Reader Question: Small cap and Value Tilts

I received a thoughtful question from reader A.J. concerning how to index:

“Hello. I love your website.

I've read dozens of books on investing: Paul Merriman, Malkiel, Ferri, Ellis, Bogle, Swedroe, etc. All of these guys disagree on how to index! It is confusing. Some of them wholeheartedly believe in value and small stocks. I've seen their research, it seems very solid.

On the other hand, how can anyone predict the future?

In Bogle's book, He says that ‘if someone wants to tilt, it would be reasonable to do 85% total stock market fund, 10% value stocks, 5% small stocks.’

So that is what I've done with my US and International holdings. Can I get your thoughts on this? Thanks.”

Thanks for the kind words. Without knowing more about your financial life, I can’t advise you directly, but I can tell you how I view my own portfolio.

The truth is that we just don’t have enough historical stock information to make confident judgements about fine differences in stock allocations. I’ve chosen an allocation for my stocks, but I make no claim that it is optimal. As you say, “how can anyone predict the future?”

The main thing I do is stick with my allocation. I doubt it would have made much difference if I had used slightly different percentages. But what can make a big difference is tinkering. When investors make changes to their allocations, they are often shifting from an asset class that has recently performed poorly to an asset class that has recently performed well. Their reasons may sound smart, but they are really just selling low and buying high.

As long as investors are adequately diversified and have an appropriate allocation to fixed income, I doubt that fine differences among small cap tilt and value tilt percentages will make much difference. Much more important are costs and potential losses due to tinkering.

Good luck, A.J.

Capital in the Twenty-First Century

Having read several reviews touting the great importance of Thomas Piketty’s Capital in the Twenty-First Century, I decided to read it myself. While it does deal with important financial issues, it’s not a page-turner. What surprised me most was Piketty’s embrace of huge government.

Much of the book consists of dry discussions of historical data on income and wealth inequality around the world. Given a choice between a picture and 1000 words, Piketty consistently chooses both. In one memorable discussion, the reader learned that there are 10 times as many people in the top 1% as there are in the top 0.1%.

All the historical information is oddly disconnected from Piketty’s central argument. He says that because the rate of return on capital (r) is greater than the rate of economic growth (g), wealth is destined to become ever more concentrated in the hands of a small number of ultra-wealthy people.

However, it’s not quite this simple. For one thing, the wealthy spend some of their money and pay taxes. For another, they often split their fortunes among multiple heirs. And some heirs mismanage their inheritances. So, return on capital has to be enough bigger than economic growth to compensate for these factors. Maybe it is.

Another fact that does not fit with Piketty’s line of argument is that some of the more prominent ultra-wealthy people (think Warren Buffett and Bill Gates) built their fortunes rather than receiving them as inheritances. It may well be that wealth concentration is likely to increase in the future, but Piketty could have devoted more effort to convincing the reader of this fact.

Proposed new taxes

Piketty’s remedies for the problems of income and wealth concentration surprised me. I expected suggestions for high income tax rates on huge incomes, perhaps 90% on income over $1 million per year. I also expected capital taxes on great wealth, perhaps a 3% per year tax on wealth above $25 million. However, Piketty is more ambitious than this.

I should have realized my guesses were wrong when Piketty declared that he saw as reasonable a tax system where governments control two-thirds to three-quarters of all income. I find the prospect of so much of a nation’s output being centrally controlled and planned frightening.

Piketty proposes a yearly progressive capital tax on everything we own. No assets would be exempted. Your house counts. Your RRSPs count. Everything counts. Here are the proposed tax percentages with wealth amounts converted to Canadian dollars:

0.1% (0 to $300k)
0.5% ($300k to $1.5M)
1% ($1.5M to $7.5M)
2% (over $7.5M)

An example

Let’s take a look at the impact of such a tax. Imagine a couple who are retiring at 65 in a paid off home in Toronto. They have no pensions beyond CPP and OAS, but they have managed to save up $2 million for their retirement. They have saved very well.

Based on the 4% rule, this couple hope to draw $80k per year from their savings. This will be enough to live well and do some traveling. Now let’s hit them with Piketty’s capital tax. Let’s say their house is worth a $1 million so that the capital tax is based on $3 million. Their yearly capital tax works out to $21,300 on top of the roughly $8000 they’ll pay in income taxes.

This couple thought they would be able to spend about $6000 per month from their savings, but can now only spend about $4200 per month. While it is certainly possible to live a good life on this smaller amount, they have to wonder why they worked so hard to save their whole lives.

Of course, this example assumes the capital tax comes into effect just as this couple retires. If the capital tax had been in place through their whole working lives, they would never have come close to $2 million in savings. Young people just starting their careers and facing this tax would be justified in concluding that saving is futile.

In my own case, I’ve crunched some numbers to see the impact such a capital tax would have on my finances, and my conclusion is that I’d quit my job immediately. Trying to build my savings further against such a relentless drain would be pointless. Piketty’s percentages may not look big, but let’s see what they look like as 25-year figures rather than yearly percentages:

2.5% (0 to $300k)
12% ($300k to $1.5M)
22% ($1.5M to $7.5M)
40% (over $7.5M)

If we are trying to prevent wealth concentration, why are we taking money away from people whose net worth is less than $300k? Even the next bracket ($300k to $1.5M) is just middle class people with some equity in their homes and some RRSP savings. In my opinion, a wealth tax should not even kick in until wealth is at least $5 million. Applying Piketty’s wealth tax looks more like a way for governments to confiscate assets from everyone instead of just targeting the very wealthy.

