Friday, July 29, 2011

Short Takes: PRPPs and more

Money Smarts explains the Conservative government’s Pooled Retirement Pension Plan (PRPP).

The Freakonomics guys have some fun crunching the numbers on whether it makes sense to jump subway turnstiles in New York City.

Retire Happy Blog looks at what investment returns you should use in your retirement plan.

Big Cajun Man reports that the ecoEnergy program is back up and running.

Thursday, July 28, 2011

How Leveraged ETFs Lose Money

Leveraged ETFs are designed to return double or triple the return of an index each day, but they come with disclaimers warning that they won’t double or triple returns over longer periods of time due to a mysterious compounding effect. I’ve come up with a more concrete explanation that is hopefully more understandable.

An example of a leveraged ETF is the Horizons BetaPro S&P/TSX 60 Bull ETF (ticker: HXU). If the TSX 60 goes up 1% on a given day, HXU goes up 2%. The confusing part is that if the TSX 60 goes up 10% in a year, HXU doesn’t go up 20% that year.

A partial reason is the management fees charged to run HXD, but this doesn’t fully explain the seemingly missing returns. To understand what is going on, imagine a volatile 2 days where the TSX 60 goes up 10% then goes down 10%. Let’s track a $100 investment in the TSX 60 for the 2 days:

TSX 60: Start: $100, after up day: $110, after down day: $99

So, by the magic of compounding we lost a dollar. Here is the unsatisfying explanation of why things are worse than expected for our $100 investment in HXU:

HXU: Start: $100, after up day: $120, after down day: $96

For some reason we’ve lost $4. But it seems like we should only have lost $2 because HXU is designed to double the TSX 60 return. Just imagine what it would be like for a 10x leveraged ETF: our money doubles the first day and then we lose it all the second day!

To understand why the HXU losses are larger than we expected, let’s look in more detail at the holdings of HXU. To double the return of the TSX 60 with a $100 investment, HXU would have to borrow $100 so that it can hold $200 worth of TSX 60.

After the up day, HXU would hold $220 worth of TSX 60 and after accounting for the borrowed $100, we have $120 net. However, we’re supposed to be leveraged 2:1. HXU has to borrow another $20 to buy more TSX 60 so that it holds $240 worth of TSX 60 and owes $120.

After the down day, the TSX 60 investment drops by $24 to $216. HXU owes $120 leaving a new net value of $96. To get back to 2:1 leverage, HXU must sell $24 worth of TSX 60 and repay part of the loan leaving it with $192 of TSX 60 and a loan of $96.

After each up day, HXU must buy stock and after each down day it must sell stock. If this sounds like a buy high and sell low strategy, you’re right. The actual mechanism leveraged ETFs use to get exposure to an index may be more complex and make use of derivatives, but this doesn’t change the fundamental problem of buying high and selling low. Note that this explanation didn’t involve MERs, trading costs, or borrowing costs. These things only add to the drag on returns.

Of course, the TSX 60 doesn’t usually swing up and down by 10% each day. So the losses due to volatility are smaller than this example each day, but they add up over the course of a year. Over a long period of time, the HXU return will be significantly less than double the TSX 60 return.

Wednesday, July 27, 2011

A Theory about Risk Aversion

It is well known that people often make irrational financial decisions even in fairly simple situations where they have all the information they need to make a good decision. I have an idea about why we are this way that is so simple that it is very unlikely to be original, but I couldn't find this idea in other writings in a quick search.

One simple model of the value (or utility) of money is that each doubling of your savings has the same incremental value. So, if you start with $100,000, dropping to $50,000 is as detrimental as doubling to $200,000 is beneficial. For small gains and losses, the sizes of steps of equal utility differ by less. For example, a loss of only $1000 is as detrimental as gaining $1010 is beneficial.

However, throughout most of human evolution, great wealth for a single individual did not exist. Before the advent of storing food, a large kill would only last until the meat rotted or was taken by other hungry people or animals. We are simply not suited to making decisions about large amounts of wealth.

