Friday, November 29, 2013

Short Takes: Identifying Bubbles, Debt to Foreigners, and more

Here are my posts for the week:

Rule of 72 in Reverse for Mutual Funds

Crazy Arguments in Support of Leverage

Now is the Time to Consider Lowering Your Portfolio Risk (Rob Carrick mentioned this post on his Carrick on Money Globe and Mail blog -- thanks, Rob)

Here are my short takes and some weekend reading:

Jeremy Siegel gave a very interesting hour-long lecture (see video here) that includes the great quote “a bubble is an asset class that is going up in price that you don’t own.” Siegel takes a very long-term view of various asset classes and argues that Robert Shiller’s Cyclically Adjusted Price Earnings (CAPE) ratio is thrown way off by recent accounting changes that dramatically lower earnings in the last decade compared to decades past. Thanks to Canadian Financial DIY for pointing me to this one.

Big Cajun Man has a nice chart showing that the percentage of Canada’s debt owed to foreigners is lower than the percentage for other nations. However, in just 2 years, Canada’s percentage jumped from 15% to 25% owed to foreigners.

The Blunt Bean Counter has a guest post explaining severance pay laws. It turns out that the terminated employee has an obligation to seek new work to minimize the old employer’s severance costs.

Canadian Couch Potato argues that when leaving expensive mutual funds for low-cost ETFs, it is best to just pay the deferred sales charges (DSCs). He closes with “the best time to implement your portfolio is always now.” This is usually true, but not always. For example, a member of my extended family is currently waiting a month to make a change to avoid a 1.5% DSC. Waiting a year would not have been worth it, but just one extra month of high MERs is far less than the 1.5% DSC.

Million Dollar Journey explains why he finds Qtrade somewhat lacking as a discount brokerage even though many of his readers are vocal about liking Qtrade.

Sandi Martin makes some interesting admissions about her less than perfect financial habits that came from having free banking through her job for many years. I’ve always been wary of employment-related perks. For example, using a work email address for personal email becomes difficult when you change jobs. Similar problems come with joining company sports teams or leaning on other employer freebies. Free stuff is nice, but it’s important not to let your real life get too tangled up with your employer.

My Own Advisor lists some of his favourite financial advice quotes.

Wednesday, November 27, 2013

Now is the Time to Consider Lowering Your Portfolio Risk

During the 2008/2009 stock market crash, it wasn’t too hard to find people telling you to re-evaluate your asset allocation and tolerance for risk. However, that was a terrible time to lower you portfolio risk; now is a much better time to consider this question.

It’s natural for your emotions to tell you to sell stocks after they’ve dropped and to buy more after stock prices rise. To a certain extent it is these emotions that drive stock market swings. However, it’s not too hard to see that this behaviour amounts to selling low and buying high, which is exactly the opposite of what most investors want.

Re-evaluating your asset allocation isn’t necessarily a bad idea, but there are wrong times to do it. The stock market lows of March 2009 were the wrong time to consider selling stocks. Even if you were right in deciding that your stock allocation was too high for your risk tolerance, making a change back then would have caused a permanent loss of capital.

Now would be a great time to consider lowering your stock allocation. Stocks have risen tremendously from their lows four and a half years ago. If you suffered through the stock market crash and doubt that you could handle it again, lowering your stock allocation now would not cause a serious permanent loss of capital.

I’m not saying that investors should sell stocks now. I’m just saying that if you must sell stocks, now is a far better time to do so than 2009 was.

We can flip this argument on its head as well. If you are considering increasing your allocation to stocks, the recent big run-up in stock prices makes now a bad time. 2009 would have been a much better time to decide to buy more stocks.

Most of the time the best thing to do is to stick with a sensible long-term plan. However, if you’re determined to change your allocation, the best time to do it is usually when your emotions are pushing you in the opposite direction.

Tuesday, November 26, 2013

Crazy Arguments in Support of Leverage

I always hesitate to point to work that I think my readers should avoid, but I’ll make an exception here. I was reading an article called Why borrowing to invest (leveraging) is a good idea. I’ve read many reasonable articles that point out the positive side of leverage and expected more of the same here. However, I didn’t get more of the same. (Thanks to Ken Kivenko for pointing me to this article.)

