Friday, November 28, 2008

Short Takes: Emergency Funds, Hazardous Waste, and more

1. BluntMoney argues that we need to cover more than the bare minimum of expenses in our emergency funds because we will find it difficult to give up our lifestyle-related spending in a financial emergency.

2. Big Cajun Man doubts that most people are willing to pay fees to dispose of hazardous waste.

3. Preet explains different ways of weighting stocks in an index with some clear examples: cap-weighting and fair-value weighting part I and part II.

Thursday, November 27, 2008

Wedding Gift Registries: Efficient or Wasteful?

When I’m invited to a wedding, I usually buy the happy couple a gift from their wedding gift registry. Until recently, I just assumed that the list contained items the couple really want at prices they consider reasonable. Recent discussions with two couples cast doubt on my assumptions.

In both cases, the couples’ attitude seemed to be “we might as well put everything on the list and see if someone pays for it.” It was clear that they didn’t concern themselves much with whether they really want the items, and they certainly didn’t care about price.

In the case of one of the couples, I had a chance to continue the discussion a little further, and it became clear that the salesperson helping them create their list definitely encouraged the “put it on the list and see what happens” attitude.

It seems obvious enough that this approach is bad for both gift buyers and the couple getting married. Gift-buying guests have a limited amount of money to spend. If the registry contains expensive things that the couple don’t really want, then money gets diverted away from the things they do want.

It isn’t surprising that some couples compile their gift registries carefully and some foolishly. But which is more common? I would have bet on “carefully” before listening to these two couples. I can’t say that I’ve discussed wedding gift registries with very many people, and so these two couples represent a fairly high proportion of my very limited sample space.

I’m interested in reader experiences on this subject. It seems doubtful that anyone has collected data on the thoughtfulness of gift registry lists, but if anyone has, I’d like to hear about that too.

Wednesday, November 26, 2008

Manulife IncomePlus Reader Comments

A reader had some thoughtful comments and questions about my analysis of the Manulife IncomePlus annuity. Here are his comments (edited for brevity) followed by my thoughts.

1. You describe the worst case scenario in which an investor makes withdrawals beginning in the first year. The product is best suited to the investor who leaves cash in the investment for at least 15 years so that the guaranteed income grows at 5% per year (albeit simple rather than compounded) for that period.

An example will help here. Our investor Ida puts $400,000 into IncomePlus. In my earlier analysis of IncomePlus, I focused on the case where Ida draws a guaranteed income of 5% or $20,000 per year for the rest of her life. But, suppose that Ida is only 50 years old and doesn’t need any extra income until she is 65.

IncomePlus rules permit Ida to defer payments for 15 years and then collect a guaranteed $35,000 per year for the rest of her life. This figure came from increasing the $20,000 by 5% (not compounded) for each year Ida deferred payments.

On the surface, $35,000 per year sounds not too bad. But this ignores inflation. Even if inflation averages only 3%, Ida will only get $22,500 in today’s dollars in the year she turns 65. By age 90, this drops to $10,700. If inflation averages 5%, this is $16,800 at age 65 and less than $5000 at age 90. Pass the cat food.

If Ida lives to age 90, her guaranteed $35,000 per year amounts to a 3.03% per year return on her original $400,000 investment. If she dies younger than this, her return is even worse. This investment has all the inflation risk of a long-term government bond, but with lower returns than a bond.

2. You describe scenarios where the market performs poorly for 20 years.

It’s true that I’ve focused on the income guarantees. The point is that the guaranteed income is very low because of decades of inflation. However, it is possible for the guaranteed level of income to rise if our investor Ida’s mutual funds within IncomePlus perform well. Unfortunately, they have to perform very well to overcome the very high fees charged. The market could perform reasonably well and still not trigger any increases in Ida’s payments.

3. Some of the funds available to IncomePlus investors charge lower MERs than you quoted.

The funds with lower total fees are the ones containing a lower percentage of stocks. The only way to have a chance at doing significantly better than the minimum guaranteed payments is to have as much exposure to stocks as possible.

