Wednesday, April 30, 2008

Interest Rates on Unsecured Personal Lines of Credit

I know someone who has a personal line of credit whose interest rate is prime+2.5%. The “prime” refers to the bank’s prime interest rate. Most banks in Canada have prime at 4.75% right now. So his interest rate is currently 7.25% compounded monthly, which works out to 7.50% annually.

What I was curious about is how this rate compares to other unsecured lines of credit. So, I started poking around online to find out. But, it seems that this is a big secret. Every bank and other type of financial institution I checked just said that the amount over prime depends on “personal circumstances”.

I understand that the interest rate will depend on income, credit history, borrowing limit, and possibly other factors. However, the lack of available information about what is a good rate and what is a poor rate makes it difficult for consumers to find a good deal.

With mortgages, at least you can see the starting point for negotiation with each institution. For unsecured lines of credit, there seems to be just a black hole.

The only data points I have right now are prime+2.5% for the person I know, and the prime+1.5% for the line of credit I had a long time ago. If any readers can add to this, I’d like to hear about it. Let me know about any online sources of information, or just let me know what rate you have.

Tuesday, April 29, 2008

How to Succeed at Stock Picking

Learning from the best seems like a good strategy. So, I read John Train’s 20-year old book “The Midas Touch” to learn more about Warren Buffett’s approach to stock picking.

Buffett says that investors must understand the accounting information that companies are legally obligated to publish. If you can’t understand this information, then your situation is hopeless.

Investors may hope to rely on research analysts to interpret the accounting data. However, advice from good analysts gets disclosed to many people at once. There is little hope that the opportunity will still be there once the investor hears about it.

Buffett made the following comments at a Columbia Business School seminar:

“When managers want to get across the facts of the business to you, it can be done within the rules of accounting. Unfortunately, when they want to play games, in at least some industries, it can also be done within the rules of accounting. If you can’t recognize the differences, you shouldn’t be in the equity-picking business.”

Investors must understand the nuances of accounting to be successful. If you are like the vast majority of investors who understand little about accounting and its subtleties, you are likely better off investing in an index rather than individual stocks.

Monday, April 28, 2008

Questionable Studies

We hear about studies all the time. If I’m to believe what I read in the newspaper, I should cap off each meal with a couple of glasses of red wine, a beer, some chocolate, and a couple of cups of coffee. There must be a study out there somewhere showing that heroin is good for me as well.

When I’m sceptical of a study’s results as described by a reporter, I sometimes read the technical paper by the study’s authors. Reporters sometimes leave out crucial details. For example, a study might show that coffee improves concentration. You might view this result differently if you knew that the subjects were denied caffeine for two days before the tests were performed.

It’s not always the reporters who get it wrong, though. Sometimes the authors of the study mess things up. This is the case with a study by Schleef and Eisinger called  Hitting or missing the retirement target: comparing contribution and asset allocation schemes of simulated portfolios (pdf).

These researchers used past returns (1926-2005) on US stocks and bonds to investigate whether you should shift money from stocks to bonds as you age. One thing they got right was that putting 100% of the money in stocks gave the best odds of reaching a target portfolio amount after 30 years.

Surprising Results

The crazy part comes next. They compared three investment approaches:

1. Decreasing stock percentage as you age. (e.g., 90% ... 50%)
2. Constant stock percentage every year. (e.g., 70%)
3. Increasing stock percentage as you age. (e.g., 50% ... 90%)

As long as the average percentages in stocks and bonds over the 30 years is the same in each case (70% in the examples above), you’d think that all three approaches would give the same results when averaged over many simulations. That’s not what these researchers found.

They conclude that the best option is to increase the stock percentage over time (the opposite of the usual advice). Unfortunately, this conclusion is just a consequence of the strange way that they did their simulations.

Where They Went Wrong

To do each simulation, the researchers chose a starting year at random between 1926 and 2005. Then they used the returns from the 30 years starting at that point in time. If they reached 2005 before the 30 years were up, they continued from a new random starting point.

This approach may seem reasonable enough, but it means that by the time you get to the end of the 30-year simulation, you are very unlikely to be using returns from the early years of the 1926-2005 range. This creates a bias.

From 1926 to 1945, US stocks didn’t outperform bonds by very much. The difference was greater in later years. This means that in the 30-year simulations, the later years tended to have a greater advantage of stocks over bonds.

To boost returns in a given simulation, it was more important to have a high allocation to stocks at the end of the 30 years than at the beginning. This explains why approach #3 above where the stock allocation was high at the end gave the best results. But, this doesn’t reflect any real-world truth. It’s just a result of a poor choice in how to run the simulations.


In reality, there is no reason to believe that any one of the three approaches will produce higher returns than the other two.

