Tuesday, December 27, 2016

How People Can Go Years without Saving a Dime

I encounter people who have saved very little money, if any, over many years in some cases and decades in others. When we look back over long periods of time, it seems inexplicable that a seemingly intelligent person could fail to save any meaningful amount for the future. But there is a simple explanation.

When we look to past failures to save for a long time, we look like fools. But when we look to the future, we see the rest of today, along with a magical time in the future when “I’m not so busy and everything isn’t crazy.” This makes it easy to not save today. After all, what difference can a single day make? The problem is that the last decade is made up of a few thousand single days.

Of course, this magical time in the future when things are calmer will never arrive. So, it’s easy to keep putting off things like saving money, improving your diet, and exercising.

In the end, the answer to the question “how can people fail to save any money for years?” is “they do it one day at a time.”

Thursday, December 22, 2016

Taxes and Cashing in Points

My employer has a recognition system based on points. Just like Air Miles and other reward systems, we get to cash in our points for various types of goods and services. What hadn’t occurred to me until recently was the tax implications.

When we cash in our points, the value of our rewards becomes a taxable benefit. So, for someone in a 50% marginal income tax bracket, getting a $100 reward actually costs $50 in additional income taxes. This is still a reasonably good deal, but the taxes have some implications.

Just because a reward costs the company $100 doesn’t necessarily mean it’s worth $100 to me. Fortunately, we have a wide range of reward choices, so it’s likely that I’ll be able to find things I actually want.

However, these points have expiry dates, and there is no guarantee the good selection of rewards will remain. Normally, if you have points that are soon to expire, you’d cash them in for something, even if that something isn’t exactly what you want. Not so in this case. If I have to pay $50 in taxes when I cash in my points, the reward had better be worth at least $50 to me. Otherwise, I’d be better off letting the points expire.

All this feels like looking a gift horse in the mouth. But taxes have a way of taking the fun out of just about anything.

Wednesday, December 21, 2016

Clients of Skilled Financial Advisors

Certified Financial Planner Carl Richards, a.k.a. The Sketch Guy, writes “In all my years of working with clients, I can only think of two people who wanted to retire in the traditional sense.” His clients find some sort of work (paid or unpaid) they want to do for the rest of their lives, or at least well after age 65. This surprised me because it is at odds with my own experience.

I sat down and wrote down the names of the first 20 people I could think of who have retired. All but four of them retired to a life of leisure, unlike Richards’ clients. Of the four, one does small contracting jobs on the side, one runs a small farm, one had to go back to work because his pension got chopped, and the last one is partnering with his son to get the son’s real estate career off the ground. Sixteen of them are enjoying their leisure.

This speaks to how rarefied the clients of some advisors are. Virtually all financial advisors prefer rich clients. The best advisors have minimums in the hundreds of thousands, but prefer clients with millions. I guess it’s not surprising that many with the drive to make millions like to keep going as they age.

I’m sure that Richards knows his clients well, but he goes off the rails when he says “The concept of retirement, as we understand it today, is completely outdated.” This may be true for his clients, but not for the unwashed masses. We can expect the nature of retirement to evolve over time, but I’m not holding my breath waiting for the day when almost all retirees continue to work some sort of job.

Monday, December 19, 2016

Toll Roads and Bridges

The mayors of five major cities across Canada have come together to call on the provinces to give them “increased revenue powers” to charge tolls on roads and bridges. The full text of open letter is reproduced below.

The mayors complain they don’t have the money necessary to build the infrastructure Canadians need. They say “city governments have been required to rely on property taxes alone to support our growing operating budgets, with dollars stretched thinner and thinner as we serve the growing needs of the public.” Apparently, property taxes are not enough.

I find it frustrating that the substantial property taxes I pay don’t seem to be enough. Over the past decade or two, city governments have added user fees to everything they can. So, I pay these fees in addition to my property taxes. The prospect of greatly “increased revenue powers” for the city isn’t a happy one for me. I believe it’s important to fix and grow infrastructure, but why can’t some of my property taxes fund these projects?

Here is a quote that definitely did not come from any of the 5 mayors:
“The problem is that so much of property taxes gets soaked up by huge city administrative work forces. It’s not that these people are lazy. Most of them work diligently at their jobs. There are just so many of them and their job functions often contribute little to serving city residents. We have a management culture of empire-building. When we try to do something about these problems, the effort is half-hearted and the unions don’t help. With so much of property taxes diverted into salaries, there just isn’t much left for infrastructure projects. If we can get these toll collections going, it will greatly reduce the financial pressure. We’ll be able fund a few projects and take some pressure off as city administrations inevitably keep growing.”

An open letter from Canadian Mayors calling for increased revenue powers
"You rarely have to ask permission to do the right thing.

But this is the position our cities find themselves in as we attempt to do right by our growing populations.

There is no doubt that Canadian cities are where economic and social policy hits the pavement.

We are the financial engines of the country. We are where young people are looking for jobs and families are raising their children.

Cities are where our kids go to universities and where researchers are battling the diseases our loved ones suffer.

The innovations and technologies developed in our cities are providing new tools to help Canadians live and compete in the modern economy, improving our approach to everything from agriculture to construction to financial services.

When cities do well, our entire country benefits.

But still, we find ourselves begging for control over our own finances.

For too long, city governments have been required to rely on property taxes alone to support our growing operating budgets, with dollars stretched thinner and thinner as we serve the growing needs of the public.

At the same time, our transit systems, roads and vital infrastructure are suffering from decades of underinvestment.

It's time for that to change.

Across the country, mayors stand ready to lead a new approach - championing reasonable measures to increase municipal revenues so we can make a positive difference in our residents' lives.

Great responsibilities require great powers, and Canadian cities are at the forefront of a growing housing crisis, overwhelmed transit systems, alarming fentanyl abuse, mental health issues and the growing divide between haves and have nots.

As the federal government introduces stimulus funding for transit and infrastructure, cities are also required to match these funds.

This is a good deal - a real partnership that can put cities on a strong footing. But we must still ask permission from provincial leaders to introduce new revenue measures to generate these dollars, requests that are always weighted against the particular political realities of a given moment in time.

As mayors of Canada's biggest cities we are ready to champion real solutions. In Toronto, road tolls would finance a long-overdue transit expansion and ease congestion that is choking the most populated region in the country.

In Metro Vancouver, a lack of new funding tools has put a strain on property taxes and delayed crucial transit investments for years - while residents deal with crammed buses and gridlocked commutes.

In, Edmonton and Calgary, a new fiscal framework would enable more predictable, stable funding to manage growth.

And in Ottawa, we have just completed a feasibility study that outlines the possible construction of a subterranean truck tunnel to eliminate dangerous and disruptive heavy truck traffic in Ottawa's downtown core.

These large infrastructure projects come at a great cost, and it is imperative that we collaborate with the provincial and federal governments to move forward with a solution that works for all.

Canadian cities should be able to control their own destiny: mayors and councilors are elected to serve their residents and create a bright future for our cities but the fiscal power to do so sits with other levels of government.

As a result, we're forced to do our job with one hand tied behind our backs.

Our request is simple: give us the tools to do the job and the accountability that goes with them and we'll build great cities for the benefit of all Canadians."

Naheed Nenshi, Mayor of the City of Calgary
Don Iveson, Mayor of the City of Edmonton
Jim Watson, Mayor of the City of Ottawa
John Tory, Mayor of the City of Toronto
Gregor Robertson, Mayor of the City of Vancouver

Friday, December 16, 2016

Short Takes: Investor Protection Wish List, Dividend Stock Location, and more

R.J. Weiss at The Ways to Wealth chose my post Aren't the Banks the Investing Experts as a top 100 post for 2016.  There are plenty of other good articles in each of his categories.

Here are my posts for the past two weeks:

How Life Can Mess Up the Best-Laid Financial Plans

Why Do We Focus on Advisor Cost?

Here are some short takes and some weekend reading:

FAIR Canada has a clear and concise “wish list of investor protection initiatives it would like to see implemented in the upcoming year.”

Dan Bortolotti has a smart take on whether to hold dividend stocks in a TFSA. In another article, Dan’s alter ego, the Canadian Couch Potato makes sense of Capital Gains Distributions from ETFs. Another contribution from Dan is his latest podcast exploring the difference between financial planning and investing.

