Friday, March 30, 2012

Short Takes: Budget Edition

National Post has a good summary of the latest federal budget. They include actual numbers to give the changes some meaning. Those who want more detail can check out the actual budget document.

The Blunt Bean Counter breaks down the Ontario budget measures that affect personal and corporate income taxes.

Retire Happy Blog compares active and passive investing and looks at the long-term effects of fund fees.

Where Does All My Money Go? has a cool interactive motion chart to illustrate investing returns since 1970.

Big Cajun Man has an amusing strategy to cut down on wedding costs for his daughters.

My Own Advisor shares his strategy for paying himself first to build his emergency savings.

Million Dollar Journey runs through the costs of owning a pet. You can put me in the camp of people who think that the costs are nuts. People are free to spend their money as they wish, but you won’t catch me spending thousands on a cat or dog. Many years ago I read an analysis that claimed that conglomerates were buying up mom-and-pop vet operations to extract more money from pet owners. It’s amazing how successful they have been with this goal.

Thursday, March 29, 2012

Comparing My Personal Yearly Returns to a Benchmark

Stock pickers should work out their personal investing returns and compare them to an appropriate benchmark. Otherwise you have no idea how well you’re performing. On the other hand, ignorance is bliss, except for the part where you have to keep working past retirement age.

I’ve evaluated my past performance in many ways, but rarely have I done it on a year-to-year basis for my entire portfolio. After much fighting with a spreadsheet and my old account statements, I have personal return figures for each year from 1995 to 2011. These returns take into account all my investments, capital gains, dividends, incomes taxes, mutual fund redemption fees, transfer fees, margin interest, administrative fees, trading costs, and other account fees.

A particular challenge was how to handle employee stock options. I decided to treat them as though they didn’t exist until the first day I was permitted to exercise them. On this day I recorded a purchase equal to the current value of the options. So, it was as though I bought the options on that day. Any gains that occurred before this day would not count toward my investing prowess.

Return figures don’t have much meaning unless we compare them to something. For this I used index returns from a Libra Investments spreadsheet. Each year I figured out what percentages of my investments were in each of Canadian bonds, Canadian stocks, U.S. stocks, and foreign stocks. I used these weightings to compute a blend of the Libra figures for long-term Canadian Bonds, the TSX Composite, the (U.S.) Wilshire 5000, and the MSCI EAFE. This blended figure is then my benchmark for that year.

And the results are (drum roll, please) …


Obviously, the first thing that leaps out is the wild return from 1999. This was the result of an insane bet with almost everything I had on one stock. I was extremely fortunate to have this work out well for me. I would never do anything this crazy again.

1995 to 1998

This is roughly the period of time where I used a couple of financial advisors. The results actually look pretty good until you remove the effect of some split corporations that I owned for several months in 1998. These were similar to leveraged ETFs that invested in Bell Canada Enterprises (BCE) and telecom companies. These bets worked out very well. Once you remove their gains from the 1998 results, the advisor returns trailed the benchmark. Overall, my advisors lost to the benchmark by about 2% per year.

1999 to 2009

This is roughly the period where I was a stock-picker. 1999 was spectacular, but after that, my results lagged the benchmark by a little over 1% per year, on average. For an analysis that isolates my stock-picking results excluding index ETFs and advisor investments, see this earlier post.


I started buying nontrivial amounts of index ETFs in 2009 and the percentage of my portfolio that was indexed increased steadily to over 90% today (my only individual stock now is Berkshire Hathaway). 2010 was particularly painful for my stock-picking results. The part of my portfolio invested in indexes had a return of 22.6%, but once you include my fabulous picks, my return for 2010 was 12.9%. Ouch.


The compound average returns from 1995 to 2011 (inclusive) were as follows.

My returns: 9.6%
Benchmark: 5.5%

So, I outperformed by 4.1% per year. However, I can show that this was blind luck. If the stock I made the huge bet on had traded during 1999 at the same price it dropped to by the end of 2000, my compound average return would have been only 1.2%, and I would have lagged the benchmark by 4.3% per year. Essentially, I rolled the dice and won big.


For several years I had some fun feeling like a big wheel talking about which stocks I liked and didn’t like, but now I’m happy to throw away all my old annual reports and focus on other things. I believe that switching to index investing will make me richer in the future. At some point I expect that I’ll sell even my beloved Berkshire Hathaway stock, but not just yet.

Wednesday, March 28, 2012

A Theory of What Drives Typical Investors

While thinking about the curious tendency for investors to feel more comfortable owning stocks when they are expensive, an idea occurred to me. Perhaps our mental arithmetic is calculating the wrong things. To explain the idea, I need to make a brief detour into sports.

Sports fans are familiar with the idea of “stealing a game.” The home team jumps out to an early lead and holds that lead for almost the whole game. At the end, the visitors finally catch up and take a small lead just as the game ends. Most fans feel that the home team somehow deserved to win because they held the lead so long, and the visitors stole the game.

This feeling is completely irrational, but it is prevalent anyway. The visiting team scored more total points, so they deserved to win. Why should points scored late in a game be worth less than points scored early in the game?

One model of how fans feel about a game is to take a snapshot of the score difference (with a negative value if the visitors lead) every minute and average these differences over the whole game. Then the team that seems to deserve to win is determined by whether this average is positive or negative.

