Thursday, December 31, 2009

New Year’s Eve Preparations

This New Year’s Eve I’m reminded of a Gary Larson cartoon depicting a final exam at ditch-digger school with the reminder

“Have you got ...
1. Your shovel?
2. Backup shovel?”

In the same vein, I ask: Do you have a designated driver? A backup designated driver? Have a happy and safe new year.

Wednesday, December 30, 2009

The Psychology of Medical Coverage

For the last couple of years my family doctor has offered me the option of purchasing extended health coverage to pay for any of his services that I would have to pay for, such as copying records, immunizations, and filling out medical forms. The list is actually 23 items long.

I’ve never bothered to pay this “block fee” with the reasoning that I rarely need any of these services, and they are relatively cheap even if I need them one day. However, over the past year, I actually spent a total of $60 on services from my family doctor that weren’t covered by provincial health insurance.

Each time I coughed up another $20, I felt like I was losing out. If only I had paid for the insurance, I wouldn’t have to be digging into my pocket. What if I incur more costs this year and it works out that I have to pay more than the amount of the insurance?

When the papers inviting me to sign up for extended coverage for the upcoming year arrived, my first reaction was to pay. I had to think it through rationally to overcome this first emotional reaction. The coverage costs $150. I only paid $60 in a year where my costs were unusually high. It makes no sense for me to buy the insurance. Fortunately, I only have to be rational once per year in this case.

I’ve seen this sort of emotional response to medical coverage before. Years ago a former employer of mine made big changes to the pay structure, savings plan, bonus plan, and medical benefits. When it came time for employees to ask questions, they spent much more time on the coverage for new glasses than they did on non-medical issues. The amounts at stake in the bonus plan, savings plan, and pay structure were many thousands of dollars per year, but all management had to do was give in for about $100 per year on the “glasses” issue.

For some reason, Canadians (including me) seem to attach more value to extended medical coverage than it is actually worth, based on my limited observations. If this is true in general, then no doubt employers have found a way to exploit it to lower the overall cost of employees.

Tuesday, December 29, 2009

20/20 Hindsight

Most of us have thought at one time or another that we’d like to use what we know now to go back in time and make different choices. Looking back at stock prices in 2009, it’s clear that a big bet on stocks in March would have paid off handsomely.

In a discussion of leverage in November 2008, I came dangerously close to making a prediction:

“Let me reiterate that I’m not a fan of leverage, but if there ever is an appropriate time for it, now is probably that time.”

As it turns out, stocks dropped further, but are now significantly above the level on that day. Suppose that I had borrowed $250,000 against my house to invest in the TSX Composite index, which was sitting at 9424.00 that day. The lows in March would have produced a painful paper loss of nearly 20%, but I’d be ahead 24.7% as of the closing value of 11,754.61 on Christmas Eve.

Assuming that I paid about $10,000 in interest on the mortgage, my net gains right now would be $51,800. That’s not a bad payoff for minimal effort.

But, I wasn’t really making a prediction, and I wouldn’t make a big bet like this with borrowed money. If I had collapsed this investment on 2009 March 9 when the TSX Composite was at 7566.94, my loss would have been about $52,300 (assuming interest costs of about $3000). The possibility of that kind of loss is enough to cure me of actually considering such a bet.

Monday, December 28, 2009

How to Pay Less and Keep More for Yourself

Have you ever had the feeling that you pay more fees to your bank than you should, but you’re not sure what to do about it? If you’re a Canadian and answered yes, then Rob Carrick’s book How to Pay Less and Keep More for Your$elf: The Essential Guide to Canadian Banking and Investing may be for you.

Whether your concern is savings and chequing accounts, credit cards, loans, mortgages, or investing, Carrick has useful suggestions for reducing fees and getting better interest rates. He also has good insights into working with financial advisors and the ins and outs of do-it-yourself investing.

Unlike many writers, Carrick doesn’t bother to preach about the evils of debt or mutual fund fees. Instead he focuses on how to reduce interest rates on debt and fees on funds. For example, he says that debt is “an essential financial tool” in a world of expensive homes and cars. I agree when it comes to homes, but I think people should pay cash for cars. If they can’t pay cash for a car now, they should be formulating a plan to save enough to pay off this car and pay cash for the next car.

Perhaps Carrick’s approach is more useful than preaching to people already buried in debt. Warning a young person to avoid debt is one thing, but middle-aged readers who already have significant debts are probably better off learning about the advantages and disadvantages of consolidation loans.

When it comes to mutual funds, Carrick describes MERs of 2.38% for a Canadian equity fund and 1.07% for a bond fund as “reasonable”. I find them very high when much lower MERs are available, but to an investor who cannot leave the psychological safety of a financial advisor, modest reductions in fees are better than nothing.

The book does cover ways of investing with significantly lower fees (indexing), but the author doesn’t bother to try to make those who stick with mutual funds feel guilty.

Here are some thoughts on specific parts of the book:

Debt Consolidation

One thing I would add to Carrick’s discussion of debt consolidation is a potential pitfall. Once all your credit cards and other debts are paid off with the balances rolled into a home-equity line of credit, the balance-free credit cards may be too much of a temptation to spend. Unless borrowers change their ways, they end up with the consolidated debt plus a pile of new credit card debts. This may ultimately lead to losing a home.


“Don’t even think about accepting a mortgage at the posted rate.”

“Never simply renew a mortgage without trying to arrange a better deal.”

Carrick goes on to give concrete suggestions for how to follow this advice.

Mortgage Brokers

“Mortgage brokers almost always charge nothing for [their] service.” This is misleading. There may not be any explicit charge, but the broker’s fee is built into the mortgage rate and is ultimately paid by the client. It may be true that the broker is able to save the client more than the cost of his fee, but this still doesn’t make the broker’s service free.

Tied Selling

“It’s illegal for banks to require that you bring them a certain piece of business [like an RRSP account] if you want to get a mortgage.” I didn’t know this. However, you may be able to negotiate a better mortgage interest rate if you bring other business.