The interesting part of the article begins when the authors take aim at critics of leveraging:
“Critics argue that leveraging increases investment risk and that a rate of return higher than the loan’s interest rate is needed to generate a profit. But neither claim is accurate.”
Okay, this is going to be good. Apparently, leverage doesn’t increase risk and you can profit even if you pay more to borrow than you make on your investments! Let’s start with risk:
“Risk, as far as it pertains to investing, is the odds that you will lose money. By this definition, we have to question how borrowing money can impact risk. After all, whether you invest your own money or that of the bank’s [sic], it’s the performance of your investment that determines profit or loss. Leveraging will impact how much you could potentially lose, but the odds are still based on your investment choices.”
We don’t all agree on a single definition of financial risk, but no sane person ignores the magnitude of potential losses. If an investment goes badly for me, I care a great deal whether I lose $10,000 or $100,000.

Leverage magnifies both gains and losses. This increases financial risk by every reasonable definition I’ve seen.

Let’s move on to how to profit even if your investment returns are less than you pay in interest:
“If investing for a single year, then a return higher than the loan’s interest rate is needed to turn a profit. But most leveraging strategies are designed to be in effect for years, in which case the break-even rate of return drops below the loan’s interest rate.

“The reason is simple. Investment returns compound over time — in other words, gains from one year generate gains in of themselves in the following year. Meanwhile interest on investment loans is fully paid every year and does not accumulate (simple interest). As a result, investment growth outstrips the interest paid over time.”
This reasoning may be hard to follow without an example. Suppose you borrow $100,000 at 4% interest. You pay just the interest of $4000 per year for 25 years. So, you pay a total of $100,000 in interest.

You invest the money and earn a return of 3% per year for those 25 years. After paying off the initial loan, you’re left with $109,378. But you only paid $100,000 in interest. So, you’re ahead $9378. Or at least this is the reasoning of the writers of the article.

I wonder if the authors have heard of inflation or opportunity cost. From your point of view as the investor, you paid $4000 per year for 25 years and ended up with $109,378. This works out to a yearly return of 0.74%. Because this is very likely to be lower than inflation, you actually ended up with less purchasing power than you gave up with the interest payments.

Looking at this from a different angle, suppose you hadn’t used any leverage and had just invested $4000 per year for 25 years earning 3% per year. In the end you’d have $145,837. This is $36,459 more than leveraging produced. It’s hard to see any reasonable way to look at this and conclude that the leverage was beneficial.

Any time someone makes an argument that uses the term “simple interest,” you should be wary. Simple interest does not exist in the real world. All interest compounds. Paying off the interest every year creates the illusion of simple interest if we make the mistake of ignoring the time value of money.

Borrowing money to invest is an advanced investing strategy that should only be done by knowledgeable investors with a high capacity for volatility. Because it makes no sense to borrow to invest in fixed income investments, leverage is for those who can handle more volatility than an all-stock portfolio. If you’re like many Canadians with a balanced portfolio (roughly half stocks and half bonds), you should consider bumping up your percentage of stocks before thinking about leverage.

Investors who work with financial advisors need to be concerned about pitches touting the benefits of leverage. Good advisors would only recommend leverage for the small minority of their clients where it makes sense. The not-so-good advisors will see leverage as a way to collect more fees on a larger amount of money you have invested.

If you’re thinking about using leverage and are dreaming of huge riches, you should ask yourself a sobering question: if stock prices tumble to half their current value and then you lose your job, will you be okay?

Monday, November 25, 2013

Rule of 72 in Reverse for Mutual Funds

Most people have heard of the Rule of 72. It’s a way to estimate how long it takes for your money to double at a given rate of return. Less well known is that this rule can be used to estimate how long it will take for investment fees to consume half your portfolio.

The Rule of 72 says that if multiply your rate of return by the number of years you’ll earn that return and the answer is 72, you’ll roughly double your money. So, if you earn 6% each year, it takes about 72/6=12 years to double your money.

When it comes to fees, the same rule works for finding the number of years it takes for fees to consume half of your money. For example, if you invest in Investors Canadian Growth Fund, the total fund costs each year are 3.02% of invested assets. So, it would take about 72/3.02=23.8 years for half your money to be consumed in costs. This rule just gives an estimate, but it’s pretty close. The actual time is just under 23 years.

Friday, November 22, 2013

Short Takes: Shaking Up Canada’s Mutual Fund Industry, Brokerage Rankings, and more

I gave a warning about misusing TFSAs this week:

Two Common Misconceptions about TFSAs

Here are my short takes and some weekend reading:

Tom Bradley at Steadyhand makes a strong case that the mutual fund industry has lost its chance to create practices that are friendly to investors. He says that regulators need to cause a transition in the industry that is “jolting, expensive and soul searching.”

Million Dollar Journey compares the top Canadian brokerages that offer U.S. Dollar RRSPs. He compares them on fees and on how well they handle currency exchanges between Canadian and U.S. dollars. The Globe and Mail has also come out with its 2013 ranking of online brokerages.

