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.
Friday, November 30, 2012
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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.
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