Friday, August 31, 2012

Short Takes: Insurance Companies Caught by Own Fine Print, Reduced Competition in Canadian Banking, and more

Here is an amusing story of a lawyer who found a way to make money exploiting the fine print in insurance contracts. The insurance companies are trying to sue the lawyer with the argument that they don’t understand their own contracts. There are no angels here, but I’m on the side of the lawyer in this story that kept me interested right to the end.

Scotiabank made a $3.13 billion offer to buy ING Canada. Online banks are an important part of maintaining a competitive marketplace in Canadian banking. Unfortunately for consumers, it looks like competition will be reduced in this case.

The Blunt Bean Counter had some fun describing CRA information requests from taxpayers that make little sense.

Boomer and Echo argues that Canada needs a fiduciary standard for investment advisors.

Canadian Couch Potato reports that a number of ETFs are closing shop.

Preet Banerjee answers the question of whether children have to pay the debts of their deceased parents.

Big Cajun Man muses about when is the right time to downsize your life when the children leave home.

Wednesday, August 29, 2012

Inflation’s Effect on Mortgages

If you have a mortgage, inflation is your friend. Your future payments are in fixed dollars and inflation erodes the value of the money you will have to pay. This affects the riskiness of mortgages over time.

Consider the case of a $250,000 mortgage over 25 years. In one scenario, the mortgage rate is 4% with 2% inflation, and in the other scenario, the mortgage rate is 7% with 5% inflation. Here are the monthly payments in each case along with the inflation-adjusted real value of the last payment:

Scenario 1: $250,000 mortgage, interest rate 4%, inflation 2%
Monthly payment: $1315
Real value of last payment: $803

Scenario 2: $250,000 mortgage, interest rate 7%, inflation 5%
Monthly payment: $1751
Real value of last payment: $519

Initially, the scenario 1 payments are much more affordable. However, by the end of the mortgage, the scenario 2 payments are lower in real terms. In the low inflation case, people are enticed into larger mortgages with lower payments, and these payments stay fairly high in real terms (after inflation) over 25 years. In the higher inflation case, people are forced to take smaller mortgages, but get more relief in real terms over time.

So its not just today’s lower interest rates allowing people to take on big mortgages that make mortgages riskier. The fact that payments remain higher in real terms over the life of the mortgage means that the risk of default stays higher over time. People who bought homes in the 1980s suffered with high interest rates, but at least the real value of their mortgage payments eroded quickly due to high inflation.

Tuesday, August 28, 2012

A Tax Installments Question

A reader, C.M., asks the following (lightly-edited) question about tax installments: 
I have a Canadian Tax question for you.

Question: Let says John pays $3685 as his amount owing on his 2011 tax return, and in May 2012 John gets a Notice of Assessment that says his Final Balance is Nil which is what he expects because he paid all the tax he owed that year.

Now John gets a letter in the mail August 18th from CRA saying out of nowhere he has to now pay tax installments of $1843 due September 15th and December 15th for the 2012 tax season, but this makes absolutely no sense as John already paid his tax owing in 2011 in full and you have until April 2012 to file your 2012 tax return.

History: John has been in the workforce for 25 years and never missed paying taxes once when they were owed and has never had a mistake on his returns.

To me this looks like a cash grab by the Canadian government well before the tax due date of April 30th, 2012. What does it matter to the government as long as you pay what you owe, if you owe any taxes by the tax deadline?

Thanks for any suggestions you can pass on.
Few people like tax installments; they feel like some sort of punishment. An important thing to keep in mind is that installments are not an extra tax. Whatever you pay in installments will reduce the amount owing at the end of the year.

In the example above, John is being asked to pay installments because he owed more than $3000 on his 2011 taxes, and he owed more than $3000 on either his 2009 or 2010 taxes. That’s all it takes to trigger CRA to ask for installments. It has nothing to do with your record of paying your taxes on time over the years.

That said, the reason why installments exist has to do with the government making sure it gets paid. Imagine if payroll taxes didn’t exist and CRA tried to collect from everyone at the end of the year. Millions of Canadians wouldn’t have enough money to pay their taxes and CRA would have an impossible job of debt collecting.

