Monday, August 31, 2009

Studying Financial Markets with Fractals

Benoit Mandelbrot is famous for developing the idea of fractals and showing that many aspects of nature follow fractal-based laws. In his book The (Mis)Behavior of Markets he shows how his theory of fractals applies to financial markets and manages to do it with very little mathematical discussion.

Mandelbrot takes a very visual approach. His starting point is to randomly generate fictitious price charts according to modern portfolio theory and observe that the charts don’t look right. When they are placed next to real price charts, the fakes can be picked out by people just looking at them.

As it turns out, the problem is that extreme price changes are more frequent than portfolio theory predicts, and the bigger price moves tend to come in bunches. The distribution of real price changes doesn’t follow the standard Bell curve.

Mandelbrot makes convincing arguments that price changes follow a distribution that is wilder than a Bell curve. Using fractal-based methods, he is able to generate fictitious price histories that are much more realistic-looking.

Bell curves are used for statistical purposes in many endeavours, and the truth is that it is never exactly the right fit. Any time we model the real world with math the fit isn’t perfect. For example, nothing in the real world is exactly circular. The important question is whether the model is good enough to give useful answers.

Modern portfolio theory is able to give useful answers to some questions, but Mandelbrot shows that it frequently gives wrong answers as well. The main problem is that it underestimates the likelihood of big gains and big losses. A good example of this is David Li’s formula for measuring the risk of default in baskets of mortgages that grossly underestimated the chances of widespread defaults that lead to the recent global financial collapse.

Mandelbrot doesn’t leave us with any single solution to the problem of figuring out what we should own in our portfolios. One thing for certain is that we need to be prepared in the future for the kind of volatility in stock prices that we saw in the first half of this year.

Sunday, August 30, 2009

Why Does Diversification Work?

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

In an earlier post I showed how over time an investment with a given expected return is likely to have a lower actual return due to volatility. The more volatile an investment is, the bigger the difference between the expected return and the actual returns you get.

One way to reduce volatility and increase the actual return from investments is diversification. To diversify means to spread your money among multiple investments. This is the “don’t put all your eggs in one basket” advice that we often hear.

Let’s go back to the example in the earlier post where we have an investment that each month either doubles or loses 60% with equal probability. This kind of extreme case is unrealistic, but makes it easier to understand how diversification helps. We saw before that the most likely outcome was that this investment would lose almost everything over 3 years, even though the average outcome is that $10,000 grows to $7 million.

Suppose now that we have two independent versions of this investment (A and B). There are now 4 equally likely outcomes each month: both up, only A up, only B up, and both down. Let’s look at three different investment approaches:

1. Put $10,000 into investment A and let it ride for 3 years.
2. Put the $10,000 in investment B.
3. Use a combined (or diversified) strategy where we put $5000 into each investment, and after each month pool the money and split it up evenly between the two investments again.

Here is a typical outcome after 3 years:

Incredibly, both investments A and B on their own dropped down to $180, but the diversified approach grew to $36,000! Even more amazingly, look at what happens when the money is split evenly among 100 different independent instances of this type of investment:

In this case, the money grew fairly steadily all the way up to almost the $7 million expected return that we calculated earlier. Diversification among identical independent investments doesn’t change the expected return, but it does reduce volatility which drives the most likely outcome closer to the expected return.

This may seem too good to be true. That’s because it is. In the real world there aren’t investments that offer such high returns. Also, investments are not completely independent. For example, spreading money among a number of good stocks reduces volatility, but only up to a point. The stock market as a whole still has volatility because the returns of all stocks are correlated.

This idea of correlation is important for mutual fund investors. An investor may feel better owning 20 different mutual funds, but if the funds own all the same stocks, then the funds are highly correlated. This means that they all tend to go up and down together, and the investors have not reduced the volatility of their returns much.

In the examples used here, we saw the benefit of diversifying among investments with identical attributes. There would be no benefit if you diversified into a poor investment. For example, if you own 3 good stocks and you diversify into lottery tickets, your expected return and your most likely return will both go down.

Diversification is good for your investment returns, but only if each individual investment has a good expected return.

Friday, August 28, 2009

Thursday, August 27, 2009

How is Credit Card Interest Calculated?

My recent experience with accidentally paying my credit card bill late sent me back to my credit card agreement to figure out how long I’d be paying interest. The agreement does not seem to be consistent with how my account has been handled.

Here is what my credit card agreement says about the test for not having to pay interest:

We don’t charge interest on purchases appearing on your account statement for the first time if:
- you pay your new balance in full by the payment due date, and
- you also pay the new balance shown on your previous account statement in full by the due date shown on that account statement.

