Monday, December 31, 2012

Mutual Fund Salesman Fights Back

This is a funny one I got from Ken Kivenko who is a tireless advocate for the small investor up against the giant mutual fund industry. You can read his monthly newsletters at Canadian Fund Watch. Ken says he received the following message signed as the branch manager of a member firm of the Mutual Fund Dealers Association:

“Mr. Kivenko, please stop sending your Newsletter to my clients Mr. ----- and Ms. -----. Since they have been receiving your rag they constantly pester us about fund fees, returns and how our Seniors Specialists are paid. The more they read the more anxious they become. They are elderly and your stories are scaring them. It is now virtually impossible to even approach them about our new line of proprietary funds because of your rantings. The next thing I know they'll be asking about alternative investment choices. Our sales team is worried this will spread. STOP sending this material NOW! Have a good day.”

This is too funny for words, which makes me think that it didn’t really come from the branch manager of an MFDA firm, but who knows? Keep up the great work, Ken.

Saturday, December 29, 2012

HST Complications

A reader I’ll call Jeremy has a question about how to handle the HST for his practice that he operates with a partner I’ll call Sandy. Here is the situation:

Sandy runs a business offering an HST exempt service out of an office she rents. The service Jeremy offers is not HST-exempt. Because Jeremy offers a different but complementary service to the public, Sandy suggested that Jeremy offer his service out of Sandy’s office space. To keep the arrangement simple, Sandy suggests that Jeremy pay her 40% of his revenues, and Sandy will provide the office space, supplies, computers, etc. without any further charges. The idea is that Jeremy will just keep 60% of his revenues.

The complication comes with how to handle the HST. Jeremy must charge his clients the HST, but how should it be split between Jeremy and Sandy?

Possibility #1

Sandy only gets 40% of Jeremy’s base rate and gives all of the collected HST money to Jeremy. Jeremy then remits the HST money to the government based on his full revenues (not just the 60% that he actually receives).

Possibility #2

Sandy gets 40% of everything including HST money. Sandy remits her share of the HST money to the government, and Jeremy remits his share. In effect, they are treating it as though Sandy is performing 40% of Jeremy’s service, and Jeremy is performing 60% of it. This feels wrong because it is really Jeremy who is performing the service; Sandy isn’t even qualified to offer Jeremy’s service.

Possibility #3

Sandy gets 40% of everything including HST money because she is effectively charging Jeremy HST on the goods and services she provides to Jeremy. Sandy will remit her share of the HST (less any HST input credits). Jeremy will remit the entire HST amount less the HST input credit from Sandy. This seems wrong because Sandy has charged HST on Jeremy’s rent and possibly other things that HST does not apply to. It also forces Jeremy to use the complex HST accounting instead of the quick method.

I could go on listing different ways to handle the HST in this scenario, but it’s time for others to chime in. What is the correct way to do the HST accounting in this case? Are there any experts out there? Maybe The Blunt Bean Counter?

Update:  In a later blog post I explained how to handle the HST for this situation.

Friday, December 28, 2012

Short Takes: Post-Christmas Sales and more

I made a change to this blog that should go unnoticed by most readers. I now have my own domain ( instead of the blogspot address. Although I’ve set it up to automatically refer from the blogspot address to the new address, I’d be pleased if those who point to my blog from their own web sites could update the addresses. Readers of my feed should see no substantial changes. Thanks to Frugal Trader at Million Dollar Journey for the advice on how to make this change smoothly.

Now, on to this week’s short takes. It’s been a quiet week, but I found a couple of interesting articles.

Big Cajun Man has a list of things to stay away from in the post-Christmas sales.

My Own Advisor reviews the ebook The Dividend Toolkit.

Monday, December 24, 2012


The word “millionaire” is mainly used loosely to mean a person with so much money that he or she can spend far more than the average person with no fear of ever going broke. Increasingly, this loose definition does not match up with the more precise definition of a person with a net worth of at least $1 million.

Consider the hypothetical couple, Sam and Christie, both 56 years old. They met working for the same employer and have 3 children, two of whom are still attending university. Their employer is having tough times and they both got forced into early retirement. Unfortunately for them, their skills are mostly useless now that the entire industry they worked in has collapsed. Fortunately, though, they are collecting a defined-benefit pension of $5500 per month.

Using a rule of thumb that an indexed pension is worth about 15 years’ worth of payments, their pensions have an actuarial value of $990,000. Sam and Christie live in a house worth $450,000, but their mortgage is $300,000, they owe $80,000 on a line of credit, $40,000 in car loans, and $20,000 on their credit cards. This gives a net worth of exactly $1 million. Sam and Christie are millionaires.

Let’s look at Sam and Christie’s cash flow. Their monthly debt payments add up to $4700 per month. This leaves $800 per month to pay income taxes, help with their children’s tuition, heat their home, and buy food. Sam and Christie are in serious financial trouble, but they are still millionaires. Obviously, this is an extreme case. But it illustrates how being a millionaire by the precise definition can be very different from the looser definition.

Some readers might object saying that we shouldn’t count pensions. To these people I offer to buy their pensions for one-tenth of their actuarial value (if this is legal). If pensions don’t count as an asset, then these people should be happy to turn their worthless pensions into cold hard cash.

I think inflation has reached the point where we should be saying “decamillionaire” (a net worth of $10 million or more) to mean a person with enough money to be able to spend without worry. Even if $1 million is tied up in a house and $2 million in a pension, and we draw only a 2% income on the remaining $7 million, this is still $140,000 per year.

Of course, it is possible to burn through just about any amount of money as many professional athletes have demonstrated. But, I think the decamillionaire level gives about the right balance between the loose and precise definitions. Now we just have to figure out how to get the $10 million.

Friday, December 21, 2012

OK Google, You Can Keep My Ten Bucks

With apologies to the blog Give me Back My Five Bucks, I say to Google, give me back you can keep my ten bucks! That’s how much they charged me for a service that I can’t get finally got to work.

This all began with the many complaints I get from people who say that their employers block all blogspot links, so they can’t see my blog. I’ve been trying for a while to figure out how to fix this, but the only advice I ever get is that I should move to WordPress. However, I get frustrated enough fixing problems that come up with Blogger. My family would disown me if they had to endure my ranting about having to fix WordPress problems. Besides, I don’t want more features; I just want some simple blogging features to work without constant attention from me.

I poked around in Blogger settings and noticed a publishing option to “Add a custom domain”. This seemed too good to be true. Clicking on it led me to an offer to sell me my own domain for only $10 per year. So I pulled out my credit card and plunged in. Google quickly sent me a link to set up an admin account. What do I need that for? I just want all my blog pages to have a custom address instead of a blogspot address. This was my first clue that this process wouldn’t be as turnkey as I had hoped.

The link in Google’s email brought me to a page to set up an account, but all attempts to create the account ended in a server error. A few online searches gave me a suggested workaround involving requesting a password restore. This seemed to work and I now have an admin account.

Unfortunately, logging in to the admin account brought me to a set of controls that allowed me to do just about anything except connect this new domain to my blog. So, I headed back to my Blogger settings.

After going to advanced settings, I was offered a chance to type in my new domain where my blog would be redirected. This led to the error message “Another blog or Google Site is already using this address.” Handy.

Another message said “Your domain must be properly registered first” and offered a link to some “setting instructions”. These instructions began with getting into DNS settings to add some “A-records” and a “CNAME”, whatever they are. I finally located a reference to DNS settings in my admin account which then directed me to log in to some GoDaddy account, but once in there I found no reference to A-record or CNAME.

Time for another approach. The Google email ended with “At any time, if you get stuck or if you want to tell us about your experience with this service, you can find more information and get in touch through our help center (” Unfortunately, “get in touch” didn’t mean that I could direct a plea for help to an actual human. I poked around in the support area for a while but didn’t find anything useful.

It should be fairly obvious at this point that if I tried WordPress, the first time anything went wrong there is little chance I’d have the patience to fix it. I’m good with math, algorithms, and money, but not this stuff.

Update: I solved the problem.  It turns out that although I didn't need to type the "www" part when I purchased the domain, I did have to type it in the advanced settings.  Without the "www", the CNAME strings were all wrong.  I'm not proud to admit that it took me about 8 hours of work across 3 days to finally fix this.

So Google, give me back you can keep my ten bucks.

Short Takes: Interest Rate Forecasts and more

Canadian Mortgage Trends explains how wrong Amanda Lang is about the ability to forecast interest rates and how quickly they can rise or fall.

Preet Banerjee interviews Financial Advisor John DeGoey who has some very blunt words to describe the state of the financial advice industry.

