Friday, February 28, 2014

Short Takes: Retirement Magic Number and more

Thanks to Rob Carrick for a mention in his best-of-the-web roundup of my post It’s Time that Renting Got a Little Respect.

Here are this week’s posts including a chance to win a UFile giveaway:

Reminiscences of a Stock Operator

UFile Review and Giveaway

Replying to Email

Here are some short takes and some weekend reading:

The Blunt Bean Counter has reached the last installment of his series on how much money you need to retire and offers some dollar amounts.

In another good post from The Blunt Bean Counter, he explains the bizarre situation where Canadians who hold foreign stocks in their non-registered accounts at Canadian brokerages have to give detailed reports on a T1135 form. I’m all for catching tax cheats, but why such onerous reporting rules for stocks held within Canada by one of our big banks or other well-known brokerages?

Financial Crooks encounters some major T5 hassles with a joint PC Financial account. If you can believe it, she was asked to wait a month before calling again to try to correct things. That’s some amazing customer service.

Big Cajun Man published a post explaining that the Canadian government will stop issuing physical cheques in a couple of years. It’s not clear what will happen to people who don’t have bank accounts. Perhaps this deadline is artificial and is just designed to get more people to sign up for direct deposit.

Million Dollar Journey explains how construction mortgages work. (This is where you buy land and have a new home built.) It turns out that the bank doesn’t ever want to give you more money than the land and house are worth. So, you get money in stages based on how much the bank could recover in a foreclosure.

My Own Advisor channels the Wealthy Barber with his advice on RRSP tax refunds.

Wednesday, February 26, 2014

Replying to Email

I get a lot of blog-related emails. Some of them are interesting questions and comments from readers. Generally I reply to these directly. Here I reply to three emails that I would normally ignore.

Dear Christina,

Thank you for your newsletter offer. If you know how to profit by anticipating the moves Janet Yellen will make as chair of the U.S. Federal Reserve, why don’t you just go ahead and make yourself wildly rich? I don’t understand why you would share this profitable insight with me. If your motives are altruistic and it’s not too much trouble, please use your knowledge to make a pile of money and send a share of it to me.




Dear Natalie,

Thank you for your offer to give me access to your data about ultra-wealthy investors. While it’s possible that behaving like wealthy people will help make me wealthy, it seems more likely to me that causation is the other way around: becoming wealthy is what leads to behaviours like conspicuous consumption and large donations to charity. So, if I ever become ultra-wealthy and can’t figure out what to do next, I’ll contact you.




Dear Monica,

Thank you for your insights on gold and your offer for an app that provides up-to-the-second gold prices. I have decided not to turn my entire net worth into a lump of metal that fits in a backpack. Thinking back, I’ve lived through many months without any gold price updates and I was generally happy.



Tuesday, February 25, 2014

UFile Review and Giveaway

UFile has generously offered 6 activation codes for their online 2013 tax software to give away to my readers. I decided to go through the exercise of trying UFile’s online tax preparation to see how well it works in addition to giving away some codes.

UFile’s online income tax preparation uses the interview method which means that they ask you a series of questions rather than just let you flail away at tax forms. In general, I find this much easier than using tax forms, but I invariably find that some complication or other in my tax situation forces me to look at the detailed tax forms a couple of times to check that all went well with the interview.

The online version of UFile does not permit you to see the detailed forms that UFile calculates from your interview answers. I assume the reason for this is that they allow you to fill out your taxes without paying anything. It isn’t until you file your taxes that you might have to pay for an activation code. If they showed you the forms view, you could try to print them out and avoid paying for UFile’s service. This seems like a lot of trouble to avoid a modest charge, but no doubt some people would try.

Overall, UFile online worked quite nicely for the fictitious example I tried. It handled a T4, dividends, capital gains, tuition, and a T1135 for Mr. Bob Smith whose Social Insurance Number is suspiciously close to the digits of pi. The interface works well, and the explanations of what data to enter were clear.

UFile Online Pricing

1. $15.95 for an individual return. You can add a spouse for $10. Dependants whose income is under $20,000 are free.

2. Free for those filing their taxes with CRA for the first time.

3. Free for simple returns regardless of income (single T4 or just OAS and CPP/QPP, only standard non-refundable tax credits, no other deductions such as RRSPs, charitable donations, or medical expenses).

4. Free for post-secondary students.

The Giveaway

To enter the draw, send an email with the following things:
– Subject: UFile
– Answer to the following skill-testing question: (4 x 5) + (9 x 5)
– Use the email address listed at the “Contact” link (For those who are reading this from my feed or by email, you’ll have to click through to my web site to get the address.)