An alternative to a wealth tax

Bill Gates proposed a “progressive tax on consumption” as an alternative to a tax on capital. I’m not sure how to make such a tax work, but it seems preferable to Piketty’s proposal. The hypothetical couple above would likely not run afoul of a tax on conspicuous consumption.

World government

Piketty sees the competition among countries to attract business with lower taxes as a problem to be solved with coordination among countries. He recognizes that it is hard for one country to introduce a wealth tax if people can move their assets to a neighbouring country. So, he dreams of coordination that amounts to a quasi-world government setting tax rules everywhere.

I find such a prospect terrifying. At least now if a government becomes grossly inefficient, citizens at least have the difficult option of leaving. But there would be nowhere to hide from a bad world government.

Conclusion

Piketty may be right about wealth concentration being a growing problem. However, I’d prefer remedies that target the truly wealthy. The goal should not be to turn most assets over to the governments of the world.

Short Takes: TFSA Use and more

Here are my posts for the past two weeks:

Excuses to Shop

Reader Question about Non-Registered Accounts

Pension Ponzi

ETF Fear, Uncertainty, and Doubt

ETF Tips I Don’t Follow

Here are some short takes and some weekend reading:

Maclean’s explains that TFSAs are being used primarily by older Canadians. This sensible article is a breath of fresh air compared to the nonsense I keep reading about how the $10,000 TFSA limit is needed to help the middle class. As far as I can tell, proponents of the higher TFSA limit want it because it will benefit them (or their clients) personally. Promoting self-interest isn’t so bad, but making up nonsense arguments is annoying. Higher TFSA limits help those with either high incomes or substantial existing savings. That’s the truth. I would benefit from higher TFSA limits; it would allow me to put even more of my savings into TFSAs belonging to me, my wife, and adult kids. But I don’t think more TFSA room would be good for our country.

Preet Banerjee explains how inflation and the change of government affect the TFSA contribution rules in his recent Drawing Conclusions video.

Big Cajun Man says now is the time to do a TFSA transfer if you plan to make a simple withdrawal and put the money into a new TFSA in January. However, if you fill out the direct transfer paperwork, you can make a TFSA transfer at any time in such a way that it won’t count as a withdrawal and contribution.

Frugal Trader at Million Dollar Journey updates us on his journey to financial independence. His family’s annual expenses are currently in the $50k to $52k range without vacations, and he aims for $60k/year passive income by 2020. It’s not clear to me whether this will be enough to cover income taxes and 5 years of inflation. Perhaps he means the $60k figure to be in 2015 dollars so that the actual dollar amount will be larger in 2020.

Boomer and Echo look through a Morningstar report on mutual fund fees to find that Canada ranks dead last among 25 countries.

My Own Advisor tells us his “magic” strategies for growing his dividend income. The most important part of his magic strategies is to actually spend less than you make so you have funds to save and invest.

ETF Investment Tips I Don’t Follow

I came across an article promising 101 ETF investment tips from 57 ETF experts (but it appears to not be online any more). While debating whether I thought I could slog through such a long article, I decided to focus on just those tips that I don’t follow. If I have a good reason not to follow them, I should be able to explain it. And maybe I’ll find a gem among the tips that changes my mind about the way I invest.

Talking about the tips I do follow is like having a meal with like-minded friends. It’s an enjoyable way to spend time, but that’s not my purpose here. So here are just those tips I don’t follow.

4. Allocate your age as your percentage in fixed income.

I don’t have any bonds at all in my long-term savings. I only use safe fixed income investments for money I’ll need in less than 5 years. I plan to carry this approach into retirement by holding 5 years of my spending in guaranteed investments and holding the rest in stocks. I expect my allocation to fixed income to be less than my age indefinitely, but I don’t recommend this approach to others. Each person’s appetite for risk and employment situation are different.

5. Save at least 10% of pay into a target date fund.

I prefer to save much more than 10% of pay during good times because bad times are inevitable. I’m not interested in target date funds. I see the beginning of retirement as just a phase change in a lifetime of investing rather than as a final destination. I prefer to control my allocation to fixed income myself.

22. Stop comparing your investment returns to your neighbors’ or that of a specific index.

I agree it makes little sense to compare your returns to your neighbours’ returns. After all, most of your neighbours don’t know their investment returns and will likely make up wild overestimates. However, I’m leery of those who say not to compare your returns to an index. It’s true that comparing your returns to the wrong index is a bad idea. For example, don’t compare your portfolio of 5 Canadian balanced funds to the S&P/TSX. But you could compare this portfolio’s returns to a 50/50 blend of a Canadian bond index and the S&P/TSX. Whenever I hear an advisor say not to compare your returns to an index, I suspect the advisor might be trying to hide huge fees.

39. Buy and hold investing is dead and only works in bull markets where inflation is a constant.

I hear this nonsense all the time from those who try to sell their ability to beat the markets on your behalf. Fortunately, the very next tip is that buy-and-hold investing isn’t dead. Subsequent tips call buy-and-hold investing “not great in 2015,” “better than the alternative,” “the worst way to invest, except all the other methods that have been tried so far,” and my favourite “boring and the only proven long term winner.” I guess the compilers of this list didn’t mind including contradictory views.

82. Over a 20-Year Time Horizon, I’m Bullish On The Nasdaq 100 (QQQ).

This is just one of a series of items in the list where advisors talk about areas where they think there will be long-term investment success. I stopped trying to beat the market years ago. I much prefer to just own everything with very low costs and bet on human progress.