Larry MacDonald explains why tax-loss selling is not as valuable as it appears to be.

Retire Happy Blog does a good job of interpreting the latest SPIVA scorecard comparing active versus passive investing. The 5-year results look quite dismal for active investors.

Canadian Couch Potato explains the hidden cost of bid-ask spreads when trading. I wrote about this topic myself in the early days of this blog.

Big Cajun Man takes a look at the “4% rule” for drawing an income from your savings in retirement.

My Own Advisor gives us a primer on TFSAs.

Thursday, November 21, 2013

Two Common Misconceptions about TFSAs

The name Tax-Free Savings Account does a good job of making it clear that these accounts produce gains that are tax-free. However, the “savings account” part of the name leads to confusion for some Canadians. Here are two common misconceptions about TFSAs.

Misconception #1: TFSAs are just for holding cash like regular savings accounts.

TFSAs can hold a wide range of investments, including stocks, bonds, and cash just like RRSP accounts. It’s common for banks to offer TFSAs that can only hold cash and GICs, but this is the banks’ restriction, not a TFSA restriction. Most banks offer other TFSAs that do permit holding stocks and other investments. Almost all discount brokerages also offer TFSAs that allow the full range of investments.

Misconception #2: TFSAs can be treated like regular savings accounts with many deposits and withdrawals.

Most people are aware that there are limits on the total amount you can contribute to a TFSA. For those who turned 18 in 2009 or earlier, the lifetime contribution maximum is $25,500 in 2013. A nice difference between TFSAs and RRSPs is that if you make a TFSA withdrawal, you get your contribution room back, but not until the next year.

Let that last bit sink in a little: not until the next year. Suppose you opened a TFSA in 2012 and put in the maximum of $20,000. Then this year you put in another $5500. Later this year you took out $5000 and then put it back. It may not seem like you’ve contributed too much, but CRA disagrees. The $5000 withdrawal will give you extra contribution room in 2014, but for 2013 you’ve contributed $5000 too much and will be charged a 1% penalty each month on the excess.

In many ways TFSAs are much simpler than RRSPs, but there are still some rules that Canadians need to know.

Friday, November 15, 2013

Short Takes: Advisors as Fiduciaries, the Future of Marriage, and more

Here are my posts for the week:

Fight Back

Investment Survey Troubles

Expanded CPP and Debt

Here are my short takes and some weekend reading:

Anita Anand and John Chapman at the University of Toronto Faculty of Law explain in this short article why investment advisors should be fiduciaries. They say that current Canadian laws in this area are “a mess.” Thanks to Ken Kivenko for pointing me to this one.

Scott Adams has a very interesting take on the future of marriage.

Where Does All My Money Go? says you shouldn’t take up a bank’s offer to take a payment holiday.

Canadian Couch Potato shreds claims made by a mutual fund company in their ad.

Big Cajun Man lays out the reasons why some parents are pushed toward sending their kids to a private school.

The Blunt Bean Counter brings us a detailed look at the ins and outs of tax-loss selling.

My Own Advisor calls for clawing back Old Age Security at lower income levels. His reasoning is that it makes no sense for working-class Canadians to subsidize the lifestyles of upper-middle class retirees.

Financial Crooks investigates the fine points of getting trading commissions at RBC lowered from $28.95 to $9.95.

Thursday, November 14, 2013

Expanded CPP and Debt

The push to expand CPP has been strong lately. The idea is that too many Canadians won’t save for their retirements and must be forced to save more money. Setting aside the argument over whether it is a good idea to force Canadians to save more money, I wonder if it is even possible because of debts.

For various reasons, many Canadians simply won’t save for their retirements. Some have good reasons, but most don’t. If we expand CPP, we can force people to save more through increased payroll deductions. Those who already save for their retirements can afford to save a little less because they can expect higher CPP benefits. So, by expanding CPP, we’re mostly affecting those who don’t save now.

But how can we stop people from simply building larger debts as they head into retirement?

When Canadians carry debt into retirement, it’s as though they have pre-spent part of their CPP benefits. If CPP expands, they can borrow even more and pre-spend the increase in CPP benefits.

You might object that people aren’t this calculating. That’s generally true, but lenders are definitely that calculating. Lenders have been wildly successful at marketing debt to Canadians in recent decades. Sadly, many people just keep borrowing until lenders say no. If a borrower has higher CPP benefits coming, then lenders will delay saying no for a little longer allowing borrowers to pre-spend their increase in CPP benefits.

