Tuesday, March 31, 2009

George Soros: Hero for the Active Investor

There is ample evidence that the average active investor gets lower returns than passive investors, but that doesn’t preclude a minority of active investors from outperforming passive indexes. The great investor and hedge fund manager, George Soros, serves as a hero for the active investor who dreams of outsmarting the market.

In his book Soros: The World’s Most Influential Investor, Robert Slater looks at Soros’s life, investing record, philanthropy, and politics. Soros is best known for his 1992 bet against the British pound when the Bank of England was forced to abandon the exchange rate mechanism designed to keep currency values within certain ranges.

Soros made about a billion dollars in this high-stakes gamble against the pound and another billion dollars in simultaneous bets on other currencies. Some viewed Soros’s actions as stealing from the British people, but Soros sees himself as a “critic” of financial markets who backs his opinions about the value of stocks and currencies with big financial moves.

Soros’s investing record is legendary. From 1969 to 1993, an investment in his Quantum Fund rose over 2000-fold! His investing approach is mainly to use macroeconomic information to predict boom-bust cycles, invest early to catch the boom, and sell short before the bust comes.

Soros calls his investing theory “refexivity”. At times investor behaviour significantly deviates from the predictions of efficient market theory, and market activity starts to affect fundamentals rather than just reflecting them. This reinforcing feedback leads to a bubble that must eventually burst. The key is to predict where and when the booms and busts will occur.

Critics claim that Soros’s success came from access to information from powerful people in government and business. There may be some truth to this, but it seems likely that most of his success came from making accurate predictions a high fraction of the time.

Soros found it more difficult to give money away than to make it. His early experiences of hiding from Nazis in Budapest jails made him believe strongly in open societies, and he spent billions in efforts to open societies in Eastern Europe and the former Soviet Union.

He also spent some money in an effort to defeat Bush in 2004. It’s not that Soros has any great love for the Democratic Party. He just saw the policies of the Bush administration as running counter to the U.S. ideals of an open society. Bush statements reminded him of Nazi propaganda. However, when challenged he said “I would not call Bush a Nazi, exactly because I know the difference.”

Overall, I enjoyed this book mainly for the accounts of Soros’s high-stakes investing successes, but also for his interesting philanthropic efforts.

Monday, March 30, 2009

Understanding Ontario’s Switch to the HST

Ontario’s 2009 budget included a switch from a retail sales tax separate from the GST to a harmonized sales tax (HST). Superficially, this may seem like a trivial change because the retail sales tax was 8% and the provincial portion of the HST will also be 8%. However, there are two main differences that will affect Ontarians.

The first difference is known to most people: the HST will apply to more goods and services than the retail sales tax does. The main change is that services will now be taxed at the 13% HST rate rather than just the 5% GST rate.

If this were the only change, then it would represent a substantial tax hike. But, there is another less well understood difference that changes the equation.

Businesses can now use input tax credits (ITCs) for the HST. A business that collects HST from its customers doesn’t have to give all this money to the government. The business deducts the HST paid on the products and services it purchases to run its commercial operations. This system was used for the GST, and now it will apply to the provincial portion of the HST as well.

The net effect of ITCs is that money cycling through the economy is taxed less often with the HST than it was with the retail sales tax. To summarize:

- Total sales tax remains 13%.
- HST will apply to more goods and services than the old retail sales tax did.
- Businesses only have to pay their net HST.

The overall effect is to lower the sales tax charged to businesses, on average. Of course, some businesses specializing in services (such as my consulting business) will pay more sales tax, but the average business will pay less.

In theory, lowering the sales taxes on businesses should lead to lower prices and a net lowering of costs for consumers. In practice, we’ll have to see how things play out.

Sunday, March 29, 2009

Help Wanted – Male

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

I was rooting through my father’s old papers from a time when he was looking for work and came across the following ad that appeared in the July 31, 1964 Montreal Star:

I was struck by the obvious sexism and ageism: must be a male between 25 and 35 years old. The point is not to call out this newspaper or the company placing the ad, but to realize that this was an accepted common practice at the time.

Slow change can creep up unnoticed, but it’s obvious that the world has changed quite a bit (for the better) since this ad was placed.

Friday, March 27, 2009

Short Takes: Retirement Crisis and Tax Software

1. John Bogle, founder of the Vanguard Group, testified before the U.S. House of Representatives about the coming retirement crisis. Bogle makes many strong points about failings of our financial system that threaten retirement. An additional point I’d make is that with people living longer and the retirement age remaining fixed, we are spending in increasing proportion of our lifetimes retired. This seems unsustainable. If life expectancy increases, maybe the retirement age has to increase as well.

2. Canadian Financial DIY rated web tax preparation software. TaxChopper investigated the inconsistent results among different tax packages, and gave a detailed response.

3. Canadian Money Review reports being charged for overpaying a Sears bill! (the web page with this article has disappeared since the time of writing). This is the first I’ve heard of this one. The few times I’ve forgotten to pay a credit card bill on time, I made a big overpayment to avoid ongoing interest charges. I’ve never been charged a fee for this, but apparently Sears wants to profit from this situation by more than just failing to pay interest on a credit balance.

