Friday, October 30, 2009

Short Takes: Dark Pools, Technical Analysis, and Flat Tax

1. Jason Zweig wades into the dark pools where hedge funds trade large share volumes at lightning speed. How can the little guy hope to compete with these shadowy figures that purportedly trade on inside information? The answer turns out to be by trading very infrequently.

2. Larry Swedroe reports on a new study finding that technical analysis is a waste of time.

3. Larry MacDonald published ideas from two proponents of a flat-tax system. Unfortunately, I can’t make the numbers add up. It seems that the government would be pulling in significantly less tax money with either plan. If that’s what these flat tax advocates have in mind, then they need to explain how we will do away with big chunks of government spending.

4. Canadian Financial DIY has opinions about the new ability for Canadian retail investors to trade in Contracts For Difference (CFDs). Buyers beware. Remember that whenever you enter into a financial transaction where you don’t fully understand what you’re buying, there is a good chance that it won’t end well for you.

5. Preet wonders what the point is of having an ETF with only a few holdings when it can be cheaper to just buy the individual holdings yourself.

6. Big Cajun Man explains why debt is like fat.

Thursday, October 29, 2009

RRSP and TFSA Strategies

In an ideal world we would all make our maximum RRSP and TFSA contributions each year and look forward to being a millionaire in retirement. However, people who are able to do this are in the minority. Most Canadians have more combined RRSP and TFSA room than they will ever be able to use.

But don’t despair! Having excess room gives us some tax-saving strategies:

Income Smoothing

If your income is highly variable from year to year, you can smooth it out by making RRSP contributions in a high income year and withdrawing some RRSP money in a low income year. This reduces the tax burden if your top marginal rate is higher in the contribution year than it is in the withdrawal year.

One disadvantage of this approach is that the RRSP room will be lost permanently, but this is of little consequence if you have more room than you can use. There used to be another disadvantage before we had TFSAs: any gains on the money withdrawn from the RRSP in the future would be taxed. However, you can now put this money in your TFSA to avoid any future income taxes on your gains.

Tax Reduction for Low-Income Retirees

We’d all like to think that we’ll retire in comfort, but the truth is that many retirees have very low incomes. These people collect the Guaranteed Income Supplement (GIS). In a particular income range, this GIS gets clawed back 50 cents for each dollar of income, an effective additional tax of 50%.

For low-income retirees with a modest RRSP (converted to an RRIF), the required withdrawals each year can be 50% clawed away plus the regular income tax rate. So, some Canadians have more than 50% of their RRSP withdrawals taxed away.

In some cases, it makes sense to withdraw a large amount from the RRIF in one or more years.  Part of each large RRIF withdrawal will be clawed back, but once the GIS is fully clawed back, the remainder of the withdrawal is taxed at a much lower rate.  The result is that you get to keep more of your retirement money.  The downside of this strategy used to be that any future returns on the withdrawn money would cause GIS claw back. But, now, the money can be moved into a TFSA to avoid this problem.

Wednesday, October 28, 2009

BMO’s New Bond ETFs

As Canadian Capitalist reported, BMO has come out with several new exchange-traded funds, including some bond ETFs. Any investor considering these bond ETFs should check whether it is cheaper to buy a bond directly.

The safest of the new bond ETFs are ZFS (0.2% MER) which invests in Canadian 1-5 year bonds, and ZPS (0.25% MER) which invests in provincial 1-5 year bonds. These MERs are a huge improvement over the typical bond mutual fund MERs, but they can still be high for large investments.

An alternative to these ETFs is to simply buy a bond directly. Discount brokers allow investors to buy bonds that make periodic payments, or buy another type of bond called a coupon that just pays a fixed amount at a given end date. The safest of these bonds are backed by the Canadian government or provincial governments.

Let’s suppose that you want to invest $20,000 in Canadian bonds for 5 years. You could buy ZFS and pay 0.2% each year for a total of about 1% after 5 years. The total fee would be around $200 plus the trading commissions. Or you could buy a bond directly.

Discount brokers don’t make it obvious what commissions you pay on a bond trade. You need to figure out how many bond units you can buy with your $20,000 and look at the gap between the buy and sell price for that number of units. The total cost of buying and then selling the bond will be equal to this gap. Of course, if you keep the bond to maturity, you won’t have to pay the selling half of the commission. With this information you can compare costs and decide on the cheaper approach.

Many investors are unaware that they can buy bonds directly. An advantage of this approach is that the final bond value is guaranteed. With a bond fund or ETF, you get no guaranteed future value.

Tuesday, October 27, 2009

Pension Reform Promised Soon

Finance Minister Jim Flaherty has said that pension reform is coming soon. Unfortunately, it may not be what many Canadians are hoping for. With existing company pension plans underfunded by a total of about $50 billion, many Canadians who are retired or near retirement are justifiably worried.

One of the more notable company pension plans in trouble is Nortel’s. Without any reasonable prospect of further contributions to Nortel’s pension plan, pensioners would like to see the government back the plan with financial guarantees.