Flexible Mortgage Accounts

The author makes two strong points about mortgage accounts that combine the features of a mortgage, line of credit, and chequing account: The interest rate is usually higher than what you can get on a standard mortgage, and it becomes too easy for many borrowers to borrow more and never pay off their mortgage.

Mutual Funds

“Ignorance about mutual fund fees is bliss for fund companies. Wise up to the fees you’re paying to buy and own your mutual funds, and make sure you’re getting good value.”

Indexing in Down Markets

Carrick repeats the oft-made claim that active equity funds outperform index funds in down markets. The evidence for this is scant, but to the extent that it is true, the reason seems to be that active funds are forced to hold a percentage in cash to deal with uncertainty of fund inflows and outflows. This cash obviously performs better than stocks when stocks are dropping in price, and a fund with more cash will have a small edge over the fund with less cash.

To compensate for this, an investor could just ever-so-slightly increase fixed-income allocation when using an index fund rather than an active fund. For this reason, in Carrick’s model portfolios, I would substitute index funds for most of the active funds to save on MER costs.


This book is written in an easy-to-read style, and many readers are likely to find something useful for their dealings with banks.

Sunday, December 27, 2009

My Top 3 Investing Mistakes

This is the last regular Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. The pool of under-appreciated articles has been exhausted. Enjoy.

The Dividend Guy challenged other bloggers to post their top 3 investing mistakes.  Here is my contribution.

1. Putting my first savings into fixed income investments

I was young and nervous because I owed $85,000 on my first mortgage. My mortgage permitted doubling monthly payments, and my wife and I were taking advantage of this feature every month; I wanted the mortgage GONE. This didn’t leave much for retirement savings, but we did manage to save some money each year.

Unfortunately, I knew very little about the stock market at that time, and we put all of our savings into fixed income investments at our bank. We continued this way for several years giving up the gains available in the stock market. This was a big mistake.

2. Buying actively-managed high-cost mutual funds

My first tentative steps into the stock market were through mutual funds. I worked with a few different financial advisors who turned out to be little more than mutual fund salespeople. It took me quite a while to figure out that I was paying exorbitant fees to own these funds.

Sadly, like most mutual funds, my funds underperformed the indexes despite the assurances from my financial advisors that I owned some of the best mutual funds available.

3. Owning too much of my employer’s stock

I owned stock in my employer during the high-tech bubble. Fortunately, I sold most of it before the bubble burst, but it would have been a lot smarter to have kept the value of my employer’s stock below some percentage of my total portfolio, such as 20%. If the bubble had burst earlier, I could have lost most of my savings.

Situations like this are often tragic. Take Enron for example. Many employees had the bulk of their savings in Enron stock. They lost most of their money along with their jobs all at the same time. This was a very painful lesson for these people.

Wednesday, December 23, 2009

Walking a Mile

This will be the last post until after Christmas. Have a Merry Christmas for those who celebrate it, and to everyone else, enjoy the time off work.

There is a lot of truth to the saying that you shouldn’t judge people until you’ve walked a mile in their shoes. Looking at things from another person’s point of view can give useful insights. Let’s try this with financial advisors and Tiger Woods.

The investing do-it-yourself crowd tends to vilify financial advisors who are actually mutual fund salespeople. The truth is that I don’t tend to think ill of these people; I just choose to protect myself from them, and I think other investors should do the same.

If evil advisors were the issue, then we would have much less of a problem. Most people are basically decent and honest. The same is likely true of mutual fund salespeople. The fundamental problem is the incentive structure that they work within.

Suppose Jim sells mutual funds and has hit some hard times. The economy is bad, old clients are leaving him, new clients are nearly impossible to find, and his income has dropped considerably. Jim’s bills are piling up, hydro has threatened to cut off his service, and his daughter needs braces.

How much longer can Jim resist the temptation to call up his best client, a little old widow who calls him dearie, and recommend that she switch her $400,000 from one set of mutual funds to another? This would trigger huge deferred sales charges for the widow and bring in a commission of $20,000. Jim’s share would be enough to keep his family afloat financially for a few more months.

The pressures on Jim don’t excuse his behaviour if he recommends a pointless switch of funds just to get paid. But this does explain why even decent people have difficulty sticking to what is best for the client in a commission-based incentive structure. As a client, it’s not good enough to avoid advisors who are evil; the problem is much bigger than this.

I see a parallel between this situation and Tiger Woods’ predicament. There is no doubt that Tiger let his family down in a serious way. But I would be curious to know what proportion of men would have failed in the same way in his circumstances. It’s easy for a poor, dumpy guy in his fifties to fend off the nonexistent women who chase him. Tiger would have had a constant stream of young women looking for him.

None of this excuses Tiger, of course. But the steady reports of powerful U.S. politicians with “marital difficulties” seem to suggest that many men aren’t able to resist the same temptations that Tiger couldn’t resist.

Perhaps this is a business opportunity. In addition to bodyguards, wealthy married male athletes need a team to keep women who are on a mission away from them. This would be admitting that they can be tempted, but it’s better than getting caught cheating. I could imagine many of the athletes’ wives approving of this kind of “blocking” service. No doubt some wealthy public figures already have their people performing this service.

Tuesday, December 22, 2009

Winning the Loser’s Game

The book Winning the Loser’s Game by Charles D. Ellis was a very pleasant surprise for me. I tend not to expect much from books and am pleased to learn even one interesting thing. Ellis provides consistently solid investing information from beginning to end. The presentation is clear and concise. This book is now my best recommendation for an individual investor looking for a foundation for a lifetime of investing.

This book is in its fifth edition, which makes me regret not ever having seen it before. I certainly could have saved myself from financial mistakes armed with these ideas. Parts of the book are specific to U.S. investors, but they are not central to the main messages.

Among other high-profile roles, Ellis has chaired investment committees at both Harvard Business School and Yale School of Management. But that doesn’t mean that he aims to baffle readers with his academic brilliance. Even concepts I thought I understood well and have seen in other books were explained more clearly and simply here.