4. Larry MacDonald reports that house prices continue to decline and gives a breakdown of declines by region.

5. Big Cajun Man has some financial advice for new grads.

6. Dividend Growth Investor explains the fees charged for variable annuities.

7. Million Dollar Journey discusses the importance of spending money to enhance your life. I find I agree with this philosophy, but I fear that most people will see what they want in this advice. It’s intended to make us think twice about overspending for minimal benefit, but I could definitely see someone using “life enhancement” to justify blowing a lot of money on an expensive new car. Of course the good feelings about a new car fade in a month, and the extra $20,000 of debt lingers for years.

8. Preet has some funny math to prove that the less you know the more money you’ll make.

Thursday, March 26, 2009

Direct Energy Viewed as an Insurance Company

Direct Energy is well-known for its flat-rate natural gas plans. By guaranteeing rates for a period of time, they are in effect acting as an insurance company. Any time you buy insurance, you need to find out if the other party is financially sound enough to follow through on its promises.

According to Direct Energy, they currently offer a two-year flat rate natural gas plan in my area at a rate that is about 30% higher than the variable rate that I’m paying right now. This added 30% amounts to a premium for 2 years of insurance against rate hikes.

But what happens if natural gas supplies are interrupted and rates spike up? Will Direct Energy be able to fulfill its promises if variable rates double? I have no idea, but anyone considering entering into a flat rate plan should find out. If Direct Energy isn’t able to maintain promised rates, customers could end up paying the flat-rate premium and then paying the high variable rates too.

Any time we enter into agreements with another party who is promising to deliver something in the future, we must consider the financial health of the other party. AIG employees entered into a bonus agreement with AIG, but it turns out that the company would certainly have gone bankrupt were it not for government intervention. If AIG wasn’t too important to be allowed to fail, the bonus agreements would have been worthless, not because they weren’t legal, but because AIG wouldn’t have been able to pay.

When I left a former employer, I chose to take the commuted value of my pension rather than leave it in the company plan. I didn’t do this because I did the accounting and determined that the commuted value was worth more than the future promised payments. I did this because I doubted the company’s ability to fund the pension plan until I turn 65, and I doubted that the government would step in to protect the full amount of my pension.

It may be that Direct Energy is financially sound enough to honour their fixed rate plans even if natural gas prices spike. But, why would anyone pay the premium for a fixed-rate contract without first investigating the financial backing of the rate promise?

Wednesday, March 25, 2009

Market Timer Breakeven Date

Market timers often jump out of the stock market when they think it is going down in the hopes of getting back in at lower prices. For this to work, the investor has to get out early enough and back in early enough to avoid selling low and buying high.

This brings us to the idea of a “market timer breakeven date.” The following picture illustrates what I mean.

Let’s assume for the moment that stocks are now on the rise. A market timer getting back into the market today would have to have sold out of the market before the breakeven date shown in the picture to come out ahead. Any given day we can draw a line over to see the new breakeven date. As stocks rise, the breakeven date moves further into the past sweeping by the exit dates of investors who haven’t jumped back in yet making them losers in the market timing game.

Of course, the stock market doesn’t move in a nice smooth curve like the one shown. It jumps up and down mostly unpredictably. Looking at the chart of the TSX, the most reasonable breakeven date corresponding to today’s closing TSX index level is Oct. 24, 2008.

So, if you jumped out later than this date and haven’t jumped back in yet, odds are that if stocks continue to rise, you’ve lost the market timing game. I’m hoping that the economy continues to improve, stocks keep rising, and the breakeven date keeps moving further into the past.

Tuesday, March 24, 2009

Winning the Lottery

We’ve all heard that lotteries are a sucker’s game, and this is mostly true. Taking Canada’s Lotto 6/49 as an example, only 47% of the money spent on tickets gets repaid in prizes. So, players pay $2 for a ticket worth only 94 cents. However, there is a way to stack the odds in your favour if you have the right information.

There are any number of books and web sites touting systems for picking lottery numbers based on which numbers have been drawn more or less frequently in past draws. None of these work. My system of playing the 6/49 actually has a long-term expectation of profit.

To understand this system, we need to start with a little information about how the 6/49 works. Each player chooses any 6 of the numbers from 1 to 49 and pays $2 for this combination. There are just under 14 million combinations available. The draw consists of 6 numbers plus a bonus seventh number. The player gets prizes if his combination matches 3 or more of the drawn numbers. The more matches, the bigger the prize. 

But what happens if two players want to buy the same combination? The answer is that they can both have the same combination of numbers on their tickets. When you buy your ticket you aren’t buying exclusive rights to your combination. In fact, when jackpots get large, Canadians often buy more than 14 million tickets, which means that there have to be ticket collisions because there aren’t enough combinations to go around. 

So, if you’re lucky enough to have your exact combination drawn for the top prize, you may have to share the prize with other people who bought the same combination. A similar method is used for the other large prizes for matching 5 numbers plus the bonus number, matching 5 numbers without the bonus, and matching 4 numbers. A fixed amount of money is allocated to each of these pools and all the winning tickets share the relevant prize pool equally. 

This brings us to the main idea of choosing a combination that no other player has chosen. This won’t increase your odds of winning a prize, but it will increase the amount of money you win if your numbers do come up. In the case of the top prize, you would get the whole thing instead of sharing it. For the other large prizes, the number of winners sharing the prize pools would be slightly smaller. 

How much this helps depends on the size of the prize pools and the number of tickets bought. Generally, the bigger the prize pool, the more tickets get sold, and the bigger the advantage in buying combinations that nobody else has. 

According to the Wikipedia Lotto 6/49 page, the biggest jackpot was $52,294,712 on October 26, 2005. An estimated $99,400,000 worth of tickets were sold. From the Lotto 6/49 prize rules, this is enough information to calculate all the prize pools. 

