Tuesday, August 4, 2020

What the Experts Get Wrong about Inflation

“In the following analysis, we assume future inflation of 2% per year.”  How often have you seen something like this in investment projections or other financial analyses?  This kind of assumption leads to biases that can invalidate a financial analysis.

Even the great Benjamin Graham wasn’t immune.  In the early 1970s, he wrote the following in his book The Intelligent Investor:

“Official government policy has been strongly against large-scale inflation, and there are some reasons to believe that Federal policies will be more effective in the future than in recent years.  We think it would be reasonable for an investor at this point to base his thinking and decisions on a probable (far from certain) rate of future inflation of, say, 3% per annum.”

The following footnote was added by Jason Zweig in a revised edition of Graham’s work:

“This is one of Graham’s rare misjudgments.  In 1973, just two years after President Richard Nixon imposed wage and price controls, inflation hit 8.7%, its highest level since the end of World War II.  The decade from 1973 through 1982 was the most inflationary in modern American history, as the cost of living more than doubled.”

Readers may think I’m calling out Graham for his wrong guess about inflation.  This isn’t my point.  Graham’s mistake was that he guessed at all.  Future inflation is unknown.  Just as we treat future stock returns as a range of possibilities, we should be doing the same thing with inflation. 

We might guess that annual inflation over the next decade is likely between 1% and 3%.  But we can’t say for sure that it won’t shoot up above 5%.  You may judge this to be unlikely, but do you really want your financial security to depend on inflation definitely remaining below 3%?

The biggest effect of assuming future inflation to be at some known level is to make long-term bonds seem safer than they really are.  Once we consider the possibility of rising inflation, 30-year government bonds look a lot riskier.

Because inflation affects how much we can get for our money in annual spending, it’s better to focus on investment returns after subtracting inflation (called “real returns”).  Stock markets look volatile no matter how we view them.  Their nominal returns are volatile.  So are their real returns.  Even if we just treat inflation as a known constant, stock returns are volatile.

However, a 30-year government bond looks very different depending on how you think about inflation.  The bond’s nominal return over the full 30 years looks completely safe.  If we assume inflation stays at some fixed level, the bond still looks completely safe.  But if we correctly assume that future inflation is unknown, the bond suddenly looks a lot riskier.

I have no reason to think Graham would make the mistake of investing everything in 30-year government bonds; he understood the risk of high inflation.  But many people who use spreadsheets and Monte Carlo simulation tools don’t understand the implications of fixed inflation assumptions on their simulation results.  Personally, I avoid all long-term bonds.

When we run financial projections assuming fixed inflation, we make bonds (particularly long-term bonds) look safer than they really are.  We need to get out of the mindset of trying to guess a single value for future inflation and treat it as uncertain.

Friday, July 31, 2020

Short Takes: Money Lessons from Cats, Buy Now Pay Later, and more

With my softball league restarting, some golfing, and reading The Intelligent Investor, I haven’t done any writing recently.  But I have had a chance to ask different types of small business owners (who are opening up as much as they can) whether they will be able to operate profitably.  The most common answer is “we’ll see.”  COVID-19 is increasing their costs and forcing them to take fewer customers than they used to take each day.  That’s a deadly combination in any competitive market.  Behind brave faces I suspect many are just hoping to survive long enough to get back to normal.

Here are some short takes and some weekend reading:

Morgan Housel has an interesting description of why cats sometimes survive high falls better than low falls, followed by a jarring attempt to connect it back to a financial lesson.

Preet Banerjee and Derrick Fung
discuss the rise of buy-now-pay-later in online shopping.  Making your life worse is getting more and more convenient.

Boomer and Echo compares the financial aspects of renting versus owning a home.

Friday, July 17, 2020

Short Takes: Credit Hygiene, Defending Buy-and-Hold, and more

Here are my posts for the past two weeks:

The Limits of Offering Investment Help

Think Twice Before Taking a 5-Year Closed Mortgage

A Canadian’s Guide to Money-Smart Living

Here are some short takes and some weekend reading:

Canadian Mortgage Trends explains why you should care about your credit “hygiene” and not your credit score.

Tom Bradley at Steadyhand
defends buy-and-hold investing.

Canadian Portfolio Manager explains your ETF’s currency exposure.  (This article has a second part).  Many investors get confused about buying identical baskets of stocks in different ETFs that transact in different currencies.  The situation would get even more confusing if we tried to explain that measuring U.S. companies’ stock returns in U.S. dollars is merely a convention; companies with international operations are affected by changes in many different currencies.

Big Cajun Man
looks at RESP statistics showing that lower income families aren’t opening RESPs, even though they could be getting the Canada Learning Bond without even making an RESP contribution.

Boomer and Echo
discusses the challenge of sticking to your financial goals during the pandemic.

Thursday, July 16, 2020

A Canadian’s Guide to Money-Smart Living

Learning about personal finance makes people anxious.  Combine this with all the details to learn and the process can be overwhelming.  Kelley Keehn and Alex Fisher aim to help people get past these problems with their book, A Canadian’s Guide to Money-Smart Living.  The authors introduce the reader to basic personal finance topics without getting into too much detail.

The book begins by trying to get past emotional barriers to controlling spending and getting readers motivated to learn more about personal finance.  It then covers paying yourself first, record-keeping, planning, mortgages, debts, credit scores, and investing.

