Friday, June 28, 2013

Short Takes: Financial Illiteracy and more

I had a full slate of posts this week (although you might not count the last one about a feed aggregator and not money):

A Reader Question about Becoming Debt Free

Bernoulli’s Model of Risky Decisions

Rational Level of Saving for Athletes

I Finally Stopped Procrastinating about Google Reader’s Demise

Here are my short takes and some weekend reading:

Canadian Financial DIY points out the irony of using a stock-picking contest to raise money for financial literacy. Real financial knowledge for most investors begins with understanding the futility of trying to pick your own stocks.

Potato makes an interesting case for treating investing as one of your careers.

Squawkfox explains how to get the most from the customer service of a large company. She includes an audio recording of a successful call she made. I agree with all her points, but I think a fair measure of her success on that call came from the man answering the phone perceiving her tone as somewhat flirtatious. There’s nothing wrong with that, but it certainly wouldn’t work as well for most of us.

The Blunt Bean Counter looks at the economics of illegal tax avoidance resulting from cash payments to contractors.

Big Cajun Man says that if you’re bad with your money banks will love you.

My Own Advisor makes his pick of the top bond ETFs. I’m not a bond investor myself, but he made some picks that keep costs (MERs) down, which is important.

Thursday, June 27, 2013

I Finally Stopped Procrastinating about Google Reader’s Demise

I’m guessing there are many people like me who responded to Google Reader’s demise by procrastinating. I thought I’d have to investigate different readers and try to pick a decent one.

Finally, I just clicked on a Feedly link and was pleased to find that it had a button for collecting my Google Reader data. After one more click to authorize the collecting of some data like my email address, I was presented with a fully-functioning reader with all my feeds.

The user interface is different from Google Reader, but it seems quite easy to use so far. So, my search is over; I’m a Feedly user now (disclaimer: I have no connection to Feedly, financial or otherwise, except for the fact that I’m now a user).

One warning is that Feedly does not pick up information about which posts you’ve read in Reader. If this is a concern, you can catch up first in Reader, and then make the two-click switch to Feedly. No doubt there are other good readers out there as well, but I’m happy to declare Feedly good enough.

Wednesday, June 26, 2013

Rational Level of Saving for Athletes

We’re used to hearing stories about very highly paid athletes running out of money. Reportedly, more than half of professional basketball and football players run out of money a few years after their careers end. To deal with this problem, the NFL Players Association announced in a news release “that it is expanding its financial education program for players and former players.”

The part of the news release that struck me the most was the following result of an effort to get players to save:
“The results were groundbreaking, with over 1,000 players participating in the program, most engaging on an ongoing basis, and 48% saving at least 20% of their annual earnings in preparation for a potential lockout in 2011 based on the results of a lockout preparedness assessment.”
With a league minimum salary of $375,000 in 2011, it’s painfully obvious to me that saving only 20% of income is far too low. And this was achieved by only 48% of players who participated in a program. Further, this was only achieved with the threat of a lockout.

To demonstrate that 20% is too low a saving rate, I did a few calculations (surprise!). Let’s assume that players want to smooth their spending evenly over their remaining lifetimes (adjusted for inflation) and conservatively assume this may be 70 years. Further, let’s assume that their incomes after retirement with be insignificant compared to their pay as players.

The question I sought to answer was what percentage of their incomes should athletes save? This depends on the assumed rate of return on savings and on the number of years they play. The following chart summarizes the results:

As you can see, it never makes sense for an athlete to save less than 40% of income. More realistically, if they don’t count on playing for more than 5 years, they should be saving over 80% of their take-home pay. This contrasts sharply with a saving rate of 20% for only a minority of players.

It’s probably difficult for great athletes who have dominated opponents for most of their lives to accept that they won’t be able to succeed at some other money-making venture after they retire. I wish the NFL Players Association good luck in convincing its members to save more of their incomes. I find the stories of destitute players quite sad.

I’d be willing to try to help in some way, but be forewarned: I’m a terrible salesman and wouldn’t bother trying to line my own pockets by stroking player egos and offering them “exclusive” investments. The solution is a high saving rate, no debt, and boring index investing.

Tuesday, June 25, 2013

Bernoulli’s Model of Risky Decisions

In 1738, Daniel Bernoulli devised a simple model of risk aversion (English translation here). Nobel Prize winner and author of Thinking Fast and Slow Daniel Kahneman criticizes Bernoulli’s theory extensively, describing it as “Bernoulli’s Error.” I disagree with Kahneman. I think Kahneman misunderstands Bernoulli’s claims.