For the average player, even if all the prizes for this draw were paid out, only about 76% of the ticket sales would be returned in prizes. So, a $2 ticket was worth at most $1.52. But what about unique tickets whose combination wasn’t bought by any other player? 

I decided to run some simulations. For this draw, about 49,700,000 tickets were sold. Because there are only 13,983,816 combinations, you might think that every combination would be purchased by at least one player, but this is exceedingly unlikely. In fact, if the ticket combinations are chosen randomly, the number of combinations not purchased is expected to be very close to 400,000. 

What if some lottery insider, Ian, could get this list of combinations not purchased, and buy all of them just as sales close before the draw? This is the scenario that I simulated. I assigned 49,700,000 tickets randomly, and assumed that Ian purchased any unused combinations. The simulation determined what Ian’s payback was for each possible set of numbers drawn. This gives us a distribution of possible results for Ian. 

It turns out that Ian purchased 400,154 tickets for $800,308, and his average total prize count is $1,820,000! Ian’s payoff is highly variable, but repeating this strategy reduces the risk. After 50 lotteries, Ian’s probability of at least doubling his money is about 60%. 

Of course, because Ian is getting more than his fair share of the winnings, everyone else is getting less. So, unless you’re an insider like Ian who can improve his odds, your best bet is to avoid lotteries. 

I’d like to think that lottery officials have measures in place to prevent this type of abuse by insiders, but given how long it took them to find and acknowledge the problem of retailers cheating the system, I’m not optimistic. It wouldn’t be hard to detect lottery abuse of this type if you think to look for it.

Monday, March 23, 2009

Stock Option Friction Revisited

Last week I showed that the frictional costs of commissions and spreads are higher with stock options than they are with trading stocks. Reader feedback included Mark Wolfinger’s comment that I hadn’t accounted for interest on cash not tied up when investing with options, and Glenn’s comment that option spreads are more reasonable in the U.S. So, let’s do the accounting a little differently and see how it affects the results.

The original scenario was to compare direct ownership of 200 shares of RIM to a stock option-based synthetic version of RIM stock ownership where we buy 200 call options at the money and simultaneously sell short 200 put options at the money.

This time let’s assume that the market gets the option pricing right to account for the interest on cash that gets tied up with stock ownership but isn’t tied up with the synthetic stock option version. We can calculate the friction costs by simply assuming that each trade loses half the bid-ask spread plus whatever commissions are charged.

Stock Ownership

In the case of stock ownership, we buy and later sell 200 shares:

Trades: 2
Total shares traded: 400

Assuming $10 per trade, friction costs are then

+ 200 times the average bid-ask spread.

Synthetic Stock Option Approach

In the synthetic stock option case, we buy 200 call options and sell 200 put options initially. Later we would buy or sell 200 options depending on which type of option is in the money. However, we don’t know in advance what the spreads will be, and so we’ll assume that we wouldn’t tolerate spreads more costly than exercising the option and closing out the stock position. Let’s treat the friction costs as though the option gets exercised to avoid overestimating spread costs on options.

Trades: 3
Stock shares traded: 200
Total options traded: 400 (4 option contracts)

Assuming $10 per trade plus $1.25 per contract, friction costs are then

+ 100 times the average stock bid-ask spread
+ 200 times the average option spread.

Montreal Exchange

The average spreads from the snapshot taken of the Montreal Exchange in the original post were 2 cents for RIM stock and $2.07 for September RIM options at the money. So using the costs worked out above, friction is $24 in the stock case, and $442 in the option case. This result isn’t much different from the roughly $500 I calculated for the option case in the original post.

Chicago Board Options Exchange (CBOE)

The average spreads from a snapshot taken of the U.S. market for RIM last Friday on the CBOE were 1 cent for RIM stock and 12.5 cents for September RIM options near the money. So using the costs worked out above, friction is $22 in the stock case, and $51 in the option case.

It’s clear that for RIM stock, U.S. options have much more reasonable costs than Canadian options. However, the US$51 cost represents about 0.6% of the price of 200 shares of RIM. In addition, this option strategy simulated stock ownership for only 6 months. If we repeat this strategy for another 6 months, the total costs for a year are 1.2%. Giving up 1.2% per year is a big drag on the returns of any strategy. After 25 years, the total bite out of a portfolio would be 26%.

Stock option friction varies considerably, and investors need to pay careful attention to these costs. Option-based strategies tend to be short-term which makes the costs recur frequently. Even when these costs are minimized by trading in issues with low bid-ask spreads, the costs are significant. Stock options have a place for risk management by knowledgeable investors, but the effect of friction has to be factored into the analysis of any investing strategy.

Sunday, March 22, 2009

What is a mutual fund?

I’m starting a new Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Many people own units of mutual funds in retirement savings without knowing much about them. Here’s a little story that is hopefully more useful than the usual dry definition.

We are bombarded with messages in ads and from financial planners telling us to buy mutual funds. But, what are mutual funds? It’s a good idea to have a basic understanding of what mutual funds are before ploughing years worth of hard-earned income into them.

To start with, let’s go back to a time years ago when there weren’t any mutual funds. An average guy we’ll call Jim heard some good things about the stock market, got curious, and spoke to a stock broker about buying 5 shares of Buggy-Whips-R-Us. The stock broker seemed friendly at first, but when he asked if Jim meant 500 shares, Jim started to feel uncomfortable. The broker went on to explain that his company charges commissions whenever people buy and sell stocks, and that these charges would be nearly as much as the cost of the 5 shares Jim wanted. So, Jim left feeling small and foolish.

