Friday, September 11, 2020

Short Takes: Mortgage Deferrals, Financial Optimism, and more

I wrote one post in the past two weeks in the form of a quiz:

A Quiz on the 4% Rule

Here are some short takes and some weekend reading:

Rate Spy has some statistics about Canadian mortgage deferrers who are soon to have to start making payments again.  How much this will affect the housing market is anyone’s guess.

Morgan Housel explains why we should save like pessimists and invest like optimists.  I would add that we should avoid debt like pessimists as well.

Robb Engen at Boomer and Echo asks whether he has already achieved FIRE (Financial Independence Retire Early).  FIRE gets used to mean so many different things that it’s hard to say.  To me, financial independence means not needing income from work ever again.  So, Robb doesn’t pass this test.  I define retirement as being free from demands on my time that I can’t ignore because I need the money.  Robb doesn’t pass this test either.  However, to many people FIRE means quitting the job they don’t like to work at something they much prefer.  Robb does pass this test.

Thursday, September 3, 2020

A Quiz on the 4% Rule

Reporters and bloggers write endlessly about William Bengen’s 4% rule for retirement spending, but its details are widely misunderstood.  So, I’ve created a short quiz to test your knowledge of this rule.  I give answers below, but this isn’t multiple choice, so you’ll have to decide for yourself how closely your answers match reality.

  1. Jane retired a year ago with $500,000 saved.  She is using the 4% rule, so she initially withdrew $20,000 to spend during her first year of retirement.  Today it’s time for her next withdrawal, and her portfolio has grown from $480,000 to $505,000.  Inflation was 2%, and she’s now 66 years old.  To follow the 4% rule, how much should she withdraw today?

  2. Jane pays a hefty 2.5% MER on her mutual funds.  If she reduces her costs to only 0.5% per year, how does that change her withdrawals under the 4% rule?

  3. Tom saved aggressively during his working years and retired at 45.  How does the 4% rule apply in his case?

  4. Jim is a very conservative investor.  He invests only in GICs and bonds.  Does the 4% rule apply in his case?

  5. We can’t count on getting the same returns that U.S. investors got during the period of Bengen’s study.  How does this affect the 4% rule?

  6. Is there anything we can do to increase our safe portfolio spending level, other than shortening our retirements?


Answers below:

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  1. To follow the 4% rule, Jane should withdraw $20,400, which is her original $20,000 increased by 2% inflation; the rest of the figures in the question are irrelevant.  If you answered $20,200 (4% of the new portfolio value), you’re not alone; this is a common misconception.  The 4% rule ignores portfolio performance after retiring.  The percentage of your portfolio you spend each year after the first year will depend on how much it has grown or shrunk.  You just keep spending the same inflation-adjusted amount each year and hope your money doesn’t run out.  If instead you spend 4% of your updated portfolio value each year, you’re guaranteed to leave a sizable inheritance, and your odds of having your inflation-adjusted spending decline alarmingly over the years is quite high.  If you answered $20,000 because you thought spending stayed constant over the years, you’re close.  The idea is that spending after adjusting for inflation stays constant.

  2. William Bengen’s original study took no account of portfolio costs.  He used historical U.S. stock market returns to establish his 4% rule.  So, to follow the 4% rule strictly, Jane’s withdrawals wouldn’t change.  It’s tempting to say that because Jane is saving 2% each year, she can bump up her withdrawals to 6% of her original portfolio size (rising with inflation).  However, there are two problems with this.  The first problem is that as Jane’s portfolio shrinks (in a scenario where returns are weak), the 2% MER savings on a smaller portfolio don’t fully offset 2% higher withdrawals calculated on the starting portfolio value.  On average, saving 2% on costs makes safe withdrawals only about 1% higher.  The second problem is that Jane’s high-cost portfolio couldn’t really handle spending at 4% of the starting portfolio size.  In reality, repeating Bengen’s study to account for costs would have Jane using a little less than a 3% rule.  So, by reducing her costs, she is improving the chances that she won’t run out of money with the 4% rule, but she probably shouldn’t increase her planned withdrawals.

