Tuesday, April 25, 2017

Victory Lap Retirement

Mike Drak and Jonathan Chevreau argue that the traditional approach to retirement where you work full-time until some magic day where you fully stop working makes no sense. In their book Victory Lap Retirement, they say we should add another phase of life between full-time work and full-stop retirement where you work part-time doing something you find spiritually satisfying. Another strong theme of the book is trying to persuade readers to quit the job they’ve grown to hate.

Mixed in with the notion of a victory lap of part-time work is the idea of financial independence. It obviously takes some resources to be able to afford to quit full-time work. The authors suggest entering a victory lap after achieving financial independence, but their definition of this term differs from mine: “the point where your basic (non-discretionary) living expenses are covered by your passive (non-work) income.”

As a young adult, I lived very frugally. I know my wife and I could get by if we spent about half of what we spend now. That would be enough to cover our basic needs. But I don’t want to live that way. And I certainly didn’t consider myself financially independent when I had enough money to cover just basic needs for the rest of my life.

The working definition of financial independence that I use is having enough money to cover my current expenses (rising with inflation) until the end of a long life. This is quite different from only being able to cover basic expenses.

It seems far too easy for people who hate their jobs to use this definition of financial independence to justify quitting their jobs and entering their victory lap. Unfortunately, if they jump ship too early, this may be a victory lap spent scrambling to earn enough money to make life tolerable.

The authors encourage the reader to “Reduce your material needs and adopt a more frugal lifestyle.” This is great advice. However, don’t make the mistake of planning to be more frugal after you quit your job. The time to be frugal is during the entire time you’re working full-time. That way you’ll build more savings and make part-time work more realistic sooner. Failing that, at least live frugally for a few months before quitting your job to prove that you and your family can live on less.

In my opinion, the best part of the book is a short section called “The Trap.” It explains how you can start in an exciting job paying more than you need initially, and end up trapped in a job you grow to hate but can’t quit because you’ve become too dependent on a fat income. I’ve tried to explain this to young people to encourage them to save more money, but I’ve had little success. The authors do a much better job explaining this problem than I ever did.

The authors discuss many advantages of working longer including the claim that “Numerous studies have shown that mortality rates improve with an older retirement age.” However, every study of this type I’ve looked at has only shown correlation, not causation. It seems likely to me that sick people tend to retire younger or get laid off younger. That could be the entire explanation for why those who retire younger have poorer health outcomes. There may be no health advantage at all to working longer.

The authors offer seven “eternal truths” of financial independence. Six of these seven make a lot of sense. But “buy a home and pay it off as soon as possible” can end badly in Canadian real estate today. Prices in Vancouver and Toronto are sky-high and banks are willing to lend people more than 5 times their gross income. I’m not against home ownership, but the price has to be reasonable. Overstretching can leave you buried in debt for decades, and possibly lead to bankruptcy. If a home is too expensive, you are likely far better off renting a nice place and building long-term savings.

The authors write that once you own your home free and clear, “For the rest of your days, you’ll be able to live rent-free.” This is misleading. Homeowners pay for property taxes, upkeep, house insurance, and utilities. These can easily add up to nearly the cost of renting a house. Toss in the opportunity cost on the capital tied up in the house and renting can be a huge financial victory.

To be clear, I’m not against owning a home. I own a home. I do this because the extra cost is worth it to me, not because I’ve deluded myself that owning a home today is better financially than renting. There is no reason to believe that the huge real estate gains that baby boomers enjoyed over their lives will get replayed for millennials.

As further evidence that people should consider leaving the job they hate, the authors quote palliative care nurse Bronnie Ware, who explains that people on their deathbeds don’t wish they’d earned more money during their lives. However, I’ve had some relatives who have run out of money and wished they had more. It’s a terrible thing to outlive your money.

Before reading the book, I had assumed that both authors had reached financial independence (in the stronger sense of covering current spending levels indefinitely) before they left full-time work. However, Chevreau had “enough money in the bank to take an extended sabbatical ... and he was (and is) blessed by a wife who continued to work full-time. Mike’s situation was similar.”

I don’t want to be too critical here; this book contains a lot of useful information about how to have a happy retirement. But it also contains a strong element of “we did it and you can too.” It must be nice to be able to quit your job and follow your dreams while your spouse works. I’m not sure this qualifies the authors to encourage sole breadwinners to quit full-time work and trust that everything will turn out okay.

I think the notion of a victory lap has some merit, but make sure you’ll really be okay if your part-time income proves to be very modest. Not everyone does the type of work that lends itself to taking on a few clients part-time, and not everyone has a spouse continuing to work full-time. I think this book is worth a read, but be careful not to let your dream of a victory lap turn into a financial nightmare.

Friday, April 21, 2017

The Stock Market Only Goes Up

Here’s a chart of the S&P 500 total return for the past 8 years:


The only conclusion my lizard brain can draw is that the stock market only goes up. In Daniel Kahneman’s terms from his great book Thinking Fast and Slow (my review here), my brain’s “System 2” knows that the stock market may crash in the future, but my automatic “System 1” is sure the stock market will keep going up forever.

As my human capital dwindles, I get closer to the age where I should be shifting some of my portfolio into safer investments than stocks. I’ve done this by building up a cash reserve, but perhaps it’s not as big as it should be at this point. It’s very hard to shake the feeling that I’m losing out by not having this cash in stocks right now. My System 2 has determined that I should have some fixed-income investments just in case stocks begin a large drop. But my System 1 resisted hitting the sell button.

Younger investors have bigger concerns. Those who have been investing for 8 years or less can’t be certain they have the stomach for the risk level of their portfolios. A huge risk for investors is that they will lose their nerve in a market downturn and sell out near the worst possible time. It’s hard to know what you can handle unless you have lived through a crash of the type that we had in 2008-2009 and back when the dot-com bubble burst.

We can be sure that a market crash will come eventually, but I have no idea when it will arrive. It’s possible that today’s stock level is the lowest it will ever be in the future. It’s also possible that stocks will get cut in half from today’s level. Most likely, we’ll get something in between.

Don’t let your lizard brain blind you to the very real possibility that stock prices will drop significantly from today’s levels. Try to invest your money with a mindset somewhere between fear and euphoria.

Friday, April 14, 2017

Short Takes: Mortgage Rates and Credit Scores, Bond Confusion, and more

I was on vacation for most of the past two weeks and managed only one post about debt:

Managing Debt

Here are some short takes and some weekend reading:

Canadian Mortgage Trends explains recent changes to how your credit score affects your mortgage interest rate. It certainly makes sense to charge more when the risk of default is higher, but I’m not sure that credit scores are a very good measure or default risk. But maybe they’re the best we’ve got.

Canadian Couch Potato tries to clear up a common point of confusion about bonds: the fact that higher interest rates mean lower bond prices.

Where Does All My Money Go interviews Sandra Foster, an expert on personal finance and estate planning.

Big Cajun Man takes on the common misconception that a Tax-Free Savings Account can only hold cash like a regular savings account.

Boomer and Echo calls for an overhaul of the finance industry.

My Own Advisor considers the possibility of trying harder for financial independence and an earlier retirement.

Monday, April 3, 2017

Managing Debt

Debt is a big part of modern life. The high cost of university leads to student debt, and sky-high real estate has many Canadians in large mortgages. And that’s just the kinds of debt that most easily justified. Then we have the growing lines of credit and credit card balances that come from failing to save up for the cars, clothes, electronics, restaurant meals, and home upgrades we want.

Finance Blog Zone asked bloggers for their takes on how to manage debt. I read through them all and found 7 of them that caught my eye either because I found the ideas interesting or because I disagreed. Here’s my take on their takes.

Brave New Life

Brave New Life says “College debt and a home mortgage are the only two acceptable debts. Ever.” And for emphasis: “No debt for cars.” There may be narrow circumstances when other forms of debt make sense, but this is an excellent starting position. Too often when I try to tell people that borrowing for a car is a bad idea, their reaction is “that’s great, but is it better to get a car loan or a lease?”

Andrew Hallam

Instead of the usual boring debt advice, Andrew Hallam does a great job of stirring emotions. “Declare war against [debt],” “Crush the debt with the smallest outstanding balance” to “frighten your other debts,” and “Then go after your next smallest debt and ruthlessly obliterate it.” He even suggests taping the carcasses to a cupboard for inspiration. Reading this almost made me wish I had a debt to kill.

Fitz Villafuerte

Fitz says “Focus on how to make more money, rather than wasting time in worrying about how to pay your debt.” Unfortunately, for people with debt-building personalities, earning more money just leads to ever-higher spending and more debt. For those with very low incomes, earning more money can be the right answer. But too many people blame their overspending on their supposedly inadequate incomes. There’s nothing wrong with trying to earn more money, but examining spending is necessary.

