Friday, March 16, 2018

Short Takes: Financial Advisor Knowledge, EI, and more

I managed only one post in the past two weeks, but it’s of significance to me:

Why I Retired

Here are some short takes and some weekend reading:

Robb Engen at Boomer and Echo gives the results from a study showing that financial advisors who give poor advice to their clients tend to act on this advice in their own portfolios. This suggests they don’t know that their advice is bad. This makes sense. I expect that most advisors’ financial knowledge is limited to whatever they learn from their employers’ training and sales materials.

Gail Vaz-Oxlade says our Employment Insurance (EI) system is broken. She has a number of examples of people encountering senseless denials and delays. This reminds me of working for a large company that had periodic “travel freezes.” This just meant it was harder to get approval for travel, but not harder in any sensible way. You just got hit with a time-consuming process and arbitrary rejections that had nothing to do with the merits of the travel. I’m not surprised to learn that EI does similar things. It’s hard work to reject only those who deserve to be rejected. It’s much easier to reduce costs by making arbitrary rejections.

Luke Alexander has some useful tips for air travelers. One concerns how airlines manipulate you using information about past searches for flights.

A Wealth of Common Sense tells the story of people who gamed lotteries for millions in profits. This is a case of government lottery designers failing miserably. I’d like to think that some lottery executive lost his job over the mistakes, but that’s probably too much to hope for.

Tom Bradley at Steadyhand reminds us that the important battle over mutual fund trailers rages on. We need to bring the costs of investing out into the open where investors can see them. In another interesting article, Tom explains that low interest rates and high debt can’t last forever. His assessment of the timing of higher rates: “Slow moving train wreck.”

Big Cajun Man explains the ins and outs of RDSP grants.

Preet Banerjee interviews Cait Flanders, author of the book The Year of Less.

Monday, March 12, 2018

Why I Retired

Although I’m younger than the typical retiree, I retired about 8 months ago. It may seem obvious why someone would want to retire, but I’ve been reflecting on what caused me to take the plunge when I did. There were a number of factors that influenced my decision.

1. Adequate savings

I wouldn’t have retired if I didn’t have enough savings. The thought of running out of money makes me conservative about my savings. But my best effort at analyzing my future spending and investment returns shows I have more than enough buffer. Even my wife seems (mostly) convinced we’ll be okay.

2. Autonomy

I’ve never been very good at doing what others want me to do instead of working on whatever interests me at the moment. As I age, my desire for autonomy has been increasing. My employer gave me tremendous freedom to work on just about anything that might help the company. Even so, work chafed me when I wanted to do other things.

3. Taxes

I’m not asking anyone to feel sorry for me that I had a good income and had to pay high taxes. However, I needed to make a decision for myself and my family, not for others. It was disheartening to see part of my income get more than half taxed away. This was most directly visible with bonus payments where I could see that the after-tax amount less than half of the pre-tax amount.

However, taxes on my working income weren’t the only factor. Because my RRSP and TFSA are full, I was adding to non-registered savings. So, I faced significant annual taxes on non-registered investment gains. It began to feel futile to continue earning and saving. Again, I don’t expect any sympathy, but you have to expect me to act in more own interests. I judged the after-tax benefit I’d get from more savings to be not worth the effort.

I tried taking a month at a time off work without pay, reasoning that I’d be eliminating the most heavily taxed part of my income. But in the end I decided to extend that to a full 12 months each year. There’s a good chance I’ll pay less income tax over the rest of my life than I paid in 2017, adjusting for inflation.

4. Wealth Taxes

Currently in Canada, we tend not to tax wealth. We tax incomes at the federal and provincial levels, and have sales taxes on consumption. The main exception to this lack of wealth taxes is property taxes on real estate. However, this could change. Thomas Piketty called for a huge expansion of wealth taxes in his book Capital in the Twenty-First Century. British Columbia recently expanded property taxes on homes worth over $3 million. This is a small start, but it could easily be just the beginning of the spread of wealth taxes.

I hope we don’t see expanding wealth taxes from spendthrift governments thirsty for more cash, but it’s hard to say this is an unlikely outcome. If this does happen, then any further saving I do would become completely futile.

5. Changes at work

My employer made some major changes to the company’s structure and the types of business they would seek. The management team had some big winners and big losers. While these changes didn’t affect me much, they created a natural breakpoint for me. This made it easier to bow out without feeling like I was abandoning my company.


In a less charitable moment, my wife might summarize all this as “lazy.” There’s probably some truth to this, but this is my blog and I get to put these reasons into my own context.

I had been thinking about retiring for some time, but the changes at work were what sparked me to pull the trigger. I wouldn’t have considered retiring if I wasn’t confident I had enough savings. Taxes weren’t a dominant consideration, but even if I wanted to save more to be able to afford a more extravagant lifestyle, incomes taxes and possible wealth taxes make this difficult anyway. I have more than enough things I want to do to fill my days, and I now have the autonomy to do what I want.