  3. The part of Bengen’s study that produced the 4% rule assumed 30-year retirements.  This would take Tom only to age 75.  So, the original 4% rule doesn’t apply well in his case.  He expects to have a long retirement, and has to reduce the spending amount from his portfolio somewhat to compensate.

  4. Bengen’s 4% rule came from portfolios 50-75% in U.S. stocks, and the rest in bonds.  This doesn’t apply to Jim’s case.  Suppose Jim expects the returns on his GICs and bonds to match inflation.  Then he can just divide the length of his retirement into 100%.  For example, to cover 40 years of retirement, Jim can spend 2.5% per year rising with inflation.

  5. The 4% rule is based on the worst-case starting year of retirement.  In U.S. data, the worst periods include the aftermath of the 1929 stock market crash and the poor inflation-adjusted stock returns from the late 1960s to the early 1980s.  So, the important question is how likely your returns are to be worse than these periods.  The eye-popping U.S. returns in other time periods isn’t relevant.  So, the fact that experts believe future returns won’t match historical U.S. returns isn’t a positive thing for your retirement, but it’s not as bad as it seems for the 4% rule.  Adjusting down to a 3.5% rule may be sufficiently safe.  Having to reduce the withdrawal percentage further by about half of portfolio costs is a bigger concern for many Canadians.

  6. Yes.  We can be more flexible with changes to the amount we spend each year.  This means being prepared to spend less if returns disappoint.  Bengen’s study assumed no flexibility at all.  At the other extreme of very high spending flexibility, we could use something like the table of RRIF withdrawal percentages that tell you how much of your current portfolio to withdraw each year.  These percentages are probably about right for someone paying about 1% each year in portfolio fees.  However, this plan could have your inflation-adjusted spending level change drastically over the course of a few years.  Not all of us can be this flexible.  There are intermediate levels of flexibility with plans that set spending floors and ceilings.  However, the less flexible your spending plan, the lower your starting spending level needs to be.

Friday, August 28, 2020

Short Takes: Socially Responsible Investing, Future Returns, and more

Here are my posts for the past two weeks:

The Intelligent Investor


Count on Yourself


Here are some short takes and some weekend reading:

Mr. Money Mustache explains an easy way to go about socially responsible investing.  He also describes all he is doing in this area.

Justin Bender estimates future return rates for Vanguard Canada’s asset allocation ETFs (VCIP, VCNS, VBAL, VGRO, VEQT).  They’re not very high because stock and bond prices are very high right now.

Neil Gross
isn’t impressed with proposed changes to the Ontario Securities Commission’s mandate.

Big Cajun Man is getting free online access to his credit report due to a data breach.  It’s crazy that he can’t get them to spell his name right.  My TransUnion credit report swapped my home address with my brother’s home address for a few years, and I can’t get that fixed either.  They even use this address in authentication questions before they’ll send me a free credit report.

Tuesday, August 25, 2020

Count on Yourself

Author and personal finance columnist Alison Griffiths wrote the book Count on Yourself aimed at beginning investors to teach them do-it-yourself index investing.  She takes a gentle approach starting with interesting stories and working in financial material slowly.  This approach works well initially, but the final range of recommendations allows so many possibilities that many readers will remain confused about what to do with their investments.  Published in 2012, much of the detailed information about discount brokerages and index ETFs and mutual funds is now out of date.

A strong part of the book is the explanation of why low-cost index investing is better than the expensive mutual funds most Canadians own.  She makes this case with stories and case studies presented in a way that is accessible to the many Canadians who know little about investing.  Today, you could simplify the recommendations for the novice investor down to just choosing one of Vanguard Canada’s asset allocation ETFs.

Griffiths shows that she gets people’s aversion to figuring out the many financial aspects of their lives: “Have you ever compared extended medical/dental plan rates among the various insurers?  I have.  It takes days and brings on a sudden urge to clean the basement.”  She recommends trimming the list of financial things in our lives, including credit card balance insurance, retail credit cards, and extended warranties.

