Tuesday, June 30, 2009

Madoff Given 150-Year Sentence

Bernard Madoff was sentenced yesterday to 150 years in prison for investment fraud. At this point, the only people charged with a crime are Madoff and an outside accountant.

Before his arrest, Madoff’s firm’s accounts showed $65 billion in assets, but only $1.2 billion have been recovered so far to return to investors.

It is difficult to get a sense of scale of this fraud. One way to think of it is that the staggering 150-year sentence amounts to less than a day in prison for every million dollars missing in investors’ accounts.

It seems inconceivable that only two people could have perpetrated this fraud. If prosecutors are unable to convict any other guilty parties, they would have to consider their efforts to be a failure.

Monday, June 29, 2009

Assaults on Pensions Continue

The latest attempt to wiggle out of pension obligations to make the news is by the Globe and Mail in contract negotiations with its 440 unionized workers. Workers have rejected the latest offer and have given their union leadership a mandate to strike.

Initially, the Globe and Mail wanted to move workers from a Defined Benefit (DB) pension plan to a Defined Contribution (DC) pension plan. Later they offered to allow current workers to remain in the DB plan (with higher contributions), but new workers would go into a DC plan.

If financial pressures continue to mount for the Globe and Mail, it seems likely that there will be more attempts in the future to modify pension plans to reduce costs.

There are many factors that go into how much DB and DC plans actually cost a company, but the bottom line is that if the company is saving money on its pension, then retired workers, on average, must be getting lower benefits.

All this can be upsetting news for the wave of baby boomers reaching retirement age, but these assaults on pensions will intensify in the coming years. This isn’t what I’d like to see happen; it is a prediction, but not a wish.

Sunday, June 28, 2009

Insurance is not the Same as Protection

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

A while ago during a temporary gap in my house insurance, some of my friends joked about coming over to my place and “having an accident” to make some big money. Of course they weren’t serious, and we all had a good laugh.

Later on I thought about what had made the joke funny. If you think about it, a fraudster would have better luck getting a big settlement from an insurance company than from me. So, for a short while my house was probably the worst place to target for faking an accident. But my friends and I all got the joke instantly, even though it doesn’t seem to make much sense after some thought. What is going on?

To answer this you need to look at how house insurance is marketed and sold. The best example is one insurance company that shows the image of a giant protective blanket enveloping your house. As long as you don’t think about it too much, you have the feeling that house insurance actually helps prevent accidents. The marketing promotes this subconscious idea. Of course, if you think about it, it’s clear that all the insurance does is give you money if something bad happens (that is covered). This is valuable enough, but accidents are just as likely to happen whether you have insurance or not. So, my friends’ jokes depended on our false sense that insurance somehow prevents bad things from happening.

When making decisions about what insurance to buy, it is important to keep in mind that insurance is essentially a financial matter. You are not buying protection from calamity so much as you are buying financial compensation when accidents happen.

Friday, June 26, 2009

Short Takes: Media Coverage Dampens Stocks and more

1. According to a study reported by Larry MacDonald, stocks with high media coverage underperform stocks with low media coverage (the web page with this article has disappeared since the time of writing). The next logical question is whether the media coverage causes the diminished returns, or whether for some reason the media gravitates to certain stocks because they are likely to have lower returns.

2. Preet gives us a credit card payoff calculator. Hopefully this will inspire people to pay off their high-interest debt and not cause them to give up because it will take too long.

3. Million Dollar Journey recommends an eye-opening exercise of figuring out how long your savings would last in a “worst-case scenario”. My fearless prediction is that those whose finances are the most precarious are least likely to try this exercise.

Thursday, June 25, 2009

Grocery Bag Lessons in Economic Incentives

In many areas, grocery stores and other big box chain stores recently began charging a nickel for plastic bags. From a rational point of view, this should not have made a big difference. However, once the initial grumbling died down, there was a huge change in customer behaviour.

In our household, this nickel charge would have added a little less than a dollar a week to our grocery bill. But, the drive to save these nickels is compelling to us and seemingly to most other people as well. We bring our own bags, and when we’re forced to pay for a bag or two, we put more items in each bag.

The net result has been a huge decrease in the number of plastic bags given out by stores. And this change happened almost overnight because of a tiny charge for bags.

Economic incentives like this one are often a much better way of driving behaviour than setting rules. Governments serious about driving citizens to greener choices would do well to design effective economic incentives rather than imposing rules.

Wednesday, June 24, 2009

New Financial Regulations are not Socialism

President Obama plans to stiffen regulation of the U.S. financial sector, and critics are calling the planned changes socialism. However, this is far from the truth. In fact, the abuses that went on before the financial collapse were undermining capitalism, and changes are needed to regain a healthy capitalist system.

