Monday, February 28, 2011

Buffett’s Latest Wisdom

Warren Buffett’s latest letter to Berkshire Hathaway shareholders is out and contains his usual mix of wit and wisdom about not only Berkshire but other financial matters. Here is a sampling of some interesting nuggets:

America’s Future

“Throughout my lifetime, politicians and pundits have constantly moaned about terrifying problems facing America. Yet our citizens now live an astonishing six times better than when I was born.”

“America’s best days lie ahead.”

On Buffett’s Desire to Buy Large Businesses

“Our elephant gun has been reloaded, and my trigger finger is itchy.”

Investing Horizon

Berkshire has made many infrastructure investments in its businesses that won’t pay off until well into the recovery from the recession: “At Berkshire, our time horizon is forever.”

Dream of Home Ownership

“Our country’s social goal should not be to put families into the house of their dreams, but rather to put them into a house they can afford.”

On the 2008/2009 Stock Market Crash

Quoting an investor in 2009, “This is worse than divorce. I’ve lost half my net worth – and I still have my wife.”

Yield on Cost

Dividend investors often mistakenly think of yield on cost (dividends divided by original cost of shares) as a measure of investment returns. Even Buffett can’t help but think a little bit this way: “I wouldn’t be surprised to see our share of Coke’s annual earnings exceed 100% of what we paid for the investment.”

Beta as a Measure of Risk

Buffett is very critical of the use of Beta as a measure of investing risk. Beta is a measure of the kind of volatility an investment has experienced over a recent period of time. In his search for a replacement when he’s no longer around, Buffett says “we were looking for someone with a hard-to-evaluate skill: the ability to anticipate the effects of economic scenarios not previously observed.”

Compensating Money Managers

In an attempt to fairly compensate a new Berkshire money manager, Todd Combs, he “will be paid a salary plus a contingent payment based on his performance relative to the S&P. We have arrangements in place for deferrals and carryforwards that will prevent see-saw performance being met by undeserved payments.” Poor compensation models for hedge fund managers mean that “Investors who put money with such managers should be labeled patsies, not partners.”


Buffett is no fan of leverage. A big loss can be tough to take, but with leverage your net worth could go to zero: “any series of positive numbers, however impressive the numbers may be, evaporates when multiplied by a single zero.”

Friday, February 25, 2011

Short Takes: Trapped Trillions, Getting the Best Mortgage Rates, and more

The winners of the TurboTax giveaway were

1. Rob
2. Lyne

Congratulations!  Both winners have been contacted by email.  Thanks to all who entered.  On with the interesting articles this week:

Jason Zweig explains why U.S. companies are sitting on mountains of cash they can’t access. This hurts job recovery and explains why some companies borrow money even while they have large cash reserves.

Canadian Mortgage Trends summarizes the Bank of Canada’s study on how people get the best mortgage rates. The most interesting part to me was the fact that new clients get better deals from banks because existing clients face switching costs.

Canadian Couch Potato shifts his gaze to the best way to rebalance a portfolio. Beyond rebalancing with strategically-applied deposits and withdrawals, the number one way that people can benefit from rebalancing is to buy stocks during a crash and sell them during a boom. Sadly, these are exactly the times when investors are most likely to decide not to rebalance.

Big Cajun Man reminds us that if your medical expenses are high enough you can get a break on your income taxes.

Money Smarts says that retirement isn’t all-or-nothing. Don’t give up just because you don’t think you can save up the magic number of dollars you’ve been told you need. A modest retirement is better than a poor retirement.

Million Dollar Journey explains the danger of chasing dividend yields.  Spoiler alert: the danger is loss of capital (dropping stock price) from unsustainable yields.

MoneyNing explains how to blow $10 million in 10 years.

Financial Highway lists 8 degrees that give a poor return on investment.

Thursday, February 24, 2011

Understanding Income Tax Installments

Some Canadian taxpayers have to pay income tax by quarterly installments. The rules surrounding these installments are confusing and few people understand them well. It helps to go through the reasons why installments exist and why the system works the way it does.

Why do income tax installments exist?

Most people with jobs get income tax deducted from their paycheques. This means that the government gets paid throughout the year rather than getting a lump sum at the end of the year. It would be easy to make up impressive-sounding reasons for this but the real reason is that if we paid it all at the end of the year, too many people would blow all their income and the government wouldn’t get their money.

Some people make income through the year that doesn’t have any income tax deducted from it. A common case is a retiree with a large investment in bonds. The government doesn’t want to wait until the end of the year to get their tax money. So, these people have to pay quarterly installments.