This model gives more value to points scored early in the game, which is ironic considering that players who score points late in a game are judged to be more heroic. No fan would agree to an explicit statement that early points are worth more, but their gut feel about who deserves to win a game seems to implicitly value early points more.

What if this type of gut feel carries over to investing? Suppose that for a given year, a stock index started at 10,000, took a bone-rattling drop to 6000 by mid-year, and then recovered to 11,000 by year-end. An investor who held an ETF based on this index from the beginning of the year to the end with no trading made a 10% return. Ordinarily, a 10% return with low inflation is a fairly good year, but it may not feel this way.

Investors would have been beside themselves with worry over the excruciating 40% drop. If their gut feel tends to be based on the average price over the year as an emotional measure of how the year went, it would feel like they suffered big losses. The end of year price recovery more than compensates for the loss in reality, but perhaps only partially compensates for the emotional loss because the average index level for the year was around 8000 or so.

Consider a market timer who sold on the way down at 8000, and bought back in as the index rose again to 9000. If he started with $90,000, then he owned ETFs worth 9 times the index level. After the index dropped to 8000, he cashed out $72,000. When the index bottomed and then recovered back to 9000, he bought back in with his $72,000 (and owned 8 times the index level). The index finished at 11,000 leaving the market timer with $88,000 for a $2000 loss (2.2%) on the year.

The market timer’s return is obviously a lot worse than the buy-and-hold investor’s return of 10%, but the emotional model makes a different calculation. The market timer was out of stocks while the market was at its worst going from 8000 down to 6000 and back up to 9000. He avoided the worst of the pain and sleepless nights. The market timer feels better than the buy-and-hold investor even though his results are significantly worse.

So, the conjecture is that investors’ feelings about investments are affected by the average value of their holdings over a period of time. I don’t know if this idea has any validity, but it does seem to explain some peculiar investor behaviour.

Tuesday, March 27, 2012

Optimizing the Timing of RRSP Contributions

Most people who make RRSP contributions for the 2012 tax year will do so either with periodic payments throughout 2012 or at the last minute in February 2013. There are those who suggest that people should make their 2012 contributions right now to take maximum advantage of deferred taxation. I have my own approach, but I don’t necessarily suggest that others should follow my lead.

I agree with those who say that last-minute contributions are less than optimal. At the same time, I don’t like making a contribution until I’m certain that I’ll use the deduction the next time I file my income taxes. Consider the following potential sequence of events.

- I make a large RRSP contribution today.
- Tomorrow my boss decides he’s tired of me and fires me.
- I decide to drift into semi-retirement and never make a large income in any one year again.

RRSP contributions work best when they are deducted against income that is taxed at a high marginal rate. I haven’t made enough money yet this year to get into the higher tax rates. And I prefer not to make a contribution just assuming that I will have a high income in some future year.

So, my strategy is to wait until I’ve earned enough this year that I’d want to make an RRSP contribution even if I never made another cent until next year. The result is that I tend to make my RRSP contributions in the spring or summer. Then I fill out a T1213 form to get my payroll taxes lowered for the rest of the year.

Much of my financial decision-making takes into account very negative possible outcomes. Some may say that it’s not worth delaying an RRSP contribution for fear of being fired, but I consider a few-month delay to be a very minor cost to protect against the case where I lose my job after I make an RRSP contribution I wish I hadn’t made.

This line of reasoning works for me in my circumstances, but I doubt that it applies to many other people.

Monday, March 26, 2012

What Should Investors Wish for?

You’ve just plowed some hard-earned money into the stock market. You watch the second-by-second price changes of your latest purchase. Each little increase validates your latest investment decision, and every time the price drops a little you feel some of your life energy drain away. But once you get some control over your emotions, what should you really be hoping for? Many people offer simple answers, but the real answer is a little more subtle.

If you are entering retirement and will be selling stocks in the near future, it makes sense to want higher prices. But if you plan to be a net buyer of stocks over the next few years, you should actually be hoping for lower stock prices. However, the reason why stock prices are rising or falling is important for both buyers and sellers.

Broadly speaking, stock prices consist of two components:

1. A value based on long-term future prospects. This is sometimes called “intrinsic value.” Unfortunately, we cannot know the intrinsic value with certainty. Generally, the best guess is the current stock price.

2. A premium or discount based on such current market conditions as interest rates, levels of fear and greed, political instability, etc.

Anyone who owns stocks should be hoping for an increase in intrinsic value. Rising profitability and better future prospects for the businesses you own is a good thing whether you are planning to buy more or sell in the near future.

It is the second component of stock prices where buyers and sellers should differ in their hopes. Those who expect to be buying more stock should be hoping that fears lead to stocks being priced at ever-greater discounts to their intrinsic value. Sellers should be hoping for optimism that allows them to sell at ever-higher premiums to intrinsic value.

So, everyone who is invested in stocks should be hoping that our economy ticks along strongly and that businesses become stronger and more profitable. But buyers should be hoping that most people don’t recognize this strengthening of businesses. Buyers should want unwarranted pessimism about stocks. However, we should expect most investors to cheer rising markets whether this is in their best interests or not.

Friday, March 23, 2012

Short Takes: Conviction for Selling an Indexed Annuity and more

An insurance agent was convicted of felony-theft for selling a complex market-linked (indexed) annuity to an 83-year-old woman who seemed to show signs of dementia. Perhaps the test for dementia should be whether you’d be willing to buy one of these market-linked annuities where the commission to the selling agent can be up to 12% of the invested lump-sum or even higher.