Boomer and Echo discuss the dangers that await when you work with a financial advisor who doesn’t have to serve your best interests.

The Blunt Bean Counter explains how the U.S. estate tax affects Canadians.

Preet Banerjee explains compound growth in this video that is part of his “Learn About Investing” series.

Big Cajun Man isn’t a fan of financial advice from family.

Wednesday, December 14, 2016

Why Do We Focus on Advisor Cost?

Canadian investors have a problem. The mutual funds they own typically charge 2-2.5% of their savings (not just returns) each year. Over an investing lifetime, these hidden costs can consume as much as half of their savings, leaving them with half as much retirement income. You’d think that investor advocates would be calling for lower-fee mutual funds instead of just focusing on the part of the cost that goes to financial advisors. But there is method to this madness.

The second round of changes to the Client Relationship Model sets out rules, known as CRM2, mandating that reports to clients include, among other things, clear information about the dollar amount clients pay to their advisors. But there is no such requirement concerning the other fees that mutual funds quietly withdraw from investor savings.

This may seem like an oversight, but it is actually a targeted measure. To see why, we need to back up a little. A great many mutual funds, particularly the largest ones, do not seriously try to make market-beating returns. They are actually what are known as closet indexers. They own a portfolio of stocks and/or bonds that closely match stock and bond indexes.

You may wonder how such funds can expect to attract investors if they aren’t even trying to be the best. To begin with, they eliminate the risk of making bad investments and being among the worst mutual funds. Their other strategy is to pay financial advisors commissions and yearly trailing fees for steering clients into their mutual funds.

Some financial advisors resist the temptation to recommend mutual funds based on how much the advisor gets paid, but a great many don’t resist. So, this strategy works for mutual funds wishing to pump up their assets under management.

A disadvantage for these mutual funds is the lost revenue that flows to advisors. To compensate, the mutual funds set high Management Expense Ratios (MERs). The MER is money quietly removed from investor savings continuously. Closet indexers with high MERs are soaking their investors with high fees and are splitting the spoils with financial advisors.

If CRM2 can make advisor pay more visible, the hope is that their clients will start paying attention to these costs. If advisors are forced to limit themselves to reasonable fees, they won’t have any incentive to recommend poor mutual funds that happen to pay big commissions and trailing fees. So, if CRM2 has the desired effect, high-priced closet-indexing mutual funds will have trouble attracting investors.

Whether this strategy will work or not remains to be seen, but at least there is a rationale for shining a light on advisor costs when it is actually the total cost of investing that matters.

Monday, December 12, 2016

How Life Can Mess Up the Best-Laid Financial Plans

I frequently see people whose financial plans rest on a steady income. I’m not just talking about those living hand-to-mouth, never saving a dime. There are also the “spreadsheet planners” who have their financial lives all mapped out. They borrow large sums for a house or to invest, and rely on a steady income to keep up with the interest payments. As long as everything proceeds exactly as they planned, they’ll be multi-millionaires by the time they get close to retirement age.

I’d like to introduce these people to Heather Von St. James. Heather had a great life going but was hit with mesothelioma, a cancer caused by asbestos. Her story about the personal and financial costs she faced is definitely worth a read. (Disclaimer: I have no financial connection to Heather; I just found her story compelling.)

One takeaway from her story is that your income is not fully secure no matter how safe it seems. Heather’s story is a very specific case, but there are many different problems that can lead to long-term or permanent loss of income. In addition to health problems, you could face a situation where the type of work you do is no longer in demand. Workers in their thirties may find it hard to believe what they do could become irrelevant, but over a decade or more, many things are possible.

Heather points out that she was “under the care of my sister, who had taken three weeks off work to care for me while I recovered. All of her expenses came out of her pocket; she never got reimbursed for anything.” So, it’s not just your own health that is a potential concern. Your spouse, child, parent, or sibling could need your help. In Heather’s sister’s case, her loss of income was temporary. But, problems with a child’s health could easily force you to find different work with more flexible hours.

To the extent possible, we need financial plans that take into account the possibility of a reduced income. Taking on a huge debt is risky. You could be forced to sell your house or investments into a bear market.

There are a number of things you can do to reduce your risk. Being Canadian and having access to public health care is a good start. Having long-term disability insurance also helps. But there are still events that these protections won’t cover such as getting laid off and being unable to find new work at the same pay. The best thing to do to protect yourself is to build savings and limit your use of leverage. This means not borrowing based on the full size of your current income.

If you wish to learn more about mesothelioma, follow this link.

Friday, December 2, 2016

Short Takes: U.S. Fiduciary Rule, Jack Bogle, and more

I attended the Canadian Personal Finance Conference (CPFC16) recently. Here are my favourite quotes:

“A house is a forced spending plan as much as it’s a forced saving plan.” - Rob Carrick, columnist for The Globe and Mail on the CPFC Housing Panel

“You don’t borrow money from a bank, you borrow it from yourself.” - Preet Banerjee on learning how to hate debt again

Here are my posts for the past two weeks:

The Real Reason Why a Big Mortgage is a Bad Idea

Loyalty Points Battles

Here are some short takes and some weekend reading:

Brokers and insurance companies are desperate to preserve their right to deceive their clients. The latest effort to stop a fiduciary rule is an appeal to free speech.

Jack Bogle always gives a good interview, but this one is great. One gem concerns the path to real learning: “I glance at anything favorable to indexing; I pore over anything unfavorable. You don’t need people to tell you you’re right all the time. You need people to tell you that you’re wrong.” Another good quote is “Wall Street is a casino, that’s a fact.”

Justin Bender explains the catch behind commission-free trading of ETFs at National Bank Direct Brokerage. The result is that those who like to get new contributions working right away have to pay commissions.

Canadian Couch Potato has started a new podcast and the first episode is about DIY investing.

Potato announces a new web site for comparing robo-advisors (co-created by Sandi Martin). The focus is on comparing costs, but they take into account differences in other aspects of the robo-advisor offerings as well.

The Blunt Bean Counter sees a lot of estate planning mistakes, and he lists the top 10 here.

Boomer and Echo question whether reward points should be allowed to expire.

My Own Advisor interviews Ken Kivenko, a tireless advocate for individual investors. I admire Ken’s work, but after his description of his own investments, I’m not sure I agree when he says he is “very conservative.”

Big Cajun Man says debt is a four-letter word.

Monday, November 28, 2016

Loyalty Points Battles

The latest battle over expiring Air Miles prompted Robb Engen to call for a law banning loyalty point expiration similar to the ban on gift cards and pre-paid cards. This is sensible in that it removes one method loyalty point programs have to devalue points. However, it doesn’t solve the whole problem because there are many other methods.

The most obvious way to devalue points is the slowly increase the number of points it takes to get rewards. Aeroplan has been doing this for years with their miles. Another commonly-used way to devalue points is to place arbitrary restrictions on when points can be redeemed.

Clever businesspeople can certainly find other inventive ways to reduce their liability once the number of points they give out swells. One explosive way would be to set up a corporate structure so that the liability rests with a corporation starved for cash that goes bankrupt. This is similar to the way fitness clubs used to renege on multi-year pre-paid memberships.

So, is it all just hopeless for the consumer? Not at all. Just keep all this in mind and protect yourself. For example, when comparing two programs, one with points and one that gives back dollars, discount the points somewhat before comparing. I’d rather get 2% cash back monthly on my credit card than get 3% in the form of points. (Even better would be if credit cards stopped giving anything back and charged merchants less, so that all prices could go down.)

Another way to protect yourself is to use up points as quickly as possible. Getting gift cards for a place where you routinely shop works well. I do this with Aeroplan miles (although it takes more miles to get a $100 gift card each time.)

An important way to protect yourself is to not let loyalty points change the way you shop. Spending money you wouldn’t have spent otherwise to collect more points is throwing away dollars to get back pennies. And once you have some points, if you wouldn’t have bought a Santa cuckoo clock for cash, then you’re not getting ahead buying one with points.

Loyalty point program rely on the fact that we get excited about seemingly free stuff without ever doing the math, or accounting for future changes in rules. But you can count on the fact that companies offering loyalty points are doing the math.

Thursday, November 24, 2016

The Real Reason Why a Big Mortgage is a Bad Idea

We can try to justify taking on a huge mortgage by doing detailed projections of house price increases and accounting for various housing costs, but this isn’t the path to a useful answer. It’s unexpected factors that drive this decision.