So, you have to pay your bill in full on time two months in a row to get back to interest-free purchases. That should have meant that my most recent bill wouldn’t have any interest on it, but I was charged interest.

My best guess is that the way a purchase is handled is related to the status of your account at the time the purchase was made rather than the time it appears on the statement. However, this is just a guess.

After having read through the whole agreement, it became obvious to me that the rules for charging interest are simply not clear. If there are any readers who can point me to a more precise description of how credit card companies charge interest, I’d appreciate it.

Wednesday, August 26, 2009

Credit Card Interest Rollercoaster

I admit it. I forgot to pay my credit card bill back in June. By the time I realized what had happened, my payment was 10 days late. Unfortunately, it’s been three months now and I can’t seem to get off the credit card interest rollercoaster.

I’ve received good advice in the past to just call the credit card company and get them to reverse the interest because this was a simple mistake. I didn’t bother because the amount was small, and I felt like I deserved my fate.

Initially, in an attempt to get back on the straight and narrow, I found out what I owed in total (including recent purchases) and paid a little more thinking that that would end the interest cycle. When the next bill came it had interest on it again. The amount was even smaller, but still annoying.

Once again, I found out my total amount outstanding including recent purchases and paid a little more. Once again, this month’s bill has interest on it. The amount of interest is smaller still, but somehow more annoying.

It’s time to try something different. I’ve already paid enough to cover the bill plus recent purchases plus a buffer of about $13. My plan now is to not use the credit card again until they stop charging me interest.

I doubt that this is what the credit card company had in mind when they set the rules that seem to make it impossible to get out of the cycle of interest, but it’s a game for me now. I have no problem paying cash for a while.

Tuesday, August 25, 2009

How Much House Can You Really Afford?

The recommended maximum debt levels for homeowners have always sounded high to me. But this has been little more than a feeling until I looked over some old numbers from when I bought my first house. This exercise has confirmed for me that the maximum debt levels are alarmingly high.

According to the Canada Mortgage and Housing Corporation, housing costs (including mortgage payments, property taxes, and heating expenses) should not exceed 32% of your gross income. When other payments on such things as car loans, lines of credit, and credit cards are added in, the total should not exceed 40% of your gross income.

I agree that people shouldn’t exceed these levels, but how sensible is it to even come close to these percentages? I decided to compare these figures to my own experience buying my first house.

My wife and I had a 27% down payment, and although the mortgage amount looks small now, it was scary for us back then. We spent a little more on the house than we planned to (as many first-time home buyers do). The monthly mortgage payment seemed large, but we were confident that we could handle it.

Adding in property taxes and heating, our initial housing costs were 22% of our income. This put us well below the 32% limit. We had no other debts, and so we were at just over half of the overall 40% debt load limit.

Because we were very nervous about being in debt, we put on a full-court press to pay off the mortgage. For the first two and a half years we took advantage of all the extra payment features of our mortgage including extra amounts each month and a lump sum each year.

Over those first two and a half years, the total of our mortgage payments, extra payments, property taxes, and heating payments were almost exactly 40% of our income. This was the best we were able to do during a period with favourable conditions: we weren’t long out of school and were used to living frugally, and we didn’t have any children yet.

To have started out with payments adding up to 40% of income would have been madness. The slightest hiccup would have sent us off the rails. As it turned out, we couldn’t sustain the pace we had set once we had our first child. After that we reduced our mortgage payments to less than half of what we had been paying.

Prospective homeowners should seriously consider buying much less house than the experts say they can afford.

Monday, August 24, 2009

“Nothing is More Important than Family”

The title of this post is how an ad I received for life insurance starts. This line seems intended to exploit the fact that older people have a desire to leave money for their children and grandchildren when they die. This is an admirable goal, but the particular type of life insurance offered isn’t a good way for most of us to leave money for family.

The ad goes on to explain that if you’re between 40 and 75 years old, “you cannot be turned down for any reason,” and “there’s no medical exam – and no health questions.” Wow! You’d think that everyone with a terminal illness would be lining up for this deal.

The ad contains no hint of any kind of restrictions, but the web site of the bank offering this insurance has additional information. It turns out that if you die in the first two years, your estate doesn’t get the coverage amount. Instead, your estate gets an amount that is calculated based on how much you’ve paid in premiums.

If you’re closer to the 75-year old end of the scale, two years worth of premium payments turns out to be a significant fraction of the coverage amount. So, either your family won’t collect the coverage amount, or you’ll have to pay a significant fraction of the coverage amount to maintain coverage.

It’s possible that some people are in a situation where this coverage makes sense, but it’s hard to believe that it’s sensible for very many of us. Make sure you understand what you’re buying if your life insurance doesn’t require a medical exam or any health questions.