4. The product might enable some investors, who would otherwise be too skittish, to buy into today's markets or to feel comfortable maintaining some exposure to markets during volatile times.

It is true that this product’s guarantees may draw in nervous investors. However, IncomePlus behaves more like a bond than like stocks. The high fees charged prevent investors from participating in very much of the market’s upside. In the future, IncomePlus investors are likely to see positive news about stocks, but see their payments increase minimally or not at all.

5. The fact that Manulife had to inject new capital partly to boost its reserves for products of this kind suggests the product is not as one-sided as you suggest.

Let’s try an analogy here. Suppose that I offer people a $1000 bet on the flip of a coin. But, they don’t realize that I’ve rigged the coin to come up my way 90% of the time. If I happen to lose the first flip and scramble to raise the $1000 I owe, is this evidence that the bet wasn’t one-sided? Manulife lost one round of a bet stacked in their favour. I like their chances in future rounds.

6. Those who bought earlier this year may be glad they did that rather than investing directly in mutual funds or equities.

You are right that these people are probably glad, particularly those who need money right now. However, if our 50-year old investor Ida, who doesn’t need income until she is 65, just stays invested in a low-cost stock index and waits out the current downturn, she is likely to be better off than investors who bought into IncomePlus early this year.

Despite our differences, I appreciate comments from readers. I’m more interested in learning the truth than I am in trying to argue than I’m right.

Tuesday, November 25, 2008

Hedge Fund Conflict of Interest

Before the recent financial crisis, hedge funds were generally known as mysterious investments that make outsized returns. Now they have a reputation for flaming out. The reason why so many hedge funds have failed is easier to understand once we see that hedge fund managers maximize their expected returns by taking more chances than are good for investors.

The main differences between hedge funds and regular mutual funds are

Types of investments. Hedge funds are less closely regulated and tend to make riskier investments than mutual funds make, such as shorting stocks and using leverage.

Fees. In addition to a yearly management fee, hedge funds charge a performance fee, which is a percentage of any returns over a certain threshold. A “2 and 20” hedge fund would charge 2% of the full amount invested plus 20% of all returns above the threshold.

The performance fee is supposed to align the interests of the money manager and the investors, but it does this quite poorly. On the surface it seems that both parties make money together, but there are important differences that I’ll show with an example.

Suppose that High-power Growth Hedge fund (HGH) uses a simple leverage-based strategy: it buys stocks on margin. For a concrete example, we’ll assume that HGH can borrow money at 5% interest, the expected return on stocks each year is 10%, and the volatility of stocks measured by standard deviation is 20%, a figure that is close to the long-term average for U.S. stocks. HGH’s fees are a 2% management fee plus a performance fee of 20% of returns above 5%.

What is best for investors?

Based on these assumptions, investors maximize their expected compound returns if no leverage at all is used. Without the performance fee, the optimum amount of leverage is only 16%. The performance fee clips the upside enough that it isn’t worth it to take on the higher risk of borrowing some money to invest. But the optimal amount of leverage is quite low even without the performance fee.

What is best for hedge fund managers?

It turns out that using leverage increases the money manager’s fees considerably. I ran billions of 3-year Monte Carlo simulations of HGH fund with different amounts of leverage, and the money manager’s highest expected compound return came with leverage at 249%! This means that if investors contribute $10 million to HGH, the fund would borrow an extra $24.9 million and invest the whole $34.9 million in stocks.

Using 249% leverage, investors’ expected compound return is reduced to -3% per year due to the high volatility. Don’t think of this as a steady -3% each year. HGH would have wildly swinging yearly returns like +70%, -60%, and +30%, with a significant risk of losing everything in a very bad period for stocks like the one we’re in right now.

These results show that hedge fund managers do not have their interests aligned with investors. In fact, their interests are so poorly aligned that hedge fund managers are effectively in a conflict of interest.