The purpose of shifting money from stocks to fixed income as you near retirement is not to maximize your wealth; it is to create more certainty in how much money you’ll have to live on. If the stock market suddenly goes down, at least you’ll have a few years to adapt your lifestyle to the new reality.

Based on historical data, I choose to invest 100% of my money that I won’t need for about 3 years in stocks. I use short-term bonds and cash for money that I’ll need to spend within the next 3 years.

Friday, April 25, 2008

A Strategy for Dealing with Irrational Impulses

Most of the time I discuss rational approaches to handling money. But people (including me) have irrational impulses. I know I don’t need a cool new car, but it sure is tempting to trade in my perfectly good old car for a shiny new one.

The easy part of handling money well is to make a plan. The hard part is to stick to that plan 365 days per year. Breaking the rules a few times for small amounts is harmless, but buying an unnecessary new car can throw off your finances for years.

To cut down on impulse buying, try the $100 a day rule described in this post over on the No Credit Needed blog. If you want to buy some gizmo for $100, you have to wait a day before you buy it. For a $200 gizmo, you have to wait 2 days. For a new $700 computer, wait a week. This is a simple rule that forces you to take time to make sure you really want or need the latest new toy.

This won’t work for everyone, but it could be just the right idea to help some people cut down on impulse buys that they later regret.

Thursday, April 24, 2008

It’s All Too Much

I was pleasantly surprised by the book “It’s All Too Much” by Peter Walsh. I usually don’t get much out of books in the motivational or self-help category, but this one is different. The ideas can be applied to your financial life as well.

I thought I was pretty good at getting rid of junk that I don’t need, but Walsh systematically went through the types of things that we own and explained why we keep them and why we don’t need most of them. The feeling that he wrote parts of the book specifically for me was eerie.

My house isn’t particularly cluttered, but I realize now that I could get rid of at least half of my stuff and not miss it. In fact, the extra space in my house would make my life better. At a minimum, I would be able to find the things I do need more easily.

I work hard to handle my finances rationally, but I realize now that I do some things for emotional reasons. This doesn’t automatically make them wrong, but looking at them in a different light made me realize that I’ll be happier if I make a few changes.

Do you subscribe to magazines that you don’t read, but you like the idea of the sort of person you’d be if you did read them? Cancel the subscriptions.

Do you own stocks with a dim future, but you’re still hoping that they’ll get back up to what you paid for them? Choose an opportune time to capture the capital loss and sell them.

Do you pay monthly fees for services for your bank account that you don’t use? Investigate your options and choose something cheaper. Just because you’ve done things a certain way for a long time doesn’t mean you have to keep doing them this way. Things change over time and so can you.

I highly recommend this book to change your thinking about uncluttering your life literally and figuratively.

Wednesday, April 23, 2008

Mortgage Interest Rates Dropping?

The US Federal Reserve, the Bank of Canada, and the Bank of England have all cut interest rates. This should be great news for mortgage holders, right? Not so fast.

Not all of these interest rate reductions have made it down to the mortgage interest rates charged by banks. The gap between central bank rates and mortgage rates offered by banks has been growing.

So, don’t rush in to renegotiate your mortgage assuming that the new rate will be much lower. Take a careful look at the new rate your bank offers and compare the interest savings to any penalties charged for breaking your current mortgage. You may be better off to keep your current mortgage.

Tuesday, April 22, 2008

The Advantages of High Oil Prices

Oil prices are up to a record $117 per barrel. This has the obvious disadvantage that we’ll pay more to fill up our cars. But, there are advantages as well.

High energy prices create a greater incentive to develop alternative forms of energy. We can’t depend on oil forever. We need other forms of energy, but they are expensive to develop. Higher oil prices increase the chances that other energy sources can compete. Investors will be more willing to sink money into alternative energy development.

Another advantage of higher oil prices is that it will spur some businesses that consume large amounts of oil to become more efficient.

Closer to home, higher gas prices cause some people to choose not to drive. This means that there will be fewer cars in my way when I’m forced to drive on the highway at rush hour.

As we run out of oil, we need prices to rise to induce the necessary changes to reduce oil use and shift to other forms of energy. Governments may be tempted to change tax levels or even subsidize oil to reduce the shock, but this would be a mistake. If prices stayed constant, we would merrily burn the last barrel of oil without having prepared at all for an oil-free world.

Monday, April 21, 2008

Credit Card Balance Insurance

My wife’s credit card was reissued recently and she had to go through the usual activation process. She placed the 800-number call and was prepared to go through some automated menus to activate the card. To her surprise, an actual human came on the line to ask her if she wanted to buy balance insurance for a little less than $1 per month per $100 of balance.