Sunday, August 23, 2009

Understanding Investment Risk and Volatility

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

In a previous post, I showed how the average real return in the U.S. stock market from 1926 to 2000 is 9.3%, but that this translated into a compounded real return of only 7.4%. The reason for this difference is the volatility of the returns. Let’s go for a better understanding of the cost of volatility without any advanced math.

A Simple Example

Suppose that you have $10,000 invested for two years. In the first year you lose 10%, and the next year you make 10%. It might seem at first that you have your $10,000 back, but that isn’t exactly right. After the first year you were down to $9000, and then in the second year you earned 10% on that $9000 to get a total of $9900. In the end you lost 1% of your money.

However, the annual returns were -10% and +10% for an average return of 0%. The lost 1% over the two years is not due to a negative expected return; it is due to the volatility of the returns. The average return is 0%, but the compounded return is about -0.5% per year.

Another Example

Extreme examples are sometimes useful to bring out subtle points. Let’s consider an example that is unlikely to exist in the real world. Suppose you find an investment that returns either +100% or -60% with equal chance after a month. Each month either you win and your money doubles or you lose and 60% of your money disappears.

On the surface, this sounds great. Adding up the returns and dividing by 2, we see that the average return is 20% each month. If you could compound $10,000 at 20% per month for 3 years, you would have $7 million! You decide to go for it, and here is the result:

What happened to the millions? The original $10,000 is down to $180. A first thought is that due to bad luck, the investment returned -60% more often than +100%. But, it turns out that both happened exactly 18 times.

To understand this, we need to think about it in a different way. Instead of +100%, think of it as multiplied by 2. Instead of -60%, think of it as leaving you with 40%, which is the same as divided by 2.5. So your investment is multiplied by 2 half the time and divided by 2.5 half the time.

Now it makes perfect sense that the investment value would drop. Starting with $10,000, after one rise (to $20,000), and then one drop (to $8000), we have lost 20%. Over 3 years, this happened 18 times. The compounded annual return is -10.6%.

Does all this mean that the original calculation of the average return being +20% and expecting to have $7 million at the end is wrong? No, it doesn’t. If you repeated this experiment enough times, you would find that on average you would really get $7 million. In over 98% of the trials the return would be less than average, but in a very small fraction of the trials the return would be an outrageously large amount. It is these large amounts that inflate the average to $7 million.

The most likely outcome is still that you will lose most of your money. In real life, this effect isn’t as dramatic, but the idea is the same. The average stock market return from 1926 to 2000 was 9.3%, but due to the volatility of the returns, the compounded return was only 7.4%.

Friday, August 21, 2009

Short Takes: Middle Class Squeeze, Cheap Travel, and Banning Advisor Commissions

1. Rob Gerlsbeck wrote an interesting piece claiming that the Canadian middle class is being unfairly squeezed financially (the web page with this article has disappeared since the time of writing). I don’t buy Gerlsbeck’s arguments. I find that they fall into the category of telling people what they want to hear. It’s easier to sell an article if it tells people they are beautiful, their problems are someone else’s fault, and chocolate, alcohol, and coffee are good for you.

2. Million Dollar Journey has some specific tips for saving money on travel including saving on airfare, accommodation, sightseeing, and food.

3. Preet reports that the planned ban on financial advisor commissions in the UK has partially spread to Australia.

4. Canadian Financial DIY takes issue with the MacLean’s article making the case against having kids. The article may be largely correct from an objective point of view, but people are definitely not wired to be objective when it comes to children.

5. Big Cajun Man plans to cut back on cell phone use and switch to a pay-per-use plan. Good luck!

Thursday, August 20, 2009

Questions about Ponzi Scheme Operators

It’s understandable that victims of Ponzi scheme operators like Bernard Madoff and Earl Jones focus mostly on trying to get their money back and on seeing criminals punished. Not being a victim myself (so far) allows me enough detachment to question the mindset of the guilty.

Do these people enter into their occupations planning to defraud investors or do they get tempted to dip into the money or to overstate the returns they generate? Once there is a gap between actual amount invested and the amount investors are told they have, it wouldn’t take too long for this gap to grow out of control.

The part that is most baffling to me is why more Ponzi scheme operators don’t try to run off to some other country and hide. As the end is drawing near and the amount of money still in their control dwindles, it becomes obvious that they will eventually be found out. Perhaps the onset of the recession sped up the demise of the Ponzi schemes enough that their operators hadn’t finalized plans to hide from their victims in some remote corner of the planet.

Maybe there is nowhere in the world to hide from authorities who would try to track down Madoff given the incredible size of his fraud. But in Jones’ case, you’d think that he might be able to take the last $3 or $4 million and try to hide. Maybe he just waited too long until he didn’t have enough money to live on if he ran away.