I will only use your email address for the purpose of contacting the draw winners or to send a personal reply if your message is particularly clever but you don’t win.

Another benefit of going to my site when reading a post is to see the comments other readers leave on that post. All entries received before noon Eastern Time on Sunday, March 2 will be considered for the draw. I will make a random draw without favouring any particular entries. I reserve the right to eliminate entries that I judge to be outside the spirit of the contest. Good luck!

Monday, February 24, 2014

Reminiscences of a Stock Operator

I was somewhat skeptical about a recommendation to read a century-old book about stock trading, but Reminiscences of a Stock Operator (annotated edition) by journalist Edwin Lefèvre is an entertaining and illuminating historical novel. The book is written in the first person about character Larry Livingston and is based mainly on the life of the great trader Jesse Livermore. The version of the book I read was greatly enhanced by journalist Jon D. Markman‘s extensive annotations explaining many terms unfamiliar today and giving many back stories to put Lefèvre’s writing into context.

The main character makes a fortune and then loses it again several times over, each time gaining new insights into stock trading. The limited regulation of the time permitted extensive leverage and many attempts to corner markets. Common themes are manipulation of the investing public and back-stabbing among big traders. No doubt the many trading lessons woven into this story would have some usefulness to traders today.

Here are a few parts of the book that struck me as particularly interesting:

Livingston describes a complete hierarchy of chumps: those who bet blindly, those who buy on dips and memorize some simple rules, careful traders who listen to too many experts, and semi-pros who take profits too quickly in a bull market. I could definitely see my former self among the extensive description of these chumps.

“It was never my thinking that made the big money for me. It was my sitting. ... I’ve known many men who were right at exactly the right time [but traded out of their positions too soon].”

The average man desires “to be told specifically which stock to buy or sell. He wants to get something for nothing. He does not wish to work. He doesn’t even wish to have to think.”

A funny line about telling tall tales: James J. Hill “was worth from fifty million to five hundred million, the estimate depending upon the state of the speaker’s liver.”

“There was practically no opportunity for me to make big money [from 1911 to 1914]. The market flattened out.” For traders to be successful, they need action (volatility) and victims (bad traders).

“Lefèvre’s implicit message is: Just say no to all tips ... No doubt he would be appalled by financial cable television.” Seeking tips is “not so much greed made blind by eagerness as it is hope bandaged by the unwillingness to do any thinking.”

Even a century ago regulations were stricter on stock manipulation than they had been years before: “Most of the tricks, devices and expedients of bygone days are obsolete and futile; or illegal and impracticable.”

A comment related to modern day behavioural finance: “there is profit in studying human factors—the ease with which human beings believe what it pleases them to believe.” Attributed to Thomas F. Woodlock: “The principles of successful stock speculation are based on the supposition that people will continue in the future to make the mistakes that they have made in the past.” This is the reason why modern-day active investors want index investors to get into the active fray and make mistakes.

In Livermore’s later years “outside financiers pooled their shares in a company that was not moving fast enough for their liking and hired pros like Livermore to sell them to the public at higher prices.” Stock manipulation seems mainly to be an exercise in creating a pattern of trades that moves prices and draws the public into the wrong side of trades at favourable prices for the manipulators. The public are essentially chumps in this exercise. “The big money in booms is always made first by the public—on paper. And it remains on paper.”

It’s hard to say how helpful the lessons of this book are to traders today. No doubt they need to know at least as much as this book teaches, but I suspect that it takes far more skill and automated tools to make money trading today than was required a century ago. This book describes a romantic time when it was possible for a lone trader to make short-term money on the mistakes of other traders. Even if there is no useful lesson on how to get rich, this story is worth the read.

Friday, February 21, 2014

Short Takes: Optimal Asset Allocation, Foreign Withholding Taxes, and more

I wrote another 3 posts this week:

Telling Us What We Want to Hear about Our Retirement Magic Numbers

The Double-Up GIC

Double-Up GIC – the Catch

Here are some short takes and some weekend reading:

Canadian Couch Potato answers a reader question about how to find the optimal portfolio asset allocation percentages. Within reason, just about any allocation percentages can work out well if you stick to them. If you keep tinkering so that you’re a closet active investor, you may be headed for poor results.

In another good post, Canadian Couch Potato shows how to work out the foreign withholding tax cost of ETFs holding foreign stocks. Fortunately, he works out all the details for many different ETFs.

The Blunt Bean Counter has part 5 of his series on how much money you need to retire.

My Own Advisor explains why he is keeping his 14-year old car.

Big Cajun Man thinks that any income you have to declare on your taxes for bank account interest should be net of bank account fees.