Canadian Couch Potato explains how the cost of currency conversion has nothing to do with current fair exchange rates.

Million Dollar Journey gives a snapshot of where he is with his RESP, which is based on TD e-Series mutual funds. He also lays out his complete RESP strategy for shifting from stocks to safe investments as his children approach the end of high school.

Big Cajun Man says that store-fronts for the telecom companies like Bell and Rogers are no-ops in the sense that they offer little of value over visiting the company’s web site. Increasingly, low-level employees of businesses have almost no discretion to make any decisions themselves. Business strategies are created at the corporate level, coded into software for the company web site, and broken down into inflexible rules for low-level company employees.

Freakonomics discusses a better way to measure inflation than governments currently use.

Thursday, December 20, 2012

Lotteries over the Long Run

People who play the lottery generally know that their odds of winning are very low. However, some ticket buyers I’ve spoken to believe (or hope!) that they’re bound to win if they keep playing long enough. I decided to do some simulations of the Lotto Max lottery to examine this belief.

I ran a million simulations of playing 2 tickets per week for 25 years. At $5 per ticket, that’s a total cost of $13,000 for each of a million lottery players. I included all the gory details about how the prize pools are determined, winning a free ticket when matching 3 numbers, and everything else.

A simplifying assumption I made was to treat all chosen number combinations as random instead of having some of them chosen by people. I also had to make assumptions about ticket sales: I chose sales of $25 million per draw when the previous jackpot was won and sales of $15 million more than the previous jackpot when it wasn’t won. This crudely models the hysteria that comes with big jackpots.

The results were dismal. The median total winnings were $1840. This means that for the $13,000 invested, half of the million lottery players had total winnings of less than $1840 and half more.

How many of the lottery players at least made back their $13,000? Only one player out of 529. So 528 out of 529 lottery players would lose money over the 25 years.

How many lottery players hit it big with enough money to retire permanently ($5 million or more)? Only one player out of 10,000. In a town of 10,000 lottery players buying tickets for 25 years, 9999 of them would never realize their lottery-based retirement dreams.

How long would you have to keep playing 2 tickets per week before the odds of winning the big jackpot reach 50/50? The answer is about 1900 centuries!

I don’t expect to make a dent in lottery sales with rational arguments, but if even one person stops buying lottery tickets after reading this, I’d be happy.

Wednesday, December 19, 2012

McAfee’s Persistent Trickery

I recently received what appeared to be a reminder from McAfee to renew my subscription to their antivirus software. On the surface this seems like a useful reminder service for an existing customer who wants to maintain continuous security coverage for my PC, but all is not what it seems.

A curious omission from the McAfee email was any mention of when my subscription expires. After some digging for an old password, I was able to log in to my McAfee account to discover that my subscription will last another 20 months! Why would I want to extend my subscription for another year or two now? There’s half a chance that my PC won’t even be working by then.

Another annoyance is that McAfee renewed an old subscription on a PC that I had scrapped. I thought I had been careful to check the “never automatically renew” box, but either I missed it or this box got reset somehow. Fortunately, renewal attempts by McAfee don’t work if I have an updated credit card with a new expiry date and 3-digit code, but this time they managed to renew me on a junked PC before my credit card had expired.

Getting my money back took some effort. After calling the 800-number and waiting for quite a while, the first person on the phone tried to put me off by saying they couldn’t refund my money. After I got a manager on the phone, he promised to return my money, but only after he found out that I have another McAfee subscription on my current PC. I’m not sure how cooperative he would have been if I was leaving McAfee altogether.

It bothers me that it takes such diligence to keep from overpaying. McAfee is entitled to run their business as they please, but this has left a bad taste in my mouth and makes me wonder about trying their competition.

Tuesday, December 18, 2012

Newspaper Paywalls

In an interesting blog post, The Blunt Bean Counter asks whether newspaper paywalls will save newspapers or if they are just a last ditch effort to save an industry that will ultimately fail. I think the answer is some of each.

Revenues for newspaper businesses will continue to decline as more people opt not to pay for a physical newspaper each day. It will take some time but people like me who like to flip through the dead-tree version of newspapers will eventually die off. Newspaper business people recognize this and hope they can replace subscription revenue from physical papers with subscription revenue from web site access.

For the most part, this won’t work; collectively, people will never pay as much for web site subscriptions as they pay for physical newspapers. The reason is simple: competition. It costs far less to run a newspaper as a web site than it does to deliver physical newspapers. Production and delivery costs are eliminated and there is far less need for administration and other jobs that traditionally existed with newspapers.

If a newspaper is able to operate with bloated administration, it will get undercut on price by a new competitor. No doubt people in the newspaper business feel that they have already cut to the bone, but the cutting will continue.

In the future we will need reporters, fact checkers, editors, and web site programmers, but we won’t need many of the overhead jobs that exist today. The music industry went through this fairly quickly and it will happen to newspapers slowly over the coming years.

Getting back to the original question of whether paywalls will save newspapers, it depends on what we mean by “save”. Paywalls will not allow the newspaper business to persist as it exists today. Overhead costs will be ruthlessly torn out of these businesses to the point where they will become radically different from today’s newspaper businesses. However, there is every reason to believe that paywalls will be used by some online news businesses in the future.

Friday, December 14, 2012

Short Takes: Financial Gurus, Taxing the Rich, and more

Daniel Solin, senior vice president of Index Funds Advisors, bluntly describes the need of fund managers and the financial media to anoint financial gurus as seers of future stock market prices.

Scott Adams comes at just about every subject from a unique angle. In discussing whether it makes sense to raise taxes on the rich, he had a great quote: “fairness is a concept invented so dumb people can participate in debates.”

The Blunt Bean Counter is giving away copies of Rob Carrick’s book How Not to Move Back in With Your Parents.

Big Cajun Man goes into rant mode when he can’t find some tax receipts and can’t seem to follow his own advice about staying organized. It always amazes me how people don’t spend 10 seconds to file away an important receipt to save an hour at tax time looking for it. Occasionally I’m guilty of this myself, but for the most part I’m pretty organized.

Where Does All My Money Go? explains how to deal with some common problems that arise in closing on the sale of a home.

Thursday, December 13, 2012

Snowbird Tax Trap

So many Canadians like to spend their winters in the U.S. that we have a name for them: snowbirds. If you’re a snowbird or aspire to be one, beware of U.S. tax law. If you’re not careful, the IRS will treat you as a nonresident alien subject to U.S. income taxes. Fortunately, there are ways to avoid this fate.

Be careful of taking people’s word on these tax rules. I’ve heard so many contradictory explanations of the rules that I decided to dig through the IRS website to find the truth. The main things you need to understand are the Substantial Presence Test and the exception to this test called the Conditions for a Closer Connection to a Foreign Country. It’s also important to know that if you wish to assert a closer connection to Canada, you have to file Form 8840. On page 3 of this form it says “If you do not timely file Form 8840, you will not be eligible to claim the closer connection exception and may be treated as a U.S. resident.”

I’ll summarize the highlights of the relevant rules, but there are exceptions. For example, the rules are different if you have a green card or have applied for one. You should read and understand the information at the 3 links above.

The rules mainly hinge on how many days you spend in the U.S. each year. Some days don’t count, such as “Days you are unable to leave the United States because of a medical condition that develops while you are in the United States.” See the Substantial Presence Test for a full list of the days that don’t count.

Substantial Presence Test Highlights

To figure out whether you meet this test, you need to know how many days you spent in the U.S. this year and each of the previous 2 years.

If in the current year you spent less than 31 days in the U.S., then congratulations, you don’t meet the test. Otherwise, you have to do the following calculation:

(days this year) + (1/3 of days last year) + (1/6 of days the year before last)

If this adds up to 183 days or more, then unfortunately you meet this test. This is the part that few people seem to believe. They’re sceptical that the rules actually involve a calculation like this.

If you stay longer than 121 days (about 4 months) in the U.S. year after year, then you’re going to meet this substantial presence test.

Conditions for a Closer Connection to a Foreign Country

All is not lost if you meet the substantial presence test. You may qualify for an exception based on having a closer connection to a foreign country and still avoid having to pay U.S. income taxes. The main criteria for getting this exception are that you stayed less than 183 days in the U.S. and you really do have a closer connection to another country. However, you have to file Form 8840 or you may give up your eligibility for this exception.

Form 8840 asks many questions all aimed at determining to which country you have the strongest connection. It’s not obvious what answers the IRS considers acceptable for getting the exception.

