Friday, November 28, 2014

Short Takes: Investing Myths, Discount Broker Rankings, and more

Don’t forget to enter the draw for a copy of John Robertson’s new book The Value of Simple. Here are my posts for this week:

The Point of Diversification

Book Giveaway: The Value of Simple

Future Shop Looks Out for Its Customers

Here are some short takes and some weekend reading:

Tony Robbins does a great job explaining the 9 most common investing myths. The first few are particularly well-written. These are some things I wish I had known in my youth.

Rob Carrick has published his 16th annual ranking of online brokers. I’m glad to see that my choice of BMO InvestorLine is still high in the rankings.

The Blunt Bean Counter gives some detailed instructions on how to properly do some tax-loss selling. He also discusses flow-through shares. This interests me because I’m having a good year financially, and looking at the total tax listed on my pay stub is painful. However, I’m not sure if it is too late for the 2014 tax year, and I’m not sure if I want more risk and complexity in my life. If I just procrastinate for another month, I’m sure to be too late and won’t have to think about this any more.

The Reformed Broker reports that Jon Stewart now regrets having abused Jim Cramer. For those who missed it, Jon Stewart interviewed Jim Cramer on the Daily Show some time ago and ambushed Cramer with what amounted to an accusation that Cramer played a role in the 2008-2009 financial crisis. Of course, even if Cramer is innocent of this charge, he’s still guilty of encouraging ordinary people to become stock pickers and offers wildly overconfident advice on many individual stocks.

My Own Advisor has a very good guest article about making good decisions that reduce risk and improve expected long-term returns.

Potato is pleased with the initial reviews of his new financial book The Value of Simple.

Big Cajun Man wrote about the future possibility of TFSA retirement welfare bums amassing huge TFSAs but still collecting the Guaranteed Income Supplement (GIS). I wrote some time ago about possible changes to GIS rules to take TFSA assets into account.

Million Dollar Journey updates some model portfolios with some new ETFs.

Boomer and Echo considers whether investors are willing to pay for up-front advice.

Scott Ronalds at Steadyhand uses an example case to illustrate some sound personal finance and investing advice.

Wednesday, November 26, 2014

Future Shop Looks Out for Its Customers

I don’t shop much. I like to say that there is only one shopping day left until Christmas because I’ll only shop one day. But my wife and I wandered into Future Shop recently, and I'm pleased to say that they saved me from an impulse purchase.

As we entered, a young employee was hurrying by, but he took the time to pause and say “Hi guys! Welcome.” Despite the fact that I still find it sounds strange to hear a woman included among “guys,” the friendly gesture improved my already good mood.

I then made an impulse decision to buy a piece of electronics whose price is about $100. Stepping quickly to find a cash, I found none had any cashiers. No problem, though, because there were a couple of desks on the other side with employees behind them.

The first desk was the “customer service desk” where one customer with multiple receipts laid out was waiting for an employee seated on a chair facing the other way. The prospects didn’t look good. The second had a young guy tapping away at what looked like a cash register and talking on a phone. He politely directed me back to the customer service desk.

With some residual good feelings about our greeting I proceeded to wait for a while with my new treasure and credit card in hand. It didn’t take too long for impatience to set in as neither the employee facing the other way nor the customer in front of me moved for a couple of minutes.

I timed out and left.

So, I offer my thanks to Future Shop for saving me from myself. I now have the chance to sleep on my decision to buy this item. If I decide to buy it anyway, though, I’ll probably go to a store a little quicker to take my money.

Tuesday, November 25, 2014

The Value of Simple

Many good investing books advocate simple, index-based investing strategies. No doubt some readers are lulled into thinking that these strategies are just too simple. However, real-world complications find their way into even the simplest of strategies. John Robertson makes a strong case for investing simplicity in his new book, The Value of Simple. (The giveaway for this book is now over.)

The main thing that separates this book from other investing books is that Robertson goes into detail for how to invest using each of three different financial institutions and types of funds: Tangerine funds, e-Series funds at TD Direct Investing, and Exchange-Traded Funds (ETFs) through Questrade. He judges these to be good trade-offs between cost and simplicity. He goes through the important practical steps of using each type of account using a few screen-shots.

