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.