Monday, November 24, 2008

Lotteries, Millionaires, and a Sense of Scale about Money

Most of us dream of living the life of a millionaire. Many of us regularly buy lottery tickets, and more of us buy them when jackpots get larger than normal. However, few of us have a good sense of what is truly a large amount of money.

Imagine a young guy named Jack who is 25 years old and starting a new job. We look into a crystal ball and see that Jack will average an inflation-adjusted income of $50,000 per year for the next 40 years. If you’ve never done the math, it can be surprising to realize that this amounts to two million of today’s dollars.

Now if Jack were to win $1 million in a lottery, this would be only half as much as his total 40-year income. Even with investment returns, Jack would risk running out of money if he were to quit his job and spend $50,000 per year. Even if he kept his job, he would risk running out of money if he spent $100,000 per year.

So, unless Jack spends his winnings quite modestly, his good fortune will be temporary, and the money will be gone in a few years. We see this fate befall many lottery winners. Sadly, many end up spending themselves into huge debts after the money runs out. They simply didn’t understand that their big prize wasn’t so big compared to the length of a human lifetime.

For the average person to be able to quit working and live large, a lottery win of about $5 million or more is needed. Even then caution is required. A sequence of poor choices, such as buying a money-losing dream bar or restaurant, can easily wipe out $5 million in a few years.

The truth is that most millionaires accumulated their money while living frugally. Their financial habits are an important part of what has made them wealthy. Ironically, most real millionaires don’t live like millionaires.

The next time you encounter found money, whether it is a large sum or small, try figuring out how much it represents per day over 50 years of life. So, a $50,000 inheritance divided by 50 is $1000 per year, and divided by 365 is $2.74 per day. Doing this might make you hesitate before wasting “found money.”

Some may find this “dollars per day” idea depressing, but I don’t see it that way. It comforts me to realize how long my expected lifetime will be.

Friday, November 21, 2008

Short Takes: Bonds and a Boot to the Head

1. Preet explains why bond returns have been strong for the last 28 years and why the next 28 years are highly unlikely to have such high bond returns.

2. The Big Cajun Man discusses some Canadian bank woes along with a funny “boot to the head” video clip by The Frantics.

Thursday, November 20, 2008

Auto Bailout: Throwing Good Money After Bad

There is a big difference between the financial crisis and the plight of U.S. automakers. The financial crisis affected all financial institutions everywhere. U.S. automakers are being crushed by foreign competition. The financial crisis is definitely making things far worse for U.S. car companies, but the fundamental problem is that Asian companies make better cars.

I’m not necessarily arguing against some sort of assistance for the U.S. auto sector, but it has to be with an eye toward becoming competitive. Unless GM, Ford, and Chrysler start making better cars, they will keep coming back to government looking for more handouts.

Some people dispute the fact that Asian cars are generally better than American cars. This is largely patriotism rather than reason, but let’s examine it anyway.

It is actually quite challenging to find unbiased information about car quality. Almost everything written in magazines and newspapers about cars is heavily influenced by the auto industry. The best source of real information I’m aware of is Phil Edmonston’s Lemon-Aid books that come out each year. (Disclosure: I have no affiliation with Edmonston other than having bought a few of his books.)

The Lemon-Aid guides rate all cars on a scale from one to five stars. I have the 2002 and 2007 editions for new cars and minivans, and I collected the ratings for all American and Asian cars. Here are the results:

This is a huge edge for Asian cars over American cars. Unless a bailout comes with a realistic plan to become competitive in car quality, the U.S. government is just throwing good money after bad.

This brings us to the reason for American car companies being uncompetitive. One guess is that U.S. car companies have ploughed money into advertising at the expense of designing better cars. This may be a symptom rather than the underlying problem. Some commentators blame the unions for high costs and low productivity. I don’t know if this is true or not. If it is true, then lawmakers should make some tough decisions and solve the problem before giving out money to failing companies.

There is no doubt that if any of the big three U.S. automakers fail it will cause huge problems for the economy. However, a bailout without a plan to become competitive is a step toward a planned economy where subsidies suppress innovation.

