Thursday, October 19, 2017

Burn Your Mortgage

Many people are familiar with Sean Cooper’s story of living extremely frugally for a few years while he saved up a large down payment, bought a home, and paid off his mortgage by age 30. Cooper built on the interest in his story by writing a book called Burn Your Mortgage. I expected to like this book because I believe paying off your mortgage and any other debts is a good idea (I paid off my first mortgage by age 28). However, despite many good parts of the book, there is too much cheerleading for home ownership for me to recommend it.

A common theme throughout this book is treating rising housing prices as a permanent reality. “The last thing you want is to find yourself priced out of the market.” “It’s probably wise, if you’re in the financial position to do so, to buy now while you can still afford to.” Even though this book came out in 2017, it already has a dated feel now that home prices have been dropping in Vancouver and Toronto.

Another part of this theme of rising house prices is the claim that real estate has been a better investment than stocks. See my recent post on cheerleading for home ownership for one example. Another is a chart of home sale prices from 1980 to 2015 with the caption “Canadian real estate prices have been trending upward over the past 25 years. That’s more than we can say about the stock market over this same time.” I can’t do better than John Robertson’s image of the S&P 500 total return superimposed on Cooper’s home price chart.

The early chapters of the book cover advice on basic personal finances building up to how to save up for a down payment. One quote I particularly liked is “It’s not how much you make; it’s how much you save.” The more I see of other people’s finances, the more I realize that overspending can happen at any income level.

One section offers “25 Ways to Save Big.” This is a decent list of things that many people buy mindlessly, but each item includes a suggested amount of annual savings that just seems random. This attempt to quantify savings marred an otherwise interesting list.

Some of the advice is too superficial for readers to follow without a lot more knowledge. One example is “Carefully weigh the pros and cons of a car loan versus leasing to see what makes the most sense.” This ignores the best option: save up and pay cash for a car. Another problem is that those who just compare monthly payments might think they’re following this advice.

There are advantages and disadvantage to using the Home-Buyer’s Plan (HBP) to use RRSP assets for a down payment, but Cooper’s justification is pure FOMO: “in this crazy real estate market where home prices are rising a lot faster than wages, it’s hard to turn down a 30% risk-free return.” To start with, the HBP allows you to increase the size of your down payment with money you’ll have to pay back later; this is not the same as a 30% return. Further, it’s dangerous to make big financial decisions based on the belief that house prices will keep rising.

The second part of the book contains a lot of useful advice on the details of buying a house. Cooper even allows that “sometimes it makes sense to rent until you’re financially ready to buy a home.” More excellent advice is to “Love They Neighbour.” It’s difficult to understand how important it is to work at getting along with neighbours until you’ve had a bad neighbour. “A good neighbour can make your time at home pleasant; a bad one can make it a living nightmare.”

I was suspicious of a quote Cooper attributes to Warren Buffett: “To build true long-term wealth, you must buy and hold real estate.” This turns out to be from a list of 13 Buffett quotes that were “translated” for real estate investors. The actual Buffett quote is “Our favorite holding period is forever.” But Buffett is referring to the businesses his company owns, not real estate. This is another example of true believers in some investment approach trying to recruit Buffett as one of their own.

In a section listing the pros and cons of buying a home, one of the pros is “forced savings.” There is some truth in the idea that forced savings helps people, but as Rob Carrick once said, a home comes with “forced spending” as well. Curiously, Cooper says forced saving is good because “Most people put their mortgage ahead of all other debts.” If you’re paying off your mortgage and allowing other debts to grow, that’s not forced savings. You’re not saving anything if your net worth isn’t growing.

One section contains some good, detailed advice on choosing a real estate agent. However, along with several good ideas is the advice to “Visit their website to read testimonials.” That’s not a good idea. For some reason humans are wired to be influenced by stories, even when they are deliberately misleading. In Ontario, regulated health professionals aren’t even permitted to publish testimonials.

In a discussion of mortgages and how much you can borrow, Cooper discusses the two main debt ratios. For the gross debt service ratio, he recommends that we “aim for a GDS ratio 30% or below (up to 35% in pricey real estate markets).” For the total debt service ratio, he recommends that we “aim for a TDS ratio of 37% or below (up to 42% in high-cost cities).” This idea that it’s okay to borrow more in hot markets is nonsense. You can’t suddenly handle more debt just because houses are expensive. And hoping to get bailed out by prices continuing to rise after you buy is a bad plan.

In a section discussing the pros and cons of mortgage brokers, Cooper says they have “No cost.” This is just wrong. The broker’s fee is baked into the rate you get. Now, it could be that a mortgage broker can still get a better rate than you could negotiate yourself from a lender, but that doesn’t mean the broker has no cost. Any time it seems like someone is working for you for free, you’re probably missing something.

A good section on breaking a fixed mortgage explains how expensive this can be. Many people would be shocked to learn that it could cost $20,000 or more to break their mortgage. A statistic that surprised me is that “70% of people change their mortgage before the end of its term.” Presumably, this doesn’t always involve a huge penalty, but such penalties are common enough that home-buyers should understand this potential cost.

The book’s last section covers topics that come after you’ve bought your home such as insurance, wills, and becoming a landlord. Becoming a landlord isn’t for everyone, but those who choose this path get some useful advice from Cooper on pitfalls and good practices.

“A rental property is the ultimate solution to building long-term wealth and achieving financial freedom.” I disagree. I’ve known too many people who tried to make money this way and ended up losing a lot of time and money. It takes a certain personality type to be able to deal effectively with tenants and to negotiate with various types of contractors for repairs and upgrades. You also need to develop a keen sense of the value of real estate to buy and sell at good prices. Only a small minority of people seem to do well at being a landlord. It’s much easier to build wealth with passive investments in the stock market.

An appendix lists a number of “side hustles” to make some extra money. This list of ideas can be a good starting point for an energetic person seeking ideas. One that made me cringe, though, is “If you’re healthy, get paid to test out new drugs.” Yikes!

The best parts of the book discuss frugal living and the advice on important details of the house-buying process and becoming a landlord. However, if asked whether I’d recommend this book to my sons, I’d have to say no; they are bombarded with enough messages to buy now while they still can. I think they’re better off using price-to-rent ratios to decide when to rent and when to own.

Tuesday, October 17, 2017

Cheerleading for Home Ownership

I’ve been a happy homeowner for many years now. I prefer owning my home to renting. But I have no illusions that this is the better choice financially. Price to rent ratios today mean I’d very likely come out far ahead if I sold my house and started renting a comparable house. But I’m not going to sell because I choose to pay the price of ownership. Unfortunately, many homeowners need to believe they will win financially, and they come up with poor analyses to justify this belief.

One such example comes from Sean Cooper’s book, Burn Your Mortgage:

“Let’s say you bought a home a decade ago for $250,000, with only 10% down ($25,000). You later sold it for $400,000, making $125,000 in profit (for simplicity’s sake, we’ll ignore associated costs such as mortgage interest, mortgage insurance, property taxes and closing costs). Even though your home only went up in value by 60%, that’s a 500% return on your initial investment (down payment) of $25,000. Try finding that kind of return in the stock market!”

For accuracy’s sake, let’s sacrifice some of the simplicity of this analysis. Let’s assume your mortgage rate was 3% for the past 10 years, and you had to add CMHC insurance of $5000 to your mortgage. This gives mortgage payments of $13,060 each year on a starting mortgage balance of $230,000. After 10 years, your mortgage balance dropped to about $157,800 so that your equity was $242,200.

Let’s say your annual property taxes were $4000, total maintenance costs averaged $6000 per year, and insurance was $1000 annually. When you bought the house, the closing costs were $10,000, and when you sold it, the real estate fees and other costs totaled $20,000.

It wouldn’t be fair to stop here because you are getting the benefit of living in the house. So, we have to factor in rent. In my area, a place that would have sold for $250,000 a decade ago and is worth $400,000 today would have rented for an average of about $1500 per month over the 10 years. Let’s say the extra utilities an owner has to pay that are usually included in rent come to $2000 per year.

Grinding these numbers through a spreadsheet, we find that the internal rate or return on this investment was 8.7% per year. Somehow we went from an eye-popping 500% return to a pleasing, but down-to-earth return, despite a 60% increase in house price and 10:1 initial leverage.

What would have happened if your home’s value had only risen to $300,000? The internal rate of return would have been -1.2% per year. That’s right—even if your house appreciates by 20%, you can lose money on the investment.

Never trust simple analyses of the investment value of owning a home. The reality is almost always much worse than it appears. Having said all that, I own my home and don’t plan to sell. But I don’t own with the expectation of making a profit.

Friday, October 13, 2017

Short Takes: Income Swings, Buy vs. Rent, and more

Here are my posts for the past two weeks:

Stock-Picking Skill

Liberating Your Losers

The Success Equation

Here are some short takes and some weekend reading:

A new C.D. Howe Institute study concludes that Canadians whose incomes vary from year to year face an unfair tax penalty and that reforms are needed. I agree. My income is highly variable, and it seems unreasonable that during good years I’m incented to delay new work until January.