Much of the first half of the book is aimed at women, including some musing about “if all the world’s financial affairs had been turned over to women.”  In my limited experience, many male leaders are self-centered and ruthless, and when a woman rises to the top, she’s not much different.

One piece of bizarre advice is if you have a high tolerance for risk, “go ahead and be a day trader, dabble in foreign exchange, or play the options market.”  It’s one thing to increase your expected return with higher-risk assets, like more stocks or small-cap value stocks, but it makes no sense to do things that reduce your expected return.

Another piece of advice that makes little sense to me is to avoid owning stocks in a TFSA.  For anyone using a TFSA for short- or medium-term savings, this makes some sense.  However, some investors, like myself, use TFSAs for long-term savings.  There’s nothing wrong with owning stocks in a TFSA in this situation.

To reduce the numbers of ETF choices, Griffiths stated the criteria she used for selection.  I liked the bond ETF criteria: avoid high yield bonds, longer-term bonds, and MERs over 0.5%.  She says that “bonds have a specific job to do in a passive portfolio, and that is to provide income safety.”

One piece of advice you don’t see many places is to allow small monthly contributions to build up for a few months before investing to reduce commission costs.  For investors who pay commissions when buying ETFs, this is sensible.  The same would apply for selling investments after retirement.

Another curious piece of advice “for the math challenged” who “have trouble working out percentages”: “call up your brokerage … and tell them how much you have to invest and what your breakdown (asset allocation) is, and they’ll tell you how many units you should buy.”

In conclusion, parts of this book may be useful for novice investors who need to be eased into understanding personal finance, investing, and the rationale for avoiding expensive mutual funds.  However, the detailed recommendations are too complex and now out of date for this type of reader.

Thursday, August 20, 2020

The Intelligent Investor

Warren Buffett credits Benjamin Graham with writing “by far the best book about investing ever written,” The Intelligent Investor. It holds a mythical status among value investors. Graham produced four editions from 1949 to 1973. I read the revised edition, which is Graham’s 1973 edition with added material from Jason Zweig in 2003 to explain parts of the book and to add more modern examples.

For anyone planning to read this book, I recommend Zweig’s revised edition. Graham’s writing is at times subtle and indirect, and assumes knowledge of historical context that may be unfamiliar to readers so many decades later. Zweig does an excellent job of clarifying Graham’s meaning at critical points.

This book is filled with Graham’s widely-quoted ideas, including the distinction between investors and speculators, the Mr. Market parable, and margin of safety. I won’t explain these ideas here.

The most remarkable part of the book is in Graham’s 1973 Introduction:

“The determining trait of the enterprising (or active, or aggressive) investor is his willingness to devote time and care to the selection of securities that are both sound and more attractive than the average. Over many decades an enterprising investor of this sort could expect a worthwhile reward for his extra skill and effort, in the form of a better average return than that realized by the passive investor. We have some doubt whether a really substantial extra recompense is promised to the active investor under today’s conditions. But next year or the years after may well be different. We shall accordingly continue to devote attention to the possibilities for enterprising investment, as they existed in former periods and may return.”

What intellectual honesty! He is saying that while his methods worked in the past, they may not work any more because markets have changed. A few years later (1976), Graham was more certain about the demise of his value investing ideas:

“I am no longer an advocate of elaborate techniques of security analysis in order to find superior value opportunities. This was a rewarding activity, say, 40 years ago, when our textbook ‘Graham and Dodd’ was first published; but the situation has changed a great deal since then. In the old days any well-trained security analyst could do a good professional job of selecting undervalued issues through detailed studies; but in the light of the enormous amount of research now being carried on, I doubt whether in most cases such extensive efforts will generate sufficiently superior selections to justify their cost.”

One may ask what value this book has if its author no longer believes in its ideas. One answer is that some parts of the book are relevant to investors who have no intention of picking individual stocks, particularly Zweig’s added material. Another answer is that readers who decide to pursue value investing despite Graham’s warnings will benefit. They may not beat the market, but Graham’s ideas will help them limit downside risk.