To understand how the financial system was undermined, we need to understand the nature of the gambles taken by financial companies. What they did was to take risks that had a high chance of a modest payoff and a low chance of a huge loss.

Why did they do this? So that the individuals involved could make money. Consider the following simplified example. Imagine that an employee can take a gamble with his company’s assets that collects a $5000 premium, but has a one in a million chance of losing $10 billion.

From the company’s point of view, this is a bad gamble because if we do this a million times, we will collect $5 billion in premiums, but we expect to lose $10 billion once for a net loss of $5 billion. However, things look very different from the employee’s point of view.

Suppose that the employee takes this gamble 200 times per day for 250 days per year. As long as the bad outcome never happens, the company will make $250 million, and the employee can expect an 8-figure bonus at the end of the year.

The employee gets to continue with these gambles collecting huge bonus cheques each year until the bad outcome finally happens and sinks the company. This is a disaster for the company, but the employee gets to walk away with tens of millions of dollars in bonuses.

The best part of all this is that the employees look like they are doing a good job making all this money for the company. As long as shareholders don’t understand the risk being taken, they will be very happy with the results until the fateful day when the worst happens.

This little game is very profitable for the management of financial companies and is the reason why regulators are focusing on trying to assess and control the total risk being assumed by financial companies. Viewed in this light, it is easy to see why dishonest management is unhappy to see the party end and would call any new regulations “socialism” or “communism.”

Of course, it could very well be that the new regulations will go too far or will constrain the financial system too much, but this is a risk that we have to take.

Tuesday, June 23, 2009

Entrust Takeover Vote Delayed to July 10

A former employer of mine, Entrust, is in the midst of a battle over a takeover bid by Thoma Bravo for $1.85 per share. Entrust’s board of directors is split over whether the deal is in the best interests of shareholders, and shareholders haven’t embraced the deal.

The vote on the takeover was originally scheduled for June 8, but was delayed to July 10. The stated reason was to “allow stockholders adequate time to evaluate the new information,” but it seems obvious enough that the real reason for the delay is that the vote would have failed.

I have now received 4 mailings urging me to vote for this takeover, each one more shrill than the last. The latest mailing contains the following on its own line:


The “TODAY” part adds an amusing air of desperation to the request.

The bid to complete this takeover took a blow when Arnhold and S. Bleichroeder Advisers, LLC, who control about 2 million votes and are accumulating shares, announced that they would vote against the deal. Their number one reason is that the price is too low.

One of the side benefits of direct stock ownership is getting to follow these little dramas.

Monday, June 22, 2009

Fantasy Airfare Ads

Two years ago a law passed requiring airlines to advertise the full price of airfares. Unfortunately, it contained a provision to delay implementation, and this delay has continued to today. There seems to be little political will to enforce such a rule despite the fact that it is popular with Canadians.

I decided to try a little test. Air Canada has a listing of special offers, the first of which is a $295 flight from Montreal to Bogota. However, here is a full listing of all the charges that came up for this route after I chose the lowest costs I could find:

$314.99 outgoing flight
$314.99 return flight
-$15.00 receive no Aeroplan miles for outgoing flight
-$15.00 receive no Aeroplan miles return flight
$30.02 surcharge
$252.00 fuel surcharge
$31.00 airport improvement fee
$17.00 air traveler security charge
$11.18 JS
$1.55 GST
$36.88 Columbia domestic airport tax
$979.61 Total

So, $295 turned into $979.61, a 232% jump! If they just increased the $252 fuel surcharge a little and maybe added another surcharge or two, they could advertise flights for just $1.

It has reached the point where advertised prices for flights are just meaningless. It’s high time that airlines started advertising all-in prices.

Sunday, June 21, 2009

What Makes the Stock Market Go Up?

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

Over the last 100 years, the Dow Jones Industrial Average has gone up by a factor of about 150. But this is only about half of the return because it doesn't include dividends. So you can multiply this by another large factor to get the full returns. Of course stocks have had some major blips in the last century, but this represents a relentless rise in stock prices. Even factoring out inflation, stocks have made an impressive long-term run. In the short term stocks rise because there are more potential buyers than sellers, and when demand outpaces supply, prices must go up.

Over the long term it seems like the stock market creates wealth out of nothing. Science teaches us the law of conservation of energy, we often hear that there is no free lunch, and we talk of zero-sum games, but the stock market doesn’t seem to be bound by any such law. Over the long term, almost everybody who stays in the game seems to win.

What makes stock prices rise over the long term? The short answer is innovation and hard work. The increasing number of people is a factor too, but the main driver of stock market prices is the continuous improvements in our lives due to better ways of doing things, better tools, and better toys. When a company hits the market with a better product at a lower price, the average person’s life improves a little, and this ultimately translates into more overall value in the stock market.