Friday, March 2, 2018

Short Takes: Buffett’s Bet, Closet Indexers, and more

Here are my posts for the past two weeks:

Foreign Withholding Taxes on New Vanguard ETFs

Measuring Returns in Different Currencies. I’m guessing this article bounced off most people, including any investment professionals who read it. The way we measure relative returns between countries if often wrong.

Here are some short takes and some weekend reading:

Ahmed Kabil has an interesting article on Warren Buffett’s bet against hedge funds as well as other types of long-duration bets.

Tom Bradley predicts a lean future for closet indexers, a term referring to mutual funds that charge fees as though they invest actively but are actually very close to being index funds. In Canada, such funds collectively hold hundreds of billions of dollars.

Ellen Roseman explains how vendors can get your new credit card information when you get an updated card.

Tom Spears goes through the things CRA auditors look for as red flags.

Robb Engen at Boomer and Echo wrote an interesting “annual letter to householders” modeled after Warren Buffett’s letter to shareholders.

The Blunt Bean Counter explains that there are only a few weeks left to set up a precribed rate loan to a family member at 1%/year.

Big Cajun Man has a thought that should be scary to some: “all debts must be paid.”

Tuesday, February 20, 2018

Measuring Returns in Different Currencies

Thinking about returns of stocks in different countries and in different currencies can get confusing. If Canadian stocks rise (in Canadian dollars) and U.S. stocks rise more (in U.S. dollars), almost everyone would agree that U.S. stocks performed better, even if the Canadian dollar rose by enough to make up the difference. This way of thinking makes no sense to me.

Suppose that in a particular year, Canadian stocks rise 10% when measured the usual way in Canadian dollars. In the same year, U.S. stocks rise 15.5% when measured in U.S. dollars. But the Canadian dollar rises 5% during the year. Most would agree that U.S. stocks had superior returns.

However, let’s look at this from a few points of view, starting with a Canadian investor who thinks in Canadian dollars. The Canadian stocks case is easy: a 10% gain. Now let’s consider the case of a C$10,000 investment in U.S. stocks with the Canadian dollar at 80 cents U.S. The investment is US$8000 and it rises by 15.5% to US$9240. But Canadian dollars rose 5% to 84 cents U.S. This converts to C$11,000 for a gain of 10% measured in Canadian dollars.

So, from the point of view of a Canadian investor, stocks in Canada and the U.S. performed the same, a 10% gain. If we go through the same exercise for a U.S. investor, the gain for Canadian and U.S. stocks will both be 15.5% measured in U.S. dollars. The same will be true for investors in any other country. Everyone in the world will see Canadian and U.S. stocks giving the same performance. So how can it make any sense to decide that U.S. stocks performed better?

This scenario was created to give the same returns for Canadian and U.S. stocks, but we get similar outcomes in other cases. If a Canadian investor sees Canadian stocks perform 5% better than U.S. stocks, then U.S. investors and all other investors in the world will see the same 5% better performance for Canadian stocks over U.S. stocks.

People think that stock returns measured by the country’s own currency are somehow the “actual return”. But this way of thinking is misleading. Returns are always relative. If every investor in the world sees Canadian and U.S. stocks as performing equally well in a particular year, how can it make any sense at all to decide that U.S. stocks performed better? The answer is that it doesn’t make sense.

Saturday, February 17, 2018

Foreign Withholding Taxes on New Vanguard ETFs

When Canadians own foreign stocks, taxes on the dividends are often withheld by the foreign country. This can apply with U.S. stocks as well. This is a complex area. The amount of taxes silently withheld and whether you can effectively recover them depends on the country and the type of account you have.

Yesterday, I said I wanted to know the foreign withholding tax drag on the new Vanguard Canada ETFs. Justin Bender has done the analysis. He has a pdf with the foreign withholding tax details for RRSP and TFSA accounts, as well as an article discussing other aspects of Vanguard’s new ETFs.

In a personal note, Justin goes on to explain “The withholding tax drag in a taxable account is only about 0.01% to 0.02% for the three ETFs.” Thanks, Justin.

Friday, February 16, 2018

Short Takes: New Vanguard ETFs, Worrying about Stocks, and more

My only post in the last two weeks was about TFSA advice:

Puzzling TFSA Advice

Here are some short takes and some weekend reading:

Canadian Couch Potato reviews Vanguard’s new one-fund solutions. They look like excellent single ETF solutions for DIY investors. One thing I’d like to see is an analysis of foreign withholding taxes to help DIY investors make informed tradeoffs between cost and simplicity.

John Robertson has an interesting message for those very nervous about the recent stock market decline.

Big Cajun Man coins a new term for exploiting the elderly with slimy sales practices.

Robb Engen at Boomer and Echo explains that the recent big drop in stocks may have been a record when measured in points, but is far from a record in the sense that matters. Unfortunately, it is mostly media types who hype such “record” drops, and their desperation for headlines will keep them from understanding Robb’s message. Remember the Upton Sinclair quote: “It is difficult to get a man to understand something when his salary depends on his not understanding it.”

The Blunt Bean Counter has a guest expert explaining laws related to powers of attorney for personal care and medical assistance.