Bottom Line

For most Canadians who spend roughly the same length of time in the U.S. each year, you can avoid paying U.S. income taxes by staying at most 121 days (about 4 months) each year, and you may be able to extend this to 182 days (about 6 months) if you file for an exception with Form 8840 each year and the IRS accepts your exception.

Wednesday, December 12, 2012

A Passive Investing Movie

I highly recommend having a look at a 54-minute movie called Passive Investing. The discussions are mostly non-technical and fairly easy to follow. They even cover the lifestyle advantages of switching to passive investing. For more details about this movie see Canadian Couch Potato’s description.

What prompted me to write a post about this movie is an issue that is more technical than the film itself. Canadian Couch Potato made the following remarks about the movie’s mention of the capital asset pricing model (CAPM):
“CAPM—which predicts the expected return of a security based on its beta—is still widely taught, but it doesn’t do a particularly good job of explaining returns in the real world. (The Fama-French three-factor model is a dramatic improvement.) So I’m surprised the film’s website describes CAPM as ‘the mathematical foundation of passive investing.’”
He is right that the three-factor model is better at modeling past investment returns than CAPM. However, what matters is the future and not the past. The important question is what features of past returns will persist into the future?

We can devise ever better models of past returns by adding in more factors, like momentum effects over certain durations and reversion to the mean effects over other durations. In the extreme, we can just take the entire database of past returns and call it a model. This extreme model exactly matches the past, but future returns for each stock will not exactly match past returns.

So we return to the question of what features of past returns will persist into the future. For CAPM to be useful, we need the risk premium to persist. Over the long run we hope that a diversified portfolio of volatile assets will continue to earn higher average returns than safer investments. In my opinion, it seems like a safe bet that people will continue to prefer safe investments and will be willing to pay a premium for them.

Fama and French modeled the fact that small-cap and value stocks have enjoyed higher returns than their riskiness would indicate using CAPM. Do you believe that small-cap and value premiums will persist into the future? Maybe there are good reasons why these premiums will persist based on human nature. But this seems less certain than the persistence of the risk premium. Certainly, if enough investors were to embrace the three-factor model, it would eventually erode the returns of small-cap and value stocks.

With my own portfolio, I’ve cast my bet on the risk premium and partly on small-cap and value premiums. So, in this sense I agree with Canadian Couch Potato. But I wouldn’t say an investor was wrong if he chose not to count on small-cap and value stocks to outperform in the future.

Monday, December 10, 2012

New Tools for Shafting Shareholders

When we buy shares in a company, one of the things we count on is that all shares are treated equally and get an equal slice of the company’s profits. The Financial Post reported on research into changing this equal treatment:
“A global research project launched Wednesday by Mercer, Stikeman Elliott LLP and the Generation Foundation will look at the concept of granting ‘loyalty’ dividends or warrants, or additional voting rights, that would ‘reward’ certain corporate shareholders for retaining their shares for a specified number of months or years.”
On the surface, this seems like a great idea. You get a bonus for holding your stock for a long time. However, all shareholder claims on company profits come from the same pie. If some shareholders get more, then others must get less.

But so what if some high-frequency trading jerks get a smaller slice of company profits? Who is to say that companies will only use their long-term shareholder bonus programs to shaft day traders? It could easily be abused in a number of ways.

Suppose that a family has controlled a large fraction of a business for over 50 years. If this company’s bonus program only gives bonuses for shares held 50+ years (allowing for inheritances), then they are simply awarding an ongoing yearly bonus to themselves and nobody else.

Suppose that a company grants itself the power to issue stock that is deemed to be long-term stock. Then company insiders who exercise stock options can receive shares that allow them to be treated like long-term shareholders even if they are really short-term shareholders.

It’s true that some companies have multiple classes of stock. For example, Berkshire Hathaway has A and B shares. However, the differences in share rights are fairly easy to understand. BRK B shares have 1/1500 of the economic interest of a BRK A, but only 1/10,000 of the voting rights. Investors can take this into account as they see fit in deciding on the price they’re willing to pay for shares. But a complicated web of different classes of shares based on how long they’ve been held could be made to be very difficult for investors to understand if company insiders choose to make it complex.

I’m cautiously supportive of creating incentives to encourage investor to think about the long term, but we have to be careful about giving company insiders new tools to help them divert more than their share of company profits into their own pockets.

Friday, December 7, 2012

Short Takes: Defined Benefit Pensions as Bonds, How Parents Direct Inheritances, and more

My Own Advisor explains how he considers his defined benefit pension to be like a large bond that allows him to take more equity risk with the rest of his portfolio. This makes a lot of sense, but something that many people don’t consider with defined benefit pensions is the risk that you won’t collect as much as you think. If you decide you can’t stand your job or get laid off, you may be left with only a very modest pension (or none at all if you take a commuted value when you leave). Even government jobs aren’t as safe as people used to think, particularly with all levels of government facing huge deficits. When balancing a portfolio, it makes sense to consider only the value already accumulated in the pension rather than the entire future value if you stay until retirement age.

Boomer and Echo tells a story of parents financially supporting spendthrift adult children at the expense of their responsible children. Perhaps living only for today pays off if you have wealthy parents willing to bail you out.

Canadian Dream Free at 45 makes the case that good financial habits are more important than far-away goals of huge retirement savings.

The Blunt Bean Counter takes a look at how Canadians use RRSPs and whether they raid them too soon. The answer seems to be that some leave RRSPs alone until retirement, some raid them too early, and some have well-laid out plans for using them prior to full retirement. This one generated quite a few comments.

Big Cajun Man has some fun creating some sayings in Mad Lib style. My favourite is “Hoarding is valuing the invaluable”.

Preet Banerjee wants your financial questions for The Bottom Line Panel on CBC’s The National.

Young and Thrifty explains how to reduce your payroll taxes using a T1213 form.

Retire Happy Blog says there is value in simplifying your personal finances and suggests ways to do this.

Thursday, December 6, 2012

I Don’t Know My Way Home in the Dark

Having spent much of my working life around type A personalities who pour all their effort into their careers and have little in the way of personal lives, I’ve always respected those who sacrifice some career advancement to get life balance. This doesn’t include just high-powered business executives; I’ve seen it in a mechanic as well.

The way we pay for car repairs usually involves book hours instead of real hours. A book lists the number of hours each type of repair is supposed to take. Then you pay for this number of hours no matter how long the repair takes.

Mechanics vary greatly in how long they take to complete repairs. A former mechanic friend (I’ll call Dan) used to routinely take less than half the book hours to complete his work, but he says that he worked with some mechanics who would spend all day on a 2-hour job.

Dan was well-liked by his employer because he made maximum use of the space he took up in the garage (i.e., he made them lots of money). And he was well paid because he was compensated for 15-20 book hours per day, even though he was only there for 8 hours per day.

Dan’s employer routinely tried to get him to work more hours, but he always refused saying “I don’t know my way home in the dark.” This was a clever way of saying he preferred a rich life outside work over making more money.

All this came to an end when Dan’s employer tried to impose new rules that capped his pay at 125% of his actual hours worked. So now Dan is in a completely different line of work, but he still manages to get time for his family and a few rounds of golf each week. It can be difficult to turn down career advancement and higher pay, but it is worth it to me.

Wednesday, December 5, 2012

Do We Really Need Christmas Gift Exchanges Any More?

I get the feeling that enthusiasm for Christmas gift exchanges is mostly limited to children and shopaholics. I think this comes from the fact that most of us already have the small things we want.

There was a time when gift-selection was quite easy. When everyone one needed food and clothing it wasn’t too hard to pick a gift to make or buy. But now it’s hard to find the right gift for everyone on your list. Most people have the basic things they need and want. A gift sweater may never be worn again after the obligatory trying it on for the camera.

It’s normal for the enthusiasm for Christmas to fade with age, but the age where this begins seems to be getting younger. And it’s hard to blame teenagers of well-to-do parents for losing some interest in Christmas, unless their parents buy extravagant gifts like a new car. How excited do you really need to be about getting an eleventh gaming system?

It would be nice to see all the wasted money and energy that goes into wandering around big-box stores channeled into more useful pursuits such as volunteerism. Offering to help an elderly neighbour clear leaves or reading to children at a library are more useful than a few more plastic toys for a child who already has hundreds of them.

I’m not calling for a complete end to Christmas gift-giving. But I think it makes sense to shrink your Christmas list to mostly children and just a few adults. And maybe use some of your freed-up time to do some good in your community.

Tuesday, December 4, 2012

Emotions and Rational Thinking in Investing

There is an uneasy relationship between emotions and rational thinking in investing. I’m a believer in using careful rational thinking when making big life decisions like how to invest your life’s savings, but it isn’t possible to keep emotions out of the equation entirely because most of life’s core goals are fundamentally emotional.

