Wednesday, April 30, 2014

Anti-Rebalancing

Investors find many ingenious ways to underperform stock indexes. Sadly, many have no idea that their brilliant moves actually work out badly over time because they don’t track their returns accurately. Among the ways that investors manage to harm their portfolios is what I call “anti-rebalancing”.

The idea of rebalancing your portfolio is that you start with fixed percentages of various asset classes, and when they drift away from the fixed percentages, you bring them back in line. For example, suppose Beth holds 4 funds in equal amounts: Canadian stocks, U.S. stocks, foreign stocks, and bonds. Every so often she checks which fund balance is higher than the others and which are lower, and she makes some trades to get the amounts back in balance.

This sounds easy enough in theory, but isn’t so easy in reality. After the explosion of U.S. stocks in 2013 and the relative underperformance of foreign stocks, Beth is supposed to sell some of her U.S. stock fund and buy more of her foreign stock fund and bond fund. It can be hard to make the decision to sell your best performer and buy the dogs.

This brings us to what I see some investors do: anti-rebalancing. They sell some of their dog funds and buy more of their top performers. This can actually work out well sometimes. Maybe U.S. stocks will shine again in 2014. Unfortunately, over time, anti-rebalancing works out worse than rebalancing. This is because rebalancing amounts to buy low and sell high, which anti-rebalancing amounts to buy high and sell low.

Few investors think of their strategy as anti-rebalancing, though. They offer intelligent-sounding reasons why their allocation percentages need to change. Maybe they decide the sentiment that the U.S. is losing its place of world dominance is overblown and they should keep a sizable portion of their savings in U.S. stocks. Whatever the reasoning offered, the bottom line is that they pour more money into whichever fund is up the most.

If you think of yourself as an index investor, but you make your own judgements about portfolio changes instead of simple rebalancing, I urge you to look over your history of trades and see what would have happened if you had rebalanced mechanically. The majority of investors who do this exercise honestly will find that their trades have actually hurt their returns.

Tuesday, April 29, 2014

The Downside of Naked Put Options

The obvious upside of naked puts is that you get to say “naked” without being inappropriate. However, they have downsides as well. A colleague of mine (let’s call him Jim) took the time to understand how naked puts work and reacted the way many people react: they seem like free money. I’ll explain what naked puts are and why they don’t give free money.

Let’s use Jim’s example Bank of Nova Scotia stock (BNS). The buyer of a put option on BNS has the right, but not the obligation, to sell BNS shares at a set “strike” price to the seller of the put option. In Jim’s example, he could sell put options on BNS for $6.25 each. If the BNS shares drop, the option buyer could force Jim to buy BNS shares at the strike price of $66 any time until January. The “naked” part of a naked put refers to the fact that Jim does not have a short position in BNS shares that would be closed out if he is forced to buy the BNS shares.

The way Jim sees it, he can’t lose. If he is forced to buy the BNS shares, he gets them for $66 less the option premium of $6.25, or about $59.75, which is much less than BNS shares trade for as I write this. If he isn’t forced to buy the shares, he gets to keep the $6.25 option premium. He wins either way!

To understand the flaw in Jim’s reasoning, let’s compare his strategy to simply buying BNS shares at the current price. For one thing, BNS shares will pay dividends between now and January. So, the gap between the current price and his apparent price of $59.75 is smaller than it appears because of these dividends.

Next, consider what happens if BNS falters before January. If BNS shares drop in price, the option buyer will force Jim to buy the shares. Jim won’t be as interested in owning BNS shares at an effective price of $59.75 if there is a business reason why their price has dropped.

Now let’s see what happens if BNS shares rise sharply on some good news. In this case, instead of making money from owning BNS shares, all Jim will get is the $6.25 premium. Jim will have missed out on some significant upside.

Writing naked puts isn’t a free ride; it will sometimes work out well and sometimes not so well. Averaged out over time, there is more upside to simply owning stock than there is to writing naked puts.