John Robertson gives a thoughtful and balanced discussion of whether to buy or rent a home.

Canadian Couch Potato interviews Mike Foy to discuss J.D. Power’s research into investor satisfaction with Canadian online brokerages. He also explains why the latest attack on index funds is just more nonsense.

Robb Engen at Boomer and Echo explains why he doesn’t hold bonds in his portfolio.

Big Cajun Man liked Doug Hoyes’ book enough to lift a few ideas from it.

Thursday, October 12, 2017

The Success Equation

Success in most endeavours is a combination of skill and luck. As Michael L. Mauboussin explains in his book The Success Equation: Untangling Skill and Luck in Business, Sports, and Investing, we have a tendency to decide we were skillful when we succeed and unlucky when we fail. We make many other mistakes as well when it comes to recognizing the role of luck in our lives. Mauboussin teaches methods of measuring skill and luck.

Some activities involve little or no luck, such as chess or checkers. If a chess master beats me soundly at one game of chess, he or she is likely to beat me another 10 times in a row. Other activities involve to skill at all, such as roulette and lotteries, unless you count not paying as a skill. A test of “whether an activity involves skill: ask whether you can lose on purpose.” If you can lose on purpose, there must be some skill involved. Most activities, like sports, business, and investing, combine luck and skill.

It turns out that there are statistical techniques to measure the contributions of skill and luck to success. For example, using such methods we can measure the amount of luck involved in single-season records of sports teams. From most skill to least skill we have the following ranking: basketball, soccer, baseball, football, and hockey.

Even though there is so much luck in sports outcomes, fans are quick to blame their heroes for the loss of a single game. But even if you don’t make that mistake, don’t be too smug. We also attribute way to much skill to CEOs who often just get lucky, and we definitely attribute too much skill to investors who get lucky in the markets.

One study found that skill at handling day-to-day finances increases to age 53, on average, and declines thereafter. I guess that means I can expect a low, slow descent that ends with an inability to tell door-knockers to get off my property.

With activities that involve a lot of luck, like investing, “the focus must be on process” rather than on outcomes. Reinforcing poor choices just because they work out well isn’t a good path to success. A challenge with focusing on process is that you have to know a good process. Mauboussin summarizes Benjamin Graham’s approach to value investing as an example of a good process. This approach worked well in Graham’s day, but even he was no longer an advocate of his methods back in 1976. Since then, the stock market has become much more competitive requiring ever more sophisticated means of outsmarting other investors.

Not many books leave me pondering their contents after I’ve finished reading them, but this is one such book. If you want to compete in a complex area where feedback is clouded by luck, such as active investing, it pays to understand the lessons Mauboussin teaches.

Tuesday, October 10, 2017

Liberating Your Losers

Recently, Jonathan Chevreau wrote about a way to try to save money on taxes called “liberating your losers” from your RRSP. It’s no fun owning a losing investment, and when it’s in your RRSP, you don’t even get a capital loss for your taxes. Chevreau offers a way to reduce the sting. Unfortunately, it doesn’t work.

The idea is to withdraw a losing investment from your RRSP so that when it rebounds, you’ll only pay capital gains taxes on 50% of the increase. If you leave the investment in your RRSP you’d end up paying taxes on 100% of the increase when you eventually withdraw the assets from your RRSP/RRIF.

According to Chevreau’s broker friend, this makes sense “when you have had bad timing in your RRSP/RRIF investment choices; when you're confident your investment will return to its previous higher value; and if you prefer to pay tax on 50 per cent of a capital gain rather than 100 per cent of income.” The first condition just means you’ve made an investment that lost money, and the third condition is that you’d rather pay less tax.

Unless you’re Warren Buffett, the middle condition (that you’re confident the investment will rebound) requires you to hallucinate that you have investment skill that makes your judgment of the investment’s value better than the collective judgment of all other investors. If this is true, why not invest more in this investment that’s sure to rebound? The truth is that this investment is no more likely to generate future profits than any other investment you might choose in the same class. However, even if you’re right about the investment rebounding, the strategy of liberating your losers doesn’t make sense, as I’ll show.

To avoid making mistakes analyzing investments inside and outside RRSPs, it helps to think of part of your RRSP belonging to the government. If you expect to pay 40% tax on RRSP/RRIF withdrawals, then think of your RRSP as only 60% yours. Whatever gains your investments make in the future, the government will get 40%, so you might as well think of 60% of the money belonging to you and growing for you, and 40% for the government. The government bought this slice of your RRSP back when you got a tax refund on your contribution.

Thinking about the government owning a chunk of your RRSP isn’t pleasant, but it can keep you from making mistakes when thinking about different strategies. A silver lining is that the 60% of your RRSP that’s yours is completely tax-free. All the taxes you owe are taken into account by allocating 40% of your RRSP to the government.

Getting back to the strategy of liberating your losers, let’s consider an example. Suppose you invested $25,000 in XYZ stock within your RRSP a few years ago and its value has dropped to $5000. Now you’re considering liberating your losers and hoping to save on taxes. The truth is that only $15,000 of that initial investment was yours, and only $3000 is currently yours. If you withdraw your XYZ stock from your RRSP, you’ll have to pay $2000 in income taxes.

By doing this you’re actually increasing your stake in XYZ stock. Before the withdrawal, you really only owned $3000 worth of XYZ stock, and afterward you owned $5000 worth. This suggests an alternative strategy: leave the XYZ stock in your RRSP and buy $2000 worth of XYZ outside your RRSP.

Let’s name these strategies “liberate” and “buy more.”

Liberate: Withdraw $5000 worth of XYZ stock from your RRSP and pay $2000 in taxes.

Buy more: Leave the XYZ stock in your RRSP and buy $2000 more XYZ for you non-registered account.

Suppose XYZ stock doubles. Which strategy is better? In the liberate case, you own $10,000 worth of XYZ stock in your non-registered account, and you have a $5000 capital gain that will generate $1000 in taxes when you sell.

For the buy more strategy, you have $10,000 worth of XYZ in your RRSP (of which only $6000 is really yours), and you have $4000 of XYZ in your non-registered account for a total of $10,000 worth of stock. You have a $2000 capital gain that will generate $400 in taxes when you sell.

One difference between these two strategies is that you’ll pay more capital gains taxes with the liberate strategy. Another is that further gains will generate more capital gains taxes with the liberate strategy. This is what I assume Jamie Golombeck meant when Chevreau quoted him as saying “But you then lose your tax-free compounding indefinitely, which is why I don't like it.” It’s clear that the buy more strategy is superior.

But what about all the extra tax you’ll pay when you ultimately sell your XYZ stock and withdraw the money from your RRSP/RRIF? It’s true that the government will get more tax with the liberate strategy. But that’s because you invested $2000 in XYZ stock on the government’s behalf in your RRSP and it doubled. With the buy more strategy, both you and the government came out ahead. Unless you hate the government so much that you’d rather both lose than both win, I suggest just focusing on your own after-tax gains.

Does liberating your losers make sense if you’re forced to make a RRIF withdrawal, but you don’t need the money to live on? The short answer is no. In this case, the “buy more” strategy changes but is still superior to the liberate strategy if XYZ stock is going to perform better than your other investments.

The alternative to liberating XYZ stock begins by choosing $8333 worth of some other investment(s) within your RRIF that you think will perform worse than XYZ. Sell 40% of these investment(s) and buy XYZ stock with the resulting $3333. Use the remaining $5000 of the investment(s) to make an in-kind withdrawal from the RRIF. If XYZ outperforms the other investment(s), then after working through the details, you’ll find that this strategy works out better than liberating your losers.

In summary, liberating your losers is a bad idea. It only seems good when your understanding of RRSP/RRIF taxation is muddled.

Thursday, October 5, 2017

Stock-Picking Skill

When researchers talk about someone having skill at stock-picking, they are using the word “skill” differently than we’re used to. I might be impressed that a stock-picker seems very smart and knows far more than I do, but this is far from having skill in the technical sense.

To illustrate what we typically mean by “skill,” let’s consider golf. Over the years, I’ve golfed with many people whose abilities impressed me. There are dozens I’ve played with who I’d say have golf skills. Worldwide, there are millions of people who I would judge to be skillful at golf if I saw them play.

But what if we define “golf skill” differently? What if we decided that only those who have an expectation to earn more in prize money and endorsements than they spend on travel and equipment count as being skilled at golf? By this definition, I’ve never golfed with a skillful player. Worldwide, there are perhaps a few thousand players who have skill in this sense.

Does this strict definition of golf skill make sense? I suppose it makes sense for someone considering making a living at golf. But the vast majority of golfers play for fun, and there is nothing wrong with deciding that a player is skillful, even if they have no chance of making a living at it.