I didn’t find a gem that changes my mind about my investment approach, but I still find it useful to read the ideas of those who disagree with me from time to time. Doing this too often can be exhausting, but doing it too little keeps you from learning. After all, I would never have switched to index investing if I had just read about the latest ways to beat the market.

ETF Fear, Uncertainty, and Doubt

There have been a number of prominent articles about the dangers of trading Exchange-Traded Funds (ETFs) over the past year. The latest ETF story is from the Wall Street Journal. I read each of these articles looking for some new concern, but they tend to be the same recycled fears along with a scary title. Here I’ll list the categories of concerns and what I do to try to avoid trouble.

1. Some ETFs stink.

Yup, that’s right, not all ETFs are great. Some have high built-in fees and others are too narrowly-focused to be safely owned by the unwary. I stick to very low cost index ETFs.

2. Investors can lose money trying to actively trade ETFs.

True. That’s why I don’t trade them actively. Apart from a rare need to rebalance my portfolio to my target asset allocation, I don’t plan to sell any ETFs until I need the money in retirement. I buy more ETFs when I have more savings to invest.

3. Sometimes ETFs trade for prices far from their Net Asset Values (NAVs).

The NAV of an ETF is the price it should trade for based on the current price of the stocks or other investments it holds. ETFs are structured to keep their prices close to their NAVs, but it’s possible for ETF prices to differ significantly from their NAVs. This is rare, but it has happened. That’s why I always use a limit order.

If I’m going to buy an ETF, I first check that the bid-ask spread is small, and then I place a limit order for a few pennies more than the current ask price. Most of the time my order gets filled at the current ask price. But it’s possible for the price to run up on me. In this case, my order won’t be filled at a price higher than my limit. Similarly for sales, I place my trade a few pennies below the current bid price to limit the damage in case there is some sudden volatility.

Some people ask why I go a few pennies worse than the best currently available price. The answer is that I couldn’t be bothered to have to place my order again if the market happens to move a penny and my order never gets filled. By placing my order a few pennies away, this rarely happens to me. Because the market gives you the best available price even if you say you’ll accept a slightly worse price, my strategy rarely costs me extra.

4. Investing in ETFs cuts into the livelihoods of people peddling expensive mutual funds.

This is the unstated motivation behind some ETF fear mongering. I can’t tell for any particular article whether the writer has this motivation, but you can be sure that it is behind some stated ETF “fears.” Just to be clear, I have no reason to think this particular Wall Street Journal writer’s motivation is anything but concern for investors losing money trading ETFs using market orders.

I’d be pleased to hear if there is something else I should be doing to protect my portfolio, but I’m not going to lose sleep over yet another article about ETF dangers.

Pension Ponzi

Canadian baby boomers don’t have to look very far in their circle of friends to find people retiring in their 50s on very generous life-long public service pensions. In their book Pension Ponzi, Bill Tufts and Lee Fairbanks try to persuade readers that “public sector unions are bankrupting Canada’s health care, education and your retirement.” Of course, unions argue differently. As with most debates between sides with polarized views, there is lots of room for both sides to be wrong.

While the authors make a number of excellent points, they hardly give a balanced view. This book is written to outrage you more than it is written to inform you. I’ll go through some of the book’s good and bad points before offering my own thoughts on public service pensions.

The Good Parts

Mounting public debt is a sign that governments at all levels in Canada have been overspending for decades. “There is really only one place that meaningful cutbacks can occur, and that is the size and cost of the government workforce and its salaries, benefits, and pensions.” When companies face tough times, they are forced to cut jobs. The same is true for governments if they plan to balance their books.

“The age for regular retirement in the public sector needs to be raised to 65 for full benefits, with penalties for early retirement.” I don’t like the use of the word “penalties” here because pension reductions should not be seen as a punishment. If you start collecting a pension in your 50s, you’ll collect money longer than if you start at age 65. The pension payments must be reduced to make the total payout the same.

To remain competitive, companies must routinely evaluate their workers and lay off workers who don’t perform well. However, “neither incompetence nor lack of achievement is cause for anyone to lose their job in the public sector.” This point is somewhat overstated, but it is largely true. Few bad public sector employees lose their jobs.

The “oft-touted idea that public sector employees would all receive more money were they working in the private sector is totally unfounded.” There is a very wide range of talent within the public sector. The most talented government employees in technical positions could do well in private industry, but many of the others could not get and hold a comparable private sector job. If public sector workers could easily make more money in the private sector, more of them would do so.

The Not-So Good Parts

Much of the book is devoted to describing specific pension-related abuses by top bureaucrats. These problems should be fixed, but I doubt they are representative of the typical public sector retiree. The authors use these examples to boil readers’ blood rather than inform them.

The authors give many dollar amounts in their examples of waste and abuse. Unfortunately, they adjust for inflation and investment returns only when it suits them. The pension abuses are bad enough without overstating them by adding up nominal dollars to be spent in future decades without adjusting for inflation.

The authors point to a report showing that a family with 2 children only needs 43% of their pre-retirement income to have the same disposable income in retirement. They arrive at this figure by deducting child costs, employment costs, mortgage payments, and retirement saving, and accounting for the reduction in income taxes. It is not fair to compare this 43% figure to a 70% pension. If we’re going to say that public service workers actually make much more than they appear to earn because of their pensions, then the actual percentage of their true incomes they receive as a pension is well below 70%. Put another way, we cannot count the retirement savings for the example family as part of income unless we’re prepared to count employer pension contributions as part of income for public sector workers.

My Take

Among the many people I’ve dealt with professionally in government as well as friends working in the public sector there is a strong feeling of entitlement to their pensions. On one level, this makes sense: they expect to receive what they were promised.