Most investing books back away from the details Robertson takes on. This is mainly because these details are untidy and make the whole topic of investing more complex. But this is a big part of Robertson’s point. You need to start with a simple strategy, because by the time you encounter the nitty-gritty of opening accounts and splitting your money across TFSAs, RRSPs, and other accounts, you’ll be glad you started off with a base strategy that is as simple as possible.

Other topics covered in this book include the importance of keeping fees low, the power of compounding (explained using non-threatening bunnies), passive investing, risk and realistic return expectations, taxes, asset allocation, rebalancing, and much more.

A good point Robertson makes concerning financial advisors is that we tend to think they are valuable for choosing investments, but “this is where they add the least amount of value. Many people would be better served by discussing spending, saving, emergency plans, and charting a long-term course.”

Another interesting point concerns thinking of mortgage payments as a form of fixed-income investment. “It doesn't really make much sense to hold large amounts of bonds or GICs to earn some interest when you are paying more on a mortgage.”

The author is “not fond of” the strategy to buy “dividend-paying stocks and ‘live off the dividends.’” He finds that this generally can be too conservative because “dividends are just one component of total return.” But it can also be “too risky if there’s a concentration in a small selection of companies paying high (and unsustainable) dividends.”

There’s not much to criticize in this book. In an example of the power of getting started early with investing, the author imagines someone who saves $10,000 per year for 35 years. Of course, this just isn’t realistic for most people. Most are able to save more later in life because of inflation and because their income rises faster than inflation. However, if shading the truth here helps to convince more young people to start saving early, perhaps it’s not such a bad thing.

Overall, this book covers the topics a do-it-yourself investor needs to know and avoids the things they don’t need to know like how to pick individual stocks or how to time the market. I highly recommend this book to anyone who feels confused about how to invest. I also recommend it to anyone who thinks stock-picking and market timing are good ideas.

The book giveaway described below is now over:

Just send an email with the following things:
– Subject: Book Giveaway
– Answer to the following skill-testing question: (6 x 9) + 2 – 6
– Use the email address listed at the “Contact” link (For those who are reading my feed, you’ll have to click through to my web site to get the email address.)
– Indicate if you wish to be excluded from either the paper book draw or the e-book draw (the default is in for both draws)

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, November 30th 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, November 24, 2014

The Point of Diversification

The most common explanation of the value of diversification is avoiding big losses. Investing everything you owned in Nortel stock before the bankruptcy would have been a disaster. However, there is another side to the value of diversification.

Josh Brown reported that many are blaming active fund managers’ failure to keep up with markets in 2014 on Apple’s success. Apparently, many fund managers owned proportionally less Apple stock than its percentage in the index.

This failure to own high-flying shares is the other side of the benefits of diversification. In any given year, there are relatively few stocks that give huge gains. If you only own a few stocks and choose them essentially randomly, there is a good chance you’ll miss all the big winners. The advantage of an index is that it always gets its share of all stocks, including winners and losers. Keep in mind that a “winner” is a stock that performs better than the index, and a “loser” earns less than the index.

There is an asymmetry that makes winners rarer than losers. Some winners more than double, particularly if you look at periods of longer than 1 year. But losers can only lose 100%. The net effect is there have to be fewer big winners than big losers. And among random concentrated portfolios, there will be some portfolios that win big because they happen to pick a stock that wins big. But there will be more random portfolios that lose to the index because they miss the big winning stocks. To maintain balance, the rarer winning portfolios tend to beat the index by more than the more common losing portfolios lose to the index.

With this understanding, we see that fund managers moaning about missing out on big winning stocks is actually an expected result. With Apple having such a large market capitalization, the effect may be bigger this year than most, but it’s not all that unexpected.

All that said, the other theme of Brown’s article, that Vanguard funds had a big year compared to other funds, is mainly due to the fact that Vanguard’s fees and trading expenses are much lower than those of other funds. But the fact that Vanguard’s index funds didn’t miss out on Apple stock helped as well.