The goal of payroll taxes is to collect the right amount through the year so that each taxpayer owes or is owed little at the end of the year. However, there are many types of income not subject to payroll taxes, such as investment income. The installment system exists to smooth out the collection of taxes owing through the year instead of trying to collect everything at the end of the year.

The fact that a particular taxpayer, like John, is able to plan properly and pay his taxes owing at the end of the year is not considered. If he owes more than $3000 one year and also in one of the two previous years, then installments are triggered. Note that the installment amount CRA is asking John to pay adds up to his taxes owing for 2011. However, the installments go toward John’s 2012 taxes owing. The presumption is that his 2012 income will look similar to his 2011 income.

Depending on John’s income for 2012, he may not have to pay the installment amounts asked for by CRA. To understand how installments work and how much you actually have to pay, see a previous post on understanding income tax installments.

Monday, August 27, 2012

PRPP Costs (Redux)

A while back I was trying to figure out if PRPP rules would permit PRPP administrators to offer inducements to employers at the expense of plan participants. The idea was to determine whether employers are likely to choose administrators who offer the employees the best deal or whether the choice would be based on the best kickbacks flowing to the employers.

Shawn Patton pointed me to recently published PRPP regulations. Here are the sections on permitted inducements and low cost requirements:

19. An administrator may give, offer or agree to give or offer to an employer and an employer may demand, accept or offer or agree to accept from an administrator, as an inducement to enter into a contract with the administrator in respect of a PRPP
(a) a product or a service on more favourable terms or conditions than the administrator would otherwise offer if the inducement is for the equal benefit of the employees of that employer who are eligible to be members of the PRPP; or
(b) in relation to a transfer of assets into the PRPP administered by the administrator, an amount no greater than the employer’s costs associated with the transfer of assets into that PRPP.


20. The following criteria shall be used to determine whether a PRPP is being provided to its members at low cost:
(a) that costs are to be at or below those incurred by members of defined contribution plans that provide investment options to groups of 500 or more members; and
(b) that costs are to be the same for all members of a PRPP.
Suppose that the costs incurred by defined contribution plans to groups of 500 or more members is 1.5% of participant assets each year, but that a PRPP could be run profitably at 1% per year. Suppose further that a PRPP administrator sets its “standard” costs at 1.5%, but then offers a special deal to all potential employers: we’ll kick back 0.25% to the employer and reduce the employees’ costs by 0.25%. This seems to meet the conditions in the regulations, but diverts half the cost reductions to employers rather than having plan members enjoy the full savings.

It’s not clear that the savings even need to be split. If the “standard” costs are set at 2%, could the PRPP administrator offer 0.5% to the employer and a 0.5% discount to employees? The actual costs to the employees would then be 1.5% per year even though the never-used standard cost level is set at 2%.

Note that if a low-cost PRPP administrator offered a competing plan at a cost of 0.75% per year, this would be the best deal for employees, but employers would have a strong incentive to choose a PRPP that offers a kickback.

Potential objections to this kickback scheme:

1. PRPP administrators and employers would never do such a thing.

Grow up.

2. What’s the big deal if a measly 0.5% goes to employers?

That 0.5% compounds year after year. Over the course of 40 years of saving, 0.5% per year drag would reduce total plan member savings by about 9%.

3. PRPP Administrators and employers couldn’t get away with this for legal or other reasons.

I want this to be true. Please explain why they can’t get away with this.

Friday, August 24, 2012

Short Takes: Defending Index Investing, and more

Canadian Couch Potato has fun shooting down some silly arguments against index investing.

Million Dollar Journey defends 30-year mortgages. Guest blogger Sean Cooper shows that it is possible to use 30-year mortgages responsibly, but overall I think the country is better off without them. Having a 25-year mortgage wouldn’t affect Cooper’s plan much, and preventing some borrowers from overextending themselves has high value.

Big Cajun Man saved $1200 in one phone call to his cable company.