Better processes make it possible to produce goods with less effort, which frees people up to do other things and make other goods. This ability to do more with less means that the sum total of all the things we can produce rises over the years, and this is reflected in stock market prices.

If you still believe in continued innovation in our society, then you should be comfortable with the long-term prospects of stocks as a whole.

Friday, June 19, 2009

Short Takes: Buy and Hold and more

1. Larry Swedroe patiently debunks a recent Wall Street Journal attack on the buy and hold strategy. It’s amazing that people make claims that can be easily proven wrong by just looking at the numbers.

2. The Male Storm reports that if you’re willing to jump through a few hoops you can get $200 free from TD Canada Trust.

3. Larry MacDonald reports on the dismal interest rates offered on new Ontario bonds compared to bank GICs.

4. Preet has a great idea for a Father’s Day gift.

5. Big Cajun Man runs down the latest changes to the Consumer Price Index.

Thursday, June 18, 2009

Obama’s Sweeping Financial Regulations

Some details of Obama’s plans for sweeping reform of financial regulations are now out. Even the full report lacks detail because of the scope of the reforms.

It’s hard to figure out what effect all this will have on individual investors. The goals seem to be to prevent large financial disasters like the one the U.S. is now pulling out of and to increase consumer protections. Not surprisingly, commentators disagree on whether these reforms will achieve these goals.

One of the more interesting things I found on this topic is that Edward Yingling, President and CEO of the American Bankers Association (which represents all banks), doesn’t like the reforms. If bankers were supportive of the reforms, I would have suspected that Obama was on the wrong path.

A common theme from these experts is that “the devil is in the details.” There just isn’t enough information available yet to know what specific new regulations will be put in place to make investing in the U.S. safer.

The commentator who made the most plausible prediction was Ethan Siegel of the Washington Exchange, a firm that follows legislation for institutional investors. Siegel predicted that financial companies will try to slow down adoption of the new legislation, and there will be “opposition from congressional committee chairs who oppose giving up oversight of federal agencies proposed to be phased out or consolidated.”

Even when changes will benefit the vast majority of people, there will still be an unhappy minority who oppose the changes. Here’s hoping that Obama’s changes get adopted and that they actually do help the majority of people.

Wednesday, June 17, 2009

CRA No Longer Taxing Loyalty Programs

Until recently, if you accumulated points in some sort of loyalty program (like frequent flier points) while on business you were supposed to declare the value of these points as income. I doubt that many people actually declared this “income”.

This was one of those rules that make a criminal out of many people who just didn’t bother to do the accounting (assuming they were aware of the rule in the first place). For most business travelers, the value of such points is fairly low and there was very little point in figuring it all out.

Fortunately, the Canada Revenue Agency has changed the rule on loyalty program points. As long as you meet the following test, you no longer have to declare these points as income:

- the points are not converted to cash,
- the plan or arrangement is not indicative of an alternate form of remuneration, and
- the plan or arrangement is not for tax avoidance purposes.

I’m not 100% sure how these new rules would be interpreted, but it seems that the majority of people who collect points on business travel will no longer be required to declare the income.

Tuesday, June 16, 2009

Retirement, Zvi Bodie Style

Recently, the Wealthy Boomer discussed the investment ideas of Zvi Bodie, a Boston University finance professor (the web page with this article has disappeared since the time of writing). Bodie advocates investing 100% of assets in inflation-protected bonds called Real Return Bonds in Canada and TIPS (Treasury Inflation-Protected Securities) in the U.S.

These bonds pay a guaranteed rate of return on top of inflation. However, this guaranteed rate is quite low. Bodie uses 2% as a long-term estimate. The attraction is that these bonds are very safe even from inflation.

Bodie uses the example of saving 100 kopecks per year for 40 years, and then withdrawing an inflation-adjusted 280 kopecks per year for 30 years of retirement. All this comes with no worries about stock returns or inflation.

This sounds appealing, but it’s worth looking a little closer. To save for 40 years before retiring at age 65 means saving starting at age 25. I’m all for starting to save for retirement early, but realistically, few people start saving serious amounts for retirement at age 25.

Instead of talking about kopecks, let’s try dollars. Let’s say that a 35-year old worker Wanda saves $5000 per year (after tax) in a Tax-Free Savings account (TFSA). We’ll assume that Wanda does this for 30 years and that the amount saved each year rises with inflation.

Wanda never touches this retirement money for 30 years and earns 2% above inflation each year. How much can she withdraw each year for 30 years starting age 65? The answer is an inflation-adjusted $9200 per year. If this doesn’t sound very good to you, then I agree. Between this and the Canada Pension Plan, Wanda probably has enough for rent and food, but not much else.