But there is more to this feeling of entitlement. I would say that almost everyone I know who has been in government for at least 25 years doesn’t like their jobs. They tough out as many years as they can to get to a pension they’ve earned through suffering.

The most common complaints I hear are bad coworkers, bad managers, and insufficient meaningful work. It’s normal for workers to complain a certain amount in the private sector, but things seem much worse in the public sector. No doubt there are parts of the public sector with good working conditions, but this seems to be more an exception than the rule.

The problem is that Canadians derive no benefit from the suffering of public servants. We can’t afford to pay people for enduring poor coworkers and a dysfunctional work environment. I would love to see a more efficient public sector where workers feel that their efforts have real meaning. This can only happen if the public service does a better job of identifying poor performers at all levels and laying them off.

Steve Jobs famously declared that he wanted only A-players working at Apple, no B-players. The public service doesn’t have to get rid of B-players; they just have to stop employing the obvious F-players.

On the specific pension issues raised in this book, here are my thoughts:

Pension Accrual: For the most part, pensions accrue at 2% per year for a 70% pension after 35 years. For some occupations, a 70% pension is reached after only 30 years. People should not be able to have a standard retirement before age 65. An accrual rate of 1.5% so that workers reach a 60% pension after 40 years makes more sense. For occupations with physical demands, it should be standard practice to shift workers to less demanding roles in their later years.

Retirement Age: The standard retirement age should not be earlier than 65. Like CPP benefits, anyone collecting a pension sooner than age 65 should get a reduced pension, even if they’ve reached the 40-year mark. This is not a punishment; it simply reflects the fact that pensions that start early will be paid longer. There should not be bridge benefits for those retiring early unless there is a corresponding reduction in pension benefits. Anyone who wishes to retire early should save up to make up the difference for a reduced pension.

Retirement Salary: Currently, pensions are based on an average of the best few years of income. This encourages “spiking” to artificially inflate earnings at the end of a worker’s career. The pension should be based on lifetime average earnings, but with appropriate adjustments for inflation and investment returns. CPP is a good model here. If you earned half the maximum pensionable earnings 30 years ago, this counts the same as earning half the pensionable earnings today, even though the dollar amounts are higher today.

Employee Contributions: It makes sense for employees to contribute half the value of a pension and for the government employer to contribute the other half. However, this can’t be based on unrealistic return expectations in defined-benefit plans. If you assume high investment returns, then you’ll conclude that very little needs to be saved today to cover pension payments in the future. Using realistic returns means employees would make a fair contribution to their own pensions. But it doesn’t make sense to use low bond returns either. The correct return to use is somewhere between bond rates and historical real stock returns.

Overall, I found this book useful for learning the important issues in the public service pension debate, but it is far from balanced. I encourage readers to seek out other points of view before drawing any conclusions.

Reader Question about Non-Registered Accounts

A reader, R.V., asked the following thoughtful question about investing in a non-registered account:

“As I approach maxing my registered accounts, I need to start thinking about perhaps opening up a non-registered account.

At present, I do the following:
TFSA: TD e-series funds (25% each of Bonds, CAD Index, US Index, & Int'l Index)
RRSP: 70% VXC and 30% VAB via a brokerage account

For Non-reg, I was thinking of HXT. Benefits of a swap-based ETF is no dividend to worry about and only need to be capital gains tax upon selling.

Do you have any comments and/or recommendation on some non-reg ETFs? What do you normally buy for your non-reg account?”

To start with, R.V. is obviously handling his finances very well given that he has maxed out his RRSP and TFSA. He has also chosen good diversified low-cost index mutual funds and ETFs. If he can stay invested and not tinker too much with his asset allocation, I’m optimistic about his future.

I don’t give financial advice directly for a couple of reasons. For one, I don’t know R.V.’s situation well enough to be certain of what’s best for him. Another reason is that I’m a big believer in learning the right answer yourself instead of just trusting experts. However, I can describe the way I invest my own money and why I do it that way.

I split my money into short-term and long-term savings based on whether I’ll need it within the next 5 years. My short-term savings only go into safe investments that come due when I need them like GICs, government bonds, savings accounts, and cash. From here, on, everything I discuss applies to my long-term savings.

I treat all of my long-term savings as a single portfolio with a single asset allocation. I don’t mind having skewed asset allocations in each account if the whole portfolio mix is as I want it. I use VCN for my Canadian stocks and I fill up my non-registered accounts as much as possible with VCN to get the preferred tax treatment on Canadian dividends. It’s still better to have VCN in an RRSP or TFSA, but when there’s no room left, Canadian stocks are better in a non-registered account than non-Canadian stocks.

Some people choose to put their bonds in a non-registered account because they expect bonds to have lower returns than stocks. Bonds get poor tax treatment in a non-registered account, but this has to be balanced against the higher expected returns of Canadian stocks. I haven’t had to make this decision because I don’t own bonds in my long-term portfolio.

HXT is potentially a good choice for a non-registered account because the swap arrangement causes dividends to get turned into deferred capital gains instead of paying taxes on the dividends every year. I’ve chosen not to use swap-based ETFs because I’m uneasy with the counterparty arrangement. There are experts who say that counterparty risk is very low and that even if there is a default, the losses would be modest. Another potential risk is that the government could change tax rules for these swap-based ETFs. I’ve just decided that I don’t need these risks in my life.