One factor that many don’t properly take into account is repair costs. We all know the furnace, roof, and other expensive items will need replacing, but we usually can’t predict when. This makes it easy to ignore such infrequent large costs in a budget. Some inexperienced homeowners may even forget about predictable costs like property taxes, house insurance, and condo fees.

Another category of unexpected factors is reduced income. If you buy a house with a spouse right up to your joint affordability limit, any reduction in income can be devastating. We’ve all been told that we could lose our jobs, but in my experience, most people don’t think this will happen to them, even though it’s common. You may believe you could lose your job, but that you’d find another one easily enough. It’s very common for people losing their jobs to end up with a lower-paying job. Getting forced into permanently lower pay can happen to anyone, but is common for those over 50.

Health problems are another common reason your family income can drop. You may not be able to work at all or have to get a lower-paying job. Health issues are a common reason why some people are forced to retire before they want to.

Another factor younger people tend not to think about is that you may want to do something new later in life. If we could stop people on their commute to work and get them to answer honestly how they feel about their jobs, an alarming number of them would say they dread going to work and feel desperate and hopeless. They are trapped in their jobs by debt. They yearn to do something else, but that something else likely pays less money, at least for the first few years.

We can push all these worries aside by just leaving a healthy gap between the size of mortgage you take on and the size of mortgage a lender will let you have. Don’t give up future flexibility for an expensive house.

Friday, November 18, 2016

Short Takes: Active Management Police, Lake Wobegon Research, and more

Here are my posts for the past two weeks:

Pandering to those with too much debt

Helping students handle credit cards well

Some financial policies to look for with a Trump presidency 

Making arguments with made-up data

Jobless Manufacturing

Here are some short takes and some weekend reading:

The Reformed Broker offers a funny piece satirizing the pressure on active management. I think the real pressure is on expensive management. I’d like active funds more if they were as cheap as the passive funds I own.

Allan S. Roth gives a scathing indictment of the Journal of Financial Planning that once again published a flawed study claiming that active mutual funds outperform index funds and that fees don’t matter. One amusing conclusion of the study is that even index funds produce alpha.

Tom Bradley at Steadyhand takes off the gloves in criticizing big banks that “accidentally” double-charged their clients.

Canadian Couch Potato explains some benefits of reverse share splits in ETFs.

Preet Banerjee explains how to calculate your CMHC insurance premium based on your house down payment (video).

Boomer and Echo have a good set of tips for negotiating a raise. It’s a good idea to look out for your interests, but it can be taken too far. I’ve worked with a few people over the years who were very good at the politics of getting higher pay and promotions. The trouble came when company fortunes forced layoffs, and these people were prime targets because their pay outpaced their usefulness to the company.

Jason Zweig reports on a new type of fund called an interval fund. Buyer beware.

Potato has a difficult personal story about failing to get disability insurance.

Insureye has a clear and informative list of insurance myths and facts. It covers insurance for home, car, life, health, critical illness, disability, and travel. I’ve never seen such useful insurance information gathered in one place before.

Big Cajun Man explains that when it comes to university costs, rent can be a bigger problem than tuition.

My Own Advisor breaks down his big investment goal into smaller sub-goals.

Million Dollar Journey answers a reader question about Whole Life Insurance for children.

Wednesday, November 16, 2016

Jobless Manufacturing

Decades ago, well-paid manufacturing jobs were plentiful. Many people performing these jobs were solidly in the middle class. Recent protectionist talk in the U.S. has given voice to those hit hardest by the loss of these jobs. These people dream of returning to better times. Unfortunately, this won’t happen, but perhaps not for the reasons they think.

Globalization has brought us cheaper goods and has shifted jobs to countries with lower-paid workers. On the whole, these changes have been positive for countries like Canada and the U.S., but localized areas have been hit hard by the loss of manufacturing jobs. Our modern economy has created many new jobs as well, but they require different skills and many of them provide less than middle-class pay.

But it’s important to realize that globalization is only one reason why manufacturing jobs left. Another important reason is automation. Factories are now filled with machines to do jobs that used to be done by people. This trend will not reverse.

If the U.S. becomes increasingly protectionist to the point of blocking the import of all foreign goods, this will spark the return to making goods in the U.S. But every manufacturer’s goal will be to automate as much production as possible and hire as few workers as possible. The amazing technology available today guarantees that these manufacturers would succeed in near-complete automation.

Even if the U.S. closes its border, we will never return to conditions decades ago when well-paid manufacturing jobs were plentiful. The past will stay in the past.

Monday, November 14, 2016

Making Arguments with Made-Up Data

Economic inequality around the world has been increasing in recent decades. It’s tricky to find the right balance between sharing the wealth and reducing the incentive to work and innovate. This is an important debate, but it is filled with nonsense arguments using made-up data. For some reason, people are impressed by arguments that include some sort of numerical evidence, even if the numbers make no sense.

In a discussion of government spending and public debt, I once heard someone say that every dollar the government spends gets re-spent seven more times in the economy. The implication is that government spending provides a free multiplier effect, but just a little thought shatters this dream. If the government were to borrow and spent a few trillion dollars, it wouldn’t somehow grow and make us all rich. But this made up statistic seemed to win the argument at the time.

A widely-cited web site is the Global Rich List. It purports to tell you where you stand in the world based on either your net income or wealth. For amusement, I punched in that I was American (didn’t feel like scrolling to find Canada) and earned a net income of US$50k. The site told me that only 18,653,583 people in the word have at least this net income. Let’s round this up to 19 million.

I understand that big numbers make most people’s heads spin, but this struck me as a suspiciously low number. I wandered off to Wikipedia’s page on U.S. personal income. We have to be careful because it gives gross income figures rather than net income. The chart says that more than 35 million Americans make more than $75k. Presumably, these people net more than US$50k. And this is just the U.S. What about Canada, Australia, Europe, and the wealthiest in Russia, China, and India? The world-wide number has to be far greater than the 19 million reported by the Global Rich List.

Now the purpose of this web site is marketing. They want to drive donations to a charity. Maybe getting the numbers wrong actually helps with this goal. I’d like to think that they’ve simply made a mistake and would fix it if they knew. It’s possible that few people have noticed the problem and none have pointed it out before now. What troubles me most is that there is little incentive to fix the problem. Few people will notice the error, and charitable donations are flowing in.

Some say we’re in a post-factual world. The fact that the Global Rich list site just sits there pumping out bad data with no negative consequences seems to support this idea. I try to do my part in promoting rational discussion by rejecting arguments based on bad data whether they support my point of view or not. More of us need to think critically about the statistics we hear and reject them if they make no sense.

Thursday, November 10, 2016

Some Financial Policies to Watch for with a Trump Presidency

Donald Trump’s electoral victory came in part because he appealed to Americans who feel left behind in the modern economy. These people seem to believe Trump will improve their financial prospects. With this in mind, I’ll be watching for policy changes that affect American taxpayers and retail investors. Two in particular are a fiduciary rule and bank leverage.

Fiduciary Rule

When brokers and other financial salespeople sell investments to the American public, mostly for their retirement accounts, they are allowed to sell grossly over-priced investments. The high fees can consume one-third to one-half of an investor’s savings over an investing lifetime (these fees are typically even higher in Canada). The Department of Labor has been moving toward a fiduciary rule, which means the salespeople would have to put their clients’ interests ahead of their own and choose lower-priced investments. We’ll see if this rule gets abandoned now that Trump has been elected.

Bank Leverage

If banks never borrowed money, their profit margins would be very slim. To make banks profitable, they borrow enormous sums of money. The amount they borrow is much more than the assets they hold. When the ratio is ten to one, profits and losses are magnified by a factor of ten. This ratio is often called the “capital-to-assets ratio.” When times are good, banks make good profits that enrich their owners and top management. If times are bad enough, such as during the 2008-2009 U.S. housing crash, banks can’t pay back their loans, and taxpayers bail them out. For bank management, it’s a case of “heads, I win”, and “tails, taxpayers lose.” This creates what is known as a moral hazard because banks have an incentive to take big risks. To combat this problem, U.S. laws such as Dodd-Frank and the Volcker rule are in place to limit leverage, which reduces the odds of banks being unable to pay their debts and protects taxpayers. However, these rules also limit bank profits and executive bonuses. It will be interesting to see what happens to these rules in a Trump presidency.