Getting back to stock-picking, does it make sense to call someone skilled just because I’m impressed with their knowledge and insight about stocks? The answer is no because the purpose of stock-picking is profits. I’ve never met anyone who admits that their stock-picking efforts tend to lose money but they do it anyway because it’s fun. A few such people may exist, but the vast majority of stock-pickers believe their efforts are likely to be profitable; they wouldn’t pick their own stocks otherwise.

Roughly speaking, the definition of stock-picking skill is the expectation of earning higher compound returns (after factoring in costs) than an appropriate benchmark. The word “compound” is important here because it implies a rational level of risk aversion. This is similar to the concept of risk-adjusted returns. (The way the math works out, the expected compound return is approximately equal to the median return rather than the arithmetic average return.)

A major challenge with this definition of stock-picking skill is that there is so much luck involved. Even Legg Mason Value Trust’s record of beating the S&P 500 every year for 15 years seemed certain to be skill before 3 years of substantially underperforming the market. It’s very difficult to say with any confidence that a particular stock picker has skill. Another challenge is that stock pickers can shop around for a benchmark they look good against.

A paradox of skill at stock picking is that the better everyone gets at it, the less skill there is in the world. The definition of skill at stock picking involves beating the market, which implies beating the average returns of other investors. So, you can only have skill if you’re enough better than other stock pickers.

As more and more talented stock pickers enter the field, the talent threshold for having skill rises. With each passing decade, market professionals increase their domination of trading in stock markets. Retail stock pickers are no longer much of a factor. To have skill, you need to be substantially better than the typical professional stock picker, a tall order.

There is even some doubt in the case of the great Warren Buffett. I’m satisfied that Buffett demonstrated skill over his long and hugely successful career. But does he have stock picking skill today? He has two huge forces working against him. The first is that his competition has been getting better over the decades. The second is that he’s investing so much money that he’s forced to focus on the stocks of only the largest businesses that already attract a huge amount of attention. He may still have skill, but it’s hard to be certain.

I’m satisfied that stock-picking skill must be very rare. Among professional stock pickers, skill is, at best, uncommon. Among retail investors, skill is so rare that you can safely assume that anyone you meet almost certainly doesn’t have skill, regardless of any claims they make.

Friday, September 29, 2017

Short Takes: Pension Changes, the Middle Class, and more

Here are my posts for the past two weeks:

The Wealthy Renter

What We Need on Credit Card Statements

Straight Talk on Your Money

Here are some short takes and some weekend reading:

Frederick Vettese makes the case for changing federal civil servants’ pensions to a target-benefit plan to save taxpayers a lot of money. The government could save even more money by eliminating employees they don’t need.

Andrew Coyne does some clear thinking about taxes and the middle class. He shows that when there is a raging debate, it’s possible for both sides to be very wrong.

Larry Swedroe summarizes Vanguard research that debunks dividend myths.

Squawkfox explains the steps necessary to open a Registered Disability Savings Plan (RDSP). It’s work, but the substantial free government money available makes it worth the effort.

Big Cajun Man was on his best behaviour for a podcast with Doug Hoyes. He even explained how he got his nickname (but left out the profanity).

Monday, September 25, 2017

Straight Talk on Your Money

There are many writers offering financial advice to the typical Canadian, but Doug Hoyes, author of the book Straight Talk on Your Money, is a licensed insolvency trustee. He’s seen enough to have good insights into the kinds of financial mistakes we make. Unlike many writers who offer black-and-white opinions, Hoyes sees the shades of gray.

The book promises to dispel 22 financial myths that are holding us back and that “Everything you know about money is wrong.” But the contents are actually more thoughtful and nuanced than advertised. Even the section titles are somewhat out of sync with the book’s contents. One section title declares “pay yourself first” to be a myth. The rest of the section then goes on to explain that paying yourself first is a good idea unless your finances are so dire that you can’t afford to start saving immediately.

The contrast between section titles and the contents gives the book somewhat of a newspaper feel where reporters write articles and the marketing department writes headlines. But don’t be put off by this contrast. Hoyes makes many great points getting to the core of why people have financial trouble.

The book begins with an explanation that rather than being rational, we rationalize. “Your gut makes a decision, for purely emotional reasons, and then you consciously find reasons to rationalize your decision.” Admitting this is true is a good starting point for making better decisions.

Unlike much “tough love” advice, Hoyes says that your financial troubles aren’t entirely your fault. Lost jobs, illness, divorce, and other bad luck plays a role. Aggressive and deceptive lenders deserve some blame, too. “But, blame doesn’t matter.” It’s better to work on solutions.

“Starting now, refer to your credit card only as a debt card.” Debt cards don’t deserve the positive connotations of the word “credit.” When it comes to credit scores (debt scores?), “focus on your goals, not your credit score.”

Hoyes recommends diversification in a different sense than the usual investing definition. Bank accounts sometimes get frozen for various reasons, so “have a second bank account, at a different bank ... where you don’t owe any money.”

“Collection agencies almost never sue anyone.” Under most circumstances “you should never pay a collection agency.” I learned quite a bit from the section on how collections agencies operate, and how you should deal with them.

The author doesn’t like the labels “good debt” and “bad debt.” “Instead of asking yourself, ‘Is this good debt or bad debt?’ ask, ‘What’s the risk that I won’t be able to repay this debt?’”

It’s not a good idea to think of your house as an investment. “By viewing your house as a consumer good, not as an investment, you can free yourself from the need to buy the most expensive house and instead focus on what’s truly important to you.” On the subject of whether a house provides stability, Hoyes says it does, but there are also ways that a house anchors you down and keeps you from following new opportunities.

In another example of the contrast between the book’s section titles and its contents, one section title is “Budgeting is a Waste of Time.” However, the proposed alternative to budgeting seems a lot like budgeting. There is an important difference, but it’s somewhat subtle. By “budgeting” the book means the process of tracking every single expenditure, analyzing them, and making necessary changes. The suggested alternative is to identify necessary spending along with big things that are important to you and to set aside money immediately from each pay cheque into bank accounts to cover these items. Whatever is left after these important things doesn’t need to be tracked. I guess the idea is that if you run out of money for the less important things that you don’t track, you can do without them for a while. Of course, this assumes that you’d actually do without instead of just running up your credit (I mean, debt) card.

On the subject of helping your kids with a house down payment, the author has a warning: “I can tell you many stories of parents who provided the money for a down payment, and as a result the kid bought a house much bigger than he or she could reasonably afford, which caused severe financial pressure for the kid, because the cost of a house is more than just the cost of the mortgage.”

Overall, I found this to be a thoughtful book with useful insights into why we get into financial trouble. It’s potentially directly useful to readers for their own finances and useful to those who try to help others with their finances.

Wednesday, September 20, 2017

What We Need on Credit Card Statements

The most prominent parts of my credit card statements are two numbers: my money-back rewards for the current month and the total rewards I’ve received since I got the card. This gave me an idea for “improving” credit card statements.

What if the most prominent part of a statement was the total interest you’ve paid since you got the card? For many of us, that would be zero or close to zero, but for too many it would be a nauseatingly big number, perhaps a 5-figure sum.

I’d be interested to see what effect this would have on people’s credit-card spending. It would likely be a slap in the face at first, and later there would be some numbness to it, but it might help some people control unnecessary spending.

Another possible effect would be for people to spend with a different card. If seeing the total interest we’ve paid over the years is painful, it makes sense that people would avoid this pain by using a different card.

Sadly, this will very likely remain just a thought experiment. I don’t think there are any credit-card issuers who’d be willing to reduce their profits this way unless the law forced them to do so.

Monday, September 18, 2017

The Wealthy Renter

It seems that everyone wants you to buy a house: your parents, real estate firms, mortgage brokers, and even the government. Alex Avery decided to make a case for renting in his book The Wealthy Renter: How to Choose Housing That Will Make You Rich. His reasonable and balanced analysis contrasts sharply with the usual cheerleading for owning a house.

We’ve all heard people say something like “renting is just throwing money away,” or “why pay your landlord’s mortgage when you can own your own house?” This advice is based on the mistake of comparing rent to a mortgage payment. Typically, renters pay for little other than their rent – maybe a few utilities. Homeowners pay property taxes, maintenance costs, utilities, insurance, and an opportunity cost on home equity. It’s the total of all these costs that we should be comparing to rents.

Avery goes through an example of an $850,000 home and concludes that the cost for an owner to occupy the home is between $4000 and $8000 a month. The high end of this range involves some double-counting and implausibly high maintenance costs,1 but a range of $4000 to $6000 per month is quite plausible. Most people would find this range shockingly high and simply wouldn’t believe it even after seeing the logic behind it. They’d be wrong.

Some might object that homeowners can look forward to gains on the value of their home. Avery gives a series of charts showing that while house prices are up quite a bit since 1991, “Canadian house prices haven’t delivered returns anywhere near those of the Canadian stock market.”