To the extent that I have any philosophy in life it would be “sustainable happiness”. Without the sustainable part, drugs would be a good solution to produce a burst of happiness. But this is hardly sustainable. So, I try to eat well, get regular exercise, and treat others well in a bid to be happy for the long term. The pursuit of money is not an end in itself, but a means of achieving freedom, comfort, interesting experiences, and ultimately, happiness.

There are those who say that money doesn’t matter. They are partly right and partly wrong. Of course money matters, but what you give up for it matters too. I’ve consistently turned down career opportunities because they would have demanded so much time that my connection to family and friends would have suffered. In these cases, I would have said that the extra money doesn’t matter. I sometimes see people justify extravagant spending saying something like “money doesn’t matter” or “you only live once”. In these cases I think these people are usually reducing their future happiness.

So, despite the fact that success in life is best defined by emotions, I think it pays to keep emotions out of your decision-making when facing big financial decisions, such as buying cars and homes and investing your savings. You need to be aware of what makes you happy, and take this into account in making big decisions, but the decision-making itself should be rational.

Monday, December 3, 2012

Credit Card Cash-Flow Arbitrage

Years ago I noticed that my wife and I have different payment dates on our credit cards. Until recently, I never really thought about the implications of this difference, but it does present an opportunity to “optimize” cash flow.

The following calendars illustrate the differences in our credit card statements.

My next statement will cover purchases from roughly Nov. 16 to Dec. 15, and the payment will be due Jan. 5. I indicated a full week for the payment to illustrate that it is sensible to pay somewhat early to avoid interest charges.

Note that my wife’s credit card dates are shifted forward 19 days. This creates an opportunity that I hadn’t thought much about before, but I’m sure that many people use. For purchases between Dec. 16 and Jan. 3, my wife will have to pay before Jan. 24, but I won’t have to pay until before Feb. 5. Similarly, for purchases between Dec. 4 and Dec. 15, I’ll have to pay sooner.

To optimize cash flow, it’s always better to use one credit card or the other, depending on the date. For us, this is easy to handle because we don’t distinguish between my money and her money. Sometimes I pay her credit card bill and sometimes she pays mine. So, if we happen to be together when making a large purchase, we can optimize cash flow by checking the date and using the right credit card.

As I’ve argued before, the savings that come from paying bills later are modest. So, the main benefit of optimizing which credit card to use is cash flow. Sometimes the financial events going on in your life make it convenient to defer a payment by a couple of weeks.

I tend not to have cash flow issues much because I maintain a cash buffer and save a lot of my income, but I do play little mind games to create artificial scarcity to control my spending. If I’ve shifted cash into long-term savings, I could just take it out again to buy something I want, but usually I treat the money as inaccessible. In this case, credit card cash-flow arbitrage becomes a way to defer a payment until after a pay cheque or dividend payment. Mind games on top of mind games.

Friday, November 30, 2012

Short Takes: Tax Glitch when RRSP passes to Spouse and more

The Blunt Bean Counter discusses the unintended consequences when an RRSP/RRIF passes to a spouse but the spouse doesn’t put the proceeds into an RRSP/RRIF. The result could take inheritance money away from others named in the will.

Retire Happy Blog makes a lot of sense in a controlled rant about the harsh realities of investing. There is no magic way to invest money safely to get a high return. One minor point I would disagree with the idea that investors got safe high returns back in 1981. People should focus on after-inflation returns. GICs may have been better in 1981 than they are now, but not by as much as it appears after you account for inflation.

Big Cajun Man has some house-hunting tips.

My Own Advisor was surprised at how expensive it is now to go to a movie. My best suggestion is to cut your costs in half by eating before you go to the movie.

Monday, November 26, 2012

RRSP vs. TFSA Debate Misses an Important Detail

There is no shortage of experts who debate whether you should put your long-term savings in an RRSP or a TFSA. However, they gloss over an important detail: you have to put more money in an RRSP to get the same effective savings as money placed in a TFSA. Taxes make savings in an RRSP worth less than the same dollar amount of savings in a TFSA.

The line of thinking of some analyses goes as follows. Suppose you have $6000 to save. If you put it in a TFSA, it will grow tax-free until you take it out. If you put it in an RRSP and you’re in a 40% marginal tax bracket you’ll get a $2400 tax refund, it will grow tax-free, but you’ll have to pay taxes on withdrawals in the future. So, things balance out to some extent.

What is missed in this analysis is that in the RRSP case, you’re effectively saving less money. If the investment grows to $60,000 over a number of years but your marginal tax rate stays the same, the TFSA will give you $60,000 you can spend, but the RRSP will only give you $36,000 you can spend. Your effective amount of savings is less in the RRSP case.

To make a true apples-to-apples comparison, you should consider different-sized contributions. If you’re considering contributing $6000 into a TFSA, the corresponding amount of savings in an RRSP would be $10,000 (for a 40% marginal tax rate). Note that after you get the $4000 RRSP tax refund, you’re out of pocket $6000 in both cases.

Now when we consider a scenario where your savings grow by a factor of 10, if you’re marginal tax rate stays at 40%, you’ll end up with $60,000 you can spend in both cases. With these two cases as the basis for comparison, we can then go on to look at what happens if your marginal tax rate changes in the future. The rule is simple: if your future marginal tax rate is higher the TFSA will work out better, but if the rate is lower the RRSP will work out better.

Long after you’ve made your choices and have some money in both RRSPs and TFSAs, it’s important to remember that the balance showing on your RRSP will be partly your money and partly government money, but your TFSA balance is entirely your own.

Saturday, November 24, 2012

What Do Big Banks Make on ATM and Debit Fees?

Most of us have some experience with how much the big banks charge us for ATM cash withdrawals and debit transactions. But it’s more difficult to find out what it actually costs the banks to provide these services.

The Financial Consumer Agency of Canada says the cost of withdrawing cash at your own bank’s ATM ranges from $0 to $1.50, and at another bank’s ATM it costs between $1 and $6. In my case, I get charged 60 cents for cash withdrawals at my own bank’s ATM, and the last time I had to use another bank’s ATM I was charged an extra $1.50 for a total of $2.10.

But what does it cost the banks to provide cash withdrawal at ATMs? A partial answer comes from Intrerac’s fees. They say “A single interchange rate of 75 cents per transaction applies to all Interac Cash transactions.” It’s not clear whether this is just for cash withdrawals between banks or for all ATM cash withdrawals. It’s also not clear to me who maintains ATMs and keeps them stocked with cash. Is this part of the service that costs 75 cents per cash withdrawal or is the maintenance and feeding of ATMs an extra cost?

Moving on to debit transactions, banks charge both customers and merchants. But the only information I have about the bank’s costs are another line from the same Interac page: “the Interac Association member fee charged to participating Members for the Interac Debit service is $0.007019 per transaction.” Less than a penny per transaction is definitely much less than the charges merchants see and the account withdrawal charges customers see.

I’m quite good at doing a sensible analysis when I can get useful numbers, but in this case I have more questions than answers about the basic data. If any readers can point me to useful sources of information, I’m interested.

Friday, November 23, 2012

Short Takes: Hot Water Heater Door-Knockers, Stock Picking Games, and more

Preet Banerjee has some more fun with a hot water heater door-knocker in his latest podcast. Watch out for shoe thieves!

Andrew Hallam argues convincingly that well-meaning teachers who have their students play typical stock picking games are actually teaching all the wrong lessons.

My Own Advisor tackles the tricky subject of foreign income reporting to CRA and when you have to file a T1135 form with your income taxes. He runs through a number of scenarios that help explain the rules.

The Blunt Bean Counter lays out the rules for when employment benefits are taxable.

Tom Bradley at Steadyhand responds to a BNN host who asks what investors should do amid all the financial turmoil the world is enduring. Bradley’s answer is that if you have a sound plan that you’ve been following, stick to it. A steady hand indeed.

Canadian Capitalist examines Malcolm Hamilton’s contention that right now saving in a taxable account is futile in the sense that guaranteed investments make a negative after-inflation return. It may be true that sticking with guaranteed investments you will see an erosion of purchasing power, but what alternative is there? If you don’t need the money for a long time, you can choose stocks and bonds to get a positive real return as Canadian Capitalist illustrates. But if, for example, you need the money as a down payment on a house in two years, there is little choice but to accept this eroding purchasing power. You could get full value by blowing all the money right away, but that won’t do much good when it comes time to buy a house.

Big Cajun Man displays something similar to ethical investing by refusing to invest in a company that treated a loved one poorly when employed by the company.