The Motley Fool says “Ignore the experts. Index funds are for chumps.” The article writer, Rich Smith, demonstrated 20/20 hindsight in his reasoning, and he forgot to include “buy our investing newsletters” in the article’s title.

Canadian Mortgage Trends reports that ING is ending its business of mortgages that require no income confirmation. Apparently ING will still offer mortgages where people state their income and are taken at their word.

Retire Happy Blog takes a look at the math of indexed annuities. The term “indexed annuity” can mean many things. In some cases it means an annuity linked to equities or to the consumer price index (CPI). In this case, it means an annuity whose monthly payments rise by a fixed percentage each year.

The Blunt Bean Counter covered 3 potentially costly topics: (1) making sure you get the right kind of electronic receipt when making a charitable donation online, (2) income tax refunds that low income people come to expect won’t be coming this year, and (3) TFSA audits.

Big Cajun Man has a good rant about all the paperwork involved with his RESPs.

Money Smarts shows how to find a lost retirement account and actually does the work to find a reader’s lost account.

Million Dollar Journey breaks down the numbers on revenues and profits for a Tim Hortons franchise.

My Own Advisor paid for some disappointing plumbing work and then discovered that he could fix the problem himself.

Thursday, March 22, 2012

Getting Tax Refunds Right Away

Because I was expecting a tax refund this year, I’ve already filed and received my refund. The delay from filing electronically to having the refund deposited in my bank account was only 9 days. What does this say about the value of “instant cashback” from tax preparers?

To begin with, thanks to CRA for the fast turnaround. I’ve had some challenges in dealing with CRA, but this year has been a breeze (so far).

To those who would point out that I should arrange my finances so that I don’t have a tax refund, I say, “you’re right,” but events conspired against me this year.

On to the value of “instant cashback.” H&R Block offers to give you your tax refund immediately for a fee of 15% on the first $300 and 5% of the rest. This would be a steep price to pay to get your money 9 days sooner. If I had used this option, my implied interest rate would have been (366/9)*5% = 203% per year (based on fictitious simple interest). Compounded out, this is a whopping 627% per year.

I realize that many people need help with their taxes and some have difficulty getting bank accounts or a reliable place to receive mail to get their refunds from CRA. But there must be a better solution than paying such a high price to get money right away. I’d be interested to know what efforts CRA is making to give people an option other than giving away 5% of their refunds.

Wednesday, March 21, 2012

Asset Allocation vs. Consistency

Investors who embrace passive investing often spend a lot of time agonizing over their asset allocation percentages. I used to be no different. However, I now think that sticking to a strategy may be more important than the percentages.

When researchers do back-testing of passive investment returns based on fixed asset allocation percentages, a key assumption is that investors would actually stick to these percentages. However, this is more difficult than it seems.

The truth is that many so-called passive investors reduce their allocations to stocks right after a stock crash and increase it again after stock prices soar. Allocation percentages will naturally rise and fall as stock prices move, but many investors go beyond failing to rebalance; they sell at low prices out of fear and buy back at higher prices. This is disastrous for long-term returns.

Unless you have a far-out plan like leveraging yourself to the eyeballs and dividing your money equally among junior mining stocks, Greek bonds, and hog futures, I think that the ability to stick to a plan is more important than using the perfect asset allocation percentages.

People discuss whether they should have 15% or 20% in an international stock index, but they rarely think about whether they’ll be able to hold on (or even rebalance) through a stock market crash.

Tuesday, March 20, 2012

Mortgage-GIC Arbitrage

Recent musings at Blessed by the Potato about BMO’s 2.99% closed 5-year mortgage offering made me wonder about the possibility of running an arbitrage with a mortgage and a GIC.

Outlook Financial offers a 5-year GIC at 3.10%. It would seem that if you owned your home outright you could take out a mortgage, put the proceeds in a GIC, and make a free 0.11% per year for 5 years. On a $250,000 mortgage, this would be a total of about $1375. This won’t make you rich, but it’s not trivial.

There are a number of potential problems here. For one, the fine print on the BMO web page includes “If we require you to obtain an appraisal, the appraisal fee would increase your APR.” So, you may not be able to get 2.99%.

Another potential problem is hidden compounding assumptions. In Canada, most mortgage rates assume semi-annual compounding. This means that 2.99% is really 1.495% every 6 months. This compounds out to 3.012% per year. I was once offered a variable mortgage by BMO where the rate assumed monthly compounding. If that applied here, the compounded rate would be 3.031%. It could be that Outlook Financial’s GIC rates have built in compounding as well. In the end, I’m not sure what actual arbitrage spread is available.

A third potential problem is insolvency. Outlook Financial is backed by the Deposit Guarantee Corporation of Manitoba (DGCM) and not the Canada Deposit Insurance Corporation (CDIC). At a 0.11% spread, if the odds of losing your GIC money within 5 years are more than 1 in 900, this arbitrage is definitely not worth it. How much lower the odds have to be for this arbitrage to makes sense is a personal choice.

The potential gains aren’t enough to entice me to try this arbitrage, but it makes me think.