Renting and investing the difference would have made you richer than owning the average Canadian home. However, this analysis is based on low-cost methods of investing in the stock market. For investors who pay Canada’s sky-high mutual fund costs, the gap is smaller, but still favours stocks over houses. A homeowner might proudly say that his home has tripled in value, but he forgets inflation and all the money he spent on property taxes, maintenance, and other costs.

At a time when banks will lend 5 to 7 times your gross annual salary for a mortgage, the author says “if you want to build wealth, there are much better things to spend your money on than housing. Minimizing consumption of housing is crucial to building wealth.”

In addition to comparing owning to renting, Avery gives some detailed analysis of what drives housing prices. This begins with “Buildings never go up in value,” and “Only land can go up in value.” He also analyzes the 6 biggest housing markets in Canada. Toronto house prices are at 40 times annual rents, which is very high. At first I thought this was for comparable dwellings, but I’m guessing this isn’t the case.

What has really allowed homeowners to do well, Avery explains, is leverage. Investing in a house with borrowed money amplifies returns. Of course, stock investors can use leverage too. But leverage comes with risks, whether investing in stocks or a house.

“Home buying needs to be seen for what it really is: an investment in land plus consumption of the glamorous building that has been erected on that piece of land.” This makes it clear why owning a smaller house is better for your long-term finances.

“The thought of never being able to afford a house because house prices have risen so quickly you can never catch up is irrational. So is buying a house to get into the market.”

Avery includes an excellent chapter “How Housing Can Dictate Your Career in Surprising and Unexpected Ways.” This is something I’ve tried to explain to my sons. The exciting job you start with can end up being a trap if you build a lifestyle that needs your full income. Having a huge mortgage can leave you biting your tongue at work for fear of upsetting the boss and losing your job. This is something I’ve seen many times in coworkers.

One of the claimed benefits of owning a house is the forced savings. This is true to a point. If you rent and just spend all your income, you could end up worse off than a homeowner. To get the full benefit of renting, you need to save and invest some of the money you didn’t spend on home ownership. Avery explains several ways to automate your savings.

So, why is there so much cheerleading for owning a home and almost none for renting? “The primary, and often only, beneficiaries of renting are the renters themselves.” Those who benefit from all the forced spending by homeowners are the ones who promote owning. “Renting is the more logical, cheap, flexible, and low-risk way to live.”

Overall, this book gives a very thoughtful analysis of owning versus renting. Unlike most promotion of owning, the author is not a cheerleader for renting. He acknowledges advantages and disadvantages on both sides. I recommend this book to anyone struggling with a decision of whether to buy a home or rent.


1 For the high end of the range of monthly home ownership costs, Avery starts with the asking rent for a comparable house before adding other costs. But a landlord might include allowance for some of these costs in the asking rent. The maintenance cost range goes too high as well. As Avery later explains, “The rule of thumb for maintenance costs is 2 to 5 percent of the value of the house in most markets, and lower where house prices are particularly high.” Essentially, the cost of maintaining a house doesn’t go up much just because the land under it becomes more valuable. So, 5% is an unreasonably high estimate for a house sitting on expensive land, which is the case for most $850,000 houses.

Friday, September 15, 2017

Short Takes: Mortgage Delinquencies, Indexing Distortions, and more

Here are my posts for the past two weeks:

What’s Your Income

Payoff

Here are some short takes and some weekend reading:

Scott Terrio, a licensed insolvency trustee explains why low mortgage delinquency rates aren’t a good sign. He says “the low delinquency rate will catch up with the reality of Canada’s overburdened households.”

Lawrence B. Siegel explains why “indexing doesn’t distort anything.”

Reporter Sara Mojtehedzadeh went undercover working in food production for a temp agency. Her story contrasts sharply with the claims made by her employer about working conditions. Strangely, she had to collect her pay from a payday lender.

Patrick McKenzie has some interesting and authoritative advice on what to do if someone creates credit accounts in your name. These things can lead to long-lasting problems if you don’t handle them correctly. Unfortunately for Canadians, some aspects of this advice are specific to Americans. I’d be interested in comparable advice for Canadians.

The Blunt Bean Counter gives his perspective on proposed new tax rules for private corporations.

Squawkfox goes through the ways that the recent interest rate hike from the Bank of Canada can affect you. The main effects are interest rates on debt. She observes that banks aren’t usually very quick to increase the rates they pay on savings accounts and GICs. I wonder how long it will take for higher interest rates to change annuity payments.

Dan Bortolotti summarizes a study of ETF investors. It turns out that they handle their ETFs poorly for a couple of reasons.

Big Cajun Man says if you try to take some form of loan from a big bank, they’ll try to get you to open a chequing account as well.

Tuesday, September 12, 2017

Payoff

Employers would like to know the secret to motivating their employees to give their best effort. According to Dan Ariely, author of Payoff: The Hidden Logic That Shapes Our Motivations, the answer to what motivates us is complex, but his research has yielded some interesting results. I find just about everything Ariely writes to be fascinating, and this short book is no exception.

The book isn’t just about what motivates us at work. Ariely also tackles our attachment to our own ideas and creations, the importance of money (and sometimes lack of importance), and the urge for symbolic immortality. In short, “this book is about what we really want out of life before we die.”

One seeming contradiction Ariely points out is that happiness and meaning often don’t go together. A marathoner is strongly motivated to run hard for hours and finds deep meaning in the effort, but it’s hard to say that a person whose face is twisted in pain is happy, at least while still running.

Some of Ariely’s experiments revealed that “the more effort people expend, the more they seem to care about their creations.” This was true even when the experimenters manipulated conditions to cause subjects to work harder to produce something of lower quality.

On the subject of whether to pay someone to do certain tasks around your house or do them yourself, Ariely says that “a little sweat equity pays us back in meaning—and that is a high return.”

We search for meaning, even after our deaths. Some of us even seek to control others from the grave. “A man named Samuel Bratt, whose wife had no doubt badgered him about his smoking, bequeathed her £333,000 under the condition that she smoke 5 cigars a day.” German poet Heinrich Heine “left his estate to [his wife] on the condition that she remarry to ensure that ‘there would be at least one man to regret my death.’”

Overall, this book is entertaining, clear, concise, and gave me useful insights into motivation.

Monday, September 11, 2017

What’s Your Income?

The raging debate over the federal government’s plan to change certain tax rules for corporations has a glaring contradiction. The government insists that the changes only affect those making more than $150,000 per year. Opponents say it’s hitting middle-class business owners. Who’s right?

Consider the example of a professional whose efforts earn $250,000 per year. This professional has a personal corporation. So, it’s actually the corporation that has an income of $250,000. The professional draws a personal income of $100,000 from the corporation, leaving what’s left after taxes within the corporation. He plans to continue drawing an income from the corporation throughout his retirement. So, what is the professional’s income?

The government would say the professional’s income is $250,000, and he uses his corporation to spread his income over his lifetime to reduce his total tax bill. Many opponents of the government’s tax plans say the professional’s income is $100,000, and he’s an example of a middle-class earner getting hit hard by unfair new tax rules.

This issue isn’t as simple as it first appears. The professional’s efforts may only earn a lot of money for a modest number of years. Taking into account many years in school and several years of struggling to build a good reputation, lifetime average earnings may be well below $250,000 per year, even after adjusting for inflation and adjusting for the typical income increases salaried employees get.

I’ll leave it to readers to decide for themselves which side they think is right.

Friday, September 1, 2017

Short Takes: Charts for Your Wall, Too Many Advisors, and more

Here are my posts for the past two weeks:

Email Replies

Small Business

Here are some short takes and some weekend reading:

Charlie Bilello has a great set of charts for those making overconfident market predictions.

Preet Banerjee interviews John de Goey who says “there are way too many advisors in the business,” and “we could easily get rid of one-third of all advisors in Canada and not make a ripple in terms of access to advice.” I agree with this. Most financial advisors are paid for their sales effort and not for their advice. The only way to lower Canada’s unreasonably high cost of investing is to lower the total amount of money that goes to advisors and fund managers. This necessarily means there will be fewer advisors.

Jason Zweig has 19 questions to ask your financial advisor along with the “correct” answers. While this is an excellent list of questions, few advisors would have the best answers, and those who do would likely only handle wealthy clients.

Canadian Couch Potato explains the upcoming change to stock-trading settlement periods.

Boomer and Echo aren’t fans of “core and explore” investing.

Preet Banerjee explains asset allocation for investing beginners in his latest video.

Big Cajun Man describes a trick for keeping your employer from taking back some or all of a direct deposit. I’d be interested in knowing whether this trick actually works or whether banks would just track down further transactions.