While most investing books go through a litany of different investments and approaches an investor can use, Ellis also tells us what we cannot do. “Virtually all how-to books on investing are sold on the false promise that the typical investor can beat the professional investors. He or she can’t, and he or she won’t.” Ellis backs up this bold claim convincingly.

The different ways of trying to beat the market are examined one by one and knocked down. Ellis contends that while less efficient markets in the past made it possible for clever investors to beat the market, today’s markets are dominated by professionals controlling 90% of the money. This makes it impossible for anybody to beat today’s markets consistently. “The problem is not that investment research is not done well. The problem is research is done very well by very many.”

“All the basic forms of active investing have one fundamental characteristic in common: They depend on the errors of others.” To profit, an active investor has to find cases where the consensus estimate of other professional investors is wrong. Even the best do-it-yourself stock pickers have little chance because they are up against an army of professionals.

Ellis’ conclusion is that the best approach to investing involves using low-cost indexing either with index funds or ETFs, whichever works out to have the lower cost. He lists a litany of “unfair” advantages index investing has:

– Higher returns
– Lower fees and expenses
– Convenience
– Lower taxes
– Freedom from errors (fewer decisions)
– Less anxiety

Here are thoughts on some of the details in the book:

Efficient Markets

Ellis believes that markets are very efficient at getting the relative prices of equities right. However, he believes that the entire market can still get under-priced or over-priced.


“The principal reason you should articulate your long-term investment policies explicitly and in writing is to protect your portfolio from yourself.”

“It is in ... periods of anxiety – when the market has been most severely negative – that investors predictably engage in ad hoc ‘reappraisals’ of long-term investment judgment and allow their short-term fears to overwhelm the calm rationality of long-term investing.”

Regression to the Mean

It seems that Ellis couldn’t help but suggest some active management at least once. Although he thinks actively-managed mutual funds are a loser’s game, he recognizes that many investors will play it anyway and offers some advice that includes a “good test”.

“If the fund underperformed the market because the manager’s particular style was out of favor, would you cheerfully assign substantially more money to that fund?” He thinks the answer should be yes because “the manager will almost certainly outperform the overall market averages when investment fashion again favors his or her style.”

This seems to contradict the results in Figure 14.1 that show that past mutual fund performance gives almost no information about the future. “The data have zero predictive power – with this one exception: The worst losers do tend to keep losing.”

Old People

We should be tolerant of petty behaviour by old people when it comes to how they control their money because “it’s probably just another way of expressing fear of death.”


“Don’t invest with borrowed money.”


Speculating in commodities is “not investing because there’s no economic productivity or value added.” Ellis calls commodities a negative-sum game. “Consider the experience of a commodities broker who over a decade advised nearly 1000 customers on commodities. How many made money? Not even one.”


This book has fewer minor errors than the typical book. I found so few that it isn’t too tedious to list them. In Figure 16.1, the range of inflation percentages should go from 3% to 7% rather than 2% to 6%. On page 132 at the end of the second paragraph, “then” should be “than”.


Winning the Loser’s Game is a clearly-written book that takes a strong stand on how people should invest their money. It will challenge the thinking of many individual investors whether they trust their money to active mutual fund managers or pick their own stocks.

After such a positive review, I should address questions about my motivations. McGraw Hill sent me a free review copy of this book, but I made no promise to give a positive review. I have written reviews for McGraw books that I didn’t like as well. I may be right or wrong, but I have written what I actually think rather than what someone paid me to say.

Monday, December 21, 2009

Irrational Need for the Latest Investment to Perform Well

Nearly a month ago I made an RRSP contribution and used the money to buy an index ETF. I then watched how it performed 10 minutes later, an hour later, a day later, etc. Even now I find myself more interested in how this ETF is performing than the rest of my portfolio. This happens every time I make a new investment or add to an existing one.

Of course, this is all irrational, but I just couldn’t help being pleased that the ETF stayed above my purchase price during the first day. It shouldn’t make a difference to me whether I make $100 on this investment or some other one, but it does. I do my best to keep irrational emotions like this from affecting my decisions, but that doesn’t stop me from having the emotions.

I assume I’m not alone in this need for new investments to perform well. Do other investors find themselves caring more about recent purchases than the rest of their portfolios?

Sunday, December 20, 2009

Mutual Fund Front Running

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

Among the games that mutual fund managers play to artificially boost reported returns, such as closing underperforming funds and fund incubation, you can add a practice called front running.

Larry Swedroe describes front running in his excellent book Rational Investing in Irrational Times. A fund family starts up a new fund hoping to report good returns and attract a flood of investors. They begin by choosing some stock that has low trading volumes so that a modest size purchase will drive its price up sharply.

The fund family then purchases a block of shares for the new fund. Then they purchase a larger block of shares for one or more of their large established funds. This will drive the price of the shares up and artificially inflate to apparent returns of the new fund.

Done correctly, the number of shares purchased for the established funds isn’t enough to make much of a difference to their returns. But, the new fund’s returns will look great and with a little advertising, new investors should flood in.

Of course, the reported returns don’t reflect any particular talent of the new fund’s manager. After the new fund swells, it isn’t any more likely than any other fund to do well. Investor’s should view the reported returns of any new fund sceptically.

Friday, December 18, 2009

Short Takes: Trading Gift Cards, Men’s Health, and more

1. Do you have any gift cards you don’t intend to use, or would you like to buy a gift card at a discount? CardSwap calls itself the eBay of gift cards. I don’t know much about them other than what I learned from a press release and looking at their web site, but the idea sounds good. Are there any readers who have tried buying or selling gift cards at this web site? My biggest concern would be that some cards would come with unexpected restrictions making them less valuable than they appeared at first. The card seller may not even be aware of any restrictions.

2. It doesn’t have much to do with money, but the Big Cajun Man thinks that ED medications have improved men’s health because they are sending more men to their doctors for physicals. It’s an interesting theory, but it’s the jokes in italics that will keep you reading.

3. Larry MacDonald has put together a timeline of the huge alleged Canadian Ponzi scheme. It’s troubling that the scheme seems to have been uncovered in 2004, but couldn’t be shut down until this year.