Preet Banerjee recorded a hot water tank door knocker for his latest Mostly Money Mostly Canadian podcast.

Thursday, August 23, 2012

Getting an Early RRSP Tax Refund

For those who make their yearly RRSP contributions much sooner than the deadline of 60 days into the next year, it’s possible to get your tax refund well before filing your tax return for the year. You can do this by sending a T1213 form to CRA and taking the letter they send back to your payroll department. In my case, I’ve had to solve a minor problem of producing evidence that I made the contribution.

The basic idea is that if you contribute to your RRSP, your payroll department is allowed to take this into account and deduct less tax from your pay. So, you effectively get a refund over the course of the year instead of waiting until you file your income taxes. However, you have to prove to CRA that you actually made the contribution.

The T1213 form asks for your “payment arrangement contract,” which you would have if you make periodic RRSP contributions. However, I tend to contribute lump sums online with my discount brokerage, and they don’t send me any paperwork until the next February.

For two years now, CRA has accepted screenshots of the transaction history of the account I sent money from and the RRSP account that received the money. In fact, this year it took only 7 business days to go from mailing in my T1213 to handing CRA’s positive reply to my payroll department. I’m looking forward to a big bump in net pay on my next pay deposit.

There are a couple of things to be careful about here. One is to make sure that you’re not double-counting. If you make RRSP contributions that your employer already knows about, they may be already reducing your payroll taxes.

The second thing to be careful about is the second to last line of the T1213 form: “Subtract income not subject to tax deductions at source.” You’re not supposed to abuse the T1213 form to reduce payroll taxes and end up owing money when you file your income taxes.

Wednesday, August 22, 2012

The Malign Hand of the Markets

After the near financial meltdown in 2008, many wonder what can be done to stabilize financial markets. Too much government control seems like a bad idea, but letting those who run financial firms continue to enrich themselves at public expense is also a bad idea. In the book, The Malign Hand of the Markets, author John Staddon offers a prescription.

Staddon goes through a number of topics with thoughtful commentary before finishing with his answers to stabilizing financial markets. He begins by explaining various ways that markets can work poorly, which he calls a “malign hand” as opposed to Adam Smith’s invisible hand. One example is problems with the market in scientific research that result from a monopoly buyer, the government. Other examples involve the separation of short-term profits from long-term risks.

Another type of problem that can lead to a malign hand is asymmetric information. Some businesses seek to confuse their customers. When it comes to confusing contracts, Staddon suggests that “If average-IQ citizens cannot understand the contract within a limited study-time related to the amount of money at risk, then the agreement could be declared null and void.”

In explaining why people so frequently make poor financial choices, the author observes that people “live now in environments that have changed drastically in recent centuries—a short time in evolutionary terms. Hence many of their instincts may be poorly adapted to their current environment.”

In his critique of the financial industry, the author observes that agricultural employment shrank from “41 percent of the population in 1900 to 1.9 percent in 2000” not because people eat less now, but because of efficiencies. Despite the advent of computers which should have reduced the size of the financial industry, it has grown and uses “technology to complexify and baffle.” Computers make possible “a swarm of complex new financial products that contribute to systemic instability and whose social value is almost certainly negative.”

Among Staddon’s recommendations for fixing the financial industry, he suggests that only banks that do retail (boring) banking should be allowed to be limited liability companies. Any firms that deal in financial markets should have to be partnerships so that the partners would be responsible for losses beyond the value of their shares.

Recognizing that forcing risky firms to be partnerships is a big change, Staddon suggests a quicker improvement, which would be to tax financial risk progressively. “A common risk management tool is something called value at risk.” This measure could be used for taxation. Small firms would pay very little per unit of risk, but large firms would pay much more per unit of risk. This creates a disincentive to forming too-big-to-fail firms.

Staddon takes on a controversial subject with thoughtful analysis. I recommend this book to anyone wishing to think deeply about the problems in the world’s financial system.