Friday, November 21, 2014

Short Takes: Lottery Fictions, Recovering Madoff Losses, and more

Here are my posts for this week:

Evaluating Reasons to Avoid Index Funds

Dividends vs. Capital Gains in Retirement

Core and Explore

Here are some short takes and some weekend reading:

John Oliver (video) has a very funny and hard-hitting take on lotteries and the supposed good things they fund.

NBC News reports that more than $10 billion of losses from Bernie Madoff’s Ponzi scheme have been recovered to be given back to victims who will get back nearly 60 cents of each invested dollar. This is somewhat misleading, though. Victims will get back a percentage of what they put in, not including returns. So, a long-time investor whose investments had tripled on paper would only be getting 20% of the amount on his phony statements. But this is certainly better than nothing.

Jason Zweig reports on a study that found that individual forex traders lose an average of 3% per week. Remember this the next time you see a come-on for entering the supposedly profitable world of forex trading.

A Wealth of Common Sense shows that the impressive back tests on the “Tony Robbins All Weather Portfolio” are mainly the result of the 30-year bull market in bonds.

Million Dollar Journey takes a look at the subtle difference between using Norbert Gambit’s to exchange money from U.S. to Canadian dollars versus the other direction.

Big Cajun Man has some fun coming up with financial book titles. I liked “The Best Financial Arguments to have with your Spouse.”

Boomer and Echo asks whether banks should have a hand in promoting financial literacy. Another question: should cigarette companies have a hand in promoting quitting smoking?

John Heinzl does a good job of explaining why spousal RRSPs can still be valuable even though retirees are permitted certain types of income-splitting.

My Own Advisor explains that one of his motivations for managing his money well is that he doesn’t want to be part of the statistics of seniors carrying debt into their retirement years.

Thursday, November 20, 2014

Core and Explore

The idea of “core and explore” investing is that you commit the bulk of your portfolio to a sensible “core” strategy, and use a small percentage to “explore” some of your own stock picks. Much has been written about the merits of this investing approach, but my thinking differs from what I’ve read before.

As a starting point, it’s important to admit that for the vast majority of investors, the explore part of the portfolio will underperform a core index strategy over the long term. I won’t defend this assertion here, but if you reject it, then you won’t agree with much else I say. However, it’s not automatically true that core and explore is a bad idea just because the explore part of the portfolio is likely to underperform.

One possible benefit of core and explore is that it allows an investor to scratch the itch to make stock picks with a small amount of money in the explore pot instead of making much bigger bets with the entire portfolio. In effect, allowing some exploring may be the only way for some investors to stick with a boring but solid plan with the bulk of their portfolios.

Of course, adopting core and explore may harm some investors as well. It’s inevitable that an investor will make a couple of good (or lucky) picks in the smaller explore part of the portfolio. This could embolden the investor to begin making stock picks with the entire portfolio.

In the end, whether or not core and explore is a good idea for a particular investor depends on that investor’s psychology. Given the choice between being 100% indexed and using core and explore, how would a particular investor fare with each? If the investor would execute the index strategy without fail, then it is very likely the better strategy. However, if the investor would constantly tinker with allocation percentages with pure indexing, but exploring with a small amount of money would prevent such tinkering, then core and explore is better.

So far, I’ve only considered the investor’s expected returns as a measure of how to invest. But there are other considerations as well. For example, some people find it fun to pick stocks. Few really do any meaningful analysis, but it can be fun to channel your overconfidence and think you can just know that a company will do well. It can also be fun to talk about your picks with other people. This fun has some value. The problem is that it also has a cost in likely long-term portfolio underperformance.

Few people are able to assess the expected underperformance of their stock-picking. One method is to assess the drag due to taking on uncompensated risk based on some model of stock returns. The math isn’t overly difficult but extremely few investors will estimate the cost and decide whether the fun justifies the cost. A complicating factor here is that most stock-pickers really do think they can pick above-average stocks. If this is really true, then there is no reason to stop stock picking. But we know that it isn’t true for the vast majority of investors.

Some may think that if only 10% of a portfolio is allocated for exploring, then the most the investor can lose is 10%. This depends on what the investor does after losing some money on bad stock picks. Will the investor just live with an explore part of the portfolio that is only 5%, or will he or she replenish it back to 10%? With replenishing, the total losses over decades can be much more than just 10%.