I consider it more important to maintain my portfolio’s asset allocation than to focus solely on minimizing taxes. So, I’m content to have some U.S. and international stocks in my non-registered accounts even if it results in paying some taxes. Right now, my portfolio’s total costs (commissions, spreads, MERs, other fund costs, and foreign withholding taxes) are below 0.2% per year. Trying to save another basis point or two by distorting my asset allocation would be letting the tax tail wag the investing dog.

Whatever strategy R.V. settles on, it’s important to avoid tinkering too often. Our instincts can lead us to buy high and sell low. When we have intelligent-sounding reasons to modify our strategy, it’s often just fear keeping us from buying low and greed pushing us to buy high.

Excuses to Shop

My wife received some credit card spam that started as follows:

“The year is almost over, but you can still build your January rebate! Use your [brand of credit card] to earn cash back on special gifts, last-minute holiday purchases and everything in between.”

She laughed and showed it to me. My first thought was who would spend an extra $1000 now just to get $20 more back in January? Most people aren’t great at math but they’re not this bad. This message seems like it shouldn’t work on anyone. But credit card marketers can’t be this dumb. There has to be more to this than I saw at first.

One possibility is they are aiming this message at people with multiple credit cards in an attempt to get them to use this particular card more often for things they were going to buy anyway. But I think there is a better explanation.

I think this message is mainly aimed at shopaholics. Addicts will latch onto any excuse to scratch their itch. Compulsive shoppers need an excuse to shop for things they don’t really need or want and will latch onto just about any idea no matter how nonsensical: rebates, points, Black Friday, Cyber Monday, and Boxing Day/Week/Month.

So this message wasn’t meant for me or my wife. It was meant for more profitable customers who need excuses to compulsively overspend.

Short Takes: Private Car Sales, Faulty Investing Assumptions, and more

Here are my posts for the past two weeks:

How Much Do You Need to Save to Retire?

The Overconfidence Gap

Value of a Public Service Pension

Here are some short takes and some weekend reading:

Ellen Roseman explains the trouble you can get into if you sell a car privately but the buyer doesn’t transfer ownership.

A Wealth of Common Sense brings us an excellent list of faulty assumptions about investing.

Dan Hallett gets riled up about income funds that trick investors with unsustainable monthly payments. It’s sad when people count on regular income that is certain to drop eventually.

Big Cajun Man got an answer from CRA about whether his son continues to be eligible for the Disability Tax Credit.

Kerry Taylor meets Sean Cooper, the millennial with a paid-off house, to find out if his critics are right about whether he received financial help from family and whether he lives an intolerably cheap life.

Preet Banerjee explains how the new Canada Child Care Benefit works. My main takeaway is that these benefits are way more generous than anything I ever got when my kids were young.

Boomer and Echo explain how they turned a blog into a profitable business. He says “bloggers shouldn’t have to apologize for advertising.” I agree with this, but I have a different objection. I don’t like it when a blog tricks me into reading what appears to be a useful article but is actually advertising. I don’t mind advertising if I can clearly see the difference between it and a real article.

My Own Advisor says that when it comes to “fools with tools,” it’s not the credit card tool that is the problem but the fool who wields it. I’d say banks, credit card companies, and retailers play a role as well when they use sophisticated methods to encourage people to live beyond their means.

The Blunt Bean Counter clarifies a complex tax issue: Capital Cost Allowance (CCA) on rental properties.

Value of a Public Service Pension

At one time I considered taking a job with the federal government. I had a competing offer in the private sector and set about comparing them based on various factors such as how much I’d enjoy the work, the commute, and total pay. A tricky part was placing a value on a public service pension. The value of a pension is very sensitive to the investment return we assume.

Let’s look at a simple example of a government worker:
– Starts work at age 23 making $40,000 per year
– Works for 35 years
– Retires at age 58 with an indexed pension of 70% of best 5 years average salary
– Pension is reduced by the amount of CPP benefits starting at age 65
– For first 20 years working receives raises of inflation + 4%
– For final 15 years working receives raises of just inflation
– Lives in retirement for 25 years until age 83

With the details in this example, we can calculate what percentage of this worker’s salary would have to be saved from each pay to cover the pension benefits. Of course, the rate of return on investments affects this calculation; the higher the investment returns the less you have to save.

The following chart shows the relationship between investment returns and how much we need to save to cover the pension. Keep in mind that we are talking about a “real” investment return, which means the return after subtracting out inflation.

At one extreme, if we could count on earning returns of 6% above inflation on saved money, we’d only need to set aside a little over 9% of the worker’s salary to cover the pension benefits. At the other extreme, if returns only match inflation, we’d need to set aside a whopping 49% of the worker’s salary!

At an investment return of inflation plus 4%, we’d need to save about 16% of the worker’s salary. This would be fairly reasonable: perhaps the worker could contribute 8% of pay and the government could match that dollar for dollar. Unfortunately, guaranteeing investment returns of 4% over inflation is a lot to ask.

Some commentators think that the expected future returns of stocks will be about 4% over inflation, on average. But this isn’t certain and will come with a lot of volatility. So, we couldn’t invest people’s pension money 100% in stocks. Adding a significant bond allocation drops the average return.

I actually invest my own long-term savings 100% in stocks, but I’m prepared to delay the start of my retirement if stock returns happen to disappoint. If I had taken the government job, I could have planned my retirement date without worrying about when stocks happened to take a slump.

Another thing to consider is that pensions do away with longevity risk. Even if our example worker lives to 110, the pension payments just keep rolling in every month. We have to save more to account for this possibility.

When I was comparing my two job offers, I settled on inflation plus 2% as a reasonable investment return to count on. Based on the chart above, this values the pension at 28% of salary, which is very valuable. In the end I still chose the private sector job, but the pension made the decision a lot closer.