Tuesday, August 21, 2012

Combating Car Insurance Fraud

I get a lot of pitches from companies wanting me to write about their products, which I mostly ignore, but Alexey Saltykov at InsurEYE sent me something interesting. It’s a graphic that explains the 3 most common ways that fraudsters might try to involve you in a car accident (see below or click here). (Disclaimer: I have no business or financial connection to InsurEYE.)

My first question after looking at these fraud scenarios is what can I do about this? If done well, it would be almost impossible for the victim to avoid the collision, and then it would be almost impossible to convince an investigating police officer that the collision was a fraud rather than poor driving by the victim.

Alexey’s answer to this question is that he uses a dash cam:

Here is a link to a supposed case of a fraudulent collision. The collision seems so minor that it’s hard to tell if this is real or staged, but I get the idea. I’m not likely to buy a dash cam any time soon, but I can see that it would be almost impossible to prove fraud without one.

Monday, August 20, 2012

Fast Food Hurts Your Wallet

A friend, Glenn, pointed me to some interesting research from the University of Toronto that links fast food to heavily discounting the future and poor financial decisions. Here is the abstract:
“Based on recent advancements in the behavioral priming literature, three experiments investigated how incidental exposure to fast food can induce impatient behaviors and choices outside of the eating domain. We found that even an unconscious exposure to fast-food symbols can automatically increase participants’ reading speed when they are under no time pressure and that thinking about fast food increases preferences for time-saving products while there are potentially many other product dimensions to consider. More strikingly, we found that mere exposure to fast-food symbols reduced people’s willingness to save and led them to prefer immediate gain over greater future return, ultimately harming their economic interest. Thus, the way people eat has far-reaching (often unconscious) influences on behaviors and choices unrelated to eating.”
So, if you ever want to live the good life of being both healthy and wealthy, stay away from fast food.

Friday, August 17, 2012

Short Takes: Bogle on Stocks, Pumping up Mortgage Penalties, and more

John Bogle says the recent past has been the “worst time for investors that he has ever seen,” but “long-term investors must hold stocks, because risky as the market may be, it is still likely to produce better returns than the alternatives.”

Canadian Mortgage Trends reports that the 3-months interest penalty on some mortgages is based on a higher interest rate than your actual mortgage rate. Maybe people need to start hiring lawyers to read their mortgage contracts.

Rob Carrick gives us some tongue-in-cheek definitions of financial terms. I liked “Contrarian: Someone who is wrong in predicting what will happen, but in a different way than the herd.”

Big Cajun Man details his experience trying to get a reasonable deal on a new cellphone from Telus.

Give Me Back My Five Bucks has a very sensible way to look at prioritizing spending.

Preet Banerjee looks at some research showing that women tend to outperform men at investing.

Wednesday, August 15, 2012

Managing the Emotional Side of Portfolio Watching

Checking on your portfolio every day can be agonizing. One day you’re up $1000 and the next you’re down $1000. Toss in the fact that experts estimate that we feel losses twice as intensely as we feel gains, and an oscillating portfolio can leave you depressed even if the daily gains tend to be a little bigger than the losses. I’ve found that a minor change to the way I view my portfolio makes a big difference to me.

I used to store my portfolio information on one of the free online services. It produced numerous statistics including the daily gain or loss in both dollar terms and percentage terms. In the last couple of years I’ve been using my own spreadsheet that does some extra calculations like telling me when it’s time to rebalance. Crucially, though, my spreadsheet does not report daily gains or losses. I only work out gains and losses roughly once per year.

To know whether I made or lost money during a given day or week, I’d have to remember a past portfolio value. My imperfect memory doesn’t allow me to do this with any reasonable accuracy. So, I no longer agonize over short-term gains and losses. I just check to see if rebalancing is necessary (which is rare) and occasionally adjust the portfolio for new money I’ve added.

I find this an interesting case where I’m happier and more likely to make good investing decisions because I have less information.

Tuesday, August 14, 2012

CRA Processing Reviews

I was (un)lucky enough to be selected this year for a CRA processing review. This was a virtual certainty given that I was paying tuition for 3 people at once. They want to see documentation for all the tuition deductions I claimed. Some people mistakenly refer to these reviews as an audit, but audits are much more involved.