Million Dollar Journey shows how you can save money with instructions on doing your own snow blower maintenance.

Thursday, February 20, 2014

Double-Up GIC – the Catch

The point of my Double-Up GIC was to illustrate the tricky rules used in market-linked GICs by taking these rules to the extreme. The advertising of market-linked GICs makes it seem like you have a guarantee to get your money back if stocks fall and can get the market return if stocks rise. This isn’t the case. Market-linked GICs have rules that significantly reduce the return you get if the stock market goes up.

The catch with my Double-Up GIC is that each of the 560 linked stocks must go up during all 60 months for you to get your full 100% return. Any excess return for a stock in a month above 0.00206% is wasted, but any drop in a stock counts fully. Across all the stocks there are a total of 560*60=33,600 monthly returns. If all the negative returns compound to a 50% loss, then these losses will completely cancel all the capped positive returns. So, if one-eighth of the stocks show a loss of 1% or more in the first month, you’re already guaranteed to get only your principal back and no added interest after the 5 years. So much for the dream of a double up.

It would take quite a conspiracy to cause the markets to go up so consistently that this GIC pays any interest at all. If I had no empathy and sold such a GIC to some suckers, I would invest enough of their deposits in a 5-year stripped bond to cover the return of principal and invest the rest in two ETFs that cover the TSX 60 and S&P 500. This way I couldn’t lose on having to pay back the principal, and if stocks happen to perform so magnificently (perhaps due to runaway inflation) that I owe some interest after 5 years, my stock investment would most likely cover the interest I owe.

Of course, the tricks the big banks use to limit interest payments aren’t this punishing, but you have to read through the fine print and do some math to see why market-linked GICs won’t give you much of the returns from stocks.

Wednesday, February 19, 2014

The Double-Up GIC

Canada’s big banks all offer various types of market-linked Guaranteed Investment Certificates (GICs). The idea is that your principal is 100% guaranteed, and if the stock market performs well enough you get higher returns than standard GICs pay. It’s like you can have your cake and eat it too. However, the returns usually have a fairly low cap. I decided to design my own market-linked GIC that I’d be happy to offer to the public if it weren’t for two things1.

My Double-Up GIC would offer the potential for a 100% gain over 5 years. The big banks tend to offer much lower maximum returns. The interest paid would be linked to the Canadian TSX 60 stocks and the U.S. S&P 500 stocks. However, even if stocks crash, investors’ principal would be 100% protected and would be paid back after 5 years.

Here is the detailed calculation of the interest payment. In each of the 60 months we start with that month’s compounded share of the potential 100% gain (1.162%). Then we take the month’s returns of each of the 560 stocks and cap each stock’s return at its compounded share of the month’s maximum return (0.206 basis points) and then compound all the stock returns together. Then we compound together the 60 monthly returns to get your final 5-year return. If this final return is negative we move it up to zero; you never lose principal.

A big advantage of the Double-Up GIC is that it uses compound interest rather than the simple interest calculation many of the big banks use to calculate your market-linked GIC returns. We all know that compound interest grows your money faster than simple interest. Another advantage is that my interest calculation is much simpler than the elaborate calculations some of the big banks use.

Like other market-linked GICs, the Double-Up GIC strikes a balance between the bank’s desire for profits and investors’ desire for the appearance of safe access to stock-like returns.

1 Financial regulations and my ethics.

Tuesday, February 18, 2014

Telling Us What We Want to Hear about Our Retirement Magic Numbers

Wouldn’t it be great if we didn’t need to save so much money to have a great retirement? Well, if you don’t look too closely, David Blanchett, Head of Research at Morningstar Investment Management, can help with his paper Estimating the True Cost of Retirement.

Blanchett’s paper is very clearly written making it quite easy to follow his logic:
1. Most studies of safe retirement spending levels assume that spending increases by inflation each year (i.e., flat spending in real terms).

2. Thorough research of real spending data shows that retirees’ spending, on average, does not increase by the full amount of inflation each year.

3. A typical conclusion based on flat spending is that the maximum safe withdrawal rate is 4% at the start of retirement.

4. Using the actual spending curve for the age range 60-95, the safe withdrawal rate at the start of retirement is closer to 5%.
Isn’t this great news? If you thought you needed $2 million to retire well, Blanchett says you only need $1.6 million. However, if you see a possible flaw in the logic, I’m with you.

As long as you imagine retirees sitting beside their wheelbarrows full of cash and deciding “you know, I just don’t feel like spending as much this year as I did last year,” Blanchett’s logic seems to make sense. But what if retirees are dragged kicking and screaming into a lifestyle of lower spending by the fact that their savings are drawing down dangerously quickly? Maybe they start to spend less not because they want to, but because they have to.