The same is true for those hoping to draw from other pension plans that are in financial trouble. But the Harper government hasn’t given any sign that it intends to pony up the massive pile of cash that would be necessary to back these pension plans.

All indications at this point are that Flaherty intends to change the rules going forward to encourage companies to be more conservative in their pension funding. For example, the surplus cap of 10% may be increased.

However, none of this will help people whose pensions are threatened right now. Nortel pensioners want government backing, but should taxpayers be made to pay for this? Even if the government relents and decides to back pension plans, it is likely to have various restrictions and caps that would leave pensioners receiving less money than they were promised by their employers.

Monday, October 26, 2009

Why is Investing Different from Other Endeavours?

I’ve argued in the past that trying to time the market is a near impossible game for most of us to win over the long term. This prompted the question “why should we bother trying to do anything like becoming a doctor or a lawyer – there will always be someone else who is better.”

It’s certainly true that we can’t reasonably expect to be the very best doctor, lawyer, programmer, or poker player in the world. However, doctors don’t have to compete against every other doctor in the world. It might be tough if the world’s best doctor has the office next door, but under typical circumstances, a doctor merely needs to be in the middling range among his peers to run a successful practice.

In the case of a poker player, he just needs to find a game where he is an above average player. The fact that better players exist in the world is of no concern if they aren’t seated at the table.

However, when it comes to market timing, you can’t choose your opponent. Equity trading is essentially a world-wide game where everyone must compete against the very best players all the time. When trying to decide whether now is a good time to jump in or out of the market, an army of professionals with much better access to relevant information than the typical trader are competing in the same game.

Sunday, October 25, 2009

To Win with Stock Options, Someone Has to Lose

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

Not to be too philosophical, but my experience has taught me that I’m best off to conduct myself as though there exists a single objective reality that applies to all of us rather than each of us having our own separate realities.

What does this mean for the investing world? If several people all buy 100 shares of ABC stock at the same time for the same price, then they will all get the same return over a given period of time. Some of these people bought ABC stock for very smart reasons, and some might have bought it because they have the initials ABC. Some of the investors are smart, some dumb, some nice, and some mean, but they will all get the same return.

This all seems obvious enough, but you have to keep it in mind when you read the come-ons for businesses that want to set you up with an account to trade stock options.

Stock options are side bets between two parties on whether a stock will go up or down. A bet that the stock will go up is called a call option, and a bet that the stock will go down is called a put option.

Descriptions of stock option strategies usually go something like this:

“If you think ABC stock is poised for a big move upward, buy call options. When ABC stock rises, you will make a lot more money than if you just bought the stock instead of the options.”

Statements like this are true because they start with “if”. But what happens if ABC stock doesn’t go up? You’ll lose your money, that’s what. For every bet you make with stock options, there is someone on the other side betting the opposite way. You can’t both win; the stock can’t go up for you, but down for the other guy.

One of you will win the bet and the other will lose. This is what is called a zero-sum game. Across everyone who plays, the total wins and losses add up to zero. Actually, it’s worse than this because of trading commissions when you buy or sell options. So, in reality, the average person involved in stock options loses money.

When you trade in options you are making bets ON the stock market, but you’re not invested IN the stock market. Because of this, you’re not taking advantage of the fact that the average stock market investor makes money over time. This means that stock option trading has a built-in disadvantage when compared to investing in stocks.

To win with stock options by enough to beat the strategy of simply buying and holding a stock index there have to be enough others who are losing money with stock options.

Thursday, October 22, 2009

TFSA Rule Changes Likely Helpful to Investors

The Canadian government’s planned TFSA rule changes have been described as needed to prevent sophisticated abuses by savvy investors, but on closer examination, the biggest effect may be to protect investors from themselves.

The penalty for over-contributions to a TFSA used to be 1% each month, but this has been changed to taxing any return on the excess amount at 100%. Apparently, some investors were deliberately over-contributing looking for short-term gains that would then be tax-free, except for the 1% each month.

However, most investors who chase short-term gains lose money. This new rule will have the effect of saving many reckless investors from following a strategy that has a built-in 12% per year drag on returns. This is almost like borrowing on a credit card to invest.

The new rule against swaps between RRSPs and TFSAs is designed to prevent a scheme to shift money from an RRSP to a TFSA as I explained previously. For an investor who tried this and failed to execute it well, the result was just paying a bunch of fees to a brokerage for shifting stocks around.

Canadian Capitalist observed that one could achieve a cash for stock swap between an RRSP and a TFSA by just selling stock in one and buying the same stock in the other. This raises the question, why ban swap transactions? I have three possibilities:

1. The government hasn’t thought of this.

2. The new rules will actually cover this kind of dual activity in an RRSP and TFSA.

3. The government thinks that the costs of commissions and spreads will make it impossible to profit from this strategy.

UPDATE:  A 4th potential reason: investors may be able to play games with the fair market value on a swap by picking either end of the day's trading range after the fact.  This would not be possible if the swap is accomplished virtually by buying and selling stock in the two different accounts.

Overall, the new rules may prevent some sophisticated investors from exploiting TFSAs, but for most investors who try such games, the rules will save them from themselves.