My first thought upon hearing her story was that credit card balance insurance must be very profitable if the bank is willing to pay people to annoy customers while they activate their credit cards. Even though she declined the insurance, I decided to investigate further.

The Financial Consumer Agency offers this understated warning: “Credit balance insurance is usually more expensive than regular forms of disability or life insurance.” The insurance charges from the big 5 Canadian banks compound out to between 9.4% and 11.9% per year!

The list of conditions that must be met to collect on the insurance contains the following ominous line: “your account must be in good standing.” I’m not sure how “good standing” is defined, but it seems like something that could be used to deny insurance coverage just when you need it. If you’re thinking of paying for credit card balance insurance, you should find out what “good standing” means.

Unless I get some evidence to the contrary, I’m going to lump credit card balance insurance into the same category as extended insurance coverage on consumer items: pure profit for the sellers. All such offers sound to me like “would you like to pay extra for that?”

Friday, April 18, 2008

How to Buy a Car

The invention of the car lease was a tremendous boon for the car industry. Few people can understand the financial implications of car leases, and at the same time, leases have lower payments than car loans. Many cars would not have been sold if the car lease didn’t exist.

Even the word “lease” works well here. It gives the illusion that someone else is taking the financial risks of car ownership, and the driver is just leasing it. But, you are taking the risks whether you buy or lease.

The idea behind a car lease is simple enough. With a 3-year car loan, the full car price is spread across 3 years at some interest rate. For a 3-year lease, the difference between the car price and its expected value after 3 years is spread across 3 years of payments at some interest rate. After the 3 years, you have to pay the residual amount (possibly by selling the car back to the car company).

Naturally, a lease gives lower payments than a loan for those 3 years making the lease seem attractive. Car companies have strong incentives to make the payments as low as possible to attract car buyers. The money lost in payments has to be made up in various fees charged at the end of the lease’s term. Essentially, the lease overestimates the car’s residual value and penalty clauses kick in when the car isn’t worth as much as predicted.

Few people can understand the financial implications of lease contracts, and it’s not surprising that car leases are a bad deal for most car owners. A possible exception is for people who can deduct lease payments on their taxes (such as the self-employed), but even then the economics may not work out well.

It may seem that I’m about to argue for car loans over leases, but that’s not where I’m headed. In fact, I think both options are a bad idea for most people. It is usually a bad idea to go into debt for a depreciating asset. Almost all cars are expenses, not investments.

The best approach to buying a car is to save up for it, pay cash, and then start saving immediately for the next car. If people bought cars this way, they would think twice about overpaying for a car that is much more expensive than they need.

It’s safe to say that few people will take this approach to car buying. But for those who do, the financial benefits will be huge.

Thursday, April 17, 2008

Ric Edelman’s “Lies about Money”

Ric Edelman runs a financial planning firm and has authored several books including “The Lies about Money.” I also reviewed his audio book “Building Wealth” (see the review here) and I was interested to see if he would be giving more self-serving advice.

It’s obvious that Edelman is very knowledgeable about financial matters. He has the ability to analyze various financial products and options and make sound choices. What is difficult to determine is when his advice is sound and when it serves the interests of his financial planning firm.

The biggest change from “Building Wealth” to “The Lies About Money” is that he is no longer a supporter of the actively-managed mutual fund industry. His firm has switched to recommending institutional funds rather than traditional mutual funds.

To justify this switch, Edelman goes through a litany of sins committed by the mutual fund industry. This part of the book is excellent. I wasn’t aware of some of the abuses, and his explanations are easy to follow.

The troubling part of this for me is his complete reversal from the earlier book. The mutual fund industry didn’t just start committing these abuses yesterday. Most of the abuses have been going on for a long time. Surely Edelman was aware of all this before now. Once his firm had made the switch to institutional funds, it became safe (and profitable) to run down the mutual fund industry.

This book contains a healthy amount of promoting his firm’s services. Here is how I would paraphrase one part of the book discussing investing:
You can’t do this alone. It’s very complicated and you don’t know enough. Even if you know enough, you don’t have the time. Even if you have the time, you probably want to do something else. Even if you want to manage your own money, what happens when you die and you’re spouse doesn’t know what to do? Even if you decide to go it alone using ETFs, be careful – there are subtle, complicated issues that must be understood to choose ETFs correctly.
Of course, there is some truth in all this, but it is designed to scare you more than it is designed to educate you.

When choosing between an advisor and investing on your own with ETFs, an important issue is the advisor’s fees. An advisor may provide some benefit, but is this benefit greater than the cost of fees the advisor charges? Edelman doesn’t discuss his firm’s fees except to hint that the loads on institutional funds are between 0.5% and 2%. Presumably, his firm charges yearly fees as well, but he doesn’t discuss this.