Monday, February 5, 2018

Puzzling TFSA Advice

I often see advice related to TFSAs and RRSPs that is strange or just plain wrong. I hate to pick on Gail Vaz-Oxlade, but her recent article giving TFSA advice was spot-on except for one puzzling part I didn’t agree with:

You can hold any investment you can buy for your RRSP inside your TFSA, including stocks, bonds, GIC, and mutual funds. But you should probably stick with interest-bearing investments.

Why? Well since all the capital gains inside [a] TFSA [are] tax free, it also means any capital loss can’t be claimed [to] offset your other capital gains.

To start with, your mix of investments in cash, bonds, and stocks should be based on personal factors that have nothing to do with the tax properties of various types of accounts. Because few people use up all of their RRSP and TFSA room, all of their savings outside of a chequing account should be in either RRSPs or TFSAs.

If your asset mix includes $50,000 in cash, perhaps as emergency savings, and you have no savings in non-registered accounts, then by all means keep the $50,000 in a TFSA. But don’t bias your asset mix to extra cash just to avoid investing in stocks in a TFSA. More cash in your TFSA should mean less cash or cash-equivalents in your RRSP.

If you’re in the enviable position of having used all your RRSP and TFSA room, you get to decide what part of your savings should go in a non-registered account. Suppose your asset mix includes at least $50,000 cash and $50,000 in the Canadian stock exchange-traded fund VCN. The question is which to hold in your TFSA and which to hold in a non-registered account.

The best savings account I'm aware of pays 2.3% interest. VCN pays more than this in dividends, but dividends have preferred tax treatment in a non-registered account. Ignoring capital gains for the moment, paying taxes on 2.3% interest in a non-registered account isn't much different from paying taxes on the VCN dividends in a non-registered account.

The choice of which investment to hold in your TFSA comes down to the capital gains. Over a single year, VCN may be up or down, but over decades, it’s far more likely to be up than down. It’s better to get your capital gains tax-free than it is to worry about keeping your capital losses. If getting capital losses over the long term is likely, then you should re-evaluate the way you invest.

Friday, February 2, 2018

Short Takes: New Vanguard ETFs, Tied-Selling, and more

Here are my posts for the past two weeks:

The Incredible Shrinking Alpha

I’m Done with RRSPs

Your Complete Guide to Factor-Based Investing

Here are some short takes and some weekend reading:

Rob Carrick reports on new ETFs from Vanguard that contain both bonds and global stocks.

Big Cajun Man explains the regulations against tied selling by banks. They apply to such things as requiring you to get a chequing account with a bank in order to get a mortgage.

Robb Engen at Boomer and Echo discusses using annuities to create your own pension income. He says “I perked up when I saw the payout rates were between 5 and 7 percent of the initial deposit. Now, keep in mind, those rates won’t increase with inflation each year, but it’s still a healthy (and guaranteed) amount to receive for life. … why wouldn’t a relatively healthy 70-year-old male not want to turn $250,000 into annual income of $17,669.89?” He’s downplaying the devastating effects of inflation over many years. I’ve watched older family members struggle to get by as the buying power of unindexed pensions erode. People should really be looking at annuities with increasing payouts to counter the effects of inflation. The starting payouts are lower, but this gives a better idea of the annuity’s actual returns.

Monday, January 29, 2018

Your Complete Guide to Factor-Based Investing

If you’ve ever wondered whether you should be taking advantage of the historically above average returns of small stocks, value stocks, momentum stocks, and other types of market anomalies, Your Complete Guide to Factor-Based Investing, by Andrew Berkin and Larry Swedroe, is the book for you. It’s based entirely on “evidence from peer-reviewed academic journals,” and it helped me focus my thoughts on the degree to which I want to pursue factors.

The authors begin with a treatment of the seven factors they consider “worthy of investment”: market beta, size, value, momentum, profitability and quality, term, and carry. For each of these factors they discuss persistence, pervasiveness, robustness, whether they are investable given real world concerns such as trading costs, and whether there are logical explanations for the existence of above-average returns.

In the case of size and value factors, “While small-cap stocks as a whole have provided higher returns (the size premium), small-cap growth stocks have produced below-market returns.” This is the reason why I invest in the exchange-traded fund VBR; it contains only small value stocks.

Financial institutions “are momentum traders, while private households are instead contrarians taking the other side.” If this is representative of who makes money from momentum and who loses, the ever-shrinking role of private households as direct stock investors would seem to point to a reduced momentum premium in the future. But I’m not making any predictions.

“While momentum has offered investors the highest risk-adjusted return of all the factors we have discussed, it also has a ‘dark side’ – it has experienced the worst crashes.” That’s enough to scare me off momentum investing, particularly now that I’m retired.

The carry factor consists of assets that yield a high return if the asset’s price remains the same. One example is choosing to hold the currency of a country with high interest rates. “Carry can be like picking up nickels in front of a steam roller. It has been profitable of the long term, but one must be sure they can handle being run over every so often.” That leaves me out.

After going through the investable factors, the authors address what has happened after factors are published. “You need to be aware that the publication of research on anomalies does lead to increased cash flows from investors seeking to gain exposure to their premiums, which can then lead to lower future realized returns.”