Bernoulli’s theory of decision-making is best described with some examples. He claims that doubling your net worth is as positive as dividing it by 2 is negative. So, if your net worth is $200,000, receiving another $200,000 is as positive as losing $100,000 is negative.

Bernoulli applies the same type of rule to smaller changes as well. Going from $200,000 to $250,000 is multiplying by 1.25. Going from $200,000 to $160,000 is dividing by 1.25. So, winning $50,000 is as good for you as losing $40,000 is bad for you. (For the more mathematically-inclined, the utility of your net worth is proportional to its logarithm.)

Kahneman’s extensive research has shown that people don’t think this way. They tend to be more risk-averse than Bernoulli’s model indicates. When trying to avoid losses, people tend to be more risk-seeking than Bernoulli’s model. Across several pages in Thinking Fast and Slow that Kahneman devotes to criticizing Bernoulli’s theory, the argument seems to boil down to the fact that people don’t make decisions consistent with Bernoulli’s model.

I agree with this. However, after reading Bernoulli’s paper, I see no evidence that Bernoulli was trying to model human behaviour. He was trying to model rational behaviour. In section 7, Bernoulli looks at how much people “should be willing to venture,” not how much they are willing to venture. In section 14, he says that anyone who accepts a certain type of gamble “acts irrationally.” In section 15, he says that offering certain types of insurance is “foolish” and “unwise.” It seems clear that Bernoulli was not trying to model actual decision-making; he was modeling rational decision-making.

Some may think that we should make decisions about gambles based on simple mathematical expectation. So, if you’re offered a chance to either win $10,000 or lose $9999.99 on the flip of a coin, it is rational to accept. This is incorrect. We can see this if we take it to the extreme. Imagine you’re given a chance to gamble for everything you own: double (plus a dollar) or nothing. This is a bad bet. The misery you’d face in your future if you lost far exceeds to benefit you’d get if you won. A certain amount of risk-aversion is perfectly rational, and Bernoulli sought a rule to decide which risks are rational to accept.

It’s quite true that Bernoulli’s model has its challenges. It will fail in some narrow circumstances such as desperately needing money for a life-saving operation. Another challenge is deciding what counts in your net worth. How do you model future income (human capital)? How do bankruptcy laws factor in?

Despite these challenges, I’ve found Bernoulli’s theory to be an excellent model of rational behaviour. I’ve learned from Kahneman’s research that Prospect Theory is an excellent model of the way people actually make decisions. Faced with a chance to make $300 or lose $200 on the flip of a coin, Prospect Theory explains why people turn down this gamble, and Bernoulli explains why it is rational to accept the gamble. Any tension between the two theories is easily explained by the fact that people are sometimes irrational.

Monday, June 24, 2013

A Reader Question about Becoming Debt-Free

Here is a lightly edited question from a reader who calls himself or herself “Debt Free”:
I've read over a bit of your blog, and I enjoyed it. I'm on a mission to pay off HUGE debt. I need some help (support – not asking for money). I need to be accountable to someone for my daily spending to keep me on track so to speak. This is my situation:

Credit card #1 Balance $6500, Int. Rate 19.99%
Credit card #2 Balance $11,800, Int. Rate 19.99%
Credit card #3 Balance $3600, Int. Rate 28.99%
Credit Line Balance $14,000, Int. Rate prime plus 5% (currently 8%)

Car Loan balance $17,000, $177 biweekly
Mortgage balance $114,000, $163.08 weekly
Child support $500 per month (this is likely to change end of this year)

Full time job $2926 (net) per month
Part time job $1700 (net) per month

Do you have any suggestions? I would like to have this paid off in 2.5 years from now.

Any advice you can pass on would be greatly appreciated.
Debt Fee, I’m glad you’ve enjoyed the blog. I’m happy to give you some thoughts. Maybe other readers can offer suggestions, too.

To start with, the only way I know of to become debt-free is to spend less than you make. The gap needs to cover all the interest plus some principal to make any headway. We need to crunch some numbers to see where you are.

I need to make a few assumptions. Let’s assume your line of credit and credit card minimum payments are 2%, except for the higher interest rate card which is 3%. That makes the total minimum payments $754 per month. Your mortgage, car loan, and child support average about $1593 per month. This totals $2347 per month.

However, if you just make minimum payments, it will take decades to pay off these loans. If we add in $500 per month in additional principal repayments, you’re up to $2847 per month. This leaves only $1179 per month for food, gas for your car, insurance, and everything else.

This is very tight. You need to look at some changes. Can you expand your mortgage to pay off the high-interest debts? If not, can you expand the line of credit to pay off the credit cards? If you do this, do you have the self-control to not just run up the credit cards again?