Why are the installment rules so complicated?

Suppose that retiree Rhonda will owe $4000 in taxes for the 2011 tax year. A nice, simple solution would be for Rhonda to pay $1000 each quarter and owe nothing more at the end of the year. However, we have to be clairvoyant to get this right. What if Rhonda’s situation changes during 2011 and she ends up owing much more or less than $4000?

The government’s solution is to base 2011 installments on previous tax years on the assumption that Rhonda’s situation won’t change much. Of course this will be wrong in some cases, but the installment amounts have to be based on something. Even basing the payments on 2010 won’t work because the first installment is due March 15, but Rhonda doesn’t have to file her 2010 taxes until the end of April.

How does CRA calculate the instalment amounts?

The first two installments of 2011 (March 15 and June 15) are calculated based on Rhonda’s 2009 taxes. Suppose that Rhonda owed $6000 for the 2009 taxation year (not counting any 2009 installments she may have made). Then CRA will ask Rhonda to pay $1500 in each of the first two quarters of 2011.

For the last two installments of 2011 (September 15 and December 15), CRA will base the amount on Rhonda’s 2010 taxes. Suppose that Rhonda owed $4500 for the 2010 taxation year (not counting any 2010 installments she may have made). CRA will then want the total of 2011 installments to add up to $4500. Rhonda has already paid a total of $3000 in her first two 2011 installments. So, CRA will ask for $750 in each of the final two installments of 2011. This system is a little bit complicated, but it makes some sense once you work through it.

Do I have to pay these installment amounts?

The surprising answer is maybe not. You actually have three options:

1. Just pay the amounts CRA calculates for you.

2. Pay one-quarter of your 2010 tax owing (not counting any 2010 installments paid) on each 2011 installment. This requires that you figure out your 2010 taxes owing before the first installment date (March 15). This is probably not too difficult.

3. Pay one-quarter of your 2011 tax owing on each installment date. This obviously requires some clairvoyance.

The problem with options 2 and 3 is if you get the amount wrong and pay too little, CRA will hit you with interest and possibly penalties. However, these options are obviously much more attractive if your 2009 taxes owed were much higher than they were in 2010 and will be in 2011. One approach would be to guess your 2011 taxes owing and add a safety buffer.

Note that if you follow option 1 or 2 and the total of the installments turns out to be too little to cover your 2011 taxes owing, you’re supposed to be safe from interest and penalties, but you still have to pay the excess owed at the end of the year. Note also that the rules for farming and fishing are different from what I’ve described here.

Wednesday, February 23, 2011

Debt-Free Forever

In some ways Gail Vaz-Oxlade reminds me of a sports coach who empathizes with players’ feelings one minute and calls them pathetic weaklings the next. Her book Debt-Free Forever delivers tough-love messages, hope, and wake-up calls for the debt-ridden.

Most financial books are aimed at helping those who are well-off optimize their finances and investments to make even more money. This book is aimed at the other end of the spectrum where people have multiple maxed out credit cards but still can’t resist the latest iThing or pair of boots. If you’re ready, Vaz-Oxlade has practical steps to right your financial ship. “If you’re still waffling, put away this book and go buy something else you don’t need.”

Vaz-Oxlade delivers practical advice for spendthrifts in a blunt but engaging style. Most people who overspend know they need to spend less and just telling them to spend less is unlikely to help. This book lays out practical steps for people to change their habits.

Tough Messages

If you have some reason why you can’t start improving your financial life right now, the author invites you to “insert your pathetic excuse here”. The decision to take out a pay-advance loan is “dumber than a sack of hammers”. If writing down your spending “sounds like too much work, you’re a dope.” Those unwilling to work hard when they need more income are “lazy doofuses”. These parts of the book amuse me the most.

House Maintenance

“The rule of thumb is that you should be budgeting between 3% and 5% of the value of a home for annual maintenance.” In 2010 I replaced my roof and I still didn’t get to a total of 3% for maintenance for the year. This rule of thumb seems off to me unless the author and I have very different ideas of what counts as maintenance. But it certainly is true that new homeowners need to expect maintenance costs.

Stopping Pre-Authorized Charges to a Credit Card

If you can’t get some merchant to stop charging you each month, you might try cancelling your credit card. However, this won’t always work. Vaz-Oxlade says “If you want your account to actually be cancelled, you must report that card lost.” Clever idea.

