Friday, August 29, 2014

Short Takes: Closet Indexing, Rent vs. Buy Calculators, and more

Here are my posts for this week:

Leverage Quiz

When Genius Failed

Here are some short takes and some weekend reading:

Jason Zweig gives a clear explanation of why fund managers tend to make their portfolios match the index fairly closely even if their investors would prefer bolder moves.

Potato reviews several rent vs. buy calculators. He takes a much deeper look than writers of most such review posts and actually explains what’s wrong with some of them.

Tim Stobbs explains his approach to early retirement in an interesting interview. His approach sounds very sensible. The one thing that concerns me in declaring my own financial independence is the possibility that when my health eventually declines somewhat, my expenses will rise. I might need to pay someone to mow my lawn, shovel snow, or clean eavestroughs. I may have more direct expenses such as physiotherapy. For this reason, I think early retirement enthusiasts should add a buffer to their current spending to account for possibly needing to spend a little more in their 60s than they do in their 40s. There will obviously be increased spending due to inflation, but I’m talking about more spending in real terms (after accounting for inflation). The dream of early retirement can still be very real, but it might be sensible to delay it by a year or two to create a buffer.

My Own Advisor lists some Canadian dividend stocks to buy and mostly forget. While I don’t believe any investor with a concentrated portfolio can afford to just forget about a stock, it can be okay to not pay much attention if you’re sufficiently diversified.

Big Cajun Man complains that he thought public education was free. Back to school costs prove otherwise.

Million Dollar Journey has begun net worth updates for Sean Cooper. Sean’s frugality and drive for income should put most readers to shame.

Tuesday, August 26, 2014

When Genius Failed

What happens when smart guys including some Nobel Prize winners borrow $125 billion to invest with huge leverage, gain further leverage from derivative contracts, and rely on markets remaining rational and investments remaining mostly uncorrelated to avoid blowing up? This is the story of the hedge fund Long-Term Capital Management (LTCM). Spoiler alert: they blew up.

Roger Lowenstein’s book When Genius Failed is an interesting account of LTCM’s seeming wild success starting in 1994 followed by its spectacular failure that threatened to take down the U.S. banking system in 1998. Apparently, “long term” is 4 years. Lowenstein does a good job of blending financial events with the personal interactions that were important to this story.

In its first four years, LTCM total returns were a staggering 311%! Even after deducting stiff management fees, investors were up 185%. Unfortunately, when trades started going against LTCM’s huge leveraged portfolio, it took only 5 months to erase all those gains and leave the fund’s total return at underwater at -67% before fees and -77% after fees.

“There wasn’t any risk—if the world had behaved as it did in the past.” At one point traders were shocked to see swap spreads surge as high as they did. Surges like this had “happened in 1987 and again in 1992,” but LTCM’s “models didn’t go back that far.”

You may wonder whether LTCM’s partners were evil geniuses who risked investor money and collected fat fees without risking their own money. This wasn’t the case. The partners believed so strongly in their methods that they left all their fees in the fund. They even found ways to add extra leverage to their personal stakes in the fund.

At one point not long before the blow-up, many outside investors were forced to take much of their money back. “The forced redemption of their money would come to seem a godsend.” The partners did this to increase their own stakes in the fund, a decision they came to regret.

One bad day showed the failure of LTCM’s models. LTCM, “which had calculated with such mathematical certainty that it was unlikely to lose more than $35 million on any single day, had just dropped $553 million” in one day.

George Soros had an opinion on LTCM’s methods: “The idea that you have a bell-shape curve is false. You have outlying phenomena that you can’t anticipate on the basis of previous experience.”

LTCM’s “employees, like most at Wall Street firms, had gotten most of their pay in the form of year-end bonus money. Most of those bonuses had been invested in the fund and went down the drain.” A bond trader said, “we ended up working for nothing.”

In the book’s epilogue, Lowenstein asks a good question. Regulators limit lending so that “loans do not exceed a certain ratio of capital. ... Why, then, does Greenspan endorse a system in which banks can rack up any amount of exposure they choose—as long as that exposure is in the form of derivatives?”

I found this book to be an interesting read, and it is instructive for anyone who doesn’t already have a healthy fear of leverage.

Monday, August 25, 2014

Leverage Quiz

When you borrow to invest, it is called using leverage. I’ll explain the basics of leverage and then hit you with a one-question quiz to see how well you understand its effects.

If you have $100,000 and borrow $100,000 more so you can invest a total of $200,000, it’s called using 2:1 leverage. If you borrowed $200,000 to invest a total of $300,000, that’s 3:1 leverage.