Do you really need your car? Cars are not only expensive to buy, but they are also expensive to operate. If you have some equity in your home, you might consider selling it, paying off debts, and renting until you get some savings again. Another possibility is to take on a renter in your home.

I think it would be very difficult for you to maintain your current minimum payments and come up with additional cash to repay some principal each month. You may be forced to make some tough choices.

Friday, June 21, 2013

Short Takes: Fund Fee Transparency, a Going it on Your Own Story, and more

My only post this week was a review of a great book:

Thinking Fast and Slow

Here are my short takes and some weekend reading:

Rob Carrick wrote an interesting piece on some young financial advisors who welcome unbundling of fees for financial advice because they hope it will drive bad advisors out of the market. The remarks from the Advocis president are funny. The claim that fewer investors will get financial advice presumes that all people with advisors are getting advice in the first place. Picking a few mutual funds is not proper financial advice.

Preet Banerjee interviews Barry Choi. In this podcast Barry tells the story of starting out with a financial advisor, having problems and dumping him, and even ending up in a confrontation with the advisor.

Big Cajun Man has a great diagram that compares pay-day loan businesses to loan sharks.

My Own Advisor has some thoughts on dumping your big-bank financial advisor.

Monday, June 17, 2013

Thinking Fast and Slow

Daniel Kahneman won the Nobel Prize in economics in 2002 for his brilliant work along with the late Amos Tversky on the way people make decisions. Kahneman clearly worked hard to make the conclusions of his research accessible to all in his book Thinking Fast and Slow. No other book as given me as much useful insight into the workings of my own mind.

I understand much better why I would hesitate before accepting a 50/50 bet to lose $200 or win $300, and why I have an opinion on the future of Apple stock even though I know I really have no idea what will happen. The key is to understand the workings of my “System 1”.

Kahneman portrays the human mind as consisting of two actors, System 1 and System 2. He’s careful to explain that they are not really separate characters inside your mind; speaking of them like they are separate entities is so useful for helping the reader understand the research results that the book would be far less useful without them.

Roughly speaking, System 1 is the fast and involuntary part of your brain. It sees potential threats and answers just about any question quickly, whether it knows a good answer or not. System 2 is slow and lazy by comparison. It usually just accepts judgments from System 1, but sometimes it kicks in and thinks things over to come to a decision different from System 1’s decision.

It is my System 1 that is overly averse to losses. It tends to feel losses about twice as intensely as it feels gains. System 1 is the reason why my initial reaction was to turn down a 50/50 bet to lose $200 or win $300. It is my System 2 that takes its time to verify that the 50/50 coin toss will be fair and decide to accept the bet.

It is my System 1 that decides quickly if Apple stock will go up or down based on available evidence. Of course, it might just substitute an easier question, such as “do I like Apple?” System 2 almost always accepts System 1 judgements; it couldn’t possibly verify every decision made by System 1. There was a time when I acted on my System 1 judgement of what would happen to Apple. Now my System 2 overrides these snap decisions and prevents me from trading Apple stock.

System 2 is good at coming up with reasons to back up the judgments that come from System 1. Most people would turn down the $200/$300 bet. When pressed they could come up with intelligent-sounding reasons for their decision. But the real reason is that their System 1 hates losses. The truth is that “you know far less about yourself than you feel you do.”

System 1 is a remarkable machine that we can’t do without, but it does tend to make certain types of predictable errors. One such error is to confuse familiarity with truth. “A reliable way to make people believe in falsehoods is frequent repetition.” This explains some of the “reporting” on Fox News.

System 1 “deals well with averages but poorly with sums.” Perhaps this explains why I’ve found that when asked about casual spending such as lunches out, most people can fairly accurately say the average cost of their lunches and seem to know how often they buy lunch, but consistently underestimate by a long shot their total spending on lunches.

The human mind tends to be bad with probabilities. When it comes to small risks, “we either ignore them altogether or give them far too much weight – nothing in between.”

The idea of regression to the mean is familiar to me, but Kahneman shows how it can be hidden. For example, a sports coach who praises good performance and criticizes poor performance can easily get the impression that criticism works and praise doesn’t. However, even without any words from the coach, unusually poor performance is usually followed by an improvement, and strong performance is usually followed by a more average effort.

If we like a person, our mind’s “halo effect” tends to make us think well of them in all respects, including assessment of their skills. It works the other way too: we judge people we don’t like to be bad at everything. Kahneman uses the example “Hitler loved dogs and little children” to drive home this point. We instantly expect someone who makes such a statement to follow it with denials of past atrocities and other offensive statements.