Finding a Better Job

“Don’t quit your job before you get another one.” It’s amazing how many people can’t follow this simple advice. The best time to look for a job is while you have a job. You seem more valuable to employers and you’re in a better bargaining position. If you’re already making $20/hour, it’s easy to ask for $25/hour from a new employer. If they say no, it’s no big deal. But if you have no job, you might just have to accept an offer of $15/hour.

Visualizing Goals

The author stresses finding some way to create a visual reminder of your goals that you see every day including some sort of checklist where you can check off the steps along the way. I can see the importance of this. Deciding to spend less isn’t a one-time decision. It involves many choices day after day. Having a visual reminder can make it easier to do the right thing at times of weakness.

The Point of Thrift

“The point isn’t to eliminate every small pleasure from your life. The point is to choose those pleasures consciously”.


“You want to blow $50,000 on a wedding? Then have $50,000 in the bank. It’s that simple. But to go into debt for a wedding is just about the stupidest thing I can think of.”

Disability Insurance

This section was quite muddled. The book suggests that the reader write down 5 names, put them in a hat, and draw one. It then asserts that there is a 92% to 98% chance of that person becoming disabled (presumably at any point in his or her working life). I’m not sure what the hat had to do with anything unless the author really intended to quote the probability that at least one of these 5 people would become disabled. In any case, this just sounds like scare-mongering. Disability insurance makes sense at a reasonable price and doesn’t make sense otherwise.

RESP Subtlety

Suppose that Grandma opens an RESP for her grandchild. Grandma is called the subscriber. If she hasn’t named a “contingent subscriber,” when Grandma dies the RESP money will likely go to her estate with government grant money lost and taxes to pay.

Losing Your Job

I’ve had friends lose their jobs and I never really know what to say to help other than to help them find new jobs. This book has several pages covering emotional and practical aspects of job loss that I think could be helpful for many people.


This book is aimed at those who handle their finances poorly. This is definitely not me. However, I was pleased to get some insight into the way that spendthrifts think and how to help them if they want help. For that reason this book could be of interest to those who wouldn’t benefit directly.

Tuesday, February 22, 2011

TurboTax 2010 Giveaway

QuickTax is now called TurboTax to line up with the U.S. product name. This appears to be a change in name only. A quick look at the Canadian version of TurboTax 2010 shows that it is quite similar to the 2009 version. I wanted to do a more extensive review before giving away copies of TurboTax 2010 but I’m still waiting for too many tax forms.

For those who have never used QuickTax before, you get two different views of your tax information. One is the traditional blue forms that induce fear in even the most fearless Canadian. The other is a more friendly “Easy Step” view where the software takes you through a long series of questions until you’ve entered everything required to fill out the forms.

For the most part, I use the Easy Step view because it’s easier and I’m less likely to forget things. Occasionally I switch over to the forms view to check on something or to understand exactly how a certain claim affects the calculations. On rare occasions over the years I’ve had to go to the forms view because I had an unusual situation that Easy Step didn’t handle.


I’m giving away 2 “coupon codes” for any online version of TurboTax 2010 (Canada). To enter, just send an email to the contact email address in the upper right corner of my blog with the subject “TurboTax”. Readers who subscribe to my feed will have to click through to my web site. Another benefit of going to my site when reading a post is to see the comments other readers leave on that post. All entries received before noon on Thursday, February 24 will be considered for the draw. I reserve the right to eliminate entries that I judge to be outside the spirit of the contest. Good luck!

Friday, February 18, 2011

Short Takes: Harry Markowitz Interview and more

Preet Banerjee brings us some short videos of interviews with Harry Markowitz. The topics are somewhat advanced and are quite interesting. My favourite part is Markowitz’s assertion that you can’t borrow unlimited amounts at the risk-free rate. This has been my criticism of many investing strategies that have the built-in assumption of borrowing at the risk-free rate.

The Blunt Bean Counter gives us the benefit of his experience to explain who is likely to be audited by CRA.

Financial Highway says that free checking accounts are becoming scarce in the U.S.

Big Cajun Man gets a good rant going about the idea of good debt. I’ll allow that it makes sense to take on certain types of debt, but once you have debt you’re better off working toward getting rid of it.

Million Dollar Journey gives a rundown of the top Canadian stock screeners.

Money Smarts explains how to do a background check on a Canadian financial advisor.

Thursday, February 17, 2011

RRSP Home Buyer’s Plan – A Cautionary Tale

Money Smarts recently ran a piece about the RRSP Home Buyer’s Plan and this reminded me of some trouble I got myself into years ago with this plan. Today the 90-day rule says that RRSP contributions made less than 90 days before making a Home Buyer’s Plan withdrawal cannot be deducted from your income in any year. The old rules used to have a longer restriction as I found out.