Wednesday, November 19, 2008

Courses on Gambling with Stock Options

I’ve been getting a lot of requests lately to place advertising on my blog. Unfortunately, most of it is completely inconsistent with my message about how to handle money. Many are from payday loan companies. It’s sad that some people have got their finances into such bad shape that they feel the need to take loans from these companies at such exorbitant interest rates.

The latest advertising request came from a web site (that I won’t name) devoted to strategies for gambling with stock options. There are some sensible uses for options, but this web site was not promoting sensible strategies.

The strategies were a long-winded version of the following:

“If you think a stock will go up, buy a call option.”
“If you think a stock will go down, buy a put option.”
“If you think a stock will have a big move, but don’t know which direction, ...”
And so on.

There are dozens of option strategies for ever more specialized situations. The problem is that you can’t predict the future to tell which option strategy to use. If you buy a call option, but the stock doesn’t go up, then you lose your money. If you split your money among several guesses, you will lose money, on average, due to the commissions and spreads on the option purchases.

Much of the promotional material on the web site focused on “success stories” that give no information about how the typical person has fared trading options with this web site’s advice. One promotional video included the following breathless come on:

“All these people, people just like you, found a simple, easy way to make the kind of money they never thought possible. They found the key that unlocks the unlimited potential wealth created by the stock market. And best of all, they found out how to do it risk free through the free [company name] expo coming to your area.”

Saying “risk free” here makes it sound like the option strategies have no risk and that you’re guaranteed to make money. In fact, the “it” that is “risk free” is the expo that you can attend without paying any money. The option strategies are definitely risky.

Let me reiterate that there are specialized circumstances where stock options can be part of a sensible investing strategy as a form of insurance to reduce risk. I’ve never had the need to trade in options myself, but it could come up. However, if anyone is telling you to use options to get rich, you should be very suspicious.

Tuesday, November 18, 2008

MER: Death by a Thousand Cuts

It’s time to bring out the heavy artillery (by which I mean pictures) to explain the effects of the Management Expense Ratio (MER) charged by mutual funds. Fees charged to manage your money are a good example of a death by a thousand cuts. They are barely noticeable over short periods, but are devastating over long periods.

For the charts we’ll use a MER of 2% per year. This figure is on the low side for actively-managed funds in Canada, and on the high side for funds in the U.S. I collected some data from 1950 to the present on the S&P 500 index, the 500 biggest businesses in the U.S. Any other index, including Canadian stocks, would have worked equally well and would give similar results.

Our hypothetical investor, Harry, has $100,000 in a tax-sheltered account. He puts it all in stock funds that we’ll assume perform as well as the S&P 500 (including reinvested dividends) less the 2% MER each year. All returns in the examples below will be real returns, meaning that we account for inflation.

Harry likes to check his returns each day; so let’s see what a typical day looks like. The S&P 500 data from 1950 to the present show that 90% of the time, daily returns are between $1400 down and $1408 up. Let’s call these a bad day and a good day. The 2% MER on $100,000 is $2000 per year, which works out to a little less than $8 per trading day. The following chart sums this up:

The MER in red is barely noticeable. Why should Harry care about eight bucks when his portfolio is swinging up and down by hundreds or thousands of dollars each day? It turns out that the daily ups and downs partially cancel out, but the daily MER costs all point in the same direction: down.

Suppose that Harry takes a month-long vacation without checking on his portfolio. What kind of change can he expect when he gets back? To answer this, I found all the one-month returns of the S&P 500 since 1950 including reinvested dividends and removing inflation. Finding the return values that bracket 90% of the cases gives us a “good month” and a “bad month” for the following chart:

The MER is still quite small compared to the possible swings in return over a month. However, the MER is growing. Now let’s see how the MER compares to the possible returns over a year:

Over a year, the MER is noticeable, even on a bad year. This is like watching the height of Harry’s daughter Hanna. Her growth isn’t noticeable to people who see her every day or month, but her grandparents who only see her once a year sure notice the difference.

