Friday, August 12, 2022

Short Takes: Factor Investing, Delaying CPP and OAS, and more

I haven’t written much lately because I’ve become obsessed with a math research problem. I’ve also had an uptick in a useful but strange phenomenon.  I often wake up in the morning with a solution to a problem I was thinking about the night before.  Sometimes it’s a whole new way to tackle the problem, and sometimes it’s something specific like a realization that some line of software I wrote is wrong.  It’s as though the sleeping version of me is much smarter and has to send messages to the waking dullard.  Whatever the explanation, it’s been useful for most of my life.

Here are some short takes and some weekend reading:

Benjamin Felix and Cameron Passmore discuss two interesting topics on their recent Rational Reminder podcast.  The first is that they estimate the advantage factor investing has over market cap weighted index investing.  They did their calculations based on Dimensional Fund Advisor (DFA) funds used in the way they build client portfolios.  They also take into account the difference between DFA fund costs and the rock-bottom fund costs of market cap weighted index funds.  The result is an expected advantage of 0.45% per year for factor investing.  Others would be tempted to try to justify a much larger advantage, but to their credit, Felix and Passmore came up with a realistic figure.  As far as I could tell, this figure doesn’t take into account their advisor fees.  So they still have to sell the value of their other services to potential clients rather than claim these services come “for free” with factor investing.  The second interesting topic is a discussion of a study showing that “couples who pool all of their money (compared to couples who keep all or some of their money separate) experience greater relationship satisfaction and are less likely to break up.  Though joining bank accounts can benefit all couples, the effect is particularly strong among couples with scarce financial resources.”  Although my wife and I never joined bank accounts, we do think of all we have as “ours” instead of “yours” and “mine”.  For example, which one of us gets cash from a bank machine or pays the property taxes is determined by convenience rather than some division of expenses.  However, it appears that this study would lump us in with the group that didn’t pool their money.

Robb Engen at Boomer and Echo does an excellent job illustrating the power of delaying CPP and OAS to age 70 for certain retirees.  However, this creates what he calls the Retirement Risk Zone, during which the retiree spends down assets in anticipation of large CPP and OAS payments at age 70.  This approach makes a lot of sense for those with average health and enough assets to get through the Retirement Risk Zone, but most people are very resistant to this idea.

Neil Jensen announces that Tom Bradley of Steadyhand Investment Funds was inducted into the Investment Industry Hall of Fame.  Tom Deserves it.  He created an investment firm that focuses on client success rather than treating client assets like an ATM, and he regularly writes articles that teach important investment concepts in an age when we see so much useless commentary on stock prices.

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.