Million Dollar Journey debates the necessity of having an emergency fund. One thing I learned from all the comments is that we all seem to have different definitions of “emergency fund”, and that too many people can’t even imagine becoming unemployed for an extended period of time.

Thursday, November 22, 2012

Following from the Front

Have you ever had the experience of driving a long distance on a mostly deserted highway with some jerk behind you the whole way? I’m not talking about tailgating, but just staying strangely close when there are no other cars around. Can you believe that this has any connection to personal finance? Read on.

I’ve been on the “jerk” side of the deserted highway story several times. But the funny part was that I had my car on cruise control. So, I wasn’t really following. My car has no advanced features where it adjusts speed based on vehicles in front. It’s not plausible that the two cars’ cruise controls were so perfectly synchronized that we were able to stay together for so long. The only reasonable explanation is that the other driver was adjusting his speed to keep me behind. Most likely he was doing this subconsciously.

Sometimes in this situation I speed up temporarily to pass the other car just to break the spell. Slowing down temporarily usually doesn’t work because I later catch up again.

From the point of view of the other driver, some jerk was staying behind him. But if he wanted to see where to lay blame, he should have adjusted his mirror.

Now let’s connect that little story to the personal finances of a hypothetical but all too typical couple, Justin and Sandy. They were married 20 years ago, bought a house together 5 years later, and had 2 kids. When they first got the mortgage, their total debt was about $200,000. Over 15 years, they made a combined total income of $2 million. Their mortgage is smaller now, but their lines of credit and car loans are bigger. Their total debt is still around $200,000.

Is it just an amazing coincidence that Justin and Sandy have made no progress on their debt in 15 years? They’ve each had raises, had a bout of several months of unemployment, and took pay cuts when landing a new job. But through it all their debt has remained nearly constant. Their spending has almost exactly matched their after-tax income.

If you talk to Justin and Sandy about their still too high debt level, they will complain about losing jobs, the cost of braces, and many other outside forces that hurt their finances. But the correlation between their income and their spending is just too strong to be a coincidence. The truth is that they are continuously adjusting their lifestyle to match their income.

Just as the driver in front of me believed that I was matching his speed to stay close, Justin and Sandy believe that outside forces are driving their spending. But, just as it was the driver in front who was matching speed, it is Justin and Sandy who are adjusting their lifestyle to their income. In a sense, they are following from the front.

To make any significant progress with their finances, Justin and Sandy need to do something to control their spending even while their total income is high. Some possibilities are to move to a cheaper home closer to work, own cars that are less expensive to buy and maintain, or eat out less.

If you think fate is doing things to you to keep you from reaching your financial goals, consider the possibility that you’re really just following from the front.

Monday, November 19, 2012

What Causes Mortgage Defaults?

Recently, Rob Carrick interviewed Rick Lunny from the Melrose Management Group to discuss mortgage defaults. Lunny explained that the main reason people default on their mortgage is not rising interest rates, but people losing their jobs.

Lunny said that he had “been involved in studies that go back 30 years, and you see that unemployment is the number one reason for mortgage default.”

Let’s take a look at the history of Canadian interest rates for the past 30 years:

The trend of dropping interest rates should smack you in the face. How could Lunny’s study say much about whether rising interest rates lead to mortgage defaults? Apart from 1988 to 1990, Canadians haven’t had to face much in the way of rising interest rates in the past 30 years.

Keep in mind that it’s not high interest rates that cause your payments to rise. After all, the bank takes into account current interest rates when they decide how much to lend to you. What causes your payments to go up is the increase in interest rates. And we just haven’t had enough sustained interest rate increases over the last 30 years to learn much about their effect on mortgage defaults.

Lunny is no doubt correct that losing a job is a big reason behind defaulting on a mortgage. But his studies don’t tell us much about what will happen in the future if interest rates rise significantly. For all we know, rising mortgage payments due to rising interest rates may become an important cause of mortgage defaults as well.

This illustrates the problems you can get into when you use past data as a model for the future. Obviously, interest rates can’t drop another 14% over the next 30 years. So, our interest rate future is guaranteed to look different from the past 30 years.

Friday, November 16, 2012

Short Takes: Rogers Threatens $2 Million Charge, Fuel Efficiency, and more

Ellen Roseman has a story of Rogers telling one of its customers to pay a bill for $225 or face a charge of $2 million!

My Own Advisor reports that Kia Canada misreported its cars’ fuel efficiency and is planning to pay actual cash to their customers in compensation.

Gail Vaz-Oxlade argues that women need to build up their financial lives independent of their husbands (in a post no longer online), taking into account their unique circumstances such as living longer than men and possibly taking time off from work to have children. This is sensible advice. However, she also says “When a woman and a man divorce, his standard of living most often goes up while hers goes down.” Divorce drives up total living costs: an extra rent, extra furniture, possibly an extra car, etc. Most likely both men and women end up with a lower standard of living, on average. Is it really plausible that on average all the extra living costs and more get shifted to women in a divorce, and men end up better off? I can believe that this happens some of the time, but I also know of cases of men living on just a fraction of their former pay due to hefty support payments for their children and ex-wives. In most cases I suspect that both men and women lose out financially in a divorce.

The Blunt Bean Counter explains how to save on your taxes with tax-loss selling. He also has some thoughts on what to do if you’ve got a large capital loss from previous years.

Money Smarts brings us his best financial tip: take the long-term view.

Retire Happy Blog looks at some key ages in retirement planning from 55 to 71.

Andrew Hallam makes the case for hiring an oddball financial advisor.

Preet Banerjee has a video of himself driving a BMW around a racetrack in the rain. Not all of the passengers stayed calm.

Big cajun Man finds a lot of things to worry about at 2:00 am.

Malcolm Hamilton explains why it is futile to try to safely beat inflation when your savings are outside of a tax shelter.

Thursday, November 15, 2012

My Best Financial Tip

Today, bloggers across Canada are promoting financial literacy by writing about their best financial tip in a campaign organized by Life Insurance Canada. I’m pleased to contribute this post.

I decided to pick a financial tip different from what you’re likely to see elsewhere:

TIP: Don’t look for a financial advisor who can steer your savings around stock market drops because these advisors don’t exist!

Too many people have the wrong expectations of their financial advisors. They get upset when their portfolios drop in value and blame their advisors for not avoiding this loss of money. If the whole stock market or bond market goes down, then your portfolio will almost certainly go down too. If the whole market doesn’t drop, but you lose money anyway, then maybe you have a legitimate beef with your advisor. If you think you already have an advisor who can see stock market plunges coming, either you misunderstood the promises he made, or he misled you.

You may ask, what’s the use of a financial advisor who can’t keep me from losing money? Well, many Canadians take the time to learn simple indexing strategies and invest on their own. Other people who are lucky enough to have good financial advisors get the benefit of someone who chooses a reasonable level of investment risk and who helps them plan for their future financial needs. Unlucky Canadians get a salesman dressed up as a financial advisor who sells expensive products without properly explaining the hidden fees.

The sensible way for most people to invest their savings is with broad diversification and low fees. If you plan to use a financial advisor, look for someone who helps you make a plan, explains costs clearly, and chooses a reasonable level of risk for your situation. If instead you go looking for a hot-shot advisor who promises future riches based on soundly beating the market, you’re likely to be very disappointed.

Wednesday, November 14, 2012

Are Dividends Worth More than Capital Gains?

To buck the trend in most articles titled with a question I’ll actually answer it: no, a dollar of dividends is worth the same as a dollar of capital gains. However, that didn’t stop a commenter, Rob, on a Canadian Couch Potato post from arguing differently. Please note that the Canadian Couch Potato himself was on the correct side of the math on this question, although he had the good sense to spend less time arguing with Rob.

Rob’s argument ran as follows. If you had invested $100 in the UK stock market in 1945, it would have grown to $7401 by 2011 if you lived the good life and spent all the dividends. However, if you had reinvested the dividends, you would have $131,469 by now! The return in this case is 18 times higher than the returns due to capital gains alone. So, this must mean that the dividends must be worth 17 times more than the capital gains.

We could take this a step further and observe that the average compound return in the UK stock market due to capital gains and dividends are 6.7% and 4.5% per year, respectively. Amazingly, even though the return due to capital gains is higher, the dividend return is worth 17 times more. This makes a dollar of dividends worth about 25 times more than a dollar of capital gains!

Of course, all this is nonsense; a dollar is a dollar. There can be differences due to taxation, but if we stick to thinking about tax-advantaged accounts like RRSPs and TFSAs, all dollars of return are equal.