Wednesday, October 21, 2009

TFSA Abuse

There seems to be no limit to the number of clever schemes that tax experts come up with to avoid paying taxes. The Canadian government is planning to make some changes to the rules governing Tax-Free Savings Accounts (TFSAs) to close some loopholes.

The most interesting tax avoidance scheme involves swaps between RRSPs and TFSAs. Before now I wasn’t aware that such swaps were permitted without any tax implications. The idea is that if you have $5000 in cash in one account and $5000 worth of stock in the other, you can swap the cash for the stock without it counting as a withdrawal or contribution.

This makes some sense. After all, the total value in each account doesn’t change. It’s like one account bought the stock from the other account at fair market value. However, this swapping idea led to an amusing scheme to shift assets from an RRSP to a TFSA. I’ll explain it with an example.

Suppose that Tammy the tax avoider is nearing retirement with $100,000 in an RRSP and $5000 in a TFSA. Tammy is facing the prospect of having to pay income taxes on the $100,000 as she withdraws it from her RRSP over time. She’d much rather have the money in a TFSA where it can be withdrawn tax-free.

Tammy begins by buying 500 shares of (hypothetical) ABC shares for $10 each:

TFSA: $0 plus 500 ABC shares
RRSP: $100,000

Suppose that ABC stock goes up to $12. Then Tammy swaps the TFSA shares for $6000 cash in the RRSP:

TFSA: $6000
RRSP: $94,000 plus 500 ABC shares

Then the stock goes back down to $10, and Tammy swaps them back for $5000:

TFSA: $1000 plus 500 ABC shares
RRSP: $99,000

Since the stock went up then back down, Tammy hasn’t made any money, but notice that she has managed to shift $1000 from her RRSP to her TFSA. If ABC stock cooperates by continuing to bounce up and down, Tammy can keep shifting money from her RRSP to her TFSA.

The proposed new rules for TFSAs will apply a 100% tax (ouch!) to TFSA amounts that can be attributed to such a scheme. Tax avoidance is all fun and games until your money gets confiscated.

UPDATE: Some have suggested that when performing a swap, there is the opportunity to select any price in the day's trading range.  This means that when stock moves out of the TFSA, a high price can be chosen, and when it moves back into the TFSA, a low price can be chosen.  This makes this scheme much more effective.

Tuesday, October 20, 2009

The Future of Bonds

Rob Carrick wrote a provocative piece about the effect of rising interest rates on the bond market called Latest horror flick: Attack of the bond market. This made me take a look at how bad the carnage would be if interest rates rose.

Poking around at my online brokerage, I found a $100,000 Canadian strip bond coming due 2029 Dec. 1 that they would sell to me for $43,818. When you own a strip bond you don’t get any periodic payments; you pay for it, and in this case you get your $100,000 when it comes due, unless you sell it first.

The return on this bond works out to 4.19% per year for just over 20 years. However, according to the Bank of Canada, the average return on long-term Canadian bonds over the last 10 years is 6.38%. This raises the question, what happens to my strip bond if interest rates return to the average level?

Suppose that in just over 5 years, the yield on my bond rises to 6.38%. By this time, it would be a 15-year strip bond and would sell for $39,546. This price is calculated so that the 6.38% return would make the bond worth $100,000 over the 15 years from 2014 to 2029.

So, my bond’s value would drop from $43,818 to $39,546, a loss of 9.75% in just over 5 years. This is roughly a 2% loss per year before considering inflation. If I owned long-term bonds in a bond mutual fund, the loss would be more like 3% to 3.5% per year because of the added fees.

These potential losses if interest rates return to average levels aren’t devastating, but investors usually choose bonds for safety, not to lose a few percent every year.

Monday, October 19, 2009

Swine Flu Dividend

Even though the swine flu hasn’t caused the devastation that some predicted, it has still harmed many people. Widespread concern over this flu has had a curious financial side effect that I didn’t know about until my wife pointed it out to me.

A couple of nights ago my family enjoyed a large pork roast that fed four hungry people and left enough for lunch for two. I wasn’t too surprised to find out that the roast cost only $5.50 because my wife routinely finds good deals on meat.

But this wasn’t a case of a pork roast that was a day from its expiration date. My wife tells me that pork is almost always on sale now and that this roast would have cost more than $10 a year ago.

Many factors go into the pricing of goods, but the dominant factor for pork right now is the swine flu. For some reason, people are avoiding pork because of this new flu. This makes no sense at all; experts say that you can’t catch swine flu from eating pork, but people are avoiding pork anyway.

So there you have it. A combination of a new flu and widespread ignorance has a small silver lining: cheap pork. Of course, pork producers won’t see this as a silver lining. That’s why they would rather call the swine flu the H1N1 virus. I’m not too optimistic about the new name catching on soon.

Sunday, October 18, 2009

Hidden Mutual Fund Fees?

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

Many people don’t like to talk about money, and so I try not to discuss money unless others show an interest. On a few occasions when the subject came up, I’ve encountered people who think that they don’t pay fees on their mutual fund investments.