Edelman discusses many other subjects expertly. But, I wonder when he says that we shouldn’t count on social security and that we’ll need more income during retirement that we realize, is he educating us or is he pumping up the total assets his firm manages?

At one point, Edelman asks the question “has this entire program been nothing but a sales pitch?” Despite the fact that I learned a few useful things, I would have to answer yes.

Wednesday, April 16, 2008

Portfolio Growth after Retirement

Russell Investments reports that up to 60% of portfolio growth may come after retirement (the web page with this article has disappeared since the time of writing). This seems surprising at first. We tend to think that the portfolio growth phase ends when we retire.

Of course, it depends on what they really mean by this statistic. They say that money available during retirement consists of about 10% money saved while working, 30% investment growth before retirement, and 60% investment growth after retirement.

So, they aren’t saying that your retirement nest egg will necessarily continue to grow substantially after you retire (because of withdrawals). What they are looking at is the total of your portfolio plus all the withdrawals during retirement.

The fact that 60% of growth comes after retirement isn’t so surprising if you think about the way that portfolios grow. A portfolio that grows at 10% per year will double about every 7 years, and 60% of the growth is in the past 10 years. In his 1998 annual report, Berkshire Hathaway’s Chairman Warren Buffett could have reported that 60% of his company’s total growth had come in the previous 3 years. With this in mind, it’s surprising that there isn’t more growth over a 25-year retirement.

It’s the withdrawals during retirement that cut into future investment returns. Still, it doesn’t take a very high yearly return to get up to the 60% figure.

Suppose that a retiree withdraws 1/25th of his money in the first year of retirement, 1/24th in the second year, and all the way to withdrawing all that remains in the 25th year. For 60% of his money to come from post-retirement returns, he needs an average return of 6.7%.

I’m certainly hoping to make more than 6.7% per year on my money after I turn 65, at least for the first 15 years or so. At any given time, I intend to have 3 years worth of living expenses in fixed income investments and the rest in the stock market.

This means that more than half of my money will be in stocks into my 80’s (if I make it that long). Over such a long period of time, I expect my mix of stock and fixed income investments to average more than 6.7% per year. But, there are no guarantees when it comes to the stock market.

Tuesday, April 15, 2008

Found Money

Found money comes to us in a number of ways. You might find a forgotten $20 bill in an old jacket. You might get an unexpected $1000 bonus at work. Or you might get a $50,000 inheritance from a long-lost aunt.

Many people believe that it’s okay to spend found money (or at least some of it) frivolously to bring a burst of happiness into their lives. Let’s examine this line of thinking.

We all have things that we like to do, but are forced to limit how much we do them for various reasons. You might like coffee, but you limit your intake for health reasons. You might like hosting huge parties, but are limited by the cost.

We tend to look for excuses to do the things we like:

“It’s Friday, let’s have a beer.”
“I just got a bonus. Let’s blow it all on some fireworks.”
“My inheritance just came in. Let’s remodel the kitchen.”

For some people, these things could be the best use of money. However, when it comes to found money, we often tend to blow it on things that are not the best use of the money.

Does this mean that we shouldn’t ever have any fun in our lives? Absolutely not. In fact, I’m about to argue that found money should be spent in a way that brings the most happiness possible over the long term.

For an avid golfer, wouldn’t it make more sense to put the bonus from work toward a golf membership than to spend it all on fireworks that are gone in less than an hour? There is no doubt that setting off fireworks can be a lot of fun, but the golf membership is very likely the better choice.

For larger amounts of found money it becomes more important to stop and think. Imagine a couple who get a $50,000 inheritance. They have very modest incomes and have a mortgage, a car loan, and a line of credit. They really want to remodel their kitchen.

Their choice is to either pay off the car loan and line of credit or go ahead and remodel the kitchen. Because they are dealing with found money, they may give in to their temptation to remodel the kitchen. But, they are almost certainly much better off to pay off the loans.

Choice #1: Get the shinier kitchen. A week or so after the kitchen is remodeled the new kitchen excitement will wear off and all the money will be gone.
Choice #2: Pay off the car loan and line of credit and eliminate $1000 per month in interest payments for the next 5 years.

For a couple of modest means, Choice #2 is far better. If the kitchen really is a disaster, then a compromise is possible where they spend, say, $5000 on improving the kitchen and the rest goes to debt repayment. But, this only makes sense if the kitchen improvement is truly needed. It makes no sense to waste even a fraction of a large sum of found money on something that doesn’t have a lasting effect on your happiness.

It may seem like this way of thinking will prevent you from ever letting loose. This is not true. Our couple can let loose with some of the extra $1000 they won’t be spending on interest every month. The larger the sum of money you are dealing with, the more important it is to think your choices through carefully.