4. Preet says that new cell phone competitors are coming to Canada to drive down prices. It’s about time.

5. Tax Guy reports that Americans can take income tax deductions for car damage due to drunk driving. Don’t expect to see this in Canada anytime soon.

6. Canadian Investor has done a comparison of Emerging Market ETFs trading in the U.S. and Canada.

Thursday, December 17, 2009

MER Drag on Returns in Pictures

This blog has featured many attempts to explain the damage that investing fees, primarily MERs on mutual funds and ETFs, can have on your savings. This latest effort uses a picture.

This picture makes use of Robert Schiller’s monthly historical data on the U.S. S&P 500 index. Although, I’d prefer to use Canadian stock market figures, U.S. figures are easier to get, and the results would look much the same for Canadian stocks. I traced the path of a $10,000 investment 50 years ago under three different conditions:

1. The money follows the S&P 500 with dividends. We track real returns, meaning that the effect of inflation is factored out.

2. The money follows the S&P 500 with dividends less MER fees of 0.17% per year. This is the MER level of the widely-popular iShares large capitalization index of Canadian stocks (XIU).

3. The money follows the S&P 500 with dividends less MER fees of 2.5% per year. This is the MER level of a typical Canadian stock mutual fund.

Here are the results:

As the chart shows, a 0.17% MER ETF tracks its index fairly closely, even over 50 years. However, the 2.5% MER has decimated returns. The final portfolio value is less than one-third of the value for the lower MER.

Although a percentage like 2.5% sounds like a small figure, it gets deducted from the same portfolio year are year and eventually adds up. Like the flow of water slowly carving a groove in rock, MER costs slowly carve away a big chunk of your savings.

Update:  A reader, Thicken My Wallet, asked what the chart would look like if the MER were set at 1%, which is the fee level set by many newly-issued ETFs.  Ask and ye shall receive:

As we can see, the 1% MER took quite a bite.  The final portfolio value is more than 1/3 less than in the 0.17% MER case.  Even fractions of a percentage point matter over an investing lifetime.

Wednesday, December 16, 2009

Sometimes Frugality can be Taken Too Far

A while back I discovered that there were mice in the drop ceiling of my finished basement. After cleaning up the mess they made, I set some mouse traps with some peanut butter in them. Mice really seem to like peanut butter and it lasts forever in the traps. The first time I noticed that I’d caught a mouse, it had been there for a while and didn’t smell too good. After disposing of the mouse, I proceeded to try to clean up the trap to use again.

The cleaning was unpleasant and the trap still stunk afterwards. It wasn’t until after I reset the trap and put it in place that I thought about how foolish it was to do all that work. The last time I checked, mouse traps at a local store range in price from about 50 cents to $2 for a “deluxe” model.

So now I consider mouse traps to be disposable. If there is the slightest bit of unpleasantness in trying to dislodge a dead mouse from a trap or clean it up, it goes in the garbage with the mouse. Now I catch 3 or 4 mice per year and happily buy new traps periodically. I’m still trying to figure out how they get in, but at least the disposal part of this job is easier now that I’ve looked at this more rationally.

Tuesday, December 15, 2009

An Experiment with the Modified 4% Rule

Recently we discussed a modified 4% rule where we base the size of monthly withdrawals from retirement savings on the current portfolio size rather than the portfolio size at the beginning of retirement. Let’s follow this up by looking at actual market data to see how monthly retirement income is affected.

Because U.S. data is more readily available, I’ve gathered returns on the S&P 500 (including dividends) since 1988, adjusted for inflation. Let’s consider the case of Rita who retired in 1988 with a portfolio worth $750,000 in today’s dollars. The actual figure in 1988 was a little over $400,000.

Rita has 100% of her money in the S&P 500 index. This is obviously a more aggressive portfolio than most retirees would want, but let’s see what happens to Rita’s income.

Using the modified 4% rule, Rita would start drawing 1/12 of 4% ($2500 in today’s dollars) per month. But this amount gets adjusted each month depending on whether the portfolio grows or shrinks. Assuming that Rita managed to stay alive for nearly 32 years, here is how her income changed over the years:

Rita had only one month where her inflation-adjusted income dipped below $2500 to $2479. By the year 2000, the buying power of her income had tripled. However, this was followed by one big drop from 2001 to 2003, and then another big drop in early 2009 where it reached $2711.

It seems that Rita fared rather well over the years considering that her income started at $2500 per month. However, if her lifestyle had expanded to consume her income when it was over $7500, she may have found the subsequent drop painful.

Things would have been far different for Ray who retired in 2001. Just two years later his retirement income was chopped in half. This may seem to be an argument against modifying the 4% rule, but if Ray had stuck to making monthly withdrawals based on his 2001 portfolio size, he would run out of money fast. Ray’s situation isn’t so much an indictment of the modified 4% rule as it makes it clear that a portfolio 100% in stocks is risky.

One thing that this experiment has left out is that it makes sense for retirees to increase the percentage of their portfolio that they spend as they get older. If Rita turned 65 in 1988, then she is 96 now with a portfolio worth over $1.1 million as of the end of October. She can probably afford to spend more than 4% each year now. How much more is an interesting question.

[Update: Reader Blitzer68 pointed me to an excellent article by William Bernstein on this subject that I highly recommend.]

Monday, December 14, 2009

Modifying the 4% Rule

What amount can an investor, Ian, withdraw safely each year from a portfolio 50% in stocks and 50% in bonds? Suppose that Ian wants to fix some dollar amount and bump it up by inflation each year, and wants a high probability of not outliving the money. According to a 1994 paper by William Bengen, the answer if Ian is between 60 and 65 years old is about 4% of his starting portfolio size. This has come to be called the 4% rule.

So, starting with $750,000, Ian should be able to withdraw $30,000 the first year, and then bump up the withdrawal amount by inflation each year. With reasonable probability, Ian won’t run out of money during his remaining lifetime, according to Bengen.

Patrick at A Loonie Saved noted a logical inconsistency with this 4% rule. Two investors in exactly the same situation might receive different advice. Let’s illustrate this with an example.