Once you’ve leveraged your portfolio, there are two ways basic approaches to maintaining that leverage. One is to rebalance periodically so that you maintain the same level of leverage. This means that if you’re leveraged 2:1 and stocks go up, you borrow to buy more shares to maintain the 2:1 leverage. If stocks go down, you sell shares and pay off some debt to get back down to 2:1. The other basic approach is to treat the debt and investments separately, just paying the loan interest. Your leverage ratio goes up and down as your investments go down and up.

If you had invested in the exchange-traded fund of Canadian stocks called XIU over the past 10 years reinvesting dividends along the way, your total return would have been +143%. With that background, here’s the question:

Q: If you had invested in XIU over the past 10 years with 5:1 leverage, rebalanced weekly and paying 4% per year interest on the loan, what would your total return have been (ignoring trading costs)?

a) +715%
b) +582%
c) +103%
d) -48%


(spoiler below)













I grabbed some historical prices for XIU, did some spreadsheet calculations, and found the correct answer to be d) -48%. This can be hard to understand on an intuitive level. If you invest 5 times as much, why don’t you make 5 times more money? If XIU returns were so much higher than the loan interest, how could you lose money? There are many ways to answer these questions. A simple answer is that when rebalancing you are always buying more stocks when their price is up and selling when their price drops. This buying high and selling low creates a drag on returns that grows with the amount of leverage.

Another way to explain the poor results with high leverage is by explaining volatility drag. If you make 0% twice, your total return is 0%. But if you make 10% then lose 10%, you end up down 1%. Your average return is the same in each case, but the second case has a drag on returns due to volatility.

Volatility drag grows as half the square of the standard deviation of returns (per year). With no leverage, volatility drag for a stock index is usually somewhere close to 2% per year. When you leverage 5:1, you’re growing your return by a factor of 5, but you’re growing the volatility drag by a factor of 25. This makes it close to 50% per year! This huge drag overwhelms the 5 times higher returns.

You could choose not to rebalance your leverage ratio and just treat the debt separate from the investments. However, this just trades volatility drag for the possibility of a complete blow-up. If you start with $100,000 and borrow $400,000 more and invest the whole half-million, all it takes is a 20% investment loss to completely wipe out your original capital. If the lender demands his money back while you’re under water, you’ve lost everything and more.

All this is why leveraged hedge funds are so risky and why brokerages generally don’t permit you use more than 2:1 leverage for stocks. If you plan to borrow to invest, do so with great care.

Friday, August 22, 2014

Short Takes: Bad Financial Ads, Executive Pay Abuses, and more

Here are my posts for this week:

TFSA Penalties Poised to Rise

Test Driving Financial Rules of Thumb

Here are some short takes and some weekend reading:

Dan Hallett uses his expertise to pick apart the misleading aspects of a few ads for investments. The rule seems to be “if it’s misleading but legal, run it.”

Eric Reguly does a great job of explaining executive pay abuses. Stock options do a terrible job of aligning the interests of shareholders and company executives.

Tom Bradley at Steadyhand is advising retired clients to rebalance by topping up their cash reserves. He says “the general range used by our clients is 12 to 24 months” worth of spending in cash reserves. When I started looking at retirement income strategies, I chose 5 years of spending as a cash buffer. I think the difference is that Steadyhand’s client’s portfolios generally contain a significant allocation to bonds that reduces risk. My strategy was based on the cash buffer being the only safe component; the rest of the portfolio is stocks.

Million Dollar Journey provides a complete set of resources for those considering the Smith Manoeuvre. Take some time to understand the risks well before jumping in. In my opinion, leveraged investing is only appropriate for a small minority of investors.

My Own Advisor gave his take on several financial rules of thumb which prompted me to do the same.

Big Cajun Man found that even Cosmopolitan Magazine had some financial advice he needed to heed.

Wednesday, August 20, 2014

Test Driving Financial Rules of Thumb

Taking a close look at some financial rules of thumb began with a post at Brighter Life and jumped to My Own Advisor. Here I give my take on some very common rules of thumb.

Your retirement income needs to be 70% of your working income.

This is obviously just an average or typical case. You should really look at your spending needs, including saving up for bigger items like replacing a car, windows, furnace, flooring, or roof. My family’s spending is currently about 40% of the combined take-home pay for my wife and me. It makes no sense for us to target a retirement income almost double what we need right now. Retirement needs are driven by your spending, not your income.

Keep an emergency fund equal to six months’ income.

I’m a big believer in liquidity. Access to credit may seem like adequate protection, but lenders may take away access to credit in tough financial times. If you lose your job when the biggest employer in town goes bankrupt, banks may not be in a hurry to lend to you. If you can borrow, the rates may be painful.