Another puzzling part of all this is that Madoff and Jones ran their schemes with enough skill that it seems that they could have run a legitimate business and made a very comfortable income. When it comes to the risk of doing jail time, it seems that some are far less risk-averse than I am.

Wednesday, August 19, 2009

Some Hope for Young People and their Money

You don’t have to look too far to find examples of young people making poor financial choices such as plunging into debt with a car loan. However, a small choice by one of my sons brightened my day.

He received a $25 movie theatre card for his birthday. Those who give bad advice about found money might suggest a mini-splurge. Perhaps he could go to a movie and buy enough popcorn and chocolate to wipe out the card in one evening.

Instead, he noted that movies cost only $4.25 on Tuesdays, and he can see almost six movies with his card as long as he eats before going. Bravo! A great many adults would do well to show this kind of financial restraint.

Tuesday, August 18, 2009

New Retirement Plan

The advocacy group CARP has a multi-part plan for pension reform (the web page with this article has disappeared since the time of writing), but they had me at the first part.

Currently, a retiree with no income or pension gets $13,636 per year from Old Age Security (OAS) and the Guaranteed Income Supplement (GIS). CARP would like to see these benefits “substantially increased” and for benefits not to be reduced for married couples.

Suppose that the total benefits jump to $18,000 per year, and that a married couple would get $36,000 per year. Assuming that no income tax would be paid on this, I think my wife and I could live on $3000 per month. This brings me to a possible new retirement plan.

Add up your current total retirement savings and divide by the number of years left until you turn 65. If you think you could live on this amount each year, then you could quit your job right now! Your savings would run out just in time to start collecting the new and improved OAS and GIS.

This strategy isn’t without its risks: maybe CARP’s proposals won’t be adopted, and maybe you can’t live on as little money as you thought. On the plus side, this plan may have you retiring much sooner than you thought possible.

If too many Canadians find their inner frugality and adopt this plan, I’m not sure who would be left to pay the taxes to cover OAS and GIS payments, but math doesn’t seem to be a big part of CARP’s plans.

Monday, August 17, 2009

Wise Investing with Larry Swedroe

It can be a challenge to write new and useful financial articles regularly, and many financial writers fall into the trap of speculating about short term movements in stock prices or interest rates. Larry Swedroe, author of the book Rational Investing in Irrational Times, avoids this trap and brings us consistently useful essays.

Here is a selection of Swedroe's recent articles (none of which appear to be online any more):

Should Average Investors Do it Themselves? Another interesting question is how can you expect an investor, who can’t handle his own investments, to be able to choose a competent and honest financial advisor?

Is ETF Tradability Good or Bad? You’d be surprised how much lower investors’ returns are compared to the ETFs they own.

Why You Shouldn’t Expect to Outperform the Market To beat the average at investing, you have to take money away from someone else. Do you think you’re better than those you are trading against?

Sunday, August 16, 2009

Inconsistent Reports of Long-Term Stock Returns

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

When giving out investing advice, many authors report long-term average stock returns, but the numbers seem to differ from one author to the next. Surely, we have lived only one history. Some differences can be explained by the authors studying different time periods or different baskets of stocks. However, there is another reason for differences that relates to how the average is calculated.

In Chapter 6 of Worry-Free Investing, Zvi Bodie and Michael Clowes discuss U.S. stock returns from 1926 to 2000. They give real returns, which means the returns after inflation is subtracted out. Based on the historical data, they calculate the average yearly real return on stocks to be 9.3%. But, others say that the long-term real return on U.S. stocks is 7%.

This may not look like a big difference, but if you play around with one of the many free retirement calculators available online, you’ll find that an extra percent or two of return on your investments each year makes a big difference over the long term. So, which one is the correct historical average return?

It turns out that they are both right because they are talking about different things. The 9.3% figure comes from taking the returns from each of the 74 years, adding them up, and dividing by 74 (a simple average). This is what we usually mean by the average return. It is sometimes called the arithmetic average to distinguish it from other types of averages.

According to Bodie and Clowes (see pages 86 and 87), $100 of stock in 1926 rose to a value of $20,000 in the year 2000 (after factoring out inflation). If the stock market had risen by the same percentage every year instead of jumping up and down, what return would have given the same performance? Instead of 9.3%, the answer is 7.4%. This is the average compounded return (also called the geometric return).

The difference between the average return and the compounded return depends on how much returns vary from one year to the next. The more an investment’s value jumps up and down, the bigger the difference between the two kinds of average. This may seem similar to what is going on with risk-adjusted returns but they are not the same. Risk-adjusted return calculations artificially penalize volatile investments by more than this difference between the two types of average.

