Friday, June 27, 2014

Short Takes: Bogle Speaks, Despicable Heirs, and more

Here are my posts for this week:

RRIF Withdrawal Rates do not have to Rule Your Life

RRIF Minimum Withdrawals are Designed for a 6% Real Return

Here are some short takes and some weekend reading:

Charles Rotblut interviews John Bogle (founder of Vanguard) about index funds, ETFs, and more. Bogle has a great way of explaining important investing concepts very clearly.

The Blunt Bean Counter makes some interesting observations about the different types of people who are expecting an inheritance. They range from decent people to the despicable.

Life Insurance Canada says that it’s hard to deal with insurance companies that sell directly online without an insurance broker. We can be justified in being suspicious of the opinion of a broker who doesn’t like companies that don’t use brokers, but the experiences described seem genuine.

Million Dollar Journey has the story of 29-year old Sean Cooper who has amassed a net worth of $500,000. Many would find his measures extreme, but even a small slice of Sean’s methods would help the finances of most young people.

Big Cajun Man thinks the government-supplied thermostats that allow the government to turn off your air conditioning during peak electricity usage times are a good thing. I think it’s a great idea for everyone other than me to get such a thermostat.

My Own Advisor updates his progress toward his financial goals. He achieved the goal of maxing out his and his wife’s TFSAs by moving assets from a non-registered account. While this may be a smart move, it sounds a little like a cheat because it’s not really new savings. I guess it comes down to whether the intent of the goal was to control spending enough to grow TFSA savings or if the goal was simply to fill the TFSAs.

Wednesday, June 25, 2014

RRIF Minimum Withdrawals are Designed for a 6% Real Return

Did you ever wonder where the magic RRIF minimum withdrawal percentages came from? I may have figured it out by accident. I was creating a chart to show that these minimum withdrawals will deplete RRIFs over time and that yearly payments would very likely decrease over time. Then I came across an amazing coincidence.

I set out to find out how RRIF payments would change over time if the investments make a steady real return. “Real return” means the return above inflation. So, if the return is inflation+3% every year, what will your inflation-adjusted RRIF minimum withdrawals look like? I calculated this for real returns from 0% to 6%. The following chart shows the results. Keep in mind that the incomes are inflation adjusted. So, the chart shows how your purchasing power changes over time.


The first thing that jumped out at me was the 6% real return line. In this case, your minimum withdrawals almost exactly keep up with inflation from age 72 to 94 (and then fall like a stone). This can’t be a coincidence. It must have been a design goal for the percentages. Essentially, the RRIF minimum withdrawals are designed for a steady return of 6% over inflation.

Unfortunately, averaging such a high return over many years is not very likely. It could happen for an all-stock portfolio with no investment fees, but even then you shouldn’t count on it. For investors with a more balanced portfolio and who pay fees, inflation+2% is much more realistic. Unfortunately, if you look at the line on the chart for a 2% real return, the results don’t look too good; your purchasing power falls quickly and is cut in half in about 16 years.

It’s not too hard to see why retirees probably shouldn’t spend all of their RRIF minimum withdrawals in their early retirement years. It’s prudent to save some money for later years as their RRIF income falls.

Monday, June 23, 2014

RRIF Withdrawal Rates do not have to Rule Your Life

A very persistent myth is that retirees are forced to overspend their retirement nest eggs because forced RRIF withdrawals are so high. I get numerous comments to this effect on my articles, and other writers call on the government to reduce forced RRIF withdrawals. There is a simple remedy:

Don’t spend all the RRIF withdrawal that lands in your chequing account.

This story begins with the 4% rule of thumb that many people use for retirement income. The idea is that when you enter retirement, you calculate 4% of your starting savings amount as a withdrawal for the first year. Then you increase this withdrawal by inflation every year. So the 4% amount applies only to your level of savings on day one of your retirement.

There are a number of problems with the 4% rule as I explained in a post on a retirement income strategy. One serious problem is that the original research that led to the 4% rule assumes that you pay no investment fees. I showed that the safe withdrawal rate drops quickly as fees rise.