In a recent case, an acquaintance who I’ll call Rosie offered her reason for believing this. Rosie said that she knew that some people paid fees, but she checked her statements regularly, and she had never seen any fees listed.

Of course she does pay the Management Expense Ratio (MER) and possibly front or back-end loads. I decided to have a look at some of my old statements from back in the days when I owned mutual funds. Sure enough, there weren’t any references to fees even though I know I paid them.

How widespread is the mistaken belief that investors don’t pay any fees on their mutual funds? I’d be very interested in the results of a poll. Among those who know they pay fees, it would be interesting to find out how much they think they pay.

Disclosure rules are supposed to prevent this sort of confusion. Each mutual fund has a document called a prospectus that discloses fees, and investors have to be given a copy of the prospectus. However, I suspect that people read the prospectus about as often as they read the 16-page manual that comes with a new toaster. (Do not use in bathtub. Do not sue us ...)

Maybe the disclosure rules need to be changed to require fees to be shown prominently on statements. This would be similar to the way that credit card statements have to include information about the amount of interest charged and the interest rate.

Because MERs are so high in Canada, let’s take a Canadian example. Suppose that Howard and Cindy are in the early fifties and have been saving in their retirement savings plans (RRSPs). As of a year ago, between them they had $200,000 split across the three biggest actively-managed Canadian equity mutual funds. (The following figures are based on real fund results.)

Here is the summary part of their collective investments including a fee disclosure that doesn’t normally appear on statements:

Total Assets one year ago:

Total Assets now:

Total investment return over the past year:

This investment return takes into account the following MER fees paid:

Howard and Cindy would definitely pay more attention to the exorbitant fees charged by mutual funds if they were disclosed this way. Switching to index funds would save Howard and Cindy about $4000 per year in MER fees.

Don’t hold your breath waiting for this kind of disclosure. There would be huge opposition to it from the mutual fund industry.

Friday, October 16, 2009

Short Takes: Bond Yield Fantasy and Alternative Minimum Tax

1. Larry MacDonald explains the difference between a bond’s nominal yield and its yield to maturity. If any fixed income product such as a bond or preferred share is paying a rate that seems too good to be true, check whether it will be redeemed soon for less than its current price.

2. Million Dollar Journey explains the Alternative Minimum Tax (AMT). The AMT exists to prevent high income people from driving their income taxes to zero with certain types of deductions. If you’re old enough to remember NDP politicians thundering about the number of millionaires who pay no tax, you’ll see the motivation for having an AMT that gets wealthy people to pay some tax each year. AMT can be a pain if it applies to you, but the difference between the AMT and the amount resulting from the regular tax calculation becomes a deduction in a future year.

3. Big Cajun Man has a take on the great debate of whether you should contribute to your RRSP or pay down your mortgage.

4. Preet explains why investing in managed futures over the last couple of decades would have reduced portfolio volatility.

5. Jonathan Chevreau reports that Invesco Trimark is traveling the country pushing an asset mix that would have performed better over the last couple of years than the traditional mix of stocks and bonds (the web page with this article has disappeared since the time of writing). Of course, there is no guarantee that adding commodities, real estate, and other exciting assets to your portfolio will help over the next two years. I’ll be following Trimark’s advice as soon as I perfect my time machine.

6. Ellen Roseman helped some Sears Canada customers get satisfaction after the company’s call centre moved overseas causing delays and frustration.

Thursday, October 15, 2009

Canadian Investors Lose Sight of the Real Prize

A recent survey of investor attitudes concluded that “Canadian investors are more influenced by soft issues such as their relationship with their investment advisor than by hard-core financial factors such as portfolio performance.”

It’s amusing to see portfolio performance described as just one of the “hard-core financial factors.” Portfolio returns should be the main concern of an investor. Instead, “investors are desperate for relationships with investment advisors that help them feel more comfortable.”

It’s hard to know for certain why people focus on less important issues, but I’ll try a guess. Maybe most investors have no idea what returns they should expect, but they know how they feel and they know whether they like their advisor as a person. So, the judge their experience by the things they understand.

In a perfect world, people would be able to examine their portfolios to determine their asset mix and then compare their returns to a similar mix of index returns. This comparison would expose sky-high MERs most of the time. Unfortunately, few investors can do this.

Wednesday, October 14, 2009

Draw Results and More Money Emotions

The giveaway winners of 4 copies of the book The Secret Language of Money by random draw are Aaron, Gene, Nora, and Adrian. The winners have been contacted by email. I accidentally jumped the gun and held the draw too early. Because I contacted the winners too early as well, I would have done a second draw for a fifth book for any last-second entries, but there weren’t any.

Thanks to all who entered the draw.  Here are a few more interesting tidbits from the book.

Affinity Bias

Apparently, we tend to overestimate the value of things we like, such as familiar stocks and favourite sports teams. This explains why I always found so many willing Torontonians to take my bets against the Toronto Maple Leafs during the 1980s.