Which of these two averages is the right one to use? That depends on what you are using it for. If you want to know the average return for one year, then use the arithmetic average. If you want to know what is likely to happen if you let some money ride for a long period of time, use the compounded return.

Friday, August 14, 2009

Short Takes: Information Overload, Active Investing, and more

1. According to a recent report, information overload costs workers 8 hours of productivity each week. They define information overload as the “disruption of the work day with irrelevant material, including e-mails, meetings, automated news feeds and Twitter.” The phrase “information overload” portrays the worker as a hapless victim of these information interruptions. This is silly. People compulsively check their Blackberries and iPhones out of boredom. Noise and visitors are interruptions; Twitter, email, and text messages can be ignored, but are just more interesting than the task at hand.

2. Where Does All My Money Go? hosts a guest article by a financial advisor with some clear thinking on the active versus passive investing debate.

3. Canadian Financial DIY has some fun with an analogy between inflation and alcohol.

4. Larry MacDonald is pessimistic about the future of TV because his young children seem to prefer using a computer. I see the world of TV changing rather than dying. My children are older and they do watch TV, but they do it on their computers while playing a computer game and chatting with friends, all at the same time. The days of having a large screen dedicated solely to cable or satellite content will eventually fade away. Most people will have all the screens in their homes connected to some sort of computer. Video content will arrive in a variety of ways. I’m not sure that life will be any better, though.

5. Big Cajun Man tries to decide whether to drive, bike, join a car pool, or take the bus to his new job. Taking a car is certainly the easiest path.

Thursday, August 13, 2009

Taxing Ponzi Victims

It’s bad enough that the victims of Bernard Madoff and Earl Jones have lost their money, but now they have a tax mess spanning many years. Fortunately, there are tax rules in place to alleviate some of the pain.

To illustrate the potential tax unfairness, consider a hypothetical investor Ian who invested $200,000 with a charismatic guy who turned out to be running a Ponzi scheme. For 10 years, Ian received a cheque for $1000 every month along with a statement showing his savings rising steadily. Ian’s last statement before the Ponzi scheme was uncovered showed a balance of $300,000.

Each of the last 10 years Ian has been paying taxes on the $12,000 interest at his marginal tax rate. If the tax man treats Ian’s $300,000 as suddenly going to zero, then Ian will have a net capital loss of $200,000. Unfortunately, Ian doesn’t have other investments with capital gains, and so he can’t make much use of this large capital loss.

In reality, though, Ian’s money didn’t evaporate suddenly. The Ponzi operator actually returned some of Ian’s money to him each month and stole the rest a little at a time. One way to look at Ian’s investment is that he put in $200,000 and had $1000 of it returned to him each month for 120 months.

Taking this view, Ian shouldn’t have paid any tax on the $1000 per month, and he should be left with an $80,000 capital loss. In most cases the tax rules will permit Ian to re-file his income taxes for some number of previous years to reflect this reality.

The U.S. has the concept of a “theft loss” that permits victims to offset any type of income against the loss. Canadian tax authorities can choose to make similar allowances for victims. This is a complex part of tax law and victims would be wise to consult experts to maximize the amount of past taxes on phantom income that can be recovered.

Wednesday, August 12, 2009

Portfolio Rebalancing: Discretion can be Dangerous

One of the advantages of typical asset allocation where investors maintain fixed percentages of stocks and bonds is that portfolio rebalancing makes us automatically sell high and buy low. However, this advantage only exists if you actually do the rebalancing.

Unfortunately, many investors seek reasons to avoid rebalancing at the very time it would give the greatest advantage. Catherine Gordon on the Vanguard blog discussed rebalancing recently. I don’t want to pick on her too much, but her remarks include the following:

“This is a good time to take a hard look at that allocation and ask questions such as, ‘Was I really too aggressive for what I was trying to do?’ or ‘Was I truly diversified?’”

It may not be her intention, but when stocks are down, many investors asking themselves these questions would decide that they had been too aggressive and should not rebalance from bonds to stocks.

This past March would have been a fantastic time to have sold bonds to buy stocks to maintain a chosen asset allocation. However, too many investors, driven by fear, failed to act.

When failing to act, one investor might just stick his head in the sand and another might say “I’ve decided that my model portfolio was too aggressive.” The latter investor may sound more intelligent, but a truism in investing is that if two people take the same actions, they will get the same results no matter who is smarter.

Many commentators debate how often one should rebalance, and whether it should be done on a time schedule or triggered when percentages deviate by a certain amount. The truth is that these considerations matter little compared to whether the investor chooses a rule and sticks to it.

Sadly, too many investors use their discretion to avoid rebalancing during times when it would do the most good.