In the end, those who choose core and explore investing will do so for emotional reasons and will not know in advance how much money it is likely to cost them compared to pure index investing. But at least being 90% invested with a core plan beats being 0% invested with a core plan.

Tuesday, November 18, 2014

Dividends vs. Capital Gains in Retirement

Trying to maximize your after-tax retirement income is a complicated business. Cheerleaders for dividend investing are convinced that the dividend tax credit makes it a no-brainer that a dividend strategy is best to minimize taxes. However, as we’ll see, there are good strategies that use the 50% capital gains exemption as well.

Let’s look at two investors in the same situation but using different investment strategies. Dean, the dividend investor, and Carla, the capital gain investor, are both 58 years old, single, and living in Ontario. (No, there will be no romance in this story.) They both have a $500,000 RRSP and $1,232,000 in a non-registered account. (I’ll explain this cooked-up number.)

Dean owns dividend stocks that we’ll assume earn a 2% capital gain and 4% dividend each year. Dean’s dividend income is 4% of $1,232,000, or $49,280. This just happens to be the maximum he can earn and pay no taxes other than the $600 health premium.

Carla earns the same total return of 6% each year, but she owns the exchange-traded fund HXT so that all her returns are capital gains. Obviously, her return will not be exactly 6% each year, but as we’ll see, her strategy is flexible. Carla’s plan is to withdraw the same annual income as Dean ($49,280), but she is going to split it between her RRSP and her non-registered account so that her total taxable income is $14,700. This is the level of income where she pays about $600 in taxes, the same as Dean.

Carla’s withdrawals will be spread evenly through the year. Let’s assume that the average capital gain on her withdrawn capital during the first year is 3%. If Carla withdraws $35,091 from her non-registered account, this will be a $34,068 return of capital and a $1022 capital gain of which $511 is taxable. If she withdraws $14,189 from her RRSP, she will exactly hit her income target of $49,280 and her taxable income target of $14,700.

In the second year, Carla will have more deferred capital gains and won’t be able to withdraw quite as much from her RRSP. Her RRSP withdrawals continue to decrease in future years as her non-registered account capital gains build up.

I simulated 7 years of Dean and Carla’s strategies assuming 2% inflation and assuming the income tax thresholds rise with inflation. After these 7 years, both Dean and Carla have paid the same amount of income tax (almost nothing) and have the same total assets. However, their split between accounts is different. Here are their situations at age 65 (rounded to the nearest thousand):

Non-registered account: $1,415,000 (unrealized capital gain of $183,000)
RRSP: $752,000

Non-registered account: $1,515,000 (unrealized capital gain of $514,000)
RRSP: $652,000

There isn’t an obvious winner here. Carla has managed to use up some of her RRSP tax-free, but Dean has a smaller unrealized capital gain.

Observe that Dean and Carla are now somewhat locked into their respective strategies because of the unrealized capital gains. Any change of strategy requires some selling that would lead to significant capital gains taxes.

As Dean starts to draw OAS and possibly CPP, his tax situation changes; he will be paying income taxes on his dividends. Carla will pay some taxes as well but she has more flexibility in how much capital gain she chooses to realize.

At the end of the year they turn 71, things change significantly again as they will both have to make mandatory RRIF withdrawals. Dean’s taxable income will rise to the point where he will pay significant taxes including a substantial OAS clawback. Carla’s taxes will rise too, but she will once again have more flexibility in how much capital gains she will realize.

To make a complete comparison of Dean and Carla’s strategies, we’d have to make assumptions about CPP payments, desired income levels later in life, and how much of an inheritance they’d like to leave. I don’t see much point in doing this, mainly because the strategies so far have both of them living on less in their 60s than in their 70s, 80s, and beyond. It’s more realistic to devise strategies that aim for constant inflation-adjusted income with adjustments if portfolio returns disappoint.

I’ve made a few attempts to devise tax-smart strategies based on targeting a constant after-tax real income for life (with adjustments if portfolio returns disappoint). I also included a safer risk level than Dean and Carla’s 100% stock allocation, and took into account TFSAs.