Friday, April 25, 2014

Short Takes: Trailer Park Bullies and more

Here are my posts for this week:

Taking the Gail Vaz-Oxlade Test

Filling out Tax Forms Properly for RRSP Contributions

The Levels of Personal Financial Competence

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand sums up the current battle over mutual fund trailing fees. I’d be happy to see regulators put a stop to all payments from mutual funds to advisors.

Canadian Couch Potato looks at the recent drops in ETF MERs by BlackRock and BMO.

Big Cajun Man deletes his Mint.com account to improve his online financial security.

Million Dollar Journey gives a high-level view of how to delay capital gains taxes on your business when you pass away.

Thursday, April 24, 2014

The Levels of Personal Financial Competence

Here I take a 1000-foot view and define levels 0 to 3 of personal financial competence. One of the big things I’ve learned about personal finance since I started writing this blog is the staggering number of people mired in the lower levels.

Level 0: Spend as you please and tomorrow will take care of itself

The main thing that characterizes people at this infantile level is declining net worth. They use credit to go out to eat, vacation, and buy cars. They justify their spending with nonsense like YOLO and “I’m worth it.”

I don’t include in this group retirees who are sensibly drawing down their life’s savings. Their net worth may be declining, but with a logical purpose. I also don’t include people who face serious medical problems that prevent them from making a living and require them to spend on health care. Foreseeable events like a car breakdown or needing dental care don’t get you off the hook for a level 0 label.

In my parents’ day, this level largely didn’t exist because there was limited access to personal credit. It’s not that people were smarter decades ago; they just didn’t have the same opportunities to borrow. When you go to the bank with each pay cheque, trade it for cash, and have to go hungry for a day if you don’t make the money last to the next pay cheque, reality hits you quickly. Young people today face a minefield of banks and other financial institutions sending the strong marketing message to spend as you please on credit.

Level 1: Steady state

People in steady state are managing to live within their means, but just barely. They’re not getting richer, but they’re not getting poorer either. Typically, people at this level have some debt, but they manage to make minimum payments, and they don’t build new debt any faster then they’re paying off old debt.

Everyone in level 0 will eventually be forced into level 1. You can’t spend other people’s money forever. The smart ones see the problem with living at level 0 themselves and cut their spending. The dumbest people in level 0 build up debts so large that no one will lend them any more money. Through no fault of their own, they get upgraded to level 1 and downgraded to a much lower lifestyle.

I don’t include in this level people who have enough savings to prepare them for retirement, and they choose to spend their incomes and their investment returns. Even though their net worth isn’t increasing, they qualify for a higher level.

Level 2: Saving for the long term

People in level 2 are building long-term savings. This doesn’t mean saving for a car or a vacation; it means saving for some far-off purpose such as retirement.

However, just contributing to an RRSP or TFSA isn’t good enough to make it to level 2. If you’re building debt just as fast as you’re saving, you’re not really saving at all. People who grow their lines of credit, car loans, or other debts at the same time as building long-term savings get sent back to level 0 or level 1.

The critical thing to make it to level 2 is to be building your net worth at a pace sufficient to be adequately prepared for retirement. Most people should target having a substantial nest egg by about age 60; career disruption after age 60 is very common. Maybe you won’t be able to do the same job you’ve always done, or even if you can, your employer may not agree.

Level 3: Investing savings sensibly

If you’ve made it through the minefield of overspending and are managing to increase your net worth over time, you have a shot at making level 3. As a very rough guide, I’d say that “investing savings sensibly” means investing in a way that has the expectation of beating inflation by 2% or more each year.

A lucky few have no need to seek investment returns. If you’ve got millions saved but live a modest life and see no need for anything but GICs at a few different banks, you can have your level 3 stamp right now. However, if you’re slaving away at work saving as much as you can, but saving it all in GICs, go back to level 2.

If you invest in balanced funds and pay a 2.5% MER, a little more in trading expenses, and the occasional deferred sales charge, you’re expected long-term return is less than 2% over inflation. Go back to level 2.

If you sold out of the market in 2009 and are still looking for signs that it’s safe to get all the way back in, your prospects aren’t good. Most market timers make their moves at the wrong times. Go back to level 2.