These are just two of the things that will test how serious Trump is about helping typical American people rather than helping the rich.

Tuesday, November 8, 2016

Helping Students Handle Credit Cards Well

Robert Brown has some ideas for how banks can help students learn to handle their credit cards without growing debt and paying interest. To deflect some obvious criticism, he concludes with “I honestly do feel that the big banks and other credit card providers are missing an opportunity to attract new customers – potentially very loyal customers for life – by treating them better while they are students. They will have plenty of time to profit from them once they have graduated.”

Let’s start with a minor problem. Brown thinks he knows how banks should run their business better than they do. This is ridiculous. If his simple ideas for encouraging students to avoid debt and interest were profitable, the banks would already be using them. The truth is that hooking students on credit cards is profitable on multiple levels. For one, students rarely default because their parents usually pay if necessary. For another, setting a pattern of high-interest debt makes people more profitable to banks later in life.

The bigger problem is the presumption that banks care at all what’s in their customers’ best interests. Many of us would like to believe we’re all in this world trying to help each other. But that’s just not true. What keeps any business in line is the threat of unhappy customers either leaving or demanding new laws to control the business’s behaviour.

Brown’s ideas might make some sense if he suggested creating new laws to force banks to help students. But the idea that banks would voluntarily turn away profits makes little sense.

Monday, November 7, 2016

Pandering to Those with Too Much Debt

Professor of economics at Carleton University, Frances Wooley, says that “Financial literacy education is mostly ineffectual debt-shaming.”. Her article makes a number of excellent points, but contains a dose of pandering as well.

Most of what passes for financial literacy education doesn’t help people get out of debt. True enough. The forces that drive us to spend money are complex, just as the forces that drive us to gain weight are complex. Just telling a person to spend less rarely helps.

Most people with too much debt already know their spending is a problem, so telling them again has minimal effect. There are possible exceptions with naive young people who haven’t yet maxed out their first credit cards, but just telling them to stop spending so much isn’t likely to help much either.

Businesses do what they can to exploit our weaknesses and make it very easy to spend money with the tap of a credit card. Governments can certainly do more to help simplify people’s financial lives and help them avoid mistakes.

Wooley says “It’s time to stop ‘debt-shaming’ those who, faced with inadequate incomes and rising costs, are not able to stick to a budget.” When this is directed at government, it’s a valid criticism. When the public reads this, it becomes pandering. If you’re in debt and would like it to be someone else’s fault, here you go. This might help you feel better about yourself, but it won’t stop the debt collectors.

You can blame businesses for exploiting you, and blame governments for not fixing your problems, but doing so won’t improve your life. If nobody else will help you, your only choice is to try to help yourself. This is about pragmatism, not blame. Ideally, we should all be working toward societal change that will help people at the same time as each doing what we can to help ourselves.

Friday, November 4, 2016

Short Takes: Smart Beta Verdict, Shrinking Closet Indexing, and more

Here are my posts for the past two weeks:

Crazy Mortgages

Investing Lessons from Gambling on Coin Flips

Faulty Investment Assumptions

Here are some short takes and some weekend reading:

Canadian Couch Potato has been running a long series about smart beta that ends with this post summing up his opinions. His fans who feared he’d gone to the dark side can rest easy. I appreciate his approach of keeping an open mind when looking into new ideas. We can’t learn anything new if we automatically reject all new ideas. I would never have taken up index investing if I hadn’t given it a chance. Although it seems unlikely I will make significant changes to my investing approach in the future, I won’t rule it out. One could argue that I have taken a small step toward smart beta by owning VBR (Vanguard’s U.S. small cap value ETF). However, nothing I’ve seen about smart beta has persuaded me to go any further than this.

Barry Ritholtz quotes Bill Miller saying that the shift from active to passive investing isn’t what it seems. The real shift is from expensive closet indexers to low-cost indexing.

The Blunt Bean Counter explains important changes to the Principal Residence Exemption (PRE) for capital gains on your home or cottage. Under the new rules, it is important to declare home sales on your taxes, even if you don’t have to pay any extra taxes. Based on my experience trying to explain such things to non-experts, I predict that many people will decide that these complications don’t apply to them and they will ignore it. In many cases, ignoring these new rules will end expensively.

Canadian Portfolio Manager has begun a series of video tutorials explaining the mechanics of setting up an ETF portfolio at discount brokers (including screenshots). This video is for BMO Investorline. Be sure to read the article as well because it describes some minor slip-ups made in the video.

Jason Heath takes some financial details from a couple and looks at whether they can retire. I find Heath’s approach to analyzing this case more interesting than most articles of this type. A good quote: “Anyone can retire at any age ... It’s just a matter of whether or not you can live comfortably based on your existing financial resources.”

Tom Bradley at Steadyhand says that a TV show about sensible investing would be “the worst TV show ever.” I’m pretty sure I’d watch at least one episode.

Preet Banerjee has some money-saving tips for traveling abroad in this “Drawing Conclusions” video. He also brings us an interesting interview with accountant Mark Goodfield, a.k.a. The Blunt Bean Counter.

Big Cajun Man managed to get a trading account transferred from TD to Questrade in only 10 days.

Boomer and Echo say the Feds aren’t killing the housing market.

My Own Advisor is thinking about minimalism to reduce clutter, costs, and other things that distract from the things we truly enjoy in life.

Million Dollar Journey describes the experience of transferring a defined-contribution pension from a former employer to a self-directed Locked-in Retirement Account (LIRA).

Thursday, November 3, 2016

Faulty Investment Assumptions

Ben Carlson wrote an interesting piece called Faulty Wall Street Assumptions where he goes through some misguided ideas financial professionals perpetuate about the way to investment success. What Carlson understands well, but may not show through to his readers is that it isn’t the financial professionals on Wall Street and elsewhere who are misguided. They are exploiting our faulty assumptions. Investors like you and me are making the mistakes.

Let’s go through most of Carlson’s list of faulty assumptions and look at why financial professionals behave the way they do.

Investing is about finding new opportunities and security selection.

The very best investors with superior access to company information may be able do well looking for new ideas, but retail investors just jump from one dashed hope to the next. Click-bait screams “5 NEW INVESTMENT IDEAS!” to exploit our weakness. Why would anyone go to the trouble of finding great new hidden gems and then give them away to us? We may get fooled, but those who peddle “exclusive opportunities” know what they’re doing.

A 200-page prospectus is a good idea.

When advisors give you long account statements and massive documents about new investments, they want you to ignore them. They want you to just trust them instead of trying to understand what you are buying. Most investments amount to a mix of stocks and bonds that can be explained simply. Demand an understanding of what you’re buying.

Clients want to be impressed.

I think Carlson got this one a little muddled. He paints a picture of misguided advisors working against their own interests and those of their clients. It’s true that clients may be best off if their advisors don’t try to impress them. Unfortunately, advisors will make more money over time if impressing clients is part of their strategy. The onus is on clients to be impressed by simplicity and clarity instead of being impressed when they get baffled. Many advisors sell expensive investments by walking a fine line between offering simple-sounding stories and using complexity when clients try to dig into the simple stories.

People care about risk-adjusted returns.

Carlson is spot-on with this one. Clients don’t care about the textbook concepts that advisors need to understand to do their jobs well.

Intelligence is all that matters.

The truth is that being brilliant won’t make you a successful active investor. The investing world is jammed full of brilliant people. You have to be much more brilliant than most of the other active investors. However, brokers and advisors have little to gain by explaining this to their clients. Clients are profitable when they think they’re getting brilliant advice and can be talked into making active moves. Brokers and advisors have little to gain and a lot to lose by saying “we’ve got some very smart people helping us choose these trades, but they’re no smarter than the guys on the other side of the trades.”

You have to have an opinion about everything.

In social settings, I hear friends ask financial guys all sorts of impossible-to-answer questions like “will interest rates go up?” and “will Apple stock tank?” The financial guys always have a smart-sounding response, even if they don’t really answer the question. It’s in their best interests to behave this way. It would be better if people understood that nobody knows the answer to these questions, but that’s not the world we live in. Once again, the onus is on clients to understand their advisor’s limits. Self-interest drives advisors to give answers when they don’t really know. An advisor who says “I don’t know” too many times is a former advisor in most cases.