Monday, March 19, 2012

Messing Up Good Financial Advice

Wealthy Boomer quoted the BMO Retirement Institute concerning some sound retirement advice about debt. Reading through the very sensible advice, it occurred to me that there are many ways to mess it up as I’ll show with some questions and answers.

Canadians’ “priority should be to retire free of debt, including a home mortgage.”

Q: Does this mean that as long as I am debt-free I’ll be fine in retirement?

No. Becoming debt-free is an important start. Then you have to build some savings for retirement in the form of a pension or your own savings.

“A paid-up home is the foundation of financial independence”

Q: Does this mean that I should buy the biggest home the bank will let me buy?

No. If you are going to buy a home, you shouldn’t over-stretch your budget. Think about what home you need rather than the biggest you can afford.

Q: Does this mean that I have to own a home to have a decent retirement?

No. Choosing to rent can be a sensible choice, but you should be planning to build even more retirement savings to cover rent during retirement. Homeowners have the option to sell a home and use the proceeds to pay rent. Renters need other savings to pay rent during retirement.

“If you’re paying 5% interest on a mortgage of $400,000, just by moving from a 30-year amortization to a 25-year one can save $70,000 in interest over the life of the mortgage.”

Q: Will a shorter amortization period guarantee me a comfortable retirement?

No. Many people build up lines of credit at the same time as they pay off a mortgage. In effect, they are saving nothing at all. The main value of a shorter amortization period is forced savings. But this doesn’t work if it doesn’t cause you to spend less. The goal is reduced spending, not just paying off the mortgage early. In truth, when we properly account for inflation, the savings from the shorter amortization period are much less than $70,000 (but still substantial). Paying less interest is good, but the forced savings is more important.

In the end, you can’t just focus on one area of personal finance and ignore other areas. You have to consider your finances as a whole to see whether you are headed to a comfortable retirement or not. No matter how good the advice is in a blog post, it is always possible to mess it up if you’re determined to live beyond your means.

Friday, March 16, 2012

Short Takes: Muppet Clients and more

An executive director at Goldman Sachs leaves the firm where he has “seen five different managing directors refer to their own clients as ‘muppets’.” He paints a picture of a company focused on finding ways to shift clients’ assets into their own pockets.

Retire Happy Blog makes a good point that you have to look at the numbers to make big financial decisions like purchasing an annuity.

Young and Thrifty makes an interesting point that teachers may have difficulty teaching financial literacy to students because their high pay, job security, and guaranteed pensions give them little reason to care about many personal finance issues. There was also discussion of the difficulty of attracting qualified math teachers. Of course, the private sector would solve this problem trivially by offering math teachers more pay than other teachers. I’d love to watch someone suggest this in a teacher union meeting.

Big Cajun Man isn’t too happy with those who say that civil servants get free gold-plated pensions. He’s right that pensions aren’t completely free for civil servants. But they are mostly free and are entirely gold-plated.

Canadian Couch Potato posted a spreadsheet for tracking your asset allocation across multiple accounts.

Where Does All My Money Go? has a cool interactive graph that illustrates European government debts.

Thursday, March 15, 2012

Lifecycle Investing – a Leveraged Strategy

In the book Lifecycle Investing, authors Ian Ayres and Barry Nalebuff propose an investing strategy for diversifying across time that involves all-stock investing with 2:1 leverage while you are young. Many readers would be tempted to quickly dismiss this idea as crazy, but the authors are not crazy and they do a good job of answering (almost) all objections.

Common advice is to think about all of your savings together as a single portfolio. Even if you have multiple accounts, your focus should be on having a sensible overall asset allocation; the allocation within any one account is less important. Ayres and Nalebuff take this a step further to say that you should take into account future savings as well.

So, if you are destined to save $200,000 over the course of your lifetime, and a 50/50 split between stocks and bonds suits you, then ideally you should have $100,000 worth of exposure to stocks and $100,000 exposure to bonds for your entire life. If we treat your future savings as a kind of bond, then your focus should be on maintaining $100,000 exposure to stocks.

The problem is that while you are young and have modest savings, you don’t even have $100,000 in savings. The authors’ answer to this is leverage. However, they recommend limiting the leverage to 2:1 using margin at a brokerage or using deep-in-the-money call options. The authors caution that the interest rate (or implied interest rate) must be low for this strategy to make sense.

By limiting leverage to 2:1, you wouldn’t be achieving $100,000 of exposure to stocks for your whole life, but it would be closer than any other commonly-advised investing strategy. With this approach, your investing life has 3 phases: (1) 2:1 leverage until stock exposure reaches the right level, (2) gradual deleveraging, but still owning no bonds until your portfolio holds more than you need exposed to stocks, and (3) holding a mix of stocks and bonds.

The authors perform many simulations comparing this strategy to more common strategies showing that the lifecycle approach has lower volatility and higher returns due to its superior diversification across time. This is true even when the asset allocations are adjusted so that both approaches have the same overall stock exposure.

The authors give some practical information about how to follow their advice using margin or stock options. They also show how to calculate the implied interest rate on borrowing when using stock options.


1. Future savings are more stock-like than the authors suggest.

Although the authors point out that if your income is heavily tied to the stock market then early leverage isn’t for you, they portray future savings for most people as more or less bond-like. It is easy for someone of baby boomer age to look back and think that their life’s path was more or less destined to happen. But this is just 20/20 hindsight. A 25-year old can’t know that he or she will have stable employment and be able to save money steadily.