Kahnemen tells an amusing story where he demonstrated to a Wall Street firm that based on statistical evidence provided by the firm, they had absolutely no stock-picking skill whatsoever. However, “people can maintain an unshakable faith in any proposition, however absurd, when they are sustained by a community of like-minded believers.” At this point I’m not sure if Kahneman was talking about stock picking, religion, or both.

In an experiment showing a failing of System 1 thinking, students were given a chance to win a prize if they pulled a red marble from one of two urns. They were told that the first urn had 1 red marble out of 10 marbles total. The second had 8 red out of 100. More than a third or students chose the second urn because it contained more winners even though the better odds of winning are with the first urn.

To show that we’re susceptible to how a question is framed, consider two drivers. The first changes from a 12 mpg gas-guzzler to one that runs at 14 mpg. The second driver changes cars from one that gets 30 mpg to a 40 mpg car. Who saves more money? The surprising answer is that the first driver saves more money. If the figures were given as the number of litres (or gallons) per 100 km (or miles), the correct answer would have been more obvious.

The book summarizes the “focusing illusion” with the following interesting quote: “Nothing in life is as important as you think it is when you are thinking about it.”

Overall, I found this book very valuable to me personally. I now understand why it is so important to figure out when it is safe to trust my snap judgements and when I should slow down and think things through. I highly recommend this book to my readers.

Friday, June 14, 2013

Short Takes: Banning Advisor Commissions, Canadian Real Estate, and more

My only post this week drew some good comments:

Anchoring and Income Taxes

Here are my short takes and some weekend reading:

Canadian Couch Potato weighs in on the banning of financial advisor commissions debate and the arguments made by the president and CEO of Advocis.

Tom Bradley at Steadyhand explains what really has him concerned about Canadian real estate. No matter what happens over the next 5 years, I’m sure that his last statement will be true: “we’ll look back in 5 years and say, ‘Wow, what were we thinking? It was so obvious.’” Human brains are such that things we can’t predict in advance seem inevitable in hindsight.

The Blunt Bean Counter gives three tax-saving strategies that he says are an easier way to save money than being frugal with every small purchase.

Million Dollar Journey explains stop-loss orders. Some traders seem to like this type of order, but I don’t see how they’re any use for investors.

Wednesday, June 12, 2013

Anchoring and Income Taxes

My employer pays a modest bonus for each invention employees have that result in a patent filing. I had a few of these this year and recently received a letter showing me the size of this bonus. But this is a gross amount before the taxman takes his bite.

So now my mind is anchored on the gross amount of the bonus. Next week’s pay cheque will be somewhat of a let-down because I will actually receive just over half of this figure.

I don’t mean to sound like I’m complaining about getting a bonus. This should be a happy event and it is happy for me. But, I think my employer makes a mistake by giving me a piece of paper with the gross amount printed in bold.

Perhaps many people don’t really look at their pay stubs and wouldn’t be struck by the much smaller after-tax amount. However, I do look at each of my pay stubs. This incentive scheme would work better on me if the letter they gave me had a prominent after-tax figure.

Friday, June 7, 2013

Short Takes: Tax Efficiency in Fixed Income, TFSA Over-Contributions, and more

I wrote 4 posts this week that drew quite a few reader comments that are worth checking out:

Can a Raise be Bad for Your Finances?

Foreign Exchange Fees

Invest Side-By-Side with Me

Couch Potato Investors are Rare

Here are my short takes and some weekend reading:

Canadian Couch Potato explains why a new ETF based on strip bonds is tax-efficient for fixed-income investors using taxable accounts.

The Blunt Bean Counter thinks that both investors and their advisors are to blame for TFSA over-contributions.

Big Cajun Man says you shouldn’t make big financial decisions late in the day, and that people who try to sell you big-ticket items know you’re less likely to buy the next morning.

My Own Advisor explains why he’s not interested in trading futures.

Million Dollar Journey is getting close to a million dollars. I assume the blog will disappear the instant the magic million dollar mark is reached :-)

Thursday, June 6, 2013

Couch Potato Investors are Rare

Passive investing using low-cost index ETFs and mutual funds is rising in popularity. The number of investors who are excited by the idea of couch potato investing is growing every day. However, in a recent conversation I had with Canadian Capitalist, he observed that enthusiastic couch potatoes usually don’t really invest passively. Sadly, I have to agree.

Let me start by admitting my own transgressions. It took me many years as a stock-picker before I finally decided that I was better off investing passively. Even then I took my sweet time selling off individual stocks and buying low-cost broadly-diversified ETFs. I still hold one individual stock (Berkshire Hathaway) for less than 10% of my portfolio. I don’t intend to ever buy more Berkshire, but this is still a deviation from index investing.