Monday, April 14, 2008

Fixed Income Real Returns

Several members of my extended family invest exclusively in fixed income investments, mostly at banks. For many years now they have longed for a return to higher interest rates like they had in the 1980s.

They think that they made more money back then, but this wasn’t really the case. They may have earned more than 10% interest per year, but this doesn’t take into account taxes and inflation. To find out the real return, you need to deduct taxes and inflation. This is even more painful when you realize that you have to pay taxes on the part of the return that is eaten up by inflation.

Back in the 1980’s people felt like they were making more money, but in reality, their principal was being eroded. This misunderstanding led them to spend more than they should have.

An Example

Suppose that years ago you got 12% interest, but inflation was 7%, and your income tax rate was 40%. Then your after-tax real rate of return was 12*(1-0.4)-7=0.2%.

Suppose that today you are getting 4% interest, inflation is 2%, and your tax rate is still 40%. Then your after-tax real rate of return is 4*(1-0.4)-2=0.4%.

Even though fixed income investors might feel poorer today, their real return is actually not much different. The main difference is that they used to spend large chunks of their principal.

Friday, April 11, 2008

More Consequences of TFSAs

An interesting consequence of the proposed Tax-Free Savings Account (TFSA) is a short-term increase in income taxes paid by Canadians. Let me explain.

Money contributed to RRSPs is untaxed until it is withdrawn. Any money contributed to a TFSA is taxed immediately. Once the TFSA becomes law, some of the money that would otherwise have gone into RRSPs will go into TFSAs instead. This increases the amount of income tax governments collect in the short term.

In the short term, almost all retirement savings withdrawn by Canadians will come from RRSPs and RRIFs. So, the government will collect taxes on part of new savings and almost all withdrawals.

Eventually, all this will balance out. Suppose that half of new retirement savings will go into each of RRSPs and TFSAs. In the short term, most of the money coming out of retirement savings will be coming from RRSPs and RRIFs and will be taxed. Over time, though, the mix of money being pulled out of retirement savings will shift to half coming from each type of account.

Money can be addictive

It will be interesting to see how governments react when this short-term burst of extra taxes disappears. I’d like to think that the government will anticipate this effect of TFSAs and will pay down debt instead of getting addicted to the extra money. How likely is that?

Thursday, April 10, 2008

Secondary Effects of TFSAs

According to Newton, for every action there is an equal and opposite reaction. If the proposed Tax-Free Savings Account (TFSA) becomes law in Canada, we should expect reactions to the changes it will cause.

The main factor that determines whether TFSAs or RRSPs are better is tax rates. If your tax rate will be higher when you withdraw money than it was when you contributed money, then you should prefer a TFSA. Ironically, it is often the poorest seniors who fall into this category because of clawbacks.

As a senior’s income rises, the Guaranteed Incomes Supplement (GIS), the age credit, and Old Age Security (OAS) all get clawed back, which can make the effective tax rate very high. For example, a senior with an income of $12,000 who withdraws an extra $1000 from an RRSP or RRIF will pay an extra $780 in income taxes, mainly because of the GIS clawback. This is a tax rate of 78%.

Effective tax rates can be even higher due to other government programs with income tests. Having a higher income can make a senior ineligible for certain government programs.

With a TFSA, any money you withdraw won’t count as income. RRSP income can be clawed back with high tax rates, but this won’t happen with a TFSA. Or will it?

Current Rules vs. Possible Future Changes

Under current rules, withdrawing money from a TFSA wouldn’t trigger any clawbacks. But, there is no guarantee that things will stay this way. The GIS is intended to help very poor seniors. In the future, there could be seniors with substantial TFSA savings that generate a comfortable tax-free income. These seniors would remain eligible for the GIS if nothing changes.

The GIS is not intended to make well-to-do Canadians a little wealthier. Future governments would be tempted to change this situation. An obvious fix would be to take into account TFSA income in determining the amount of GIS a senior would receive.

Such a change would be politically unpopular, but there are many ways to make it more palatable. The GIS could be scrapped and replaced with a more generous program that includes tests for high TFSA income. Other creative approaches are possible as well.

I don’t claim to see into the future, but I think it is dangerous to assume that TFSA income will never be factored into clawbacks of government programs.

Wednesday, April 9, 2008

Superior Investors

In a previous post I explained how it is possible for superior investors to beat market averages by focusing on long-term value instead of short-term stock prices. This is the exception to efficient market theory.

This can make it tempting to become a stock picker. Confidence can be dangerous. Before you jump in believing that you can beat the stock market average, understand that most people who try to do this will fail. It’s not possible for most people to be above average. Add to this the trading costs and volatility that come with individual stock picking, and most stock pickers will make less than the stock market index.