Blanchett discusses this very possibility midway through Section 5 of his paper:
“What is less clear ... is whether the change in expenditures (i.e., consumption) is by choice or by need. It may be that the reason average expenditures decrease is because the average retiree did not save enough for retirement and is therefore forced to reduce consumption not out of want, but out of need.”
Blanchett then goes on to provide strong evidence that spending reductions are indeed forced. He breaks up his sample of retirees into four quadrants, high and low spending and high and low net worth. In the quadrants where both spending and net worth are matched (low-low or high-high), spending tends to drop in retirement, although more so for wealthier retirees. In the low-spending, high net worth quadrant, spending actually rises considerably faster than inflation. The high-spend, low net worth quadrant sees the biggest spending drops.

To summarize, the only quadrant of retirees who have a choice as to whether they can increase spending are the low spenders with high net worth, and they choose to spend more each year. So, a reasonable hypothesis is that the majority of people who spend less as they age do so because they are forced to rather than just wanting to spend less.

Having made this point very well, I thought Blanchett’s paper would head off in a different direction, but this section just becomes a dead end. Section 6 picks up again with the presumption that if most people spend less each year in retirement, that’s good enough for you too.

When you dream about retirement, does it include forced reductions in spending? I have little doubt that this is the fate awaiting most people, but it seems like a strange goal. I’m hoping that as I become less physically capable I’ll have more money available to give my granddaughter free use of my car in return for driving me to my poker games, or to pay my whole family’s way to a vacation with me in Aruba.

At the very least, any recommendation to spend 5% of savings in the first year of retirement should come with the following explanation. “Most people are forced to reduce their spending through retirement as their savings dwindle. I think this is good enough for you too, so go ahead and start spending 5% of your savings in the first year.”

Friday, February 14, 2014

Short Takes: Robo-Advisors, Retirement Magic Number, and more

I wrote 3 posts this week:

Cushioned Retirement Investing

Adjusting the 4% Rule for Portfolio Fees

The Gap Between the Financial Advice You Need and What You Get

You can follow me on Twitter (@MJonMoney). Here are some short takes and some weekend reading:

Canadian Couch Potato thinks that robo-advisors are unlikely to come to Canada because the market isn’t big enough. However, on 2014 Jan. 15, David Chilton tweeted “Solid, unbiased, ultra-low-cost financial advice will be automated in user-friendly apps over the next few years. Will change everything.” I guess we’ll see what happens.

The Blunt Bean Counter added two more instalments to his series on how much money you need to retire. See part 3 and part 4.

Where Does All My Money Go? has Preet’s latest podcast where he gets a teacher’s perspective on financial literacy in schools. Kyle Prevost makes some very candid remarks about teachers and their math abilities and financial skills. In another interesting remark he says that economics majors can’t get into a faculty of education program.

Million Dollar Journey has a comprehensive guide to cutting the cable cord.

Big Cajun Man suggests some Valentine’s Day gifts in the form of contributions to registered savings plans. I’m guessing that this type of gift would go over well for couples who already save very well, and would cause a great deal of unhappiness for couples who desperately need to save more.

SquawkFox has some ideas for Valentine’s Day for those on a budget.

Wednesday, February 12, 2014

The Gap Between the Financial Advice You Need and What You Get

Most people need financial advice. You don’t need much experience explaining financial matters to people to see that most need help. However, this doesn’t mean we can make the logical leap to saying that people need the services of a typical financial advisor. There is a huge gap between the financial advice people need and what they get from the typical advisor.

The typical financial advisor will choose investments for you (usually high-fee mutual funds) and handle the mechanics of opening accounts and investing your money. While people need some guidance to choose an appropriate asset allocation, the truth is that opening accounts and choosing investments isn’t all that difficult. One option is to take a risk-tolerance quiz and choose one of Canadian Couch Potato’s model portfolios.

Here is a sample of the types of questions that people really need help with:

1. Should I invest in an RRSP, TFSA, RESP, or something else?

2. My advisor wants me to borrow to invest. Should I use leverage?

3. How can I pay my advisor fairly for his or her advice but keep other investment costs to a minimum?

4. The market just dropped 500 points! Should I sell?

5. The market has been climbing crazily lately! Should I buy more stocks?

6. Which accounts should hold my stocks and which should hold bonds?

7. When I retire, how much can I safely spend without running out of money when I’m old?

8. How should I organize my finances to reduce income taxes?

There are great advisors out there who give good advice to their clients on these questions and more, but such advisors are in the minority.