People need certainty.

It’s true that people “really need is an honest assessment of the current situation and the prospects for the future.” While it may be dishonest to offer certainty, it is profitable. Advisors who subtly give the message “just follow me and you’ll be okay” do well. This is unfortunate, but it is reality. It’s the clients who need to look past this offer of certainty and try to understand what they’re getting.

Complex markets require complex solutions.

Once again, it’s true that simple solutions are best for the vast majority of investors, but advisors have learned that simplicity usually doesn’t sell. Until clients demand simplicity, expect advisors to convey the message that investing is complex, but that they can handle it for their clients to simplify their clients’ lives.

Past performance is all that matters.

It’s true that past performance does not guarantee future performance. However, we’re not wired to think that way. Touting past performance is an effective way to sell investments, even if it’s fundamentally dishonest. Advisors who want to actually help their clients will explain the need to avoid chasing recent winners, but expect many advisors to exploit our weaknesses and keep selling past performance.

Clients need more choices, more ideas, more products, more portfolio changes, more everything.

It’s true that clients don’t need this churn. But churn creates profits for brokers and advisors.


There are honest financial professionals who seek to do what’s best for their clients. However, financial incentives are powerful motivators. Even honest people are guilty of motivated reasoning where they find a way to believe that their actions are good for their clients. Further, there are many advisors with minimal training who just do what their employer’s tell them to do and have no real idea of what’s good for their clients. The result is a world where we all have to look out for our own best interests and not just blindly trust others.

Tuesday, November 1, 2016

Investing Lessons from Gambling on Coin Flips

Imagine you get to play a profitable game. You’re given $25 and get to gamble on the flips of a coin. Whatever amount you wager gets doubled or you lose the wager. The profitable part is that you’re told the coin is biased; heads comes up 60% of the time. After betting for a half hour (enough time for about 300 bets), you get to keep whatever money you have left. Your wagers have to be multiples of a penny, and you’re told there’s a cap on your winnings, but not the amount of the cap. If you bet enough to put you at or over the cap, you’ll be told at that point the amount of the cap. What betting strategy would you use?

The experiment

Victor Haghani and Richard Dewey ran this experiment on 61 “college age students in economics and finance and young professionals at finance firms.” Their very readable working paper is available here. Despite the financial sophistication of the subjects, they didn’t do very well with the betting.

The experimenters capped winnings at $250, but only 13 of the subjects got to $200. In fact, 17 of them ended up with less than $2. The most surprising finding to me is that 41 subjects bet on tails at least once, 29 bet on tails more than 5 times, and 13 subjects bet on tails more than one-quarter of the time!

An online version of the game is available if you’d like to try it before I give away strategy details. However, they’re not giving away real money any more.

Given how poorly the subjects did in this fairly simple game, it’s hard to be optimistic about people making sensible choices in the much more complex world of investing.


After reading the game’s rules, my first thought on the correct way to play was to repeatedly bet on heads with a fixed fraction of the current bankroll. How to choose the fraction of bankroll to bet goes all the way back to Daniel Bernoulli in 1738 who suggested that we should treat money as having logarithmic utility. This may sound complex, but it’s not too difficult. It just means that each doubling of your net worth is equally valuable, and that each new dollar you get is worth a little less than the last dollar.

The standard way to derive the correct fraction to bet isn’t very accessible to many readers, but an equivalent way to look at it is easier. Let’s call the betting fraction x. So, if we always bet 15% of the current bankroll, then x=0.15. Your money grows by a factor of 1+x if you win, and 1-x if you lose. After 5 tosses, the median outcome is 3 heads and 2 tails. If you bet on heads each time, this median outcome grows your money by a factor of (1+x)3(1-x)2. If you try different values of x, you’ll find that this expression is largest when x=0.2. This means betting 20% of your money on each coin flip.

So, the first bet would be $5, leaving you with either $20 or $30. If you lost, the next bet would be only $4. If you won, the next bet would be $6. After the first bet, because your odds of winning are 60%, your expected bankroll is $26. So, on average, your bankroll grows 4% on each bet.

This method of determining the fraction of your money to bet is known as the Kelly Criterion. The two researchers suggest this approach as a good way to play their game. Indeed, it is a good way to play the game, but not optimal. Getting back to the experiment, “average bet size across all subjects was 15% of the bankroll,” which is actually more conservative than the Kelly Criterion. However, betting on tails and erratic bet sizing sunk several subjects.

A slightly modified game

Suppose the subjects knew in advance that the cap on winnings was $250 and knew they’d get exactly 300 bets. Further, let’s assume that $250 is small enough in each subject’s life that we can treat the money as having linear utility (this means each extra dollar won is worth the same as the last dollar won). This doesn’t seem like a huge difference in the game. However, the optimal strategy in this case is very different from what you get with the Kelly Criterion. In fact, the optimal strategy doesn’t even depend on the coin’s bias!

The experimenters’ goal was to create an experiment that mimics the properties of investing as closely as possible without costing them too much money. Even this simple experiment put them at risk of losing $250 to 61 subjects, for a total of $15,250. Fortunately, poor play reduced their costs significantly.

Unfortunately, the $250 cap on winnings makes optimal play quite different from optimal investing strategies. This means that chastising subjects for betting patterns that differ from the Kelly Criterion can be misguided. No doubt many subjects made bets that can’t be justified, but as I’ll show below, optimal betting doesn’t look much like the Kelly Criterion.

The authors’ simulations of strategies based on the Kelly Criterion gave the expected value of the game as “just under $240.” However, when the $250 cap is known, the optimal strategy has an expected outcome of $246.60.

I found this result with a method that gave exact results rather than using Monte Carlo simulations. I also used computation methods with large integer values to avoid floating point rounding errors. The general method was to start at the end and work back.

After the last bet, the value of each bankroll amount ($0.00, $0.01, $0.02, ..., $250.00) is just the bankroll amount. (To take into account utility, you could replace these values with their utilities, but that isn’t what I did.) Backing up one bet, we look at every bankroll amount and every possible bet size and choose the bet size that maximizes the expected outcome. Then the value of each bankroll amount before the last roll is the expected value after the optimal last bet.

As an example, if you have $125 before the last bet, your best strategy is to bet it all. This has an expected outcome of $150 because of the coin’s bias. Working through all possible amounts you could have before the last bet, we can find the expected final bankroll given the best bet size. We can then go back to the second to last bet. Continuing this way, we can back up a total of 300 bets. Starting with $25, the expected outcome works out to $246.60.

A continuous version of the game

It turns out that this game is actually easier to analyze if we eliminate the restriction that bets be multiples of a penny. The outcome doesn’t change much by removing this restriction. When bets are multiples of a penny, the expected outcome is $246.6063. When fractions of a penny are permitted, the expected outcome is $246.6066, just 3 hundredths of a penny more.

To analyze the unrestricted game, let’s start with the simple relationship between bankroll size and final winnings after the last bet. They are equal:

Now, let’s back up one bet. If you have less than $125, your best move is to bet it all with an expected increase of 20%. If you have more than $125, your best move is to bet enough that you’d end up with $250 if the coin comes up heads. This gives the following relationship between your bankroll before the last best and your expected winnings:

It looks like we nailed down the ends of the blue line, grabbed it in the middle, and stretched it up 20% to make the red line. If we then analyze the best bet size on the second to last bet, it turns out that there are often many bet sizes that are equally good. A simple rule that gives one of the optimum bet sizes is to bet the difference between your bankroll and the closest one of $0, $125, or $250.

With this strategy, the new line can be calculated from the red line in a similar way to the way we made the red line. Start by nailing down the red line at the ends and in the middle where the slope changes. Then grab each half of the red line in the middle and stretch it up to increase the slope of its first half by 20%. This gives us the relationship between the bankroll with 2 bets left and the expected final winnings:

Notice that the middle two segments of the green line have the same slope, so we only have slope changes at $62.50 and $187.50. With 3 bets left, tied for best strategy is to bet the difference between your bankroll and the closest one of $0, $62.50, $187.50, or $250.