Tuesday, August 29, 2017

Small Business

What do you think of when you hear “small business?” Maybe you think of a roofer who has enough work to employ three helpers. Or maybe you think of a hair-cutting place. Do you ever think of lawyers who make half a million dollars per year and incorporate themselves to defer and reduce their income taxes?

Opponents of the Trudeau government’s planned income tax changes for private corporations have been vocal lately. They have a lot to lose. The “tax planning” opportunities using private corporations are very effective at reducing taxes.

There are some good arguments on both sides of this debate, but one part of it irks me: referring to incorporated professionals as “small business.” It’s not that this is technically wrong; it’s that it’s deliberately misleading. The public has sympathy for the types of businesses they think of when they hear “small business.” This sympathy dries up quickly if we talk about highly-paid professionals reducing their income taxes.

Getting into the substance of the proposed tax changes, I think there are two parts that make a lot of sense. One is that private corporations shouldn’t be able to get income deductions for paying family members who had little or nothing to do with earning the income. The other is putting a stop to complex maneuvers designed to turn income into capital gains to cut the tax rate in half.

The merits of the changes designed to attack passive income inside a private corporation are less clear to me. Professionals hold assets in their corporations as a means of smoothing income over a lifetime. In a sense, it’s like using an RRSP to reduce income today and create an income after retirement.

Everyone should be allowed to save some money tax-free to create income in retirement (when it will be taxed). The debate is how much income we should be allowed to defer. Government employees with defined-benefit pensions get an advantage over those who use only RRSPs because the government undervalues future pensions. I certainly can’t replace 70% of my income from my RRSP savings. This means government employees get to defer more income than most of the rest of us even after taking into account their reduced RRSP room (called a pension adjustment).

Professionals using private corporations are deferring significant amounts of income as well, although working out how much they defer gets complicated when we take into account the partial tax payments they make at the corporate tax rate.

Another complication in this debate concerns doctors. Few people will cry over some lawyers and accountants leaving for greener pastures, but doctors are clearly in a different category. I don’t know what the long-terms effects of the new tax measures will have on our medical system, but I doubt the correct answer is “none.”

We need more reasoned debate on these issues. But, please don’t refer to private corporations of highly-paid professionals as “small business.”

Monday, August 21, 2017

Email Replies

Reader feedback is the best part of writing my blog. But some of the email I get is less welcome. Here is another installment of replies to emails I usually ignore.

Dear Brenton,

Thank you so much for the chance to register for your lucrative trader service. Your list of 15 triple-digit winners in just 8 months is indeed impressive. If you had started with $10,000 and let it ride through these great picks, you’d now have 736 million dollars! But, I’m puzzled. Now that you’re so wealthy, why do you need me to pay when I register?

Sincerely,

Michael

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Dear Melanie,

I’m so glad that my blog passed the test to join your publishing partners network. One of the tricks I use to keep quality up is that I never run advertorials. If I were to start publishing the “customized and relevant content” you provide, I’m afraid that my blog would then drop below your standards. It seems we’re caught in a catch-22.

Sincerely,

Michael

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Dear Robert, Reed, Michael, Joon, Brian, Craig, and many others,

Thank you for the many invitations to join your class action lawsuits. I have indeed suffered losses related to the companies you mentioned. However, my losses aren’t related to trading shares in these companies. I’ve lost time from my life dealing with the flood of class-action-related emails. Thank you for limiting my time losses by marking the emails with “IMPORTANT” and “ALERT”. This helped greatly in determining quickly that the emails were unimportant.

Sincerely,

Michael

Friday, August 18, 2017

Short Takes: Begging the Fed, Asset Classes, and more

I managed only one post in the past two weeks:

Create the Retirement You Really Want

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand has a funny and accurate take on a letter from bondholders trying to avoid losses on poor investments by warning the U.S. Fed not to raise interest rates too fast.

Preet Banerjee comes back from an extended hiatus to explain asset classes in his latest video.

Big Cajun Man found that all of his credit card limits counted against the size of mortgage he could get.

Salman Ahmed at Steadyhand has some suggested questions for the guy who brags he earned a 30% return last year.

Potato says the advisor vs. adviser distinction is a meaningless distraction from finding good financial advice.

Tuesday, August 8, 2017

Create the Retirement You Really Want

Most retirement books focus strongly on finances and investing, but in Create the Retirement You Really Want, Clay Gillespie looks at a wide range of retirement issues from figuring out what you want to do during retirement to leaving a legacy. Readers are likely to find some topics relevant to improving their own retirements.

The book is a mix of standard non-fiction style writing and story-style using hypothetical retirees. Thankfully, the stories get to the points quickly rather than trying to be good fiction. I found this worked well. I would not have had the patience to read longer fictional parts.

I was surprised the book contained so little about investing. The hypothetical retirees deal with an advisor who offers three portfolio possibilities with targeted real returns of 2%, 3%, and 4% per year. Apart from varying the allocation to stocks, there was little mention of how these returns would be achieved. I thought it would at least have made sense to discuss the importance of keeping costs low. Canadians who pay 2.5% or more per year for their mutual funds can only dream of earning a compound average annual return of 4% above inflation for decades.

The topics covered included figuring out your dreams for what you’ll do during retirement, what it will cost, health, wills, events that derail your plans, cottages, and family bickering over inheritances. I particularly liked the discussions of cottages and inheritances. I’ve heard accountants and advisors warn about problems in these areas, but Gillespie illustrated the potential complexities and conflicts well.

One part of the discussion of inheritances surprised me: “giving back and leaving an inheritance is always important to retirees.” I know many people who’ve said they have no intention of leaving money behind. Either Gillespie is saying that people tend to change their minds as they age, or perhaps he only advises wealthy people who end up leaving inheritances.

The author shows a better understanding of inflation than some advisors. “When most people think about returns, they think only in nominal terms. They forget inflation. But inflation is very real, and retirees feel the impact more than any other group because they often live on fixed incomes. Real return is the number that people should really focus on.”

Gillespie believes that “an initial withdrawal rate of 5.5 percent is sustainable if you have the proper retirement income strategy in place.” I’m skeptical that an income strategy will make much difference. This sounds a lot like a claim to be able to beat the market. The right withdrawal rate depends on age, asset allocation, portfolio costs, and willingness to reduce spending if market returns disappoint.

The book contains some plugs for financial advisors. One is included with some statistics: “Only 29% [of Canadians] use the services of a financial advisor (even though investors who use an advisor are more confident and optimistic about their financial futures).” Of course, the implied causality here is questionable. Having lot of money makes people “confident and optimistic about their financial futures.” Also, financial advisors seek out people with a lot of money, and those with a lot of money are more likely to find a good advisor. The root cause of the correlation between financial optimism and using an advisor is having a lot of money.

While many financial advisors push their clients to leverage their portfolios, Gillespie believes it’s a mistake to avoid paying off debt in favour of saving for retirement. He gets full marks for this in my opinion. The best plan involves getting total debt down to a manageable level while you’re relatively young and then keep it dropping while simultaneously building savings. Gillespie says “good debt and bad debt is just splitting hairs,” a point I’ve made before.

“It’s always a good idea to exhaust your non-registered funds before dipping into your registered savings.” I don’t think this is always true. Between retirement and age 71, it can make sense to make an RRSP withdrawal in a low-income year where the withdrawal would be untaxed or taxed at a very low rate. Figuring out when this makes sense can be tricky, though.

In one section a hypothetical couple derail their carefully constructed retirement plan to follow the advice of a do-it-yourself (DIY) investing brother-in-law. This section paints DIY investing as chasing risky biotech stocks. There certainly are people like this who try to draw others into their risky strategies, but DIY investing can also mean low-cost diversified investing.

Advice we hear frequently is not to put money in the stock market if we’ll need it within 5 years. Gillespie has an interesting way of saying something similar: “Always invest based upon when you want your money back.”

Overall I found this book useful for its treatment of a wide range of retirement issues. However, its main purpose seems to be to drive home the point that you need a financial advisor to steer you. Of course, the challenge for most of us is trying to find a quality advisor, particularly for those with modest portfolios.

Friday, August 4, 2017

Short Takes: Mortgage Delinquencies, Stupid Investments, and more

Here are my posts for the past two weeks:

The Behavior Gap

You Can’t Have Your Sears Cake and Eat it Too

Here are some short takes and some weekend reading:

Estate administrator Scott Terrio explains why today’s low mortgage delinquency rate means almost nothing in predicting future mortgage delinquencies.

Freakonomics Radio has a very interesting investment podcast called “The Stupidest Thing You can Do With Your Money.”

The Blunt Bean Counter explains the Liberal government’s new tax proposals for private corporations. He says “the impact of these proposals is potentially massive,” and “I don't think most small business owners have any idea what is about to hit them.”

Financial Services Commission of Ontario explains how to protect yourself when renting a car. Many of us have had that moment of doubt about whether to pay for the rental company’s insurance coverage that often increases the rental cost by 50% or more. This article explains how to get coverage with your credit card or your current auto insurance policy.