We could just as easily have imagined an investor who gave away enough shares to charity each year to eliminate his capital gains and then reinvested his dividends. In this case, the original $100 would have grown to only $1776. Now we can say that the dividends only produced a return of $1676, but the capital gains and dividends combined produced a return of $131,349. So, the capital gain returns are worth 77 times more than the dividends. On a per-dollar basis, capital gains are worth 52 times more than dividends.

Of course, this line of reasoning is nonsense as well.

At its core, we can simplify the mistake with this logic into the following little story. Justin starts with a 1-inch by 1-inch piece of pizza (one square inch). If he extends it to 20 inches long, then he adds 19 square inches. But if he then extends the width to 10 inches, he adds 180 more square inches. So he reasons that width is more important than length. His friend Jim extends the width first and length second and concludes that length is more important. But, both are mistaken because length and width are equally important in determining area.

The moral of this story: don’t let people with bad math confuse you about investing.

Monday, November 12, 2012

Your Property Taxes May Not be Going Up as Much as You Think

A wave of new property tax assessments has hit Ontario homeowners. The form we receive is a blur of numbers, and it’s not easy to figure out what will happen to your property taxes. In fact, we’re still missing one key piece of information to work out our 2013 property taxes.

My home’s assessment went up 23% from 2008 to 2012. Does this mean my taxes will go up 23%? Nope. Assessments get phased in over 4 years.

My phased in assessment increase for 2013 is 5.7%. Does this mean my taxes will go up 5.7%? Nope. There’s more to it than that.

My form tells me that the average phased-in assessment went up 6.4% in my area. So, my assessment actually went up 0.7% less than the average. Does this mean my property taxes will go down 0.7%? Hahahaha! Property taxes don’t go down.

The average property tax increase has nothing to do with assessments. Each municipality goes through a drawn out political process to decide on a tax increase. It begins with strong talk of a 0% increase. Then the municipality says that to get a 0% increase, they have to cut food programs for starving children, close libraries, and eliminate all arts funding. After the ensuing public outcry, the municipality announces a slightly more than inflation property tax increase.

Suppose that the municipality decides on a 3% tax increase. Then I can expect an increase of about 0.7% less than this, or about 2.3% for 2013. You can use the information on your assessment form to get an idea of what your property tax increase is likely to be. This process has given me reasonably good predictions in the past. Your mileage may vary.

Friday, November 9, 2012

Video of a Debate about Financial Advice in Canada

The Business News Network ran an interesting debate about whether Canada should expect a fiduciary standard from financial advisors. The combatants were tireless advocate for Canadian investors Ken Kivenko (president of Kenmar Associates) and Greg Pollock (president and CEO of Advocis – the Financial Advisors Association of Canada).

A fiduciary standard means making decisions based solely on what’s best for the client. Currently in Canada, most financial advisors must meet a much lower standard that permits them to sell financial products that are suitable for the client from a risk point of view even if the product is very expensive and pays the advisor handsomely. Many investors are surprised to learn that their financial advisors don’t have a fiduciary duty.

My favourite part of the debate was when Pollock said “we’ve been the envy of countries around the world in terms of the way our financial services are regulated.” This attempt to take the good feelings about the strength of Canadian banks and attach them to our financial services industry didn’t go unnoticed. Kivenko correctly pointed out that while our banking system is envied for its strength, this envy doesn’t carry over to Canadian investors who face the highest mutual fund costs in the world.

Pollock made an interesting point about how it makes no sense for order-takers like discount brokerages to take on a fiduciary duty and refuse to sell investments to their clients. However, I don’t think investors expect a fiduciary duty when they choose investments themselves and execute trades online. It’s when an investor receives advice from a financial advisor that it makes sense to expect a fiduciary standard.

The gap that exists right now comes when a salesperson sells financial products to make commissions with little regard for the client’s interests, but the client doesn’t realize the nature of this relationship. It is in these situations that we need to impose a fiduciary standard. A strict order-taker like a discount brokerage is one thing, but as soon as a salesperson suggests a specific investment, clients need a fiduciary standard.

Short Takes: World’s Skinniest House, Rule of 40, and more

Give Me Back My Five Bucks has some cool pictures of the world’s skinniest house.

Jonathan Chevreau interviews Malcolm Hamilton who explains the rule of 40 for mutual fund fees. Hamilton is always worth listening to because he explains his ideas clearly and gets the math right.

Canadian Couch Potato explains why market-beating strategies don’t last.

The Blunt Bean Counter says that worrying about higher marginal tax rates is a weak reason to avoid earning extra income. A much better reason is “I already have enough income,” but not many of us can say this with a straight face.

Big Cajun Man argues that time is an important financial variable. I agree. If you save a little each month, time will turn it into riches. But, if you borrow a little each month, time will bury you.

Where Does All My Money Go? explains the U.S. financial cliff coming in January.

Thursday, November 8, 2012

Combating Wireless Phone Bill Shocks

We’ve all heard horror stories of Canadians getting massive wireless phone bills because they used a service they thought was covered by their plan, but their provider disagrees. Fear of this sort of problem makes some people shut off their phones whenever they travel, particularly in foreign countries or even just close enough to the U.S. border to get picked up by a U.S. tower. I think I have a partial solution to this problem.

No doubt there are situations where a wireless phone user knowingly runs up a multi-thousand dollar bill because he or she is doing something just that important. But most of the time, people running up huge bills would stop whatever they were doing if they knew the costs were so high.

What if your phone were to pop up with a message on the screen saying “you have now incurred $50 in extra charges so far this month” and demanded that you type in some password to continue? If you continued to use extra services, you’d get messages at $100, $150, and so on. High rollers might prefer a threshold higher than $50, and other people might prefer something smaller, but $50 seems like a reasonable default value. Allowing users to change their personal threshold would be useful.

Does something like this already exist? Do wireless network providers make it possible to access billing data in real time so that this function could be performed by an app?

This isn’t a perfect solution in the battle between wireless phone users and the providers who try to extract as much money as possible, but it would be helpful for users in Canada’s not very competitive wireless phone market.

Tuesday, November 6, 2012

How will Today’s Election Affect the Stock Market?

I’m of two minds about today’s U.S. election. On the one hand, voting is an important democratic right and Americans should get out and vote. On the other hand, when my son was young and didn’t want to wear a warm top, I used to placate him by letting him to decide if he wanted to wear a red one or a blue one.

The conventional wisdom is that electing a Republican will boost stocks, and electing a Democrat will sink stocks. There are many people who try to profit from short-term stock moves caused by election results. These people are already taking into account recent polls. So, everything I know about the likely outcome of today’s election is already factored into stock prices. I don’t think there is any easy short-term money on the table.

But what about long-term effects on stock prices? Maybe one of Obama and Romney would be better for business overall. But how can I profit from this? Stocks tend to rise in price faster than bonds. Maybe this gap in expected growth rates will be different depending on who wins the election. But, so what? If the risk premium remains positive, I should have some of my money in stocks no matter who wins the election.

In the end I can’t see any reason to deviate from my current plan to maintain a broadly-diversified low-cost index portfolio. I don’t plan to make any changes immediately before or after the election no matter who wins.

Monday, November 5, 2012

Treat Fixed-Rate Mortgages as a Kind of Insurance

Too many discussions of whether you should go for a fixed-rate or variable-rate mortgage center on trying to predict future interest rates. This is a waste of time. I don’t believe anyone can guess future rates better than the yield curve. Even if someone out there has a better prediction, I couldn’t distinguish him or her from all the other prophets who claim to see the future, but can’t. We should simply view fixed-rate mortgages as a kind of insurance.

To make things a little more concrete, suppose you’re trying to choose between a variable-rate mortgage that starts at 2.75% and a 10-year fixed-rate mortgage at 4%. On a $250,000 mortgage in Canada amortized for 25 years, the monthly payments are $1151 and $1315, respectively. I think of the extra $164 per month (about $20,000 over 10 years) as a premium for insurance against rising interest rates.

It’s tempting to try to guess which mortgage will be cheaper. After all, if interest rates rise to the point where your average variable rate over the 10-year term is more than 4%, you could come out ahead with the fixed rate. But this line of thinking is a waste of time because we just don’t know what will happen to interest rates. It’s better to focus on whether you need the insurance.

All insurance is priced to earn a profit, and fixed-rate mortgages are no different. Most of the time people who buy insurance lose money on the deal, and variable rate mortgages end up cheaper than fixed-rate mortgages most of the time. The purpose of insurance is to protect you from financial losses so great that you couldn’t recover. We don’t buy fire insurance because it is a bargain; we buy it because the financial loss of a burnt-down house is so great for most of us that it’s worth it to over-pay for protection.