In modern times, if you are offered a 50/50 chance at winning $20 or losing $10, and you’re satisfied that the game is fair, it is rational to take the chance. However, an ancient human or pre-human might make a different calculation because he is always just a few missed meals from death.

Suppose that a hungry ancient human could either stay with a small kill to eat a day’s worth of food or take off after larger prey for a 50/50 chance of either getting triple his need for the day if he succeeds or going hungry the rest of the day if he fails. It seems perfectly rational for him to take the safe choice, fill his belly now, and hunt again the next day.

This line of thinking may also explain lottery tickets. Early humans used to routinely walk away from wealth. Once the belly is full, extra meat or berries have little immediate value. It makes sense to give away small amounts of food you don’t need right now in return for a shiny rock or even just the prospect that the receiver might give a favour in return some time in the future.

So the theory is that we are not well adapted to making decisions about years worth of wealth. We tend to make decisions about small amounts of money as though we have very little, even if we actually have enough money to survive for months or years.

Tuesday, July 26, 2011

The (Dis)Advantages of Buying Penny Stocks

I happened across an ad claiming that “Penny stocks are the secret to buying happiness during a recession.” I couldn’t resist having a look. The link took me to an “advertorial” by SmarterLifestyles entitled “The Advantages of Buying Penny Stocks.” (I prefer not to give the link, but determined readers can search.) The article contains a number of misconceptions about penny stocks.
“Penny stocks offer an incredible upside for potential investors.”
They also offer incredible downside. That’s the nature of highly volatile investments.
“Low prices allow novices to explore the markets, without risking an extensive amount of money.”
Nonsense. You can just as easily buy one share of a $100 stock as 100 shares of a $1 stock. Either way you’re investing $100. I don’t recommend either investment because the commission (likely $5 or $10 or more) is too pricey for such a small investment.
“If the stock were to dip in price, the investor will not have lost excessive amounts of money.”
More nonsense. If you’ve invested $100 and the stock goes down 50%, you lose $50 whether you have one share that dropped from $100 to $50 or 100 shares that dropped from $1 to $0.50.
“Another advantage to penny stocks is that they are easy to buy.”
Penny stocks are no easier to buy than “regular” stocks.
“The biggest advantage is the potential for very high returns on investment.”
There is also the potential of very high losses. Unfortunately, high volatility is bad for long-term returns.
“It is not uncommon for some penny stocks to double or triple in price in extremely short periods of time.”
It’s also not uncommon for penny stocks to drop to near zero in extremely short periods of time.

People tend to like penny stocks because they seem cheap, but this is an illusion. Companies divide their ownership in some number of shares. The number of shares is quite arbitrary. If a company is worth $100 million and has a million shares, each share is worth $100. The company could just as easily issue 100 million shares so that each share is worth only $1. Don’t be fooled into thinking that penny stocks are a good way to put your toe into the stock market.

Monday, July 25, 2011

Indexing Looking Forward and Looking Back

An interesting thing about indexing is that it is never the best investing strategy when we look back in time. There is always some other strategy that would have been better if only we had known to make the right decisions.

If only I had known the stock crash of 2008 and 2009 was coming. I could have sold out of stocks in advance and bought back at the bottom. But I didn’t know and I rode stocks down and back up again. Unfortunately, we can’t invest to make past returns. We can only invest and accept whatever the market brings in the future.

A common human failing is the tendency to think that past events were predictable. We don’t know what will happen over the next month, but after it happens we tend to think that it was obvious that things would unfold as they did. But it was not obvious beforehand.

For those who look back, there is always a strategy that beats indexing. But for those who look forward, the best bet for the vast majority of investors is investing in inexpensive broad indexes.

Friday, July 22, 2011

Short Takes: Bold Chinese Piracy and more

Piracy in China has reached a new level: counterfeiting entire Apple stores. Getting harassed on street corners in China by sellers of fake goods is commonplace, especially if you look western, but a fake Apple store is a new one to me.

Big Cajun Man reminds parents not to miss out on the Canada Learning Bond if they have children young enough to qualify.