Compulsive Spending Cycle

I have always found the tendency for some people to buy things they don’t really want or need to be baffling. According to the authors, buying things makes some people feel good in powerful ways. Unfortunately, this immediately leads to shame for having spent money they can’t afford to lose. Then they need to spend again to feel better and the cycle continues.

Senior Citizen Vulnerability to Scams

This one is likely to be controversial. “The prefrontal cortex – the home of logic, level-headed decisions, and long-range planning – is the ideal resource for debunking a scam or outing a con.” But scams promise big returns quickly and this fires up the limbic system and bypasses the prefrontal cortex. But higher brain functions “tend to wane with advancing age” and the “very old are very prone to this sort of emotional hijacking.”


No great insight here, but quite funny:

“Politicians seem to fulfill various roles in our lives. They watch out for the common good; they attend to all manner of logistics in the managing of the social order; and they lead us in times of trouble. And they do one more thing: Now and then, they flame out in entertainingly spectacular fireballs of scandal and self-destruction.”

Tuesday, October 13, 2009

What Follows a Lost Decade?

Commentators bemoan the lost decade for stocks. In Canada, returns were positive, but low over the last decade, but in the U.S., returns of the S&P 500 were actually negative. According to Larry Swedroe, this is the first time since the great depression that this has happened over 10 or more years.

However, if we subtract out inflation, returns look even worse. As Larry shows, there have been three periods of at least 10 years since the depression that the S&P 500 has failed to beat inflation. These periods ended in 1947, 1983, and now (at least we hope it doesn’t continue).

This is all very depressing, and can make us want to give up on stocks altogether. However, I wondered what happened after these bad times. Here are the S&P 500 total returns (including dividends) for the decade after these “lost decades”:

1948 to 1957: 14.4% above inflation
1984 to 1993: 10.7% above inflation
2009 to 2018: ?

As you can see, those first two decades were spectacular! There is no guarantee that the upcoming decade will match these impressive results, but it does give us some hope.

Monday, October 12, 2009

When Can I Retire?

Happy Thanksgiving, Canada! This is a Thanksgiving version of the usual Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

A major concern for many people is how old they will be when they can retire. This depends on a number of factors such as how much you save, how well your investments perform, how much you spend during retirement, and how long you live.

Retirement calculators can figure this out for you based on a number of assumptions. However, most of them don’t give you a feel for how the final answer would change if your investment returns are volatile instead of perfectly steady.

There was a good post over at the Canadian Financial DIY blog about using Monte Carlo analysis for financial planning. Monte Carlo analysis just means simulating possible outcomes many times to see how the final answer changes.

I decided to use Monte Carlo to see how the mix of stocks and bonds in a portfolio affects when you can retire. I had to make some assumptions:

- Stocks and bonds will have the returns and volatility as reported in the paper Portfolio Optimization by John Norstad (2002-09-11).
- Retirement money has to last until you are 90 years old.
- After retirement you will invest conservatively and get steady returns 3% above inflation.

The simulations were based on the following saving and spending rates:

- You save $600 per month (rising with inflation) in a retirement account while working.
- You will spend $4000 per month (in today’s dollars) during retirement.

I ran each simulation until there was enough money to retire. After a million runs, I found the median retirement age as well as the age range that covered 90% of the simulations.

Here are the results if you start saving at age 25:

StocksBondsRetirement Age
Median (Range)
0%100%75 (65-82)
50% 50%66 (56-76)
100%0%57 (47-72)

The width of these age ranges shows that there is quite a bit of uncertainty. There isn’t much doubt that historically stocks have been better than bonds at giving investors a chance to retire early.

Here are the results if you waited until age 40 to start saving:

StocksBondsRetirement Age
Median (Range)
0%100%80 (74-84)
50% 50%75 (68-81)
100%0%69 (60-80)

The advantage of stocks is evident here as well. The other thing to note is the power of starting to save earlier. In the all-stock case, the 15-year head start in saving led to retirement about a decade earlier.

It makes sense to use short-term bonds for money that you will need to spend within the next 3 years or so, but I haven’t found a good reason to own bonds for the long term.

Sunday, October 11, 2009

What I Want My Children to Know About Money

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

Part of my motivation for writing this blog is to pass on what I know to my children before they are on their own making financial decisions. Even though I make my choices carefully and put time into understanding how things work, I have made some financial mistakes and other people have taken advantage of me financially from time to time.

People like to say that money isn’t everything, and this is true. Relationships, fun, interesting activities, and challenging pursuits lead to a full life. Money can’t give you these things, but it can give you more freedom to pursue them.

Most of us trade our time for money by taking jobs. The jobs we have vary in how fulfilling they are, but very few of us can honestly say that we would do our jobs for nothing. Even the best jobs have unpleasant parts, and almost all of us do some fraction of our jobs only for the money. So, for most of us, to say that money isn’t important is to say that our time isn’t important, and this is wrong.

Money represents your hard work and your time. You could have spent this time with friends and family, travelling, or any of a number of other pursuits that would have been more enjoyable than your current job. Handling your money wisely will contribute to your future happiness.