If you think the main job of a financial advisor is to choose investments, then you’ll likely pay a very high price for a fairly simple service. If you think the main job of an advisor is to help you outperform the market, then you’re very likely to be disappointed. Consistently beating the market is exceedingly difficult and an advisor who could really do it likely wouldn’t waste his or her time talking to you.

If you’re going to pay for financial advice, make sure you’re getting the help you need on the difficult questions and not just a person who chooses expensive mutual funds.

Tuesday, February 11, 2014

Adjusting the 4% Rule for Portfolio Fees

The 4% rule for retirement spending comes from a 1994 paper by financial planner William Bengen called Determining Withdrawal Rates Using Historical Data. Bengen showed that portfolios with 50% to 75% U.S. stocks and the rest in intermediate-term treasuries would last for 30+ years with yearly inflation-adjusted withdrawals of 4% of the starting portfolio value. However, Bengen assumed that you don’t pay any investment fees. Here I replicate Bengen’s study and look at how fees affect the results.

The retirement spending plan tested by Bengen differs from my ideas on Cushioned Retirement Investing in two main ways. With cushioning, you adapt your spending somewhat if investment returns severely disappoint, and the cushion leads to your portfolio volatility dropping through retirement. Bengen tested a strategy where you choose the withdrawal amount based on your portfolio size at the start of retirement. Once the withdrawal amount is set, you only adjust it for inflation. Bengen also assumes that you stick with a fixed asset allocation throughout retirement.  This inflexible approach is how he calculated his safe initial spending percentage, but he was clear that a real retiree may choose to increase or decrease spending in the face of a portfolio that is declining severely or growing wildly.

So, if you have a million dollars at the start of retirement, the 4% rule says you get to spend $40,000 in the first year and bump that up by inflation every year. Bengen checked how this strategy performed for 51 retirees retiring each year from 1926 to 1976. The retirees were assumed to own U.S. stocks and intermediate-term treasuries in either a 75/25 or 50/50 ratio.

I used Robert Shiller’s online data to replicate Bengen’s results. Shiller only had long-term bond data rather than intermediate-term, but I found it made little difference to the results. The number of years that each portfolio survived differed by a year or two from Bengen’s results in only a few places.

Bengen found that with the 4% rule, all 51 retirees’ savings lasted for at least 30 years and only 5 of them lasted for less than 40 years. So, I used this as standard for what is acceptably safe. Running my simulation, the largest withdrawal that passed the acceptability test was 4.03% for the 50% stock portfolio, and 4.00% for the 75% stock portfolio. So far so good. The results match Bengen’s.

Next, I introduced portfolio fees. For management expense ratios (MERs) ranging from 0% to 4%, I repeated the simulations to see what maximum withdrawal rate would pass the tests. You might think that the maximum withdrawal rate would simply be 4% minus the MER; this isn’t true because the MER is charged on an ever-declining portfolio size, but the 4% applies to the starting portfolio size.

Here are the results:

By the time the MER reaches 2.2% for a portfolio 75% in stocks, the 4% rule has become the 3% rule. You might think that using a 3% rule is just a more conservative approach, but this isn’t the case. Using a 3% rule with a 2.2% MER is just as risky as using the 4% rule with no portfolio costs (not that it’s possible to get away with no costs at all).

If you blindly follow the 4% rule without understanding where it came from, you’ll likely end up running a much higher risk than you realized of running out of money later in retirement.

Monday, February 10, 2014

Cushioned Retirement Investing

Most of us believe that we should reduce the riskiness of our portfolios when we retire. However, there is little agreement on exactly how to do this. One common rule of thumb is to use your age as your percentage in bonds. However, such fixed rules just don’t take into account people’s unique circumstances. I prefer a technique I call Cushioned Retirement Investing to reduce risk. This technique is based on the simple principle that you shouldn’t invest money you’ll need in the next 5 years in risky investments.

There is nothing magical about the 5-year threshold. More daring types may choose 3 years, and more conservative types may prefer 7 years. I’ll stick to the 5-year figure for this discussion.

The main idea is that you keep any money you’ll need in the next 5 years out of the main part of your portfolio. Because the main part of your portfolio only holds funds that will be there for 5+ years, it can stick to your preferred asset allocation for your entire life. If you have a 75/25 split between stocks and bonds through your working life, you can keep the same allocation in retirement, as long as you maintain 5 years of living expenses safely off to the side.

By “safely off to the side,” I mean something like a high-interest savings account (HISA), short-term government bonds, or guaranteed investments at a bank. However, any bonds or guaranteed investments have to come due before you need the money.