The Blunt Bean Counter explains how to use CRA's low 1% prescribed interest rate for income splitting.

Retire Happy Blog has a list of potential questions to ask a financial advisor before hiring him or her.

Million Dollar Journey's Frugal Trader is concerned with whom to name in his will to get the millions he expects to have by the end of his life. He makes a good point that if he remains financially conservative and never eats into his capital, he'll leave a lot of money upon passing.

Thursday, July 21, 2011

Pooled RPPs Won’t Help Current Retirees

With the Canadian political parties squabbling over the Conservatives’ plans to reform pensions using Pooled Registered Pension Plans (PRPPs) rather than expanding CPP, a key factor that isn’t discussed much is that current retirees aren’t likely to get extra money each month.

Many groups have put forth suggestions for pension reform in recent years. Most of these suggestions have not included plans to give more money to current retirees, but usually this fact was not made clear. Those who are retired now or who will retire soon can be forgiven if they thought expanding CPP would mean they’d get more money in retirement.

With the Conservatives pushing defined contribution PRPPs, it should now be clear that you won’t get more money out in retirement unless you put more money in while working.

Wednesday, July 20, 2011

Irrational Risk Avoidance

Behavioural economists have found many ways to expose our irrational tendencies. Given a choice between two options, people are sometimes too conservative and at other times too reckless.

One example is whether you’re willing to play a game where you toss a coin and win $20 for heads or lose $10 for tails. From a purely mathematical point of view, almost all people should be willing to play this game. But many are not. Of course the reasons for refusing to play may have nothing to do with math. Some people object to gambling. Others fear that the game is somehow rigged.

Usually, I can overcome any initial irrational feelings about these games to figure out which choice the researchers consider to be the correct choice. However, there is one game that I have a hard time with:

Suppose that you win a prize and your reward is one of the following two choices:

1. $3000 for certain.

2. $4000 with a probability of 80% and nothing with probability 20%.

It turns out that a strong majority of people choose the certain $3000. An insurance company with deep pockets would say the expected value of choice 2 is 80% of $4000 or $3200, which is more than $3000, and therefore choice 2 is better. For those of us without effectively unlimited resources, the calculation is a little more complicated.

To take into account the cost of volatility, it’s best to look at the expected compound return. (For mathy types this is the expected value of the logarithm of your net worth.) It turns out that even if your net worth is only $5000, you should go for choice 2. The majority of us who have much more to our names than $5000 should have a strong preference for choice 2.

However, I can’t shake the feeling that choice 1 feels better. In fact, if I were actually given a chance to play this game only once, I’d probably take the sure $3000. For most of the other test questions I’ve seen researchers use, I’m fairly confident that I could make the more rational choice, but not for this question. So chalk one up for the ancient brain that sees losses in terms of getting eaten by a lion.

Tuesday, July 19, 2011

Cap-Weighted vs. Fundamental Indexing

Investors have their choice of index method based on either traditional capitalization-weighted funds or fundamentally-weighted funds. The terms used in this battle may be somewhat intimidating, but the ideas are simple enough. The more difficult question to answer is which indexing method will produce higher returns.

Traditional indexes are cap-weighted. For a stock index, this means that each stock is held in the index in proportion to the total value of the company. So if the market says that company A is worth $10 billion, and company B is worth $1 billion, the index will have 10 times as many dollars worth of company A stock as company B stock.

Continuing this example, if a cap-weighted basket of stocks contains $10,000 of company A stock, it will contain $1000 of company B stock. The number of shares may not differ by a factor of 10, though. If A shares trade for $10, then we have 1000 A shares, and if B shares trade for $100, we have only 10 B shares.

The fundamental indexing crowd points to examples like Nortel to say that cap-weighting is crazy. The more overvalued Nortel became, the more dollars worth of Nortel stock was included in the index. This means that wildly overvalued companies tend to dominate index portfolios.