If your portfolio turnover exceeds 100% per year, odds are very strong that you’ll trail market averages badly. Go back to level 2.

If you pore over mutual fund descriptions of the type Gordon Pape used to publish each year to decide where to move your money, you’re likely a performance chaser who will lose out over time. Go back to level 2.

If you’ve been reading analyst reports and are sure that Blackberry is poised for a rebound, even though less than half of your previous picks didn’t work out, go back to level 2.

Personally, I’m hoping to beat inflation by at least 4% per year, on average, with index investing. It’s ironic that the average dollar invested with a plan to beat the index will end up doing worse than the index. Those who take the biggest chances to beat the index actually belong back in level 2.

Conclusion

It would be interesting to see the results of a poll asking people to self-assess their level. Because the average person can’t grow wealth faster than the economy grows, there is limited room in level 3. But I’d bet that a great many people think they’re at level 3.

For the most part I’ve aimed this blog at people who are in levels 2 and 3. Being a natural saver, I have no personal experience of living in level 0 or level 1. However, from reader feedback and watching friends and family, I’ve gained some insights.

Preet Banerjee’s excellent book, Stop Over-Thinking Your Money, is mostly about moving people from levels 0 and 1 to level 2. He says that if you can start saving and avoid the worst investing mistakes, you get an A in personal finance. You can expect me to keep writing about moving from an A to an A+.

Wednesday, April 23, 2014

Filling out Tax Forms Properly for RRSP Contributions

Those who make an early start at contributing to their RRSPs for the year are sometimes confused about how to file their income taxes properly. It’s important to fill out Schedule 7 in the correct year.

Although TFSAs have blunted the traditional RRSP rush each year near the end of February, many Canadians still wait until the last minute to make their contributions. These last-minute contributors know that they can make an RRSP contribution in the first 60 days of this year and still take a deduction on last year’s income taxes.

However, some early birds have already used up their 2013 RRSP room and got ahead of the game by making a 2014 RRSP contribution during the first 60 days of 2014. Some of these people mistakenly think they should wait until they file their 2014 income taxes to declare this contribution. That’s not how it’s supposed to be done.

Even if you don’t intend to take a deduction for an RRSP contribution you made in the first 60 days of this year until you file your 2014 income taxes, you still declare the contribution on your 2013 income taxes. You then have the option of deferring taking the RRSP deduction until a later year (2014 or later).

If you fail to declare the RRSP contribution you made in the first 60 days of 2014 on your 2013 income tax return, you can’t just wait for 2014 and put it there. You have to amend your 2013 income tax return. This is one case where doing the right thing and getting ahead of the game can lead to some confusion.

Tuesday, April 22, 2014

Taking the Gail Vaz-Oxlade Test

I’ve learned a lot from watching Gail Vaz-Oxlade work with people who manage their money poorly. She understands what they’re doing wrong and knows when they need a hug and when they need to be called morons. However, I find her prescriptions don’t apply well to people like me. To illustrate, I’ll take a recent test she posted on her blog.

Like 10% of Canadians in a study Gail quotes, I give myself an A in financial literacy. However, Gail correctly observes that “many Canadians may have a false sense of confidence.” Here are a few facts about my finances before I leap into taking Gail’s tests:

– I save more than half of my take-home pay.
– This savings level is not really part of any plan. I just look back at my credit card, bank account, and trading account records and see that I’ve saved more than I’ve spent.
– I check my account statements closely for errors, but I maintain high enough balances that I don’t have to check often to see if I have enough money for a particular purchase.