What if Wanda rolled the dice and invested in a mixture of stocks and bonds and earned average compound returns of 5% over inflation? In this case she’d be able to withdraw over $22,000 per year for 30 years.

Of course there is no guarantee that anyone would average 5% over inflation. Wanda might instead have better or worse returns. To avoid this risk, she could just resign herself to the guaranteed $9200 per year, but this isn’t very appealing either.

The truth is that most people won’t manage to save even $5000 after tax each year for their retirement. They are faced with the choice of a guaranteed pittance each year during retirement using Bodie’s plan, or rolling the dice with riskier investments. My personal choice is to roll the dice.

Monday, June 15, 2009

Book Giveaway Results

The winners of the random draw for the book Inside the Mind of the Turtles: How the World’s Best Traders Master Risk, by Curtis M. Faith, are Marina and Alan. I have contacted the winners and have collected their addresses. The publisher, McGraw-Hill, says that the books should arrive in the next week or so. Thanks to everyone who entered the draw.

Portfolio Rebalancing

Many commentators advocate an investing strategy based on fixed percentage asset allocations among different types of stocks (large cap, small cap, domestic, foreign), bonds, cash, and possibly other things like commodities, real estate, or precious metals. This brings us to the question of what to do when assets grow beyond or shrink below their target percentages.

The main debate is between rebalancing periodically based on time, such as quarterly, or rebalancing based on percentages, such as when an asset is more than 5% off its target percentage. I don’t particularly like either approach. I prefer a focus on costs.

Suppose that an investor doesn’t have enough savings to qualify for low commissions on ETF purchases, and pays $25 per trade. If this investor doesn’t want to spend more than 1% on the sell and buy commissions, then all trades for rebalancing should be $5000 or more (and trades with new money should be $2500 or more).

This leads to a simple rule: rebalance when the allocation of some asset class is off by at least $5000. This may mean that for small portfolios, allocations can be very far off on a percentage basis. The fact that the portfolio is small means that this is not a major problem. As new contributions come in, the balance will be improved.

With this strategy, larger portfolios will be kept closer to the chosen asset allocation. As portfolios become very large (and qualify for lower commissions), a 1% rule might lead to frequent trading. In this case, the investor can switch to a rule based on a combination of trade size and deviation from the desired allocation.

By this I mean that rebalancing would take place when the allocation to an asset class deviates from the desired percentage by some amount (say 5%) AND the rebalancing would involve trades of at least a minimum size (say $5000).

I’m not a big fan of rebalancing at fixed times because it allow investors to ignore the need to rebalance when the stock market gets “scary”. If stocks drop by large amounts, this is the best time to rebalance. However, most investors ignore their asset allocations until stocks rebound. In this way, they miss the opportunity to profit from the plunge in stocks.

Much of the value of fixed asset allocations comes from buying asset classes when they are down. Failing to do so eliminates most of the upside of the asset allocation strategy.

Sunday, June 14, 2009

Fund Managers Running Scared

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

An index investing strategy is a major threat to the mutual fund industry. When you put your money in a low cost index fund, you are no longer paying the high fees charged by actively managed funds. Each investor with $100,000 in mutual funds with a Management Expense Ratio (MER) of 2% pays $2000 per year in fees. Up that to the $500,000 you’re hoping to have one day and the fees are $10,000 per year. It is no wonder that the managers of these high cost funds are highly motivated to fight against indexing.

Try typing “the case against index funds” into Google. You’ll get plenty of hits. The most amusing hit I saw was called “How to Market Against Index Funds.” At least the title makes the motivation very clear. I read through several of the articles I found while keeping an open mind about the possibility of learning about some real problems with indexing. After all, nothing is completely good or completely bad. Here are some of the main points in the case against indexing along with my thoughts.

Argument #1: Some index funds aren’t very diversified.

This is true to a point. For example the Vanguard Energy ETF is an exchange-traded fund that tracks an index of energy stocks. This fund is for investors who like energy stocks, not for those looking for diversification. The implication of this criticism is that all index funds lack diversification, and that you need an active portfolio manager to be safe from having all your eggs in one basket. This is simply not true.

S&P 500 index funds invest in 500 of the biggest U.S. companies, and the iShares Large Cap fund holds 60 of the biggest Canadian companies. If you are concerned about owning only large companies, then there is the Vanguard Total Market ETF that holds 1200 of the largest U.S. companies plus a representative sample of the remaining stocks. If you are concerned with owning only companies from one country, then there are international index funds. Some of your money could go into low cost bond funds as well, or you could buy a bond directly. There is no reason to pay high management fees to get diversification.

Argument #2: Our gains are more intelligent.