To combat this problem, fundamental indexing came to the rescue. Instead of relying on a company's current stock price, fundamental indexes use a company's fundamental factors such as revenues and earnings to arrive at a value for the company. This fundamental value is used to choose the weight of the stock in the fundamental index. Nortel's share of the index would not have grown so large in a fundamental index because it's revenue and earnings were low compared to the market's assessment of Nortel's total value.

One disadvantage of fundamental indexes is that they require more trading. With cap-weighting, if a company's stock doubles in price, it's share of the index roughly doubles and there is no need to buy or sell shares to maintain the cap-weighting. With fundamental indexing, if the share price doubles without any change to the company's fundamentals, the index must sell off about half of the shares. Similarly, the index must buy more shares when their prices drop. This need for adjustments means that fundamental index funds have higher trading costs than cap-weighted index funds.

If the stock markets do a decent job of valuing stocks, then cap-weighting should win out due to the lower transaction costs. However, if the markets regularly create some high-fliers like Nortel that are destined to crash, then fundamental indexing is likely to benefit by more than its added transaction costs.

I don't see any way to predict which method will work better going forward. Some back-testing studies indicate that fundamental indexing would have worked well in the past. I tend to be sceptical of any investing strategy that increases costs; so I've made my personal bet on cap-weighted indexes, but I have no strong feeling about which will win over the next few decades.

Monday, July 18, 2011

The Problem with Money? It’s not about the Money!

Jane Honeck believes that at the core of our money troubles are unexamined beliefs that drive us to self-destructive behaviour that limits our ability to succeed financially. In her book The Problem with Money? It’s not about the Money! she lays out a series of exercises designed to root out your hidden beliefs, examine them, and find ways to break out of old patterns.

An example might be a woman who believes that good people don’t have money. This belief would cause her to unconsciously waste money to remain poor and good. To change the pattern, she might seek out counterexamples such as Warren Buffett and recognize that her personality won’t change if she has money.

The ideas in this book are quite far from the rational approach I usually take with financial decisions. However, if people’s problems are emotional, perhaps the solutions to these problems require techniques that deal with emotions.

The methods described in this book are really designed to be used by an expert to help people with money problems. Honeck has tried to adapt them to a book format where the reader essentially helps himself. I had somewhat of a feeling that the book was in part a large ad for Honeck’s services. In fact, the final page of the book is devoted to how the reader can engage Honeck for coaching, a workshop, or a presentation.

In the end, the methods described in the book can be used for good or evil. I can see an expert using these ideas to help people with deep-seated issues with money. I can also see these techniques used to draw people into ever more expensive workshops and treatments without really helping them. But this isn’t the fault of the methods themselves. It’s possible that some readers really will figure out how to help themselves using this book.

Saturday, July 16, 2011

Studying the Value of Financial Planning

Update:  Preet Banerjee wrote a Globe and Mail piece on the FPSC study as well.  Thanks to Preet for including my remarks in his article.

Financial planners would like to be able to say that their services give their clients peace of mind and a feeling of control over their financial futures. To this end, a new study seeks to measure the differences in financial comfort between those who use a financial planner and those who don’t.

The Financial Planning Standards Council (FPSC) approached a market research firm to perform such a study. The results from the first year of a five year study are summarized starting on page 7 of the April 2011 FPSC publication called FPStandard.

The most obvious problem for a study of this kind comes from the fact that financial planners tend to prefer wealthy clients, and wealthy people are much more likely to feel good about their finances than poor people. It would hardly be surprising if a bunch of rich people with financial planners felt better about their finances than a bunch of poor people without planners. We can hardly conclude that the financial planners made the difference.

To remedy this problem, this new study controls for net worth. This means that we compare the feelings of investors who are all in the same range of net worth. Unfortunately, the tables summarizing the study results on page 10 do not seem to show the data that was controlled for net worth.

The only mention of the data controlled for net worth I found was in a bullet point on page 9 saying that the value of financial planning was apparent in some net worth ranges. By implication this seems to mean that it was not valuable in other net worth ranges.