Here’s the first test (edited for length):
1. If you track your spending daily, take an A. If you do a weekly check, you score a B. If you’re over-confident enough to believe that you only have to check in once a month, you’re passing, but just. Never look at your account because you’ve got overdraft protection so nothing too bad can happen? You FAIL.
Given how often I check my accounts, I deserve roughly a C on Gail’s scale.
2. Do you live on a budget and stick pretty close to the plan? Take an A. If you have a budget but sometimes are surprised by expenses, you score a B. If you have a budget in your head, and never go over on your spending, you’re passing, for now. If you don’t have a budget at all because you think they’re stupid or you can’t be bothered to manage your money with this level of detail, epic FAIL.
I’m partly a D and partly an “epic FAIL” on this one. I don’t have a budget, but I never go over on my spending. I just look into the past to see how much I spend and use this to predict my future.
3. Do you have a specific amount that you set aside every month automatically for both retirement and emergencies? Take an A. If you save “pretty regularly” but not automatically, you score a B. If you’re using a round-up program for savings, all you get is a pass. Less than that, you FAIL. You also FAIL if you claim you can’t find even a dollar a day to save.
I probably deserve a C on this one. Whenever cash has built up to a certain threshold in one of my accounts, I invest it. I usually just make one RRSP contribution in a year. I fill up my TFSA whenever there’s enough cash around. Any other cash gets invested in my taxable trading account.

Overall, my performance doesn’t look good on Gail’s scale, but my personal financial results are likely in the top few percent. I have friends who handle money similarly to the way I do. Gail’s methods are very successful for helping most people, but there seems to be a subset of us who don’t need Gail’s approach. However, I’d bet that most of the people who think they don’t need Gail’s approach are wrong.

Thursday, April 17, 2014

Short Takes: Aging Financial Brain, Buying Nothing, and more

With Easter upon us, I’ve compiled my short takes a day early. Here are my posts since my last set of short takes:

Bad Advice on Retirement

Is it OK to Pay Off Your Mortgage before Saving for Retirement?

Personal Financial Education Can’t Solve All Problems

Here are some short takes and some weekend reading:

Jason Zweig explains some of the things that happen to an aging brain and how they affect investing decisions. I’m guessing that most of us are sure this won’t happen to us, but we’re almost all wrong.

Mr. Money Mustache says that while spending on experiences makes us happier than buying things, buying nothing at all makes us happiest.

Preet Banerjee was a victim of financial fraud recently. He describes what happened and how he solved the problem.

Potato announces his new “Automagical Financial Planning Ballparkinator” to answer the question of how much you need to save. I like the fact that he advertises clearly that any such calculation is necessarily just an estimate.

Alexandra Berzon explains the hidden game behind professional poker where players invest in each other.

Canadian Couch Potato explains that tracking the adjusted cost base is different with U.S. listed ETFs than it is with Canadian ETFs.

Squawkfox offers a rule of thumb for fixing or replacing: if it costs less than half the original purchase price to fix the item then fix it.

The Blunt Bean Counter lists some of the common mistakes his clients make on their taxes.

Big Cajun Man got way out of date with his data in Quicken. I found the same thing happened to me in my brief experiment with Quicken. I prefer to track a few things with spreadsheets.

My Own Advisor has some advice for his younger self.

Million Dollar Journey explains that the Canadian tax deadline has moved to May 5 among other tax advice.


Wednesday, April 16, 2014

Personal Finance Education Can’t Solve All Problems

I’m a believer in life-long learning. We’re better off when we take the time to learn what we can about personal finance. However, some people seem to believe that if we just taught personal finance well enough in schools, we’d prevent so many people from handling their money poorly. Education is valuable but will never be a complete solution.

The first reason why personal finance education isn’t enough is human nature. We know we should eat well and exercise, but many of us are fat and out of shape anyway. When I eat a donut, it’s not because I lack education; it’s because I had a lapse in willpower and the donut was available. Similarly, personal finance education will help to a point, but even those who know better will often lack the impulse control to make consistently good money decisions.

Another reason why personal finance education isn’t enough is that businesses that make money from our poor choices will adapt. Financial institutions have been remarkably successful at marketing debt to the masses. If their current marketing methods stopped working due to better education, they’d change their methods. Many successful businesses are made up of nine parts providing valuable goods and services and one part exploiting human weaknesses. Maybe their adaptation wouldn’t be fully effective, but it would work to partially undermine any widespread personal finance education.