But whatever spending percentage you settle on as safe for your situation, it’s certainly going to be less than the forced RRIF withdrawal percentages. One thing to keep in mind is that the RRIF withdrawal percentages are based on your portfolio size in the year of the withdrawal. In contrast, the 4% rule is based on your starting portfolio value. However, even taking this into account, the forced RRIF withdrawal percentages will have you drawing down your RRIF faster than the 4% rule would in the vast majority of cases.

It’s at this point that so many people seem to throw their hands up and say the government forces people to draw down their savings too fast leaving them destitute in later life. This is nonsense. Just because money leaves your RRIF doesn’t mean you have to spend it. For example, you could put some of it in your TFSA to spend in a later year when your RRIF payments have shrunk.

It’s unfortunate that the default RRIF percentages are too high for a sustainable retirement income. No doubt many people just spend their RRIF withdrawals without much thought. So, it’s true that the current RRIF withdrawal rules will lead to many people overspending early in retirement. But that doesn’t have to be your fate. Thoughtful retirees can choose their own safe spending levels and save any excess RRIF withdrawals.

All the moaning about high forced RRIF withdrawals would be easier to take if the writers were to point out that people don’t have to spend all the money. It’s sensible enough to call for smaller minimum withdrawals to protect the unwary, but we should also try to educate retirees about how to protect themselves until the government acts.

Friday, June 20, 2014

Short Takes: Indexing Effects on Markets, 4% Rule, and more

I wrote only one post this week:

Which is the best credit card?

Here are some short takes and some weekend reading:

Chris Philips at Vanguard gives some of the best answers I’ve seen to questions about the effects of indexing on markets. One thing I would add is that not all money allocated to index funds is truly passive. Many investors trade index funds actively leading to the creation and destruction of index fund units. This is a form of market timing that competes with other active investors.

Norman Rothery points out that the 4 per cent rule for retirement withdrawals each year is based on the assumption that you pay no investment fees. This fact is rarely mentioned. I recreated the study behind the 4 per cent rule and then studied the effect of fees.

Boomer and Echo have a thoughtful list of 5 investing lessons learned. To the first lesson I‘d add that distinguishing skill from luck goes beyond comparing returns to an appropriate benchmark. Even if you beat a benchmark over a year or five, you may have been just lucky and have no expectation of beating the benchmark in the future.

Rob Carrick says “don’t sell your stocks if you’re worried about a market decline.” That’s good advice, and the second paragraph has a good lesson as well: “The market will fall at some point, but it’s pointless for most investors to try and predict when.” However, the rest of the article focuses on opinions of whether the market is overvalued and whether other investors are scared. Most investors should simply ignore such things and focus on their long-term plans.

My Own Advisor lists his picks for the top Canadian equity ETFs. My favourite from the list is VCN.

Big Cajun Man is no fan of the land transfer tax. He gives an Excel formula for calculating this tax in Ontario.

Million Dollar Journey is looking for people interested in writing about their own journeys to a million dollars now that Frugal Trader has finished the trek. I wonder if he would be interested in hearing from someone who is heading back down to a million dollars through living the good life in retirement.

Tuesday, June 17, 2014

Which is the Best Credit Card?

The one with no balance.

<rant>

I know some bloggers make a lot of money with credit card referrals, but enough already. I just don’t care which credit card is best. As long as I don’t carry a balance, don’t pay a yearly fee, don’t pay for any idiotic insurance, and get a little cash back, the rest is small stuff.

Find a way to cut back on some spending that isn’t improving your life much and you’ll come out much further ahead than picking some whiz-bang credit card.

The only exception I can think of is if you can use a personal credit card for work costs such as travel, get reimbursed and get to keep credit card rewards. Outside of that, all the excited talk about choosing credit cards is just a big yawn.

</rant>

Friday, June 13, 2014

Short Takes: Giving Away Patents, Trying to Cheat Risk, and more

Here are my posts for this week:

Stock Volatility Grows Slower than Expected

Low Inflation Makes Mortgages Riskier

Here are some short takes and some weekend reading:

Elon Musk takes the remarkable step of allowing competitors to use inventions in Tesla Motors’ patents. His reasoning for doing this includes an accurate indictment of the current patent system.