Celebrating Financial Freedom

Dr. Jason Cabler attacks the mindset of seeing debt as inevitable: “too many people believe that debt is just a normal part of life, but it doesn’t have to be.” Getting too comfortable with debt is a bad idea. It’s better to see debt-freeness as the normal life state.

Bert Martinez

“Money is an emotion. Debt is an emotion too. How you feel is more important than what you know.” I don’t know what this means or how it can help someone. It’s true that there are a lot of emotions tied up in money and debt, but that doesn’t help me understand Bert’s advice.

J. Money

J. Money says debt problems can be the result of habits. “The best thing that got my money straight was taking a 40 day ‘no spend’ challenge.” This changed his habits and “I didn’t realize how often I’d go shopping when I was bored!” This is some practical advice for people to try instead of just telling them to stop overspending.

Leslie O’Connor

“Don’t look at debt as ‘the enemy’ or ‘a disease’. It is just one small factor in your overall, long-term financial growth.” This works for people who handle their finances well. But for those with debt problems, telling them it’s not a big deal is terrible advice. Andrew Hallam’s advice to declare war is a much better idea.

To close, I’ll stick with something I wrote once before: Debt is a crushing burden that weighs down people’s lives and dreams.

Friday, March 31, 2017

Short Takes: Car Loans, Big Spenders, and more

Here are my posts for the past two weeks:

Pension Rip-off

Tangerine Credit Card Changes

The Undoing Project

Here are some short takes and some weekend reading:

Preet Banerjee reports that “car loans have quietly emerged as one of the major risks to Canadians’ household finances.” He goes on to give a practical example of how to get off the treadmill of car debt.

Kurt Rosentreter has some entertaining tough words for high-income people living it up. Apparently, he deals with a lot of boomers with big incomes who handle their money as badly as anyone else.

Finance Blog Zone has a long list of bloggers discussing how to manage debt (including yours truly). Seven of them caught my eye either because I found the ideas interesting or because I disagreed. I may write about the details next week.

Tom Bradley at Steadyhand tells you who your best friend is when you’re worried about the markets.

The Blunt Bean Counter explains the budget’s measures aimed at professionals who use work-in-progress deductions and use private corporations.

Canadian Couch Potato takes a look at some new mutual funds from TD that hold broadly diversified index ETFs in percentages that change based on active investment decisions. While this is interesting news, I’ll stick with indexing that includes as little human discretion as I can achieve.

Robb Engen explains why he doesn’t invest in non-registered accounts. The dominant reason most people avoid non-registered accounts is that they never use up all their TFSA and RRSP room. In some cases, people have investments that aren’t allowed in TFSAs and RRSPs. In other cases, people have income too low to bother with an RRSP, but somehow managed to fill their TFSA. A commonly used reason is the desire to take advantage of the dividend tax credit. However, in most cases, this is misguided and people would be better off using their TFSA.

Big Cajun Man applauds rule changes that make it easier to apply for the disability tax credit.

My Own Advisor interviews Sean Cooper, author of Burn Your Mortgage.

Million Dollar Journey discusses how to deal with big banks trying to sell you products you don’t need and refusing to help you index your portfolio to reduce MER costs. He observes that if his “friend can reduce his portfolio drag from 2% to 1%, it can lead to a 30% larger portfolio after 30 years.” I assume this is just using the estimate of 1% for 30 years adding up to 30%. The actual increase is 35% taking into account compounding effects.

Wednesday, March 29, 2017

Pension Rip-off

A friend of mine who is collecting a defined-benefit pension had a complaint I’d never heard before. He is convinced he’s being ripped off because his pension benefits only go up by inflation each year, but the plan’s assets go up faster than inflation. I know this isn’t right, but it took a while to think of a good way to explain why.

Let’s start with the analogy of a mortgage. Suppose you have a 5-year mortgage with an annual interest rate of 3%. Even though your unpaid balance is supposed to go up by 3% each year, your payments stay the same for the full 5 years. Does this mean the bank is getting ripped off? Not likely. Banks know a thing or two about coming out ahead.

The truth is that your flat monthly mortgage payments are calculated to take into account the 3% interest on the declining mortgage balance. If your payments increased by 3% each year, your starting payment would be a lot lower. But banks are smart enough to know that they shouldn’t expect you to be able to keep up with ever-rising payments.

The situation with pension benefits is similar. Suppose the value of your pension starting at age 55 is $1 million. Based on an assumed 4.1% real return, mortality tables from the Society of Actuaries, and ignoring any coordination with CPP, your CPI-indexed pension benefit would be $5363/month. However, if you wanted your benefits to rise by 4.1% above inflation each year, your starting benefits for a $1 million pension would be only $3010/month.

But why would anyone want such rising benefits? By age 95, the benefits would be worth nearly 5 times more after factoring in inflation. This makes little sense. It’s better to receive more now instead of getting ever more money into old age.

The short answer to the question of whether my friend is getting ripped off is no, he isn’t. The 4.1% real return earned by the pension assets are what allow him to get a higher starting pension amount.

Monday, March 27, 2017

Tangerine Credit Card Changes

Following quickly on the heels of adding new account fees, Tangerine is now making some less than friendly changes to their credit card.

The most important change to me is that they are increasing the foreign exchange fee from 1.5% to 2.5%. So, using this credit card is going to cost me more when I travel, primarily in the U.S.

The change that’s likely to annoy more customers is reducing credit-card rewards. Currently, certain categories of transactions get 2% cash back and the rest get 1%. The rest will now get only 0.5%.

Of course, we’d all be better off if there was no such thing as credit-card rewards and retailers were charged less to accept credit card payments. But I’m not holding my breath.

A slew of other fees that affect those who handle credit poorly are going up as well.

I still find Tangerine products to be better than most of what I can get at the big banks, but future fee increases could change that.

Wednesday, March 22, 2017

The Undoing Project

People make certain systematic errors in their judgments. We’d like to think this is only true of others, but it’s true of us as well. Even brilliant people who are experts in their fields make certain types of predictable mistakes. Michael Lewis’s book The Undoing Project traces the lives and work of Daniel Kahneman and Amos Tversky whose joint work “created the field of behavioral economics.” This book gives an interesting account of the two men’s lives and a gives fascinating insight into their results.

With most examples of the types of judgment mistakes people tend to make, I had to admit that I’m susceptible to the same mistakes. I’d like to think that understanding these tendencies will help me avoid some future mistakes, but I’m not sure it will help as much as I hope. The current “powerful trend to mistrust human intuition and defer to algorithms” is sensible.

Most of the time, the automatic judgments our brains make work very well for us. But when they don’t work well, it’s hard to stop making mistakes. It’s easier to understand this problem when it’s our eyes that make the mistake. Consider the Müller-Lyer optical illusion.


The two horizontal lines are the same length, but the bottom one looks shorter. After we measure and convince ourselves that they’re the same length, our eyes continue to tell us the bottom line is shorter. We can’t turn off the automatic wrong answer our eyes give. So it is with certain types of judgments our brains make. A key insight by Kahnemen and Tversky was that people “weren’t just making random mistakes ... they were doing something systematically wrong.”

An example of a common mistake comes from the “Linda story.”
“Linda is 31 years old, single, outspoken and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.”
The question Kahneman and Tversky asked was “which of the following alternatives is more probable?”
“Linda is a bank teller.
Linda is a bank teller and is active in the feminist movement.”
85% of subjects chose the second option, even though logic dictates that it can’t be more likely than the first option because the second is a subset of the first. Even when they changed the question to make it clear that the first option doesn’t mean that Linda is “NOT active in the feminist movement,” subjects still favoured the second option. Graduate students with training in logic and statistics made this mistake. Even doctors made this type of mistake.

The book also contains plenty of the humour we’ve come to expect from Michael Lewis. Tversky was once told by an English statistician that “I don’t usually like Jews but I like you.” His reply was “I usually like Englishmen, but I don’t like you.”

Another example came from the way Tversky didn’t worry about the many demands for his time: “The nice thing about things that are urgent is that if you wait long enough they aren’t urgent anymore.”

In an odd definition of “winning,” Tversky’s wife once had to take her eldest son to an emergency room because “He had won a contest with his brother to see who could stick a cucumber farther up his own nose.”

Asked “if their work fit into the new and growing field of artificial intelligence,” Tversky replied “We study natural stupidity instead of artificial intelligence.”