People are not well suited to making good long-term financial decisions. Better education would help, but we’re still likely to keep buying ridiculously expensive vehicles on credit and keep giving away half our savings to mutual fund salespeople.

To improve the finances of the average person, we need a two-pronged approach. One prong is improved personal finance education. The other prong is better government policies and regulation. We need to make it easier for people to make good choices. Workers should have the option of a simple low cost retirement savings plan. A more difficult challenge is to help people avoid building foolish debt.

Financial institutions are unlikely to worry about personal finance education efforts because they can confidently count on their ability to market their products in different ways. However, any government effort to steer Canadians away from debt and poor investment choices is likely to be met with fierce resistance. But the potential rewards for the average person are enormous.

Monday, April 14, 2014

Is it OK to Pay Off Your Mortgage before Saving for Retirement?

Many financial advisors would say you shouldn’t defer saving for retirement to pay off your mortgage first. However, the truth is that paying off your mortgage first can be a perfectly sensible strategy as long as some important conditions are met.

The main condition you need to meet is that you are saving for the long term in some form. This should be at least 10% of your take home pay directed to long-term savings, preferably more. Commissioned financial advisors can make money if your savings are in the form of RRSP or TFSA contributions, but making extra payments against your mortgage can work for you as well.

Note that I said “extra” mortgage payments. It’s no good to save nothing in an RRSP or TFSA and just make your regular mortgage payments for 25 years. That’s just using your mortgage as an excuse to overspend right now.

Suppose your family take-home pay is $70,000. Then if you’re going to defer making RRSP or TFSA contributions, you should be paying at least $7000 extra each year against your mortgage. This will pay off your mortgage many years early. Then you can aggressively build RRSP and/or TFSA savings.

Another condition you have to meet for this strategy to make sense is to avoid building up other debts. If you’re paying extra on your mortgage but building debt on your lines of credit, credit cards, or with car loans, you’re not really saving. This applies to RRSP and TFSA savings as well; if you’re building debt at the same time, you’re not making any progress.

Most financial projections will show that you’re better off making RRSP and TFSA contributions early on instead of paying off your mortgage aggressively. However, the difference isn’t huge. What really matters is the amount you’re saving. If you save enough, you’ll benefit whether you save this money in an investment account or use it to reduce your mortgage.

Monday, April 7, 2014

Bad Advice on Retirement

In a recent Reuters article, Linda Stern explains that there is a big difference between an ideal retirement and the kind of retirement people end up with. She’s right about this. But she goes off the rails when she suggests that you should plan for a typical retirement.

Apparently, “Most people spend a lot in their first year or two of retirement ... But over time, retiree spending drops substantially.” It’s hardly surprising that people spend now and worry about the consequences later.

But when Stern advises that retirees plan to “start their retirements withdrawing 5 percent or more of assets in their first year of retirement” because retirees “don't inflate their spending on an annual basis to match the Consumer Price Index,” she goes off the rails.

I find this logic nuts. Other people plan poorly, overspend initially, and endure the painful reality that they’ve wasted a chunk of their savings and have to cut way back. So, I should set out to do the same thing?

Thanks, but no thanks. I’m going to try to avoid any painful cutbacks. I may not succeed, but I’m not going to throw in the towel right away.

Friday, April 4, 2014

Short Takes: Advisor Benefits of Low Fund Costs, High Frequency Trading, and more

I'm on vacation this week which leaves this week's short takes a little thinner than usual. Here are my posts for the week:

What Distinguishes Good Financial Advisors from the Poor Ones?

Feds Announce Sweeping CPP changes

More on CPP changes

Here are some short takes and some weekend reading:

Preet Banerjee shows how financial advisors could make $1 million more in their lifetimes if their clients invest in lower cost products, even if the percentage cost of advice remains constant.

James Osborne explains clearly why high frequency trading (HFT) is not a concern for buy-and-hold index investors. In short, HFT takes a small bite out of you only when you trade or the finds you own trade.

Canadian Couch Potato wrote a very good April Fools’ joke. The description of his new mutual fund had me laughing hard by the end.