Some of the arguments given by active stock pickers amount to saying that their returns are somehow better than the returns on an index fund because of some vague attribute like intelligence, precision, or global-mindedness. This raises an important question: would you rather make a 10% return intelligently or 12% mindlessly? I’m not advocating investing without thinking, but what matters ultimately to your financial future are results, not the process.

Argument #3: Some people need their hands held.

The argument here is that some people need advice, and if they try to manage their own money they might get nervous and sell at a bad time. There is a lot of truth to this. Many people do panic and sell near a market bottom when they would have been better off just holding on. However, there are two problems with this argument.

How much should people pay for this “steady hand”? If you have $200,000 invested in mutual funds with an average management expense ratio (MER) of 2%, then you are paying $4000 every year to have your hand held. You might consider finding some cheaper way to avoid getting panicky and making poor decisions.

Just because you are invested in actively managed mutual funds does not mean that you automatically have someone there to stop you from making rash decisions. Many people own mutual funds in a self-directed account and are able to trade in an out of funds without the benefit of a friendly expert to calm their nerves. Fund managers may try to hold on to stocks that have dropped in price, but some of the fund’s investors will sell out of the fund forcing the manager to raise cash by selling stocks.

Argument #4: Over such and such a time period active funds beat index funds.

It is true that over some periods of time, actively managed mutual funds give higher returns than index funds. When making this kind of argument, the fund manager has to select the time period carefully, because most of the time, index funds win out. Where actively managed funds tend to win by a very small margin is in periods where the stock market performs very poorly. This is because most funds have to hold some cash (often around 10% of the money in the fund) to deal with the volatility of investors entering and leaving the fund. So over a period of time where stocks don’t do as well as interest on cash, a fund with 90% of its money in stocks and 10% in cash will beat an index fund with nearly 100% in stocks.

However, stocks have been much better long-term performers than cash. The cash component of actively managed funds is actually a factor in their long-term underperformance compared to index funds. For the investor who prefers to buffer bad times in the stock market by holding cash, a solution with lower fees than owning actively managed mutual funds is to own index funds along with some cash.

Argument #5: Some index funds do not have low costs.

This is certainly true. There are fund companies who have tried to jump on the indexing bandwagon and offer index funds, but with high costs to trap the unwary. This is a nice job if you can get it – charging high management fees without having to do much management.

This argument is like saying that medicine is bad because some people sell bad medicine. Investors in index funds just need to pay attention to management expense ratios (MERs) and avoid funds with high expenses.

In summary, I’m not necessarily against active stock picking. What I am wary of is paying a high price in the form of management expenses and other fees for the services of an active fund manager.

Friday, June 12, 2009

Short Takes: Book Giveaway, Cash for Clunkers, and Securities Lending

1. To enter the draw to win a copy of Curtis M. Faith’s book Inside the Mind of the Turtles: How the World’s Best Traders Master Risk (see review here), send an email with the subject “Book” to the address shown on the upper right corner of this blog. The draw will close Sunday June 14 at noon. I will contact the winners to get (Canadian or American) postal addresses.

2. Preet explains the new “cash for clunkers” program in the U.S. that pays people to trade in old gas-guzzlers for a fuel-efficient car. Maybe this is a business opportunity for Canadians to sell their old vehicles to Americans who want a new car, but don’t have a clunker to trade in.

3. The interest costs of borrowing stock for shorting had been mostly a mystery to me. Larry MacDonald gives several pointers to sites that explain securities lending.

4. Frugal Trader compares features of high-end chequing accounts. The monthly fees on these accounts looks like the amount I pay per year on bank fees.

5. Big Cajun Man reports that membership in registered pension plans actually rose in Canada during 2007. It seems a safe bet that this trend reversed in the past 17 months.

Thursday, June 11, 2009

Valuing Extreme Events

Much of economic theory is built on the assumption that financial returns follow the well-known Bell curve. However, there is much evidence to support the idea that the Bell curve understates the likelihood of extreme events.

Some theorists believe that financial returns follow a Cauchy distribution, which is superficially similar to the Bell curve:

However, the Cauchy distribution is narrower in the middle and higher at the sides. This means that mild events are a little less likely and extreme events are more likely.

To see just how different these curves are for extreme events we need to look at the same curves on a log plot where each horizontal gridline represents a factor of 10:

A 5-standard deviation event on the Bell curve is very unlikely, but the same event on this Cauchy distribution is about 6000 times more likely.

So, if a financial institution was selling insurance against unlikely events based on the Bell curve, it might charge a million dollars, but really have a 6-billion dollar exposure if the events actually follow a Cauchy distribution.

It’s not hard to see the potential danger of using the wrong math to value extreme events. Of course, this danger is mostly a problem for taxpayers who bail out financial institutions.