Young People Have a Financial Advantage

Children tend to look at the money that adults have and think that the adults are better off. This is only superficially true. Adults usually have more money, but they have obligations that use up their money. Most adults settle into a lifestyle whose costs consume all of their incomes. Each small raise at a job is met with increased spending.

Changing careers often means at least a temporary drop in pay, and starting your own venture may mean no pay at all for a while. Most adults are unwilling or unable to change their lifestyles to accommodate such changes. These people are trapped in their jobs whether they like them or not, and losing their jobs can be traumatic. But, it’s not all doom and gloom; just a modest amount of savings can serve as a buffer allowing people to make the career changes they want.

One advantage young people have is that they are less set in their ways. They may want expensive things, but they can more easily make do with less. Taking the bus isn’t too painful if you have never owned a car. Young people can more easily choose to live frugally, build up some savings, and invest those savings for big long term gains.

The big opportunity for young people is the chance to begin their financial life by saving some money and avoiding debt. If you get into debt early, you are setting yourself up for a life of financial insecurity and limited choices. If you save and invest, you will have a secure financial base that will give you choices in how you live your life.

Friday, October 9, 2009

Short Takes: Book Giveaway, Personal Debts Rising, and more

1. To enter the draw to win one of four copies of the book The Secret Language of Money by David Krueger and John David Mann, send an email with the subject “Book” to the address shown on the upper right corner of this blog. The draw will close Tuesday October 13 at noon. I will contact the winners to get postal addresses.

2. Big Cajun Man reports that Canadians’ personal debt is rising at a record pace.

3. Larry Swedroe explains why you shouldn’t necessarily trust your broker’s recommendations.

4. Larry MacDonald reports that the trend away from mutual funds and into ETFs continues.

5. Canadian Financial DIY finds a fund whose management doesn’t get paid unless the fund makes money.

6. Guest blogger Daniela Garritano has some detailed energy saving tips for cold weather.

Thursday, October 8, 2009

Book Giveaway: The Secret Language of Money

We attach all sorts of emotional meanings to earning and spending money according to The Secret Language of Money, by David Krueger and John David Mann. The authors seek to help you rewrite your money story to improve your life, but it is much more than just a self-help book. The publisher, McGraw Hill, has graciously offered four giveaway copies for my readers (but the draw is now over).

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 Tuesday October 13 at noon. I will contact the winners to get postal addresses. This time, McGraw Hill has agreed to send books to winners even if they live outside Canada and the U.S.

When it comes to investing, spending, debt, and financial scams, many of our decisions are driven by emotions. Because I see myself as a rational person, I didn’t expect much of what was said in the book to apply to me, but I did see myself in some of the examples. More often Krueger and Mann helped me understand the baffling actions of other people.

Even if you aren’t interested in having a financial emotions makeover, the book contains many well-written personal stories that are entertaining in addition to making a point. In some cases, I think the authors go a little overboard in attributing all actions to emotions. Surely, we make rational choices sometimes.

The rest of this review is a list of some of the interesting parts of the book and some parts I disagreed with.

The Right Brain

In studies of human brains, EEG readings show that when we have strong emotional stimulation our left brain shuts down and the right brain takes over. When we get a big fat bonus or the stock market crashes, “we may suddenly abandon our best strategies and most carefully thought-out game plans.” At the very moments when we most need to be rational, the rational part of our brains takes a break.

The Financial Crisis

The authors say that the financial crisis was caused by many house-buyers losing their heads at once, and that the “$700 billion bailout’s principal goal was to restore public confidence” and that this is “quite a price tag for a PR campaign aimed at changing an emotion.”

While I believe that emotions were an important part of the crisis, this characterization is misleading. The fundamental problem was that some very rational people figured out how to get rich by selling risky assets to other people who didn’t understand the risks. Selling mortgages to people who can’t pay them back isn’t a problem for the person who passes the risk along to someone else.

Once house prices began to fall the number of mortgage defaults exploded and this began to take down big financial institutions that couldn’t pay their huge debts. The bailout was needed to contain this very real problem. The authors make it seem that if we were all simply told that the bailout was taking place (but no money actually printed), the restored confidence would have solved the problem. This is not true.

A Tricky Auction

The authors describe a scenario where someone auctions off a $100 bill to investment specialists and investment gurus, and the winning bid is much more than $100. In a previous post, I explained how this is a trick rather than evidence that the bidders were irrational about money.

Slot Machines

What motivates us to take risks is the rush of dopamine that we get when the risk pays off. “The less predictable the reward is, the longer and stronger our dopamine neurons fire, giving us more of that natural high.” This effect is thoroughly researched by slot machine makers who exploit it as much as possible.

Credit Card Experiment

MIT students set up a sealed bid auction for Boston Celtics tickets. Half the bidders were told that they’d have to pay in cash (and would be given time to get the money). The other half had to pay by credit card. The average bid from the cash group was only half that of the credit card group. Apparently, money isn’t very real to us when we pay with plastic.

That’s enough for now. I’ll add a few more interesting parts when I announce the winners of the draw.

Wednesday, October 7, 2009

A Tricky Auction

What would cause someone to bid more than $20 for a $20 bill? Max Bazerman of the Harvard Business School routinely auctions off $20 bills and gets bids above $20. Are the bidders dull? No, they are usually very bright people who have been tricked.