Undeterred, our hero had an idea. What if he got several of his friends together to pool their money? If ten people wanted to buy 5 shares each, they could spread out the commission charge on buying 50 shares. After the Buggy-Whips-R-Us stock went way up, they could sell all the shares and split the money.

So far, all I have described is an investment club, but we just need to add a few more things to get to the modern mutual fund.

Jim’s investment club was wildly successful and eventually grew to hundreds of members. They bought and sold many types of stocks and had fair rules in place to determine what fraction of the stocks each member owned. However, it became increasingly difficult for the members to agree on what stocks to buy and sell. Most members had little to contribute, but several members would argue fiercely. Jim realized that they needed an executive committee elected by the members to run the club and an investment committee chosen by the executives to choose the stocks to buy and sell.

As the club continued to grow, it controlled a lot of money, and Jim decided that the club could afford to pay a clever guy named Ted to do the stock picking. The idea was that a professional would make more money than the existing investment committee on the investments, and this extra money would be more than Ted’s salary; the members would make more money.

At first Ted seemed to work out well. It was hard to tell over a short time whether he was doing a good job, but Ted always explained his decisions to the membership and patiently answered questions. However, there were some rough periods, and Ted got nervous whenever the club discussed replacing him or going back to the old system of volunteer members doing the stock picking. Ted began to spend as much time protecting his job as he did on stock picking. He would take credit for the club’s stocks increasing in value even when it was just because the whole stock market had gone up and had nothing to do with Ted’s brilliance. Whenever the club’s stocks went down, Ted would talk about the current “difficult period in investing” and the “troubled waters” in these “turbulent and frightening times”.

Because working for the investment club was Ted’s full time job, he was able to put a lot more effort into achieving his goals than the volunteers on the club’s executive committee who had other jobs. Over time, Ted was able to increase his pay significantly, hire assistants, and control who served on the executive committee.

As the club continued getting bigger it became a mutual fund with the club members owning units in the fund. Ted’s role was filled by a company that specialized in money management, and although the mutual fund was officially being run by its board of directors chosen by the fund’s owners, in reality the club was being run by the money management company. Jim no longer had any meaningful say in how his club ran.

Fortunately, the government enacted laws to protect mutual fund owners. The management company has to make certain key information about investment style and risks available to new purchasers of mutual fund units, and there are rules about how the fund’s investment returns can be presented.

This story isn't literally how mutual funds formed, but it illustrates the basic idea behind mutual funds and the motivations of the various players involved. Funds are a lot simpler than they might seem from looking at the vast array of information available about mutual funds.

Friday, March 20, 2009

Thursday, March 19, 2009

Stock Option Friction

Stock options are often demonized as recklessly risky investments. Others tout options as useful tools for managing risk in a portfolio. An aspect of stock options that isn’t discussed much is the frictional costs of commissions and spreads in stock option investing.

The people I have known personally who have dabbled in stock options have been burnt badly. They approached options with a gambler’s mentality and lost. This is enough to justify the advice many give to stay away from options unless you are an expert or are getting advice from an expert.

On the other hand, if used correctly, stock options can reduce the overall risk in a portfolio. There is no free lunch, though. If the portfolio risk is lower, then the expected return is lower as well.

An aspect of stock option investing that has always concerned me is the high friction. Frictional costs are the costs associated with trading in and out of stock or option positions.

When I buy or sell stocks or ETFs, I pay a visible $10 commission. A less visible cost is the spread between the bid price and the ask price. The bid price is the highest price someone is willing to pay for the stock, and the ask price is the lowest price someone is willing to sell the stock for.

The spreads on stock options are much higher than the spreads on stocks, and stock option investing usually involves more trading than direct investing in stocks, which costs more in commissions.

An Example: RIM stock

Suppose that I wish to own 200 shares of RIM stock. As I write this, the current quote on RIM is

Bid: $52.00
Ask: $52.02

If I make a market order for RIM, I would pay the ask price. The total cost of buying 200 shares of RIM would be 200 shares times $52.02 per share plus the $10 commission for a total of $10,414.

When the time comes to sell the shares, with a market order I would get the bid price. My total frictional costs would include the two commissions plus the bid-ask spread. The two commissions cost $20 total, and the 2 cent per share spread on 200 shares would cost $4. So, the total frictional cost is $24.

Another Approach: RIM Options

As I write this, the current quote on the Montreal Exchange for September 2009 RIM options struck at $52 is

Call option:
Bid: $9.40
Ask: $10.90

Put option:
Bid: $8.70
Ask: $11.35

The first thing to observe is that the bid-ask spreads are about 100 times the spread on RIM stock. Another minor consideration is that (at my discount broker) commissions on option trades are $10 plus an extra $1.25 per option contract. A contract corresponds to 100 options.

To properly compare direct stock ownership costs to option trading costs, we’ll use what is called put-call parity. It turns out that if you own an at-the-money call option and short an at-the-money put option at the same time, it is the same as owning a share of the stock, except for a few differences I’ll discuss in a moment.

So, if we buy two call contracts and sell short two put contracts on RIM, it is about the same as owning 200 shares of RIM. If RIM shares go up, you’ll get this upside with the call contracts, and if RIM shares go down, you’ll pay for this from the shorted put contracts.