Processing reviews are quite common when you file your return with tax software and therefore don’t submit any forms or other documentation. CRA is simply doing a spot check to see if you have proper documentation for some of your deductions.

I find the language used in the CRA letter to be quite amusing:
“To determine if we have assessed your return correctly, we need additional information.”
A more accurate, but more adversarial statement would be
“We need to see documentation to make sure you’re not a lying deadbeat.”
Don’t get me wrong, though. I’m quite happy that CRA does these processing reviews to keep people in line. Otherwise cheating would be rampant and honest people would have to pay more taxes to make up the difference.

I do feel sorry for those who manage to lose their documentation in the few months since filing their taxes. It wouldn’t be too hard to imagine that a box gets lost in a move or any number of other ways to lose some paperwork.

I can see this being a particularly difficult problem for someone running a small business with low margins. If you have revenues of $250,000 and total costs of $200,000 (not including paying yourself), having even a small percentage of the deductions disallowed due to inadequate documentation could be devastating.

Friday, August 10, 2012

Short Takes: JOBS Act Side-Effect for Investors and more

Jason Zweig explains how the U.S. JOBS Act is making it more difficult for investors to understand the stocks they invest in.

Canadian Couch Potato has come out with a second edition of his book The Money Sense Guide to the Perfect Portfolio after the first edition sold out. I reviewed the first edition.

The Blunt Bean Counter looks at tax issues with online poker and offshore trusts.

Preet Banerjee says that the extreme couponing we see in the U.S. just isn’t possible to the same extent in Canada.

Big Cajun Man has a list of financial tweets he’d like to see with a #YOLO tag (you only live once).

Million Dollar Journey answers reader questions about ETFs vs. no-load mutual funds and starting a portfolio.

Wednesday, August 8, 2012

Investing Outperformance is Necessarily Rare

Unlike the fictional Lake Wobegon where “all the children are above average,” in the real world we can’t all be above average. If one investor gets above-average returns, there must be some other investor whose returns are below average. Because of a compounding effect, there actually have to be many below-average investors to compensate for one above-average investor.

Consider two investors, A and B, who each start with $10,000 to invest. Suppose that after 40 years, they have an average of $250,000. Their average compound return per year works out to 8.4%. If investor A ends up with $475,000, then investor B must end up with only $25,000 to make the average $250,000. But look at their individual compound average yearly returns:

Investor A: 10.1% (1.6% above average)
Investor B: 2.3% (5.6% below average)

So, what has happened here? If A and B exactly balance each other out to give the correct average portfolio size, why is B’s yearly return so far below average, while A’s return is not much above average? This is a compounding effect. Investor A ended up with 1.9 times the average portfolio size, but investor B ended up with a portfolio 10 times smaller than average. This difference between 1.9 and 10 leads to the +1.6% and -5.6% figures.

Let’s look at this from another point of view. Suppose that a group of investors each start with the same portfolio size and invest for 40 years. Suppose that outperformers make 10% per year above the average return, and underperformers make 10% per year below the average return. How many underperformers does it take to compensate for one outperformer? The answer is 45!

In a more extreme example, if Warren Buffett has outperformed the average by $40 billion, it would take a million investors each underperforming by $40,000 to compensate. So, we see that investing outperformance is necessarily rare and that there have to be many who underperform for each high flyer. Of course, none of this applies in Lake Wobegon.

Tuesday, August 7, 2012

Financial Values

Mark at My Own Advisor asked whether you are living your financial values and proceeded to list his values. I decided to see how his values line up with the way I run my financial life. I’ve listed each of Mark’s values below along with my thoughts.

Continually reduce our mortgage debt by using prepayment privileges every month.

I no longer have a mortgage, but when I got my first mortgage my wife and I doubled every payment for nearly 3 years and made a 10% lump-sum payment each year. This might have been overkill, but we hate debt.

Use our line of credit only when necessary for major home renovations or emergencies.