Let’s see what happens over 25 years:

Now the MER really begins to dominate, consuming 44% of the returns in the good scenario and 73% of the returns in the bad scenario. This should make it clear how much damage a “little” 2% MER can do.

Monday, November 17, 2008

Bond Trading Fees

Whenever I buy bonds through my discount broker, the commissions they charge me are hidden. When I want to buy a particular bond, they just quote me a price, and when I decide to sell the bond, they just quote me another price. There is never any mention of commissions.

Of course, discount brokers don’t let you trade bonds out of the goodness of their hearts; they make money somewhere. With stocks it is more obvious. You pay commissions and lose some money on the spread between bid and ask prices.

Right now I only have one bond. It is a British Columbia coupon for $14,000 coming due 2010 June 18. A “coupon” is a bond that is bought for a discount to the face value and pays no interest until the coupon comes due. So, I paid less than $14,000 for it, and will get $14,000 in June of 2010.

To figure out the fees I’m charged for trading this bond I first checked what I could get for it if I sold it: $13,438.14. The cost of buying another identical bond is $13,532.82. So, the total fees charged for buying and selling this bond are $94.68. I’ve actually done this calculation twice about a week apart to see how stable these costs are. The total fees the first time were $96.01. Based on just two data points, the total cost of a buy and sell is about 0.7% for this bond.

Let’s compare this to the costs of trading $14,000 worth of XIU, an index ETF of the S&P/TSX 60. I would pay $9.95 for each trade, and based on 1000 shares and a bid-ask spread of $0.02, the total spread cost of a buy and a sell is about $20. So, the total fees are $39.90. Based on this example, trading the bond is nearly 2.5 times more expensive than trading the index ETF.

If any readers would care to check on their costs of trading bonds with their brokers, I’d like to try to get a picture of bond trading costs.

Friday, November 14, 2008

Short Takes #5: Market Bottom, Nortel, and Carpooling

1. I think it’s funny that the day after CIBC predicted a market bottom (the web page with this article has disappeared since the time of writing), stock markets in Canada and the US dropped 4-5%. It seems to be human nature to listen to these predictions when all evidence shows that nobody knows what will happen to stocks in the short term. I believe those who say that current stock prices will seem low looking back 5 or 10 years from now, but that doesn’t preclude the possibility of another 20% drop in the short term.

2. The Big Cajun Man asks if Nortel is a dinosaur, and discusses its prospects and planned reorganization.

3. Ellen Roseman asks who will be responsible for credit card fraud when credit card companies start giving us “chip and PIN” cards. Credit card companies would love to make consumers responsible for fraud based on the reasoning that the system is secure and the customer must have done something wrong. However, it is impossible to use even a chip and PIN card safely. Consumers are expected to insert their cards and type their PINs into a device supplied by a stranger. The consumer can’t control the risk in this situation. The risk should continue to be borne by credit card companies and banks. If the new technology is more secure, then the credit card companies and banks can look forward to lower losses due to fraud.

4. When negotiating, Thicken My Wallet advises: never throw out the first number. I’m left with the image of two people sitting silently staring at each other. It’s amazing how few people can withstand long pauses in a conversation.

5. Preet starts a new job, and plans to explain in his blog how the financial industry works from an insider’s point of view. He also plans to create financial products with lower fees to benefit investors.

Thursday, November 13, 2008

Money for Nothing and Your Stocks for Free

In his book Money for Nothing and Your Stocks for Free, author Derek Foster offers two strategies for boosting investment returns: selling put options and leveraging your house. Let’s examine these strategies.

1. Selling Put Options

Foster suggests finding a good dividend-paying stock that you’d like to own. However, instead of just buying the stock, he wants you to sell put options on the stock. How this works is best explained with an example. I’ll use some actual (approximate) figures for Royal Bank stock (ticker: RY).