For many people, even inflation plus 2% is not a realistic return expectation for their own savings given that most Canadians pay huge mutual fund fees in the 2-3% range every year. This makes a government pension look even more valuable to the average Canadian.

However, I’m confident in my ability to keep portfolio costs very low, so I think using inflation plus 2% as a safe return expectation made sense for me. Your mileage may vary. Whatever return expectation you think is reasonable, it’s clear that the value of a pension is very sensitive to this assumption. It’s also clear that pensions are very valuable no matter what reasonable returns you expect.

The Overconfidence Gap

Over the years, the many people I’ve worked with have had both good and bad traits. No doubt they’d think similar things about me. The one trait that I find most tiring is a high overconfidence gap, which I define as the difference between how good you think you are and your actual abilities. Confidence is a useful thing in many contexts, but it can be deadly for your finances.

As a baseball coach, I routinely talk up players’ confidence before sending them to bat. Believing you can hit the ball improves how hard you try and leads to better outcomes. Confidence also leads to more improvement over time. Too much confidence can cause problems, but for the most part confidence is useful in baseball.

I’ve watched the cycle many times. A batter goes to the plate with confidence and either gets a hit or doesn’t. Failing causes a short-term blow to the ego that fades before the next at bat. Confidence helps. Even overconfidence helps within limits.

When it comes to investing, a large overconfidence gap can be very dangerous. You need some confidence to be able to take your money out of a savings account, but too much confidence leads investors to take wild chances on their hunches. I’ve done it myself piling most of my net worth into one stock. But I don’t do this anymore.

The cycle I observe among some high-tech workers is they are very confident in their assessment of some stock. They buy, the stock tanks, and they protect their egos with some explanation of why the bad investment wasn’t their fault. Then they do the same thing over again time after time.

It can be very hard to examine a stock, form a strong opinion, and admit to yourself “it’s just a coin flip whether I’m right or wrong.” It’s staggering that we often think we can do a little work on the side and beat full-time investment professionals at their game.

Even more baffling are the stock-pickers who don’t even read company financial statements. It’s impossible to pick stocks well without examining financial statements and comparing their meaning to the stock’s current price. A quick test I have for those touting a stock is to see if they can quote any of the company’s major financial figures from memory.

Confidence is important in many areas of our lives, but overconfidence can hurt you financially. Mind the overconfidence gap.

How Much Do You Need to Save to Retire?

Just poke around the internet for a while looking for answers to how much money you need to save before you retire and you’ll get answers ranging from next to nothing up to $3 million or more. It looks like some of them must be wrong, but it all comes down to your spending and pensions.

Let’s take an example. A Canadian couple, Mary and Bill, are both 65, have no debts, have no workplace pension, and are about to retire. They both worked enough to get maximum CPP benefits. Together they can expect CPP plus OAS of $3200 per month rising with inflation.

Suppose that $3200 is enough to cover their spending. Then the total savings they need is zero. Nada. Zilch. It can be dangerous to count on being able to work until age 65, to count on maximum CPP benefits, and to assume you can live on $3200 per month, but now that Mary and Bill have made it to 65, they need no savings beyond a modest emergency fund.

What happens if Mary and Bill have a more expensive lifestyle? Let’s say their spending is double their government pensions, $6400 per month after income taxes. Based on a series of assumptions, I work out that they need about $1.1 million in savings. This is hugely different from the first case where they needed no savings.

Let’s take it one step further and see what happens if they want to spend triple their government pensions, or $9600 per month after income taxes. Again, based on several assumptions, I calculate that they need about $2.4 million in savings.

No doubt others would calculate different amounts of savings needed to support the larger spending levels, but the point is that the need for millions of dollars in savings to retire comes from spending more than your pensions.

If you can live on your available inflation-indexed pensions, then you don’t need savings. If you need more money than this, your savings needs climb quickly. How much you need to save is so sensitive to how much you spend that we should never expect consensus among experts on how much you need to save.

Short Takes: Stock Return Expectations, Bond Index Criticisms, and more

Here are my posts for the past two weeks:

Enough Bull

Retirement Spending Stages

Choosing Investments You Understand

Taking My Investment Decisions Out of the Loop

Here are some short takes and some weekend reading:

Jonathan Clements explains why stock investors should expect about 6% return per year and 2% inflation for the next 10 years. A 4% real return sounds just fine to me. I’m not sure why we “need to save like crazy to compensate for the market’s likely modest gains.” However, I’m definitely with him that investors “should make sure they capture as much of those gains as possible, by opting for low-cost market-tracking index funds.”

Canadian Couch Potato explains why certain criticisms of bond indexes are wrong.

Tom Bradley at Steadyhand adds to my list of complaints about index-linked GICs.

Jonathan Chevreau explains that Real-Return bonds aren’t as safe as they appear because it’s difficult to match their maturities to when you’ll need to spend your money.

Squawkfox uses her foray into gourmet olives to motivate us to track our spending. It can be an eye-opener to see where the money goes.

Big Cajun Man explains the latest step he’s had to take so that CRA will continue to recognize his son’s disability.

Boomer and Echo helps a reader deal with RRSP over-contributions.

My Own Advisor tests himself on Gail Vaz-Oxlade’s 9 major money mistakes. He definitely gets a passing grade. But, like me, he doesn’t have a budget. I’m always torn talking about this because I see no need to have a budget myself, but I know others who desperately need one but don’t have one.