I would say “non-optional major home renovations” like a new roof makes sense, but far too many people use lines of credit for optional things like new kitchens and bathrooms. This is usually a mistake. Save up for a new kitchen or do without. My wife and I have a line of credit, but use it rarely. Lately, we’ve used it because we didn’t want to sell some non-registered investments. However, we tend to pay it off in just a few months.

Save and invest at least 10% of our net income every year.

On average, we’ve saved much more than 10% of our incomes each year. Saving 10% will get you into better financial position than most Canadians, but you need to save more than this to have the freedom to change to a less lucrative career or take time off from work.

Hold a percentage of bonds that closely matches our age.

I’ve never followed this one. I’ve held bonds to cover planned expenditures that are within 3 years, such as tuition for my sons, but I’ve never bought bonds with savings that I designate as long-term. As I see it, the main virtue of bonds is to help investors stick with a long-term investing plan rather than sell everything when market gyrations turn their stomachs.

Have an emergency fund.

I think this is a good idea, although I’ve never had an explicit emergency fund. When I was young I had substantial cash in a savings account, and in recent years, I’ve kept modest cash balances in various trading accounts.

Always be on the lookout for ways to cut back on everyday expenses.

My wife does most of the everyday buying, so changing my day-to-day spending wouldn’t make much difference. And her home position is to be so thrifty that I shudder to think what our lives would be like if she spent even less.

Avoid carrying any credit card debt in any month.

I couldn’t agree more. Over the years, I’ve forgotten to pay my bill on time a couple of times, but apart from these mistakes, I don’t pay any credit card interest. Carrying a credit card balance is financially devastating.

Optimize our RRSPs.

Mark says “1) We make RRSP contributions automatic, sending over a bit of money every month. 2) We optimize our RRSPs in that we only contribute enough to offset paying any additional income taxes come tax time.” Maxing out our RRSP contributions has worked best for my wife and me. I can certainly understand if some people prefer to save in TFSAs and don’t have enough total savings to max out their RRSPs as well.

Keep the majority of our RRSPs indexed.

I used to actively choose stocks, but now my retirement savings are fully indexed.

Keep some U.S. dividend paying stocks in our RRSPs.

I keep all of my U.S. stock ETFs in RRSPs to save the U.S. 15% withholding tax.

Maximize our TFSAs.

So far I’ve kept my excess savings above my RRSP room in non-registered accounts. But now that the total TFSA room is becoming more substantial, I plan to max out our TFSAs at some point.

Keep some Canadian dividend-paying stocks in our TFSAs.

When I fill up our TFSAs, the plan is to use them for Canadian stock ETFs to avoid the 15% withholding tax on U.S. ETFs held in TFSAs.

Don’t invest in anything we can’t explain to a 10-year-old.

I don’t invest in things if I don’t feel like I understand them. I think this lines up fairly well with what Mark means here.

Always keep taxes and inflation top of mind when making any investment decision.

I’ve seen cases where people focus too much on taxes when making an investing decision, but far more money is lost by people who fail to take into account taxes and inflation. I definitely agree with Mark on this one.

Reinvest all dividends and distributions whenever possible.

I do this but I don’t have it set up automatically. I just let cash dividends build up in an account until there is somewhere between $3000 and $5000, and then I buy more of whichever ETF is below its allocation in my target asset allocation percentages.

Avoid investing in any “hot stocks”.

Check. I’ve done this in the past, but no more.

Never own a mutual fund again.

Check. Although I see no problem with owning mutual funds if the costs are sufficiently low.

Only own companies that pay dividends.

I don’t agree with this one. In registered investments, it makes no difference whether gains are dividends or capital gains. In non-registered accounts, I’d rather have capital gains so that I can defer taxes until I sell.

Minimize money management fees.

Check. This is a very important one.

Buy more bonds when equities are priced high.

As I explained earlier, I don’t own bonds for the long term, but I do rebalance my portfolio when its percentages are too far off target. So, I tend to sell things that are priced high and buy things that are priced low.