Carl Richards of the BAM Alliance explains how investors who try to get higher returns with lower risk are invariably disappointed once the market changes.

Canadian Couch Potato proposes a way to estimate expected future stock and bond returns.

John Heinzl brings us a very interesting interview about financial fraud. Stan Buell is a victim himself and knows a lot about how others are victimized.

Steadyhand has a chart that puts our current interest rates into historical context.

Jason Zweig shares some sensible thoughts on dividend investing.

Million Dollar Journey answers the question of how much money you need to save monthly to reach your target retirement number.

Big Cajun Man isn’t a fan of selling leverage to widows.

Scott Adams had me laughing pretty hard at his latest invention: the money toilet shredder.

Wednesday, June 11, 2014

Low Inflation Makes Mortgages Riskier

One of the ways that pressure on home-buyers can drop over time is that inflation erodes the purchasing power of mortgage payments. However, this pressure valve is less effective with today’s low inflation.

Imagine a young couple taking on a 25-year $250,000 mortgage. Today, they might pay a mortgage rate of 3.5% and expect 2% inflation. Imagine a 2% increase in both (5.5% mortgage rate and 4% inflation). How does that change the financial pressure on our couple?

In the first scenario, the mortgage payment is $1244/month, and in the second scenario the payment is $1515/month. But this only tells part of the story. The following chart shows how these payments change over time when we adjust for inflation.


In the first scenario, the purchasing power of the mortgage payments drops by 39% over 25 years. In the second scenario, the purchasing power of the mortgage payments drops by 62% over 25 years. While the first couple starts with lower payments, the pressure of these payments drops less over time.

The next factor to consider is that housing prices are way up mainly because mortgage rates are so low. Imagine that in the first scenario, the mortgage size increases so that the payments start at $1515 (the same level as the second scenario). Now the blue line in the chart above rises up to start at the same level as the red line, and the couple in the first scenario starts with the same financial pressure as the second scenario. The really bad news is that the couple in the first scenario will have most of this pressure sustained against them for the full 25 years. The couple in the second scenario will get far more relief over time.

Back in the very high inflation times of over 30 years ago, homebuyers just had to make it through the early years of their mortgage and inflation would help to make the payments more affordable. Today, this margin of safety is mostly gone.

Monday, June 9, 2014

Stock Volatility Grows Slower than Expected

It is well-known that stock returns do not follow the normal distribution that is commonly used to analyze returns. Less well known is that the returns from one year to the next are not independent; there are small correlations. A consequence of these correlations is that the riskiness of stocks grows slower than simple models predict.

Jeremy Siegel made this observation in his book Stocks for the Long Run. I found this result so remarkable that I decided to investigate myself. I grabbed Robert Shiller’s historical U.S. stock returns and made some calculations.

Over the past 100 years, U.S. stock market returns have had a standard deviation of 19.0%. If the returns of each year were independent of each other, we’d expect this standard deviation to grow by the square root of the number of years. So, after 25 years, we expect the standard deviation of total returns to be 5 times higher, or 95%*.

For each time period from 1 to 40 years, I calculated the standard deviation of stock returns from 100 rolling periods** ending from 1914 to 2013. The following chart shows the results of how actual stock return volatility changes over time compared to the expected values based on the simple but flawed model.


It’s hard to see in the chart, but for two-year periods, the volatility is actually slightly higher than expected. This is consistent with a small momentum effect. A good year in stocks increases the odds slightly that the next year will be good as well. However, we get the opposite effect over longer periods. A good decade increases the odds slightly that the next decade will be below average.

These correlations are too small to use for market timing, but they can be useful for long-term investors. For those who have been able to stomach short-term fluctuations, long-term returns have been far less uncertain than simple models predict.

None of this is much use for investors who limit the volatility of their portfolios for peace of mind and so they don’t sell in a panic. But for investors who ignore short-term fluctuations, history teaches that total returns over decades aren’t as wildly uncertain as we might fear.