Suppose that in the first year of Ian’s retirement stocks performed very poorly. Between the $30,000 worth of withdrawals and the portfolio losses, Ian has $600,000 left today. Assuming inflation is 3%, Ian plans to continue with the 4% of starting portfolio rule and bump up his withdrawal amount to $30,900 for the upcoming year.

A second investor, Sam, is the same age as Ian, but is just retiring today. Sam’s portfolio is also worth $600,000. However, when Sam follows the 4% rule starting now, he will only withdraw $24,000 during the upcoming year. How can it make any sense that Ian and Sam are the same age and have the same amount of money, but should withdraw very different amounts during the upcoming year?

This inconsistency caused me to modify the 4% rule for my own use. When I get to full retirement, I plan to target withdrawing 4% of whatever my portfolio is worth each year. So, if my portfolio drops in value from one year to the next, my income for the next year will drop as well.

This kind of uncertainty may not be for everyone. I’m quite comfortable making lifestyle changes to increase or decrease spending. Many people can’t do this well. On the positive side, I won’t ever run out of money this way. If my portfolio happens to perform well, I will get to enjoy rising income.

The approach I plan to use may be forced upon some investors even if they planned to follow the original 4% rule. The poor performance of Ian’s portfolio in his first year of retirement greatly increases the risk that he will outlast his money if he doesn’t cut back on withdrawals. If he sticks to the original 4% rule for 5 or 10 years, it may become very obvious that he is running out of money fast.

Sunday, December 13, 2009

The Folly of Constant Asset Allocation over a Lifetime

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

Most commentators advise investors to shift money from equities to fixed income as they age, and this makes sense. We may disagree on the exact asset allocation percentages and exactly how soon before (or after) retirement to start lightening up on equities, but it seems clear enough that the average 40-year old should have more in equities than the average 80-year old.

However, there is a body of academic work that argues that investors should maintain a constant asset allocation regardless of their age. This work is based on what is known as constant relative-risk aversion (CRRA). I’ll show the problems with CRRA in an example below.

One consequence of the CRRA assumption is that the optimal asset allocation percentages remain constant regardless of the length of the investor’s investment horizon. Paul A. Samuelson advocates this view in his keynote address to “The Future of Life-Cycle Saving and Investing” conference.

To show the problem with CRRA, I’ll consider a case where it gives silly results. To do this, I’ll have to pick a particular constant level of risk aversion. Morningstar uses the CRRA assumption in their star rating system for mutual funds. I’ll base my analysis on the risk aversion level chosen by Morningstar.

A Fun Example

A beer company decides to promote their new brand of beer sold in cases of 24 by roaming around to different bars giving away $24 to people who are drinking the new brand. The prize crew enters a bar and descends on a table where two friends, average Avery and rich Richard, are sitting drinking the new brand of beer.

As both men accept their $24 prizes, Avery is thrilled, but Richard is only mildly pleased. Avery comments “I guess a rich guy like you doesn’t get very excited by a lousy $24. How much bigger would your prize have to be to make you as excited as I am?”

The answer to this question depends on how much money Avery and Richard have. Suppose that Avery’s net worth is $120,000, and Richard’s is $6 million. According to the CRRA assumption, to make Richard as excited as Avery, his prize would have to be $340 million! This is obviously ridiculous.

Just for fun, let’s make some seemingly inconsequential changes. Each man calculates his net worth more accurately, and Avery’s comes out $20 higher than he first thought, and Richard’s comes out $2400.10 higher than he first thought. Now, the CRRA says that Richard’s prize must be $11 trillion!

You may find it hard to believe that CRRA could get these answers so horribly wrong, but that is what the math says. In fact, if Avery’s prize were $25, then according to CRRA there would be no amount you could give to Richard to make him as happy as Avery.

Is This a Fair Test? Yes, it is.

Most theories are based on approximations and simplifying assumptions. These theories can be shown to be wrong in extreme or unimportant cases. However, my example is directly relevant to long-term investing. CRRA gives answers that are close to reality for small risks. But, for the large dollar amounts involved in long-term investing, CRRA gives ridiculous answers.

Matthew Rabin has an interesting paper where he discusses the problems of extrapolating from people’s attitudes about small risks to making decisions about large risks.

In truth, CRRA is more of a mathematical convenience than a valid theory. With CRRA, how much money you have and how much money you want to have aren’t relevant when deciding on your asset allocation. Without CRRA, Morningstar would not be able to give star ratings for mutual funds without knowing your net worth and your future needs for money.

So, if anyone tries to tell you to maintain the same asset allocation for your whole life, remember that this advice is based on a faulty theory.

Friday, December 11, 2009

Short Takes: Flu Shot Edition

I got my flu shot Thursday. Actually, I got two shots: one for the H1N1 (swine) flu and the other for the “regular” seasonal flu. I only planned on getting the swine flu shot, but the young man I first encountered was a good salesman. The whole process took 25 minutes, including filling out a form, standing in line briefly, getting the shots, and waiting the mandatory 15 minutes to make sure I didn’t have some sort of reaction. Apparently, the long lines have dwindled and the bracelet system isn’t needed any more in my community. So far the shots hurt less than the standard tetanus booster.

1. Who knew there were so many ways to calculate the return on a portfolio? Preet answers a reader question about the Modified Dietz return calculation.

2. According to Larry MacDonald, parents in need can sue their adult children for support if they supported their children financially when they were minors.

3. Ellen Roseman helped some people who made an online purchase, but were charged more on their credit cards than was indicated in the online checkout form.

4. Canadian Financial DIY shows how ETF investors can do some tax loss selling while maintaining their asset allocations.

5. The Tax Guy looks at who gets the contents of a joint bank account when one of the account holders dies.

6. Big Cajun Man thinks that the TD Bank is daring him to find another lender with lower interest rates.

Thursday, December 10, 2009

Door-to-Door Hot Water Tank Salespeople

Just when it seemed that the fixed rate natural gas marketers had stopped coming to my door, hot water tank marketers started ringing my doorbell. So far I’ve had two of these guys show up, both pretending to work for my natural gas supplier, but they don’t.