Applying this insurance principle to a fixed-rate mortgage, we need to examine the bad outcome we fear. What if variable mortgage rates rise to 10% over the next 5 years? This would drive your monthly payments up to about $2200. Would this break you financially? Would you lose your house because you couldn’t make the payments? If your answer is yes, then you should consider the fixed-rate mortgage. If you have lots of margin in your finances and could tolerate this rise in payments, then a variable rate mortgage may be your best choice.

One thing to keep in mind is that your insurance only lasts for the 10-year mortgage term. After that, you are subject to prevailing mortgage rates. Fortunately, at that point you’d only owe about $178,000 on your mortgage and would likely be in a better position to handle higher rates.

However, most people only consider 5-year terms for their mortgages. The value of this insurance is much more modest because you could be hit with higher rates in only 5 years. Still owing $218,000 after 5 years, would you really be in a much better position to handle higher mortgage rates than you were 2 or 3 years into your mortgage when you had the insurance?

Instead of trying to predict future movements in interest rates, choose between fixed- and variable-rate mortgages by thinking about your ability to handle big jumps in mortgage rates. And be careful about the length of term you choose because the benefit of a fixed term goes away when the term ends.

Friday, November 2, 2012

Short Takes: Defending Stock-Picking, Debt Reduction vs. Weight Reduction, and more

Tom Bradley at Steadyhand makes his case for why it’s possible to win at stock picking. What makes his argument unusual is that he acknowledges the obvious mathematical fact that stock-picking winners must take money away from stock-picking losers. Too many advocates of active investing pretend that we can all somehow be above average. Bradley explains why he thinks he can beat the index without resorting to magical thinking.

Big Cajun Man shows an important difference between how you progress toward debt reduction and weight reduction goals. I found this to be a very interesting insight.

Canadian Couch Potato says that teaching your children important lessons about investing shouldn’t begin with stock-picking.

Preet Banerjee says it’s time to plan your Christmas spending now, but he doesn’t mean to start buying gifts now.

Congratulations to Tim Stobbs at Canadian Dream: Free at 45 who is now mortgage-free at age 34. Not to be competitive, but I paid off my mortgage at age 28. However, I bought a bigger house a couple of years later and got a new mortgage that I paid off at age 35.

Money Smarts was a little annoyed at an article claiming that ETF costs are way higher than just the cost of MERs. He shows that with a more reasonable investment plan, MERs really are the bulk of investing costs.

Million Dollar Journey says that financial independence doesn’t come from paying off debt and having safe investments, but rather from having a huge nest egg. I think he’s right about the independence that comes from having large savings, and right about needing to invest in the stock market rather than just GICs, but I disagree about the debt part. There is nothing wrong with making paying off debts a central part of your financial plan. Unfortunately for financial advisors, if you pay off your debts, you’ll have less money to invest with them.

Freakonomics has an amusing story of free enterprise being discouraged at Bible School.

Tuesday, October 30, 2012

Value Averaging Doesn’t Work

Andrew Hallam wrote a piece in the Globe and Mail that likened enhancing performance in sports by blood doping to an investing method due to Michael Edelson called “value averaging”. Value averaging is simple enough to understand, and if you use the wrong method of evaluating its results, it seems to boost returns. However, the reality is that it doesn’t boost returns, and it drives up your investing costs.

The idea of value averaging is to keep your portfolio increasing at some target rate, regardless of what happens in the market. For example, if you target a 0.5% return each month, if the market goes up more than 0.5%, you sell some of your portfolio; otherwise, you add more cash to buy more assets. No matter what happens in the market, your portfolio rises steadily.

An immediate problem arises: where do I get this cash to pour into my investments when the market drops? The answer is that you’re supposed to keep a side pot of cash that you either put money into or take money from each month. Over time this pot of cash could either dry up or become quite large depending on how the market moves. To deal with this, the strategy calls for a reset every so often (say 3 years) where you reset the cash level to some fixed percentage of your portfolio’s size.

The selling point of value averaging is that you add money when the market is down and pull money out of the market when it’s up; buy low and sell high. This gives an internal rate of return (IRR) that beats the market return and also beats dollar-cost averaging. So far, what’s not to like?

The problem is that the IRR calculation only takes into account the money actually invested in the market. It ignores the cash that you have to keep on the sidelines. However, this cash is real money that you have to keep around earning low returns.

When you factor in the cash, value averaging gets worse returns in most markets than a simple buy-and-hold strategy. It isn’t hard to see why this is true. At any given time, a buy-and-hold investment is fully invested. However, a value averaging investment is only partially invested. The tendency for markets to go up creates an opportunity cost for the cash on the sidelines. This cost exceeds the boost that comes from a higher IRR.

One remedy for this problem might be to start with no cash on the side and plan to borrow as necessary to run the value averaging strategy. However, there is a gap between the best interest rate you can get on your cash and the lowest interest rate you can get when borrowing. This gap serves as a drag on value averaging returns. Another problem with this remedy is the possibility of becoming highly leveraged if markets drop significantly.

If you are interested in a more technical critique of value averaging, read Simon Hayley’s paper Value Averaging and How Dynamic Strategies Bias the IRR and Modified IRR. He concludes “Value averaging does not boost profits, and will in fact suffer substantial dynamic inefficiency. It also imposes additional direct and indirect costs on investors as a result of its unpredictable cashflows. The strategy thus has very little to recommend it.”

With the promise of lower returns and higher trading costs with value averaging, I’ll happily stick to my buy-and-hold approach with occasional rebalancing.

Monday, October 29, 2012

Defending ‘Homemade Dividends’

Dividend investors and indexers often disagree strongly on the relative merits of their investing strategies. Recently, the Dividend Growth Investor argued that homemade dividends produced by selling some stock are not as good as real dividends. However, we can easily show that the core of the disagreement comes down to whether or not dividend stocks have an expectation of higher total returns.

For the purposes of this discussion, let’s compare an indexed portfolio of stocks that pay a 2% dividend to a dividend stock portfolio that pays an average of 4% dividends, both in tax-advantaged accounts. For the investor who wishes to live on 4% of his portfolio each year, his choices are to go with the indexed portfolio and sell 2%1 of his shares each year, or go with the dividend portfolio and live off the 4% dividend.

Dividend Growth Investor argues that “when someone sells a portion of their portfolio, they end up with less [sic] shares.” However, if the two portfolios get the same total return, then the shares in the dividend portfolio will be worth 2% less than the index portfolio shares are worth just prior to the sale of 2% of the index shares. After this sale, the two portfolios will have the same portfolio value.

Dividend Growth Investor goes on to argue that “Sometimes share prices fall or stay flat for extended periods of time, which could spell trouble for these [index] investors.” The implication here is that the index portfolio is shrinking, but the dividend stock portfolio is not. However, this can only be true if the dividend stocks are getting a higher total return. Otherwise, if index stocks are flat, dividend stocks are suffering a 2% capital loss each year.

I could go on, but all of the arguments come down to the same thing: will carefully-selected dividend stocks get higher total returns than the index or not? If the dividend stocks outperform, then the dividend investors are right; otherwise the indexers are right. Unfortunately for the dividend investors, the apparent evidence for long-term dividend stock outperformance has significant survivorship bias. If the indexers are right, then they have the advantage of a slight boost to returns that comes from better diversification.

1 The actual percentages are slightly off these approximate figures due to compounding effects, but I’ll use the round numbers to avoid muddying the waters.

Friday, October 26, 2012

Short Takes: Pitching Leverage to Seniors, Students with Credit Cards, and more

Depth Dynamics has an interesting story of a pitch to financial advisors to get them to promote leveraged investing. They also tell the story of a couple in their 70s who lost money after being talked into using leverage. Thanks to Ken Kivenko for pointing me to this one.

Rob Carrick says that students handle credit cards better than many people think. I wonder, though, whether the various statistics Carrick quotes include the effect of parental help. Some students’ parents pay their credit card bills for them every month. And some parents pay off credit card bills for students who get themselves into debt trouble. This doesn’t always happen, but it happens often enough to skew the statistics to make it look like students handle credit cards better than they really do. You can be sure that banks know that parents are often willing to bail out students with debt problems. This makes students good candidates for credit cards (in the banks’ eyes).

Mr. Money Mustache makes a thoughtful case for why paying someone else to maintain your property and possessions doesn’t make as much sense as you might think.

Jonathan Chevreau reiterates his case for saying “financial independence” rather than “retirement”. He has a good point that the real goal ought to be financial independence. Once this is achieved, we can decide whether or not to work.