Tuesday, August 11, 2009

Sophisticated Portfolio Rebalancing

Typical advice for investor portfolios is to choose some asset allocation such as 50% stock and 50% bonds, and rebalance as necessary to maintain this balance. PŮR Investing Inc. offers a different approach that focuses on risk. Their approach actually combines two strategies that are sometimes at odds.

PŮR is critical of typical target date funds that slowly reduce portfolio risk on a fixed schedule as the target retirement date nears. PŮR proposes two strategies:

1. Rebalance individual portfolios to maintain a fixed level of risk rather than a fixed percentage asset allocation.

2. Choose a level of risk over time designed to get the portfolio to a target dollar amount.

The first strategy involves selling out of investments when volatility increases. So, when stock prices start to jump around, shift money to bonds to maintain a fixed risk level, and when stock prices becomes less volatile, shift back.

The second strategy involves choosing a level of risk that maximizes the chances of building the portfolio to a target amount by the investor’s retirement date. PŮR describes this idea delicately by saying that as the portfolio builds close to the target amount, money is shifted to safer investments. This sounds much better than saying that when the portfolio value drops, start taking bigger chances to try to make the money back.

When we think about these strategies in isolation, they tend to sound quite smart. Get out of stocks when they become risky, and buy more stocks when the price is low. But, what do you do if stock prices become more volatile at the same time that they have dropped in value? The two strategies will offset, and minimal action will be taken.

I'm convinced that the second strategy makes sense; investors have little choice but to take some chances to reach a minimum standard of living for retirement. The first idea about maintaining constant risk is intriguing, but I’m still mulling it over. It’s not clear to me whether it will give investors better results than standard asset allocation.

Monday, August 10, 2009

Cracks in the Pension Silver Lining

The rating agency DBRS released a pension analysis this month: Canadian Private Pension Plans – Losing or Cruising? As Canadian Financial DIY reported, the executive summary says that we’re closer to ‘cruising’ than ‘losing’ and that “the outlook for pension plan funding remains manageable.” We’re to believe that the silver lining for the recent bad news in pensions is that we’re going to be okay in the end. However, this summary appears to be a rosy view of the report details.

The detailed tables show the average private pension plan to be underfunded by 5.5%. This doesn’t sound too bad, but it lumps under- and over-funded pension plans together. However, Bank of Nova Scotia isn’t going to give its $1.1 billion pension surplus to Air Canada, BCE, Manulife, and Nortel which are collectively underfunded by $5.7 billion.

If we treat over-funded pension plans as simply full, then the average pension plan’s shortfall rises to 8.2%. Again, though, this understates the problem because people in problem pension plans can’t share the wealth in more solvent plans. One-quarter of plan participants are counting on a pension plan that is underfunded by between 15% and 43%.

More from the report: “Using the higher corporate-based discount rate, accounting valuations benefited from lower obligations, offsetting much of the impact from weak asset returns.” This is accounting speak for the losses due to the recent stock market drop haven’t been counted because we expect future returns to make up for the losses. If you don’t believe that future returns will fully make up for recent losses, then you’d have to think that the underfunding situation is worse than the reported numbers.

I don’t believe that the sky is falling. But I do think there is a big risk that many Canadians will get smaller pensions than they were promised. How much smaller remains to be seen.

Sunday, August 9, 2009

Book Giveaway Results: Ravens

The giveaway winners of 5 copies of the book Ravens by random draw are Mike, Bella, Blair, Lyne, and Gene. The winners have been contacted by email. Thanks to all who entered the draw.

Do Financial Advisors Provide a ‘Steady Hand’?

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

One of the arguments for using financial advisors is that they provide a steady hand that helps keep you from making rash investment decisions that will hurt your returns. A study by Bullard, Friesen, and Sapp released in December 2007 casts doubt on this argument.

The study showed that mutual fund investors actually get lower returns than the funds’ reported returns because of poor market timing. You would think that working with a financial advisor would keep investors from making such mistakes, but apparently not. Another aspect of the study was to examine how investors working with a financial advisor fared compared to other investors.

The study’s authors summarize: “We find that investors who transact through investment professionals using conventional distribution arrangements experience substantially poorer timing performance than investors who purchase pure no-load funds.” Instead of a steady hand, we find that investors working with financial advisors actually have more losses from poor market timing. This raises the question, is the ‘steady hand’ on your shoulder to guide you, or is it in your pocket?

The steady hand argument supposes that financial advisors are actually knowledgeable about investing, and that they have their clients’ best interests in mind. I have no doubt that honest and knowledgeable financial advisors are out there, but they may be scarce.

Friday, August 7, 2009

Short Takes: Book Giveaway, Securities Lending, and Retroactive TFSA Room

1. To enter the draw to win one of five copies of George Dawes Green’s novel Ravens (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 Saturday August 8 at noon. I will contact the winners to get (Canadian or American) postal addresses.