Each time I work out the final result in an analysis that is more complex than the scenarios above, I find that capital gains strategies give slightly higher income than dividend strategies. While I’ve tried to optimize each strategy, I can’t guarantee that I’ve made the best possible choices to minimize taxes.

So, I can’t say with any certainty whether dividend investing is better or worse for taxation, and it may depend on the specifics of account sizes and other factors. What I can say with some confidence is that those who focus solely on the dividend tax credit are missing the big picture.

Monday, November 17, 2014

Evaluating Reasons to Avoid Index Funds

It’s important to read books and articles that make arguments that are at odds with your current thinking once in a while. Understanding counter-arguments is a good way to make sure your reasoning is sound. After all, I would never have stopped stock-picking if I hadn’t read about indexing with an open mind. With that in mind, I read an Investopedia article entitled “5 Reasons to Avoid Index Funds.” Here I go through the arguments made in this article.

1. Lack of Downside Protection

It’s true that index portfolios do not prevent short-term losses. Just think of how much more money you could make if you could always trade out of stocks that were about to drop. The Investopedia article points to several strategies for making money when you know the market will drop. The problem is that you don’t know when the market will drop. As a matter of fact, most of the time that investors try to time the market, they end up making less than if they had just stayed invested in the index the whole time. This applies not only to retail investors but to professionals as well. Just riding out market downturns with mechanical portfolio rebalancing beats investor judgement over the long run.

2. Lack of Reactive Ability

If you could tell when certain stocks are under- or over-valued, you could certainly beat the index. Unfortunately, there is no evidence that anyone can do this consistently. Every so often a star money manager makes good moves for a few years, but they almost always come crashing back down to earth.

3. No Control Over Holdings

It’s true that the index contains all stocks including companies you may not want to own for moral or other reasons. Some investors believe they can identify poor companies they prefer not to own. All the evidence says that the vast majority of investors cannot consistently choose winning stocks. But if you’re determined to avoid certain stocks despite the fact that doing so will likely lose you money, then indexing is not for you.

4. Limited Exposure to Different Strategies

The Investopedia article says “there are countless strategies that investors have used with success.” There are even more strategies investors have used that led to failure. Jumping around between different strategies is often harmful to returns. So often they see their holdings decline in value and jump to shiny new stocks that have performed well lately. Unfortunately, you can’t capture past stock returns. Recent strong performers often stumble. Constantly jumping from losers to recent winners is a formula for losing money.

5. Dampened Personal Satisfaction

It’s certainly true that some people enjoy the “satisfaction and excitement” that comes with using their own judgement to make stock picks. But this satisfaction and excitement can give way to pain when investors take big risks and lose big. This can be more than just the pain of losing money; it is painful to the ego to have your overconfidence stomped by reality. This overconfidence can lead investors to take wild chances. Stock indexes sometimes drop significantly, but they have always recovered eventually. This is not true for individual companies. Some stocks go to zero and this can permanently damage a concentrated portfolio. I prefer to find my challenges and excitement in activities other than stock-picking.

Overall, I found the article disappointing. I would have preferred to learn something new that challenges my current thinking.

Friday, November 14, 2014

Short Takes: Cognitive Biases, Happiness Letters, and more

I wrote one post this week answering a reader question about why index portfolios don’t all use dividend ETFs:

Why don’t couch potato portfolios use dividend ETFs?

Here are some short takes and some weekend reading:

A Wealth of Common Sense explains a cognitive bias we have that prevents us from admitting we don’t know something. This bias can be very costly for investors. Another good article demonstrates that envy is a bigger driver than greed. The second minute of the monkey experiment video is funny.

Jason Zweig explains why you should be concerned if you receive a “happiness letter” from your brokerage. In another good article, he looks back at his 1999 advice to avoid internet stocks. His was nearly a lone voice at the time. I was very fortunate that I decided to mostly avoid internet stocks through that period because I worked for an internet company and didn’t want to put too many eggs in one basket.

Big Cajun Man reports that unemployment in Canada has been on a fairly steady decline for 5 years now. I’ve certainly noticed more companies flying banners announcing they are hiring. Getting back to the heady days of the late 1990s when some companies lent Hummers to software developers on weekends seems too much to hope for, but it would be nice to see a friendlier job market for young workers.