A curious comment in the same bullet point is that because financial planning showed value for low net worth people, this “effectively debunks the myth that financial planning is only useful for the rich.” I wasn’t aware that this myth exists. The criticism related to net worth that I’m aware of is that planners themselves prefer wealthier (and thus more profitable) clients.

Another complication here is that many people think they have a financial planner, but they are really just working with mutual fund salespeople. Financial professionals come with different amounts of training and different designations, but few investors understand the distinctions.

The crazy thing about this numbers game is that the final study will likely show that financial planning brings improved peace of mind and feeling of control over finances even when we control for net worth. When marketers quote only the results without controlling for net worth, they undermine the study’s legitimate message.

Friday, July 15, 2011

Short Takes: Free Air Miles and more

Americans have no love for dollar coins. There have been several failed attempts to get them to stop using one-dollar notes. However, some people have found a clever and amusing way to use dollar coins to get free air miles.

Tom Bradley at Steadyhand hints that the Steadyhand Funds perform well on the “gap” measure which is the difference between reported fund returns and the returns actually experienced by investors in those funds. This gap measure is one way to gauge how well financial advisors help investors make rational decisions.

Retire Happy Blog leans toward debt repayment in the debate about whether to contribute to a TFSA or pay down debt.

Money Smarts updated a chart of the average wait time when phoning Canadian discount brokerages.

Big Cajun Man has heard all the talk of the U.S. debt ceiling and coins the term “debt floor” to be the point where you get out of debt. Personally, I’ve never liked the term debt ceiling because I think of increased debt as sinking (or digging). So I’d prefer to use debt floor to mean the maximum one can borrow. Maybe “dungeon level limit” is better.

Thursday, July 14, 2011

The House that Bogle Built

In The House that Bogle Built, author Lewis Braham tells the story of how John Bogle built Vanguard and championed low-cost index investing. This book is much more than just a historical account, though. Braham explains the different sides of various investing related arguments such as passive vs. active investing and more. Brahma isn’t shy about injecting his own opinions as well. However, where he differs with Bogle, I usually found Bogle’s arguments more convincing.

Braham is no breathless admirer of either Bogle or Vanguard. As one example, Braham calls one Vanguard advertising campaign a “schmaltzy video” containing “true sanctimony”.

A big part of Bogle’s achievement with Vanguard was to separate control over invested assets from the management of the assets. A competitor to Vanguard is quoted as saying “By giving the client a fair shake, you’re going to destroy this industry.” However, many of Vanguard’s competitors continue to “put the desire to earn profits for their management companies above the desire to earn profits for their shareholders.”

One area of Vanguard that Braham criticizes is its “Partnership Plan”. This plan pays a bonus to Vanguard employees based on a percentage of the money Vanguard saves its investors on management fees compared to the rest of the industry. Braham sees this plan driving Vanguard to sacrifice “potential outperformance in favor of asset gathering.” He thinks that Vanguard could do a better job trying to beat the market with its active funds instead of just getting bigger. I’d be more concerned about this if I thought they could beat the market consistently.

I find it interesting that Vanguard’s low-cost index ETFs are most useful to me, but Bogle is no fan of ETFs. ETFs are designed to be traded and Bogle has shown that investors tend to buy and sell them at the worst possible times. I’ll see what I can do to hold on for the long term.

Despite serious health problems most of his life, Bogle didn’t allow himself to be held back. His doctor reported that Bogle refused to quit playing squash and instead brought a defibrillator to the court. Bogle reported back to his doctor that “I’m consistently winning. My opponents are so demoralized and fearful they’ll have to resuscitate me, I beat them every time.”

In the latter part of the book, Braham justifies his beliefs in active investing, tactical asset allocation, and fundamental indexing. To his credit he explains the counterarguments as well. In general, I found the counterarguments more compelling.

On the subject of voting company shares, Braham calls on Vanguard to lead the industry in voting company shares against excessive compensation proposals for the company’s top management. This seems long overdue.

On the whole this book is a worthwhile read for its account of Bogle’s life, Vanguard’s history, and it’s tackling of contentious investing issues.