Throughout the book, each factor always gave impressive-looking returns, but the section on implementing a diversified portfolio of factors gave a single example where using factors boosted market returns by 0.3% annually, and standard deviation dropped by 1.8%. This shows that those readers who don’t understand the math behind the analysis can be fooled by seemingly big factor returns.

The book contains ten appendices, including one on smart beta: “while there really is in fact such a thing as smart beta, much of it is nothing more than a marketing gimmick – a repackaging of well-known factors.” Other appendices explain why dividends are not a factor, and why other possible factors were rejected based on the authors’ criteria.

In an appendix discussing the default factor for corporate bonds, the authors point out that “Like many risky assets, high-yield debt does not have a normal return distribution.” This criticism extends to virtually all of the academic analysis this book is based on. Stock returns don’t follow the normal distribution, making discussions of volatility, Sharpe ratios, and the entire capital-asset pricing model (CAPM) suspect. It’s a lot to ask, but I’d like to see factor analysis using a pricing model built on a stable distribution that better follows the fait tails we actually see in stocks returns. No model is perfect, but the normal distribution underestimates the probability of extreme events by such a huge margin that it treats extreme events essentially as though they can’t happen at all, which is dangerous.

Some important information for factor investors didn’t appear until the seventh appendix. “If a portfolio already has exposure to market beta, size, and value, adding exposure to momentum cannot contribute that much more in the way of incremental returns.” So, each factor looks impressive on its own, but combined they are less than the sum of their parts. “When adding exposure to additional factors, you may also increase the turnover of the portfolio, raising trading costs and reducing tax efficiency.”

The final appendix lists mutual funds and exchange-traded funds that give access to the investable factors. Some of the funds have quite high expense ratios. This represents costs that you pay whether the factors deliver higher returns or not. If we add other fund costs such as trading costs to the expense ratios, and we eliminate funds whose costs are above, say, 0.25% per year, some factors no longer seem investable.

Overall, I found this book very helpful in understanding factor-based investing. However, it’s not for the casual reader. A decent grasp of CAPM is needed to follow the discussion well. I don’t know if I’ve chosen the right level of factor tilts for the stock portion of my portfolio (80% market beta and 20% small value), but I’ve made my peace with my choices.

Wednesday, January 24, 2018

I’m Done with RRSPs

For years, a big personal financial focus for me and my family has been making annual RRSP contributions, but no more! I’m done with RRSPs. Or at least I’m done with contributing to them now that I’m retired.

It’s a strange feeling to contemplate starting to withdraw from RRSPs/RRIFs. Long-time successful savers often have a hard time turning off the saving habit, and I’m no different. My spreadsheets that contain multiple layers of conservative assumptions tell me how much I should be spending each month, but I rarely get there.

RRSPs are a great personal finance tool to reduce income taxes over a lifetime. But, barring unforeseen new sources of income, I expect that the RRSP room created by my 2017 income will go unused. Instead, I expect to make annual withdrawals starting at the end of 2018 to use up my lightly-taxed income room.

I’m interested in hearing from others about how it felt to transition from being savers to spenders.

Monday, January 22, 2018

The Incredible Shrinking Alpha

Over the decades it’s been getting harder to beat the average returns of purely mechanical investment strategies according to Larry Swedroe and Andrew Berkin in their book, The Incredible Shrinking Alpha. Looking for superior stocks may have been profitable many years ago for intelligent investors with the right temperament, but even the most brilliant money managers today usually fail to beat the markets.

In this short book, the authors go through their reasons for why markets have been getting tougher: there is less “dumb” money to exploit, the market is being “overgrazed,” and “the level of competition is getting ever tougher as better data and technology are used by ever more skilled managers.” Then they go on to give their prescription for how you should invest your money.

In the article Measuring Stock-Picking Skill, I explained the meanings of the terms alpha and beta in this context, and why I don’t fully agree with the authors when they try to prove that past successful investors didn’t have stock-picking skill. I won’t repeat this here.

To beat the market, you actually have to outperform other investors. To buy a stock that is cheap, you have to buy it from someone who is foolishly selling the stock at too low a price. So, if it were easy to beat the market there would have to be a large pool of terrible investors giving away their money. However, “there has been a substantial downward trend in the fraction of U.S. equity owned directly by individuals.” As time has passed, more and more assets have been controlled and invested by professionals.

Passive investors may get higher returns than the average active investor, but “Active managers play an important societal role—their actions determine security prices, which in turn determine how capital is allocated.” “Passive investors are ‘free riders.’” So, active investors benefit us all, but end up with lower returns, on average, for their trouble.

One of the reasons why alpha is hard to find is that “Alpha is a finite resource” and there are many brilliant professionals chasing their share. The authors’ prescription for how individual investors should handle their savings is diversify, invest in passive funds, and keep costs low.

I think this book is worth a read, especially for those who try to pick their own stocks. You should either convince yourself that the authors’ arguments don’t apply to you (I know they apply to me) or invest in indexes.