So, why would I turn down a free hot water tank? After all, my tank is more than 5 years old and may not have peak efficiency (according to one salesperson). I’ll save money because of the lower gas consumption.

What these guys failed to mention is that they don’t work for a company that I already have a relationship with, the rental charges on the new tank will be higher than I’m paying now, and I would have to lock in this rental charge rate for many years (15 years according to some reports).

Based on the rental charge I extracted from one salesperson and a quote from Sears for a new hot water heater, I could buy a new tank for less than three years worth of rental charges. So, when I decide the time is right to dump my old tank, I’ll be buying a new tank and dumping the rental charges.

Wednesday, December 9, 2009

Cheap: The High Cost of Discount Culture

In her book, Cheap: The High Cost of Discount Culture, Ellen Ruppel Shell argues that our drive for low prices and inability to determine product quality has led to eroding job quality in the U.S. and the rest of the world. Large retailers give us cheap goods, but they also kill the jobs requiring skill and replace them with low-skill minimum-wage jobs.

Parts of this book contain a balanced treatment of issues carefully explaining both sides. Other parts descend into more of a rant that still manages to be thoughtful and entertaining.

While it’s unlikely that any reader would agree with all of the author’s arguments, this book is consistently interesting as it discusses price discounting, behavioural finance, outlet malls, craftsmen, food production, and trade with China.

In the author’s view, most large retailers are a major part of the problem (most notably Walmart), but there are a few large retailers that set a good example (Wegmans and Costco). Walmart pays poor wages and has high worker turnover, but Wegmans and Costco manage to offer low prices while paying much higher wages and treating workers well enough that employee turnover is low.

Here is a sampling of some of the interesting details:

Difficult Decisions

Faced with a difficult decision, we tend to ask ourselves a related question that is easier to answer. But the easier question is usually the wrong question. Rather than decide whether to buy a new pair of shoes, it’s easier to decide whether to get the black ones or red ones.


Most of us have seen a product advertised at some price, like $30, only to discover that it is really $50 with a $20 mail-in rebate. Apparently, we make our purchasing decision based on the $30 figure, but most of us don’t send in the rebate: “redemption rates greater than 35 percent are considered marginal by manufacturers and retailers.”

Curiously, setting a deadline for sending in a rebate increases the percentage of customers who send it in. Even stranger is that up to a limit, making the process for sending in the rebate more difficult increases the percentage of customers who send it in.

Workers’ Rights

According to MIT professor Richard Locke, there is “only one force powerful enough to enforce workers’ rights and protection: guilt. And there is only one institution capable of evoking that force: the Vatican.” I’m not too optimistic about this approach. I suspect that improving the lot of workers in China and other countries will happen very slowly as trade brings in wealth. I would prefer to see better working conditions sooner, but I’m not optimistic that this will happen.


The author makes an interesting case that our drive for cheap goods is harming the quality of jobs available in the U.S. and the rest of the world. This book is worth reading whether you agree with the central premise or not.

Tuesday, December 8, 2009

How Price Discounts Affect Purchasing Decisions

When we see a consumer item deeply discounted, we tend to react in one of two ways:

1. “What a bargain! I’ll take five.”

2. “I knew those things were no good.”

Sometimes we see a low price as an opportunity, and other times we see it as a sign of low quality. In their paper, Motivating Discounts: Price Motivated Reasoning, researchers On Amir and Erica Dawson sought to find out what determines which way we react. It turns out that our reactions are determined by what we thought of the product before seeing the discounted price.

If we’re already attracted to a product, then we see a discount as a bargain. If we’re neutral or negative about a product, we see the discount as a sign of low quality. A curious side effect of our behaviour is that deep discounts “discourage purchases by all except those who liked the product in the first place.” We’re less likely to buy a deeply discounted unfamiliar product than we are to buy it at the regular price.

We can see this happening among investors in individual stocks. When XYZ Corp. shares take a tumble, fans of XYZ are happy to buy more, but those who don’t like XYZ see the price drop as confirmation of their opinion that the company is failing.

If the Amir and Dawson results apply to stocks then we can expect investors looking at XYZ stock for the first time to be less likely to buy shares after the price falls than before the price falls, even if they know of no specific reason why the price dropped.

Monday, December 7, 2009

Preferred Share Yield Fantasy

The dividend yield reported on preferred shares is often misleading. These reported figures don’t take into account potential gains or losses when these shares are redeemed. Unwary investors can get surprised if they chase high yield without reading the fine print.

Preferred shares are issued by companies to raise capital. Typically, they are sold for $25 each and promise fixed quarterly dividends until they are redeemed for $25 each. With common stock, shareholders own a slice of the company, but investors in preferred shares just get dividends. The name “preferred” comes from the fact that if the company has financial trouble, owners of preferred shares get paid before owners of common stock.

Just because a preferred share starts and ends its life at $25 doesn’t mean that it holds steady at $25. If market conditions make the fixed dividend payment more or less attractive, the share’s price will fluctuate up and down.

Usually preferred shares get a higher dividend (in percentage terms) than common stock gets. For example, as I write this, Royal Bank of Canada stock (ticker: RY) is paying a 3.58% dividend, but the series AR preferred shares (ticker: RY.PR.R) is listed as paying a 5.62% dividend.

For fixed-income investors looking for higher yield on their money, 5.62% probably looks pretty good. After all, Royal Bank isn’t likely to go out of business or struggle so badly that they can’t pay the preferred share dividends. But, it is dangerous to chase yield without checking the details.

Royal Bank’s series AR preferred share prospectus says that these shares initially paid a fixed 6.25% dividend. How could the payments be only 5.62% per year now if the dividend is supposed to be fixed? The answer is that the current share price is up to $27.80 instead of $25. The total dividend amount per year of $1.56 hasn’t changed, but it is now only 5.62% of the current share price.

