Friday, July 15, 2022

Short Takes: Savings Account Interest, Reverse Mortgages, and more

EQ Bank says they’re “excited to announce an increased interest rate!”  It’s now 1.65%.  Meanwhile, Saven is up to 2.85%.  Unfortunately, Saven is only available to Ontarians.  It’s normal for banks to offer different rates, but the gap down to EQ is disappointing.  Fortunately, the fix is easy; with just a few clicks, my cash savings are mostly in Saven.

Here are my posts for the past four weeks:

A Failure to Understand Rebalancing

Portfolio Projection Assumptions Use and Abuse

Here are some short takes and some weekend reading:

Jason Heath explains the advantages and disadvantages of reverse mortgages compared to other options.  He does a good job of covering the important issues, but doesn’t mention home maintenance.  With reverse mortgages, the homeowner is required to maintain the house to a set standard.  It’s normal for people’s standards for home maintenance to decline as they age, sometimes drastically when they don’t move well and can’t afford to pay someone else to do necessary work.  Reverse mortgage companies have no reason to go around forcing seniors out of poorly-maintained homes now, but once they have a lot of customers who owe more than their homes are worth after costs, their attitude is likely to change.

Robb Engen at Boomer and Echo
defends some aspects of mental accounting and sees problems with others.  Here is my thinking.  I see some forms of mental accounting as a rational response to the fact that the time and effort we put into making decisions has a cost. So, if we’re trying to be rational and account for all relevant costs when making decisions, we have to limit the time we spend making decisions. This necessarily means using easy rules of thumb (or mental accounting rules) that we only examine infrequently.  However, these rules of thumb do have to be examined occasionally to make sure they’re not wrong.

Big Cajun Man
says Nortel is still paying him tiny amounts he’s owed.  He also makes a good point about clutter costing money.

Thursday, July 7, 2022

Portfolio Projection Assumptions Use and Abuse

FP Canada Standards Council puts out a set of portfolio projection assumption guidelines for financial advisors to use when projecting the future of their clients’ portfolios.  The 2022 version of these guidelines appear to be reasonable, but that doesn’t mean they will be used properly.

The guidelines contain many figures, but let’s focus on a 60/40 portfolio that is 5% cash, 35% fixed income, 20% Canadian stocks, 30% foreign developed-market stocks, and 10% emerging-market stocks.  For this portfolio, the guidelines call for a 5.1% annual return with 2.1% inflation.  This works out to a 2.9% real return (after subtracting inflation).

We’ve had a spike in inflation recently, but these projections are intended for a longer-term view.  The projected 2.9% real return seems sensible enough.  Presumably, if inflation stays high, then companies will get higher prices, higher profits, their stock prices will rise, and the 2.9% real return estimate will remain reasonable.  Anything can happen, but a sensible range of possibilities is centered on about 3%.

However, the projections document has an important caveat: “Note that the administrative and investment management fees paid by clients both for products and advice must be subtracted to obtain the net return.”  For a typical advised client, total fees for products and advice can be around 2%, leaving only a real return of 0.9% for the client.

This creates a dilemma for the advisor: to use 2.9% and conveniently forget to subtract fees, or use the embarrassingly low 0.9% that will surely make clients unhappy.  It’s easy enough to justify using the larger figure; just pretend that great mutual fund selection will make up for the fees, even though all the evidence proves that this rarely happens.

But it gets worse.  The guidelines offer some flexibility: “financial planners may deviate within plus or minus 0.5% from the rate of return assumptions and continue to be in compliance with the Guidelines.”  So, unscrupulous advisors can lower inflation by 0.5% and raise all return assumptions by 0.5% to get a 3.9% expected return assumption (if they conveniently forget about fees) and still claim to be following the guidelines.

The typical problem with sophisticated portfolio projection software and spreadsheets is the return assumption baked into them.  No matter how impressive the output looks, it’s only as good as the underlying assumptions.