* A technicality here is that we are treating returns as following a lognormal, distribution. To calculate standard deviation, we don’t use the return r for each year, but we use ln(1+r). This means that even if the log of the return is a large negative number, the actual return is never less than -100%.

** Because I used rolling periods, I had to adjust the standard deviations upward to compensate for bias. Statisticians are used to adjusting the volatility of a sample up by a factor of n/(n-1) to remove bias. With rolling periods, the adjustment is more complex. With rolling periods of m years and n rolling samples (n=100 in this case), to remove bias we increase volatility by a factor of 1/(1-m/n+(m-1)(m+1)/(3nn)) when m<n, and by a factor of 3nn/((n-1)(n+1)), when m is greater than or equal to n.

Friday, June 6, 2014

Short Takes: Million Dollar Destination, Technical Analysis Failure, and more

Here are my posts for this week:

A Financial Quiz

Currency Exchange using Royal Bank Stock

Here are some short takes and some weekend reading:

Frugal Trader at Million Dollar Journey has completed his journey and is now a millionaire. Welcome to the club. He’s looking for reader input on what to focus on next. For my own finances, I’ve been focusing lately on how much my savings could pay me per month for the rest of my life (rising with inflation) and what fraction of my current spending that represents. I’ll declare myself financially independent when this reaches 100%.

Rick Ferri reports on a study of the dismal investment returns of investors who use technical analysis.

Canadian Couch Potato explains the various ways your assets are protected from the failure of a financial institution.

Larry MacDonald says that housing bears have been wrong for 6 years and that predicting short-term housing prices is very difficult. I agree. I’d be willing to make a modest wager that Canadian housing will underperform its long-term average appreciation over the next decade. But, I wouldn’t put much of my money at risk on such guesses. Of course, real estate returns aren’t fully captured by changes in housing prices. Landlord returns are boosted by rents and lowered by upkeep and property taxes.

Rob Carrick says that saving for retirement should come before paying down your mortgage. I think it all comes down to your savings rate. Any extra money you put in an RRSP, RESP, or against your mortgage is a form of long-term saving. Deduct any new debt you’re building and you get your net long-term savings. As long as you keep your net savings at a reasonable level, everything will take care of itself.

My Own Advisor says he has a better way to budget. I handle my money similarly to the way he describes; neither of us uses detailed budgeting. However, I think this works for only a minority of people. Most people need detailed budgets to avoid overspending. But few people actually do detailed budgets. Not surprisingly, lots of people overspend.

The Blunt Bean Counter explains how an estate freeze can reduce taxes when you transfer a business to your children.

Big Cajun Man came up with his financial anti-bucket list: the things he hopes never to do.

Squawkfox writes about her battle with depression. This isn’t financial, but it gave me some useful insight into a common problem that I don’t understand well because I’m not a sufferer.

Thursday, June 5, 2014

Currency Exchange using Royal Bank Stock

In the past I’ve used the exchange-traded fund DLR to make cheap currency exchanges at InvestorLine. I decided to try Royal Bank stock (ticker: RY in both Canada and the U.S.) because it has a smaller spread to save me more money and it’s easier to trade.

For those not familiar with the Norbert Gambit for saving money on currency exchanges, please take a look at Canadian Couch Potato’s excellent guide. The lowest risk method of doing the Norbert Gambit is to using the exchange-traded fund DLR which just holds U.S. dollars and can be bought and sold in either Canadian or U.S. dollars. Unfortunately, you can’t buy or sell the U.S. dollar version online at InvestorLine; you have to call an agent, which is a pain. So, I decided to try using Royal Bank stock instead.

With my new savings always in Canadian dollars, my portfolio allocation tends to get out of balance by having too much in Canadian ETFs. I needed to sell about $60,000 worth of Canadian ETFs, change currency to U.S. dollars, and buy U.S. ETFs. The problem is that the currency exchange rates offered by InvestorLine have a large built-in spread that can be expensive.

Here are the steps I took:

1. Sold Canadian ETFs (settled in Canadian dollars).
2. Bought 830 RY on a Canadian exchange (settled in Canadian dollars).
3. Sold 830 RY on a U.S. exchange (settled in U.S. dollars).
4. Bought U.S. ETFs (settled in U.S. dollars).