The prospectus also says that Royal Bank can redeem these preferred shares on 2014 Feb. 24 for $25. But an investor buying now is paying $27.80. That’s a loss of $2.80 per share. The 21 quarterly payments left until the redemption date add up to $8.20. That leaves the investor a profit of only $5.40. Taking the present value of the share purchase, dividends, and $25 redemption, the yield works out to only 3.96%.

Another consideration for taxable accounts is that for most Canadians the $8.20 will be taxed as dividends and the $2.80 will be a capital loss.

Preferred shares are worth considering along with other fixed-income investments, but to make an informed decision, it pays to understand their risks along with the fine print and tax consequences.

Sunday, December 6, 2009

Mutual Fund Full Disclosure

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

Many investors seem unaware of the fees they pay to own their mutual funds. Disclosure rules are intended to prevent this sort of problem, but they don’t seem to be effective enough.

Suppose that you meet with a financial advisor and agree to invest with her. She seems like a great person, and her investment advice seems sensible as far as you can tell. Then she hands you the following disclosure statement:

Initial portfolio size: $150,000
Initial investments: 30% bond fund, 50% stock fund, 20% international stock fund
Estimated Fees:
Immediately: $6300
Year 1: $3135
Year 2: $3324
Year 3: $3526
Year 4: $2718
Year 5: $2781
Year 6: $2838
Year 7: $4815
Year 8: $5164
Year 9: $5540
Year 10: $5944
10-year total: $46,086

Gulp. Surely these can’t be right. Will you really pay this much? Yes, you will. These numbers were calculated based on the fees charged by three popular mutual funds offered in Canada. The bond fund has no load, the stock fund has a deferred sales charge, and the international stock fund has a front-end load. The dollar amounts assume a 4% per year return in the bond fund and an 8% per year return in the stock funds.

This type of disclosure would be a real eye-opener for investors and would make it harder for financial advisors to hide fees. It might also encourage more competition on fees among mutual funds.

Friday, December 4, 2009

Short Takes: Exchange-Traded Notes and more

1. Preet explains how leveraged Exchange-Traded Notes (ETNs) hide snowballing interest charges.

2. Big Cajun Man found that opening a Registered Disability Saving Plan (RDSP) isn’t as easy as opening RRSPs and TFSAs.

3. Million Dollar Journey looks at how to claim a capital loss on a de-listed stock like Nortel.

4. Mike at Four Pillars decided to collapse his leveraged investing plan (the web page with this article has disappeared since the time of writing). The big danger for anyone considering leveraged investing is that it will seem like a great idea when the stock market is booming (expensive stocks) and will later seem like a terrible idea when the stock market is crashing (cheap stocks). At least Mike stuck it out for the last 9 months while stock prices rose from their lows.

5. Potato concludes his story of looking for a place to rent in Toronto and has some advice for landlords.

Thursday, December 3, 2009

The Impact of MERs on Mutual Fund Returns

In a recent post, Canadian Capitalist showed that the effect of the HST on investor returns in mutual funds is small compared to the drag caused by fund MERs. I thought that while this conclusion is correct, his calculation of the MER impact was a little off. It turns out that we were both (slightly) wrong.

In the example, Investor A puts $100 to work in the equity market for 25 years at an average annual return of 8%, giving a final portfolio value of $685. Investor B makes a similar $100 investment in a mutual fund with a 2.5% MER. Reasoning that Investor B’s return dropped to an average of 5.5% per year, his final portfolio value works out to $381.

With the HST, the MER drag rises to 2.7% leaving 5.3% average return each year, and the final portfolio value is $363. So, compared to Investor A’s $685, the MER costs Investor B $304, and the HST costs him another $18. It’s clear that while the HST isn’t helping, the real problem is the high MER.

At first I thought that these calculations were a little off because the MER would knock 2.5% off the year-ending portfolio size, not the year-starting portfolio size. With this reasoning, Investor B’s return would be calculated as follows:

(1 + 0.08)*(1 – 0.025) = 1.053

This gives a 5.3% average return each year. Adding in the effect of the HST, we replace 0.025 with 0.027 and the average annual return drops to 5.084%.

It turns out that the truth is between Canadian Capitalist’s method and mine because of the way that the MER is reported. Mutual funds take the total costs of running the fund during the year and divide by the average assets under management during the year. The result is the MER percentage.

As it turns out, to calculate the effect of the MER on investor returns, you’ll need the e-to-the-power-of-x button on a scientific calculator or the EXP() function on a spreadsheet. For a detailed explanation of where the formula I’m about to use comes from, see the math section at the end of this post.

Here is how you can find the average yearly return after the MER is deducted:

(1 + 0.08)*(e^(–0.025)) = 1.05333

If we assume that the HST is deducted daily along with the MER, this changes to

(1 + 0.08)*(e^(–0.027)) = 1.05123

So, the average annual return is 5.333% without the HST and 5.123% with the HST. The portfolio ending value for Investor B is $367 without the HST and $349 with the HST. Compared to Investor A’s $685, the MER costs $318, and the HST costs an extra $18.

The conclusion hasn’t changed: The HST is still a minor concern compared to MERs. But, I’ve learned something new about MERs as a result of seeking precision in these calculations. Canadian Capitalist is working on a spreadsheet that takes into account more details of how mutual funds are actually run to see what effect MERs have on returns.

The Math

Given the daily values of an index (including dividends) for a year, we’re looking for the returns generated by a mutual fund 100% invested in this index. We’ll assume that there are no net fund inflows or outflows each day of the year.

Some definitions:

m – MER (expressed as a fraction)
n – number of days in a trading year
A – average assets under management
C – total fund costs removed from the fund during the year
R – index return for the year
F – fund return for the year
v0, v1, ..., vn – index values over one year (v0 is starting value on the first day, v1 is the closing value on first day and the opening value on the second day, etc.)
f0, f1, ..., fn – corresponding fund values over one year

The average assets under management (based on each day’s closing value) are

A = (f1 + f2 + ... + fn)/n.