To get to the line showing the expected winnings with 3 bets left, we nail the green line down at the ends and the two points where the slope changes (not the middle). Then drag each line segment up as before:

It’s getting a little harder to see what’s going on, but the purple line has 4 different slopes. The first 1/8 of the way it has slope 1.2*1.2*1.2. The next 3/8 of the way, its slope is 1.2*1.2*0.8. The next 3/8 has slope 1.2*0.8*0.8, and the final 1/8 has slope 0.8*0.8*0.8. Some readers may recognize that the bankroll gets divided into segments that look suspiciously like Pascal’s triangle, and the expected winnings follow the Binomial distribution.

Suppose your bankroll is at at one of the 3 points where the purple line changes slope (bankroll of $0, $31.25, $125, $218.75, or $250). Call these the nailed-down points. Then the optimal strategy is to bet enough to get to one of the nearest nailed down points of the green line. Which nailed down point you get to on the green line depends on whether you win or lose the bet (except if you’re already at $0 or $250). The optimal strategy on the second to last bet will take you to a nearest nailed down point on the red line.

This rule works all the way back to the start when you have 300 bets left. If you are ever on a nailed-down point, you just keep jumping to other nailed-down points until finally you end up with nothing or the full $250. The following chart shows the expected winnings for optimal play with 300 bets left. This is the same chart we would have produced if I had continued the above sequence of charts for 300 steps (except that below I only show the last line and not all that came before it).

The blue curve is actually made up of 301 line segments. It shows that optimal play gives the maximum payout of $250 with high probability for all but the smallest starting bankrolls. When you start with $25, the odds are 98.64% that you’ll get the full $250. For the first wager, bet amounts from $1.99 to $3.16 are equally good.

However, if we play this game for 10,000 bets, the best starting bet drops to between $0.37 and $0.51. And if we are given only 3 bets, the optimum strategy is to just bet it all 3 times hoping to end up with $200. So, we see that optimum bet sizing can be very different from the Kelly Criterion.

As promised earlier, optimal bet sizes don’t even depend on the coin’s bias. In the procedures where we nailed down lines grabbed them in the middle and stretched them up, the coin’s bias affected how high we stretched the lines up, but not the bet sizes.

If heads comes up only 55% of the time, the expected winnings drop from $246.60 to $168.56. If heads comes up 70% of the time, the expected final bankroll is less than one-millionth of a cent under $250. But the bet sizes don’t change, even though the Kelly Criterion would have you making different bet sizes.

Not knowing the winnings cap

Returning to the original games where subjects don’t know the winnings cap, the optimal strategy depends on your opinion of the probability distribution of the winnings cap. However, for any reasonable assumed distribution that would not destroy the experimenters financially, optimal strategies won’t look much like the Kelly Criterion.

This doesn’t mean that the Kelly Criterion is wrong in other contexts. It just means that the winnings cap changes this game significantly. We can’t say that subjects are crazy for making bets that don’t agree with the Kelly Criterion. While Kelly-sized bets work reasonably well, there are many other strategies that work well, and some that work better for this game.

Probably the biggest challenge for the experimenters is that the amount of money at stake is fairly small compared to the subjects’ other assets, including human capital. This shows up most at the end of the game where is makes sense to make large bets. When you’re handling your actual portfolio, situations where it makes sense to bet it all are highly contrived.


These experimenters have done some fascinating research that digs into how people understand investment risk. Despite the fact that the game they designed has limitations that are hard to fix, their results were illuminating, mainly because the subjects performed so poorly. Another conclusion readers can draw is that I enjoy analyzing games and dug further into this one than was necessary to explain the game’s differences from actual investing.

Monday, October 24, 2016

Crazy Mortgages

For anyone who got their first mortgage more than a decade ago, the reality of getting into today’s housing market can be an eye-opener. In describing the effects of the latest new government mortgage regulations, Rate Spy writes
“Today, someone with 10% down who makes $50,000 a year can qualify for a $300,000 home purchase. That hypothetical maximum mortgage amount will plunge 18% to $246,000.”
Mortgage experts have become desensitized to such numbers, but to me they look like there must be a typo. Someone earning $50,000 per year can get a $300,000 home with only $30,000 down! That leaves a mortgage of about five and a half years of gross earnings. It seems crazy for someone to dig such a huge financial hole. Dropping this mortgage size to about four and a half years of gross earnings isn’t enough better.

Rate Spy goes on to write
“This one regulation alone could shut out more buyers from the market than possibly any of the prior rule changes.”
Good. I’d be horrified to learn that one of my sons made such a huge financial mistake.

I have no opinion yet about other criticisms of the government’s new mortgage regulations. However, reducing the size of mortgage people can get for a given income is sensible. As I frequently tell my sons, renting is better than becoming a slave to your mortgage payment for decades.

Friday, October 21, 2016

Short Takes: Coexisting Active and Passive Investors, RDSPs, and more

Over the past two weeks I managed only one post on the difficult subject of how to determine the best way to invest your savings during retirement:

Prime Harvesting in Retirement

Here are some short takes and some weekend reading:

Lasse Heje Pedersen explains how passive investors are forced to do some trading due to various types of index changes, which creates an opportunity for active investors to outperform. Thus, active and passive investors can reasonably coexist when there are few enough active investors that they can recover their costs from out-trading passive investors. Despite the academic look of the SSRN page, the paper itself is fairly short and very readable.

The Blunt Bean Counter brings in an expert to discuss the Registered Disability Savings Plan (RDSP).

Big Cajun Man has more trouble depositing money into his son’s RDSP. His musing about how difficult it will be to get money out is definitely food for thought.

Boomer and Echo tries to explain to the anti-RRSP crowd why RRSPs are not a scam. I’ve tried to do the same thing with pictures.

Million Dollar Journey updates a comparison of prepaid wireless plans for 2016.

Squawkfox settles debates over whether certain items, such as premium gasoline, are a waste of money.

My Own Advisor’s update on his 2016 predictions should make it clear that it’s dangerous to wager real money on such predictions.

Monday, October 17, 2016

Prime Harvesting in Retirement

There are many theories about asset allocation in retirement. Some say that your bond percentage should be your age. Others say it should be your age minus 20. Some even say your stock percentage should rise as you age in retirement (a so-called “rising glide-path”). In his book Living Off Your Money, Michael H. McClung recommends a strategy called “Prime Harvesting” that I examine here.

The book is very technical and covers many retirement topics, but I’m going to try to be as non-technical as possible in this article and discuss only Prime Harvesting. I’ve been thinking about the best way to handle a portfolio in retirement for some time, and this book promises new ideas and a strong evidence-based approach.

First of all, “Prime Harvesting” is a great name. If you ever get into a discussion about this subject, you’ll sound like the smartest person in the room if you say, “Well, I use Prime Harvesting.” Fortunately, Prime Harvesting can be described with a few simple rules:
1. At the start of each year, if your stocks are worth more than 20% more than they were when you started retirement (adjusted for inflation), sell off the excess above the 20% gain.

2. If there isn’t enough cash to make up your intended withdrawal for the year’s spending, sell bonds to make up the difference.

3. If you run out of bonds, sell stocks to make up the rest of your spending needs for the year.

4. If step 1 produced too much cash, buy bonds with the excess.
Even though these rules are simple enough, their implications aren’t immediately obvious. Let’s look at two extreme examples to get a feel for Prime Harvesting.

Booming Stocks: If stocks boom, you end up selling off excess stocks to create cash to live on, and you keep buying bonds with what’s left over.

Lagging Stocks: If stocks give below-average returns for long enough, you end up living off your bonds until they’re gone, and then you sell stocks to live.

Having stocks boom is the happy case, but let’s think about what life is like when stocks lag. Your portfolio hasn’t been performing as well as you’d like, and all your bonds are gone. Now your work experience is getting very stale and you’ve got a risky 100% stocks portfolio that is smaller than you were hoping. How well are you sleeping?

Let’s make this a little more concrete. Suppose Liz retires today with $750,000 and plans to spend $30,000 per year (rising with inflation). She begins with $300,000 in bonds and $450,000 in stocks (a 60/40 split), and uses Prime Harvesting.

Suppose that bonds lag inflation by a modest 0.5% per year for the next 9 years because interest rates rise a little. (This isn’t a prediction, but it doesn’t seem unlikely.) Suppose as well that stocks mildly disappoint by averaging 2% above inflation for the next 9 years. (Again, not a prediction, but doesn’t seem terribly unlikely.)