My Own Advisor describes a retirement money management strategy from Daryl Diamond called a “cash wedge.” It is broadly similar to what I call cushioned investing, others such as Dan Hallett call bucketing, and Tom Bradley at Steadyhand calls a spending reserve. The basic idea is important but not new: during retirement it’s important to have some safe cash available in case your riskier investments drop in value significantly.

Million Dollar Journey compares various gas reward programs. It can be fun to optimize cash-back rewards, but keep in mind that real savings comes from things like driving less, getting a smaller cheaper car, and moving closer to work to reduce your commute. Few people truly understand how expensive cars are. Gas is just the beginning. If you add up fuel, insurance, maintenance and repairs, licensing, and car payments, you might find the total hard to believe.

Boomer and Echo have a story of a basement renovation that came in under budget. I like feel-good stories like this, but don’t count on it for your own home renovation. I’ve resisted doing too much renovation of my house because home renovations are a worthy rival to cars and eating out as huge money wasters. No doubt some home renovations are necessary and others increase a home’s value, but most home renovation costs just become decades of payments.

Monday, November 10, 2014

Why Don’t Couch Potato Portfolios Use Dividend ETFs?

A reader, L.P., asks the following question (edited for length and clarity):
“Why don’t sample couch potato portfolios in books and blogs use dividend ETFs for the equity portion? Wouldn't an ETF like VDY outperform XIU over the long haul? Long-term dividend investing has good historical returns. Higher dividends can accumulate over the long run. I'd imagine that a dividend ETF full of solid dividend payers would correlate closely with the general market performance if not slightly better in downturns? Is my thinking off?”
Thanks for the thoughtful question. First off, let me say that dividend investing can be a reasonable approach as long as investors are well diversified. Certainly, an ETF like Vanguard’s VDY is reasonably well diversified within Canada. However, some dividend investors go off the rails when they convince themselves that dividend-paying companies are much better than other companies.

Dividend stocks tend to be value stocks. An ETF like VDY will tend to perform similarly to a value stock index, although VDY is a little less well diversified because it omits value stocks with lower dividends. The total return, consisting of capital gain plus dividend, of dividend stocks will tend to be similar to the total return of value stocks. This means that dividend stocks with their higher dividend will tend to have lower capital gains than other value stocks.

If value stocks perform well over a given period of time, they could outperform a broad index ETF like XIU. Historically, there has been a value premium, but having a value tilt has performed better than focusing more narrowly on just dividend stocks.

You might see some analyses that seem to show that “solid” dividend stocks outperform the broader index by a wide margin. This is typically a result of survivorship bias. If we look at just companies that have paid increasing dividends for decades, it’s obvious that they have been great investments that have outperformed in the past. But there is no guarantee that this outperformance will continue into the future. Solid long-term dividend payers sometimes cut their dividend or go bankrupt. Think of GM and Kodak. If you don’t include the performance of GM and Kodak among other long-term dividend-payers, your analysis has survivorship bias.

As for dividend payers performing better in downturns, I think it is more likely that dividend investors perform better in downturns. This biggest risk during a downturn is that investors will lose their nerve and sell low. Some dividend investors ride out the temporary drop in stock prices by keeping their focus on the steady dividends.

In summary, while well-diversified dividend investing can work well for investors, it is not the path to outperformance that many think it is. The flip-side of higher dividend payments is typically lower capital gains. It is the total return of stocks that matters most in the long run.

Friday, November 7, 2014

Short Takes: When a DIY Investor Passes on and more

Here are my posts for this week:

Flash Boys

A Deeper Look at My Portfolio

Here are some short takes and some weekend reading:

Dan Hallett looks at the options for how a surviving spouse should manage a portfolio after a DIY-investor dies. My strategy has been to have my wife do all the trading in her own accounts. Slowly but surely she is learning the details of our fairly straightforward portfolio strategy.

Preet Banerjee reports on a study showing that professional fund managers in Sweden don’t manage their personal portfolios any better than non-experts in the same socio-economic class. I hope the study’s authors split people into classes by their wealth before the time period of study and not after. Otherwise, the results are biased. Wealthier classes always have some people who were in a lower class but got lucky taking big investment risks.