Kahneman and Tversky faced a lot of opposition from economists. One economist’s paper opened with “The agent of economic theory is rational, selfish, and his tastes do not change.” That may make it easier to build theory, but it doesn’t sound much like actual people. But economists clung to this view that people were rational even in the face of mounting evidence from Kahneman and Tversky.

In this battle over whether people are rational, Kahneman and Tversky even reached back to a paper written in 1738 by Daniel Bernoulli (English translation here). Bernoulli offered a model of financial decision-making that we now call utility theory. He believed that people should treat a doubling of one’s net worth as just as good as halving it is bad, even though the dollar amounts won and lost are different.

Tversky wrote that “Bernoulli sought to account a bit better than simple calculations of expected value for how people actually behaved.” I’ve read the translation and I see no evidence this is true. My reading of Bernoulli’s paper was that he sought to model rational choices, not the irrational choices people actually make. I went into more detail on this subject a few years ago.

In explaining Bernoulli’s theory, Lewis writes “The marginal value of the dollars you give up to buy fire insurance on your house is less than the marginal value of the dollars you lose if your house burns down—which is why even though insurance is, strictly speaking, a stupid bet, you buy it.”

Just because fire insurance on a house has a negative expectation, it isn’t a “stupid bet.” I don’t know if this misunderstanding is just Lewis’ or if it is Kahneman and Tversky’s as well. It is irrational to accept a 50/50 bet to either double your net worth plus a dollar or lose everything, even though it has a positive expectation of 50 cents. Bernoulli’s theory isn’t a perfect model of rational decision-making, but it is far better than simple expectation.

All that said, Kahneman and Tversky’s prospect theory is an excellent model of how people actually make decisions, which is clearly different from a purely rational method.

Overall, I found this book up to Lewis’ usual high standard. It gives very accessible insight into Kahneman and Tversky’s work and gives interesting accounts of their lives and collaboration. Anyone who enjoys this book should consider reading Kahneman’s Thinking Fast and Slow.

Friday, March 17, 2017

Short Takes: Honest Fund Disclosure, Juicing Returns, and more

Here are my posts for the past two weeks:

Recognition Points Update

Tangerine Adds Some New Fees

Retirement Spending Plan Question

Balance Transfer Offer

The Case for Delaying CPP and OAS to Age 70

Here are some short takes and some weekend reading:

Jason Zweig brings us the best mutual fund disclosure ever. Brutal honesty can be hilarious.

Larry Swedroe explains how mutual fund families use IPOs to juice the returns of new funds. He also shows how they shift returns from one fund to another with front-running: “A large fund family with a small-cap fund has the small-cap fund buy shares of stocks with a low market cap and limited liquidity. Other funds in the same family then pile in, buying more shares. The limited supply of stock allows the large fund family to drive up prices with relatively small purchases by each fund. The returns of the new fund then look great.”

Canadian Couch Potato uses his latest podcast to explain why active share have little predictive power for fund returns and takes a shot at Gordon Pape’s poor investment advice.

The Reformed Broker points out that U.S. household wealth grew by a staggering $40 trillion during Obama’s presidency. That’s quite a jump considering how his political enemies have had some success painting his financial impact as a negative. Of course, presidents have only a limited impact on the growth of wealth, even if they tend to get the credit or blame.

Retire Happy has a very clear explanation of the difference between a TFSA beneficiary and a TFSA successor holder. It pays to understand this difference.

Tim Cestnick describes an interesting trick to decide after the federal budget is announced whether to realize capital gains at the 50% inclusion rate that existed before the budget.

Squawkfox reports that 39% of Canadians don’t understand the benefits of paying more than the minimum credit card payment. She uses her engaging style to explain the benefits of paying more than the minimum.

Big Cajun Man has some tax tips including the fact that CRA offers auto-fill now. I was skeptical at first, but I’ve heard from others that it works well.

Boomer and Echo explain why a 4-minute portfolio is tough to beat.

My Own Advisor updates his progress on his 2017 financial goals. I really like his first goal: “Do not to incur any new debt.” He says this goal goes without saying, but it’s an important reminder for his readers. It only goes without saying for those who’ve already figured out how bad debt can be. More naive readers might find this goal enlightening.

The Blunt Bean Counter explains the tax consequences of borrowing from or lending to your small business.

Million Dollar Journey updates us on Frugal Trader’s progress to building enough portfolio income to make his family financially independent.

Wednesday, March 15, 2017

The Case for Delaying CPP and OAS to Age 70

There are good reasons why some people start collecting CPP and OAS benefits as early as possible. However, many people start collecting CPP and OAS early for emotional reasons that don’t hold up under scrutiny. The main reason to delay benefits until age 70 is simple enough: most of us need to plan for the possibility of a long life.

Let’s start with some basics about CPP and OAS payments. Old Age Security (OAS) can start anywhere from age 65 to 70. Most Canadians at age 65 are eligible for the maximum pension (currently $578.53/month and rising with inflation). However, waiting until age 70 gives the payments a 36% boost (0.6% for each month of delay). A 70-year old just starting OAS today would get $786.80/month.

Canada Pension Plan (CPP) benefits are more complex to calculate. Doug Runchey has a great description of how to calculate your CPP pension. The biggest CPP retirement pension a 65-year old can collect today is $1114.17/month, rising with inflation. However, the average is $644.35/month. Whatever amount you’re entitled to, you’re allowed to start payments as early as age 60 or as late as age 70. The penalty for starting at age 60 is a 36% reduction, and the benefit for waiting from 65 to 70 is a 42% boost. So, the maximum payment at age 60 is $713.07/month, and the maximum starting at age 70 is $1582.12/month. That’s quite a big difference.

One technicality about CPP is that delaying benefits from age 60 to 65 can reduce your calculated pension a little if you’re not working past age 60 because you’ll have more years with no CPP contributions. (There is a special “dropout” that allows you to not count the years from 65 to 70.) So, depending on your exact circumstances, the dramatic difference between CPP at age 60 and at age 70 can be a little smaller than I showed, but it doesn’t affect the rest of the discussion much.

There are some good reasons to start collecting CPP and OAS as soon as possible. If you have much lower than normal life expectancy for any reason, it makes sense to collect some money while you’re still alive. If you have no savings and you plan to live only on just the total of your pensions (including the lower CPP and OAS payments that come from taking them early), then it makes no sense to delay CPP and OAS.

Suppose you have a normal life expectancy and have at least enough savings to be able to make it to age 70 without collecting CPP or OAS. This means that if you calculate the boosted payments you’ll get from CPP and OAS at age 70, your savings will cover withdrawals of at least this amount for the years from when you retire until you’re 70. So, you have a real choice: take CPP and OAS sooner or later?

There are some strong emotional reasons to take CPP and OAS sooner. One is that we discount the future too much. Another is that we sometimes use the fact that CPP is available at age 60 to justify retiring at 60, whether we have enough savings or not. Yet another is that it’s psychologically hard to spend down one’s savings, and as Frederick Vettese explained, you’ll have to do that faster if you delay CPP and OAS.

I’ve heard people try to justify taking CPP at age 60 saying that they want to have some money to spend while they’re still young enough to enjoy it. However, they could just spend more from their savings to achieve this. If delaying CPP and OAS to age 70 has a net benefit, then doing so will allow you to spend a little more during your early years of retirement than if you took CPP and OAS as early as possible.

We only need to consider one dominant fact to see that delaying CPP and OAS is a big win: you might live a long life. The scenario that puts the most strain on your finances is living a long time. If your financial plan works for a long life, then you won’t have financial trouble if you don’t live so long.

If you do live a long time, you’ll get the most value from CPP and OAS if you wait until age 70 to get larger payments. Knowing that you’ll be better covered after age 85 with big CPP and OAS payments makes it possible to spend more early on. The problem with longevity risk is that we are forced to plan for living to 95 even if we expect to only live to 85. The great thing about large CPP and OAS payments is that they keep growing with inflation as long as you live. This eliminates part of your longevity risk.

If you live a long life, the math overwhelmingly supports taking CPP and OAS at age 70. Doing so makes it possible to spend more in your 60s than you could do safely if you take CPP and OAS early. But what if you don’t live long? You’re still better off delaying CPP and OAS. You don’t know in advance that you won’t live long, so you’re still forced to plan for the possibility of a long life.

You may see some analyses with detailed calculations to decide when to take CPP and OAS. These often use normal life expectancy to make the choice. These analyses just aren’t relevant to most of us because we have to plan for the possibility of a long life. An exception is if you’re wealthy enough that you plan to under-spend your assets and longevity risk matters little.