Another problem is that it takes a very long time to tell if you have a talent for judging to true value of companies. An investor could just be lucky for 10 years and then suffer disastrous losses because he really doesn’t know what he is doing. By the time you have invested long enough to know whether you are a good stock picker, much of your investing life may be over.

If you have any doubts about your investing abilities, you should consider an indexing strategy rather than picking your own stocks.

Tuesday, April 8, 2008

Efficient Market Theory

According to proponents of efficient market theory, it isn’t possible to do better than market averages by picking your own investments. New information gets incorporated into stock prices almost immediately making it impossible to profit from this information.

On the other hand, there are a handful of people like Warren Buffett who have outperformed stock market averages for so long that it couldn’t possibly be a fluke.

Both sides in this argument make a strong case. But who is right? As usual, the answer is somewhere in between.

Price vs. Value

At any given moment, the price of a stock is determined by the crowd of people making bids to buy and sell shares. If some good news comes out, the stock’s price will shift upward due to the change in bids coming from the crowd.

The crowd isn’t necessarily right, though. A stock’s true value, which is based on the company’s future prospects, could be $20 even though the crowd sets a price of $10. But this doesn’t necessarily mean that you will make an instant profit by buying the stock at $10. The crowd might continue to undervalue the stock for a long time.

At the other extreme, we have bubbles (like the high-tech bubble and the recent housing bubble) where prices rise unreasonably high and stay there for a long time.

You can only profit from changes in a stock’s price. By buying a stock worth $20 for $10 you are hoping that the crowd will eventually see the real value and increase the price. This is usually a better bet than buying stocks worth only $5 at a price of $10, but there are no guarantees.

How do Superior Investors Succeed?

Superior investors are better than the crowd at assessing a stock’s true value. They buy stocks for less than their true value and wait. This strategy doesn’t work out every time, but it succeeds often enough to give these investors above average returns.

Does this mean that efficient market theory is wrong? Not exactly. If you examine most of the arguments made in support of this theory, the focus is short-term. Short-term trading success has nothing to do with the true value of a stock. The only way to make money in the short term is to predict changes in the price set by the crowd.

Short term trading is about trying to outguess the crowd about how stock prices will change. Without inside information, I can’t see how this is possible given the speed at which new information flows to all investors.

Efficient market theory says that you can’t reliably predict what the crowd will think faster than the crowd thinks it. This makes sense to me.

Which side is correct?

For short-term traders, efficient market theory is essentially correct. I’ve never seen any evidence that anyone can reliably make money with short-term trading without using inside information. For long-term investors, it seems that some investors are capable of judging a stock’s value better than the crowd.

Monday, April 7, 2008

Why Do Equities Give the Highest Returns?

Why does the stock market give higher returns, on average, than bonds or interest on cash? We can observe that this has been true in the past, but why is it true? There are many ways to answer this question, but I’ll pick just one.

Everything else being equal, people tend to prefer lower risk investments. Most people would take a sure 5% return over an investment that has a 50/50 chance of giving either 0% or 10%. It’s just sensible to reduce risk if you can do it without giving up anything else.

All investments have some type of risk. With an individual stock, the main risk is that the company will produce lower than expected profits. Stocks are riskier than bonds and interest on cash. So, stocks have to offer higher returns than bonds and cash to attract investors.

Suppose that most people believe that the stock market will give lower returns than bonds for the next decade. This would cause people to sell stocks and buy bonds leading to stock prices dropping and bond prices rising. Eventually, with the price changes, we would get to the point where people believed that stocks and bonds would give the same returns for the next decade.

But, it wouldn’t stop there. People would still prefer bonds because bonds would offer the same expected returns with lower risk. Investors would keep selling stocks and buying bonds. Once prices stabilized, stock prices would be low enough that stocks would offer higher expected returns than bonds.

Assuming that everyone was right in their expectations, stocks would then give higher returns than bonds in the future.

What if everyone is wrong?

The prices of stocks and bonds reflect the opinion of the masses. But, what if everyone is wrong? Doesn’t that mean that stocks could give lower returns than bonds? Yes, this could happen. However, it is much more likely to happen when everyone is optimistic about stocks than when they are pessimistic. Optimism drives up prices and lowers future returns.

In fact, investors like Warren Buffett with cash to invest prefer to see widespread pessimism about stocks to bring down stock prices. When most people are optimistic about future stock market returns, they bid up prices. When prices are high, Warren Buffett knows that future returns are likely to be much lower than everyone else believes, and he can’t find anything to buy at a good price.

Can everyone be wrong indefinitely?

If most people are overly optimistic, prices will rise to the point where strong future returns aren’t possible. This situation can’t last forever. Eventually, returns will drop and the masses will stop being so optimistic. However, prices can be out of line either too high or too low for extended periods.