According to Douglas Hoyes, “it is very difficult, if not impossible, for a creditor to garnishee a pension,” but if the debts are backed against seniors’ homes, then the threat of losing one’s home will keep seniors making interest payments out of their expanded CPP benefits.

You might think that I’m offering this line of thought as an argument against expanding CPP, but that’s not where I’m headed. I’m actually a supporter of a modest expansion of CPP as long as the higher benefits go to those who make the higher payroll contributions. What I’m looking for is some sort of solution to the debt problem I described.

If we were to expand CPP, how would we stop Canadians from building up larger debts that eliminate some of the upside of higher CPP benefits?

Wednesday, November 13, 2013

Investment Survey Troubles

In Rob Carrick’s latest roundup of personal finance links on the web he asked his readers to take a short Qualtrics survey to “help build a better investor risk assessment tool.” Unfortunately, the survey has problems that will muddle its results.

The main question on the survey asks which of 4 investments you’d be most comfortable with. Here is the exact wording:
“Investments with higher potential returns typically involve greater risk. The following chart shows four hypothetical investments of $10,000, each with a different potential best and worst outcome at the end of one year. Which investment would you be most comfortable with?”
You are presented with 4 bar graphs giving ranges of possible portfolio returns going from safest to riskiest. Here were the ranges I was presented.

Portfolio A: 0 to $10,900
Portfolio B: -$9600 to $11,200
Portfolio C: -$8900 to $11,800
Portfolio D: -$8400 to $12,400

Just based on the numbers, it’s hard not to choose Portfolio A because its midpoint is more than double the midpoints of the other portfolios. So, even though I tend to be comfortable with volatility, I had to choose the least risky choice in this survey because it offered the highest expected return.

Another problem is that the bar graphs shown were hopelessly out of scale. For example, it shows the downside of Portfolio D as about 4 times bigger than the downside of Portfolio B, even though B actually has the greater potential for loss.

I suspect that the survey results will have some meaning for respondents who look only at the picture and ignore the numbers on it. However, crazy people like me who actually look at numbers will mess up the survey results.

This isn’t the end of the problems, though. When I went to look back at the survey again, I was presented with a different chart. After a few browser reloads, I saw that there appeared to be 5 different charts. Three of these charts had big mismatches between the numbers and the bar graph sizes. The other two were to scale, but still showed the safest investment as having the highest median return.

Overall, I seriously question whether this survey can produce any meaningful results about investor attitudes towards investment volatility.

Tuesday, November 12, 2013

Fight Back

Over her years of using her Toronto Star column to help consumers fight back against unfair company practices, Ellen Roseman has built up wide-ranging consumer skills. Her book Fight Back teaches us what she has learned and goes further with many parts written by experts in different areas. Across 81 short, easy-to-read sections, Roseman covers how to deal with almost every conceivable consumer problem.

The broad categories covered in this book are banks, finances, telecom suppliers, travel, retailers, cars and houses, and the courts. I’ve had troubles in most of these areas, and I find this book very valuable. However, Dave Chilton, who wrote the foreword, shows he is better at singing Roseman’s praises than I am when he starts with “I LOVE ELLEN ROSEMAN’S WRITING.” I agree.

In the rest of this post I’ll discuss specific parts of the book that I found interesting.

Mutual Fund Companies

In the past “many [mutual fund] companies treated investment advisors as their customers, while ignoring the needs of investors. That is no longer true.” I find this surprising. I’d like to hear more from Roseman to understand what she thinks has improved.

Right of Set-Off

“If you keep your operating account with the same bank where your loans are, your funds could be seized by the bank if you get behind on your loan.” This “right of set-off” makes it useful to have “some funds that are beyond the reach of your lending bank.”

Telecom Discounts

Roseman isn’t afraid to describe some tricky tactics to counter those used by internet, cable, and phone companies. These companies have specific deep discount percentages they sometimes offer to keep a customer. “If you know what the discount percentage is, you can pretend you were offered it and you are now calling back to confirm taking it.”

Travel Insurance

“If you make a mistake in any one of your answers [on a health history questionnaire], you will not be able to collect on your insurance ... even if the reason for your claim has nothing to do with the erroneous answer.”

Rental Car Insurance

What car rental companies offer “is not insurance but a collision damage waiver (CDW). This means that the rental company waives its right to collect a high deductible from you if the car is damaged.” I’m not sure I understand this. Does this mean that rental cars are already insured but the deductible is high? If so, I can afford a fairly high deductible as long as the bulk of any very large judgements is covered.

Credit Card Disputes

In my limited experience, credit card companies seem very accommodating when I dispute charges. However, you lose your zero-liability guarantee if you “have reported two or more unauthorized events in the past 12 months.”