Tom Bradley at Steadyhand takes some shots at index-linked GICs offered by Canada’s big banks. I’ve never seen one of these GICs that I thought was good for investors.

Big Cajun Man gives us his take of advice to borrow to invest: “Blow it out your ear.”

Sean Cooper at Million Dollar Journey updates his net worth. He is known for living very frugally but has decided to live a little and has quit his part-time job.

My Own Advisor discusses his strategy for short-term savings.

Wednesday, November 5, 2014

A Deeper Look at My Portfolio

I recently revealed my portfolio’s asset allocation and the reasoning behind it. It consists of just 4 Exchange Traded Funds (ETFs). This might make some think that I’m not sufficiently diversified. To explain why this isn’t true, I’ll take a deeper look at these ETFs. I’ll also go over many of portfolio costs that investors face.

The following chart gives some basic information about the ETFs in my portfolio:

ETF Allocation Asset Class # Stocks MER Purchase Currency
VCN 30% Canadian 248 0.05% C$
VTI 25% U.S. 3772 0.05% US$
VBR 20% U.S. Small Cap Value 812 0.09% US$
VXUS 25% World ex. U.S. 5783 0.14% US$


If we focus initially on the “# Stocks” column, we see that each ETF contains within it a large number of individual stocks. For example, VCN holds 248 stocks and is intended to be representative of the entire Canadian stock market. Similarly, VTI holds 3772 stocks and represents the entire U.S. stock market. With even more stocks is the international ETF called VXUS at 5783 stocks. These three together cover the whole world and form the core of my portfolio. This is extremely broad diversification with a total of over 9500 different stocks.

The remaining ETF, called VBR, could be considered somewhat narrow because it contains only U.S. small capitalization value stocks. However, even this ETF holds 812 stocks. The style of stock is somewhat narrow, but the number of stocks is high. Overall, holding only 4 ETFs is misleading when it comes to the optics of diversification. I’m well diversified and hoping that the historical outperformance of small cap value stocks continues into the future.

Portfolio Costs

The blended Management Expense Ratio (MER) of my portfolio is 0.08%. This means that I pay $80 per year on each $100,000 I have invested. For the lucky among us who manage to amass a million-dollar portfolio, this is $800 per year. If I were invested in typical mutual funds in Canada, this would be more like $20,000 per year. More savvy investors who seek out professional portfolio management for a million-dollar portfolio still pay about $10,000 per year.

Another cost I have is international withholding taxes on dividends from VXUS. When spread across my entire portfolio, this adds about another 0.09% per year in costs. The U.S. has dividend withholding taxes as well, but fortunately, a tax treaty with Canada eliminates U.S. withholding taxes in RRSP accounts. This doesn’t apply to TFSAs or non-registered accounts, though. I’d have to pay taxes in non-registered accounts anyway. So, my main rule for “asset location” is to never hold VTI, VBR, or VXUS in a TFSA.

Other costs are very small for me. ETFs and mutual funds have internal trading costs that are not part of the MER, but these are very small for my 4 ETFs. However, I’ve seen trading costs in the 0.25% range for some actively-managed mutual funds, so investors can’t just ignore this cost. I also have to pay trading commissions ($10 each), and I lose half of the bid-ask spread on each trade. Fortunately, these costs are very low for me because I rarely trade.

Currency Exchange

Another category of costs is currency exchanges. Notice that 3 of my ETFs trade in U.S. dollars. This means that I can’t buy them directly with Canadian dollars; I need to exchange Canadian dollars for U.S. dollars first. All currency exchanges cost money. Unfortunately, this cost is usually hidden in the quoted exchange rate.

A good way to tell what currency exchange costs you is to look at a round trip: Canadian dollars to U.S. dollars and back to Canadian dollars again. If you lose 2% on a round trip, then each exchange costs you about 1%. That’s a $100 cost on a $10,000 exchange. This isn’t too far off what most of the big banks charge. When you make a trade and click the “settle in Canadian dollars” button, it’s easy to forget about this hidden cost.

There is a great way to save money on large currency exchanges called the Norbert Gambit (see Canadian Couch Potato’s detailed explanation). I use a variant of this method using Royal Bank’s interlisted stock instead of using the ETF called DLR. My way is a little cheaper but a little riskier because it involves holding Royal Bank stock for a few minutes.