Back in 1990, how many people predicted the demise of Nortel? Yet tens of thousands of people were thrown out of work. Only a tiny fraction quickly found new jobs at the same pay. A much more typical scenario was a 2-year search ending with a new job paying 75% of what Nortel paid.

The authors address this objection partially saying that while total lifetime savings may be uncertain when investors first start out, even conservative estimates mean that 2:1 leverage makes sense to start. As investors age, their lifetime saving picture becomes more clear and it becomes easier to decide when to move to the second and third investing phases. In my opinion, the future is more uncertain than the authors portray it to be.

2. Life events drive many people to spend some or all of their retirement savings before they reach retirement age.

This is the most serious objection. Continuing with the Nortel example, thousands lost their jobs at the same time that stock prices crashed. If these people had been lifecycle investing, their savings would have been decimated at the very time that they needed to withdraw some of it to live on. In effect, lifecycle investing would have forced them to sell almost all of their stocks when prices were lowest.

The authors could counter that lifecycle investing is not suitable for people in volatile careers. However, viewed through the eyes of people in their 20s, almost all future career paths are volatile, even if they don’t realize it. Few Nortel employees in the 1990s would have believed what was waiting for them.

3. People have proven that they cannot handle huge drops in their portfolios.

Most experts advise people to have some bonds in their portfolios to moderate big drops in stock prices. This may be bad for long-term returns, but it stops some people from panicking when stock markets crash.

I recognize that some investors are more able to handle volatility than others, but asking a young person to stay the course in lifecycle investing can be a tall order. Imagine that a young person struggles to save $20,000 and watches it drop to $8000 because of 2:1 leverage and a 30% drop in stock prices. How many people could remain rational in such circumstances? Far too many would sell everything and swear off stocks for life.


The authors’ contention that investors should include a time component in their thinking about diversification makes sense. However, I think Ayres and Nalebuff vastly understate uncertainty about the future. I’m not sure whether this objection is fatal to lifecycle investing. I’d like to see the authors include in their simulations the possibility of having negative savings due to job loss at the same time as the stock market crashes. Until they address this possibility adequately, I can’t recommend that young people follow their lifecycle investing plan.

Wednesday, March 14, 2012

The Dangers of Some Income Funds

The dream of many people as they approach retirement age is to derive a safe and steady monthly income from their savings. One fund that seems to fit the bill is the popular BMO Monthly Income Fund that holds nearly $5 billion. However, investors may be in for a nasty surprise.

Let’s start with the positives. This fund has a very nice looking performance chart. Apart from the blip around the end of 2008, it has been on a steady uphill climb. Another great thing is that it has paid a steady monthly distribution of 6 cents per unit per month since the beginning of 2002.

So, what’s not to like? Many people would be surprised to learn that the unit price for this fund has dropped from $9.63 in January 2002 to $7.65 on 2012 March 8. How is this possible? What happened to the nice chart that mostly went up? Well, charts like this assume that distributions are reinvested. If you spend the monthly income, your remaining money does not follow this nice chart. I wonder how many investors mentally double-count the distributions.

What’s worse is that there has been a total of 24% inflation since January of 2002. Overall, the purchasing power of an investment in 2002 has dropped 36%. With the fund yield now at 9.4%, if the distributions stay the same, it is all but certain that investors’ principal will keep dropping at an ever increasing pace. The alternative is to reduce the monthly distributions. Either outcome would be an unwelcome shock to naive investors.

Even though this fund has a respectable 10-year return of 5.58% per year, the monthly distributions have been more than the returns. It is reasonable for people to dip into their principal as they approach end of life, but this should be carefully planned. Naive investors who use this fund from too young an age without understanding the erosion of principal may be in for a shock.

Tuesday, March 13, 2012

Portfolio Rebalancing Based on Expected Profit and Trading Costs

Please see the updated post on this subject that computes better thresholds in certain cases.

The idea of rebalancing a portfolio to maintain target asset allocation percentages is simple in theory, but tricky in practice. It is not obvious how far asset class percentages should be away from their targets before it makes sense to rebalance. I have developed a scheme that I use myself that I fully automated in a spreadsheet. Instead of obsessing over my portfolio’s returns, I can just check whether one cell is red to indicate that I need to rebalance.

Investors should use any new savings or withdrawals they make as opportunities to rebalance by buying low asset classes or selling high ones. However, as a portfolio grows, rebalancing with new savings and withdrawals is unlikely to be enough to maintain balance when asset classes have big swings.

Common advice is to rebalance a portfolio on a fixed schedule, such as yearly. This has the advantage of allowing investors to avoid obsessing over their portfolios all the time, but has the disadvantage of missing potentially profitable opportunities to rebalance. Computing thresholds automatically in a spreadsheet permits me to check one cell in the spreadsheet for a glowing red “rebalance” once or twice per week without having to look at anything else. This gives me the advantages of threshold rebalancing without the disadvantages.

When choosing rebalancing thresholds, most experts advise investors to either use percentage thresholds or dollar amount thresholds. For example, you might rebalance whenever you’re off target by more than 5%, or alternatively by more than $2000. However, these approaches don’t work for all portfolio sizes. Percentage thresholds lead to pointless rebalancing in small portfolios, and dollar amount thresholds lead to hourly trading in very large portfolios. We need something between these two approaches.