The Blunt Bean Counter has a guest expert explaining estate planning for blended families who have a marriage contract and others who don’t have a marriage contract.

Taking My Investment Decisions Out of the Loop

All the evidence says that the vast majority of us aren’t good active investors. Our choices tend to be worse than random, and we pay investment costs on top of this. Even index investors can have these problems. Here I explain how I’ve tried to automate my investment decisions as much as possible to take myself out of the loop.

Investors have many worries. Is now a good time to be buying stocks? Should I be selling now? Are there better mutual funds than the ones I own now? Should I shift more money into bonds? Less?

Unfortunately, the evidence shows that most of us make worse than random choices when we try to answer these questions. It’s tough to admit that we can’t beat a coin flip.

My response to this dilemma is to ignore my opinions on the market and invest in indexes. And as long as I’m not trying to beat the market, I maximize my returns with low-cost highly-diversified index ETFs.

But even after making this decision, investment choices can creep back in. For example, when adding new money, which ETF should you buy? I automate this choice using a fixed asset allocation. I have a target percentage of my portfolio for each ETF I own. When I have new savings to invest, I buy those ETFs that are below my target percentage.

Another investment choice that can creep back in relates to rebalancing. If my ETFs have different returns, my portfolio’s percentages can get out of balance too much to fix when I add new money. However, if I use my judgment on when to rebalance, I’m effectively making an active decision. So, I have a method to compute rebalancing thresholds. If my percentages get outside a range computed in my portfolio spreadsheet, then I rebalance.

This leads us to the next subtle form of decision-making. If I bury my head in the sand instead of paying attention to my spreadsheet, I’m effectively overriding the spreadsheet’s decision and substituting my own active decision. This is a common problem because many of us can’t bear the thought of selling an investment that has gone up to buy one that has gone down recently. I deal with this problem by having my spreadsheet send me an email with rebalancing instructions. I get these rarely, but always act on them.

The next area where my own discretion sneaks in is with new money. Over time I accumulate dividends and build savings in the various accounts that make up my portfolio. I have to decide when to invest this cash. In this case, I again let my spreadsheet decide. I have a formula for balancing trading costs against the opportunity cost of sitting on cash. This results in a cash-level threshold for each account. If the spreadsheet tells me the cash level in any account goes over its threshold, it’s time to buy.

I don’t believe the advice to “trust your gut” works well in investing. The evidence says your gut isn’t worth much. No doubt there are other subtle ways that my own decisions worm their way into my portfolio, but I believe I’ve managed to keep myself almost completely out of the loop, just the way I want it.

Choosing Investments You Understand

Some very common advice is to only invest in things you understand. It’s certainly a good idea to avoid investments you don’t understand, but it’s all too easy for a salesperson to give you the illusion of understanding. For this reason, I doubt it helps people much to tell them to choose investments they understand.

Let’s take the example of mutual funds. Suppose a financially naive young couple hear the following pitch:

“A mutual fund is a pool of money invested by expert money managers in stocks and bonds. We have a collection of 5 diversified funds that returned 9% per year over the past 5 years. If you start contributing $500 per month into your RRSP and increase this as your pay increases, then a 9% return will give you over a million dollars in 30 years.”

What’s not to understand about this? Our young couple will feel safe checking off the “make sure you understand the investment” item on their checklist. More experienced investors will know this couple doesn’t really understand, but the couple won’t know this.

Let’s try pitching an even more dubious product, index-linked GICs:

“The stock market has the potential for big gains and GICs provide safety. We’ve found a way to combine them to get the best of both worlds. If stock markets perform well, our index-linked GICs give higher returns than regular GICs, and if the stock markets crash, your principal is 100% guaranteed.”

Again, this explanation gives the illusion of understanding to naive investors. More sophisticated investors know that there is hidden bad news in index-linked GIC interest formulas, but naive investors don’t know this. They have a nice tidy story that feels easy to understand.

The sad truth is that a lot of advice like “invest in what you understand” and “get a good financial advisor” is difficult to follow without more financial savvy than most people have.

Retirement Spending Stages

It’s definitely true that most people’s retirement spending declines as they age. Financial Planners tell a story of how this reduction in spending is natural and that you should plan for it in your own retirement. Here I tell a different story that leads to a different conclusion.

Certified Financial Planner Roger Whitney captured the usual story of the three stages of retirement clearly:

“In the ‘go go’ years of retirement, your spending may be at its peak. This is the time for travel, activities, adventures and family.

In the ‘slow go’ years, your spending may slow as you become more settled.

In the ‘no go’ years, you may spend even less as you settle in even more.”

This sounds so logical that it’s easy to accept the advice to spend a lot in your early retirement years. But let’s analyze this a little further.

Let’s call these stages, the 60s, 70s, and 80s. Will you really want to start cutting spending when you’re only 70? It’s true that, on average, people do begin to spend less when they’re this young, but why? I can understand being less adventurous at 85, but why only 70?

Let’s try a completely different story to explain the drop in spending:

In the ‘dumb-dumb’ early years of retirement, people see their big pots of savings and spend too much. Even if they try to stick to a reasonable spending level, they tend to dip into principal for larger items like fixing a roof, replacing a car, or helping an adult child.

In the ‘uh-oh’ years, people realize they’re spending too fast and begin to cut back.

In the ‘oh well’ years, there is little money left and people live on their government benefits and any pension streams they may have.

Obviously, this narrative doesn’t apply to everyone, but it does apply to many, which skews all the spending statistics. If spending less were a common choice, then planning for it would make sense. But if it’s forced on retirees because of overspending, then it makes no sense to bake it into your plans.