(I had to be careful to get the Canadian/U.S. exchange and the settlement in Canadian/U.S. dollars right in each case.)

I completed all steps in just a few minutes without having to call InvestorLine. If I had used DLR, I would have had to have called InvestorLine for step 3. Using RY stock is a little riskier because of the possibility that its price might change between steps 2 and 3. DLR doesn’t have this risk because the investments inside DLR are just U.S. dollars.

I did all this on a Tuesday. Immediately after making the trades, my account showed that I had 830 RY on the Canadian side of my account, and -830 RY on the U.S. side. In reality, it takes 3 days for trades to settle. In my case settlement was on Friday. It wasn’t until another two business days after Friday that the +830 RY and the -830 RY were wiped out. Fortunately, this cancellation of the offsetting shares of Royal Bank stock was automatic; I didn’t have to call an agent.

Update: See here for a description of an interest charge I was hit with weeks later that I discovered and got reversed.

This trick was well worth the small extra effort because I saved $491 compared to just using InvestorLine’s currency exchange. I’d be interested to hear readers’ experiences with the Norbert Gambit at InvestorLine or other discount brokers.

Monday, June 2, 2014

A Financial Quiz

I enjoy taking financial quizzes, even the type that ask dumb questions like “is taking a vacation financially irresponsible?” Of course, the answer is “it depends,” and people get to argue about it pointlessly. I have a very short quiz with more objective answers.

1. Siblings Amy and Brad inherited $50,000 and contributed the money to their RRSPs. Amy invests her money in North American stock index ETFs with low fees. Brad chooses his favourite 5 stocks each year and invests all his money in them. If Brad’s choices are essentially random, what is the probability that he will have less money than Amy after 40 years?

A) Less than 50%.
B) 50%
C) More than 50%.

2. A third sibling, Charlie, also received $50,000 and put it in his RRSP. Charlie decides each month which way the stock market is going and either invests fully in North American low-cost stock index ETFs or he parks it in short-term government debt. What fraction of the time does Charlie have to guess right for him to end up with more money than Amy?

A) Less than 50%.
B) 50%
C) More than 50%.

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1. The correct answer is C. Brad’s chances of ending up with less money than Amy with his stock-picking is greater than 50%. Under one set of assumptions (*), Brad ends up with less money than Amy with a probability of about 65%. It might seem like the odds should be 50% because Brad is choosing randomly from the same set of stocks that Amy owns, but this isn’t the case. For the probability to be above 50%, it might seem like there must be some missing money, but this isn’t the case, either.

To understand why, imagine that there are many Brads all stock picking. Most Brads will lose to Amy and a minority will beat Amy. But the winning Brads tend to beat Amy by more than the losing Brads lose to Amy. This is the nature of taking greater risk; it tends to concentrate winnings in fewer hands. It takes two losing Brads who end up with $100,000 less than Amy to make up for one winning Brad who ends up with $200,000 more than Amy.

Investors with a rational level of risk aversion should prefer to invest like Amy. Investing like Brad only makes sense if Brad can pick stocks that are sufficiently above average that it compensates for the extra risk Brad is taking.

2. The correct answer is C. Charlie has to be right with his market timing guesses more than 50% of the time to keep up with Amy. In one experiment, Charlie needed to be right 60% of the time to get the same returns as Amy. In this case, the explanation is simpler. Over the long run, stocks returns are higher than short-term interest rates. If Charlie’s guesses are purely random, he will be out of the stock market half the time and, on average, will lose money compared to Amy who remains fully invested. Charlie has to be right more than half the time just to keep pace with Amy.

The theme of this quiz is that the feeling that stock pickers and market timers are as likely to win as they are to lose is incorrect. Both will lose more than half the time if their guesses are random. They have to have above-average skill among the professional investors who dominate modern stock markets.

* Assumptions: many lognormally-distributed stocks with identical expected returns, 50% standard deviation, and identical correlation coefficients of 0.16, so that the overall market has standard deviation 20%.