In this scenario, at the start of Liz’s tenth year of retirement she will sell the last of her bonds and draw partially on her stocks. She’s left with about $530,000 (adjusted for inflation) in stocks and is very nervous. Can she still afford to spend $30,000 per year?

Then the worst happens. Stocks crash 30% in year 10, are down another 10% in year 11, and are flat in year 12. She’s now got less than $250,000 (inflation adjusted) left. Her withdrawals are completely unsustainable. She needs to cut them in half. Stocks subsequently rise steadily for years but the damage has been done to Liz’s portfolio.

To be fair, I should point out that McClung also examines strategies for variable withdrawals to adapt to disappointing portfolio returns. However, these strategies would not significantly reduce Liz’s spending until after she is 100% in stocks and gets slammed by the 30% stock market crash.

How could McClung advocate a strategy so likely to leave retirees with 100% stock portfolios? The answer is that his extensive back-testing never encountered a scenario exactly like the one I described. By chance, even milder versions of this scenario haven’t occurred in the past.

McClung says that historical market data represents “known risk” and that returns outside the historical data is “speculative risk.” He would classify the scenario I described as a speculative risk. Despite the fact that McClung demonstrates a strong understanding of the risks of data mining, I believe his recommendations suffer from data mining.

To understand data mining, think of the example of trying to raise a teenager. Good strategies involve understanding what they’re going through. But if you look to the past and develop strategies taking into account drive-in movies and sock hops, then you’re guilty of data mining. You’ve over-fitted your strategy to the past and it won’t work today.

When it comes to testing financial ideas, it’s difficult to tell when you’re guilty of data mining. I can’t prove that McClung is guilty, and he can’t prove he isn’t. However, I don’t think my example of Liz’s retirement is all that unlikely. All it takes is a period of at most modest stock growth following by a crash.

If the leaves on a tree represent each historical return pattern we’ve experienced, then speculative risk comes from the possibility that your retirement will have a return pattern that is outside the tree’s boundaries. However, I believe that return patterns that cause problems for Prime Harvesting exist within the tree’s boundaries, but at places where is currently no leaf. In other words, there are return patterns that cause problems for Prime Harvesting, but are well within the character of past returns.

All this said, I’m a fan of McClung’s rigorous approach to looking for real evidence to back up retirement advice. The challenge is to define what is a reasonable range of likely future stock and bond return patterns. In my opinion, McClung is clinging too closely to historical returns. We simply have far too short a history of returns to say that we’ve seen all there is to see. Even seemingly inconsequential differences from historical returns can give big problems for Prime Harvesting.

McClung attempts to deal with the data mining problem by testing ideas on data from different countries and performing simulations where returns in 5-year groups get randomized. These efforts certainly help, but they aren’t enough. In the end, his recommendations are heavily influenced by the worst retirement period that started in 1969.

I certainly don’t know what portfolio allocation strategy is best, but I think it shouldn’t involve huge increases in portfolio risk over time. Modest adjustments to risk level could be sensible, but starting with a 60/40 allocation to stocks and bonds, and ending up 100% in stocks after a decade makes no sense to me. The fact that it has worked out reasonably well in the past brings me little comfort.

Friday, October 7, 2016

Short Takes: Danger of Boredom, Smart Beta, and more

Here are my posts for the past two weeks:

Shrinking Bonds

Selling off the last of my individual stocks

Here are some short takes and some weekend reading:

Jason Zweig explains the dangers of becoming bored with investing.

Canadian Couch Potato wraps up his series on smart beta with a discussion of the quality factor. When you first start digging into smart beta, it seems like minor tweaks to index investing. But as this explanation of the quality factor makes clear, you can find yourself almost all the way into the world of stock picking swimming with sharks.

Preet Banerjee explains some of the scary aspects of group RESPs in one of his Drawing Conclusions videos.

A Wealth of Common Sense says “good riddance” to financial advisors in the U.S. who are thinking of quitting because of new fiduciary rules.

Boomer and Echo looks at different areas where we may not make rational financial decisions. No doubt this annoyed some readers; few people react well to being told they’re irrational.

Big Cajun Man encourages people to speak up if their financial advisor or institution isn’t making sense. We tend to think it’s our fault if we don’t understand, but it isn’t. It’s their fault and they deserve to hear about it from you.

Million Dollar Journey gives an update on his journey to financial freedom.

My Own Advisor explains the new mortgage rules.

Thursday, October 6, 2016

Selling Off the Last of My Individual Stocks

I can’t be accused of being impulsive when it comes to investing. It took me about 7 years to slowly shift from stock picking to just this week fully embracing index investing. We’ve finally sold off the last of our Berkshire-Hathaway stock.

We held on to the last shares for tax reasons, but we’ve finally now realized the last of my wife’s capital gain on Berkshire. Our portfolio now looks as I described it a couple of years ago.

We now own only 4 different ETFs, and I have a spreadsheet that alerts me if I ever need to rebalance or invest new money. It feels good to have a simple plan that eliminates almost all aspects of my own day-to-day decision-making. I still have to make some final decision about investing during retirement, but that’s a long, slow process.

The total costs for my portfolio come to a little less than 0.2% per year. This includes ETF MERs, ETF internal trading costs, trading commissions, bid-ask spreads on trades, and foreign withholding taxes. Over the next 40 years, this compounds out to 7.7%. If this sounds high to you, typical costs are far worse. Paying 2.5% for 40 years compounds to over 63%. This consumes nearly two-thirds of each dollar that stays in your portfolio that long!

One nice side effect of this approach to investing is the sense of calm I feel when an article or talking head tells me that the market is about to crash or that I’m missing out on some great stocks. Deciding in advance to do nothing in the face of this “news” has improved my life.

Tuesday, September 27, 2016

Shrinking Bonds

As I write this, Canadian 30-year bonds yield 1.674% per year. If we assume that Canada will be able to maintain its 2% inflation target, these bonds will lose purchasing power for the next 30 years. Investors today are willing to tie up money for 30 years and get back less at the end of it all. This seems remarkable to me.

Of course, investors can choose to sell these bonds before they mature, but if we follow the life of an individual bond, its owners will share the loss of purchasing power for 30 years. Some investors may hope yields will drop further creating a capital gain. Some may think inflation will drop or that we might even have deflation. Others may think that alternative investments, such as stocks or real estate, will fare worse.

I don’t know if bond investors are being rational, but I find it hard to look past the apparent near certain loss of value. Over 30 years I’m hoping my stocks will roughly triple in real value and that my house will hold its value. I may be disappointed, but it’s hard to buy bonds with disappointment seeming to be a near certainty.

Bonds have the virtue of reducing portfolio volatility. This is useful for investors who can’t handle too much volatility or who have enough money that they don’t need to take much risk. However, these benefits aren’t enough to get me past the thought that buying bonds today is a money-losing proposition.

Friday, September 23, 2016

Short Takes: Fact-Resistant Humans, Financial Makeover, and more

I managed only one post in the past two weeks looking at the Air Miles fiasco:

Thousand-Foot View of Air Miles

Here are some short takes and some weekend reading:

The New Yorker cracked me up with a piece on “fact-resistant humans.” There’s not much of a connection to money, but it’s a good read nonetheless.

Mr. Money Mustache does an interesting case study of a young man’s finances and spending. A great quote: “it is impossible to out-earn the habit of spending all your money.”

Potato discusses the problem of companies such as Valeant and Nortel growing to dominate Canadian stock indexes. It’s true that when such companies topple, they bring the index down. But the flip side is that when they soar, they bring the index up. It’s only market timers who are harmed over the long run by stocks that inflate and deflate.

Million Dollar Journey looks into tax-efficient non-registered investments for children.

Canadian Couch Potato continues his series on “smart beta” with a look at the size factor.

My Own Advisor has a good list of ways to ruin your retirement plan.

Big Cajun Man goes through some financial priorities that come ahead of RESP contributions.

The Blunt Bean Counter analyzes income tax concerns for Olympic athletes and NHL players.

Thursday, September 15, 2016

Thousand-Foot View of Air Miles

Many collectors are upset that their Air Miles are set to expire and choices for cashing them in are slim. Boomer and Echo’s open letter sums up the current situation well. Ellen Roseman has even started a petition calling on LoyaltyOne to help collectors save their Air Miles. Sadly, this conflict was quite predictable.