After initial setup, this portfolio has taken very little time to maintain. The main activity comes when I have new money to add. I use a spreadsheet to tell me which ETFs are below my target allocation and I buy them to get back in balance. On the rare occasion that this isn’t enough to keep the balance, I have some rebalancing rules coded into the spreadsheet to make a cell glow red if I have to do something.

Before choosing your own portfolio allocation, make sure your costs are sensible for your portfolio size and that you can truly handle the volatility of the allocation to stocks you choose.

Monday, November 3, 2014

Flash Boys

You wouldn’t think that a book about high-frequency stock trading could be a compelling read, but Michael Lewis’s story-telling skills make his book Flash Boys a page-turner even for readers with a modest knowledge of stock trading. I’ve read several articles explaining high-frequency trading (HFT), but Lewis weaves much clearer explanations in with the stories of the people who set out to stop high-frequency traders from exploiting the rest of us.

The book describes many ways that high-frequency traders get an unfair advantage, but the biggest problem was a form of front-running. Stock trades often get split up among different exchanges because no one exchange is offering enough shares to fill the order. High-frequency traders would place “very small bids and offers, typically for 100 shares, for every listed stock. Having gleaned that there was a buyer or seller of Company X’s shares, they would race ahead to the other exchanges and buy or sell accordingly.” So, whichever exchange the split up order arrived at first would tip off the high-frequency traders, and they were able to get to other exchanges so fast that they could trade ahead of the rest of the split up order.

This ability to front-run is disturbing enough but high-frequency traders also have an incentive to create unstable markets. The more that stocks prices change in a fraction of a second, the more money they can make from knowing the new price before everyone else.

Lewis explains convincingly that stock trading is rigged, but it’s likely that many readers would come away with an overly pessimistic view of stock ownership. When Lewis says that high-frequency traders are “removing money from the pockets of investors large and small,” I think he should make a better distinction between “traders” and “investors.”

High-frequency traders take money from you when you trade or your fund manager trades on your behalf. They aren’t taking any money from you while you’re just holding stocks. Of course, you have to trade sometime if you’re going to own stocks, but you can control how often you trade.

To day-traders, the cut high-frequency traders take is like a scalping, but for investors who hold their stocks for 5 or 10 years or longer, the HFT cut reminds me of the complaint about a sandwich that is stingy on the ham: “the pig never even felt the slice coming off its arse.” Investors can control the size of the HFT cut over the course of a year by avoiding too much trading and avoiding buying funds whose managers trade too much.

With that one criticism about the distinction between trading and investing out of the way, I’ll move on to some of the good points of this excellent book.

The book opens with a description of a group building a straight fiber-optic connection that gave the fastest data path from markets in Chicago and New Jersey. They proceeded to sell access to the link to 200 firms for $10.6 million each. One buyer was so interested in gaining more exclusive access to the link that he came back with only one question: “Can you double the price?”

An unlikely group decided to create a new stock exchange (IEX) with the goal of preventing HFT abuses. One of their challenges was preventing high-frequency traders from moving close to the exchange to get a speed advantage. Their clever solution was to “coil thirty-eight miles of fiber and stick it in a compartment the size of a shoebox to simulate the effects of the distance.”

When the people at newly-formed exchange, IEX, analyzed their trading data to see which brokers were following the rules and which were abusing their clients, it turned out that only 10 of 94 were client-friendly.

Some might argue that the actions of high-frequency traders are just capitalism and that Lewis is against free markets. This isn’t true. He makes the distinction as follows:
“It’s healthy and good when traders see the relationship between the price of crude oil and the price of oil company stocks, and drive these stocks higher. It’s even healthy and good when some clever high-frequency trader divines a necessary statistical relationship between the share prices of Chevron and Exxon, and responds when it gets out of whack. It was neither healthy nor good when public stock exchanges introduced order types and speed advantages that high-frequency traders could use to exploit everyone else.”
I highly recommend this book. I hope readers conclude they should choose an investment strategy that minimizes trading rather than concluding they should avoid stocks altogether.