The rules of the auction are simple enough:

– No talking among bidders.
– The first bid has to be a whole number of dollars.
– Subsequent bids have to go up by exactly one dollar.
– No bidder can bid twice in a row.
– The highest bidder pays the bid amount and gets the $20 bill.
– The second highest bidder must pay his or her final bid but get nothing in return.

The last rule is a strange one and it turns out that’s the catch that leads to high bidding. But I’m getting ahead of myself. Imagine a typical scenario:

An adventurous person throws out a bid of $1. Then someone bumps it to $2. This continues until Bob bids $18 and Alice bids $19. Without thinking it through, one might think that the bidding should be over. After all, why bother to bid $20 for a $20 bill. This reasoning applies to everyone but Alice and Bob. However, Bob is in a bind. He is on the hook for $18 and would get nothing in return if the bidding stops.

So, Bob bids $20. Now Alice is in a bind because she would have to pay $19 for nothing if the bidding stops. So she bids $21 to lose only $1 instead of $19. Now Bob must bid again, and so on. The bidding continues until either Alice or Bob relents and decides that the stakes are getting so high that the madness must stop.

Alice and Bob were caught in a trap. It turns out that the best strategy was to not bid in the first place. Even the initial bid of $1 was a mistake. I would hope that most intelligent people who took the time to think through the implications of the second-highest-bidder-must-pay rule would see the problem.

However, this auction would look and feel like a regular auction where it is safe to bid less than an item is clearly worth. This familiarity might lure bidders in before they think things through properly.

The reasons given for otherwise intelligent people overbidding for the $20 bill are things like greed and an irrational desire to win the auction even if it means losing money. While I believe that these factors are very real in many auction scenarios, I don’t think they are the dominant factor here. The bidders were tricked by the extra rule punishing the second highest bidder.

It may be that Bazerman’s demonstrations to open his lectures are an excellent way to introduce the way people lose their heads in auctions, but these $20 bill auctions aren’t really a good example. Even if Alice is rational but figures out the nature of the auction too late, she might make a bid past $20 if she thinks Bob will be the one to end the madness and drop out.

Tuesday, October 6, 2009

Alternatives to Bear ETFs

A reader, Seth, asked the following question about taking a bearish position in the market:

“I read your article on leaky leveraged ETFs. I have invested less in these products in the volatile markets. Other than put options or shorting a stock like the SPY (risk of call back and paying out dividend disbursements), do you know of other ways to take a bearish position on the indexes? Are all bear ETFs calculated on compounded daily percent?”

There are other ways to bet against the market, including selling call options and investing in bear funds, but I can’t recommend them. Selling naked calls on the hunch that the market may be going down can lead to big losses if you’re wrong, and the various bear funds don’t perform well on average through all types of markets.

All the bear ETFs I’ve looked at rebalance daily and suffer from volatility losses. The bear funds I’ve seen try to make money by picking individual stocks that they expect to drop in price. These funds don’t rebalance daily, but they must rebalance once in a while or else just one bad pick could sink the whole portfolio. It is less obvious with these funds, but they suffer from volatility losses as well.

All methods of betting against the market will suffer from the problem that the market tends to go up. As an example, if the market tends to go up by 10% per year, those who short the index will underperform a long position by 20% in an average year. This built-in bias to go up means that you have to be right about your guess that the market will drop a very high fraction of the time to come out further ahead than a simple buy-and-hold long position.

I know I can’t guess market directions well enough to win at this game. I invite other readers who know of ways of betting against the market other than those already mentioned to comment. However, I’ll be shocked if any of them don’t suffer from the problem that the market tends to go up.

Monday, October 5, 2009

Adventures in Car Repair

I don’t normally try to fix my own car mainly because I don’t really know what I’m doing and the consequences of messing it up can be painful. However, I was recently cornered into trying to deal with some rust that formed just above my windshield.

I have a great mechanic who was referred to me by a close friend who is a former mechanic. However, my mechanic doesn’t do much body work and he turned me away. While plotting my next move I tried using some rust paint, but that just slowed down the rust a little; it didn’t solve the problem.

Eventually, I asked my close friend the former mechanic to take a look. He started talking about a body shop having to remove the windshield and did I want to put all this money into this car or my next car! Who thought that a little rust could be such a serious problem? I decided that I’d have to try to deal with it myself.

After scraping off some paint and grinding off some of the rust, here is what the worst of the three rust spots looked like:

The metal sticks up just a little higher than the windshield and my best guess is that when small rocks hit the windshield they ran up and hit the metal. This eventually knocked off enough paint to expose metal and allow rust to start forming. However, this insight doesn’t help much with the repair.

After a couple of hours of trying to scrape away all the rust, I applied Bondo (a fibreglass product), sanded it down, and took a half hour to clear my head of fumes and my nose of fibreglass dust. The result wasn’t very pretty, particularly in the channel between the metal and the windshield. But, pretty doesn’t matter to me much at this point.