Computing Thresholds

When asset class A rises relative to asset class B, and then A drops back down again to the original level relative to B, rebalancing produces a profit over just holding. I compute rebalancing thresholds based on the idea that the expected profit from rebalancing should be 20 times the ETF trading costs.

All the mathematical details of how I compute rebalancing thresholds are in a 6-page paper “Portfolio Rebalancing Strategy”. I’ll just give the results here.

The spreadsheet starts by computing the following quantities for each ETF:

m – Current portfolio total value times the target allocation percentage. This is the target dollar amount for this ETF.
s – Bid-ask spread divided by the ETF share price.

Other parameters are

c – Trading commission.
f – Desired ratio of trading costs to expected profits. I use 0.05 so that the expected profits from rebalancing are 20 times the trading costs.

The dollar amount threshold for rebalancing then works out to the following formula which may seem a little intimidating, but it only has to go into a spreadsheet once.

t = [m/(2f)] * [s + sqrt(s*s + 8*f*c/m)].

So, it makes sense to rebalance an asset class if its dollar level is below m-t or above m+t. As long as there are at least two asset classes far enough out of balance (with at least one too high and at least one too low), it makes sense to rebalance.

Currency Conversion

When holding some ETFs denominated in Canadian dollars and others in U.S. dollars, rebalancing may involve currency conversion, which can be expensive. To deal with this, I actually think of the Canadian and U.S. portfolios as separate portfolios with their own asset allocations. Then I think of the sub-portfolios as asset classes in a meta-portfolio that has its own asset allocation.

So, I do the same calculations on the meta-portfolio using target allocation to each currency. An important difference is that the meta-portfolio has higher trading costs than the sub-portfolios have. When using the idea of converting currency by buying and selling a stock that trades in both Canadian and U.S. dollars, rebalancing requires at least twice as many trades, and the total spreads have to include the spreads on trading the inter-listed stock.

So, instead of c=$10 for regular rebalancing, I use c=$20 for currency rebalancing, and instead of a value close to s=0.0005 (2-cent spread on a $40 ETF), I use s=0.002 for rebalancing with the ETF DLR because the spreads are about 2 cents on a DLR price of about $10. The result is that rebalancing between currencies happens less often than rebalancing in the sub-portfolios.


It took me a while to work all this out, but now I don’t have to pay much attention to my portfolio. When I have some money to add, I buy the asset class that my spreadsheet says is furthest below its allocation, and I periodically check one of the cells for the word “rebalance” glowing in red. Only when I see red do I have to investigate further and make some rebalancing trades.

My own spreadsheet is too specific to my situation, but if there is interest I may put together a generic spreadsheet that captures the ideas here.

Monday, March 12, 2012

Real Estate Strategy: Low-ball Pricing to Create Bidding War

A guest post at Where Does All My Money Go? described a strategy for selling your home where you offer a low price in an attempt to create a bidding war. This type of strategy may or may not help the homeowner get a better price, but it will definitely help the real estate agent.

In a nutshell, the strategy is to price a home at the bottom end of a reasonable price range and advise buyers that all offers will be reviewed on a particular day less than a week away. The hope is to generate a lot of interest quickly and create a bidding war that takes the price up to the top end of the price range. Note that this is likely to create a fast sale.

Real estate agents benefit most from fast sales rather than higher selling prices. Higher selling prices increase commissions a little, but faster sales lead to more sales and this helps agents a lot.

In almost all scenarios, this low-ball strategy helps the agent. If it works as planned, the house is sold quickly, and both seller and agent win. If only one offer comes in at the asked-for price, the seller must either accept the low offer or pay the agent’s commission. Either way, the agent gets paid. If no offers come in, then there wouldn’t have been any offers at a higher price anyway, and the agent can focus efforts on new opportunities instead of wasting much more time on this house.

Some might argue that agents would only try this if it is in the best interests of the seller. For this to be true, the agent has to be both competent and honest. I’m sure this is true in some cases, and I’m also sure that it is false in some cases. Overall, I would be very wary if a real estate agent suggested this strategy to me.

Friday, March 9, 2012

Short Takes: Banksters, Tactical Asset Allocation, and more

Canada Mortgage News warns of banks making no-so-great offers to mortgage clients trying to get them to renew their mortgages early. Calling them “banksters” cracked me up.

Larry Swedroe says that tactical asset allocation (TAA) is a rip-off. What do you really think, Larry? Swedroe says that TAA is just another name for market timing and the evidence shows that it hasn’t worked. What he missed is that “tactical asset allocation” sounds smart and it makes investors feel superior when they use it – as long as they don’t compare their returns to an appropriate benchmark.

Steadyhand’s Tom Bradley illustrates what’s wrong with CEO compensation. I’m glad I just sold the last Canadian bank shares I own (except for those included in VCE and XIU).

Canadian Couch Potato has some fun recommending a coma as the best state to invest in.

Big Cajun Man rants about people paying exorbitant interest rates to get instant tax refunds.

The Blunt Bean Counter says that there really aren’t any advanced tax planning strategies available to most Canadians.

Thursday, March 8, 2012

Trying the Norbert Gambit at BMO Investorline

A while back Canadian Capitalist described a “foolproof method to convert Canadian dollars to U.S. dollars” using a version of the so-called Norbert Gambit. This involves buying the exchange-traded fund DLR with Canadian dollars, journaling it over to the U.S. dollar side of your account to make it DLR.U, and selling it to get U.S. dollars. I decided to try this at BMO Investorline. Overall it worked, but there were a few surprises along the way.