Canadian Couch Potato uses his latest podcast to examine MoneySense’s role in advancing index investing in Canada and to disagree with Warren Buffett and John Bogle on international investing.

Boomer and Echo explain why you shouldn’t get mortgage life insurance. Don’t miss a comment by Travis spelling out post-claim underwriting and how it can cost you.

Thursday, August 3, 2017

You Can’t Have Your Sears Cake and Eat it Too

It’s well known that Sears Canada has been having financial trouble for some time. As often happens in these situations, the Sears defined benefit pension plan is underfunded. According to Steven G. Kelman, “Ill-advised government policies” have resulted in former employees getting only “81% of the commuted value of their defined benefit pensions.” What we have here is a tension between trying to keep companies afloat and keeping pension plans fully funded.

It’s easy to decide today that Sears should never have been allowed to delay properly funding their pension plan. But, if Sears had been forced to fully fund the plan sooner, they would have gone bankrupt sooner. If we go back to a time when there was still hope to save Sears, few people would have agreed to force Sears into bankruptcy over their pension funding. But allowing sick companies to let their pension obligations slide inevitably leads to some bankrupt companies with underfunded pensions.

We can agree that it’s unfortunate that some Sears employees won’t get their pensions. But back when Sears was still limping along, who would have decided to force them into bankruptcy and sacrifice jobs to make sure that pensions are topped up? I’m not suggesting that current jobs are necessarily more important than future pensions. But, those who focus solely on pensions need to understand that they are advocating killing off sick companies sooner.

One suggested solution is Kelman’s assertion that “governments, in my opinion, should kick in the shortfalls to make the Sears former employees and others in similar predicaments whole.” This sounds perfect until we realize that governments pay for nothing; taxpayers foot the bill. There’s no free lunch. Why should taxpayers make good on the promises of failed companies?

Another idea to protect pensioners is to put them ahead of other creditors when a company gets into financial trouble. But, then who would want to be a creditor? Any company that has an underfunded pension would have serious trouble getting credit, which would drive them into bankruptcy sooner. I’m not saying this is the wrong approach, but advocates of this idea must acknowledge that it will drive more companies into bankruptcy.

If we’re going to demand that no pension plan ever be underfunded, we have to be prepared to accept that this will bring some companies to financial ruin sooner, and will break some companies that might have survived if they had a little more time to turn around. We have to choose between pensioners and current workers. We can’t have our cake and eat it too.

Monday, July 24, 2017

The Behavior Gap

The title of certified financial planner Carl Richards’ book The Behavior Gap refers to the gap between “what we should do and what we actually do” when it comes to financial decisions. The book identifies a great many of the mistakes we make, and almost all readers who are honest with themselves will identify with some of the mistakes.

Richards is well known for his napkin drawings, and there are plenty of them in this book. One says that the cost of your mistakes rises with your level of overconfidence. “Overconfidence is a very serious problem. If you don’t think it affects you, that’s probably because you’re overconfident.”

We know we shouldn’t buy high and sell low, but “we make investing decisions based on how we feel rather than what we know. Falling stocks scare us; rising stocks attract us.”

In a drawing offering investment advice, Richards says the chance that a fund will stink rises with its expense ratio. He offers more advice when he says our decisions about how much of our company’s stock to hold should be based on principles of diversification rather than “our feelings about what’s going to happen.”

On the subject of stock mania, Richards tells the story of how during the tech bubble in 1999, he resisted “the temptation to buy technology stocks” initially but eventually gave in and lost money. It’s the last people in before the bubble bursts who get hurt the most.

Richards believes that financial planning begins with life planning. “Find out who you are and what you want. Then you can stop wasting your life energy and your money on stuff that doesn’t matter to you—and start making financial decisions that will get you to your true goals.”

If we take action based on the latest news, we’re likely to do the wrong thing. “Try going on a media fast.” “When thoughts about the market arise, let them go. Go for a bike ride.”

I was surprised to see a financial planner write that “Financial plans are worthless.” However, he followed that up with “but the process of financial planning is vital.” A single static financial plan will become obsolete as life takes a few unexpected turns. Plans need to adapt.

We’re used to being told not to make overly rosy assumptions, but “pessimistic assumptions often discourage people from doing anything to improve their outlook.” I’ve known people who buy lottery tickets because they see winning as the only way to improve their lives. They just don’t understand or believe in the power of saving small amounts regularly.

“While making wise decisions about how you invest your money is important, it doesn’t have nearly the impact of working hard and saving more.” I’m all for encouraging people to save more, but a low-cost index investor could easily end up with twice as much money each month in retirement as someone who spends an investing lifetime chasing the latest hot mutual fund. This seems at least comparable in value to saving more money each month.

In one section, Richards describes so accurately the mood in a company whose stock is soaring that it seemed like he was talking about my employer back in the late 1990s. People had “visions of early retirement,” and they knew they “should sell some of the shares,” but they hung on anyway. Many of my colleagues saw 7-figure paper valuations evaporate.

I recall asking colleagues whether they would buy back the company’s shares if they were converted to cash right now. This only caused one of my colleagues to sell. I sold too few shares myself. Richards calls this the “Overnight Test” and asks if your portfolio went to cash overnight and you wouldn’t rebuild the same portfolio today, “what changes would you make,” and “why aren’t you making them now?”

“What makes us feel safe may be at odds with the numbers.” I’ve learned this truth when it comes to retirement. My wife and I need different things to feel it’s safe to retire. For me, it’s a set of spreadsheets that analyze all the numbers in a dozen different ways. I’d just be guessing about what would put my wife at ease.

We’ve heard that simple solutions are best when it comes to finances, such as saving diligently and choosing low-cost diversified investments. “We often resist simple solutions because they require us to change our behavior.” “We’d rather look for a magic bullet: something to save us from the day-to-day grind of simply doing the work that needs doing.” “It’s much easier to entertain ourselves with the fantasy of finding an investment that will give us a fantastic return than to save a little bit more money each month. But in the end, the fantasy will fail us.” Well said.

This book is both entertaining and helpful for readers prepared to admit to themselves that they’re guilty of some of the mistakes that create this “behavior gap.”

Friday, July 21, 2017

Short Takes: Reality Check for Novice Investors and Retirement Planning

Here are my posts for the past two weeks:

Are We Saving or Investing?

The Four Pillars of Investing

The Dangers of Personifying the Stock Market

Things get quiet in the middle of summer, but I still have a couple of short takes:

Dan Bortolotti warns novice index investors that the bull market can’t last forever. When markets inevitably stumble, active managers will be quick to claim they could outperform during bear markets, even though the evidence doesn’t back up that claim.

Potato shows how to answer the question of whether you’re on track for retirement by going through an example case. As he shows, you can never know for sure that you’ll get the retirement you want, but you can find out if you’re way off.

Thursday, July 20, 2017

The Dangers of Personifying the Stock Market

Most people understand that the stock market reflects the collective actions of all stock traders, but we often personify the market, talking about it as though it has its own free will. This can lead to investing errors.

When we say that “stock markets struggled this week,” we don’t literally mean that there exists some sentient entity called the “market” that has the desire to rise, but was unable to do so this week. But thinking of it this way can create the illusion that you have only a single foe when you trade stocks.

It can also create the illusion that we can all somehow succeed against the market. When someone says that some past market event was easily predictable, such as the 8-year recovery from the 2008-2009 crash, many would agree. But it can’t be true. If we all knew stocks would rise so much, then buyers would have driven prices up right away.

When we see the stock market as the collective action of all buyers and sellers, it becomes clear that there had to be a lot of uncertainty among traders 8 years ago because stock prices just rose slowly instead of jumping all the way back up immediately. In fact, we must always be in a state where most traders are uncertain, because, if they weren’t, stock prices always shift up or down until they were uncertain.

If you’re trying to beat the market by getting higher than market returns, your real opponents are all the other stock traders, not just some single entity. Traders can’t all be winners. For every dollar of market outperformance, there has to be a dollar of underperformance.

So, when you try to beat the market, you have to ask yourself whose trading dollars you expect to take. Even worse, because almost all trading is done by professional investors these days, you need to ask yourself which investment pros’ dollars you expect to take.

None of this proves that you can’t beat the market. But it does show that the deck is stacked against anyone who tries, particularly after factoring in the costs associated with trying to beat the market.

Monday, July 17, 2017

The Four Pillars of Investing

While reading William J. Bernstein’s book The Four Pillars of Investing, I was unsure of how to summarize it. After finishing I’d say that it aims to give readers the right knowledge and expectations to become successful do-it-yourself investors. Without a solid grounding in each of the four pillars, investors are at risk of making expensive mistakes.

The first pillar, called “theory,” is less intimidating than it sounds. It teaches the link between risk and reward and that “high previous returns usually indicate low future returns, and low past returns usually mean high future returns.” This is particularly true of stocks because they show more mean reversion than you’d expect just from randomness.