2. Preet outlines the risks of securities lending as practiced by many index ETFs, and Patrick speculates on how this could become a bubble. It’s not clear to me how securities lending is most likely to cost investors a significant amount of money, but the fact that it appears to be free money makes me very suspicious.

3. Ellen Roseman finds that the Ontario Securities Commission (OSC) isn’t very effective at protecting minority shareholder rights.

4. Big Cajun Man learns a few lessons while cleaning out his basement.

Thursday, August 6, 2009

Spending Mind Games

Every so often I play a little game where I see how long I can go without spending any money. It usually lasts for only a few days, but it’s amazing how easy it is do without the small purchases in life when it becomes a competition. I'll leave it to others to stimulate the economy with their spending. 

I should point out that I have an advantage over many people in this game because my wife makes almost all of the grocery purchases. What usually trips me up is having to buy gas for my car. 

I don’t really keep track of my results, but going for a week without spending a single penny is not unusual for me. I suspect that some of my more frugal friends can go this long without even realizing it, but not so for my more spendthrift friends. 

 Some people average two stops for drive-through coffee and doughnuts each day. They also buy pop and chocolate bars from vending machines regularly. They seem addicted to spending money in small amounts frequently. 

I’d love to learn more about the psychology of people’s spending habits on small purchases. The best source of such information is likely the research groups doing work for companies on the money-receiving end of these small purchases.

Wednesday, August 5, 2009

Bank of Montreal Mortgage Fee Refunds

The Bank of Montreal has begun advertising for former mortgage holders to contact them about possible refund of fees paid.  Back in June Bank of Montreal announced that they had overcharged “penalties on certain mortgage pre-payment and early-renewal transactions” and would be refunding approximately $7.1 million to 28,000 customers.

It is not clear whether the latest announcement is part of the same refunding effort, or whether this is a new set of customers who were overcharged. The announcement says

“You may be eligible for a refund if between:
- September 1, 1998 and July 10, 2005 you paid out your mortgage.
- February 1, 2001 and August 31, 2005 you renewed or early renewed into a 6-Year Flexible Below Prime mortgage.
- May 1, 2002 and September 30, 2006 you renewed into a fixed rate closed mortgage and paid a penalty on this mortgage as a result of a subsequent early renewal or prepayment.
- October 1, 2004 and September 30, 2006 you obtained a new fixed rate closed mortgage and paid a penalty on this mortgage as a result of a subsequent early renewal or prepayment.”

I called about a variable rate mortgage that I paid off in 1999 and was told that I was not overcharged. It appears that the rebate is related to fixed mortgages that were paid off early, although the announcement doesn’t make this entirely clear.

Tuesday, August 4, 2009

Book Giveaway: Ravens

“The Boatwrights just won $318 million in the Georgia State Lottery. It’s going to be the worst day of their lives.”

The book Ravens, by George Dawes Green is a compelling suspenseful novel centered on a huge lottery win that sparks envy, greed, extortion, insincere evangelism, worship, and revenge.

For an illustration of one of the critical scenes in the book, have a look at this Ravens YouTube video.

One of my favourite parts of Ravens was where an impostor lottery representative laid out the winners’ future:

“Sooner or later you’ll tank it [give up your copier business] and get yourself an estate in Hawaii. Then you can all get some sun, which’ll be great except you’ll get too much and you’ll start to look like iguanas. And you’ll try to make friends but who you can trust, right? So you won’t know anybody and you’ll stay home and watch TV and you’ll be lonely as hell and bored ...”

This nicely illustrates what can happen in the initial stages after a lottery win. Maybe Green can write a sequel that depicts the later stages of a lottery win, where the lucky winners run out of money and declare bankruptcy. Of course, it would be tricky to make such a sequel as entertaining as this book.

Ravens publisher, Grand Central Publishing, has graciously offered five 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 Saturday August 8 at noon. I will contact the winners to get (Canadian or American) postal addresses. Good luck!

Monday, August 3, 2009

Investing is Like Surgery?

Happy Civic Holiday! This isn’t the most festive holiday, but it beats working. This is a holiday version on the regular Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

One of the choices investors have to make is whether to handle their investments themselves or work with (and pay) a financial advisor. People have a lot to say on both sides of this issue, but I’ve heard one clever argument several times now. It goes something like this:

“You wouldn’t do your own surgery, right? So, why would you try to handle your own investments? Leave this stuff to the experts.”

On the surface, this reasoning seems compelling. The image of some guy trying to operate on his own belly is pretty amusing. Anyone who comes up with a catchy line that makes people laugh must be right.