Friday, January 19, 2018

Short Takes: Minimum Wage, Index Investing, and more

Here are my posts for the past two weeks:

Dollars and Sense

Measuring Stock-Picking Skill

Underfunded Pensions

My Investment Return for 2017 

Here are some short takes and some weekend reading:

The Blunt Bean Counter brings us a thoughtful and balanced discussion of the minimum wage hike. He also discusses the importance of executors advertising for creditors.

Robb Engen at Boomer and Echo switched to index investing 3 years ago, and he explains how this has affected his life in terms of time, stress, and portfolio returns.

Canadian Couch Potato gives the Couch Potato portfolio returns for 2017. He also has a new podcast out where he interviews Shannon Lee Simmons, a fee-only financial planner and author of Worry-Free Money. During the podcast he explains that while cryptocurrencies may take over the world eventually, there is no guarantee that Bitcoin will be the winner. I’d say it’s not even likely.

Gail Vaz-Oxlade gives step-by-step instructions for getting out of debt in just 40 lines.

John Robertson compares the costs of Robo-advisors and DIY investing approaches. His comparison is relevant to those who could handle any of the choices but are looking for the right personal cost/hassle trade-off.

Big Cajun Man anticipates the day when we’ll interact with large businesses through chatbots. I’m not sure how widespread their use is right now.

Thursday, January 18, 2018

My Investment Return for 2017

Stock markets gave us above-average returns again this year, even measured in Canadian dollars that rose in value relative to U.S. dollars during 2017. My internal rate of return (IRR) that takes into account cash flows was 12.17%.

A big change for me this year is that at mid-year I retired from my job. It was a tough decision to walk away from a comfortable income, but the family portfolio sits at about 35% above what I calculate we’ll need to make it to age 100. This is a pretty healthy margin in case the stock market crashes, perhaps even healthy enough by my wife’s standards.

I don’t know if I’ll stay retired, but I seriously doubt I’ll ever work full-time again. I may do consulting work if the mood strikes and the work is interesting.

With retirement comes some fixed-income investments. I’ve written before about my intention to keep 5 years’ worth of family spending in safe investments. So, my portfolio that used to be 100% stocks now contains cash and GICs. The percentage in cash will grow with my age according to my spreadsheet calculations.

My benchmark changed for this year as well. In addition to fixed allocations to exchange-traded funds VCN, VTI, VBR, and VXUS, my benchmark has an allocation to cash. My benchmark return for 2017 was 10.60%. My actual return was higher primarily because I was slow in selling stocks to create cash. My returns were boosted by the ever-rising stock markets. If stocks had crashed, I could have lost out by not filling my cash allocation immediately.

I have a spreadsheet set up that dictates all my actions with the ETFs in my portfolio. I do this to eliminate making my own foolish choices in the moment. I haven’t yet automated the cash part of my portfolio. This happened to work out well for me this year, but I prefer to automate everything and wait for my spreadsheet to tell me what to do.

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

I had a spectacularly lucky 1999 where I took a wild chance and won. For the next decade I gave away some of these gains, and for the last several years my indexed portfolio’s actual returns haven’t deviated much from my benchmark returns. It’s good to know that the money I had invested in 1994 has grown to the point where it can buy 7 times as many loaves of bread.

Over my investing history, my compound real return (which factors out inflation) has been 8.72% annually. I have outperformed my benchmark by a compound average of 3.02% annually. Both figures are almost certain to drop in the coming years. For planning purposes, I assume that my stocks will average 4% above inflation, and that cash will just match inflation.

It’s inevitable that your portfolio actions won’t exactly match your investment plan, even if you’re an indexer. In part, I do these calculations to see whether the deviations from my plan are costing me money. When you think you’re being clever, it’s important to see if in reality you’re being dumb, unless protecting your ego is more important to you than money.

Tuesday, January 16, 2018

Underfunded Pensions

The plight of Sears Canada pensioners has been in the news lately. After reading about the hardships created by pension cuts, it’s natural to think about what we should do to prevent this in the future.

Some, like Jen Gerson, question whether pension plans should have higher priority than they do now when divvying up the assets of a bankrupt business like Sears Canada. However, the side effect of doing this is that suppliers would be less willing to extend credit to any business with an underfunded pension, and this would drive struggling businesses into bankruptcy sooner. This is a difficult choice to make when you’re still hoping that a weak business can get back on its feet.

However, the Sears Canada case looks far different from a plucky business doing all it can to survive. “While Sears’ shareholders pocketed payouts of $3.5 billion, the chain’s pension plans remained underfunded to the tune of $270 million.” Why are owners allowed to pull assets out of a business that owes money to its pension plan?

I can see where a company with a regular modest-sized dividend might be harmed if it’s forced to suspend the dividend. However, in this case, Sears Canada paid special large dividends. It seems appropriate to me to limit a company’s ability to pay dividends while its pension plan is underfunded. By itself this won’t prevent all cases of pension cuts, but it would make it harder to drain assets from a business at the expense of pensioners.

Friday, January 12, 2018

Measuring Stock-Picking Skill

Deciding whether someone has skill in picking stocks that will give higher than average returns is a tricky business. You’d think that having a long-term track record of beating the market would be proof. However, some have found ways to argue that such records aren’t proof at all. I have my doubts about the arguments.

