At the end of the day, the ETF has to buy $30 million worth of stock to get back to a 2:3 ratio:

Stock: -$180M
Cash: $270M

Suppose that instead of going up 5%, the market had dropped 5%. Then the ETF holdings are

Stock: -$190M
Cash: $300M

At the end of the day, the ETF has to borrow and sell $30 million worth of stock to get back to a 2:3 ratio:

Stocks: -$220M
Cash: $330M

Once again no matter which way the market moves, the ETF trading pushes the market further in the same direction.


So, leveraged ETFs do add to market instability, but an important question is how much? If the bulk of investor money were in leveraged ETFs then the added volatility would be a problem. But, as Canadian Couch Potato pointed out, leveraged ETFs are just a small part of the market. Another good point he makes is that regular ETFs that include no leverage, swaps, or derivatives do not add to market instability.