We tend to think of money market funds as safe, but they get their returns in part from commercial paper that “does occasionally default.” There is no excess return without some risk.

Bernstein explains the Gordon equation, which states that the market return is equal to dividend yield plus the rate of dividend growth. He goes on to explain that to this we have to add the rate of stock buybacks and subtract the rate of new share issuance. One point I’d add is that companies can make their dividend growth appear higher for a few years by increasing the proportion of earnings they pay out in dividends. For this reason, one might substitute earnings growth for dividend growth. But this has its own problems for companies that game their earnings accounting.

An amusing bit was using Trump Casinos as an example of a business with a high risk of defaulting on loans. I doubt Bernstein had any idea that years after writing it, his book would come to seem political.

It’s not hard to see what Bernstein thinks of active management when he refers to a mutual fund’s advisory fees as “what the chimps get paid.” He also says “It should be painfully apparent by now that most of the investment industry is engaged in nonproductive work.” He sums up his arguments with “Stock picking and market timing are expensive, risky, and ultimately futile exercises. Harness the power of the market by owning all of it—that is, by indexing.”

Because of the possibility of high inflation, the author believes that “Long-duration bonds are generally a sucker’s bet.”

The second pillar is the history of investing. The main purpose of this pillar is to teach readers that market bubbles and crashes happen fairly regularly, and we need to keep our wits about us and stick to a plan. As George Santayana said, “Those who cannot remember the past are condemned to repeat it.”

I’ve written before about Bernstein’s distinction between investing and saving, and I won’t say any more about it here.

I enjoyed a joke at the expense of the company “Yahoo!” where Bernstein asked if the name is an interjection “or was it simply a noun, meant to describe the company’s shareholders.”

The third pillar is the psychology of investing. People consistently make many types of investing mistakes. The first step in avoiding these mistakes is to understand them.

Some examples of mistakes are assuming “that the immediate past is predictive of the long-term future,” and our search for patterns that aren’t there. “The pricing of stocks and bonds at both the individual and market level is random: there are no patterns.”

Another mistake is seeking status through the types of investments you use. “Wealthy investors should realize that they are the cash cows of the investment industry and that most of the exclusive investment vehicles available to them—separate accounts, hedge funds, limited partnerships, and the like—are designed to bleed them with commissions, transaction costs, and other fees.”

The fourth pillar is the business of investing. This pillar is a warning about the financial industry. “The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks.” “Under no circumstances should you have anything to do with a ‘full service’ brokerage firm.”

Most mutual-fund companies aren’t much better: “The primary business of most mutual-fund companies is collecting assets, not managing money.”

The sections of the book on the four pillars are strong, but the “assembling the four pillars” section isn’t as strong. A couple of the reasons for this aren’t Bernstein’s fault: the discussion of specific investments is getting dated and is too U.S.-centric for a Canadian like me.

My main criticism is that he ends up building portfolios that are too complex. For most people, the potential benefit of slicing up portfolios into ETFs or funds based on market caps, growth/value, geography, and other factors is too small to justify the extra work. No doubt some people could manage all this well, but many investors would make mistakes and end up spending too much on commissions, spreads, higher MERs, and realized taxes. Simpler is usually better.

The short section on investing with children is excellent. He advocates buying index funds for children, letting them watch the ups and downs once each quarter, and letting them spend some dividends. I tried to do something similar for my sons, but mostly failed. Bernstein’s approach would have been better.

Bernstein is very positive about an approach to investing called value averaging. It doesn’t work. I’ve discussed why here and here, and described some experiments I ran here.

The subsection on rebalancing places a lot of emphasis on which method gives the highest returns. This can be misleading for investors. When you own many stock funds based on various factors, rebalancing can give a small boost in returns. However, most investors just rebalance between stocks and bonds. The purpose in this case is to control volatility, not boost returns.

Overall, I found this to be an excellent book for steering investors toward making good decisions about the things they can control, and remaining calm about the things they can’t control. Readers who get through the whole book are likely to become better investors.

Wednesday, July 12, 2017

Are We Saving or Investing?

When we buy shares in a company, are we saving or investing? Most of the world would call this investing, but William J. Bernstein disagrees. In his excellent book The Four Pillars of Investing, he explains why he calls this saving:

“When you and I purchase shares of stock or a mutual fund, we are not investing. After all, the money we pay for our shares does not go to the companies, but, instead, to the previous owner of the shares. In economic terms, we are not investing; we are saving.”

He continues

“Only when we purchase shares at a so-called ‘initial public offering’ (IPO) are we actually providing capital for the acquisition of personnel, plant, and equipment. Only then are we truly investing.”

It’s certainly important to make a distinction between a simple change of ownership of shares and a company getting new money to run its operations. But I find the terms Bernstein uses very unsatisfying.

When I commit money to my trading account with the intent to leave it there for a long time, I am saving. When I choose to convert cash to shares, I’m not saving again. The word most people use for this activity is “investing.” If we wish to make the distinction Bernstein is making, then I think “trading” is a better word than “saving.”

But even this doesn’t describe the situation fully. It’s true that the net actions of buyer and seller provide no new capital to the company. But the buyer has aligned his economic outcome to the fate of the company. The buyer’s viewpoint is that he has invested in the company and the seller has withdrawn his investment, even if the company doesn’t see it this way.

The most troubling part of this semantic game is that it gives an opening for obnoxious types to derail any type of investment discussion with “actually, you’re not investing at all.” It’s amazing how often people in a narrow technical field think they can police the meaning of a word that has one meaning in the technical field and another well-established meaning among the broader public.

The point Bernstein was leading up to in his book is that IPOs have historically been poor investments, on average. So, investors would do well to avoid IPOs altogether. This is a good point to make, but we need better terms when discussing the distinction between IPOs and the secondary market than investing/saving.

Friday, July 7, 2017

Short Takes: Macroeconomics, Unlocking Phones, and more

Here are my posts for the past two weeks:

Payday Loan Information

Are Payday Loan Users Victims?

Enough: True Measures of Money, Business, and Life

Arguments Against Index Investing

Here are some short takes and some weekend reading:

Preet Banerjee interviews Luke Kawa, a Bloomberg reporter, to talk about macroeconomics. It was good to get some buzzwords explained, but this interview didn’t change the feeling I’ve had for some time that macroeconomics is wild guesswork.

Big Cajun Man reports that new CRTC rules will eliminate phone unlocking fees on 2017 December 1. He uses the example of Bell’s policies to show how onerous these fees can be.

Canadian Couch Potato reports on new index ETFs from Royal Bank.

Boomer and Echo ask whether your assets under management are really being managed.

Thursday, July 6, 2017

Arguments Against Index Investing

I’m accustomed to reading arguments against index investing. The valid ones tend to point out that few index investors actually stick to their plans. The “other” arguments make less sense but get repeated frequently anyway. Jack Mintz managed to bring a great many of these less sensible arguments together in a recent short article. Here I examine Mintz’s claims.

“What happens if the day comes that the entire stock market becomes solely made up of passive investors?”

This won’t happen. We’re not close to it now. If we ever got close enough to 100% index investing, active stock picking would become profitable.

“The lure of sharply reduced investment fees has enticed millions of investors to shift their portfolios to passive investments.”

Calling low fees a “lure” implies that index investors can expect to get caught somehow. Mintz offers nothing to back this up.

“There are problems with all this passivity.”

I got to the end of the article without seeing anything to back up this vague claim of problems index investors can supposedly expect.

“Much of the argument in favour of passive investment is based on the presumed failure of active funds to provide superior pre-tax returns on a consistent basis compared to index funds.”

The failure of active funds to keep up with index funds is extremely well studied and documented. There is nothing “presumed” about it.

“But passive investment works when market prices convey all the information about a security.”

The implication here is that passive investment doesn’t work when market prices don’t convey all the information about a security. This isn’t true. The fact that the average index investor gets higher returns than the average active investor is based on simple arithmetic, not some variant of the Efficient Market Hypothesis. Only a small minority of active investors can outperform the index. The more efficient the market is, the tinier the minority of active investors who can outperform the index over the long term.

“In the presence of informational inefficiency, there is value to research and hiring advisers.”

The vast majority of trading is done by investment professionals. They can’t all beat the index. After factoring in costs, only a small minority can beat the index over the long run. Average investors have no idea which advisors will help them outperform. Trying to guess this correctly is as hard as being a superior stock-picker.

“Passive investors freeload on active investors in the presence of informational inefficiencies. Through their research, active investors will reallocate capital from poorer-performing to better-performing assets, thereby increasing the overall value of an index, making passive investors better off too.”

This is true, but it’s an argument in favour of index investing, not against it. The work of active investors sets good prices that index investors enjoy. Perhaps we’re supposed to be embarrassed to be considered freeloaders. I think active money managers can be considered freeloaders for the huge fees they charge for a service that consistently produces poor outcomes for investors.