It is conceivable, but not likely, that stock returns could be unreasonably low for 20 years. The only scenario I can see where stock returns can remain lower than bond returns for much longer than this is if the economy is in a permanent death spiral.

So, if you believe that China will crush the U.S. and eventually destroy the U.S. economy, then by all means, get out of stocks and stay out. I’m going to take a chance that the Canadian and U.S. economies will continue to thrive with various ups and downs, but no death spiral. I’ll stay invested in stocks.

Friday, April 4, 2008

QuickTax Annoyances

I finally got around to doing my incomes taxes. I’ve been using QuickTax for several years now, but there are so many other choices now that I almost chose something cheaper. In the end, I decided to stick with the annoying software I know instead of some new, likely annoying, software.

For the most part, QuickTax works well as long as you know what you are doing. There is no substitute for understanding the tax system and knowing how different deductions, income, and transactions will affect your total taxes owed. QuickTax will help with getting some choices right, but it can’t save you from everything.

Upgraded Versions

My main criticism of QuickTax is the constant attempts to get people to upgrade to more expensive versions of the product. I get along fine with the “Standard” version, but the confusing product feature lists make it seem like you need to upgrade to “Platinum” if you have any dividends or capital gains.

Even while going through the built-in interview process to do my taxes, I was hit with repeated offers to upgrade to more expensive versions. I knew that the upgrades weren’t necessary, but many people could be fooled into thinking that an upgrade is necessary to complete their taxes.

I certainly hope that the confusion surrounding which version of QuickTax to use caused more people to leave QuickTax than were caused to buy upgraded versions. I don’t like to see a company get rewarded for confusing people.


QuickTax has some sort of automatic renewal system for future years. I didn’t bother to learn about it because I’m not interested in getting locked in pointlessly. I had to refuse this option multiple times.


QuickTax gives tips and runs various optimizers on your tax situation. Maybe my tax situation is too simple, but I have never found any of these to be useful. The tips are often repetitive. Three times I had to say that my wife and I don’t have a safe deposit box and therefore couldn’t deduct its cost.

One of the optimization tips looked like it might be useful. Apparently, we were going to be better off declaring all dividends on one return rather than having my wife declare hers and me declare mine. I clicked on the button to check this out and was presented with a bewildering screen that seemed to want me to input dividend information even though I had already entered it.

I thought that QuickTax was going to figure out how much I would save and ask me if I wanted to make the change. After fighting with the confusing screen for a while, I left interview mode and figured out how to make the appropriate changes. I then owed $14 more. Thanks for the tip. (Grumble, grumble, change it all back.)

Software and Online Versions

I used the software version of QuickTax, but they also offer online versions with a different cost structure. I suspect that many people wouldn’t understand the difference right away.

Making it worse, the first Google link for QuickTax that I clicked on took me to marketing for the online version. I didn’t realize this immediately. What tipped me off that something was different from last year was the unexpected pricing structure. It took a little work to find the web page for the software version.

It seems that QuickTax is more interested in selling its online version than its software version.


The main advantage of QuickTax for me is familiarity. I stuck with it mainly due to momentum. Overall, the product works well enough for me, and I was able to avoid the trap of paying too much for added features I didn’t need.

Thursday, April 3, 2008

Eliminating the Penny and More

I like pennies. More specifically, I like old pennies, and other old coins for that matter. I’m not much of a collector, but I have a few coins that are worth $5 or $10 each.

A Winnipeg MP, Pat Martin, is expected to introduce a bill to eliminate the Canadian penny. See this Wikipedia entry for US efforts to eliminate the penny.

Despite my fondness for old coins, I don’t like getting pennies in my change. Pennies are worth too little now to consider them to be money. We give a penny and take a penny, but it doesn’t really amount to anything.

Handling pennies is like worrying about a decimal place in your weight. “I weighed 175 pounds yesterday, but today I weigh 175.1 pounds! Let me just take these pennies out of my pocket. There we go. I’m back down to 175 again.”

The truth is that pennies should have been eliminated decades ago. We’ve waited so long that we really should eliminate the nickel and dime as well. We could get along just fine if cash transactions were rounded to the nearest quarter.

Just because eliminating pennies makes sense doesn’t mean that it will necessarily happen any time soon, though. I’d like to see Martin’s legislation pass, but I’m not going to hold my breath. If it does succeed, I’d like to see Martin get started on eliminating nickels and dimes as well.

Wednesday, April 2, 2008

Buy Low, Sell High Market Timing Strategies

A reader, Jay, left comments on my market timing experiment asking specifically about strategies that buy after a market drop, and sell after the market rises. The theory behind these strategies is to buy low and sell high.

I ran some experiments to test this approach. As in previous experiments, the investor decides each month whether to be invested in the S&P 500 or not. The goal is to avoid months where stocks drop in value. I ran the experiments on S&P return data from December 1990 to March 2008.