The Blunt Bean Counter shares a retirement planning spreadsheet from one of his readers.

Big Cajun Man says that laptops don’t last as long as you might hope.

Wednesday, April 2, 2014

More on CPP Changes

By now most readers of yesterday’s post on sweeping changes to CPP have figured out that it was an April Fools’ joke. However, with the exception of very low income Canadians who are reasonably well served by the existing CPP+OAS+GIS system, I think such changes would be positive for Canadians.

Many people would be thrilled to be able to just put their savings in CPP rather than try to learn how to invest well. Further, Canadians struggle with how much they need to save for retirement because of the uncertainty of how long they will live.

Suppose that CPP payments started at age 75 and were large enough that no other savings would be needed from then on. Figuring out how much you need to save to live on from the time you retire until you’re 75 would be much simpler.

For example, if you know you’ll be fine from 75 on, and you want $30,000 per year (on top of OAS) starting at age 65, you know you’ll need to save up about $300,000 less any interest you earn from 65 to 75.

A side effect of this kind of change is that the thundering herd of people who earn their livings in financial services would be thinned dramatically. Former financial service workers would be forced toward less important pursuits like contributing to producing food or curing diseases.

With a few tweaks to make the system work well for both those with low incomes and middle class incomes, such a system is sustainable and desirable. We can cling to the vain hope that CPP payments starting at age 60 can ever be enough, or we can create a more realistic system.

Tuesday, April 1, 2014

Feds Announce Sweeping CPP Changes



Of course, this is an April Fools’ joke.  No government could survive trying to make such a change.  Too many Canadians cling to the vain hope that they can retire comfortably with minimal savings at age 60 on CPP and OAS.


Experts say that Canada’s new Finance Minister is trying to make his mark on his new job by announcing sweeping changes to the Canada Pension Plan (CPP). Claiming that “average Canadians don’t want to think about how to invest their savings,” Oliver declared the current dominant model of defined-contribution pensions “a failure.”

Citing evidence that individual investors consistently make poor choices buying high and selling low, “people need to be able to save their money in a fund they can trust, and that fund is CPP.” The current level of mandatory CPP contributions will stay, but additional contributions up to an income-tested maximum will be permitted “and encouraged.”

A further problem is that CPP payments are just too low. “Canadian who don’t save any of their income are left with CPP payments too small to live on.” To remedy this, there will be a gradual shift to CPP benefits starting at age 75 for those who make no extra contributions. “It’s a personal choice. If you choose not to save, you can work until you’re 75. If you save, then you can get CPP payments starting earlier.”

There will be a phase-in period so that Canadians under 55 currently will fall under the new system where all their mandatory contributions will be directed toward payments after they are 75. “Canadians will have meaningful CPP benefits after age 75 instead of meagre payments starting earlier.”

Those older than 55, but not currently collecting CPP benefits will get a hybrid between the old CPP rules and the new rules. Those currently collecting CPP will see no change, which means that they will not get larger payments at age 75. “We are creating a model where your CPP benefits are based on your contributions rather than just taking more from the young and giving it to older Canadians.”

With the expected growth in CPP contributions, keeping costs low and avoiding political interference in CPP management will be more important than ever. “We favour an approach based on incentives. CPP employees will receive bonuses based on how low the overall costs are. This creates a strong incentive to avoid growth of bureaucracy.” Strict auditing of costs will be used to determine bonus amounts.

Another planned change in how CPP is run is to adhere to a strict investment model of creating a portfolio investing in a representative sample of the whole world without any discretion for the investment managers. “Misguided attempts to beat the market and possible political interference in how funds are invested will be eliminated.”

Future CPP benefits will no longer be based on inflation. Any increases in benefits will come from how the CPP investments perform. “Rather than shift risk to taxpayers, all Canadians will share in global growth. Every effort will be made to smooth out benefit increases from year to year.”

We are entering “a new era” where all Canadians must make mandatory CPP contributions to give themselves a meaningful standard of living past age 75. This who choose to save more than this will have the option of saving their money in CPP and collecting benefits before they turn 75.