In many financial decisions, the truth is in the numbers, but only when you get all the facts right. If you get a fact wrong, such as not planning for the possibility of a long life, the math gives you an answer that is exactly wrong. It pays to think clearly about the gift of high CPP and OAS payments you can get by waiting until you’re 70 to collect.

Monday, March 13, 2017

Balance Transfer Offer

I have a credit card that I don’t use much any more because I get more cash back on another card. I recently got an offer related to my little-used card by paper mail:

“Save on interest - pay only 0.99% on balance transfers” “for up to 12 months”

I normally just throw away junk like this, but I decided to scan the page. Toward the bottom, my eye caught the following line:

“A fee of 3% of the balance amount you are transferring applies.”

Just how dumb are they hoping I am? This looks like at least 3.99% interest annually to me. More likely, they’re hoping to reach the inattentive and desperate.

I decided to read the 25 lines of fine print on the back. In addition to the usual stuff about how they’d jack up my interest rate if miss my payments, I saw the following:

“Please refer to sections 10, 11, 12, 13 and 14 in your Cardholder Agreement for details on calculation of interest and the application of payments.”

There just has to be a story behind something this cagey. After reading more than just the sections referenced, I think I have the story. After I make a balance transfer from another credit card, suppose I make a normal purchase on this credit card. It turns out that the balance transfer is treated like a cash advance. If I make a payment, the payment goes against interest first, then the balance transfer, and new purchases last. So, until I pay off the entire balance transfer, interest at a high rate accumulates on any new purchases.

So, if you choose to make a balance transfer, be sure to put your credit card in a cool, dry place and don’t use it until the balance transfer is completely paid off.

No matter how bad your financial situation gets, there’s always someone there to profit from dragging you down further.

Thursday, March 9, 2017

Retirement Spending Plan Question

Reader P.H. asked me a challenging question about drawing down TFSAs, RRSPs, and non-registered accounts during retirement. Here is a lightly-edited version of the question:

Over the RRSP season I had the same conversation with both my father and father in law about RRSP withdrawals. It was over which account they should tap first, their RRSP or non-registered (everyone agreed to leave TFSA until they end and to max it out forever.)

I understood that non-registered accounts should be used up first and then RRSP so that you pay less in investment taxes over time. They think they should draw out RRSP money first or even draw extra money they don’t need immediately and invest it in non-registered account so they pay less income tax over time. I tried to explain that they would have more money if they waited, but both were concerned about the 50% income tax their estate/heirs would have to pay when they died.

After some back of the envelope calculations I think we are both right. I think they would have more money for themselves to use if they did RRSP last, but they could leave a larger inheritance if they took out extra withdrawals and invested it in a non-registered account.

So, my conclusion to them was that if they wanted to make the most out of their money for their own use then leave it in the RRSP, but if they plan to leave an inheritance then they can take extra out earlier.

Does this make sense?

Love the blog.

First off, I’m glad you enjoy the blog.

I’ve thought a lot about this type of question, and I don’t claim to have a definitive answer that covers all situations. I’m not even completely sure about my own situation yet.

In all the simulations I’ve done, going with the order non-registered, RRSP/RRIF, and finally TFSA has been either optimal or not too far off optimal. But I don’t claim to have looked at all possible financial situations people find themselves in during retirement.

There are so many variables involved, including the amounts you have in each type of account, other income you have, your year-to-year cash flow needs, and whether you are married. Other important factors that you can’t know are how long you and your spouse will live and what future changes the government will make to the tax system.

A change that seems likely at some point is to take into account TFSAs when giving out government benefits. I don’t think Canadians would be too pleased to see people with massive TFSAs collect GIS and other government money intended for low-income seniors.

A strategy I’ve read in a few places is to “top up” your current tax bracket. For example, in Ontario, the marginal tax rate on income below $42,201 is 20.05%. If your income is a little below this level, this strategy would have you withdraw enough from your RRSP/RRIF to top up this bracket. If you’re going to withdraw early from your RRSP/RRIF, then this makes some sense, but it doesn’t answer the question of whether you should be making such withdrawals early at all.

The father and father-in-law in P.H.’s question both focus on the large tax bill from their RRSP/RRIFs when they die. This is understandable, but may not give the correct conclusion. It’s often the case that you can withdraw RRSP/RRIF funds at a lower tax rate today than you’ll pay later on with a huge withdrawal at death.

But comparing tax rates isn’t the only thing you should consider. There is value in deferring taxes on investment gains as long as possible. Let’s consider an example to illustrate this point.

John is 65 and is currently in a 30% marginal tax bracket. He is considering withdrawing $5000 from his RRSP, even though he doesn’t need the money today. His TFSA contribution room is fully used, and so the $3500 remaining after tax would be invested in a non-registered account.

Suppose that John will live to age 90 and earn pre-tax investment returns of 7% per year. If the money stayed in his RRSP, it would grow to $27,137. Assuming John lives in Ontario and would be pushed into the top marginal rate at death, his heirs would get $12,610 resulting from the original $5000.

In the non-registered account option, suppose that yearly taxes would reduce the growth rate to about 6% per year. Further, he would pay capital gains taxes at death. The final amount going to John’s heirs works out to $11,938. In this example, John was slightly better off leaving the money in the RRSP.

In reality, the calculation would be more complex than this because a higher RRSP balance would actually lead to larger RRIF withdrawals each year. So, the $5000 would not actually stay in the account until John dies. Also, if John had any TFSA room available to hold part of an RRSP withdrawal, the comparison changes.

As for P.H.’s split conclusion about one strategy being better for the retiree and the other better for the heirs, I suspect this just because heirs benefit when retirees spend less. A true comparison comes when we hold retiree spending constant. Keep in mind that forced RRIF withdrawals do not have to be spent; they can be saved in either a TFSA or non-registered account. So, spending the RRSP/RRIF last doesn’t mean the higher forced RRIF withdrawals must be spent.

This whole area can get quite complex. For myself, I’m going with the idea that I don’t have to get the best answer, just a good one. My core plan is to spend non-registered money first, RRSPs second, and TFSAs last unless I get new information. However, I can see the logic of making early RRSP withdrawals if I can get the money out close to tax-free in a year where my income is very low, particularly if I have TFSA room to hold some of the withdrawal.

Tuesday, March 7, 2017

Tangerine Adds Some New Fees

Tangerine is adding some new fees starting 2017 April 29.

Chequing and non-registered savings accounts will pay $10 for a year of inactivity and an additional $40 for 10 years of inactivity.

Returned items now cost $4 each.

After your first chequebook, subsequent books of 50 cheques now cost $20 instead of $12.50.

NSF charges go from $25 from $40.

These changes seem painless enough depending on how they define “inactivity,” but it pays to remain vigilant. Fortunately, more online banking options keep popping up. I’m optimistic that wary Canadians will be able to keep their banking fees low if they’re willing to move to a new online bank as necessary.

Recognition Points Update

A while back I wrote about the recognition points system my employer started using to give employees rewards for good work. I had thought the system was simple enough, but now that I have my T4, I see a few interesting (and disturbing) wrinkles.

Back in December, I thought the taxable benefit kicked in only when we redeem points. If this were the case, I would control when I got hit with extra taxes. But our finance department has since found out that CRA considers the points themselves to be valuable, so I get hit with extra taxes as soon I’m awarded points.

Fortunately, I found something worthwhile for me in the rewards catalog: gift cards for a retailer I use often enough. So, at least I can get some value back to offset my reduced pay due to higher tax withholdings.

Some more good news is that my employer has decided to give us all some extra pay to offset the taxes we pay on the recognition points. Unfortunately, they treat us all as though we’re in a 30% marginal tax bracket (Ontario income from $46k to $74k). This means higher income earners must pay some income taxes for their points.

A friend of mine works in finance at another company where the employees are treated as though they’re in a 26% tax bracket. So, I guess my company is a little better.

The most surprising news after I examined my T4 is that the company values the points 40% to 50% higher than their actual value. For the particular gift card that interests me, my initial award of 2000 points is worth $113.38, but is valued at $166.16 when calculating my taxes.

At my marginal tax rate, after the extra pay my employer gives me to offset the taxes, I pay $56.12 for my 2000 points. So, I pay about half the cost of the gift cards I get. Compared to what my employer says these points are worth, their value to me is about one-third.

In the end, I’m glad this new points system at least has positive value for me. I know the dollar amounts at stake are modest. But if it had worked out that the points cost me more in taxes than I could get back in gift cards, it would have made it hard for me to accept more reward points graciously.

Friday, March 3, 2017

Short Takes: Irrationality Benefits, Trader Feedback, and more

My only post during my last two weeks of vacation was:

The Limits of Retirement Simulators

Here are some short takes and some weekend reading:

Why Facts Don’t Change Our Minds is a fascinating article explaining why acting irrationally in certain ways was a beneficial adaptation.