Below is the explanation of my troubles that I wrote on a public forum. Something similar could still happen to you today if you run afoul of the 90-day rule. For those who like happy endings, I did eventually manage to save my $2500 (a large sum to me at the time).

I used my RRSP money to buy a house and due to some unfair rules, I may lose about $2500. If you are thinking of entering the RRSP home-buyer’s plan, you may want listen to my troubles. My life story follows.

In Jan. 1993, I had $12,000 in my RRSP. In Feb. 1993, I put in $5000 and claimed it as a deduction on my 1992 tax return. In Aug. 1993, I bought a house using the full $17,000 in my RRSP as part of the down payment. Under the rules from the first year of the RRSP home-buyer’s plan, the $5000 contribution was permissible because it applied to the 1992 taxation year. When I asked for information about the home-buyer’s plan in May of 1993 from Revenue Canada, they sent me the previous year’s leaflet, and told me to add a year to all the dates. However, one crucial date was changed for the second year of the plan. Contributions between 1992 Dec. 2 and 1994 March 2 are not permitted.

I received a cheerful letter from Revenue Canada about 2 weeks ago explaining that I would have to include the $5000 as income for 1993. After several phone calls, I discovered that I would not get this RRSP room back for the future, and that the $17,000 that I have to pay back to my RRSP would not be reduced to $12,000. This means that after paying back the $17,000, my RRSP would contain $12,000 untaxed and $5000 taxed. When I take this money out in the future, the $5000 would be taxed again. Based on a 50% marginal tax rate, this means that I lose $2500.

I finally got to speak to a pleasant and intelligent person at Revenue Canada named Mary Allen. She agreed that my $5000 was going to be double-taxed and that the situation was unfair. She also understood that even though I would probably win if I fought this, the loss of money and time in the fight would be significant to me. She said that there was one possible out. If I put $5000 back into my RRSP with a T1037 form as a home-buyer’s plan repayment, and then take it back out again with a T3012-A for the purpose of having my 1992 tax return reassessed to remove the RRSP deduction, then I could get back the right to put $5000 in my RRSP in the future, and I would only have to pay back another $12,000 into the home-buyer’s plan.

As it happens, I can scrape up $5000 to be tied up for a week or so in all of this nonsense. I have also talked to Royal Trust, and they seem quite willing to do all of this for me, even though it is just a bunch of paper work for nothing. There is still a catch though. The RRSP plan number on my T3012-A form (for withdrawing money) has to match the RRSP plan number on the RRSP deduction form that I used on my 1992 tax return. However, when I withdrew all of my RRSP to buy the house, Royal Trust closed my RRSP. Their normal mode of operation would be to open a new plan for new contributions.

Right now, my $2500 stays or goes based on whether my contact at Royal Trust can get around the normal process and use the old plan number. This whole business is making my head hurt. I'm very conservative with money. If something seems too good to be true, I avoid it. I investigated the home buyer’s plan for some time before entering into it.

Wednesday, February 16, 2011

TransUnion Stays Mum

UPDATE: Just hours after I published this post my TransUnion credit report arrived by mail.  Apart from fairly harmless errors in my home residence history everything is in order.  Chalk one up for waiting and hoping it all works out!

Just under 6 weeks ago I began the process of ordering my free credit reports from Equifax and TransUnion. Things went fairly smoothly with Equifax but TransUnion has been a tough nut to crack.

I was able to order my Equifax report by phone, and I’ve since mailed in a request to have some errors be corrected. Equifax replied by mail with an update that corrected most of the errors. (They still list a comic phonetic spelling of the name of one of my past employers, but I don’t think this will cause me trouble.)

TransUnion hasn’t replied at all. I tried to request my credit report by phone and was told I’d have to mail in a request. I mailed in a request carefully following the directions and haven’t heard back. They didn’t even mail me something to say that they wouldn’t release the information.

I suppose that they might have incorrect information about me that prevents them from adequately authenticating my identity. So, on one level I’m glad they don’t just release information about me to just anyone. On the other hand, I seem to be out of ways to get my credit report from them. The likelihood that they have incorrect information about me is troubling as well.

Their web site provided no help with how I might resolve this problem other than to offer the possibility of showing up to one of their offices in person. The nearest location is more than 2 hours from where I live. I can’t shake the feeling that if I agreed to pay for online access to my credit file this issue would get resolved, but I have no evidence that this is true.