But, this analogy breaks down very fast. Exactly who is the brilliant surgeon in the financial world? The financial planning industry would say that the average investor is not as smart as a surgeon, and I agree. Maybe professional money managers who run mutual funds are the surgeons. But these professionals as a whole don’t do any better than the stock market averages. When we take into account the fees charged to investors, index funds outperform actively-managed mutual funds over the long run.

So, professional money managers aren’t the surgeons in the analogy. This leaves financial advisors. Fee-only financial advisors might fit here. They are usually smart people who are paid for their time to give unbiased advice rather than being paid by mutual fund companies to sell their funds. I wouldn’t exactly call fee-only financial advisors surgeons, but the analogy is close.

What about the typical financial advisor who is paid commissions out of the fees that mutual funds charge to investors? Could these people be the surgeons? I could make a joke here, but let’s just say no they aren’t. These financial advisors are more like salespeople. Just like other types of salespeople, there are good ones and bad ones. But they all have to eat, and they feel the constant pressure to sell financial products that earn them commissions.

There is a lot of money at stake, and the financial industry is willing to spend heavily on marketing. It is important to understand the basics of investing even if you choose to use a financial advisor. You need to know enough to tell whether you are getting good advice or are being taken for an expensive ride.

Sunday, August 2, 2009

The Problem with Risk-Adjusted Returns

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

You may have heard of risk-adjusted returns in connection with mutual funds. The basic idea is that a risky investment may not be better than a predictable investment even if the risky investment has a higher expected return. There is some validity to this, although it is too often used to justify the poor returns of mutual funds compared to the overall stock market.

Normally, any discussion of risk-adjusted returns includes some intimidating math. I’ll explain the problems with risk-adjusted returns without needing the math, and I’ll give pointers to where the math can be found for those who are interested.

According to the theory, before comparing investments, you should do a risk-adjusted return calculation that will reduce the returns according to how risky they are. The riskier they are, the more the returns are lowered before any comparison. By “risk” here, we mean volatility, which is a measure of how much the returns vary over time. An investment that grows steadily has low risk, and another investment whose value jumps up and down unpredictably has high risk.

Sharpe Ratio

For those interested in the details of the calculations, Wikipedia has a good explanation of one theory based on the Sharpe ratio. According to this theory, the following two investments are equally desirable:

Investment A: 100% stocks
Investment B: 50% stocks + 50% government debt

The stocks could consist of a broad market index fund, and the government debt could be U.S. Treasuries or Canadian T-Bills. Investment A has a higher expected return, but is twice as volatile, and so both investments end up with the same Sharpe Ratio.

In one year, Investment A will probably have a higher return than B. But it is also possible that A will have a significantly lower return, and it would be reasonable for some investors to prefer Investment B if it is only going to be held for one year. However, over a long period of time (say 25 years), Investment A is preferable because it is overwhelmingly likely to outperform B.

This cuts to the heart of the problem with the way risk-adjusted returns are usually calculated: it doesn’t take into account how long the investment will be held. Over time an investment’s ups and downs tend to balance out somewhat. The average yearly return on an investment gets more predictable (and less risky) the longer it is held. This means that the longer you are invested, the more risk you can tolerate while seeking higher returns.

Some investments are too risky even over a 25-year period. A portfolio full of penny stocks would likely be too risky even over the course of a full lifetime. Another thing to remember is that it never makes sense to take on more risk unless you get a higher expected return. Stocks are a better bet for the long term than government debt because the expected returns are enough higher to justify the added risk.

Morningstar’s Method

Morningstar provides detailed information about both U.S. and Canadian mutual funds. They use a different theory for adjusting mutual fund returns when they assign their star ratings (1 star to 5 stars). However, this theory suffers from the same problem as the Sharpe Ratio; it doesn’t take into account how long the investor will hold the investment.

Suppose that we have a choice of two investments: an adventurous investment that we expect to have a long-term compounded return of 12% with high volatility, and a safe investment that we expect to have a long-term compounded return of 9% with low volatility. For a one-year period, the adventurous investment might deserve to have its return adjusted down to 7% because of the risk, and the safe investment might deserve to be adjusted to 8%. This makes the safe investment preferable.

Now let’s consider a 25-year period to give the volatility a chance to balance out somewhat. Now the adventurous investment deserves to have its yearly return adjusted down to 11%, and the safe investment deserves to be adjusted down to 8.8% per year. In this case, the adventurous investment is better.

Morningstar will discount the adventurous investment by the same amount regardless of how many years it is held. The same is true for the safe investment. So, if you use Morningstar’s method, one of the two investments will be judged better for both the 1-year and 25-year cases, and one of these answers will be wrong.

All of this helps to explain the rule of thumb that money not needed for longer than 3 or 5 years can go into stocks, and money needed sooner than this should go into some less volatile investment.