Buy more equities when bonds are priced high.

See above.

Put emphasis on building retirement income rather than portfolio value.

I’m not sure I see the difference. The larger the portfolio, the more income that it can generate.

Remember the stock market is unpredictable in the short-term and predictable in the long-term.

To say that the stock market is predictable in the long term may be overstating things, but it is true that stock market fluctuations tend to balance out somewhat over time.

It’s OK to splurge once in a while.

I agree, cautiously. The cost of the splurge matters. Spending an extra $100 to have some fun with your family is a great idea. Impulsively flying off to Hawaii for a $10,000 vacation when you’ve got credit card balances to pay is irresponsible.

Overall I’d say that Mark and I agree much more than we disagree.

Sunday, August 5, 2012

Giveaway Winner: The Beginner’s Guide to Saving and Investing for Canadians

Congratulation to Lyne who won the draw for the book The Beginner’s Guide to Saving and Investing for Canadians. Fortunately, Lyne’s was one of the 92% of entries with the correct answer to the skill-testing question ((7 x 8) + 6 – 2 = 60). I’m sure that other 8% just tried to answer too quickly. Thanks to all those who entered the draw, and for those who didn’t win this time, better luck next time!

Friday, August 3, 2012

Short Takes: Driving Investors out of Stocks, Why You’re Poor, and more

Jason Zweig says that Wednesday’s sudden drop in stock prices was just the latest thing to discourage retail investors and drive them out of stocks. I’m a retail investor and I didn’t even notice. Perhaps Zweig meant “retail traders” rather than “retail investors”.

Give Me Back My Five Bucks makes an interesting case that the reason you’re poor is a bad attitude and blaming others. I see a parallel with sports here. Many players moan and groan about bad calls from officials. However, players make mistakes, coaches makes mistakes, and officials make mistakes. If you’re mentally fighting both your opponent and the officials, it’s hard to win. With personal finance, it’s hard to improve your situation if you’re convinced that the world is to blame for your money problems.

Tim Cestnick explains the bureaucratic steps you must take to properly appeal a CRA ruling. Otherwise, your appeal could be rejected because you didn’t say “Mother, may I?”

My Own Advisor lays out his list of financial values.

SquawkFox resists a hard sell to upgrade her old cell phone.

Big Cajun Man manages to connect his failed investments in high-tech stocks to setting fires in a toilet when he was a kid.

Retire Happy Blog says that investing is a science rather than an art.

Thursday, August 2, 2012

“The Cult of Equity is Dying”

William H. Gross wrote a very interesting Investment Outlook piece that he begins with “The cult of equity is dying.” He argues that the century long 6.6% real return of stocks will not persist into the future. However, I don’t understand the logic in one of his arguments.

Over the past 100 years, real GDP growth has been 3.5% per year, but stocks have returned 6.6% per year. Gross likens the 3% excess for stocks each year to a Ponzi scheme. “If an economy’s GDP could only provide 3.5% more goods and services per year, then how could one segment (stockholders) so consistently profit at the expense of the others (lenders, laborers and government)?” Gross goes on to explain that if this persists into the future, the rule of 72 tells us that stock owners would double their advantage every 24 years and would eventually own everything.

The flaw in this logic is that stocks pay a slice of their returns in the form of dividends. These dividends get spent in the economy. Some dividends get reinvested into stocks, but that means that some other stock owner sells shares and receives cash that is then spent in the economy. The net effect is that all dividends are spent.  As long as the capital gains of stocks don’t grow faster than GDP growth, there is nothing unsustainable about total stock returns (including dividends) exceeding GDP growth.

Gross isn’t telling us to sell our stocks. “Common sense would argue that appropriately priced stocks should return more than bonds.” He goes on to say “If GDP and wealth grew at 3.5% per year then it seems only reasonable that the bondholder should have gotten a little bit less and the stockholder something more than that.”

Gross’s main argument is that we should expect stocks to outperform GDP by much less than 3%. He may be right about this; I have no opinion. However, I disagree that 3% outperformance is necessarily unsustainable.