Tuesday, February 15, 2011

How Tax-Free Compounding Helps

After reading about mental blocks on RRSPs, reader Robert asked for an explanation of the value of tax-free compounding in an RRSP. Here is my paraphrase of the essence of his question:
Starting with the example of a 40% marginal tax rate, an investor can either save $6000 in a non-registered account or $10,000 in an RRSP (and get a $4000 tax refund for the same $6000 out of pocket amount). With an 8% return in the first year, the RRSP would grow to $10,800 and the non-registered account would grow to $6480.

However, if the investor withdraws the RRSP money and pays taxes on it, he will have $6480 left. This is the same amount as was in the non-registered account. How is the RRSP any better?
The short answer is that we haven’t accounted for the income taxes on the non-registered gains yet. Any interest would be taxed at 40%, capital gains at 20%, and dividends at around 19%. Even if the gains are all capital gains, the investor would have to pay taxes before he could spend the money.

In just one year the advantage of the RRSP is modest, but it can be substantial over a lifetime. I put together a spreadsheet covering 35 years of contributions and 25 years of retirement for the RRSP and non-registered cases. The following assumptions are built into the calculations:

– 8% return each year (70% capital gains, 20% dividends, 10% interest)
– 4% inflation each year
– marginal tax rate 40% (This stays constant so that we can isolate the value of tax-free compounding from changes in tax rates.)
– 10% of equities turn over each year during the saving phase (no turnover during retirement)
– $6000 saved per year in non-registered account ($10,000 in RRSP) growing with inflation
– find the constant yearly withdrawal amount (in today’s dollars) that exhausts the money in 25 years

Final results of yearly (after tax) withdrawals in today’s dollars:

RRSP: $26,985
Non-registered: $18,574

This is a substantial difference in yearly after-tax spending money. With these assumptions the RRSP is clearly the better choice. Under the assumption of a constant marginal tax rate, a TFSA works just as well as an RRSP.

There are circumstances where using an RRSP is not in an investor’s interests, but this is usually when the investor’s marginal tax rate is higher in retirement than it was while working. For most people it makes sense to use RRSPs and TFSAs.

Monday, February 14, 2011

Currency-Hedged Franken-Funds

Many U.S. stock mutual funds and ETFs available to Canadians come with currency hedging to eliminate changes in the relative value of the U.S. and Canadian dollars from the fund returns investors get. This may seem natural to many, but it seems very strange to me. This comes from my view of different world currencies as a kind of asset class rather than absolute measures of value.

The basic idea of currency hedging is that if a U.S. fund goes up 10% as measured in U.S. dollars, a Canadian investor will see his investment rise 10% as measured in Canadian dollars, even if the Canadian and U.S. dollars move relative to each other. In reality, Canadian investors would usually get a little less than 10% due to tracking errors caused by currency hedging.

Just because the U.S. dollar goes up or down doesn’t mean that the value of U.S. stocks follows. Suppose that inflation rises in the U.S. and drops the value of the U.S. dollar over the course of the next decade. It doesn’t follow that U.S. stocks will drop in value too. U.S. stocks might actually be a hedge against inflation. My intention isn’t to speculate about inflation and the direction of stock prices but to point out that U.S. stock and the U.S. dollar are separate asset classes. They affect each other, but don’t move in lock-step.

What if the value of a U.S. stock fund were reported in ounces of gold rather than U.S. dollars? We might hear that one year the fund units rose from 5% of an ounce of gold to 5.5% of an ounce of gold. In this case, Canadian investors might want to hedge the value of gold instead of hedging the U.S. dollar.

We can make this even sillier. What if the value of a U.S. stock fund were reported in units of shares of Coke? Would it then make sense for Canadian investors to hedge the value of Coke shares against the Canadian dollar? This would create a Franken-fund whose value tracked U.S. stocks times the Canadian dollar divided by the value of Coke shares.

When I think of the value of a collection of businesses such as U.S. stocks, this value is independent of any particular currency. What happens to the U.S. dollar will certainly affect these businesses, but if the U.S. suddenly adopted some other currency such as the Euro, these businesses would still have their value which is driven by demand from their customers. I’m content to own U.S. stocks for the inherent value of their businesses rather than the measure of this value in a particular currency.

Note that currency hedging is different from whether a fund is purchased with Canadian or U.S. dollars. It would be possible to create a fund that trades in Canadian dollars, but invests in U.S. stocks. This saves investors from having to do currency conversions themselves. I wish there were low-cost index funds of this type in Canada that didn’t have currency hedging bolted on.

Friday, February 11, 2011

Short Takes: Cutting Cable and more

Squawkfox is in fine form with her amusing and informative account of how to break up with your cable company.