Let’s say you’d like to own 200 shares of RY that are currently trading for about $46 each. You could just buy the stock for about $9200 right now, or you could sell put options on 200 shares. Royal Bank December put options at $44 have a premium of about $3.50. This means that someone is willing to pay you $3.50 for the option to sell you a share of RY for $44 any time between now and the third Friday in December.

Based on 200 shares, you can collect $700 now as long as you are willing to pay $8800 for 200 RY shares. Of course, the option buyer will only force you to buy the shares if RY shares drop below $44 each. If this happens, your net price for 200 RY shares will be $8100 (much better than the $9200 you would have paid if you just bought the shares). If the price of RY doesn’t drop, then you get to pocket the $700 from selling the put options.

According to Foster, whether you are forced to buy the shares or not, you win; it’s a “free lunch.” If this sounds suspicious, it’s because there is a catch. What if RY shares go up to $55? If you had bought the 200 shares for $9200, you’d be ahead $1800 instead of only pocketing the $700 option premium. You are giving up potential upside to take a guaranteed small amount right now.

The only way that Foster’s strategy can be profitable is if put options are routinely overpriced. If Foster thinks this is true, then he needs to justify it. Otherwise I’d have to assume that because stock options are a negative-sum game due to commissions and spreads, his strategy over the long term will prove to be worse than just buying stock.

2. Leveraging Your Home

The dangers of borrowing to invest are well known. While gains get magnified, so do losses, and you have to pay interest on the loan. Foster does a good job of explaining the risks of leverage when buying stocks on margin and concludes “never borrow on margin; it’s simply too risky.”

Foster is much more positive about borrowing against your house to invest. However, leveraging your house has all the same risks as using margin. Foster sees the critical difference as being that there are no margin calls when leveraging your house. This allows you to ride out bad periods for stocks without being forced to sell your stocks.

However, margin calls force an investor to reduce risk. The leveraged homeowner just has more rope to hang himself. Trying to ride out a downturn in stock prices could turn out well, or it could lead to complete disaster if stocks continue to drop.

Overall, this is a clearly-written book requiring little investment knowledge to understand. But readers should think carefully and tread cautiously if they plan to follow Foster’s advice.

Wednesday, November 12, 2008

Do Investors Need to be Good at Mathematics?

In the book “Money for Nothing and Your Stocks for Free,” author Derek Foster asks why we force kids to spend so much time “calculating the hypotenuse of a triangle,” something he can no longer remember how to do, when skills like this “are never used by most people in the real world.” He advocates spending more time teaching kids financial literacy.

I agree that schools could do more to teach financial skills. However, I’m not sure how to keep vested interests from influencing the curriculum. We may end up teaching our children to buy expensive mutual funds, hire expensive real estate agents, and pay transaction fees on all purchases.

The first part of Foster’s argument is that much of the math he was taught wasn’t very important. A curious thing about discussions like this is that people who lack a certain skill are often the ones who assert that the skill isn’t important. For example, I might say that knowledge of Russian literature isn’t important in investing. In reality, I don’t know if this is true or not because I know little about Russian literature.

The reason that few people ever calculate the hypotenuse of a triangle in their daily lives is mainly because they can’t. Further, they wouldn’t recognize a situation where it might be useful. For example, measuring out a 3-4-5 triangle is a way to get a square corner when laying out a football field.

If you have to lay out bases on a baseball diamond, it can be useful to figure out that second base is 127 feet, 3 inches from home plate by calculating the hypotenuse. I once helped a volunteer who had no measuring tape figure out where to put a new pitcher’s plate by figuring out that it should be about 3 feet in front of the line from first to third base. Opportunities to make use of a skill are often impossible to recognize unless you have the skill.

Getting back to investing, I’m not arguing that you need to know calculus to succeed. In fact, people who delve too far into mathematical topics like efficient market theory and modern portfolio theory often get caught up in details and can’t see the forest for the trees. When a writer comes up with incorrect conclusions and baffles his readers with math, don’t blame the math; blame the author.