Wednesday, June 10, 2009

Our Drive to Seek Experts

“When most people are faced with making important decisions in the face of ... uncertainty, their gut reaction is to consult with experts ... even though [they] know that it’s impossible to foresee what the future will bring.” – Curtis M. Faith in Inside the Mind of the Turtles: How the World’s Best Traders Master Risk.

Television shows are filled with experts predicting whether stocks, interest rates, and currencies will go up or down. The truth is that these people are just guessing. The odds may favour a given stock going up instead of down, but either outcome is possible.

If we are betting on the outcome of a coin toss, no amount of consulting experts will allow you to determine whether it will come up heads or tails. However, for some reason we tend to seek and listen to experts who express opinions confidently about outcomes that, in reality, could go either way.

A related human quirk is the tendency to seek the perfect course of action in the face of uncertainty. Committees are often paralyzed trying to make the perfect choice when it isn’t possible to know which choice is the best. According to Curtis Faith, “the proper course is often obvious only in retrospect.” It is often best to go ahead with two or more options on a small scale and choose the best option later.

Fear of making the wrong choice leads us to let others makes choices for us. Seeking different viewpoints is sensible enough, but in the end, the ultimate decisions are our own. If your savings are lost due to poor investment choices, it is little comfort to be able to blame it on someone else.

Tuesday, June 9, 2009

Book Giveaway: Inside the Mind of the Turtles

The book Inside the Mind of the Turtles: How the World’s Best Traders Master Risk, by Curtis M. Faith is primarily about ways to both embrace risk and protect yourself from risk. The publisher, McGraw Hill, has graciously offered two giveaway copies for my readers.

To enter the draw, send an email with the subject “Book” to the address shown on the upper right corner of this blog. The draw will close Sunday June 14 at noon. I will contact the winners to get (Canadian or American) postal addresses.

Curtis Faith offers 7 rules for dealing with risk:

1. Overcome Fear. Fear clouds judgment.
2. Remain Flexible. Surprise outcomes may require a change of plan.
3. Take reasoned risks. Risk can be good if the odds are in your favour.
4. Prepare to be wrong. Plan in advance how to deal with unfavourable outcomes.
5. Actively seek reality. See the world as it is rather than as you want it to be.
6. Respond quickly to change. If your plan calls for some action in the face of unfavourable outcomes, don’t delay.
7. Focus on decisions, not outcomes. In the face of risk, good choices can have bad outcomes, and bad choices can have good outcomes.

The part of this book I liked best was the rational way of thinking about risk. A choice involves risk if there are several possible outcomes and you can’t be sure which outcome will become reality. Usually, no amount of analysis can allow us to predict the outcome for certain.

If we decide that the odds are in our favour and take a chance, the worst may still happen. For this reason, we should plan in advance what we’ll do if our luck is bad. By planning in advance for bad outcomes, we can choose a reasonable amount of risk to take on.

The main thing about this book that I didn’t like was the emphasis on trading. I think that much of the discussion about risk is useful for non-traders, but the book often comes back to trading strategies. It may be possible for a minority of traders to succeed, but it is easy to show mathematically that the average trader must perform worse than buy-and-hold investors.

A couple of good quotes:

“An economist is an expert who will know tomorrow why the things he predicted yesterday didn’t happen today.” – Laurence J. Peter

“In my experience, 95 percent of the ‘professional’ people in the investment business have no idea what they are doing. ... Most of them are just salespeople. ... You need to learn enough to distinguish between wise and foolish counsel.”

A not so good quote:

“The public at large is told that market timing is a fool’s game. ... They don’t understand what super returns people could get by just missing the worst market days.” – Van K. Tharp

Until someone shows me how to miss the market’s worst days without also missing good days, I remain skeptical of market timing claims.

Overall, I recommend this book for its useful and rational approach to thinking about risk. But, be prepared to filter out the parts that make less sense.

Monday, June 8, 2009

A Phone Call from Bell Canada

A pleasant-sounding woman from Bell Canada called me up the other day to save me some money. She told me that I could switch from my current $20 per month long distance plan to a $15 per month plan that gives more free minutes per month. This seems like a no-brainer, right?

For a second I was confused because I’m not on a $20 per month long distance plan. The Bell Canada lady checked again, and said that two different systems showed my records differently. Imagine that.

No worries, though. She still seemed to believe that I’d be better off in the new $15 per month plan because I use Yak, and Bell charges me a dollar for each Yak call plus I pay the Yak charges. This confused me again. Surely, I would have noticed if Bell were charging me an extra dollar for each Yak call.

She had lots more reasons why the new $15 plan is better than the roughly $7 I paid last month (a heavy long distance month for us). I had stayed on the call this long because I was interested in how Bell would try to sell me, but at this point I’d had enough and hung up.