The Reformed Broker reports on an interesting experiment where a brokerage reported to account holders whether their trading produced any value.

Larry Swedroe reports on some interesting insights into investors’ preference for dividends.

Boomer and Echo explains the main problems with most of Canada’s mutual fund industry: closet indexing and high fees.

Big Cajun Man says the RRSP should really be called the Tax Deferral Savings Plan. He makes a good point that people shouldn’t look at their RRSP balances and think of it as all their money

Million Dollar Journey has a good primer on asset allocation. Near the beginning are two sets of returns illustrating the effect of bonds on long-term returns. The first set is based on returns for the past 30 years and the second is based on the last 90 years. It’s not hard to see that the last 30 years have given us an amazing bull market in bonds. It will be interesting to see if we get a bear market in bonds in the coming decade or so.

My Own Advisor explains the downside of income tax refunds.

Tuesday, February 21, 2017

The Limits of Retirement Simulators

One way you can see some possible outcomes of your retirement plan is to use a retirement simulator similar to one available from Vanguard. These simulators use Monte Carlo methods to run several thousand possible patterns of investment returns to see how your portfolio holds up through retirement. Behind the impressive scientific-looking tools are some problems. Here I show the problems in pictures.

To understand these problems, we need to look at the fairly simple way these simulators work. To generate a possible outcome for your portfolio, many of these simulators begin with some actual historical investment returns from a range of years. They build your simulated results one year at a time by choosing one of the historical years randomly and applying that year’s returns to your portfolio.

Before getting into why this method has some issues, let’s go to a couple of charts. I grabbed some annual TSX investment returns for the past 47 years. Then I made a chart of portfolio growth for all 28 overlapping 20-year periods. Here are the 28 results for a starting portfolio of $20,000:


It’s hard to learn too much from this mess, but bear with me. What matters is the range of outcomes. The next thing I did was to put the 47 years of TSX returns into a random order and draw the same chart again. I used all the same return percentages, but in a different order. Here is the result:


The main thing to notice is how much more spread out the 20-year returns were in the random order case. Both charts have exactly the same log-scale. The portfolios for the TSX returns in actual order had an ending portfolio value range of $82k to $251k. For the randomized return order, the range was $46k to $339k. This is a substantial difference. Once the return order is randomized, the portfolio outcomes become much wilder.

What’s the explanation for the change? It turns out that the stock market has a tendency to revert to the mean faster than random chance would suggest. A string of years with poor returns are somewhat more likely to be followed by good returns than more poor returns, and vice-versa. When we randomize the order of the annual returns, we eliminate this effect.

So, many retirement simulators give results that are wilder than you can really expect in real life. If you choose a spending level and run the simulations, the simulator might overstate the likelihood of running out of money. On the other hand, if average annual stock returns are lower in the future than they were in the past, the simulator may be understating the likelihood of running out of money. We might hope that these effects would cancel, but it’s likely that one will dominate the other, and it’s hard to say which.

This doesn’t mean that using Monte Carlo simulations to get a sense of the range of possible outcomes is a bad idea. It’s just important not to be too impressed with the science and math. These simulations have two important limitations: they remove return correlations across time, and they assume that future average returns will match past average returns. Buyer beware.

Friday, February 17, 2017

Short Takes: Mortgage Rules, Fiduciary Rule Rollback, and more

Here are my posts for the past two weeks:

Sharing Vacation Costs

Money Skills and Spouses

Here are some short takes and some weekend reading:

Canadian Mortgage Trends reports that “Mortgage Professionals Canada has asked the Department of Finance for a moratorium on mortgage rule changes until the effects of the current changes are known.” They have 5 specific recommendations. My recommendations are different. I call on the Department of Finance to do what is necessary to protect taxpayers from the possibility of having to backstop losses if we have a significant real estate downturn. Further, I call on them to pay little heed to any organization whose primary concern is transaction volume and has minimal skin-in-the-game.

John Bogle comments on the likely rollback of the fiduciary rule in the U.S.

Tom Bradley at Steadyhand offers some interesting questions to ask your financial advisor about fees and services.

Financial Advisor Tim Paziuk says CRM2 did not go far enough in mandating clear disclosure of all mutual fund fees.

Canadian Couch Potato interviews Andrew Hallam in his latest podcast. Hallam thinks investors’ biggest mistake is paying attention to market forecasts in the media.

Andrew Hallam reminds us that what we want is low-cost funds. While most index funds have low costs, not all do.

Boomer and Echo explain why an RRSP loan isn’t always a good idea.

Big Cajun Man reports that the Canadian economy keeps creating more part-time jobs.

Million Dollar Journey reviews retirement calculators. Each one seems to have fairly serious limitations.

Monday, February 13, 2017

Money Skills and Spouses

Even in marriages where work is split 50/50, it’s common for just one spouse to take care of any individual job. This applies to money as well. A reader, D.L., wrote (with light editing):

My wife and I are in our 60's, retired, and financially pretty secure. I'm a self-directed investor. My spouse takes virtually no part in our financial life. Beside feeling that her math skills are weak, money problems were the cause of a lot of family stress when she was young.

So, I do everything from paying bills to investing. I don't resent this. She has tried to get more involved, but loses interest. This is probably less about financial illiteracy, and more about anxiety and avoidance. I would like to hear your thoughts.

As it happens, I’m currently helping an elderly family member sort out her finances after her husband passed. It’s been difficult. She wasn’t even sure which banks held her accounts. Her husband had taken care of everything money-related. Fortunately, he had decent paper records.

In my case, my wife used to handle paying all monthly bills, and I handled investing. To a first approximation, I handled anything that involved 5-digit amounts or more. She’s never liked making decisions about big dollar amounts. Over time, I’ve simplified my investment approach, and she has learned what I’m doing a bit at a time. At the same time, paying monthly bills keeps getting easier, and I’ve learned the various passwords necessary to pay the bills.

Ideally, D.L.’s wife should learn enough to take over if D.L. dies. However, it won’t do any good to show her this article and say “See. SEE!” She knows she should learn more about handling family finances, but it’s easy to procrastinate. And losing her husband is probably too difficult to even contemplate.

As a bare minimum, D.L. could write a letter to his wife or whoever helps his wife pick up the pieces after he’s gone. The letter would include account names and numbers and anything else that D.L. thinks might be helpful, such as his investment approach. Then he has to make sure he keeps it up-to-date and that his wife knows where it is.

Even better would be to slowly bring his wife into both the financial decision-making and the execution of decisions with online accounts. This would include paying bills and making trades. But, I do mean slowly. It’s tempting to go on and on explaining every little thing. It’s better to have a new 5-minute lesson every week or so. Maybe start with just logging into a chequing account and paying one bill. Keep it short and let her control the keyboard and mouse.

Over time, she will hopefully build confidence in both her ability to decide what needs to be done and how to do each step. But it has to be done slowly and calmly. I think D.L. should approach this process as collaborating with short lessons instead of anything remotely confrontational.

Friday, February 10, 2017

Sharing Vacation Costs

I like to vacation with friends, but working out how to split the costs can get tricky. When it’s just two couples, we often use the you-paid-last-time-so-I’ll-pay-this-time method. But we both have a tendency to try to pay a little too often. Nobody wants to look like a cheapskate. When more people are involved, it gets trickier.

I recall going out to lunch with co-workers when I was in my 20s. Pre-split bills were less common back then, and we’d each figure out what we owed and toss money into the pot. It almost always came up short. I never knew whether people were bad at adding taxes and tips or if someone was deliberately cheating. In later years, though, we had a different problem; we’d end up with too much money in the pot. This is better than coming up short, but it’s still a problem to be solved.

With more than two couples traveling together, there is a tendency for more than one person to try to pay for each expense. To try to pay my fair share, I’ve even resorted to wandering off late in a restaurant meal, finding the server, and paying the bill before it ever gets to our table.

One possible solution to all this is for everyone to pay their own way at every stage. But that would mean splitting up grocery bills for multiple card payments, and everyone lining up to pay for their own round of golf. It’s so much easier for one person to pay and to sort it out later.

I’m trying out a process of entering all items in a spreadsheet. So far this system has worked well. We don’t worry about getting things correct down to the penny; it’s just about making sure we end up close enough. At any given moment, we can see who has paid too much and who too little. That makes it easy to decide who should pay the next bill.

This has led to another interesting effect. Nobody wants to be the person who hasn’t paid enough. We all want to get out ahead. Of course, that isn’t possible. If one person has paid too much, someone else has paid too little; it all has to add up to zero.