Any skill is potentially useful when investing. Some are clearly more useful than others. Basic math is obviously important for investing, and I think that more advanced math can be helpful. Common sense, curiosity, and the ability to stay calm are beneficial as well.

Tuesday, November 11, 2008

Time for the Smith Manoeuvre?

Interest in investing in stocks is low right now, and interest in using leverage (borrowing money to invest) is even lower. This also applies to the Smith Manoeuvre, which is a leveraging technique for borrowing against your home’s equity to invest.

I’ve never been a big fan of leverage because it magnifies losses. If your investments do well, then leverage will make them perform even better, but if stock prices have big declines, you can be left with a lot of debt and a shrunken portfolio that won’t cover those debts.

Having said all that, using leverage now is far less risky than it was when stock prices were higher. Paradoxically, the average investor is less interested in using leverage right now. Let me reiterate that I’m not a fan of leverage, but if there ever is an appropriate time for it, now is probably that time.

I give FrugalTrader at Million Dollar Journey credit for continuing his series on his Smith Manoeuvre portfolio after the big stock price declines. It would be easy to just write about other things and return to the Smith Manoeuvre again when stocks have recovered and the subject is more popular. However, it is precisely when stocks are peaking that this topic is most popular and the use of leverage is most dangerous.

Monday, November 10, 2008

Manulife IncomePlus Default Risk

Recent stock market declines forced Manulife Financial to borrow $3 billion from the Canadian banks. This brings to mind one of the risks of buying any type of annuity including IncomePlus: default by the insurance company.

The main drawback of IncomePlus is the high fees and the likelihood of not keeping up with inflation. On the positive side is the protection from a prolonged decline in stock prices. If stocks perform poorly for a long time, customers of IncomePlus will get a steady income eroded by inflation, but at least it wouldn’t drop in absolute terms.

But if this doomsday scenario for stocks plays out, all IncomePlus customers will be leaning on the insurance guarantee all at once. What happens if Manulife runs out of money? Existing regulations require Manulife and other insurance companies to maintain certain financial reserves, and this was the reason for the $3 billion loan.

If stock prices really do decline for a long time, creditors will eventually stop lending Manulife more money. I don’t know how deep the decline would have to be to cause Manulife to default on its promises, but this is something that potential customers should know before handing over their life’s savings.

This doesn’t apply only to Manulife. Any person who considers buying any type of annuity should understand exactly what entities are backing it, and whether they are strong enough financially to make good on their promises.

Friday, November 7, 2008

Short Takes #4

1. The Wealthy Boomer reports that Canadians are dumping mutual funds but buying ETFs (the web page with this article has disappeared since the time of writing). This is encouraging news if Canadians stick to low-cost ETFs. High-cost ETFs exist, and more are likely to pop up. Much of the financial industry is willing to call their products anything as long as they can continue to collect fat fees.

2. The Big Cajun Man debates what to do with his pension after getting laid off from Nortel. He can either take the lump sum and put it in a retirement account or leave it where it is and draw a pension when he is old enough. An actuary can crunch all the numbers, but this will ignore the most important consideration: will the money still be there to draw a pension? Nortel’s pension plan is hopelessly underfunded right now, and business prospects aren’t good.

3. For fixed-income investors who want higher returns, two possible strategies are to choose higher-risk bonds or to choose longer bond maturities. Preet explains that adding equity exposure gives better returns for the amount of risk compared to higher-risk bonds, and that longer bond maturities don’t give a good risk-return payoff.

4. As I’ve explained before, Bell’s internet service just doesn’t work at my house. Yet another mailing arrived this week imploring me to “come back to Bell.” For only $17.95/month plus some fine print details that would roughly triple this price, I could get wireless home networking that would then fail to connect anywhere outside my house.

Thursday, November 6, 2008

Manulife IncomePlus Hard Sell

A member of my extended family I’ll call Don has been hit with a hard sell to buy into a Manulife Financial’s IncomePlus annuity.