I later confirmed that Bell does not charge me an extra dollar per Yak call and that the $7 included all additional Yak charges. I got the feeling that this lady was willing to say just about anything to get me to sign up for the new $15 per month long distance plan.

Sunday, June 7, 2009

An Investing Pitfall: Losing Your Nerve

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

Pundits, friends, and acquaintances confidently drone on about interest rates, the balance of trade, commodity prices, and the impending doom in the stock market. History tells us that when stock prices have been falling, the negative predictions increase. There is no reason to believe that these people know any better than anyone else whether stocks will go up or down in the short term. Anyone who could actually predict where the stock market was going in the short term could easily make a fortune fast.

Some successful investors say that one of the best times to buy is when the masses agree that stocks are doomed. This barrage of negative news about the stock market leads to a common problem for nervous investors: selling when prices are low. If the stock market then rallies, these investors lose out. I’m not advocating waiting with your cash until the world seems to be crashing down and then buying in either. This kind of market timing works for few people.

If your investments are keeping you up at night, it could mean that you are listening to too many predictors of doom, or that you have too much of your money in stocks rather than bonds. As long as you don’t need the money for a few years, there is no reason to be nervous about short-term market fluctuations.

Friday, June 5, 2009

Short Takes: Securities Lending, Financial Literacy, and Management Fees

1. Larry MacDonald shows how mutual funds and ETFs make extra money lending out shares belonging to investors. Unfortunately, it is investors who lose if the organization borrowing the shares is unable to return them and the collateral suffers losses due to being poorly invested.

2. Jonathan Chevreau reports on a push to boost financial literacy for youth (the web page with this article has disappeared since the time of writing). Amusingly, the financial literacy forum is being hosted by the Investment Funds Institute of Canada (IFIC). If Canada’s youth were to learn what they need to know about money and investing, the Canadian investment industry as it currently exists would be all but wiped out.

3. Canadian Financial DIY tries to get to the bottom of what Claymore means by “MER” and “management fees”.

4. Patrick makes a case against waiting until the market “calms down”.

5. Preet continues to look at strategies for simultaneously shorting both the bull and bear versions of leveraged ETFs. My suspicion is that over the long run the gains won’t exceed the interest on borrowed shares by enough to make this strategy sufficiently profitable, but I’ll reserve judgement until Preet is done fine-tuning this strategy.

6. Big Cajun Man saves money by buying meat at 50% off, but seems conflicted about whether he believes it is truly safe.

Thursday, June 4, 2009

Entrust Shareholders Vote on a Takeover

When you hold shares in a company, you get the chance to vote on issues that come up. Most of the time the results of these votes are expected to be a landslide, but occasionally the outcome is in doubt. This is the case for a former employer of mine.

On June 8 shareholders will vote on whether to accept an offer from Thoma Bravo to buy Entrust for $1.85 per share. The curious thing is that Entrust closed at $1.92 per share on June 3.

Shareholders are probably hoping for a better offer, or they believe the takeover will be voted down. The more interesting question to me is:

Why would anyone vote to approve this takeover?

It’s obviously better for a shareholder to sell shares for $1.92 now rather than approve the takeover and wait to receive $1.85. This reasoning makes sense for small shareholders who can sell without driving the price below $1.85.

It’s possible that shareholders with large blocks of shares might prefer the takeover because they can’t sell their shares without driving the average price below $1.85. However, it still makes sense for these shareholders to be selling shares slowly to get the higher price for some of them.

A minor complication is that a large shareholder who wants the takeover vote to pass wouldn’t want to sell shares to someone who will vote against the takeover. However, voting rights go to shareholders of record as of May 11. So, selling shares after May 11 allows the shareholder to retain voting rights while still collecting a higher price than $1.85.

Another complication is that management own shares as well, and they may vote for the takeover because they see better conditions for their jobs, or they may have struck private deals as part of the takeover that delivers them additional money.

I don’t know whether the takeover will be approved, but after receiving a third reminder to vote my shares, I’m thinking the vote may be close.

Wednesday, June 3, 2009

Let’s Make Money

I got the chance to view an advance copy of the DVD Let’s Make Money (available June 16) from Mongrel Media. It’s a documentary about the world’s financial system and how this system has failed some desperately poor countries.

I like to hear multiple opinions on important issues, but that doesn’t necessarily mean that I buy everything I hear. One thing I look for is sensible detail. Accusing an organization of wrongdoing is more credible if the accusation includes details of how things were done and what the parties had to gain from their actions.

One interesting part was remarks from John Perkins, a self-described former “economic hit man”. Perkins claims to have helped U.S. companies obtain natural resources cheaply from countries with the following steps:

- Arrange a huge loan for the country from the World Bank.
- Divert the loan to U.S. companies to build infrastructure projects in the country.
- Choose projects that benefit a few rich and powerful people in the country (so that they will agree to the deal), but not necessarily benefit the general population.
- When the population is unable to repay the loan, get them to agree to deliver their natural resources, such as oil, cheaply.