“It’s obvious that relying only on an index is absurd.”

So far we’re being lured, we have problems, we’re freeloaders, and now we’re behaving absurdly. Flinging around such characterizations is easier than making a logical argument.

“Nortel made up 36 per cent of the TSX in 2000 and went bust a few years later. Meanwhile, funds based on an index will often end up holding many unprofitable firms.”

On the other hand, index investors rode Nortel on the way up, and they own many profitable firms. The implication here is that active managers avoided Nortel’s implosion (as a group, they didn’t), and they can avoid companies that will be unprofitable in the future (as a group, they can’t).

“When the U.K. ended embedded commissions, the result was that lower-wealth investors would not or could not pay for advice, leaving them less well-prepared for retirement.”

Lower-wealth investors in Canada are already very poorly served. Most of the time, salespeople sell them expensive mutual funds without providing meaningful advice. Quality financial advisors are almost exclusively available to investors with substantial portfolios.

“Instead of favouring passive investing over active investing, policy should instead remove barriers that make financial planning costly. Ottawa charges GST on financial-management fees.”

It’s not clear to me that removing the GST from financial-management fees would lower investors’ costs. Costs are unreasonably high now. What would stop fund companies from raising fees to fill the GST gap? If you think of the GST as an extra cost for investors, you probably want to remove it. If you think of the GST as taking a slice of fees away from fund companies and advisors, then you probably want to keep it (unless you work for a fund company or advisor).

“Fans of ETFs and the companies that market the funds insist that active investing can never beat passive investing, since no human can consistently outperform the market.”

Few people claim that no human can consistently outperform the market. After all, most of us have heard of Warren Buffett. What index investors claim is that the average index investor gets higher returns than the average active investor after factoring in fees.

“The overwhelming number of studies that test the difference between active and passive funds are deficient in some respects.”

To back up this claim, Mintz cites nitpicks about benchmarks and observes that some studies found that active management beat passive in certain time-frames or under other circumstances. The truth is that the overwhelming majority of studies clearly back up the simple arithmetic argument that active managers as a group cannot beat indexes.

It’s hard to know the real motivation of those who make arguments like this. One plausible guess is that while the arguments are easy to refute, they give advisors something convincing to say to their clients in a one-on-one setting with nobody there to offer counterarguments.

One point to be clear about here is that active investing is not the enemy. For one thing, active investors help to set good prices. Investors’ real enemy is high costs. In the U.S., Vanguard offers active mutual funds with low costs. These funds serve investors well.

The best criticism of index investing is that so many investors fail to stick to their plan. Some bail out when stock prices fall. Others tinker so much with their allocations that they’re effectively market timers. Some are poorly diversified.

The passive versus active debate isn’t going away any time soon. There are too many people who make their livings from expensive mutual funds to expect them to just give up.

Wednesday, July 5, 2017

Enough: True Measures of Money, Business, and Life

John Bogle thinks there should be more to investment management and business in general than maximizing profit. In his distinguished career, he has put his money where his mouth is by creating a structure for Vanguard that strongly incents employees to minimize investor costs. In his book Enough: True Measures of Money, Business, and Life, Bogle describes Vanguard’s history and explains his business philosophy.

The book opens with the story of Joseph Heller being told that a hedge fund manager “had made more money in one day than Heller had earned from his wildly popular novel Catch-22 over its entire history. Heller responds, ‘Yes, but I have something he will never have ... enough.’” Bogle believes there are more important goals once you have enough money.

Vanguard began amid a business dispute and it was “barred from assuming responsibility for investment management and marketing.” This proved to be a happy result for investors because it helped make Vanguard the investor-friendly organization it is today. Vanguard eliminated the need for investment management by forming “the world’s first index mutual fund.” Without marketing, it converted “to a no-load, sales-charge-free marketing system.”

Keeping investor costs low is very important to Bogle. “On balance, the financial system subtracts value from our society.” He doesn’t want to add to this problem. He also shares Charlie Munger’s “concerns about the flood of young talent into a field [fund management] that inevitably subtracts so much value from society.” “Today, if fund managers can claim to be wizards at anything, it is in extracting money from investors.”

Some investors have a hard time accepting low-cost index investing approach that Bogle advocates because it seems too simple. But Bogle says that “Financial institutions operate by a kind of reverse Occam’s razor. They have a large incentive to favor the complex and costly over the simple and cheap, quite the opposite of what most investors need and ought to want.”

Canadians may be surprised to learn that Bogle is leery of ETFs: “I have serious questions about the rampant trading of most ETFs.” While Vanguard offers low-cost mutual funds, they are not available to Canadians, and we tend to look to ETFs for low costs. Bogle does “admire the use of broad market index ETFs that are held for the long term.”

Fans of diversifying with commodities will get only blunt words from Bogle. “Commodities have no internal rate of return. Their prices are based on supply and demand. That is why they are considered speculations, and rank speculations at that.”

Bogle worries that professions, including financial services, that should be worthy of trust are being undermined by profit motives. “Profession by profession, the old values are clearly being undermined. ... Unchecked market forces not only constitute a strong challenge to society’s traditional trust in our professions, but in some cases these forces have totally overwhelmed normative standards of professional conduct, developed over centuries.” “Over the past half-century-plus, the fund business has turned from stewardship to salesmanship.”

Bogle is critical of the practice of paying CEOs with stock options. This drives short-term thinking, but measuring “CEO performance should be based on the long-term building of intrinsic value.”

Convincing people to pursue more than just money can be a tall order. He quotes Descartes on this point: “A man is incapable of comprehending any argument that interferes with his revenue.”

Bogle sacrificed a great deal of personal wealth when he created Vanguard to strongly incent its employees to keep costs low. “In comparison to nearly all, if not all, of my peers in this business, I am something of a financial failure.” But he is “doing just fine, thank you.” He has enough and measures his success with a different yardstick.

Tuesday, July 4, 2017

Are Payday Loan Users Victims?

In a recent post about payday loans, reader Paul had the following (lightly edited) comment:

“You know I used to feel sorry for people who get caught up in this money cycle. But when most people would rather just watch Dancing with the Stars or an insane reality program and not spend 30 seconds on improving any aspect of their financial lives, I just can’t.

“One’s financial problems seem to always be ‘someone else’s or some fat cat banker’s fault.’ No one is responsible for themselves anymore. For the poor who struggle to make ends meet and this is the only option, yes I agree that is bad; for the rest, you get what you deserve if you can't pay for that non-essential ‘toy’ or latest iPhone you purchased you just had to have.”

There definitely are many people who deserve Paul’s criticism. But many who get caught up in a vicious payday loan cycle had plenty of help getting there. When I’m asked to referee a dispute, I like to say that we shouldn’t overlook the possibility that everyone is wrong.

Before looking at the causes of debt troubles, it’s important to recognize that on a pragmatic level, it doesn’t matter whose fault it is that you’re stuck in debt. If nobody else will help you, then you have to help yourself. So, don’t take any part of the rest of this post as an excuse to throw up your hands and declare your debt troubles to be someone else’s fault; that won’t help you.

Most of us start off young and clueless about money. It’s easy to begin a descent into debt trouble without realizing the path you’re on. These people aren’t blaming others for their problems because they don’t know they’re in trouble yet. As they begin to recognize the signs of trouble, they react in different ways. Some take positive actions to climb out of their financial hole and some blame others, but many just bury their heads in the sand for as long as possible pretending nothing is wrong.

The financial industry has great skill when it comes to promoting debt and helping people maintain their lifestyles while building debt. When your debt is split across multiple credit cards, lines of credit, car loans, and a re-advanceable mortgage, it’s very easy to lose track of whether your debt is rising from one month to the next.

If tobacco companies were to hire attractive 21-year olds to give free cigarettes to kids on their 18th birthdays, parents would riot. We react much less to banks hiring attractive people to push credit card applications on young adults. However, for many debtors, getting into a vicious payday loan cycle is the end of a descent that began with mishandling a first credit card.

Student loans are no help in teaching people to avoid debt. Tuitions have risen so high that it’s very difficult to get an education without a loan. Starting your adult life owing $20,000 normalizes being in debt. How could it hurt to add another $1000 on a credit card? At this point, the debt cycle is well established.

Any time I’m inclined to judge debtors harshly, I wonder what effect today’s debt-pushing machine would have had on me. I was turned down for student loans because I went to school in a different province, and fortunately for me, being in debt didn't seem like a normal state when I was young. If I were growing up today, I probably would be able to get student loans. Without the strong push I got toward frugality, perhaps I might have got an early taste for a more expensive lifestyle.

When it comes to Canadians’ debt problems, there’s a lot of blame to go around. But we can’t wait for banks, universities, and government to grow a heart and stop contributing to the debt cycle. The only person you can count on to get you out of a debt spiral is you.