Little Black Book of Scams

Roseman recommends reading the little black book of scams. That’s an intriguing title.

End-of-Lease Charges

Roseman says that her neighbour is on to something when he theorizes about the motives of a particular car company when it leases cars. “The company loses money on artificially inflated residual values” and it uses inflated lease-end charges “to recover the loss.” Given how so many people focus exclusively on the size of monthly payments, it’s easy to see how car companies can be tempted to drive payments lower and make up the difference at the end of the lease.

Friday, November 8, 2013

Short Takes: Analyzing Canadian Stock ETFs, Tax Credits for Disabled Children, and more

This week I fed my interest in poker:

World Series of Poker Main Event Losses

Here are my short takes and some weekend reading:

Canadian Couch Potato uses factor analysis to look for value in Canadian equity ETFs.

Big Cajun Man talks from experience when he explains how to get tax credits for school fees for a disabled child.

My Own Advisor gives a quick, easy-to-understand summary of the things you should know about RRSPs.

The Blunt Bean Counter is giving away copies of Richard Peddie’s book Dream Job.

Tuesday, November 5, 2013

World Series of Poker Main Event Losses

With the main event of the world series of poker wrapping up tonight, I thought I’d throw a wet blanket on the dreams of aspiring poker players by looking at the risk-adjusted payoff of entering this tournament. The results are worse than I expected.

The entry fee to the main event is $10,000. However, the prize payouts average only $9400 per player. Without any risk adjustment the average player is losing $600 by entering the tournament. To an insurance company with billions in assets, this analysis makes sense. But to people of more modest means, a reasonable amount of risk aversion makes the loss much higher.

A sensible level of risk-aversion involves treating gains and losses geometrically. This means that doubling your net worth from $100,000 to $200,000 is as good as it is bad to have it cut in half to $50,000. Based on this model of the utility of money, a person with a $100,000 net worth expects to lose $5918 playing in the main event if his tournament result is just random (equally likely to be first, second, or at any other position). This is a lot worse that just giving away $600.

Here are the results for other levels of net worth:

$1,000,000,000: loss of $610
$100,000,000: loss of $699
$10,000,000: loss of $1360
$1,000,000: loss of $3356
$100,000: loss of $5918
$20,000: loss of $8183

This isn’t the worst of it, though. Most people have higher levels of risk aversion than I used in this model of the utility of money. If we use what is called a “harmonic” model the results look even worse:

$1,000,000,000: loss of $620
$100,000,000: loss of $796
$10,000,000: loss of $1932
$1,000,000: loss of $4405
$100,000: loss of $7038
$20,000: loss of $9144

The lesson here is that you have to be a well above average poker player to have an expectation of coming out ahead playing in the world series main event. Of course, many poker players can convince themselves that they are good enough to win. Only a minority of them can be justified in their confidence.

Friday, November 1, 2013

Short Takes: Rebalancing for Taxes, Bitcoin Taxes, and more

This week I found a problem with a trading account statement and added a new twist to my retirement income strategy:

InvestorLine Computers Charge Me Interest

A Retirement Income Strategy Revisited

Here are my short takes and some weekend reading:

Canadian Couch Potato gives a good example of how to rebalance a portfolio while maintaining assets in tax-efficient accounts.

The Blunt Bean Counter looks at the tax side of Bitcoins.

Glenn Cooke gives a thoughtful review of Potato’s Short Guide to DIY Investing. Glenn makes an interesting pitch for keeping your stock investments in Canadian stocks, but then admits that this is likely just emotional and that including foreign stocks is probably best. Despite his assertion that we need to get emotions out of investing, he illustrates why this can be hard to do.

Larry Swedroe reviews former Federal Reserve vice chair Alan Blinder's new book After the Music Stopped and finds it to be the best he’s read so far on the financial crisis.

Where Does All My Money Go? interviews Rich Cooper who explains some of the ins and outs of a DIY approach to settling your debts for less than you owe when you’re in serious financial trouble.

Financial Crooks reviews Ellen Roseman’s book Fight Back.

My Own Advisor has made some great progress on his 2013 financial goals.

Big Cajun Man thinks that when you’re well behind your retirement savings target, reaching for high-risk investments isn’t the answer.

Million Dollar Journey looks at the advantages and disadvantages of commuting by bicycle. For me the big disadvantage is safety. I used to love cycling but stopped because I always had to travel beside cars for parts of my trip.

Canadian Capitalist updated his explanation of how employee stock purchase plan (ESPP) benefits are taxed.