The main differences between owning the stock and taking the option approach are frictional costs, dividends, tax treatment of gains and losses, the possibility that the put option gets exercised early, and margin requirements for writing puts. But the gains and losses from movement in the stock price are the same.

Let’s look at the frictional costs of the option-based approach more closely. We’ll assume that the put option doesn’t get exercised early, and that we will close out the option position just before the options expire. If RIM stock has gone up, this means selling the call option and letting the put option expire worthless. If RIM stock has gone down, this means buying back the put option and letting the call option expire worthless.

We will be making 3 option trades with a total of 6 option contracts traded. At $10 per trade and $1.25 per option contract, this is a total commission cost of $37.50. Things get worse when we consider the spreads.

We had to pay the ask price of $10.90 (see the quotes above) on the call option, and received the bid price of $8.70 for the put option. The net cost per option is $2.20. Multiply this by the 200 options of each type, and the total spread cost is $440.

The final trade to close out the option position would have a much lower spread because options on the verge of expiring have a more predictable value. I’ll assume an additional $20 in friction to close out the option position. This brings the total frictional costs to $497.50.

So direct stock ownership costs us $24 on a roughly $10,000 investment and achieving the same thing with options costs nearly $500, or 5% of the stock investment. This is a huge expense ratio over only a 6-month period. Continuing to own the stock costs nothing more, but the option investor will pay another $500 every 6 months.

The moral here is that while options have their place for knowledgeable investors to manage risk, frictional costs can be substantial and must be taken into account.

Wednesday, March 18, 2009

Economic Disaster is upon Us

The media are bombarding us with comparisons between the current recession and the great depression. Many reporters try hard to find economic measures that make our current situation seem worse than the depression.

Stock market losses over the past 9 months are one area where we seem worse off than those who experienced the losses in 1929. While Canadian stocks as measured by the TSX dropped to 5 and a half year lows last week, U.S. stocks as measured by the S&P 500 dropped to 12-year lows.

So, U.S. stocks prices are at levels not seen since 1997. And we all know what a stink-hole the world was back in 1997. Giant worms roamed the streets killing people. No, that was a bad movie I saw. Actually, 1997 was pretty good for me. I enjoyed my job, played sports, and had a loving young family. Life was good even without an iPod.

Current circumstances are no fun for those who have lost their jobs, but it’s hard to compare the inconvenience of having to take a lower paying job and cut back on lifestyle expenses against the depression era devastation of people walking away from dust farms because nothing would grow.

We seem to need to believe that our suffering is somehow greater or more important than the suffering of others, but in this case, it just isn’t true. We seem to be getting along reasonably well, and I’m optimistic about the future.

Tuesday, March 17, 2009

Collision Insurance on Cars

Until recently, I hadn’t thought much about the collision part of my car insurance. When my car insurance renewal papers arrived, I puzzled over them for a while trying to see if there was any way to reduce the premium.

To figure out whether it’s worthwhile to carry collision insurance, you have to know how much the insurance company will pay in the event of an accident. You’ll never get more than the write-off value of the car. Even though you might not want to get a new car, the insurance company won’t fix a car if the repairs cost more than they think the car is worth.

My car is getting older, and based on what the insurance company representative told me on the phone, my best guess of its write-off value is about $5000. I also have a $2000 deductible, and so the most the insurance company would ever pay me for my car is $3000. The fact that it is worth more than this to me is irrelevant.

For this $3000 of coverage I would have to pay $309. I doubt that the odds of writing off my car over the next year are over 10%, and since I can afford $3000 (in addition to the $2000 deductible) the collision insurance isn’t worth it to me.

One part of all this that I can’t understand is that the collision insurance on my car is actually higher now than it was when the car was new, even though its write-off value was considerably higher back then. Any insights from readers would be appreciated.

Monday, March 16, 2009

Income Tax Takes Time

For people who like to optimize and are expecting an income tax refund, we are now into income tax filing season. For those who will have to pay more, tax filing season won’t come until the end of April for Canadians and April 15th for Americans.

Ordinarily I prepare my taxes a little at a time until I finally receive the last slip I need and then e-file my return to get the refund as soon as possible. This year I decided to see how long it would take to complete the full task of filing my taxes. So, I didn’t do any advance work beyond storing slips and receipts in appropriate folders.

One day when I was satisfied that I had all the required information, I started working on the taxes for myself and my wife at 1:00 pm. This began with buying a copy of QuickTax online and installing it. My reason for using QuickTax is mostly momentum. I know how to use it, and haven’t seriously tried other options.

It’s amazing how some tasks always seem to take longer than they should. I didn’t complete our personal returns and e-file them until about 5:15 pm. Then I worked on my GST return for business income and drove to the bank to pay a small amount of GST owing. I got back at 7:00 pm which meant that the whole task took 6 hours.

Our returns are quite simple, and I can’t really justify why it took 6 hours, but it did. If we make the sweeping assumption that 6 hours is typical for roughly 10 million individuals or couples filing taxes in Canada, the total time devoted to filing taxes is about 7000 years, or nearly 100 lifetimes. I suppose the real figure could be anywhere from 10 to 1000 lifetimes, but no matter how you calculate it, that is a lot of time lost each year to our income tax system.

Friday, March 13, 2009

Short Takes: Tax Tips and Doing a Good Job

1. Since Monday’s close, the TSX jumped 9.5% in three days. There is no guarantee that these gains won’t disappear, but if this turns out to be the beginning of a sustained recovery in stock prices, it would be interesting to know how many market timers missed this jump while trying to predict the market bottom.