Exactly how much you need in emergency savings depends greatly on your flexibility. How much can you reduce spending? Are you able to take a job that you could get quickly but may pay less? Are you able to move to find new work? I tend to have 4 to 5 months of spending in cash. Very flexible people may need less than this and others may need more.

Don’t pay more than 3.5 times your gross annual income for your house.

This seems far too high to me. I’d much sooner rent than spend this much for a house. At current prices, it’s certainly possible to rent a nice house for much less than it would cost to own the house. As long as you’re saving the difference, renting can be much less risky.

Don’t invest more than 5% of your savings in any one stock or bond.

This is sensible for stocks and for bonds that have risk, but makes little sense for Canadian government bonds. I actually violate this rule in my own portfolio. I still have about 10% of my savings in Berkshire Hathaway stock. The large built-up capital gains make me hesitant to sell and pay the taxes.

Accumulate 20 times your gross annual income, then retire.

I don’t see the logic of basing retirement goals on my current income. They should be based on my spending. Using this rule, I get further from retirement every time I get a raise. I can just imagine a worker flying into his boss’s office in a rage: “what’s this raise garbage? My savings were up to 19.5 times my pay. I was going to retire in 6 months. Now I’m down to 18 times. I’ll have to work another 2 years!”

Never touch your retirement savings, except for retirement.

Apart from extreme circumstances, this is a sensible goal.

In retirement, you can sustainably live off of 4% of your starting nest egg, rising with inflation.

There is research that supports this rule of thumb. However, it is based on the assumption that you pay no investment fees. If you’re like most Canadians who own mutual funds and (often unwittingly) pay substantial MERs, the safe withdrawal rate is much lower – more like 3% as I showed when I repeated the research to include the effect of fees.

If your employer matches your contributions to a workplace savings plan, go for it.

This is good advice. One thing to watch out for is that if you are forced to invest in company stock with all or part of the money, you should sell out of that stock and buy something else when possible. There are so many examples of companies going bankrupt and employees losing both their jobs and their savings. Like those employees, you may think that your company can’t go out of business. Those companies went out of business and so can yours.

The percentage of your portfolio in bonds and fixed-income investments should be equal to your age.

This is safe enough, but I find it too simplistic. I prefer to put all savings I won’t need within 5 years into stocks. But this isn’t for everyone. A huge potential risk for all investors is the possibility that they’ll lose their cool during a stock market crash and sell low. The 2008-2009 crash was a good test of your ability to stay invested. If you sold stocks back then, even if you think it was for a smart-sounding reason, you may need to keep your stock allocation lower. Even if you just failed to rebalance from bonds to stocks during the crash, your stock allocation may be higher than you can really handle.

Total home ownership costs shouldn’t exceed 30% of your gross income.

This sounds too high to me. As I wrote above, renting is not a bad option when house prices are high.

Your total debt servicing costs shouldn’t exceed 40% of your income.

Again, this sounds far too high to me.

Don’t plan to retire with debt.


You need to have x times your annual income in life insurance.

This is far too simplistic. As your savings grow, your need for life insurance tends to drop. I have far less life insurance now than I did 15 years ago even though my income is higher now.

If there’s one theme running through my reactions to these rules of thumb, it’s that you should think. This shouldn’t be too hard for my readership, but too many people prefer to be told what to do.

Monday, August 18, 2014

TFSA Penalties Poised to Rise

While the number of people mistakenly over-contributing to their TFSAs has been declining each year, the size of individual penalties is likely to grow. This is a consequence of a common type of mistake and growing TFSA balances.

To illustrate the problem, consider our hypothetical hero Joe who dutifully fills up his TFSA every January. Like many Canadians, Joe doesn’t realize that his TFSA can be more than just a savings account collecting modest interest. It’s now January 2020, and after filling up his TFSA yet again he now has $75,000 saved.

Then Joe sees an ad at another bank offering TFSA rates a half percent higher than he’s getting now. That would pay him an extra $375 per year. He decides to take action and withdraws the whole $75,000 and deposits it into a TFSA at the new bank.

Unfortunately, Joe does not do a “qualifying transfer,” which is when the TFSA contents are transferred directly from one TFSA to another without Joe ever handling the money. He just does the transfer himself. “What’s the difference?” you might ask. Qualifying transfers don’t count as a withdrawal and a contribution, but doing it yourself does count as a withdrawal and a contribution.