I’ve been mulling ways to put people at ease. One possibility is to have the last line of the spreadsheet just say who should pay next instead of showing positive and negative dollar amounts. Another possibility is to add $500 to each total and say that it only goes negative if you fall behind too much.

In any case, I’d rather deal with this minor problem instead of having everyone contribute the same number of quarters every time we go over a toll bridge. There are worse things in the world than having friends who care about paying their fair share.

Friday, February 3, 2017

Short Takes: True Investment Costs, Habitual Spending, and more

Here are my posts for the past two weeks:

Is it Really Necessary to Check Your Credit Score?

My Investment Return for 2016

CEO of Everything

Here are some short takes and some weekend reading:

Steadyhand uses an infographic to show the costs that eat into investment returns, including an often-missed factor: investor behaviour.

Robb Engen gives a strong defense of the Latte factor. It’s not about denying yourself the occasional indulgence. It’s about cutting down on habitual mindless spending.

Investment News reports that an advisor “allegedly cost clients $1.3 million by placing trades through a master brokerage account and then allocating profitable trades to himself while placing unprofitable ones into client accounts.” Most retail stock pickers prefer to think about just their profitable trades, but this is a way to truly make bad trades not count.

Canadian Couch Potato interviews the great Charles Ellis in his latest podcast. “We’re now very close to 99% of all trading is done by expert professionals.” Canadian Couch Potato also has some advice for an investor just starting to invest in a non-registered account in addition to existing RRSPs and TFSAs.

Big Cajun Man discusses Bill C-462 that seeks to prevent opportunists from gouging people for help accessing disability tax credits.

Dan Ariely has some very interesting insights into the nature of financial advice and how it’s delivered.

Jason Zweig warns us about very high hidden fees in managed futures funds.

Kerry Taylor gives a primer on Tax-Free Savings Accounts on CBC News Network. Canadians have several misconceptions about TFSAs, and Kerry clears them up.

My Own Advisor measures his investment approach against some advice from Tom Bradley.

Frugal Trader at Million Dollar Journey lays out his personal financial goals for 2017.

Monday, January 30, 2017

CEO of Everything

Becoming suddenly single through divorce or the death of a spouse can be extremely difficult. Gail Vaz-Oxlade and Victoria Ryce teamed up to write the book CEO of Everything to “offer sensible advice and emotional support so you don’t have to figure out every twist, turn, and bump in the road on your own.” Vax-Oxlade’s experience with divorce and Ryce’s widowhood give them lots of personal experience to draw from.

The authors show keen insight into human nature in several ways. One example concerns the fact that in many ways we are the sum of our habits. “You can stop flossing your teeth for a while, but three weeks is a new pattern setting up to take hold; you need to end it before it becomes entrenched. Ditto eating too much or too little, isolating yourself, or drinking yourself to sleep at night.”

This book deals mostly with non-financial matters in the difficult road from couple-hood to living on your own. However, I’ll discuss primarily the financial parts of the book here. But don’t let this bias give you the wrong impression. The authors deal thoroughly with all aspects of divorce and widowhood.

There is no shortage of Vaz-Oxlade’s usual very direct style. “People who consider not having a will as some kind of reverse talisman that will protect them from dying are dopes.”

In the case of divorce, joint debt can create future problems. “If you’re on the hook for your mate’s debt ... it’s time to get your name off the documentation. Cancel joint credit cards to prevent large purchases by your spouse.”

One piece of advice I don’t understand, perhaps because I’ve never had overdraft protection is “Don’t confuse the kind of overdraft protection you ‘buy’ for which you sign an agreement, with what some banks call ‘bounce protection’ or ‘courtesy overdraft protection,’ which they offer to save you from the hassle of a returned cheque. The latter can be very expensive.” I didn’t know there were fundamentally different types of overdraft protection. What I take from this is that people should understand the terms of their overdraft protection.

“Nearly two-thirds of support orders in Canada are in arrears.” This is such a high percentage that something must be very wrong. It can’t be that almost everyone is a deadbeat.

Most people are ill-equipped to handle lump sum payments such as life insurance payouts. “It’s easy to think a lump sum of money will last forever, but if you spend $40,000 of your stash a year, $200,000 will last only five years.”

When it comes to investing, people usually ask “‘But where do I start?’ Start with indexed investing. Go online to an unbiased source and familiarize yourself with the investing world.” I’d say that if you can get started with index investing, you’d do well to stay with it indefinitely.

I’ve never seen advice to work with multiple advisors before. “If you work with a couple of people you will, in effect, diversify your advisory base and have a built-in check and balance for any advice you receive.” Advisors won’t like this much because they want to control all your assets, but maybe this is reasonable advice for someone with enough assets that an advisor would be willing to take on half.

The authors capture my feeling about keeping too much stuff. “There are things I want to be able to see that are special ... I don’t want then hidden by a bunch of crap.” Keeping thing I don’t need or want just makes it harder to find the things I do need and want.

“People seem to be under the impression that owning your home outright means you’ve got shelter costs on lockdown. I like to point out that I live in a paid-for home, and the carrying costs on my house—property taxes, insurance, maintenance, and utilities—ran to just under $1,400 a month.” Good point. Another cost to add when comparing to renting is the opportunity cost on the house equity. I use 4% as an expected excess real return of stocks vs. real estate. Others with more fixed income and whose investing approach is more expensive might do better assuming 1% or 2%. Another thing to consider is that it’s possible to be much better diversified in stocks than in owning your home.

“If you don’t plan for home maintenance, then everything that must be fixed becomes an emergency.” It’s easy to forget about expensive repairs when you don’t need any for a few months, but they are inevitable.

I’m fortunate that I have no first-hand experience with divorce or the death of a spouse. So, this limits my ability to judge the value of this book. But, like Vaz-Oxlade’s previous books, she shows that she genuinely wants to help her readers rather than just sell books. The same appears to be true of the other co-author, Ryce. I think I would get a copy of this book for someone close to me in need.

Wednesday, January 25, 2017

My Investment Return for 2016

My December account statements finally came in and like I’ve done each year for some time, I’ve calculated my return for the year. Because of the new CRM2 rules, my account statements give my annual return, but it’s done separately for each account. I think of my portfolio as a whole that just happens to be spread across multiple accounts.

It was an above-average year. My internal rate of return (IRR) that takes into account cash flows was 13.65%. As a benchmark, I use Vanguard ETFs in the same asset allocation as my portfolio and compute the IRR with the same cash flows. Because I actually own Vanguard ETFs, my return doesn’t differ much from this benchmark. The only exception from indexing in my family portfolio was a small block of Berkshire Hathaway stock that my wife held for years, but sold in October. I use ETF VTV as a benchmark for Berkshire. My portfolio’s benchmark return was 13.62%. This is a hair below my actual return, so Berkshire outperformed VTV somewhat.

If my portfolio had started the year at exactly my target asset allocation and I never touched or added or took out any money, my return would have been 13.39%. This is below my benchmark return, which means that I got lucky with the timing of my cash flows; I tended to add money when my stocks were a little down. There was no skill at all in this because I add new money with fixed rules – no discretion on my part.

If I use the benchmark index returns that Vanguard provides for each of its ETFs, the tracking error of my portfolio works out to 0.03%. For some reason, this is lower than my portfolio’s blended MER of 0.08%. I assume this is some combination of luck and possibly revenue from Vanguard lending shares to short sellers.

One of my ETFs, VXUS, has foreign withholding taxes. Non-U.S. countries retain a withholding tax on stock dividends before the rest of the dividends go to Vanguard in the U.S. Currently, this tax is a 0.20% annual drag on VXUS returns. Because VXUS makes up 25% of my portfolio, foreign withholding taxes are a 0.05% additional drag on my portfolio’s returns. By holding my ETFs in RRSPs, TFSAs, and non-registered accounts strategically, I have no other drag due to foreign withholding taxes.

Other drags on my portfolio’s returns are trading commissions and spreads. In 2016, this added up to about 0.03%. The new CRM2 rules made it easy for me to find the total commissions I paid. Spread costs took more work. This cost is half the average bid-ask spread times the total number of shares traded. For infrequent traders of very liquid ETFs, this doesn’t amount to much.

So, what’s the point of all these comparisons if the differences are so small? The point is to make sure they’re small. If my portfolio has a leak, I want to know about it.

Here’s my cumulative real return history (subtracting out inflation) on a log chart:


You’ll notice that I had a spectacularly good 1999. That was the result of a wild bet on a single stock that grew to be a very large percentage of my net worth. I was very lucky. You may also notice that my returns didn’t look very good from 2000 to about 2010. This is roughly the period where I picked stocks. All I succeeded in doing was to give back some of my 1999 gains. Since 2010, my portfolio has been mostly indexed, which is why there is little difference between my returns and the benchmark.