See Canadian Couch Potato’s review of this book as well.

Wednesday, July 13, 2011

Worthless Prizes

With four drivers in my house I often find interesting things in my car. Recently, I found a Swiss Chalet "Dip'n Win" prize strip. At first I assumed that it was abandoned because it was a loser. But that wasn't the reason.

I was actually holding a winner of sorts: a "$50 THE SOURCE GIFT CARD*". Sounds great so far. However, the next line reads "with a new 3-year phone activation." I didn't even bother trying to read the remaining 7 lines of barely-legible fine print.

This kind of worthless prize just makes me think less of Swiss Chalet. I'd think less of cell phone contracts as well if that were possible. What happened to the days when you would win a small order of fries?

Tuesday, July 12, 2011

Independent Directors

Much is made of the value of having independent directors serving on a company’s board of directors. These directors are not employed by the company and are supposed to be able to freely challenge management plans and thereby protect shareholder interests. I’m not convinced that independent directors are better than owner directors.

If a director has his or her net worth tied up in company stock, this aligns the director’s interests with those of shareholders. A director who is an employee with minimal ownership actually has interests that are opposed to those of shareholders. An independent director is somewhere in the middle.

As a shareholder, I would place more trust in an owner director than an independent director. I would look for directors whose share ownership is large relative to the income they receive from the company. In this measure, I wouldn’t count stock options as ownership and I would count any form of income whether direct or indirect.

Independent directors may work hard defending shareholders, but then again they may just pay little attention and collect their director’s fees. Or worse, an independent director and the CEO may serve on each other’s board of directors and trade favours.

Independent directors are better than employee directors, but owner directors seem best to me.

Monday, July 11, 2011

Retirement Strategies

I'm not particularly close to retirement age, but I've been thinking about what kind of real estate strategy makes sense. So far, my ideas have gone over with my wife like a lead balloon.

I'm pretty sure I don't want to live in my current house after retiring. It's great for a family. I've got a big pool, big deck, lots of rooms, and lots of grass to mow. It's great right now, but I doubt it will make me happy in 10 or 20 years.

My first thought was to sell the house at some point, reduce the amount of stuff I own as much as possible and go rent somewhere for a while. Whenever it suits us we could move on and rent somewhere else.

By moving around we could get an idea of how we want to spend each year. Maybe we'd spend 6 months in Canada, 4 months in the warmer part of the U.S., and another 2 winter months somewhere else that's nice and warm.

My wife is definitely not sold on this idea. She sees impracticality in owning little enough to make moving so frequently possible. I think she also doesn't like the idea of not having a permanent place to call home.

For my part, I definitely don't want to own more than one place. It's hard enough to maintain one home and I don't like worrying about my house when I travel. Having two places would mean that I'd be worrying all the time.

My wife's concerns are legitimate, but I think mine are as well. I'd be interested in other thoughts on this subject.

Friday, July 8, 2011

Short Takes: Earnings Surprises and more

Jason Zweig says that quarterly earnings surprises are largely planned. I remember this from the tech boom; arranging for an earnings surprise was essentially a way to market a stock.

Big Cajun Man takes a swipe at advice to build up debt while you’re young. Building up debt would be fine if you know what your lifetime income is going to be and you know that you’ll enjoy staying in the job that pays this money. This applies to nobody and so debt should be kept to a minimum.

Money Smarts and Million Dollar Journey reported on the current standings of their stock-picking contest. If I entered, I’d just pick some index ETFs and plan to finish third or fourth out of ten.

The Blunt Bean Counter takes a look at 4 different personality types when it comes to money.

Thursday, July 7, 2011

Let's Make Mortgages More Like Car Leases

Let’s face it. Buying a house is way too expensive. A $500,000 mortgage amortized over 30 years at 4% costs $2378 per month. Who wants to pay that much? Car leases give us the answer.

With a car lease we recognize that a car still has some value after the end of its lease. The customer only has to pay enough to cover the difference between the car’s starting price and its value after the lease runs out.