Those who are familiar with basic TFSA rules will realize that Joe has now made an over-contribution of $75,000. He will be penalized 1% or $750 each month, for a total penalty of $9000 for the year. The catch is that while Joe is allowed to withdraw his money, he’s not allowed to put it back again until the next calendar year (2021).

If Joe had made the same mistake back in 2009 when his balance was only $5000, his penalties for the year would only have been $600 instead of $9000. Anger over the size of TFSA penalties is bad enough right now. Without changes to either the TFSA contribution rules or to the way contributions are tracked to prevent mistakes, anger will grow along with the rising penalties.

Friday, August 15, 2014

Short Takes: Financial Happiness Secrets and more

Here are my posts for this week:

Why Market Timing Fails

Loan Pushers

Too Big to Fail

Here are some short takes and some weekend reading:

David Chilton (the Wealthy Barber) explains in this video clip the secret to a happy financial life. Saving isn’t just about making a better future; it’s about making life simpler and better right now. His remarks at the end about math knowledge are interesting. I’ve definitely noticed that people with strong math skills tend to earn more money than the general population. Whether they’re better at handling and investing that money is another question.

Canadian Couch Potato shows how to reduce transaction costs and optimize asset location by treating all family investment accounts as a single big portfolio.

Doug Runchey explains how working past age 60 affects CPP benefits in a number of example cases.

Dan Hallett takes a look at a market-linked GIC that seems good on the surface but wilts under Hallett’s scrutiny.

Big Cajun Man uses some examples to explain the TFSA over-contribution rules. Unfortunately, I think the “Savings Account” part of the TFSA name will continue to make people think they can treat it like a regular savings account.

My Own Advisor has added a new personal finance goal for the year. He’s trying to save up $4000 for home improvements. My wife and I have a system for home improvements. We do things that need doing immediately, such as replacing a furnace or appliance that isn’t working, replacing leaking windows, or fixing a leaking roof. For more cosmetic things, we just disagree on the details endlessly and never spend the money.

Thursday, August 14, 2014

Too Big to Fail

I wouldn’t have thought it possible to turn an account of the 2008 financial crisis into a story as compelling as a novel, but Andrew Ross Sorkin did it with his book Too Big to Fail. Sorkin gives an inside account of the actions of Wall Street executives and government officials that captures their panic, greed, loyalty, and in some cases patriotism.

One theme in the early part of the book is the power play that exists at the top of large corporations. In one example, an executive forcing another out of a company is just a routine “disposal of a potential rival.” In another example, one executive is pushed out but not a second because the second “appeared nonthreatening.” This is a peculiar world where competence is valued, but too much competence is threatening.

Another theme is executives making themselves rich at the expense of their own firms. Even when the market for Collateralized Debt Obligations (CDOs) “was perceptibly unraveling,” Merrill Lynch kept churning them out. “If they were worried, however, Merrill’s top executives didn’t show it, for they had a powerful incentive to stay the course. Huge bonuses were triggered by the $700 million in fees generated by creating and trading CDOs, despite the fact that not all of them were sold. (Accounting rules allowed banks to treat a securitization as a sale under certain conditions.)” So, executives made bonuses on CDOs that were causing Merrill to lose money.

A surprising part of this story to me was the degree to which discussions were conducted in face-to-face meetings. The participants spent a lot of time traveling to hastily called meetings. In one case, some Morgan Stanley executives stuck in traffic “found a break in the street divider and inched the car onto the bike lane, speeding down it.”

When Lehman Brothers finally went bankrupt, “the staff wasn’t just devastated, they were angry.” They erected a wall of shame that included photos of the CEO and president “with the caption ‘Dumb and Dumber.’”

An interesting characterization of the changes on Wall Street: In 1927, business was “defined by personal relationships and implicit trust, not leverage and ever more complicated financial engineering.” This world was “obliterated over the past decade as firms sought to go public and began using shareholder money to place what proved to be dangerously risky bets.”

Have the lessons of the financial crisis led to positive changes? “Goldman, like so many of the nation’s largest financial institutions, remains too big to fail.” Unless “regulations are changed radically—to include such measures as stricter limits on leverage at large financial institutions, curbs on pay structures that encourage irresponsible risks, and a crackdown on rumormongers and the manipulation of stock and derivatives markets—there will continue to be firms that are too big to fail.”

It’s unlikely that someone with no interest at all in the financial crisis would like this book, but the inside account of the players and their motivations certainly helps to make it an interesting read for those who have some interest in the crisis.