Perkins says that this usually works, but that he failed to convince two world leaders to accept huge loans: Omar Torrijos of Panama and Jaime Roldós of Ecuador. Perkins claims that in both cases, “jackals” were later sent in to kill these leaders.

Whether all this is true is open for debate, but Perkins gives enough detail that it seems that either his account is mostly true or his story is a complete fabrication. One thing that argues in Perkins’ favour is that his recipe for extracting resources cheaply from a poor nation looks like it should work.

Another interesting part of the DVD is an account of how various tax havens protect the identities of people who hold money in trusts. It’s not hard to see why some governments are concerned about losing tax revenue to off-shore trusts.

Overall I found this DVD interesting and recommend it to those who have an interest in world finance and the plight of poor nations.

Tuesday, June 2, 2009

Consumers Lose with Credit Card Rewards

Banks seem to be getting quite generous with credit card rewards, particularly for premium cards. However, some Members of Parliament are unhappy with the fees charged merchants to pay for these rewards.

On the surface it all seems like a great idea. You buy stuff with your credit card and later you get back a percentage in cash or in points that can be used to fly or buy stuff. Premium cards are even better because the rewards are bigger. But we know there is no free lunch. Who pays for all this?

To answer this question we have to follow the money for a couple of steps. To begin with, merchants are charged fees for accepting credit cards. The amount they are charged is called the credit card interchange rate. This rate is higher for premium cards.

Of course, since merchants get to keep less of the money from a sale, they have to raise prices. So, ultimately, consumers’ credit card rewards are paid for by consumers. But, consumers actually pay extra because banks keep a slice of the interchange fees charged to merchants.

If the interchange rate is increased by 1%, prices will have to go up by about 1% to compensate, but consumer credit card rewards will go up by less than 1%. In the big picture, consumers would be better off with a rock-bottom credit card interchange rate and no rewards.

Banks have an interest in increasing interchange rates as much as possible to increase their profits. To this end they have been flooding their customers with unsolicited premium cards. Maybe merchants need to offer discounts for using either cash or credit cards with low interchange fees.

Monday, June 1, 2009

Interest Rate Differential on Mortgages

When homeowners try to break a fixed-rate mortgage, they can be blind-sided by a whopping interest rate differential (IRD) penalty. It’s important to understand what you are agreeing to when you sign for a mortgage.

Periodically, your bank will send you a statement telling you what your current mortgage balance is, but this balance is not an accurate reflection of your obligation to the bank. To understand this, consider the following fictitious example.

Bob and Sue Ward bought a house a year ago and got a $250,000 mortgage with a 5-year fixed term at 6% interest. With a 25-year amortization, the payments were $1599.52 per month. After 5 years, the remaining mortgage balance would be $224,592.

Sue’s job is moving to another city and the Wards have now sold their house. Their latest statement says that the remaining mortgage balance is $245,501. However, this figure has no connection to the Wards’ actual obligations.

When they signed for their mortgage a year ago, the Wards agreed to make 60 monthly payments of $1599.52 and a lump sum of $224,592 after 5 years. A year into the mortgage, their obligation is 48 more monthly payments plus this lump sum.

The remaining balance shown on their mortgage statement assumes that interest rates have remained the same. But, what if rates have dropped? Suppose that the current rate for a 4-year term is down to 4%. This means that their supposed mortgage balance is a meaningless number. What the Wards really owe is 4 years of monthly payments of $1599.52 plus the lump sum.

To figure out what the Ward’s really owe, we need to find the mortgage balance that would give a monthly payment of $1599.52 and a lump sum after 4 years of $245,501 based on 4% interest. Their debt turns out to be $262,574! This is $17,073 more than the amount on their mortgage statement.

Such a large interest rate differential penalty can come as quite a shock. The Wards didn’t realize it, but when they signed for their mortgage, they were betting against an interest rate drop and lost this bet.

There are a number of potential complications when calculating an actual interest rate differential (IRD). Prepayment privileges, like doubled payments or yearly lump-sums, should lower the IRD. There are various ways of estimating the IRD, and most of these overstate a fair amount.

For example, one might say that the bank will be missing out on 2% interest for 4 years on an average balance of about $235,000. This works out to a penalty of $18,800. This is $1727 too much. The problem with this estimate is that it takes future amounts of bank losses and doesn’t discount them before collecting them in the present.

I was unable to find a description of how various banks actually calculate IRDs, although several web sites give ways to estimate the amount. The fair method that I used in the example is simple enough, and there is no excuse for using an inflated “estimate”. However, banks would rather have more money than less.