Big Cajun Man has some fun with his top 10 list of bad financial top 10 lists.

Canadian Mortgage Trends says that when you’re offered free legal fees on mortgage refinancing, those fees aren’t so free.

Money Smarts reports on changes to the Children’s activity tax credit for Ontarians.

Thursday, February 10, 2011

Understanding Market Predictions

For some reason even people who know better can’t keep themselves from listening to “experts” who make predictions about stock markets, bond markets, interest rates, and other aspects of the economy. Unfortunately, these predictions are about as valuable as confident predictions of the numbers for the next lottery draw.

Many naive investors who lose money when stock markets drop are unhappy with their investment advisors. They think their advisors should have seen the losses coming and should have done something to avoid them. The truth is that no investment advisor can reliably see these things coming. These investors are doomed to be unhappy every time there is a significant drop in equity prices.

Expecting market predictors to make accurate forecasts is about as logical as expecting someone to be able to predict the next spin of a roulette wheel. How much money will you plunk down on number 23 if a well-spoken “seer” says that 23 will come up next? This makes about as much sense as relying on specific stock market predictions.

All is not lost, though. Even if we can’t make specific predictions reliably, we can say some useful things. Getting back to the roulette analogy, we can say that there are 38 numbers (1 to 36 plus 0 and 00) and that each has a 1 in 38 chance of coming up next. With this information we can answer such questions as how likely am I to double my $100 if I bet $10 on red until my money is either doubled or gone? (Answer: 26%)

The person who can properly analyze roulette can answer a number of questions, but can never predict what number will come up on the next spin. Similarly, investing experts can say useful things about the range of possible outcomes of investing in different types of assets, but cannot say what will happen to stocks over the next year.

The good news is that if an expert properly takes into account good and bad investing outcomes and their probabilities, it is possible to devise investing strategies that match an investor’s needs. But this is a very different process from making specific market predictions. Avoiding losses in investments that have risk is impossible; the real game is to control exposure to risk and to achieve life’s financial goals.

Wednesday, February 9, 2011

Big Fat Income Tax Refund

I’m looking forward to a big, fat income tax refund for the 2010 taxation year. It will be nice to get the cash, but it would have been better if the money hadn’t been taken off my pay cheques in the first place. In many cases there is a way to do this using CRA’s form T1213 Request to Reduce Tax Deductions at Source.

The most common reason for me to get a large income tax refund is that I made a lump-sum RRSP contribution. When I’ve made that contribution early in the year, I’ve sent in a T1213 form, got a favourable response from CRA, and took it to my employer who then took less tax off each of my pay cheques.

Unfortunately, some complications with my 2009 income taxes that haven’t been resolved yet prevented me from using a T1213 form for the 2010 taxation year, but I plan to use one for 2011. If you plan to make a lump-sum RRSP contribution for 2011 well before the deadline in a little over a year, consider collecting your tax break a little at a time instead of waiting for March or April of 2012.

There can be other reasons for reducing tax deductions at source other than RRSP contributions. The form lists child care expenses, support payments, employment expenses, carrying charges and investment expenses on investment loans, charitable donations, and rental losses.

Some people feel strongly about using the tax system for forced savings. For the rest of us who aren’t in a hurry to lend money to the government, consider the T1213 form.

Tuesday, February 8, 2011

Mental Blocks on RRSPs

Many commentators have made good analyses of the advantages and disadvantages of RRSPs. However, many who rail against RRSPs make a fundamental mistake in their thinking.

For the purposes of this discussion, I’ll consider a Canadian Jerry who has a 40% marginal tax rate. If Jerry makes a $10,000 RRSP contribution, he will get a $4000 tax break. If he chooses to save outside an RRSP, he will have to pay the $4000 in taxes. This means that his choice is either to save $10,000 within his RRSP or $6000 outside his RRSP. Too many RRSP bashers lose sight of this fact.

One way to think of this is that 40% of the money in the RRSP is not really Jerry’s or is some sort of bonus. Unfortunately, we’re not really wired to think this way. If Jerry’s salary were doubled, he’d be shocked initially and would feel very lucky and somewhat undeserving. Over time, though, he’d come to think that this new salary is his due. He’d probably even come to think he deserved more. This is human nature.

If Jerry has money sitting in his RRSP for years, he will think of it as entirely his money. The past tax deductions will be forgotten over time. As he comes to the age where he starts living off his savings he will resent paying taxes on these withdrawals.