2. Larry MacDonald lists 5 tax tips. One tip in this list that I wasn’t aware of may be relevant for my mother.

3. Big Cajun Man has tax tips for parents of university students.

4. Preet describes some experiments to determine what motivates people to do a good job.

5. Frugal Trader offers tips on how to invest small amounts each month without getting hit with excessive fees. The suggestion I like best is to let the money build up until the cost of investing it is a small percentage of the amount invested. Of course, this only works if you can keep yourself from dipping into your slowly growing cash.

Thursday, March 12, 2009

Nortel vs. Beer

I offer the following story with apologies to Dean Staff who appears to be the author of the original version.

Big Ted lived a full life and died in the year 2000, leaving only $10,000 to be split equally between his sons Ted Junior and Tim. Tim took his $5000 and immediately invested in the hot stock of the day, Nortel. After paying the sales commission, he got 40 shares.

Ted Junior was more like his father and decided to spend his money on a huge party for his friends. Ted’s $5000 paid for 166 cases of beer that was all consumed in a huge bash. It took a week to clean up after this party. Ted piled all the empties in the back of his garage and forgot about them for a long time.

A month ago, Ted decided to clean out his garage. A few of his friends who had partied with him over 8 years earlier helped bring all the empties back to the beer store. There was surprisingly little breakage, and Ted got back enough from the empties to buy 13 more cases of beer for another smaller party.

This time Ted took the empties back to the beer store promptly for a return of 13x$2.40=$31.20. This was just enough to buy another case. He finished the last beer in that case last night and cashed in the empties this morning for $2.40.

Over his coffee this morning, Tim was checking his stocks. At the bottom of the list was the sad line showing his shares of Nortel. After the 10 to 1 reverse split of Nortel stock, Tim’s 40 shares had turned into only 4 shares. They now trade for only 10 cents each. Tim’s original $5000 investment is now worth $0.40.

Ted the partier put everything he had into beer three times, and he still has more money than his brother Tim who invested “for the future.”

People are likely to see different morals in a story like this. Some will say “live for today.” Others might say that stocks are too dangerous. I think the real moral is to avoid buying the hot stock of the day and make sure that your investments are properly diversified.

Wednesday, March 11, 2009

What Does DIY Investing Mean?

Do-it-yourself (DIY) investing means different things to different people. When experts list potential pitfalls of the DIY approach, the message can be misleading depending on what DIY investing means to the reader.

An investor who investigates companies and chooses individual stocks to buy is clearly a DIYer. Larry MacDonald’s article on the pitfalls of DIY investing offers good advice for someone who is considering this route to investing.

At the other extreme we have someone who hands control of his portfolio to an investment advisor who gets paid a substantial portion of the portfolio each year. This type of investor is clearly not a DIYer.

A gray area is the index investor. In one sense, index investors are DIYers because they aren’t paying for investment advice. On the other hand, they don’t choose their own individual stocks and bonds, which makes them seem less like DIYers.

For the index investor who doesn’t engage in market timing, the standard list of DIY investing pitfalls doesn’t apply. Beyond an initial decision of which indexes to buy and in what proportions, index investing takes very little time, there is no need for immersion in financial minutia, and there is no reason to stay on top of the latest business news.

The main pitfall of index investing is getting off track. Investors can be scared off track by large drops in stock prices or frightening financial media reports predicting doom. They can also get off track by becoming overly confident in their abilities and choosing to take some chances based on hunches.

Tuesday, March 10, 2009

Mind Games to Control Spending

Between job losses and investment losses, many of us have a need to reduce spending. However, when it comes to maintaining lifestyles, momentum is difficult to overcome. Adjusting the way you think about wealth might help.

Sometimes a big price increase can jolt us out of an expensive habit. People who lose their jobs often keep paying for ultra cable TV service, but what if its price suddenly rose 50% or more? Even people with healthy finances might drop down to a lesser cable package in the face of a big price increase.

This brings me to the mind game. What if we stopped measuring wealth in dollars and instead measured it in units of our favourite index ETF, like XIU for example. XIU holds stock in the biggest businesses in Canada. Each unit represents a slice of various big companies, which includes real estate and many other valuable assets.

In contrast, money is just pieces of paper, bits of metal, and electronic data that have very little inherent value. A unit of XIU has real value that the roughly twelve loonies it currently costs to buy the unit do not have.

So, instead of having $300 in my chequing account, I might think of it as having cash whose value is 25 units of XIU. In this view of the world, the 1000 units of XIU in my retirement account haven’t changed in value. What has happened is that cash has become expensive.

By this measure, most other things have become expensive too. Nine months ago, I could buy two cases of beer for about 3 XIU units, but this is up to 6 units today. Taking this view the price of consumer items has shot up over the last several months. This makes the need to cut back on spending more obvious.

All of this may be just a mind game, but if people need to spend less and can’t do it, maybe a mind game is just what they need.

Monday, March 9, 2009

Compact Fluorescent Lights Save Less than Many Believe

I saw a piece on CBC Newsworld saying that compact fluorescent lamps (CFLs) don’t save as much money as many people claim. The piece made the explanation seem mysterious and complicated, but it’s quite simple. The problem with the standard analysis is that it ignores secondary effects.