Making Yearly Adjustments

If you’re using cushioned retirement investing, you’d need to make adjustments to start each year. First decide how much money you’ll need over the next 5 years (taking into account inflation). Because of your spending over the past year, you’ll likely have only about 4 years of spending set aside. So, you’ll have to gather some cash from your portfolio, which will likely require some selling. Once you’ve got a full 5 years of spending set aside again, you’re set for another year.

The process of setting aside money actually starts well before retirement. When you’re 4 years away from retiring and you look at your needs over the next 5 years, you’ll need to set aside one year of spending somewhere safe. The following year, you’ll need to set aside another year of spending, and so on.

How Much Can I Spend?

Most of us have no grand plans for leaving a big inheritance and want to know how much we can spend in retirement. In a previous post I offered a spreadsheet that allows you to input information related to your situation and calculate the percentage of your portfolio you can spend each year. Keep in mind that the answers are only as good as the inputs you provide. There is also a page on the spreadsheet for doing the calculation in the other direction: figuring out how much you need to retire.

An Objection

Some might object that it makes no sense to maintain the same asset allocation into retirement. Keep in mind that it is only what I call the main portfolio (excluding the cushion) that maintains the same asset allocation into retirement. If we look at total savings including both the main portfolio and the cushion, things are different.

In the 5 years leading up to retirement, the cushion builds. This lowers the volatility of the total savings. Further, as you draw down your main portfolio in retirement (as most people will), the cushion becomes a larger percentage of total savings, which lowers volatility further over time.

Other Applications of Cushioning

Cushioned retirement investing isn’t just for people looking to maximize spending. It can apply equally well to those who intend to leave an inheritance. If you’ve got a $5 million portfolio, but only spend $80,000 per year, you could just keep aside $400,000 and invest the rest with an asset allocation suitable for the long term.

In fact, the principles behind cushioned retirement investing can apply even before retirement. For example, they can be used for RESP investing. You could maintain your preferred asset allocation throughout the life of the RESP, except that starting 5 years before your children start post-secondary education, you begin setting aside some money in safe investments. The idea is that this safe money is still within the RESP until it gets spent, but you think of it as outside the main RESP holdings that are invested with your preferred asset allocation.

We can even think of an emergency fund as an extension of the idea of a 5-year cushion. The emergency fund is money that you might need over the next 5 years in case you have unexpected expenses or lose some income.

Cushioning can also apply to saving up for a house, cottage, or car. If you plan to buy in less than 5 years, the money should be kept safe.


Overall, I prefer cushioned retirement investing to hand-wavy advice on how to adjust your asset allocation as you enter retirement. A side benefit is that the concept of cushioning is general enough to apply to many other aspects of financial life as well.

Friday, February 7, 2014

Short Takes: Inefficiency of Long Hours and more

I had another full week of posts. How much longer will I keep this up?

Working Out Your Retirement Magic Number

How Often Should You Buy Stocks with New Savings?

It’s Still Not Rocket Science

Abusing the 4% Rule

You can follow me on Twitter now (@MJonMoney). Here are some short takes and some weekend reading:

Freakonomics discusses a study on the effects of long work hours. Just about every high-tech company I’ve worked for celebrates employees who work long hours. I’ve long known that my own performance drops off badly if I try to work too many hours. It’s not just that I’m inefficient in hours 9 through 12 of a given day – I’m likely to be inefficient the entire next day as well. Adequate exercise, rest, and mental relaxation give me the time to reflect and “work smarter.” If I work too many hours, I’m very unlikely to see a better way of getting things done. However, any discussion of these facts at work just sounds to management ears like a lack of commitment to the company, so I usually keep these thoughts to myself.

The Blunt Bean Counter is running a series on how much money you need to retire. Here are part 1 and part 2. My concerns about the 4% rule are that many people don’t understand that you have to pay portfolio fees out of the 4% yearly withdrawal, and you need to be prepared to cut back your spending if your portfolio performs very poorly.

Big Cajun Man explains how he doesn’t use his TFSA for long-term or short-term needs, but for middle-term needs.

Million Dollar Journey explains why a mortgage vacation may be the most expensive vacation you’ll ever take.

My Own Advisor is giving away 6 codes for TurboTax online.

Thursday, February 6, 2014

Abusing the 4% Rule

The 4% rule says that it’s safe to start retirement drawing 4% of your portfolio in the first year and increasing the withdrawal amount by inflation each year. There are important caveats that come with this rule, but they seem to get lost in the retelling.