This should work out even better for houses because they go up in value. Let’s be conservative and assume that houses will go up 10% over the next 3 years. Then a home buyer should only have to pay enough so that the amount owed on the house goes from $500,000 to $550,000 over 3 years. At 4% interest, this would only cost $343 per month!

The rising debt isn’t a problem because you can always sell the house to pay it off. Compared to the old type of mortgage where the payments are $2378, this saves over $2000 each month. This is the kind of innovation we need to keep house values rising.

(In case it’s not obvious, I’m not serious about this. I’m simultaneously mocking (1) over-emphasis on monthly cash flow, (2) car leases, and (3) the growing belief that house prices will rise indefinitely.)

Wednesday, July 6, 2011

Profiting from Mileage Claims

My employer reimburses me $0.45 per kilometer (km) when I use my car for company business. This turns out not to be a good deal for me with my expensive car, but it raises the possibility of augmenting your income by using your car for business. (Side note: It’s interesting that the word “mileage” has survived in a country that measures driving distances in km.)

I did a rough calculation of my car costs taking into account initial purchase price, insurance, repairs, gas, and inflation. It turns out that my average cost has been about $0.50 per km (in today’s dollars) to drive my car. So, I lose a nickel per km on business trips. I’m not overly concerned about this small loss because I don’t use my car for business much, but it could make a big difference for people who drive for work frequently.

For a trip to a city 500 km away, the round trip of 1000 km would leave me out of pocket about $50, but someone with a cheaper and more efficient car that costs only $0.25 per km would pocket $200 after costs. This may not seem like much compensation for all that driving, but if you have to drive that much for your job anyway, you might as well pocket some extra tax-free cash.

I’d be interested to hear whether any readers use this strategy to augment their incomes. Have you done any detailed calculations to see how much extra money you’re pulling in with mileage claims?

Tuesday, July 5, 2011

Bond Misconceptions

“I keep hearing that bonds aren’t a good investment right now, but bond yields just went up. Doesn’t that mean that the bond naysayers were wrong?” Many investors seem to have a hard time understanding bonds.

In its simplest form a bond is an IOU. Some organization promises to pay you a fixed amount of money on a particular future date. The price of a bond is whatever people are willing to pay for it. If a government bond pays $1000 in a year, you might decide that it’s worth $980 to you. If a small company’s bond pays $1000 in a year, you might decide it’s worth only $900 because the company may not be able to pay.

The bond yield is just the implied interest rate when looking at the bond’s current price, the amount it is supposed to pay, and how long until it pays. So, for the one-year government bond above, the yield is 2.04% (because adding 2.04% to $980 takes it to $1000). However, the small company’s bond pays 11.1% because of the higher risk of default.

The important thing to remember is if bond prices go down, the yield goes up, and if bond prices go up, the yield goes down. So, if you hear that bond yields rose, this may be good for someone about to buy a bond, but it is bad for existing bond-holders because bond prices dropped.

A perverse thing about bond lingo is that it is possible to make every day sound like a good day: either bond prices rise or bond yields rise. Don't be fooled.

Monday, July 4, 2011

Measuring Investing Success Emotionally Can Be Costly

We may not always agree on which investing approaches are best, but some are so bad that it should be obvious. Flipping back-end loaded mutual funds monthly is just a bad idea no matter how skilled you are. Buying into IPOs you don’t understand is also a bad idea.

A common defense of bad investing approaches is something like “there is no best investing approach” and “everyone has his own way to invest that works for him.” It is true that there are aspects of each person’s situation that are distinct, but for the most part, this defense is nonsense.

If your financial advisor has you in 3% MER closet index funds and you could be investing with a different advisor who would charge you only 1% to be in low-cost index funds, then your investing approach is bad. Sticking with the high-cost advisor because he’s a good guy who makes you feel important is an expensive choice.

Very few investors even know how their portfolios are performing in numerical terms. If they don’t know the numbers, then how do they make their choices? The only remaining possibility is that their choices are based on emotions, and this can be costly.