Then I applied three layers of primer, and about five layers of black car paint. Even in an open garage, the whole process left me pretty high after breathing all the fumes. I certainly hope that I extended the life of my car by at least a year, but I have no confidence that I did any good at all. Only time will tell.

Sunday, October 4, 2009

How the World Works Financially

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

People can be split into two groups: 1) those who spend carefully, save money, and invest wisely, and 2) those who, to varying degrees, do not do these things well. For convenience, let’s call these two groups savers and spenders.

Some of the spenders’ wages get transferred to the savers, primarily in the form of interest on debts. Most interest paid by spenders becomes the profits of banks and other companies, which then gets distributed to shareholders who happen to be savers.

Of course, people don’t really fit into just two groups. Most people fall somewhere between the best of savers and the worst of spenders. You can think of people being lined up the side of a mountain based on how well they handle money with the worst spender at the top of the mountain. Now imagine money rolling downhill from the spenders to the savers.

Although I have called the two groups savers and spenders, limiting spending is not enough to make someone a saver. A saver must invest wisely as well. Imagine someone who never takes on any debt, but keeps all savings in a low interest bank account that fails to keep up with inflation. This will increase the bank’s profit and benefit the bank’s shareholders who are savers.

It may seem like being a saver is not much of a life, but in truth, it is only necessary to spend less than your wages for a while. Once you have some savings built up and invested wisely, the investments generate returns in the form of interest or capital gains. When these returns are large enough, they can be your new savings, and you can spend all of your wages. Later, you can begin to spend all your wages plus some of your investment returns. The best of savers can ultimately quit their jobs and live on their savings.

If you are a saver, one way to think of it is that spenders go to work to benefit you. If you are a spender, then you go to work to benefit savers, at least partially. No amount of claiming that money isn’t the most important thing in life changes the basic fact that spenders work for savers.

Friday, October 2, 2009

Short Takes: New Credit Card Rules and more

1. Big Cajun Man has highlights of the Canadian government’s new credit card rules designed to protect us.

2. Jonathan Chevreau has some insights into the difficulty of saving money, particularly for young people (the web page with this article has disappeared since the time of writing). One point he misses is that access to credit is more prevalent now than when baby boomers were young. Even a cell phone contract where a bill is sent at the end of the month is a form of credit. For some people, the only way they stop consuming is if they are prevented from having what they want. Long enough ago, that meant the money in their pockets was gone. Now it means all forms of credit have been maxed out.

3. Financial advisors must have to deal with a great many different financial goals that their clients have. Preet has a story about one goal that wouldn’t have made my top 100 guesses – secret children.

4. Larry MacDonald reports that the SEC is looking into regulating securities lending. This hidden risk that few investors understand needs to be addressed. Any time an activity makes money for some people and presents an unrecognized risk for others there is the potential for big trouble.

5. Leasing a car is a poor idea in most circumstances, but Million Dollar Journey has a car leasing tip to save some money.

6. Larry Swedroe reports that U.S. investors are shunning professional money management in ever greater numbers.

Thursday, October 1, 2009

The Ponzi Retirement Plan

Being a victim of a Ponzi scheme is a terrible blow. However, life doesn’t seem to work out very well for the Ponzi scheme operators either after they get caught and go to prison. There must be some way to come out ahead with one of these schemes. Here’s my best shot.

Start by setting up an investment company with some confusing-sounding plan that purports to make 20% return each year. Maybe the marketing would include stuff about sector-rotating bottom-up technical analysis wave theory. A potentially tricky bit is that investor funds would have to be protected by either the Canadian CIPF (Canadian Investor Protection Fund) or the American SIPC (Securities Investor Protection Corporation).

Next, find some reasonably healthy 70-year old and make him the following offer. If he pretends to be the person who owns and runs this investment company he’ll get a pile of money. Then find investors who agree to sink $10,000 into the fund for the long term. You would be one of these investors. No money could be taken out for at least 20 years.

Send out statements showing the assets growing by around 20% each year. This should draw in more investors in the first few years. The statements would be completely false. The money would be invested reasonably safely at lower returns, and the old guy pretending to run the company would be spending some of it.

Suppose that the old guy dies at age 90 after 20 years. At this point the fraud gets found out. There isn’t anyone left to throw in jail because he seemed to have run the show alone. The tearful investors would cry in front of television cameras about dashed retirement dreams.

All the investors would just get back their initial investment plus some modest returns and less the money the old guy spent. This might be only, say, $30,000 when their account statements indicated they had, say, $400,000. Next the investors, including you, go the CIPF or the SIPC to recover the remaining money. Of course the money never really existed. But that doesn’t matter.

I say all this in the hope that such a scheme couldn’t work. However, a letter from the Ponzi Victims Coalition states that some of Bernard Madoff’s victims will be compensated by the SIPC.

This (highly illegal) scheme illustrates why Ponzi victims shouldn’t be fully compensated for their perceived losses. It may make sense to give them back their initial investments and possibly any assets that are proven to have actually existed before being stolen, but it doesn’t make sense to give them assets that were purely fantasy on paper.