Monday, June 27, 2022

A Failure to Understand Rebalancing

Recently, the Stingy Investor pointed to an article whose title caught my eye: The Academic Failure to Understand Rebalancing, written by mathematician and economist Michael Edesess.  He claims that academics get portfolio rebalancing all wrong, and that there’s more money to be made by not rebalancing.  Fortunately, his arguments are clear enough that it’s easy to see where his reasoning goes wrong.

Edesess’ argument

Edesess makes his case against portfolio rebalancing based on a simple hypothetical investment: either your money doubles or gets cut in half based on a coin flip.  If you let a dollar ride through 20 iterations of this investment, it could get cut in half as many as 20 times, or it could double as many as 20 times.  If you get exactly 10 heads and 10 tails, the doublings and halvings cancel and you’ll be left with just your original dollar.

The optimum way to use this investment based on the mathematics behind rebalancing and the Kelly criterion is to wager 50 cents and hold back the other 50 cents.  So, after a single coin flip, you’ll either gain 50 cents or lose 25 cents.  After 20 flips of wagering half your money each time, if you get 10 heads and 10 tails, you’ll be left with $3.25.  This is a big improvement over just getting back your original dollar when you bet the whole amount on each flip in this 10 heads and 10 tails scenario.  This is the advantage rebalancing gives you.

However, Edesess digs further.  If you wager everything each flip and get 11 good flips and 9 bad flips, you’ll have $4, and with the reverse outcome you’ll have 25 cents.  Either you gain $3 or lose only 75 cents.  At 12 good flips vs. 12 bad flips, the difference grows further to gaining $15 or losing 94 cents.  We see that the upside is substantially larger than the downside.

Let’s refer to one set of 20 flips starting with one dollar as a “game.”  We could think of playing this game multiple times, each time starting by wagering a single dollar.  Edesess calculates that “if you were to play the game 1,001 times, you would end up with $87,000 with the 100% buy-and-hold strategy,”  “but only $11,000 with the rebalancing strategy.”

The problem with this reasoning

Edesess’ calculations are correct.  If you play this game thousands of times, you’re virtually certain to come out far ahead by letting your money ride instead of risking only half on each flip.  However, this is only true if you start each game with a fresh dollar.

In the real world, we’re not gambling single dollars; we’re investing an entire portfolio.  If one iteration of the game goes badly, there is no reset button that allows you to restore your whole portfolio so you can try again in a second iteration of the game.

Edesess fundamentally misunderstands the nature of rebalancing and the Kelly criterion.  They don’t apply to how you handle single dollars or even a subset of your portfolio; they apply to how you handle your entire portfolio.  If you have a bad outcome and lose most of your portfolio, the damage is permanent; you don’t get to try again.  Unless you’re a sociopath who invests other people's money in insanely risky ways hoping to collect your slice from a big win, you don’t get to find more investment suckers to try again if the first game goes badly.

Warren Buffett has said “to succeed you must first survive.”  This applies here.  The main purpose of rebalancing is to control risk.  It may be true that several coin flips could turn your $100,000 portfolio into tens of millions, but it could also turn it into less than $1000.  The rebalancing path is much smarter; it will give you more predictable growth and make a complete blowup much less likely.  It turns out that the academics understand rebalancing just fine; it’s Edesess who is having trouble.

Friday, June 17, 2022

Short Takes: Dividend Irrelevance, Housing Bears, and more

A popular type of investing is factor investing.  This means seeking out companies with attributes that performed strongly in the past, such as small caps (low total market capitalization) and value stocks (low price-to-earnings ratios).  I can’t say I’ve studied this area extensively, but one observation I’ve made is that these factors always seem to disappoint investors after they become popular.

It’s hard to figure out exactly why factors seem to disappoint, but I’m not inclined to pay the extra costs to pursue factor investing beyond my current allocation to stocks that are both small caps and value stocks.  Several years ago this combination was my best guess of the factor stocks most likely to outperform.  I’m still not inclined to try others.