Air Miles resemble a currency. In many ways it’s as though LoyalyOne minted their own money, and they control the exchange rate of cashing in Miles for flights and other goods. Collectors of Air Miles got used to one exchange rate, but it was inevitable that as the Air Miles “money” supply grew, LoyaltyOne would have a growing incentive to tinker with expiration rules and change the exchange rate.

In some ways, this reminds me of when my son was young and held onto cheques, thinking they were as good as money. I had to explain that cheques sometimes bounce and that they expire after about 6 months. It’s best to deposit them as soon as possible. Similarly, collectors of points of any kind need to think about cashing in points when possible is avoid the inevitable devaluation or expiry.

Now, it may seem that I’m building up to saying that Air Miles collectors were foolish and deserve their fate. I’m not. I hope the petition effort succeeds in embarrassing LoyaltyOne into doing the right thing. The fact that the current battle was predictable, at least in broad terms, does not make it right.

The important thing for points collectors to understand is that this is not the first time this has happened and it’s likely to happen again. Take Aeroplan as an example. The number of miles needed to get free travel has risen over the years, miles began expiring, block-outs grew, and travelers began having to pay taxes and other fees when using miles.

Don’t get fooled again. The best plans give cash back immediately. Next best is cash back within a year. After that is any points plan where you know you can use the points within a year or so for something useful. It almost never makes sense to let points affect where you shop and what you buy. Above all, don’t collect any type of points for years expecting them to hold their value.

Friday, September 9, 2016

Short Takes: Sponsored Post Crackdown, Dividend Investing, and more

Here are my posts for the past two weeks:

Thinking Differently about Investing

Adventures in Credit Reports

Here are some short takes and some weekend reading:

CBC News reports that Advertising Standards Canada will be cracking down on sponsored posts on blogs. This sounds great to me. I’m tired of getting part way through a blog post and realizing that I’m reading paid-for dreck.

Boomer and Echo explain why Echo made the switch from dividend investing to index investing. The comments are civil, and in a few cases they illustrate some dividend investors’ beliefs that can only be true if dividend stocks earn higher total returns than other stocks. One example is “In an upcoming age of slower growth, I believe it’s important to own birds in hand (dividends) vs. two in the bush (capital gains). If I’m correct, dividend investing will be more beneficial.” Another example is “it’s simply not true to generalize that a dividend stock’s price will be held back by its dividend.”

Canadian Couch Potato begins a series of articles explaining smart beta.

Potato reviews The One-Page Financial Plan and finds he is torn between praising it and damning it. He notes that the book “has been out for a little over a year so this isn’t exactly a fresh review.” This doesn’t concern me. If a book isn’t worth reading after a year or even a decade, it probably wasn’t worth reading when it first came out. Authors crave positive reviews at a book’s launch, but I write my reviews for readers.

Big Cajun Man says textbooks are too expensive and that students are a captive market being exploited.

Million Dollar Journey offers wealth-building tips for a friend (Gary) for taking advantage of free money. The only one I take issue with is the cash-back credit cards. If Gary has built a life using cash and debit cards, perhaps the reason is that it helps him avoid overspending as happens with so many of us when we use credit cards. The cash back is a small consideration compared to spending more or paying interest. Don’t spend any time thinking about cash back until you are certain you don’t spend more when using credit cards. One test of this is to imagine buying a $200 item with a credit card and then fan out ten $20 bills and imagine handing them over.

Thursday, September 8, 2016

Adventures in Credit Reports

Equifax and TransUnion are required to provide Canadians with free copies of their credit reports once per year, but you only get these reports if you ask for them. Fortunately, asking for these reports by automated telephone system or online is fairly easy as long as you can get past the authentication questions. Here I describe my experience getting these reports.

It’s not too difficult to search for “Equifax free credit report” or “TransUnion free credit report” and find ordering instructions, but don’t be distracted by their attempts to divert you to reports that aren’t free. Find the word “free” on the web pages.

TransUnion Request

TransUnion offers a way to order free credit reports online that seemed easy enough, but didn’t quite work for me. The problem was that one of the questions they used to authenticate me was based on errors in my file. They crossed up my home address with that of one of my family members. I know what TransUnion thinks my address was 13 years ago, but it seemed wrong to authenticate myself by selecting a choice that I know is wrong.

So, I moved on to their automated telephone system. The sound quality is quite bad, but I was able to answer the various questions to their satisfaction. Fortunately, I wasn’t asked a question about past home addresses. The trickiest question was whether I had asked for a copy of my credit report in the past 2 years. My last request was close enough to 2 years ago that I was forced to guess. I must have guessed right.

Equifax Request

Equifax doesn’t offer a way to order a free credit report online, but their automated telephone system is easier to use that TransUnion’s. The sound quality is better, and Equifax’s system repeats each answer back to you before asking if it is correct. TransUnion just asks if you’re happy with your answer without repeating your answer back to you.

Report Errors

I found a total of 3 errors in my TransUnion report, and 2 errors in my Equifax report. None of the errors are related to my credit history. They are all related to my history of home addresses and employers. The funniest error is a strange phonetic misspelling of a former employer’s name. The word “Cryptographic” was turned into “Kripta Grapixs.” I actually tried to correct this error 5 years ago. Apparently, trying to correct errors is futile.

The good news from this exercise is that I don’t seem to have been the victim of identity theft. I don’t have much reason to worry about access to credit, but credit reports are used in so many ways today that it pays to keep your record clean.

Wednesday, August 31, 2016

Thinking Differently about Investing

When I look back at the way I thought during my first several years of investing, I realize that my thinking is very different now. I started out too conservatively and quickly evolved to looking for big wins. Now I seek good returns while avoiding big mistakes. That’s not to say that I’m now scared of volatility. I go for the best returns I can get with the constraint that I try to keep the odds low that I’ll permanently lose a significant amount of my capital.

To illustrate what I mean, I’ll go through some examples of ways to lose capital and examine how my thinking has changed.

Any individual stock can drop 90% or more

Over the years I’ve owned several stocks that have dropped 90% or more. Before this happened to me, I didn’t think about this possibility. I once owned a stock that grew to well over half my net worth. Fortunately, I sold most of it before it dropped by more than 98% at the end of the tech boom of the late 1990s. With different timing, I could have lost almost everything.

Today I would never do anything so reckless. I choose to own many thousand of stocks worldwide through index ETFs. There are other ways to get adequate diversification, but this is my choice.

The entire stock market can drop 40% or more in just a few months

This is what happened in the stock crash of 2008-2009. The stock markets in Canada and the U.S. have always rebounded eventually from such crashes, but that doesn’t help if you’re forced to sell. I didn’t use to worry about losing my job or the leverage I had with my mortgage and possibly being forced to sell stocks low.

Now, whenever my thoughts drift to borrowing to invest more in the stock market, I remind myself of what could have happened if I had been leveraged in 2008. The losses would have been devastating. So, I stick to having no debt, I have a modest cash cushion, and I won’t invest money in stocks unless I believe I won’t need the money for at least 5 years.

Costs Matter

During my early forays into mutual funds through advisors, I didn’t know about MERs and other costs. Even as I began to learn about these costs, I didn’t appreciate that these small percentages add up to big money. Costs can easily consume half your savings over a lifetime of investing. Even as I moved to choosing my own stocks, I didn’t appreciate how expensive currency exchange could be. Today I keep my costs very low, and I use Norbert’s Gambit to save money on currency exchange.

GICs give poor returns over the long term

I invested my first RRSP contribution in GICs. At the time, I expected to keep all my savings in GICs indefinitely. I didn’t think of myself as the sort of person who could succeed in the stock market. I later went through a phase of overconfidence.

Now I realize how easy it is to beat GICs over the long run with buy-and-hold low-cost indexing. GICs are great when you need the money in the short-term, but if I had stuck to GICs, I’d only have a fraction of my current savings.

Analyzing stocks takes a lot of time

This is more about loss of time than loss of money, but both are important. I used to believe I could pick above-average stocks and had convinced myself that I enjoyed all the work. But the truth is that I can’t get an edge on professional investors, and I enjoyed the idea of making more money and not the actual process of combing through the details of dozens of annual reports. I haven’t studied a stock in detail in years and I don’t miss it.

Overall, I’m better off avoiding both overconfidence and being overly cautious. To get rewarded we must take some risk, but we have to be careful to avoid big mistakes.