The 4% rule originated with an excellent and very accessible 1994 paper by financial planner William Bengen called Determining Withdrawal Rates Using Historical Data. Bengen showed that portfolios with 50% to 75% U.S. stocks and the rest in intermediate-term treasuries would survive well with yearly withdrawals of 4% of the starting portfolio value. The idea is that once the withdrawal amount is set, you only adjust it for inflation; Bengen assumes that you don’t adjust your spending based on your portfolio’s returns.  This inflexible approach is how he calculated his safe initial spending percentage, but he was clear that a real retiree may choose to increase or decrease spending in the face of a portfolio that is declining severely or growing wildly.

Simulating retirements beginning each year from 1926 to 1976, Bengen showed that portfolios of 50% to 75% stocks lasted more than 30 years every time and usually lasted more than 50 years. Of course, he didn’t have 50 years of data for the later retirees, but he could see that these retirees were on a good path.

A detail Bengen never discussed was portfolio fees. I had to look up some of the return numbers he included in the paper to confirm that he was using S&P 500 nominal stock returns with dividends and no portfolio costs.

Let me repeat that last bit: he assumed that the management expense ratio (MER) was zero.

No doubt Bengen is a respectable fellow who had no intention of misleading anyone. Perhaps he invests his clients’ money in a very low-cost manner, and he gets paid out of their yearly withdrawals.

Of course, it isn’t possible to invest without some costs. I pay a rock-bottom 0.12% per year right now. This climbs to around 0.4% or so per year if you use TD’s e-series mutual funds well. The costs get much higher if you pay for financial advice.

The 4% rule works well in its intended habitat. The problem comes when an investor (or his or her advisor) uses Bengen’s research and assumes that it’s safe to apply it to a portfolio filled with a bunch of crappy balanced mutual funds with exorbitant MERs. This is like taking a rule of thumb about how much juice you can get from an orange and applying it to juicing a grape.

Fees matter. Investors and advisors can make fees disappear in a puff of bad logic when misapplying the 4% rule, but reality will strike when your portfolio shrinks faster than you hoped in retirement.

Wednesday, February 5, 2014

It’s Still Not Rocket Science

In a follow-up to It’s Not Rocket Science, Tom Bradley at Steadyhand has another investment book out called It’s Still Not Rocket Science. Like the first book, this one is a collection of a few years of Bradley’s essays explaining investment topics clearly. Bradley’s style contrasts sharply with the usual message from the investment industry that investing is very difficult and that you’d better hand over your money before it blows up.

Disclaimer: I did not receive any compensation from Steadyhand to write this review other than a free copy of the book. My relationship with them is limited to having met a few times and liking how they treat their clients. I’m a DIY indexer myself, but for those seeking advice, Steadyhand offers lower fees than most other options. Further, Steadyhand is actually trying to beat the index rather than charging high fees for just hugging the index.

Here are a few ideas from the book that jumped out at me.

Measuring Personal Returns

Most do-it-yourself stock pickers “don’t take the time to calculate their overall return.” This makes it easy to lie to others, “although it’s more often to themselves.” My experience has been that most people who buy lottery tickets claim they have made more than they’ve spent, and most stock pickers claim they’ve beaten the market.

Return of Capital as a Selling Feature

“A product has an advertised yield of 6 per cent, but is earning only 3 per cent from interest, dividends and capital gains (after fees). The investors’ capital is used to cover the rest of the distribution. It’s a marketer’s dream. The client makes up the shortfall and it’s positioned as a selling feature. ‘Buy now and you’ll receive a tax-efficient 6 per cent yield.’”

Unrealistic Expectations

“Our clients think we can do more than we’re capable of. Some think we know which stocks are going up and when to get in and out of the market.” These expectations are fueled by the tendency to highlight “savvy stock picks and prescient interest rate calls.” The industry advertises “the funds that are performing the best right now.”

Bradley’s essays are worth a read whether you want to be a better investor yourself or want to understand the mutual fund industry better.

Tuesday, February 4, 2014

How Often Should You Buy Stocks with New Savings?

My son recently set up his first TFSA and has $450 per month flowing into it. His plan is to buy Vanguard Canada’s exchange-traded fund VCN with this money. Once his portfolio grows, he’ll consider adding other stock indexes and other asset classes. After the first deposit, he asked me a good question: “how often should I buy VCN?”

He was clever enough to figure out that making a trade every month might be too expensive, but if he waits too many months between trades, he’s giving up potential growth. There must be some optimum number of months between trades.

The following factors affect the optimum interval between trades:

m – yearly new savings
r – excess yearly return of stocks vs. cash
c – stock-trading commission

Bid-ask spreads are a real cost, but they don’t enter into consideration because they are the same over the course of time no matter how often you trade.