Here is how I think about whether someone is ready for DIY investing:

What You Need to Know Before Investing in All-In-One ETFs

Here are some short takes and some weekend reading:

Ben Felix
explains why dividends are irrelevant.  His extensive references to peer-reviewed literature make his arguments tough for dividend lovers to refute, but they can always go with “ya, well, I like Fortis.”

John Robertson
hasn’t found it easy being a housing bear over the years, but now that prices are falling, he looks at what type of buyer would enter the market at different reduced price levels.

Justin Bender examines the merits of bond ETFs vs. GIC ladders.  Investors who want to reduce duration to reduce interest rate risk can consider an ETF of short-term bonds as well.  The way I look at the bond duration choice is whether I’d be happy to hold a 10+ year bond to maturity at current interest rates.  Interest rates have improved lately, but I still prefer to stick with short duration for now.

Thursday, June 9, 2022

What You Need to Know Before Investing in All-In-One ETFs

I get a lot of questions from family and friends about investing.  In most cases, these people see the investment world as dark and scary; no matter what advice they get, they’re likely to ask “Is it safe?”  They are looking for an easy and safe way to invest their money.  These people are often easy targets for high-cost, zero-advice financial companies with their own sales force (called advisors), such as the big banks and certain large companies with offices in many strip malls.  An advisor just has to tell these potential clients that everything will be alright and they’ll be relieved to hand their money over.

A subset of inexperienced investors could properly handle investing in an all-in-one Exchange-Traded Fund (ETF) if they learned a few basic things.  This article is my attempt to put these things together in one place.

Index Investing


Most people have heard of one or more of the Dow, S&P 500, or the TSX.  These are called indexes.  They are a measure of the price level of a set of stocks.  So, when we hear that the Dow or TSX was up 100 points today, that means that the average price level of the stocks that make up the index was up.

It’s possible to invest in funds that hold all the stocks in an index.  In fact, there are funds that hold almost all the stocks in the whole world.  There are other funds that hold all the bonds in an index.  There are even funds that hold all the stocks and all the bonds.  These are called all-in-one funds.

Most people know they know little about picking stocks.  They hear others confidently talking about Shopify, Google, and Apple, but it all sounds mysterious and scary.  I can dispel the mystery part.  Nobody knows what will happen to individual stocks.  Bold claims about the future of a stock are about as reliable as books about future lottery numbers.  However, the scary part is real.  If you own just one stock or a few stocks, you can lose a lot of money.

When you own all the stocks and all the bonds, it’s called index investing.  This approach to investing has a number of advantages.

Investment Analysis


Investors who pick their own stocks need to pore over business information constantly to pick their stocks and then stay on top of information to see whether they ought to sell them.  When you own all the stocks and all the bonds, there’s nothing to analyze or track on a frequent basis.

Risk

Owning individual stocks is risky.  Any one stock can go to zero.  Owning all stocks has its risks as well, but this risk is reduced.  The collective stocks of the whole world go up and down, occasionally down by a lot, but they have always recovered.  We can’t predict when they’ll drop, so timing the market isn’t possible to do reliably.  It’s best to invest money you won’t need for several years and not worry about the market’s ups and downs.

To control risk further, you can invest in funds that include both stocks and bonds.  Bonds give lower returns, but they’re less risky than stocks.  Taking Vanguard Canada’s Exchange-Traded Funds (ETFs) as an example, you can choose from a full range of mixes between stocks and bonds:

ETF Symbol 
    Stock/Bond % 
      VEQT           100/0
      VGRO           80/20
      VBAL           60/40
      VCNS           40/60
      VCIP           20/80


Cost

Sadly, many unsophisticated investors who work with financial advisors don’t understand that they pay substantial fees.  These investors typically own mutual funds, and the advisor and fund company help themselves to investor money within these funds.  There is no such thing as an advisor who isn’t paid from investor funds.