When investment managers have the ability to pick superior stocks, we call this alpha. If they beat the market averages by 2% per year, we say that they have an alpha of 2%. When we just invest in market index funds, we call the source of these returns beta. These returns come from putting your money at risk, but they don’t come from investment skill.

Complicating the situation is the existence of types of stocks that give superior returns. It’s well known that stock in small businesses and low-priced businesses have given superior returns over the long run. Such categories of stocks are called factors. These two examples are called the size factor and value factor. There are other lesser-known factors (e.g., momentum). Researchers are finding new possible factors all the time.

In the first chapter of their book The Incredible Shrinking Alpha, Larry Swedroe and Andrew Berkin argue that if we invest in factor stocks rather than just a regular index, the outperformance we get isn’t really alpha; it’s just another kind of beta. By this they mean that we’re not showing stock-picking skill; we’re just invested in a category of stocks know to perform better than others.

Swedroe and Berkin go on to use factors to show that investors with strong long-term investment records did it with various types of factor-based beta rather than using alpha. I have concerns about this type of argument.

My main concern is best illustrated by taking factors to an extreme. Suppose we invent so many fine-grained factors that each factor actually represents just a single stock instead of a broad class of stocks. Then by definition, alpha is impossible. Whatever stocks you pick, there are corresponding factors saying your returns are the due to beta rather than alpha.

Now, I’m not saying that factor research has gone this far, but there is no guarantee that any given factor will persist into the future. Suppose that in the next 50 years a given factor disappears because we were guilty of data mining or for some other reason. Past investors should be given credit for alpha when they recognized stocks covered by this phantom factor as undervalued.

Factor researchers work hard to avoid data-mining. They look for sensible reasons why a factor should exist in addition to just observing it’s outperformance in returns data. However, even 100 years of stock returns is only a modest amount of data. We can’t eliminate the possibility of data mining. There are a few factors that seem fairly solid, but a great many others are not.

When we examine investment records during periods of time long before the existence of a given factor was widely-known, declaring an investor’s performance to be “merely beta” seems like 20/20 hindsight. On the other hand, if a modern era investment manager used well-known factors to increase returns, we’re justified in saying any outperformance is the result of beta, not alpha.

Of course, the main point of the book that it’s not worth it to pursue alpha still stands. Alpha is scarce and trying to get it can be very expensive. I’m not a fan of venturing too far into the world of factors either. Pursuing factors increases investment costs. If the factors don’t outperform by as much as we hope, the net effect may be lower returns.

Wednesday, January 10, 2018

Dollars and Sense

If you think you spend money rationally and that businesses can’t manipulate you into spending more than you should, you probably haven’t read a recent book by Dan Ariely and Jeff Kreisler, Dollars and Sense: How We Misthink Money and How to Spend Smarter. The authors explain many of our financial “quirks” and offer ways to compensate for or even harness our irrational tendencies.

One of our common errors is to make spending decisions based on irrelevant comparisons. A good example is sale prices. Just because a crappy shirt has a $100 price tag on it and is marked down to $60 doesn’t mean it’s worth $100 or that anyone ever paid that price. It may still be a terrible deal at $60, and you definitely aren’t saving $40 by buying it.

The comparison we really should be making is whether owning the shirt is better than the other things we could buy for $60. But that’s harder than looking at the $100 “regular price” and deciding we’re getting a deal. “When we can’t evaluate something directly, as is often the case, we associate price with value.”

Some other mistakes we make are spending more when the method of payment is easier, overvaluing things because we own them, and giving in to the temptations of the present. The authors explain each of these and more with entertaining examples.

In an example of mental accounting, the authors explain that “people who feel guilty about how they got money will often donate part of it to charity.” This means that “How we spend money depends upon how we feel about the money.” Presumably, donating some of the money somehow cleans the rest of it in our minds.

The authors make an observation that I think applies far more generally than just financial decisions: “There is no limit to the effort people will make just to avoid thinking.”

The genius of credit cards is that because the real payment will be made at some point in the future, “they lessen our current pain of paying.” But then when the credit card bill comes, “we feel like we already paid at the restaurant.”

In an interesting experiment, employees in a company savings program were given the company matching amount up front each month, and then if the employee didn’t make a full contribution, they were given a statement saying “We prefunded the account with $500, you contributed $100, and the company took back $400.” This is an interesting way to harness loss aversion to get people to save more.

Over very short time periods, stocks are down almost as often as they are up. But we feel losses about twice as strongly as gains, so watching your portfolio daily will make you feel bad. The authors’ remedy is to look at your investments infrequently because the longer the time period, the more likely it is that stocks are up. Of course, this works best if you have a portfolio that doesn’t require monitoring, such as indexed investments.

We have a tendency of overvalue effort over experience. We’re happy to pay a tradesperson who takes a long time and seems to work hard. But if a highly skilled person finishes a job quickly and with high quality, we balk at paying what seems like a high price for the (apparently) low effort required.