Over the entire period, my average compound return has been 8.65% above inflation. It feels good to know that every dollar I’ve had invested the entire time has grown over six-fold in purchasing power. Going forward, I hope to average about 4% (less costs) above inflation.

I outperformed my benchmark by a compound average of 3.09% per year. But if we exclude 1999, I actually lost to the benchmark by 0.95% per year. I was lucky, and after that I wasn’t much of a stock picker. Particularly painful was a decision to sell a sizeable block of Apple stock at a split-adjusted price of $1.39. It now trades at about $120. I’m very content with my choice to index my portfolio.

It’s not necessary to go into the detail that I do when analyzing your annual returns. However, completely ignoring them is a mistake. Few investors know their annual returns. CRM2 will help some, but I’m willing to bet that if you ask someone about their returns, they’re likely to talk about their account that performed best.

Comparing your return to a benchmark may not tell you much in any given year, but there’s one pattern to watch for: if you trail an appropriate benchmark fairly consistently by about 2% per year, you may be invested in closet index funds. These are funds that pretend to be active and trying to outperform, but are actually just invested in a mix of stocks or bonds that closely match an index.

If you’re trying to get above-average returns, you should know whether it’s working or not. Otherwise, you’re just fooling yourself.

Monday, January 23, 2017

Is it Really Necessary to Check Your Credit Score?

Having a good credit score matters. It affects whether or not you can get a mortgage or other loans, the interest rate you pay, whether a landlord accepts you as a tenant, and a whole host of other reasons. However, just checking your credit score doesn’t improve it. It’s also questionable whether the credit score you see matches the score that banks and other institutions see when they check on you.

To improve your credit score, you need to maintain reasonable debt levels and pay your bills responsibly. Instead of monitoring your credit score, you can just get a free copy of your credit report from Equifax and TransUnion once per year to make sure it’s accurate. You can do this by calling them and going through their automated phone system to order a mailed copy of your report. If something is wrong, you can try to get it fixed.

These free credit reports don’t give you your score, but they do list your creditors and a measure of how responsible you’ve been with payments for each one. If your credit reports are accurate, your debt levels are reasonable, and you’ve made your debt payments on time, your credit score will take care of itself. But if your credit reports are accurate but unflattering, the only good remedy is to handle your money more responsibly. Businesses that claim to be able to improve your score can’t make the truth go away.

I frankly can’t tell whether the many of bloggers who advocate checking your credit score regularly actually believe what they write or are getting paid to write this stuff. But I think it’s better to worry less about your score and more about handling your debts well and making sure your credit reports are accurate.

Friday, January 20, 2017

Short Takes: Problems with Risk Ratings, Rising CMHC Premiums, and more

Here are my posts for the past two weeks:

Pre-Suasion

What Do You Have to Show for Your Work

Comparing Your Investment Returns to a Benchmark

Here are some short takes and some weekend reading:

Dan Hallett has some thoughtful criticism of risk ratings of mutual funds and ETFs. Personally, I don’t think of risk as “low,” “medium,” or “high.” I think in terms of possible losses. Each asset class has some amount of loss I should reasonably consider to be possible. I usually think of the entire worldwide stock market as possibly dropping 50% for some period of time before eventually recovering. The possible percentage drop is much lower for fixed-income products. For any individual stock, the possible drop is 100% (with no recovery). Using these percentages, I look at my portfolio, imagine these drops happening and ask myself “will I be OK?”

Canadian Mortgage Trends reports that CMHC is raising premiums for high-ratio mortgages, making mortgage insurance more expensive for Canadians. They complain that these increases are “not well supported by any publicly available mortgage risk data (default rates, overall credit quality, equity levels, etc.).” This is a common logical error. The real risk is that future default rates will be much different from what they have been in the recent past. CMHC premiums need to reflect the risk looking forward, not default costs looking backward. I’m happy to listen to arguments about whether the new rates make sense, but those arguments have to be based on actual risk, not assumptions that the near future will look like the recent past.

Preet Banerjee uses his latest Drawing Conclusions video to explain that the costs you see on your upcoming account statements due to new reporting rules will actually be far lower than what you’re actually paying, if you invest in mutual funds.

The Reformed Broker explains to people trying to profit from trading on the reaction to Trump’s tweets why they need to give their heads a shake.

Canadian Couch Potato updated his model portfolios for 2017. He also goes over the 2016 investment returns in various asset classes as well as the performance of the model portfolios. Just in case that’s not enough, he has an interesting podcast featuring a hedge fund manager who advises people “to give up the dream of market-beating returns.”

Jessica Moorhouse interviews Dan Bortolotti in one of her Mo’ Money podcasts. One of the many interesting things Dan had to say was that part of the problem with advisors talking negatively about indexing is that their training includes little about indexing, so they often just don’t understand it.

Robb Engen at Boomer and Echo reviews a very interesting-sounding book How to Think about Money, by Jonathan Clements. You can also enter a draw to win a copy.

Big Cajun Man reports that the bulk of the job growth in Canada in 2016 was in part-time jobs.

My Own Advisor is giving away a copy of the book Victory Lap Retirement.

Monday, January 16, 2017

Comparing Your Investment Returns to a Benchmark

Robb Engen at Boomer and Echo recently revealed his 2016 investment returns and how they compare to benchmarks. More bloggers should set a good example this way. The end of his post piqued my interest when he wrote that the new CRM2 rules will give you your “money-weighted rate of return; however you can track your portfolio returns more accurately with the help of a rate of return calculator.”

The prospect of a better method had me following the link to Justin Bender’s post called “Rate of Return Calculator – Modified Dietz Method.” He offers spreadsheets to help you calculate your returns and says that “By using an approximate time-weighted rate of return (such as the Modified Dietz method), investors will be better able to gauge their performance relative to index benchmarks.”

Measuring investment skill

Justin’s calculators don’t actually “track your portfolio returns more accurately.” Your money-weighted return is a good measure of the return you got. But comparing it to a benchmark mixes the results of your active decisions with cash-flow luck. Justin is trying to reduce this luck factor to isolate whether your active portfolio decisions made or lost money when compared to a benchmark. If you happen to get a bonus at work that you invest when the markets are low, then the boost to your return is just luck. You can get unlucky as well with when you have new money to add at a market high or need to make a withdrawal at a market low.

At first I thought Justin was claiming that the Modified Dietz method of calculating returns is time-weighted (but I’m guessing that’s not what he meant). It is clearly money-weighted. Modified Dietz is just a way to approximate the Internal Rate of Return (IRR) method, which is also money-weighted. Modified Dietz’s only virtue is that it’s easier to calculate than an IRR.

Justin’s calculator tries to remove the cash-flow luck factor by calculating a time-weighted return rather than a money-weighted return. One catch in calculating a time-weighted return is that you need to know your portfolio value each time you add or remove money from your portfolio. But, account statements usually only have month-end portfolio values. This is where the Modified Dietz method comes into play.

What Justin is actually doing with his calculators is using month end portfolio values together with Modified Dietz to approximate the time-weighted return for each month of the year. He could just as easily have used the IRR method for each month. Then he compounds the monthly returns to get an estimate of the time-weighted return for the whole year.

All this doesn’t mean that the return Justin’s calculator gives is somehow more accurate than the money-weighted return that will appear in your account statements under the new CRM2 rules. When you compare your return to a benchmark, Justin’s method of calculating your return does a better job of isolating the value of your active portfolio decisions. If you just compare your money-weighted return to the benchmark return, you might be mixing in a significant cash flow luck factor. Although, as I’ll show, Justin’s calculator doesn’t eliminate this luck factor completely.

If you’re going to use Justin’s calculator, you have to make sure to apply cash flows correctly. If you have new money available to invest, but try to time your entry, that’s an active decision. So, you should treat the new money as entering the portfolio immediately, but sitting in cash. So, the date of cash entry in Justin’s calculators should be the date the money was available to invest, not the date it was used to buy equities.

Another way to measure skill

Justin’s method of measuring the value of your active portfolio decisions is just one method. He does it by adjusting your return to remove most of the cash-flow luck. Another method is to compute a benchmark return that takes into account your cash flows. With this method, you compute a return as though your portfolio was on auto-pilot being invested in a benchmark. Each cash flow leads to a trade in the benchmark index. This gives an adjusted benchmark index that you can compare directly to your money-weighted portfolio return.