Suppose that by his retirement Jerry has $500,000 saved in his RRSP. Jerry might be starting to regret having made RRSP contributions. After all, if he had $500,000 outside his RRSP he’d pay much less income tax in the future. The problem with this thinking is that if he hadn’t made RRSP contributions, the most he could have saved is $300,000 and that’s only if he somehow managed to avoid paying any taxes on gains over the years. In reality, he’d have less than $300,000 saved.

There are people who are better off without making RRSP contributions, but these tend to be those with very low incomes or who are in special situations. Most people do benefit from using RRSPs.

Monday, February 7, 2011

Having Faith in Stock Market Predictions

When it comes to stock market gurus making predictions, I pay little attention. But what if we did believe a prediction? Laszlo Birinyi predicted that the S&P 500 would get to 2854 on 2013 Sept. 4. If we really believed this prediction, what is the best way of exploiting it?

You have to admire the precision of this prediction. Some would just predict 2800 sometime in late 2013. However, if we’re going to believe in one of these predictions, it might as well be a precise one.

So, we take it as a given that the S&P 500 will get from 1310.87 last week to 2854 on 2013 Sept. 4. One way to exploit this would be with SPX options. Last week options expiring in December 2013 struck at 2500 were selling on the Chicago Board of Options Exchange (CBOE) for 95 cents. By our magic date in 2013 they would be worth 2854-2500=354 plus a little more for the remaining time value.

Our plan would be to buy as many of these options as we can afford now, and sell all of them on the magic date. Let’s assume that with trading costs we pay $1.25 per option and make $350 in 2013. We would be increasing our money by a factor of 280. So, $100,000 would become $28 million.

Of course there are some potential problems here. Maybe buying so many of these options would drive up their price. Maybe we would have a hard time selling them all on the magic date. Maybe the S&P 500 would get to 2854 and then crash terribly before we could sell.

My question here is what is the safest way to make as much money as possible from the knowledge that the S&P 500 will hit 2854 on the magic date? I’ve offered one solution using options, but no doubt there are better ways.

Friday, February 4, 2011

Short Takes: Selling Reasonable Investment Expectations, Gaming Bond Fund Risk Ratings, and more

Better late than never! On with the interesting links this week:

Tom Bradley wrote an excellent piece on what leads money managers and advisors to promise more than they can deliver, and how they can take a different approach to give their clients reasonable expectations.

Larry Swedroe explains how bond funds game their risk ratings and make their returns look better than they really are.

Million Dollar Journey gives one person’s take on a way to convert a principal residence into a rental property with mortgage deductibility.

Big Cajun Man had a bad experience with a retailer and wonders why the retailer is more concerned about being right than continued business.

Canadian Couch Potato ends his dividend myth series with an explanation of why the popular “yield on cost” measure has little real meaning.

Potato has some analogies to explain the internet usage-based billing (UBB) debate.

Financial Highway has some suggestions for how to get a discount from your car insurance that will terrify your insurance agent.

Money Smarts weighs in on the TFSA vs. RRSP debate.

Thursday, February 3, 2011

Should Index Investors use ETFs or Mutual Funds?

The consensus among index investing experts is that index investors with small portfolios should invest in mutual funds such as TD’s e-series and those with larger portfolios should invest in index ETFs. The idea is to minimize portfolio costs. However, the best choice depends greatly on how you trade in your portfolio.

Mutual funds tend to have higher MERs than ETFs do, but buying and selling ETFs has the costs of commissions and spreads. Once the investor’s portfolio becomes large enough, the MER savings with ETFs overcome the trading costs. But we can’t determine the portfolio size where ETFs become superior without knowing the investor’s trading habits.

To illustrate what I mean we’ll consider two hypothetical beginner investors: Jack and Jill. Each investor has chosen a portfolio mix of domestic stocks, foreign stocks, and bonds with target percentages for each. Jack chose to invest in mutual funds and Jill chose ETFs.

Jack likes to stay very close to his target percentages. He takes his monthly savings and divides it up across his mutual funds according to his chosen percentages. If one asset class has made a big jump in price he might even remove some money from it and put the money into a fund that is below its target percentage. If Jack had chosen ETFs instead of mutual funds, he would have to pay for 5 or 6 trades every month. With the cost of commissions and spreads, this might add up to a drag of $1000 per year on his portfolio. He is clearly better off in mutual funds until his portfolio becomes quite large.

Jill is much less active than Jack is. Jill just lets her savings build up as cash until it reaches at least $3000. Then she buys whichever ETF in her portfolio is below its target percentage by the widest margin. While her portfolio is small this might cause the ETF she buys to overshoot its target percentage by a wide margin, but Jill isn’t concerned. She knows that the percentages aren’t critical while her portfolio is small. Her percentages will fall more closely into line as her portfolio grows.