“If we have a root canal coming in a week, it can ruin every day leading up to it.” Anticipation can multiply the impact of both positive and negative experiences. This is why when my son was having surgery and the hospital called to offer a nearer date, I jumped at the chance to end the family misery sooner.

An unfortunate example of expectations affecting performance is that “When you remind women that they are women, they expect to perform worse on mathematics tasks and they actually do perform worse on those tasks.”

In experiments involving brain scanning, researchers found that “branding doesn’t just make people say they enjoyed things more; it actually makes these things more enjoyable inside their brains.”

In the shake-your-head department, a survey found that “46 percent of financial planners didn’t have financial plans themselves.”

When it comes to big financial decisions, it’s hard to decide based on some big numbers. The authors suggest working out what you’re giving up in non-financial terms. For example, when deciding whether to buy a bigger house, we might think “the bigger house costs me the same as the smaller house plus one yearly vacation, a semester of college for each of my children, and an additional three years of working before retirement.”

On the importance of understanding the issues discussed in this book: “the struggle to improve our financial decision-making isn’t just a struggle against our personal flaws; it’s also against systems designed to exacerbate those flaws and take advantage of our shortcomings.” So, businesses know how to push our buttons and get us to spend more.

In conclusion, this book explains our many decision-making flaws and offers suggestions for making better choices in realistic ways. I find the writing clear and entertaining. It’s definitely worth a read.

Friday, January 5, 2018

Short Takes: Optimism, CPP Changes, and more

I wrote one post over the holidays:

Dalbar’s Measure of Investor Underperformance is Wrong 

Here are some short takes and some weekend reading:

Warren Buffett says “most American children are going to live far better than their parents did.” His sensibly optimistic essay is a good antidote to the pessimistic hand-wringing over lost jobs due to automation. However, he does warn that we have to make sure people at all economic levels share in the gains that are certainly coming.

Doug Runchey at Retire Happy explains the 5 proposed changes to CPP agreed to by the federal and provincial Ministers of Finance.

Mr. Money Mustache explains why you shouldn’t invest in bitcoin. He shows that he understands the issues very well.

The Blunt Bean Counter looks at the revised rules on taxing income sprinkling.

Big Cajun Man makes some financial predictions for 2018. I find it interesting that Canadians love to predict that the Canadian dollar will rise against the U.S. dollar. Of course, nobody knows what will happen to the dollar.

Wednesday, January 3, 2018

Dalbar’s Measure of Investor Underperformance is Wrong

Every year market research firm Dalbar reports how investors’ mutual fund returns compare to market benchmarks. The results get reported widely and are always dismal. In one example, Seeking Alpha says “Investors Suck at Investing.” A few people have criticized Dalbar’s methodology, which isn’t surprising given the large number of people who see their reports. What I did find surprising is that this criticism isn’t just nitpicking; Dalbar’s calculations significantly overstate investor underperformance.

According to Dalbar’s 2016 Quantitative Analysis of Investor Behavior,

In 2015, the 20-year annualized S&P return was 8.19% while the 20-year annualized return for the average equity mutual fund investor was only 4.67%, a gap of 3.52%.

So, for the 20 years from the start of 1996 to the end of 2015, equity mutual fund investors’ actual returns were supposedly 3.52% per year lower than the stock market average. Over the full 20 years, this works out to investors ending up with 48% smaller portfolios than they could have had.

This is a huge gap. To find the source of this gap, we need to start with how Dalbar calculates investors’ returns.

Dalbar’s calculation method

We can describe Dalbar’s calculation method quite simply. We need the following 3 quantities:

A – starting mutual fund assets at the beginning of the 20 years
B – ending mutual fund assets after 20 years
F – net flow into mutual funds from deposits and withdrawals during the 20 years

We begin by treating all the deposits and withdrawals as though they happened at the start of the 20 years. So the cost basis C is

C = A + F,

and the return over the 20 years is

R = B – C.

Then the 20-year return is


and the annualized return is

(1 + R/C)^(1/20) – 1.

For the 20 years ending in 2015, Dalbar used this method to get the annual investor return of 4.67%. Then they compared this to the 20-year annualized S&P return of 8.19%.

Dalbar attributes this huge gap to poor choices by investors collectively: “Over and over, it emerged that the leading cause of the diminished return is the investors’ own behavior.” However, a big part of this gap has to do with the flawed way they calculate investor returns, as I’ll show after going through other criticisms of Dalbar’s methodology.

Sequence of returns

Harry Sit says “DALBAR’s methodology confounds the impact of investor behavior and the simple consequences of return sequences.” Because new money is added to mutual funds over time, less money is invested in early years more in later years.

Referencing Dalbar’s 2012 report, Sit says “it’s entirely possible that some or all of the low DALBAR investor returns are simply due to the fact that markets rose for the first half of their time sample (the 1990s) and were flat for the second half (the 2000s).”

There is some truth to Sit’s criticism about sequences of returns, but there’s a better explanation for the huge gap Dalbar finds that I’ll get to below.

Where is the missing money?