So, I’m not a pure passive investor. But, even if we adopt fairly lax standards for what constitutes passive index investing, few self-described couch potatoes meet the test. Following are 3 categories of not-really-passive investors that I’ve seen.

Stock Picker on the Side

These investors have most of their savings invested passively, but keep 10% or 20% in a side account to scratch their stock-picking itch. The trouble is that in this smaller account their annual stock turnover might be 100%, 300%, or more. This frequent trading usually leads to losses, and replenishing side accounts takes savings away from the passive part of their portfolios.

Dividend Investor on the Side

The idea of collecting fat dividend cheques is irresistible to some investors. Fortunately, most dividend investors hold their stocks for long periods. They usually suffer from too much stock concentration, but adding some dividend stocks on the side of a passive portfolio is likely to be the least damaging of the three types of not-really couch potato investors described here.

ETF Market Timer

I’m always baffled when an investor listens to my short pitch for passive investing and responds with something like “I love couch potato investing. I’ve been doing it for a couple of years. Do you think the stock market is overvalued right now? I sold out of XIU and VTI a few months ago, but I’m wondering whether now is the time to get back in.” These people just won’t believe me when I say I have no idea where the market is headed in the short term. They are very far from being couch potatoes and their long-term returns are very likely to fall a long way short of market returns.

On average, any deviation from pure passive investing is likely to lose money. There will always be those who manage to beat the market, but more will lose to the market.

Wednesday, June 5, 2013

Invest Side-By-Side with Me

Inspired by side-by-side arrangements where a mutual fund invests in the same assets as a hedge fund, I’ve decided to start my own side-by-side arrangement. Just as these mutual funds give small-time investors access to the investment choices of hedge fund managers, my arrangement will give investors access to my stock-picking.

Just take a look at the chart of my 1999 portfolio return and you’ll see why this could be a great deal for investors. They will get access to a fund that contains my stock picks. The best part is that I won’t charge any management fee.

Here’s how it will work. Every 3 months, I’ll buy shares in my top 100 stock picks using a mixture of my personal assets and fund assets. After the 3 months are up, I’ll allocate a non-random set of shares to my personal account (based on purchase price) in proportion to how much of the purchases were made with my money. The rest of my purchases go to the fund. Then I do it over again with another 100 stock picks.

Fund investors are guaranteed to get results based on stocks personally picked by me. Who’s in?

In case it’s not obvious, this is a joke. I’ve exaggerated some of the abuses of side-by-side arrangements.

Tuesday, June 4, 2013

Foreign Exchange Fees

Reading a review of Qtrade at Money Smarts, I was struck by the description of the foreign exchange fees as “pretty good”. They may compare favourably to foreign exchange fees at other discount brokerages, but compared to a reasonable fee, they are horrendous.

For amounts over $25,000, Qtrade charges 0.96%. This is $240 on $25,000. What is there to justify such a high cost? I can understand the need to recover costs when handling actual cash. It costs money to pay employees to give out cash, and you have to take on currency risk for days to hold onto cash. However, these costs don’t apply to electronic transactions.

A simple fee of $10 plus 0.1% for electronic conversions among major currencies would leave plenty of profit margin for banks and brokerages. This corresponds to $35 on $25,000. I understand that businesses seek profits and will charge what the market will bear, but it is time that investors demanded more reasonable foreign exchange fees.

Monday, June 3, 2013

Can a Raise be Bad for Your Finances?

A heuristic I’ve heard about a few times is that you should have 12 times your gross salary saved before you retire. I’ve always had a vague feeling of uneasiness about this rule of thumb, but the problem with it never hit home with me until I started thinking about a raise I’m expecting soon.

Suppose I currently have retirement savings equal to 11 times my salary. I’m close to being able to retire by the 12 times salary heuristic. Suddenly, through no fault of my own, I get a 10% raise. Now my retirement savings are only 10 times my salary. My retirement dream is slipping away. I probably have to work an extra year or two and pray I don’t get any more raises.

This is crazy. The ratio of savings to salary just makes no sense for me. I should be calculating the ratio of my savings to my yearly spending instead. Focusing on this spending-based ratio means that raises are a good thing because they allow me to build my savings faster.

It may be that the savings to salary ratio makes sense for people who automatically increase their spending to match any pay increases, but that doesn’t apply to my family. My raises have no noticeable effect on my family’s spending. I’m going to delete the cell in my savings spreadsheet that calculates my savings to salary ratio.