It’s common for mutual fund investors to pay annual fees of 2.2% or higher.  This may not sound like much, but this isn’t a fee on your gains; it’s a fee on your whole holdings, and it’s charged every year.  Over 25 years, an annual 2.2% fee builds to consume 42% of your savings.  This is so bad that many people simply can’t believe it.

With Vanguard’s all-in-one ETFs, the annual costs are about 0.25%, which builds to only 6% over 25 years.  Giving up 6 cents on each of your hard-earned dollars may not seem great, but it’s a far cry from 42 cents on the dollar.

Closet Index Funds

Can’t we just find a mutual fund run by a smart guy who can do better than index investing?  Sadly, no, we can’t.  Every year, experts analyze mutual fund results, and every year, they come up with the same answer: most mutual funds do worse than index investing.  A few do better for a while, but sooner or later, they stumble and fall behind index investing.  They simply can’t overcome their high fees for long.  We can’t predict in advance which funds will beat the index in a given year, so jumping from fund to fund is a losing game.

But things get worse.  A great many mutual funds aren’t even trying to do better than index investing.  They are called closet index funds.  They hold portfolios that look a lot like the indexes, but charge high fees anyway.  They focus more on selling their funds to investors than they focus on investment performance.  They hope their investors don’t notice that they’re not really doing much.

Canadians who invest at big bank branches and strip mall offices of big investment companies typically own closet index funds.  If you take the trouble to look through the holdings of their mutual funds, you see a set of stocks and bonds that isn’t much different from Vanguard’s all-in-one ETFs.  The difference is the cost.

Fear, Uncertainty, and Doubt

If index investing is so superior to the typical mutual fund, why doesn’t everyone switch to indexing?  The answer is that there are many people who make their living from the high-fee model.  Their salaries depend on extracting high fees from your savings.

Most advisors in big bank branches and in the strip mall offices of big retail investment companies have a list of talking points to scare people away from index investing.  But the truth is that the only scary thing about indexing is the threat to their salaries.

Going On Your Own

If you chose to invest in Vanguard Canada’s VBAL, which is 60% stocks and 40% bonds, you’re probably going to own close to the same stocks and bonds an advisor at a bank branch or strip mall would recommend.  The differences are that lower fees would leave you with higher returns, but you’d have to open your own investment accounts and make some trades on your own instead of having an advisor tell you everything will be fine.

So, this would involve choosing a discount broker, opening an RRSP and a TFSA and possibly other accounts, adding some money, and performing trades to buy an all-in-one ETF with money you won’t need for several years.  It’s best not to invest in stocks with money you may need soon, such as an emergency fund.  

Handling your own savings this way can be scary at first, and it isn’t for everyone.  The main challenges are getting started with making trades with large sums of money, avoiding selling out when the stock market goes down and you’re nervous, and avoiding changing your plan when something enticing comes along like day-trading, stock options, or cryptocurrencies.

Making the Switch


Getting started with investing on your own using all-in-one ETFs is easier for the beginning investor than it is for someone already working with an advisor.  The good news is that you don’t have to make the switch by talking to your advisor.  The process begins with opening new accounts at a discount brokerage and filling out forms to move your money from the accounts controlled by your advisor.  Your advisor is likely to notice and might try to talk you out of it, but you’re not obligated to work with your advisor when making the switch.

One approach that might make the process easier is to open new discount brokerage accounts and only add small amounts of money first.  After you’re more comfortable with trading and everything else at the discount brokerage, you can then fill out the paperwork to transfer the rest of your assets over to the new accounts.

Not For Everyone

Investing on your own isn’t for everyone.  However, all-in-one ETFs make it as easy as it can be to invest on your own.  As long as you can avoid the mistakes that come with fear and greed, you stand to save substantial investment fees over the decades.