Note that each unit of DLR just holds US$10. This is true whether it is DLR or DLR.U. The difference is that DLR trades in Canadian dollars and fluctuates with the exchange rate, and DLR.U trades in U.S. dollars.

I don’t normally like to talk numbers about my personal accounts, so for the rest of this article, I’ll scale all the numbers down as though I was converting C$100,000 to U.S. dollars.

The bid-ask spread on DLR was C$9.79 to C$9.81. I placed an order to buy 10,100 units of DLR at a limit of C$9.81. This trade was filled at C$9.81 almost immediately. I then called Investorline to see whether I would have to wait until the trade settles in 3 days to complete the currency conversion. This is where things deviated from Canadian Capitalist’s recipe.

The Investorline representative told me that their online systems can’t handle selling DLR in U.S. dollars, but that he could do it for me over the phone for the online commission of $9.95. He also said that I didn’t have to wait the 3 days; he could do the trade immediately.

Curiously, the spread was US$9.95 to US$9.97. I’m not sure why this makes any sense when each unit is worth US$10, but at US$9.95, I was getting an implied conversion rate of 9.81/9.95 = 0.9859, which was quite close to the fair exchange rate at that time of 0.9852. So I had the representative place a limit order to sell my DLR.U at US$9.95, which was filled almost immediately at US$9.95.

After the transaction was complete, the representative told me that my implied currency-conversion rate was 13 basis points (0.13%) better than the “market rate,” which I took to mean that if I had called to ask Investorline to do the currency conversion without using the Norbert Gambit, I would have received a rate of 0.9872. This is only about 0.20% off the fair exchange rate.

It seems that you get a better rate when calling a representative than you get when converting currency online. I checked the Investorline online rates for converting $100,000, and the spread is 1.2%, or 0.6% lost for each conversion. This is a lot worse than the 0.2% cost that the representative could have given me. On $100,000, the difference is $400 for each conversion.

I found a minor glitch after the representative sold DLR.U for me: my account continued to show that I had DLR, but also showed that I had U.S. dollars from the sale. So my overall account balance shown was high by about $100,000. This was corrected the next day.

One thing that makes me nervous is that after a week my account continues to show a long position in DLR and a short position in DLR.U. The representative led me to believe that the sale of DLR.U would consume the DLR units and not create a new short position. This whole exercise won’t achieve the goal of reducing the cost of currency conversions if I have to pay margin interest. So far they haven’t tried to charge me any interest.

My complete list of transactions was to sell Canadian shares, buy DLR, sell DLR.U, and buy U.S. shares. I was able to do this all in one day and save on currency conversion costs. What could make it better would be allowing me to do the DLR.U sale without having to make a phone call. Even better would be to tighten the currency conversion spreads to make the Norbert Gambit unnecessary.

This whole area of currency conversion seems quite murky to me. The costs are not at all transparent. Doing transactions with large amounts of cash makes me nervous, but I’m reasonably confident that I paid significantly less than the default cost of $600 if I had gone the easier route.

Wednesday, March 7, 2012

Early Retirement

Many of us would be thrilled to be able to retire from our regular 9-to-5 jobs long before the standard retirement age of 65. There is a vibrant community of people dedicated to finding a way to retire when still quite young. However, most of the early retirement enthusiasts have plans without a large enough safety margin to suit me.

One blog dedicated to early retirement is Canadian Dream Free at 45 run by Tim Stobbs. Stobbs has a detailed plan to retire at age 45 on savings of $1.1 million. He and his wife plan to live on $2000/month, which sounds low, but they “both plan to do some work on the side after pulling the plug to fund some luxury items and trips.”

Most readers of this blog who plan to retire early and have described their financial plans online expect to have roughly the same low spending levels as Stobbs, seemingly without the plan to work on the side. In general, these plans look quite realistic as long as these people are able to keep their costs down to the planned levels.

I definitely understand the desire to leave the rat race and enjoy life. For several years I did consulting work that paid sporadically and gave me tremendous freedom. However, even though I have a larger net worth right now than most of those planning early retirement expect to have when they retire, I continue to work.

This is in part because I enjoy the type of work I do, but it is also because I’m quite conservative about my possible future spending needs. I had been thinking in terms of being able to spend $5000/month (after taxes). When I was young I lived extremely frugally, and I know I could do this again, but I don’t think I want to. There is also the possibility of age-related health issues leading to increased spending.

Some time ago I made a projection based on conservative spending needs and conservative investment returns, and I found that there was a risk that if I retired immediately, I might run out of money some time in my early 70s. I have very marketable skills right now, but I doubt that employers would be as interested when I’m over 70.

So, while I wish the early retirement crowd the best of luck with their dreams to amass the lump sum they think will allow them to retire permanently, I will work toward a larger lump sum.

Tuesday, March 6, 2012

Keep the Benefits of Portfolio Rebalancing in Perspective

Many commentators preach the benefits of choosing an asset allocation strategy, sticking with it, and rebalancing regularly. This is good advice, but some investors overestimate the benefits of portfolio rebalancing. If done properly it can certainly increase returns, but the gains are usually quite modest.