There were a number of details in the book I liked.  Many financial writers like to mock the idea that small amounts add up, but not these authors.  “The few dollars you spend on muffins, eating out, or other expenditures that you’re not tracking every day, might not seem like much at the time but mount up over the weeks and months and years.”

With so many people seemingly willing to pay any price for a house, it’s important to hear the downside: “Having too big a mortgage payment for your available cash can be absolutely crippling.”  A similar message about all debt: “More debt always equals less freedom.”

I was surprised to learn that “if you don’t use your account at least every month, your [credit] score can be negatively affected.”  I’m not sure if this applies only to credit cards, or if it’s true for lines of credit as well.  I sometimes go several months using only one of my credit cards, and I haven’t used my line of credit in years.

The book contains a good section on the problem with using a supplementary credit card on someone else’s account.  One of my aunt’s did this.  When her husband died, she had no credit record at all because she was using his credit card account, even though her card had her name on it.

A good point about mandatory minimum RRIF withdrawals: “Withdrawing the money does not mean you have to spend it; all you have to do is report it as taxable income.”

There were a number of parts of the book that could be improved.  One section on how to choose and work with a financial planner needed to start with an explanation of how much money you must have before any planner would work with you.  Another section on life insurance paints a picture of a professional life insurance agent carefully looking after your interests.  In reality, people need to know how to avoid agents who try to sell them whatever product generates the biggest commission.

On the subject of breaking a mortgage, the authors say that a penalty of “three month’s [sic] interest is common,” when mortgage penalties are often in the 5-figure range.  On the subject of mortgage life insurance, the authors fail to mention that typical policies use “post-claims underwriting,” which means they don’t check if you qualify for coverage until after you’re dead.

In an example of a couple getting a mortgage, the authors say that “By paying about $456 weekly [instead of $1982 monthly], for example, they save in interest costs and pay off their mortgage faster.”  This isn’t true for these numbers.  Paying biweekly or weekly shortens a mortgage when the payments are simply divided by two or four, effectively increasing the total amount paid each year.  In this example, the weekly amount is calculated to give the same amortization period as the monthly amount.

In a discussion of whether to pay down your mortgage or contribute more to an RRSP, the authors list 4 factors to consider.  However, they miss the most important factor which is how much financial risk you want to carry forward (in the form of leverage) as you age.

In the “Get to Know Your Banker” section, the authors offer mostly obsolete advice about a personal relationship with your banker.  Curiously, they end the section with the modern reality: “Loans are approved by a computer program these days – it’s rarely a human or personal process.”

The book gives a table showing the letter grading system Transunion uses for credit scores, but goes on to say that Transunion rated a particular creditor as “fair” instead of “B” as shown in the table.  I couldn’t figure out the point the authors were trying to make here.

Among the things to consider when deciding whether to buy GICs is “where are interest rates going?”  This is bad advice.  Trying to predict future interest rates is a waste of time.  Currency experts trade trillions of dollars based on interest rate expectations.  An average person trying to outsmart them is just gambling.

“While funds with high MERs may be worth it because of the professional managers they use, it means that those managers need to work that much harder to earn you a decent rate of return.”  All the evidence says that trying to find managers who can overcome high MERs over the long run is futile.

For RESPs, you can open multiple plans, “but, as with the other tax shelters, each plan must follow the maximum contribution rules.”  A reader could easily be confused by this.  The authors mean that the total contribution to all RESPs can’t exceed the maximum per beneficiary.

The last quarter of the book contains several typos that show a lack of attention to detail.

Overall, this book might be helpful to personal finance novices.  The best parts are the early sections designed to motivate people to improve their finances and give them tools for changing bad habits.

Monday, July 13, 2020

Think Twice Before Taking a 5-Year Closed Mortgage

The internet is full of debates about whether to take a mortgage interest rate that is fixed or variable.  However, what gets less attention is whether the mortgage is open or closed.  The most common fixed-rate mortgages are closed, and this means you’d have to pay a penalty if you break your mortgage.

I can already hear most people saying “but I’m not going to break my mortgage, so I don’t have to worry about penalties.”  However, the future can surprise us.  If breaking a mortgage cost us a finger, we’d think a lot more carefully about what might happen to make us break our mortgage: job loss, job moves to another city, divorce, health problems, bad neighbours, and more.

Mortgage penalties aren’t as bad as losing a finger, but they can be bad enough.  Suppose you took out a 5-year mortgage at TD Bank 2 years ago, and it has a remaining balance of $300,000.  According to Ratehub’s mortgage penalty calculator, the cost to break your mortgage would be $16,463!

Lenders deserve some compensation if you break a closed mortgage, but a penalty this big far exceeds any reasonable compensation.  The way they justify it is to do the calculations based on “posted rates,” which are much higher than the interest rates people typically pay.  The gap between the posted rate and the real rate is highest for 5 year mortgages, and gets smaller for shorter mortgages.  This declining gap size is what pumps up the mortgage penalty calculation.

So, when you’re trying to decide whether you’ll come out ahead with a fixed or variable rate mortgage, think carefully about what might happen that would force you to break your mortgage.  A mortgage penalty can easily be larger than the cost difference between fixed and variable interest rates.