From these values we can calculate

T – threshold cash balance when you should trade to minimize costs

It’s time to trade when the cash balance reaches a threshold1 T equal to the square root of 2mc/r.

I’ll do a few examples below to show how to use this formula.

We’re assuming here that the opportunity cost rate r is constant. In reality, the opportunity cost can turn out to be just about any value depending on how stocks perform. But we can’t know in advance how they’ll perform, so we just use some assumed average rate.

Another note about this formula is that it assumes that there will only be a single trade when the cash threshold is reached. It makes more sense to alternate among purchases of each ETF rather than to save up enough to make several purchases.

In my son’s case, we assumed that the opportunity cost is 6% per year (r=0.06). He pays a $10 commission (c=10). Plugging these figures into the formula simplifies the threshold where you should make a trade to approximately 18 times the square root of m.

In my son’s case, m = 12*450 = 5400. Plugging this into the formula we get that he should make a trade when his balance reaches $1320. His balance will be $450, then $900, and then $1350. Because $1350 is closest to the $1320 we calculated, he would buy some VCN every third month to minimize costs.

Let’s try another example. Suppose you receive $250 in dividends every quarter. Then m=1000. Using r=0.06 and c=10, we get a threshold of about $570. Your balance will be closest to this threshold every second quarter ($500).

An aggressive saver puts away $500 on each bi-weekly pay cheque. So, m=13,000. Using r=0.06, and c=10, we get a threshold of $2050. So, it makes sense to trade every fourth pay cheque.

Many investors will find it unsatisfying to let cash sit around while trying to optimize costs. It can certainly make sense to trade more often for emotional reasons. This is especially true if you are prone to spending the money if it’s just sitting there as cash. But for those interested in minimizing costs, this formula works well.

1 This formula is actually an approximation based on simple interest.  If we use compound interest, we end up with equations that can only be solved numerically.  It turns out that using simple interest gives a very close approximation, and there is little value in further precision.  Let t be the time between trades.  Then assuming that the yearly cash contribution m builds continuously, the cash balance will be mt when we trade.  The average cash balance is mt/2.  The foregone interest rate (using simple interest) is rt.  The opportunity cost is then (mt/2)(rt).  Add to this the commission cost c.  We incur these costs 1/t times per year.  Then the total yearly cost is mrt/2+c/t.  This is a minimum when t is the square root of 2c/(mr). The threshold cash balance for trading T=mt is the square root of 2mc/r. The only difference when new cash comes in discrete amounts instead of continuously is that we should trade when the balance is closest to the threshold value T.

Monday, February 3, 2014

Working Out Your Retirement Magic Number

How much money do you need to save to retire? This is an important question that gets a lot of debate but few useful answers. We hear arguments over whether a million dollars is enough, as though there is a single number that applies to everyone. Here I offer an answer based on a proposed retirement spending strategy that takes into account your unique circumstances.

Lately, I’ve been writing a fair bit about a proposed strategy for retirement spending in retirement (first description, adding income smoothing, yearly spending percentages, experimental results using 100 years of investment returns). The focus was on turning a lump-sum portfolio into an income stream for retirement. But we can turn this around and calculate how much you need to save to retire using this spending strategy.

I added another page to the spreadsheet that computes the percentage of a portfolio that you can spend each year in retirement based on a set of inputs you supply. (To edit this spreadsheet, you need to go to the “File” menu and “Make a copy”.)  I added a second page to this spreadsheet that collects some more inputs from you and calculates your retirement magic number. I threw in some example figures, but you’ll have to change the values in the yellow boxes to customize it to your own situation.

The spreadsheet’s example figures are based on a couple seeking after-tax retirement income of $6000 per month (rising with inflation). They plan to retire at 55 and will collect $2000 per month in other income (rising with inflation) starting at age 65. Once retired, they plan to keep 5 years’ worth of spending in safe investments, and the rest in low-cost index stock funds that they hope will beat inflation by an average of 4% per year. Their target life expectancy is 100. Their retirement magic number works out to $1,636,000. So, for this couple, a million dollars isn’t enough. Your mileage may vary.

As with any retirement planning exercise, a challenge is to add the right amount of safety margin. I find that some people in their 30s tend to think they can get by on a very low income. While I could go back to living on $2000 or less per month, I don’t want to. I meet few people over 50 who find that their low spending in youth suits them now that they’re older. It’s certainly true that many people of all age groups waste money in ways that don’t really improve their lives much, but I think it is also true that older people have less capacity for ultra-frugal living than the young have.

As always, I’m interested in feedback on these ideas, particularly if you see any problems. I hope this spreadsheet helps some people, but as always, I can’t guarantee anything about the results it produces. Think for yourself.