Consider the following example. Emily starts with a balanced portfolio worth $22,000, half in a stock ETF and half in a bond ETF. Initially, both ETFs trade for $50. Emily’s starting portfolio looks like this:

Stocks: 220 shares @ $50
Bonds: 220 shares @ $50

Now, suppose the stock ETF goes up 10% and then comes back down again. If Emily does nothing, her final portfolio value will be $22,000, the same as it was at the start. But, if she rebalances, she will make some money. Let’s see how much she can make (ignoring commissions and spreads for now).

After the stock ETF has gone up 10%, Emily’s portfolio looks like this:

Stocks: 220 shares @ $55
Bonds: 220 shares @ $50

To rebalance, Emily sells 10 shares of stock and uses the resulting money to buy 11 shares of bonds. Her portfolio is then balanced again with $11,550 in both stocks and bonds:

Stocks: 210 shares @ $55
Bonds: 231 shares @ $50

Then stocks drop back to $50 and Emily’s portfolio is now

Stocks: 210 shares @ $50
Bonds: 231 shares @ $50

Her total portfolio value is now $22,050. She has made $50 from rebalancing. This is a gain of only 0.23%. She’s happy to take this money, but it’s not a huge gain. And in reality, she will lose most of this to trading commissions and the bid-ask spreads.

The moral here is that rebalancing is useful, but it cannot make up for differences in the expected returns of different asset classes. If you choose to own different asset classes to reduce your portfolio volatility, this can be a sensible choice, but don’t think that rebalancing can make up for big differences in the expected returns from different asset classes.

Monday, March 5, 2012

Hockey Teams Seeking Public Money

The Toronto Star reported that the Ottawa Senators Hockey team claim they will go out of business if companies can no longer write off 50% of ticket costs. I’m a hockey fan, but I’m not a fan of giving professional sports teams tax breaks.

When it comes to the financial side of sports, the fan base in one city is in competition with the fan bases in other cities. To see that this is true, we start with the fact that players move around. To the extent that players can move to new teams, the market for player salaries is similar from one team to the next. Poor teams have to pony up close to as much for a given player as other teams are willing to pay for him.

This means that all teams face similar costs if they want to compete. Teams that do a better job of evaluating talent can get better players more cheaply (think Moneyball), but this is the exception rather than the rule. All teams that want to compete face similar costs whether they have a large and rich fan base or a small and poor fan base.

One way for a league to deal with this problem is to share revenues from large markets with teams in smaller markets. Another approach is to threaten the fans in a small market with losing their team and try to extract some public money in the form of direct cash, tax breaks, or subsidized stadiums.

The problem with giving in to demands for public money is that it increases the league profits, raises player salaries, and puts more pressure on other cities to pony up public money. This is not an arms race that cities should want to pursue.

A counterargument to all of this is that sports teams create opportunities for other businesses and create jobs. This is true. But it is also true of most other businesses. If we subsidize sports teams, should we also subsidize all other businesses? Who would be left to pay taxes?

Professional sports leagues are incredibly profitable. Owners and players have their squabbles over how to divide the spoils, but we should view not just team profits but also most of what players are paid as the profits of the whole league. Viewed this way, it is obvious that leagues don’t need public money.

I would rather see all Canadian cities hold firm and not subsidize professional sports. It makes no sense for small cities like Ottawa to try to compete financially with large cities like Toronto and New York.

Friday, March 2, 2012

Short Takes: Driving Saving using Anchoring, Invasive Rental Agreements, and more

The Freakonomics guys report on some interesting research into how you can use anchoring to get people to save more in their employer savings plans by supplying them with the right examples.

Big Cajun Man is facing a request from his daughter’s potential landlord for detailed personal and financial information to act as a guarantor. Does it make sense to have an online bank account that you don’t use much for these types of requests? This is similar to having an email address specifically for online registrations.

Retire Happy Blog put together a video of a stereotypical interaction between a financial advisor and client and then deconstructed it. He wants to know if he was too hard on financial advisors.

The Blunt Bean Counter looks at whether you should take into account an expected inheritance in your financial planning.

Boomer & Echo explain mortgage payment vacations.

Thursday, March 1, 2012

Can Berkshire Hathaway be Part of an Indexing Strategy?

Most proponents of indexing strategies don’t quite manage to implement a pure index approach. They often come close to pure indexing, but they can’t resist adding some sort of twist. The twist may be a form of market timing or some other active strategy. So far, the way I’ve handled my own portfolio is no different.

I’ve been on a steady transition from a pure stock picker a few years ago to about 70% indexed today. I intend to keep increasing this percentage, but I’m not sure that I’ll make it to 100%. Selling my last stocks will be fairly painless except for Berkshire Hathaway.

After having read all of Buffett’s old letters to shareholders and having held the stock for about 13 years, I’ve become attached and don’t want to sell. I’ve thought through many possible justifications for keeping it, but the only plausible one is that Berkshire is so diversified that it could be thought of as an index of a slice of the American stock market (plus some foreign holdings).

Another factor is that I can’t shake the feeling that Berkshire (BRK) is undervalued right now. There is no reason to believe that my judgement is any better than the market’s judgement when it comes to BRK, and I’ve managed to ignore my gut feelings about other stocks, but I’m stuck on BRK.

So, is there any validity to the argument that BRK is so diversified as to be index-like or am I just being emotional to the detriment of my expected future returns?