The relevant secondary effect here is heating. All energy absorbed by a light bulb ultimately turns into heat. Even the light produced will bounce around off objects and eventually turn into heat. So a light bulb inside your house is like a mini electric heater. A tiny fraction of the light might escape through a window, but for practical purposes, 100% of the energy heats your home.

Here’s an example of the standard analysis of savings. Suppose that you replace a 60-Watt incandescent light bulb that gets used 6 hours per day with a 15-Watt CFL. Power consumption drops by 45 Watts for 6 hours per day. This saves a total of 8.2 kilowatt-hours per month. Assuming a cost of 12 cents per kilowatt-hour, you save a hair under a dollar each month, or $12 per year.

A real analysis that factors in heating gives a different result. The simplest case to analyze is a house heated with electricity. During the heating months the electric heaters will have to make up the lost 45 Watts of heat that used to come from the incandescent light bulb. This exactly offsets the CFL’s supposed savings. The net savings during heating months is exactly zero.

During months requiring no heating or air conditioning, you will save the dollar each month. However, you may heat your home a little longer into spring if you’re not getting as much heat from light bulbs. This effect should be fairly small.

During months where you use air conditioning, you actually have to spend extra money on air conditioning to get rid of the heat created by light bulbs. So, the savings from using a CFL are more than a dollar per month.

Overall, the yearly savings will depend on how many months you heat and use air conditioning, but in a Canadian climate the total savings per year will be less than the $12 from the simple, but flawed analysis.

Another complication in this analysis comes if you use non-electric heating such as natural gas. As it happens, the total cost per unit of energy from electricity and natural gas for me are both about 12 cents per kilowatt-hour once you take into account all the extra charges and taxes. But, if the natural gas were more expensive than electricity, then the CFL would actually lose money during heating months.

One situation where CFLs are a very clear winner is in outdoor lighting. In this case the heat generation is irrelevant, and the cost savings of CFLs are significant. If you haven’t tried CFLs yet, you may want to start with your outdoor lights.

Friday, March 6, 2009

Short Takes: Emotional Investing, Good News on Stocks, and “the Grid”

1. Jason Zweig at the Wall Street Journal has some ideas to allow you to get a feeling of control over your investments. Investors often make big mistakes when their react emotionally. Zweig’s suggestions may help investors deal with their emotional side.

2. On a theme similar to Zweig’s article, Larry MacDonald has some ideas on how to tough it out during hard times for stocks.

3. Preet explains how financial advisor behaviour is driven by a compensation grid.

4. Potato tells us that Petro Canada Mobility is jacking up its rates for cell phone air time. In addition to increasing the cost of air time, they are increasing the minimum deposit from $20 every 6 months to $25 every 4 months, an 87.5% increase. I have a cheap Petro Canada cell phone mainly because I use it so little that the minimum deposit is relevant to me. Thanks for the warning, Potato. I’ll be getting rid of this phone if I can find a better deal.

5. The Big Cajun Man dug into his archives for the story of how he made allowances for his kids work for his family.

6. Ellen Roseman’s article about the problems people are having with Co-operators Insurance, Aeroplan, and Bell Internet generated quite a few comments.

Thursday, March 5, 2009

A Thousand-Foot View of the Credit Crisis

Big changes are taking place in the world economy due to the shock of the credit crisis. These changes have come on too quickly and severely, but the changes themselves aren’t all bad.

For this discussion it’s convenient to think of all people as being either spenders or savers (as I did once before). Spenders borrow from savers for consumption, and savers lend to spenders with the promise of getting paid back with interest.

It turns out that the promised levels of interest on borrowed money were illusory. Spenders are defaulting on loans, and savers are eating the losses. Even when bad debts are covered by the government, this amounts to a flow of money from savers to cover the bad debts.

During the long period leading up to the credit crisis, spenders were being permitted to consume more than their fair share of resources. The world economy adapted to this situation by producing goods and services consumed by spenders. The world produced too much clothing for shopping addicts and too many flashy cars.

Now that spenders have had their lines of credit cut off, there has been a huge shift in spending patterns. The economy will have to adapt to demand that includes more of the consumption habits of savers and less of spenders. Right now the pendulum has swung too far towards very low consumption. But when things settle out, our world will have less reckless consumption, at least until the next financial bubble arrives.

I’m looking forward to a world with more practical goods and services. Goods aimed at spenders aren’t going to go away; they are just going to make up a smaller fraction of our economic output. That’s a good thing.

Wednesday, March 4, 2009

Buffett’s Solution for Mortgage Abuses

In his 2008 letter to shareholders of Berkshire Hathaway, Warren Buffet offers his solution for preventing a repeat of the mortgage crisis. His ideas are quite reasonable, but governments may not like them much.

It’s hard to improve on Buffett’s explanations. So, I’ve reproduced his summary of the crisis, real reason why foreclosures happen, and his proposed solution. As sensible as his solution is, political interference very likely would undermine it.

Summary of the mortgage crisis:

“The need for meaningful down payments was frequently ignored. Sometimes fakery was involved. (“That certainly looks like a $2,000 cat to me” says the salesman who will receive a $3,000 commission if the loan goes through.) Moreover, impossible-to-meet monthly payments were being agreed to by borrowers who signed up because they had nothing to lose. The resulting mortgages were usually packaged (“securitized”) and sold by Wall Street firms to unsuspecting investors. This chain of folly had to end badly, and it did.”