The one day share of the MER is m/n. Assuming the MER is taken out based on each day’s closing values, the MER for the first day is (m/n)f1. Continuing this way, the total costs for the year are

C = (m/n)*f1 + (m/n)*f2 + ... + (m/n)*fn = mA

Sanity check: MER = C/A = mA/A = m

On the first day the index rose by a factor of v1/v0. The same thing will happen to the fund on the first day before costs. On the first day, before costs are deducted, the fund will grow to


The costs will be m/n times this quantity. After costs, the fund will hold

f1 = f0*(v1/v0)*(1–m/n)

On the second day, the fund grows by a factor of v2/v1 and costs shrink it by a factor of 1–m/n:

f2 = f0*(v2/v0)*(1–m/n)^2

Continuing this way we get

fn = f0*(vn/v0)*(1–m/n)^n

The index return for the year is calculated from the index starting and ending values for the year:

vn/v0 = 1+R

Similarly, for the fund:

fn/f0 = 1+F

Substituting these into the previous equation gives

1+F = (1+R)*(1–m/n)^n

That last factor looks intimidating, but as n becomes large, it approaches e^(-m). In this case, the number of days in a year is large enough that we can use the close approximation

1+F = (1+R)*(e^(–m))

For n=250 and m=0.025, the estimate differs from the real value by only 0.0000012. In Canadian Capitalist’s example, the difference between using the estimate and using the real equation over the 25 years is just over one cent.

If we assume that HST is paid each day, then we can just replace m by m*1.08 in the previous equation. If the HST payments are delayed, then the analysis changes a little, but the final result won't be much different.

Wednesday, December 2, 2009

What Will Happen to Interest Rates?

There is no shortage of commentators making predictions about interest rates. This is because they can get the attention of just about anyone who has investments. Those who depend on interest income want higher rates, and those who have stocks and bonds generally prefer dropping interest rates.

It is possible to predict interest rates with better success than flipping a coin, but not in any useful sense. The market’s prediction on interest rates can be found by examining the current yield curve, which is a chart showing short-term and long-term borrowing interest rates. Typically, yield curves focus on government borrowing costs in the form of bond interest rates.

The Bank of Canada maintains data on yield curves going back to 1986. Here is the most recent yield curve data for the last day of August:

Typically, short term rates are lower than long-term rates because investors demand a higher return when their money is tied up longer. So, the yield curve tends to slope up.

Sometimes the yield curve slopes up by less than usual or even slopes down. This amounts to a prediction by the bond markets that interest rates will drop in the future. If the yield curve points up more than usual, this is a prediction that rates will rise in the future.

The problem is that these predictions are already built into the prices of all equities. If you become a yield curve expert who can see what a particular yield curve says about interest rates, you won’t be able to use this information to exploit market inefficiency because it is essentially the market that made the prediction. To make money, you need to know something that everyone else doesn’t know. You need to know something indicating that the yield curve is wrong in some sense.

I’m sceptical that anyone can predict interest rate changes over the next few years any better than the implied prediction of the yield curve. Even the Bank of Canada can’t reliably predict what world events will cause it to raise or lower rates. This is why I rarely listen to talking heads making interest rate predictions.

Tuesday, December 1, 2009

Understanding Wall Street

The book Understanding Wall Street by Jeffrey Little and Lucien Rhodes is in its fifth edition and has a history going back 30 years and over a million books sold. The main strengths of this book are the wide range of investing concepts explained with clear language. The main weaknesses, although relatively minor, are the authors’ curious biases and the fact that the book hasn’t quite been updated for the internet age.

The main topics covered are

– the nature and history of different types of investments including stocks, bonds, commodities, and derivatives
– accounting basics and the various fundamental analysis ratios such as price/earnings, dividend yield, and several others
– technical analysis
– the history of Wall Street and some of its colourful personalities
– price bubbles through history

Newspaper and the Internet

Curiously, a separate section is devoted to the internet, rather than just mentioning its use as necessary in the other sections. Some of the discussion of investment information is still discussed in terms of newspaper listings. Although the book’s contents are definitely still relevant in the modern world, the incomplete update for this edition undermines the reader’s confidence. Hopefully the sixth edition will turn newspaper listings into a footnote and focus on how people really get investment data.

The Iraq War

The most amusing part of the book was a brief and pointless foray into politics: “The recent wars in Iraq and elsewhere in that region are additional examples of U.S. altruism.” There is plenty to debate about the Iraq war, but few would call it U.S. altruism.

Traditional vs. Discount Brokers

“A good stockbroker ... can be worth his or her weight in gold.” The authors endorse the traditional stockbroker saying that most investors “need the extra assistance ... that a so-called full service brokerage firm can provide.” Discount brokers “are worth considering if the investor expects to be independent and active.”

Inactive index investing through a discount broker may not be for everyone, but it has many advantages that deserve to be included in a book like this one. The brief discussion of ETFs that focuses mainly on leveraged ETFs and narrow ETFs is further evidence that the passive indexing approach was not seriously considered for discussion in this book.

Technical Analysis

The authors devote considerable space to various types of technical analysis. For the uninitiated, technical analysis is where investors study charts of stock prices and share volume to try to guess whether a stock is headed up or down.

The authors are quite positive about the usefulness of these techniques. I’m sceptical. Most of the methods seem subjective and there are so many different methods. For a given stock at a given time, there will be some methods that give the correct answer and others that give the wrong answer. The problem is that a different subset of techniques gives the right answer each time.

The authors allow that “chart patterns are never 100% reliable.” I’d say that they are about 50% reliable, or about as good as tossing a coin.

Stock Options

“The most reliable and effective technical indicators are found among stock option statistics. Options players ... are wrong more often that they are right.” I don’t know if this is true, but it won’t make options traders happy.

“Writing covered calls and writing naked puts (but strictly against shares that the investor intends to purchase anyway) are the two best and most consistently profitable applications of stock options.” If this is true, then options must be consistently overpriced so that the option writer is favoured over the option buyer.

In a section that does an otherwise good job of explaining the costs associated with option trading, the authors miss bid-ask spreads as a significant cost. The bid-ask spreads on options tend to be larger than those of stocks.


Overall, this book is a useful primer and reference for a broad range of investing concepts. Its shortcomings are minor.