Michael Edesess, Kwok L. Tsui, Carol Fabbri, and George Peacock made a point similar to Sit’s about the effect of the sequence of returns. They also made another interesting observation:

If some investors – say, the individual investors who are the main subject of the DALBAR study – systematically underperform the market, then there must be some other group that systematically outperforms the market. The trouble is, there is no evidence of any such group. One would think that if individual investors underperform the market, then it must be professional investors who outperform the market.

But they don’t. Study after study after study shows that professional investors do not, on average and in aggregate, outperform the market. So it simply can’t be true that individual investors as a group systematically underperform the market.

This doesn’t prove there is anything wrong with Dalbar’s calculations, but it creates an apparent paradox that needs to be resolved one way or another.

Moving cash flows to the start of the study period

Recall that for the calculation of investor returns, Dalbar treats all mutual fund deposits and withdrawals as though they took place at the start of the 20-year period. Wade Phau explains that this unfairly penalizes the returns of dollar-cost averaging investors.

One part of Dalbar’s report looks at the returns of investors who make regular equal-sized investments over the full 20-year period. Pfau explains that an investor who deposits a total of $10,000 steadily over the 20 years will end up with less money than an investor who deposits a lump sum of $10,000 at the beginning of the 20 years: “It is naturally less, because contributions were made more gradually over time and experienced less opportunity to grow as the market rose. On average, the contributions were invested for a much shorter period.”

Dalbar takes the dollar-cost averaging investor’s final portfolio value and calculates an annual return based on the assumption that this investor had actually deposited a lump sum of $10,000 at the beginning of the 20 years. This method gives an unfairly low return.

To fix this problem, Pfau says “the annualized investment return for this scenario requires calculating an internal rate-of-return for the ongoing cash flows that accurately reflects when the investments were made.” Instead of moving all cash flows to the start of the 20 years, Pfau says we must leave the cash flows where they are and calculate the internal rate of return (IRR).

This criticism is clearly valid for the dollar-cost averaging investor return calculation, but it’s less clear how important it is for the calculation of the overall investor return gap where cash flows are smaller relative to total mutual fund assets.

So, this left me unsure of whether Pfau’s criticism of Dalbar’s methodology in calculating the investor return gap is important or just a nitpick. The short answer is that it’s important as I’ll show.

A Thought Experiment

Let’s imagine a world where stocks give the same return every month, and cash flows perfectly steadily into equity mutual funds. To match Dalbar’s 1996-2015 study period, stocks in this world will give returns of exactly 8.19% every year.

I went to the Investment Company Institute to get information on equity mutual fund deposits and withdrawals. From 1996 to the end of 2015, net flows swelled equity mutual fund assets by a compound average of 2.12% per year. Of course, money flowed in and out at different rates from year to year, but in our hypothetical smooth world, flows will come in perfectly smoothly amounting to 2.12% each year. Investment returns then grow assets by an additional 8.19% each year.

In this smooth world, it’s not possible for investors to make good or bad choices about investment timing. After all, stock returns are perfectly steady, and investor money flows perfectly smoothly into mutual funds. Dalbar’s gap calculation should give zero in this case.

However, if we calculate investors’ return using Dalbar’s method, we get 5.90%, which gives a gap of 2.29% to the market return of 8.19%. So, the error introduced by Dalbar’s methodology can make a big difference.

If we use the internal rate of return to calculate investor return in this smooth world, the gap is zero, as it should be. This doesn’t necessarily mean that using IRR is the best way to compute investor returns, but we do know that Dalbar’s method is seriously flawed.

Dalbar’s response to Pfau

Pfau’s article includes responses from Dalbar defending their methodology. They say that their “study was developed to quantify the widely held view by investors that the returns they received were different from what was publicly reported.”

For an investor to judge his investments consistent with Dalbar’s return calculation method, he’d have to perform an unusual calculation. Suppose I’ve been investing in equity mutual funds for 20 years. If I look up the market return of 8.19% per year, I can calculate the full 20-year return of 383%. Suppose the total of my total contributions to mutual funds over the 20 years was $100,000. Am I really going to be confused about the fact that my portfolio value isn’t $483,000 when I know most of my money was invested for less than 20 years? The fact that my portfolio value is less than $483,000 has nothing to do with my poor market timing.

When we take my actual portfolio value and calculate my annual return as though I had invested the full $100,000 20 years ago, the gap between that return and the 8.19% market return also has nothing to do with my poor market timing.

This calculation is not a meaningful measure of my returns. We can take this to a more ridiculous extreme. Suppose that we measure my 50-year return by assuming I invested the whole $100,000 50 years ago. Now the return gap is even bigger. Dalbar encourages us to treat their calculated percentage as a meaningful measure of investor return when they say “the 20-year annualized S&P return was 8.19% while the 20-year annualized return for the average equity mutual fund investor was only 4.67%, a gap of 3.52%.” However, their calculations plainly do not give a sensible measure of investor returns.


Mutual fund investors might be poor market timers, but Dalbar fails to measure this effect correctly. As long as there are net inflows to mutual funds, Dalbar’s methodology will continue to overstate how much investors underperform their investments.