One virtue of this method is that it’s usually easy to find benchmark values for any day of the year and not just month-ends. So, you can more accurately remove cash-flow luck when you compare this adjusted benchmark return to your actual money-weighted return.

Example

To explain all this in more detail, I’ll make use of a simple example:

XYZ index fund had a decent year, but it wasn’t steady. By June 30 it had lost 20%, but later rallied. It finished both August and September down 10%, but briefly hit break-even on September 15. An end-of-year rally left the fund up 10% for the year.

Tim had $15,000 in XYZ fund to start the year. He had another $8000 available to invest on June 30 but with XYZ falling, he got nervous and waited until September 15 to invest the $8000 in XYZ.

Analysis

We’ll treat XYZ index fund’s 2016 results as Tim’s benchmark.

On September 15, Tim had $15,000 in XYZ fund and added another $8000. Then the fund went up 10%, leaving Tim with $25,300. Tim’s IRR for the year is 13.31%, and his Modified Dietz return is 13.27%, not much different. They’re both much higher than XYZ fund’s 10% return, so Tim looks like a genius, but this comparison mixes in cash-flow timing luck.

If Tim had just invested the $8000 right away instead of waiting for “things to calm down,” he could have ended up with $27,500. That’s $2200 more than he actually got. His IRR could have been 23.9%, and by the Modified Dietz method, it would have been 23.7%. Either way, that’s a much higher return than Tim actually achieved. This is an example of adjusting the benchmark return for Tim’s cash flows to isolate his skill, such as it was.

Any reasonable analysis would conclude that Tim’s market timing effort was a failure. Even though his return is higher than XYZ fund’s 10% return, that’s just because of the lucky timing of his added $8000. In fact, he squandered most of his luck by waiting 3 months to invest it. The comparisons that make Tim look smart just show that his good luck was greater than the poor skill he showed.

Time-weighted returns

The idea of time-weighted returns is to eliminate the effect of cash flows in and out of a portfolio. The idea is that if portfolio managers can’t control when you put money in or take it out, they shouldn’t get credited or penalized by the effect of cash flows.

We measure time-weighted returns by breaking up the year based on when the cash flows occur, calculating the return for each interval, and compounding the returns. In Tim’s case, if we ignore his market timing mistake for the moment, his return up to September 15 was 0%, and for the rest of the year was 10%. This compounds to 10%, the same as XYZ fund’s return for the year.

It’s no coincidence that the time-weighted return matches the fund’s return. After all, the goal was to eliminate the effect of cash flows. If Tim had invested the $8000 right away, his return after 6 months would have been -20%. The return from then to September 15 would have been 25%, and 10% for the rest of the year. Once again, these returns compound to 10%.

Let’s return to the case where we recorded the cash flow on September 15 and ignored the poor market timing. The actual time-weighted return is 10%. However, Justin’s calculator computes it as 5.0%. This is because the calculator did not have the portfolio value on September 15 and had to try to estimate September’s time-weighted return.

The calculator essentially treats the cash flow as happening with the market down 10%, when it was actually at break-even. And when the final portfolio value doesn’t reflect this apparent good luck of buying low, the calculator gives a low return.

This is what I mean when I say that the calculator doesn’t completely eliminate cash-flow timing luck. Ordinarily, the error is smaller than it is in this example of wildly fluctuating returns, but the error will still be there in most cases.

To get Tim’s true time-weighted return, we should really be taking into account the $8000 Tim let sit for 3 months gathering no interest. Looked at this way, Tim’s return for the first 6 months was -20%, at which point the new $8000 made his total $20,000. This grew to $23,000 by September 15 for a 15% gain. Finally, he made 10% in the rest of the year. These returns compound to 1.2%, much less than the benchmark return of 10%. So, the time-weighted return method agrees that Tim’s market timing hurt his returns, but it has to be calculated with the cash flows at the correct times.

In this case, Justin’s calculator correctly calculates the time-weighted return as 1.2%. That is because the only cash flow during the year happened at the end of a month. So, there was no error due to not having the correct portfolio value on the date of a cash flow.

Confusing definitions of “time-weighted”

There is some possible confusion when it comes to the definition of a time-weighted return. To understand this, we have to go back to the Simple Dietz method of calculating investment returns. This method just treats all cash flows during the year as though they happened at mid-year. The idea is that if you are making regular contributions, the average contribution happened roughly at mid-year.

To make this calculation more accurate, the Modified Dietz was born. This method weights each cash flow by how much of the year is left when the cash flow happens. So, Tim’s contribution on September 15 with 3.5 months left in 2016 gets a weight of 3.5/12. With Simple Dietz, all cash flows get weight 1/2.

This time-weighting used in Modified Dietz is not the same as “time-weighted returns.” The fact that they use the same words is a potential source of confusion. Both Simple Dietz and Modified Dietz are money-weighted methods of calculating returns.

More about each method of calculating returns

Regardless of which method you use to calculate your investment return, the idea is to take your starting portfolio value, your cash flows, and your final portfolio value and figure out what steady investment return would have produced the same outcome. The differences among calculation methods come down to what we mean by “steady.”

Internal Rate of Return

In the case of the internal rate of return (IRR), we define “steady” as a return at a fixed compounding rate throughout the year. Getting back to Tim’s example above, if he had invested in a fund that produced a steady compounding return of 13.31% per year, he would have ended up with the same amount of money as investing in XYZ fund with his cash flows.

One of the criticisms of the IRR is that it sometimes doesn’t give a single answer. But this only happens in wild situations where any measure of portfolio return is meaningless. An example is a portfolio that starts with $10,000, grows so wildly that it’s possible to withdraw $36,000 after 4 months, and after adding $43,100 at the 8-month mark, drops crazily to $17,160 at year-end. Three different IRR returns fit this data: 33.1%, 72.8%, and 119.7%. In almost all portfolio situations that happen in real life, IRR gives just one answer.

The following figure shows the steady IRR compounding return model. It might look like a straight line, but it’s actually increasing exponentially. If we extended it for a few years, this would be easier to see.


Modified Dietz

For the Modified Dietz method of calculating returns, we define “steady” as a kind of reverse simple interest. Instead of the return to date being proportional to time elapsed, the return to the end of the year is proportional to the time remaining. This creates a hyperbolic curve. If Tim had invested in a fund whose returns were of this form that ended the year at 13.27%, he would have ended up with the same amount of money as investing in XYZ fund with his cash flows.

The following figure overlays this reverse simple-interest pattern on top of the earlier compounding pattern for the IRR calculation. The difference between them is tiny, and it’s not hard to see why IRR and Modified Dietz gave very close to the same calculated return.


If Tim had invested the $8000 as soon as it was available, his IRR would have been 23.9%, and the Modified Dietz return would have been 23.7%. The following chart shows the compound interest and reverse simple-interest patterns. Now we see a slightly larger difference between the curves. This is because the difference between simple interest and compound interest is greater as interest rates rise. But it’s still not a big difference, and it’s not hard to see why they give close to the same results.


Simple Dietz

The Simple Dietz method has a more basic definition of “steady.” It has close to half the year’s return appear in the first instant of the year, and the other half at the last instant of the year. This method says Tim earned 12.1%. The following chart shows this return pattern.


Beardstown Ladies

An investment club called the Beardstown Ladies had their own method of calculating returns. They just ignored new contributions, effectively treating them like part of the investment return. By this flawed method, Tim earned a 69% return!

Their implied definition of “steady” has the investment return leap to infinity in the first instant of the year, and then drop back down to earth in the last instant of the year (see the chart below). This way, any cash flows have no impact because the portfolio value is infinite. If the $8000 cash flow has no impact, then the only way Tim could grow his $15,000 to $25,300 is with a 69% return.


Conclusion

There is nothing wrong with using the internal rate of return method to calculate your personal returns. This is what the new CRM2 rules will give you. The Modified Dietz method and time-weighted methods of calculating returns are not more accurate if you just want to know how your portfolio did.

However, just comparing your portfolio’s return to a benchmark can be misleading, depending on what you’re trying to measure. Being higher or lower than the benchmark can be just a matter of luck in the timing of when you had money available to invest or when you needed to make withdrawals.

To isolate the value of your active investment decisions, you need to factor out the luck of cash-flow timing. One way to do this is to compute your time-weighted return and compare it to a benchmark return. Another is to compare your actual return to what you return would have been if you had invested on auto-pilot in a benchmark.

Investing on auto-pilot won’t give you exactly the benchmark return if your portfolio had cash flows. Your personal benchmark requires a return calculation based on what your cash flows would have been if you hadn’t used any of your own discretion. You have to remove the luck factor for things you didn’t control to get at a measure of the results of the things you did control.