The first thing I tried was to assume that the investor would be invested in the stock market at the beginning and would proceed as follows:

1. If the money is in the stock market, and if stocks are priced at least 5% higher than they were one, two, or three months ago, then sell. Otherwise, stay in the market.
2. If the money is in cash, and if stocks are priced at least 5% lower than they were one, two, or three months ago, then buy stocks. Otherwise, stay out of the market.


The market timer’s compound annual return was only 3.2% compared to 11% for a buy and hold investor. How could the result be so bad? What happened was that the market timer jumped out of the market after prices rose and then waited for a decline that took a long time to come. In the mean time, the market timer was out of the market while prices rose.

Instead of just using 5% thresholds, I tried varying them over all combinations from 1% to 15%. That’s a total of 15*15 = 225 strategies. In every single case the market timer did worse than a buy and hold investor. The only time it was close was when the thresholds were set so that the market timer stayed in the market almost all the time.

As we saw in the version of my original experiment that took into account taxes, the market timer’s results compared to buy and hold are even worse if the money is invested in an account that isn’t tax deferred.

We could keep trying variations on this approach, but we’d run risk of creating a strategy that is tuned to old data but won’t work in the future like what happened in this April Fool’s joke.

All the market timing strategies I’ve examined fail in basically the same way. They stay out of the market too much of the time. The market rises most of the time and the odds are that the market will be up on average during whichever periods of time you choose to sit on the sidelines.

Tuesday, April 1, 2008

April Fools!

I hope that everyone who read this morning’s version of this post (see below) figured out that it’s an April Fools’ joke. All I did was examine past S&P 500 returns and concoct the silly “zone theory” to exactly pick out which months had negative returns and avoid them.

Following this theory really would have returned 28% per year. But, anyone could make money knowing future stock prices in advance. Zone theory was tuned perfectly to past data, and there is no reason to believe that it would work in the future.

There is also no reason to believe that you can predict what will happen next month by looking at a stock chart for the past few months. What will happen depends on information that just isn’t in the charts.

So, forget about zone theory and other crazy market timing theories and invest for the long term without obsessing on short-term fluctuations.

Market Timing Breakthrough!

After wasting so much time trying to show that market timing can’t work, I stumbled across an amazing strategy called “zone theory.” An investor using zone theory to avoid down months in the S&P 500 from April 1991 to March 2008 would have averaged 28% compounded yearly! Compare this to the pathetic 11% per year earned by a buy and hold investor.

How Zone Theory Works

Using zone theory is very easy. Here’s how. Each month’s S&P 500 return is slotted into a zone as follows.

Zone 0: less than -4%
Zone 1: -4% to -2%
Zone 2: -2% to -1%
Zone 3: -1% to 0%
Zone 4: 0% to 1%
Zone 5: 1% to 2%
Zone 6: 2% to 3%
Zone 7: 3% to 4%
Zone 8: 4% to 6%
Zone 9: more than 6%

At the beginning of each month, look at the returns for the previous 4 months. Then slot these returns into zones. Let’s say that the past returns were 7% (last month), 0.5% (2 months ago), -3% (3 months ago), and 2.5% (4 months ago). Using the table above, we are in zone number 9416.

Each zone number corresponds to a particular shape in the chart of past returns. We can then use this shape to predict whether stocks will outperform interest on cash for the next month.

Most zone numbers are bullish for stocks. We just need a list of zone numbers that indicate problems in the stock market. Here is the list of zone numbers that predict a bad month:

0305, 0307, 0314, 0575, 0722, 0740, 0869, 0890,
0926, 1089, 1490, 1753, 1817, 1920, 2495, 2558,
2617, 2785, 2825, 3057, 3072, 3092, 3149, 3181,
4003, 4374, 4616, 4625, 4654, 4900, 4929, 4950,
5268, 5290, 5501, 5522, 5546, 5557, 5558, 5584,
5751, 5895, 6119, 6178, 6187, 6373, 6545, 6808,
7224, 7243, 7346, 7403, 7472, 7536, 7818, 7852,
7855, 8098, 8178, 8246, 8258, 8469, 8476, 8691,
8715, 8899, 8904, 9052, 9208, 9261, 9686, 9898

All an investor has to do each month to use zone theory is figure out the zone number for the past 4 months of returns. If the number is in the list then sell stocks and wait until next month. If the zone number isn’t in the list, then buy stocks. It’s that simple!

The Results

A buy and hold investor investing $100,000 in the S&P 500 from April 1991 to March 2008 would end up with $500,000. Compare this to the zone theory investor who would have $6.5 million! That’s 13 times as much money! Holding stocks when the market is going to go down is for suckers.