IncomePlus is essentially a portfolio of mutual funds with very high MERs combined with an insurance component that adds even more fees. For an overall cost of about 3.5% each year, Don is guaranteed payments each year for the rest of his life of at least 5% of his original investment. For the first 20 years, this is just a guaranteed return of his inflation-ravaged capital.

If Don’s portfolio happens to grow despite the 5% withdrawal and 3.5% fee each year, there are defined times every three years when the portfolio locks in the gains, and Don’s guaranteed yearly income rises to 5% of the new portfolio size. Don would be counting on such gains just so that his income would keep up with inflation.

For Don’s income to match inflation, the mix of investments in his mutual funds would have to grow in value each year by inflation plus the 5% withdrawal plus the 3.5% fees. With a 75/25 mix of stocks and bonds, and if bonds beat inflation by 2% each year, stocks would have to beat inflation by about 11% each year. This is not likely over a long period of time. So, Don is not likely to keep up with inflation unless he dips into his capital and reduces future guaranteed returns.

Even using investments such as low-cost exchanged-traded funds (ETFs), it is difficult to design portfolios that provide investors with complete peace of mind due to longevity risk, inflation risk, and the risk of declining stock prices. Insurance companies can have a role to play in eliminating longevity risk, but any benefits to investors in the case of IncomePlus are more than offset by the ultra-high fees.

Seeing a bar chart of income stretching on indefinitely without ever going down is comforting only as long as you don’t think about inflation. If these charts were changed to take into account a plausible level of inflation, they would cease to be persuasive.

Canadian Capitalist asked “why then are advisors pushing their clients to buy these products?” I suspect he knows the answer, and it became clear to me after listening to Don. Don is contemplating a last decision about all of his savings. This includes not only the money controlled by the advisor who is pushing IncomePlus, but also his other retirement accounts. This advisor is going for the chance to get control of all of Don’s money for the rest of his life. That would give the advisor a big commission immediately and additional trailer fees indefinitely.

As far as I’m aware, Don hasn’t made a decision yet. I don’t like to tell people what to do with their money, because they know their business better than I do. But, it’s not hard to tell where I stand on IncomePlus.

Wednesday, November 5, 2008

Obama’s Win and the Effect on the Stock Market

A Barack Obama presidency is now confirmed. So, what effect will this have on the stock market? Whatever happens to stocks, we can expect the press to link it to Obama’s victory.

One theory is that Democrats are bad for business, and stocks will drop in value. Another theory is that Republicans are responsible for driving the U.S. debt to dizzying heights, and the stock market should respond positively to a Democrat as President.

Or maybe the market was anticipating an Obama win, and investors will “sell on the news” driving stocks down even though they think Obama will be good for the economy. Or maybe the opposite will happen because of some sort of double-reverse psychology.

I don’t know what will happen to stock prices for the rest of this week, but whatever happens, it will be portrayed as the inevitable effect of Obama’s victory. Surely some stock price movements will come as a result of random buying and selling that has nothing to do with the election.

Short term price movements are mostly unpredictable, and the important thing is what happens in the long term. We can only hope that Democrats will govern in a way that leads to the economic growth that is necessary to have long-term gains in the stock market.

Monday, November 3, 2008

Canadian Scammers Target U.S. Grandparents

The Better Business Bureau reports a scam that has worked on grandparents from California to New Hampshire. The scam is a variant of the loved one in trouble. In this case, a caller claims to be a grandchild traveling in Canada, in trouble, and needing a few thousand dollars.

What makes this scam so effective is a combination of factors. Grandparents are very likely to want to help a grandchild. Voices can be difficult to recognize on the phone, especially if the grandparent hasn’t seen a teenage grandchild in a while. Traveling in Canada is quite plausible for a young American. Lastly, Canadians are far too nice to run a scam like this.

I’m disgusted with these thieves, but somewhat impressed at the same time. This scam is quite clever. If these criminals put their abilities and some hard work into an honest venture, they probably would do well. Some people are willing to work very hard to avoid having to do any work.