From these examples we see that trading style matters quite a bit in choosing between ETFs and mutual funds. We also see that it is possible for beginners to choose ETFs if they are flexible about asset allocation percentages in their early investing years.

Wednesday, February 2, 2011

What is Your Portfolio's Principal?

Many investors who live off their investments use the rule of thumb that you can spend the interest you make, but shouldn’t touch your principal. I’ve found this way of thinking common among those who are now well into their retirements. However, their notions of what “principal” means aren’t necessarily useful.

The idea behind this rule of thumb is sensible enough. If your savings are adequate to produce enough return to live on and you never spend your principal, then you should be set for life.

GIC Investors

For GIC investors, the most common notion of principal is a fixed number of dollars. A retiree with $500,000 in GICs feels that he can safely spend the interest from the GICs. These investors long for the good old days when interest rates were high and they had more interest to live on.

The problem with this thinking is inflation. Each year the $500,000 of principal will have less purchasing power than it had the year before (unless there is deflation). Many people who lived off interest through the 1980s learned this the hard way. When inflation and interest rates dropped, they felt the double-whammy of earning less interest on a lump sum that was severely hammered by past inflation.

Dividend Investors

Investors who live off dividends tend to view principal as the number of shares or units they own. The dividends are then money that they can freely spend. This can work reasonably well for solid dividend-paying stocks. These stocks may earn a capital gain above inflation as well as dividends which would make this strategy a little bit too conservative.

Where this strategy falls down is when the retiree owns stocks or trusts that pay unusually high dividends. In these cases the shares or units themselves are likely to go down in value; the high dividends are actually partially a return of capital. Investors in this position are essentially spending some principal without realizing it.

What Should “Principal” Mean?

The best definition I have for principal is a fixed inflation-adjusted number of dollars. This means that an investor who doesn’t want to dip into principal must see to it that the inflation part of the overall return each year goes untouched.

This approach presents its own problems. For example, a GIC investor may find that there isn’t enough interest after paying taxes to keep up with inflation even if he doesn’t spend any of the interest. For those who own equities there will be some years when equity prices go down and it is impossible to keep up with inflation.

It turns out that the “spend the interest and don’t touch the principal” strategy can be tricky to define and even trickier to follow successfully.

Tuesday, February 1, 2011

Emotional Benefits of Dividend Investing

Dividend investing is very popular. Many investors like to have their long-term savings in a collection of dividend-paying stocks. There can be good reasons for preferring dividend-paying stocks over other stocks, but I suspect that the main benefits are emotional.

For investors in the lowest tax brackets, dividends are taxed less than capital gains. This is one good reason to prefer dividends over capital gains. However, most of the dividend investors I know are in a high enough tax bracket that they would be better off with capital gains.

Some investors believe that dividend-paying stocks pay a larger total return (dividend plus capital gains) than non-dividend-paying stocks. All evidence I’ve seen says that this isn’t true.

Some investors believe that long-time consistent dividend-paying companies are less risky than other stocks. I have no opinion one way or the other on whether this is true, but I don’t think this is the dominant reason why some investors prefer dividend-paying stocks.

From my observations, the real reasons for dividend investing are emotional. It feels good to collect dividends. You still have the same number of shares and now you’ve got some extra cash. The fact that each dividend reduces the capital value of the shares isn’t front and center in the investor’s mind.

Dividend reinvestment feels good as well. The number of shares you own grows over time without having to invest more money. Of course, if the company had retained the earnings instead of paying a dividend, the result would be essentially the same. In the non-dividend case, your number of shares doesn’t rise, but each one is worth more.

To illustrate how this works, imagine that you’ve got 2100 shares of XYZ Corporation trading at $20 each. Over the course of a year, the value of the business rises 10%. If no dividend is paid, you’d have 2100 shares worth $22 each. But, if XYZ pays a $1 dividend, the shares would rise to only $21, and you’d be able to buy another 100 shares with your $2100 dividend. So you’d have 2200 shares worth $21 each. With or without the dividend, the total value of your shares would be $46,200.

When it comes time to live off your savings, it feels better to collect dividends and spend them than having to sell off some of your shares to generate income. Once again, there is no real difference when you go through the math, but it feels bad to see your number of shares dwindling even if the total value of the shares is identical whether a dividend is paid or not.

Hard core dividend investors may have good reasons for their choice that I haven’t mentioned here, but my own observations are that the dominant reasons for choosing dividend investing are emotional.