The real reason for foreclosures:

“Commentary about the current housing crisis often ignores the crucial fact that most foreclosures do not occur because a house is worth less than its mortgage (so-called “upside-down” loans). Rather, foreclosures take place because borrowers can’t pay the monthly payment that they agreed to pay. Homeowners who have made a meaningful down-payment – derived from savings and not from other borrowing – seldom walk away from a primary residence simply because its value today is less than the mortgage. Instead, they walk when they can’t make the monthly payments.”

The solution:

“Home purchases should involve an honest-to-God down payment of at least 10% and monthly payments that can be comfortably handled by the borrower’s income. That income should be carefully verified.”

Of course, if such rules are adopted there would have to be meaningful penalties for borrowers or lenders who break the rules.

Buffett’s proposed rules (or something similar) might seem uncontroversial, but let’s look at it from the government’s point of view. Every government wants to be seen as being on the side of the people which includes helping them fulfill the dream of owning a home. Politicians often publicly admonish banks for not lending enough money to people.

Requiring a 10% down payment on a home is a major barrier to home ownership. In my opinion, it is a reasonable barrier, but it would prevent many people from buying homes, particularly if loopholes that allow people to borrow this 10% some other way are closed.

A 10% down payment would prevent many foreclosures. But, it would also deny home ownership to many people who would go on to comfortably make all their mortgage payments. The pressure for governments to seek votes by relaxing mortgage rules would eventually lead to smaller down payments.

So, we may see more stringent mortgage rules put in place in the aftermath of the credit crisis, but don’t expect these rules to stay in place indefinitely no matter how sensible they are.

Tuesday, March 3, 2009

Madoff Wants to Keep $62 Million

Bernard Madoff’s lawyers are arguing that a Manhattan apartment and $62 million are unrelated to the fraud investigation because they are in his wife’s name. Nothing ventured, nothing gained I suppose, but this one doesn’t pass the sniff test.

It’s hard to wrap my mind around the extent of the crime here. Madoff is accused of a $50 billion fraud. That would be like committing a $1 million fraud once a day for over 130 years! The idea that he could come out of this with anything more than some worn personal items in a suitcase sickens me.

It will be interesting to see whether the legal system is able to give Madoff any kind of meaningful punishment. One thing that seems certain is that the process will take a long time.

Monday, March 2, 2009

Buffett’s Justification of Option Trading Misses the Mark

I disagree with Warren Buffett on a point about his stock option trading. There, I said it (or wrote it). It’s rare that I disagree with anything Buffett writes. In fairness, it’s not that I think he made a poor investment. It’s just that I think the real explanation of why his investment is a good one is different from his justification.

Buffett’s eagerly anticipated 2008 letter to shareholders of Berkshire Hathaway arrived on Saturday. It contains his usual brilliant financial insights expressed clearly. Any number of reporters will summarize its contents, but those interested should consider reading the original letter as well.

One aspect of the letter that caught my attention was the discussion of Buffet’s option trading. He believes that certain long-term put options are mispriced, but his explanation of why they are mispriced leaves out the dominant reason.

Buffett has sold put contracts on the world’s major stock indices. These contracts amount to bets between Buffett and other parties on the value of a stock index at some future point in time called the maturity date. I can’t improve on Buffett’s explanation of these put options:

“To illustrate, we might sell a $1 billion 15-year put contract on the S&P 500 when that index is at, say, 1300. If the index is at 1170 – down 10% – on the day of maturity, we would pay $100 million. If it is above 1300, we owe nothing. For us to lose $1 billion, the index would have to go to zero. In the meantime, the sale of the put would have delivered us a premium – perhaps $100 million to $150 million – that we would be free to invest as we wish.”

Buffett has sold a total of US$37.1 billion in put contracts on the world’s major stock indices: the U.S. S&P 500, the UK FTSE 100, the Euro Stoxx 50, and the Japanese Nikkei 225. To take on the risk of possibly having to pay some fraction of this $37.1 billion, Buffett has collected $4.9 billion in option premiums.

The accepted way to value stock options is with a formula called Black-Scholes. This formula predicts that he is expected to pay out $10 billion on his put option contracts. If this turns out to be right, he will pay out $5.1 billion more than he collected in premiums.

Obviously, Buffett doesn’t believe the Black-Scholes formula or he would never have entered into these contracts. He explains that “if the formula is applied to extended time periods, however, it can produce absurd results.” Buffett continues:

“The ridiculous premium that Black-Scholes dictates ... is caused by the inclusion of volatility in the formula and by the fact that volatility is determined by how much stocks have moved around in some past period of days, months or years. This metric is simply irrelevant in estimating the probability weighted range of values of American business [many] years from now.”

Problems with estimating volatility are a factor, but the real reason why the formula fails for long-term options is much simpler. Black-Scholes denies the existence of a risk premium. You don’t need to understand the formula to see that it has no input for the expected return of the equities.

Black-Scholes assumes that the expected return of stocks is equal to the risk-free return of short-term government debt such as U.S. treasury bills. However, historical data tell us that stocks give better returns, on average, than government debt. This failing of the formula doesn’t significantly affect calculations of the premium for short-term options, but gives absurd results for multi-decade options.

An easy way for Buffett to see that risk premium is a major factor is to look at long-term call options. If volatility were the main reason why he finds selling long-term put options profitable, then he should find selling call options to be profitable as well. After all, overestimating volatility drives up the premiums of both puts and calls.

However, I’m confident that Buffett would find long-term call options much less attractive than long-term puts due to the risk premium.