Wednesday, August 13, 2014

Loan Pushers

I was out for a walk at lunchtime one day and saw a huge billboard for a payday loan company. The huge font read

$100 LOAN FOR $1

Presumably this means that you’d pay only $1 in interest on a loan of $100. This is cheaper than the usual rates for payday loans, so I suspected a catch. Then I noticed a smudge to the right of the large font. I had to cross the street to read the fine print written sideways:


The font for the fine print was so much smaller that all three words together sideways were the same height as each large character in the main message.

So, the offer is a lower cost entry to a cycle of debt and despair. It all reminds me of the techniques used by drug pushers when I was young. The first joint or little baggy is free, but you’ll have to pay when you come back for more.

Tuesday, August 12, 2014

Why Market Timing Fails

In a recent study, market timing based on Robert Shiller’s well-known Cyclically Adjusted Price-to-Earnings (CAPE) ratio failed to produce market-beating returns. Here I offer an explanation of why this doesn’t work.

Shiller’s CAPE is one way to try to measure whether stocks are currently over- or under-valued. If CAPE gives correct results, you might think it’s self-evident that getting out of the market when stocks are overvalued would be a good idea. Based on this reasoning, the study results seem to imply that CAPE is not a good valuation measure, but this isn’t necessarily correct.

Even if CAPE is completely accurate, it still isn’t necessarily useful for market timing. The problem is that it takes time for stock prices to readjust. Suppose that CAPE says prices are 10% too high. If the market reacted quickly, then next year’s returns would be 10% lower than normal. But prices don’t react this quickly.

Suppose that it takes 10 years for stock prices to adjust and bring the CAPE measure back to “normal.” This means that over those 10 years, returns were 1% lower per year than they would have been without this adjustment. So, if you normally expect to earn inflation+5%, then when CAPE says stocks are overvalued by 10% you might expect only inflation+4% for the next decade.

However, inflation+4% is still better than what you could expect from bonds, real estate, or any other common investment category. So, you can be exactly right about stocks being overvalued but still not be able to use this knowledge to make any extra money. Being out of the stock market is a bad idea more often than not.

Friday, August 8, 2014

Short Takes: Life Insurance, Media Influence on Investors, and more

I wrote one post this week replying to email I usually ignore:

Replying to More Email

Here are some short takes and some weekend reading:

Potato has some thoughtful arguments for why his family don’t need much life insurance on his life. Insurance brokers are likely to disagree strongly with him. He makes some interesting points, but it’s hard to decide to what degree I agree or disagree without some numbers.

Canadian Couch Potato reviews the book Clash of the Financial Pundits: How the Media Influences Your Investment Decisions for Better or Worse. Sounds like an interesting read.

Million Dollar Journey updates his Smith Manoeuvre (leveraged) portfolio. In my opinion, very few people are well-suited to leveraging a portfolio. Frugal Trader says “If you can’t stomach losing 20-30% in the portfolio in any given year, then your risk tolerance isn’t suited for leveraged investing.”

My Own Advisor reviews Larry Swedroe’s book The Quest for Alpha which makes a strong case for indexed portfolios. He plans to stick with his blend of indexing and dividend investing.

Big Cajun Man channels Mike Tyson to give some good advice on anticipating shocks to your financial plan.

Wednesday, August 6, 2014

Replying to More Email

I get a lot of great feedback from my readers. I get other email as well. Here is another installment of replies to emails that I usually ignore (see the first one here).

Dear Julia,

Thank you for the opportunity to profit from writing a post that directs my readers to your forex broker. Forex trading has all the advantages of trading against extremely highly skilled opponents without the built-in tendency for prices to rise that we see with stocks. If I ever lose my empathy for fellow human beings, I’ll take you up on your offer.




Dear Blair,

Forgive me if I’m a little skeptical of your claimed ability to offer unbiased financial advice to Canadian seniors. What threw me off was the phrase “Gold Price” in your organization’s name and the reference to “proprietary trading algorithms.” When you say that current seniors are the wealthiest generation ever, is it your mission to cure them of this affliction?



Friday, August 1, 2014

Short Takes: Philosophies for Investing Success and more

I wrote one post this week about how I can feel myself getting complacent about stock market risk:

Stock Markets Only Go Up?

Here are some short takes and some weekend reading:

Million Dollar Journey has an excellent list of key philosophies for long-term investing success. Beginning investors and old hands would do well to read it.

John Heinzl does a great job of explaining the problems with covered-call ETFs.

Canadian Couch Potato says that if you started investing in stocks in the past 5 years, you don’t really know your tolerance for risk yet. However, older investors who suffered through 2008-2009 had their nerves tested.

My Own Advisor gives the results of a Sun Life survey on the difference in attitudes toward retirement between men and women.

Big Cajun Man explores a market timing strategy. It might be more believable if he included references to “Dementia 5”.