The Blunt Bean Counter finds a humorous way to approach the morbid subject of whether your spouse has enough information to properly handle the family finances if you die.

My Own Advisor updates his progress toward his 2012 financial goals. It seems that he’s right on track without adding any new debt.

Big Cajun Man is a man of simple tastes who doesn’t see the need for a bucket list.

Wednesday, October 24, 2012

Investing with My Two Brains

The latest Carrick on Money post declared “my brain is a lame investor” and pointed to a well-written summary of 7 way your brain is making you lose money. Fortunately for me, I feel like I have two brains and only one of them is a lousy investor.

I have one brain that tends to be emotional and makes snap decisions. It’s quite good at deciding whether to zig or zag in a touch football game and helps me pick up tells on opposing poker players. Unfortunately, it stinks at investing. My other brain – the rational one that tries to think everything through and makes deliberate decisions – has turned out to be the better investor.

My years as a stock-picker began during the late 1990s tech boom. Along with almost everyone else, I was overconfident and took wild chances. I did use my rational brain to pore over company reports and accounting statements looking for useful information. However, when it came time to make a trade, it took my emotional brain to ignore the fact that there were almost certainly thousands of people around the globe doing a better job than I was at analyzing the company’s information. My rational brain would have seen the futility of trying to out-trade all these better investors.

In poker I’ve noticed that the bigger the pot, the worse my emotional brain performs. I’ve improved my results simply by taking my time and letting my rational brain work. When it comes to investing, almost all the decisions are for high stakes. I’m far better off making decisions slowly and carefully.

This doesn’t mean that all stock-pickers are acting emotionally. The rational question to ask yourself is whether you are really good enough to trade against the sharks. If you are, then stock-picking can be the rational choice. However, for the vast majority of us, active stock-picking is ignorance or hubris.

Monday, October 22, 2012

MPAC’s Tricky Request for Reconsideration Process

In Ontario, the Municipal Property Assessment Corporation (MPAC) administers the property assessments used to determine property taxes. I just discovered that MPAC’s estimated area of my property is way off. However, the official Request for Reconsideration process is onerous enough that I probably won’t bother to appeal.

My fun began when my latest property assessment arrived in the mail recently. The form contains an “access key” which allows me to look up the data MPAC has about my property at their About My Property web site. This seems quite civilized. It was after poking around on this site for a while that I discovered that MPAC thinks my property is about 24% larger than it really is. My best guess is that this has cost me about $1500 in extra property taxes over the years.

The problem is that my property is not rectangular. The way MPAC estimates the width is sensible, but the estimate of depth is way high.

In a burst of optimism, I started poking around for the forms page and the particular Request for Reconsideration form relevant to me. The form begins by requesting some sensible information to identify me and my property followed by a section allowing me to explain what is wrong with my current assessment. That’s when things went off the rails for me.

The form then asks for all kinds of information about my house and property that have nothing to do with the problem that needs addressing. MPAC would have me running around measuring all the rooms in my house, calculating areas, trying to figure out what “cladding” means, and trying to decide whether the finished part of my basement is 1/2 finished or 3/4 finished.

The optimistic side of me says that MPAC will see that the property area is wrong and drop my assessment enough to save me about $125 per year. My pessimistic side says that MPAC will likely stand by their method of estimating area with some rock-solid logic like “that’s the way we do it,” and they’ll use the random answers I give to the questions I didn’t understand properly to raise my taxes.

Based on a guess of the likelihood of different outcomes if I appeal, I think my statistical savings are small, and all the effort isn’t worth it. I’ll just keep paying taxes on a big chunk of lawn that doesn’t actually exist. Congratulations to MPAC for cleverly coupling a Request for Reconsideration with an extensive request for information that is mostly irrelevant to the problem the homeowner has identified. This must cut way down on complaints; it worked on me.

Friday, October 19, 2012

Short Takes: Massive Phone Bill, How Indexing Affects Professional Money Managers, and more

What’s a factor of 100 trillion between friends? A woman in France received a phone bill that had an extra 14 zeros added to it!

Larry Swedroe examines the claim that index investing increases correlations between stocks making “it harder for active managers to harvest the winners” and argues that it isn’t true. Even if it were true, why would I abandon indexing to lose money picking my own stocks just so some professional money manager can have a better chance to pick winners?

SquawkFox has some thoughts on how to get around the upcoming Globe and Mail paywall.

The Blunt Bean Counter put together a collection of punitive income tax provisions. Don’t get caught by any of these.

Rob Carrick says that “Asking a senior to co-sign or guarantee a loan is a form of elder abuse.”

Preet Banerjee says “I’ve always thought that if you really knew what you needed to know to pick the right financial adviser, you probably wouldn’t need one.” He goes on to explain what we need to know about the various professional designations.

Big Cajun Man has a list of ten things he’s actually said that have saved him money while negotiating a price.

Retire Happy Blog asks whether Freedom 35 is possible. I sort of did it at age 37, but then I gave away a lot of money. I figure that with conservative assumptions I’ve got enough money to get me into my mid-70’s. That’s why I’m back to work again. I didn’t think it was smart to wait until I’m old.

Wednesday, October 17, 2012

Fun with Studies of the Value of Financial Advisors

Do you think a financial advisor would rather take on and keep a client who already has a lot of money or a client with little savings? The answer is obvious, but this fact was missed by University of Montreal researchers who conducted the Cirano study of the value of financial advisors.

The researchers collected survey data from 3610 working-age Canadian households. They asked many questions related to income, savings, and financial advisors. Among their conclusions was the following:
“Controlling for multiple factors ... Those with 15 years or more [with a financial advisor] will have 173% more assets than if they did not have a financial advisor.”
The study’s authors offer the following thoughts on this conclusion:
“This amount is too large to be explained simply by better stock picking. One highly plausible explanation of this finding comes from the greater savings that is associated with having a financial advisor and other appropriate advice.”
Despite the fact that this 173% figure seems like conclusive proof that advisors give great value in helping their clients save and grow their money, I think there is a better explanation related to the question from the opening paragraph.

I went through the survey questions in Appendix B of the report to confirm that the researchers didn’t ask any questions about how much money advised people had before they took on an advisor or how much money non-advised people had in the past. So, previous wealth could not be part of the controlling factors. At least part of this 173% edge for advised people must come from advisors seeking out clients who already have significant assets.

Another problem is that an advisor-client relationship is more likely to sour if the client fails to save much. So, looking at people who have had an advisor for 15 years will create a large survivorship bias when you try to measure whether an advisor helps people save more money. It could be that advisors help people save more money, but it could also be that advisors dump clients who don’t save enough money.

When it comes to controversial research, it’s common for critics to focus on small problems and blow them out of proportion to unfairly discredit the work. However, in this case, the bias caused by the need for advisors to find clients with significant assets (and avoid those with little money) is potentially large enough to completely swamp the finding of a 173% edge in savings for people working with an advisor for 15 or more years. This paper adds next to nothing to the question of whether financial advisors help their clients.

Tuesday, October 16, 2012

A Mathematician Plays the Stock Market

In the late 1990s, it seemed like everyone was a stock market expert. This was fueled by the fact that it didn’t matter much which tech stock you bought because almost all of them went up. Even mathematician John Allen Paulos got caught up in the hype with WorldCom stock. In his book, A Mathematician Plays the Stock Market, Paulos weaves a humble story of his investing folly along with many understandable mathematical lessons about investing.

Like many “investors” at that time, Paulos abandoned good risk management and “invested heavily in WorldCom, as did family and friends at [his] suggestion.” He even “emailed Bernie Ebbers, then the CEO, in early February 2002 suggesting that the company was not effectively stating its case and quixotically offering to help by writing copy.” Of course, the world later found out that the real problem was “creative accounting” rather than poor marketing.

On index investing, the author makes an interesting point that despite the fact that it “generally beats the more expensive, managed funds,” investing in an index fund has a cost: “One must give up the fantasy of a perspicacious gunslinger/investor outwitting the market.”

On online trading, Paulos said “The ease with which I clicked on simple icons to buy and sell ... was always a little frightening, and I sometimes felt as if there were a loaded gun on my desk.”

There were a few not so good parts of the book, but they didn’t take away from my enjoyment of it. The author claims that the S&P 500 index suffers from survivorship bias, but I don’t think this is true. In a couple of places one of the numbers in the Fibonacci sequence is wrong. In a numerical example about compounding, one of the amounts is off by a dollar.

Overall, I thoroughly enjoyed this book and recommend it to anyone who would like clear explanations of investing matters without too much mathematical jargon, or anyone who would enjoy reading about a smart guy admitting to all of the dumb things he did while trying to get rich in the stock market.