In an appendix, Buffett convincingly defends the existence of superior investors (who were Graham’s students) against claims that efficient markets eliminate this possibility. This material comes from a speech Buffett made in 1984, well after Graham gave up on his stock-picking methods. One way to reconcile this seeming contradiction is that Graham’s best students found ways to grow beyond his teachings to outperform through stock picking in later, more difficult markets.

This fact may give the modern aspiring value investor hope. However, each new decade has seen a big increase in competitiveness of markets. Even the great Buffett seems unable to outperform any more. It may be that he is working with too much money or that he’s too old now. But it might be that markets keep getting harder and harder to beat. Even if Buffett is still a superior investor in today’s competitive markets, other value investors have to question whether they are elite enough to beat the market. And if they can’t, they are getting zero compensation (or even negative compensation) for their extra effort compared to just buying index funds.

Anyone can “equal the performance of the market averages” by “owning a representative list” (index investing). But Graham warned: “If you merely try to bring just a little extra knowledge and cleverness to bear upon your investment program, instead of realizing a little better than normal results, you may well find that you have done worse.” Unfortunately, the definition of “just a little extra knowledge” has grown substantially as markets have become more competitive.

One area that Graham warned investors to avoid was Initial Public Offerings (IPOs). He said they come out in force in bull markets and investors get burned. The tech bubble in the late 1990s showed that not much has changed.

Some of Graham’s teachings are relevant to all stock investors whether they pick individual stocks or not. “It is absurd to think that the general public can ever make money out of market forecasts.” Investors shouldn’t allow themselves “to be stampeded or unduly worried by unjustified market declines.”

Some of the best quotes in the book come from material added by Zweig:

On Jim Cramer’s stock picks: “By year-end 2002, one in 10 had already gone bankrupt.” “Perhaps Cramer meant that his stocks would be ‘winners’ not ‘in the new world,’ but in the world to come.”

On the Motley Fool: “The Foolish Four … was one of the most cockamamie stock-picking formulas ever concocted.”

On asset allocation percentages: “Once you set these target percentages, change them only as your life circumstances change. Do not buy more stocks because the stock market has gone up; do not sell them because it has gone down.”

When a company is “paying a fat dividend on its preferred stock,” “you should approach its preferred shares as you would approach an unrefrigerated dead fish.”

On Peter Lynch’s “buy what you know”: “To his credit, Lynch insists that no one should ever invest in a company, no matter how great its products or how crowded its parking lot, without studying its financial statements and estimating its business value.”

“You and no one but you, must investigate (before you hand over your money) whether an advisor is trustworthy and charges reasonable fees.”

On index investing: “By enabling you to say ‘I don’t know and I don’t care,’ a permanent autopilot liberates you from the feeling that you need to forecast what the financial markets are about to do–and the illusion that anyone else can”

“Day trading–holding stocks for a few hours at a time–is one of the best weapons ever invented for committing financial suicide.”

“The single best choice for this lifelong holding is a total stock-market index fund. Sell only when you need the cash.”

“Late in his life, Graham praised index funds as the best choice for individual investors, as does Warren Buffett.”

On what it takes to pick stocks: “begin by downloading at least five years’ worth of annual reports.” “Then comb through the financial statements.” This should be enough for most individual investors to realize that they’re not really stock-pickers. “If the steps in this chapter sound like too much work to you, then you are not temperamentally well suited to picking your own stocks.”

On mutual fund studies: “mutual funds, on average, underperform the market by a margin roughly equal to their operating expenses and trading costs.” This “has been reconfirmed so many times that anyone who doubts them should found a financial chapter of The Flat Earth Society.”

On covered call strategies: “For individual investors, covering your downside is never worth surrendering most of your upside.”

“For most investors, diversification is the simplest and cheapest way to widen your margin of safety.”

Despite being revered by value investors, it’s doubtful that this book will help anyone beat today’s markets. However, anyone who intends to try to beat the markets should consider this book to be mandatory reading, if for no other reason than to limit losses. Graham gave up on his stock-picking methods, and so should almost all individual investors.