The next time someone tells you to be like everyone else and plan for peak spending in early retirement, what you should hear is that most other people spend themselves poor in early retirement, so you should too.

Enough Bull

David Trahair came out with a second edition of his book, Enough Bull, that makes the case for avoiding stocks by investing solely in Guaranteed Investment Certificates (GICs). Unfortunately, just about all of the criticisms I had in reviewing the first edition still apply.

I won’t bother to repeat most of the points from my earlier review. The details Trahair gives about his own investing history show a person who invested more than half of his money in Labour Sponsored Investment Funds (LSIFs) and got burned. He has now retreated into the safety of GICs and recommends you do the same.

The biggest problem with his argument is that he continues to ignore stock dividends. This isn’t just nitpicking. Over 28 years, reinvesting a 2.5% dividend will double your savings. This makes a real difference to how soon you can retire and how much you can spend in retirement.

Trahair looks at the S&P/TSX Composite index in the 25 years starting on 1989 July 31 and finds the price increase (i.e., ignoring dividends) is 5.6% per year. He uses this to justify an assumption that stocks will average only a 5% return per year in the future. “Take off fees and you’ll only get 3%.”

The sad thing is that it is possible to make a reasonable case for GICs, at least for some investors. People pay high mutual fund fees, as Trahair points out. Another point that would bolster his argument is that people tend to underperform their own mutual funds because they tend to jump in and out at bad times. So, for some investors, GICs don’t look too bad. But any reasonable analysis has to include dividends.

As for me, I’ll happily accept the volatility of stocks. My portfolio of the world’s stock indexes costs me less than 0.2% per year, including fund MERs, other fund expenses, trading commissions, bid-ask spreads, and foreign withholding taxes on dividends. The gap between my average return and GIC interest rates has been substantial. Your mileage may vary.

Short Takes: Vanguard Canada ETF Changes, Income Tax Changes, and more

Here are my posts for the past two weeks:

The Consequences of Keeping Bad Employees

Timing Stock Market Peaks

Financial Dictionary

Here are some short takes and some weekend reading:

Canadian Couch Potato explains changes taking place in Vanguard Canada’s ETFs.

Preet Banerjee uses his latest Drawing Conclusions video to explain how Trudeau’s proposed new income tax brackets affect you.

Kerry Taylor (a.k.a. Squawkfox) has some fun and practical ideas for introducing money concepts to young kids. One of the points made in the article is that a lot of financial lessons need to come from parents instead of leaving it to schools. I agree.

Potato reports that he encountered some door-to-door salespeople pushing investments in condo construction. Anyone considering investing with a door-knocker might consider the merits of running with scissors first.

Big Cajun Man says you pay too much for your telecom needs.

Boomer and Echo defends the two ETF investment solution based on Vanguard Canada’s exchange-traded funds VCN and VXC. With the possible addition of some fixed income, this seems like a very good portfolio for anyone who’d rather not deal with currency exchange.

Financial Dictionary

It took me a great deal of life experience to get my far from complete understanding of the financial world. Here is my attempt to capture in as few words as possible the right way to think about some financial terms.

Bank: An entity that aims to take you for about 3% of everything you own or owe each year.

Bonds: Payday loans to governments.

Car: The most expensive part of your self-image.

Commute: The most underestimated cost of both time and money.

Debt: A crushing burden that weighs down your life and dreams.

Expenses: Anything a salesperson calls an “investment”.

Government: An entity that transfers your tax money to its employees.

Inflation: An invisible force that slowly makes your retirement income worthless.

Insurance: Something sold using the illusion that it will prevent bad things from happening.

Insurance Company: An entity that pays small claims and denies large ones.

Investment Industry: All entities whose income comes solely from dipping into your savings.

Longevity Risk: Cat food.

Lottery Tickets: A common retirement plan whose success rate increases when combined with smoking.

Organization: An entity whose main function is to pay its administrators.

Payday Loans: The last lap in swirling down the financial toilet.

Smoking: A means of combating longevity risk.

Stocks: An overconfidence tax when bought. A fear tax when sold. A wealth generator when held in great variety for a long time.

Timing Stock Market Peaks

Active stock pickers like I was for many years often feel regret when they fail to sell a stock at its peak. We almost always leave money on the table. However, expecting to hit the peak just isn’t reasonable. As a case study, I look at the one stock that made me the most money. Despite my fantastic luck, I was still nowhere near selling at the peak.

The stock market bubble in the late 1990s was a crazy time when even the dumbest investors felt like geniuses because just about everything they bought went up in a hurry. During that time I bet crazily on one stock and won. My portfolio return for 1999 was almost 200%!

Every way I look at the numbers, I conclude that I was just plain lucky. I left a huge percentage of my net worth in one stock and it happened to pay off. But even so, I often think back to what could have been if I had held onto all of it and sold at the absolute peak.

Instead of selling at the stock’s peak, I sold it off in blocks primarily between mid-1998 and mid-2000. It turns out that my total profits were only 22% of what they could have been if I was clairvoyant and had sold at the peak. That certainly doesn’t sound lucky, but I assure you that in this case it was lucky. For a stock with a huge run up and spectacular fall, selling it all at the top is nearly impossible.

What about mechanical selling strategies? What if I had set some maximum percentage of my net worth to put in this one stock? The idea is that each day I could have calculated how much of my net worth was in this stock and sold some if necessary to get below a target percentage. I decided to crunch some numbers to see what would have happened.

I calculated the profits for different net worth percentage thresholds. The profits are expressed as a percentage of the gains from selling at the absolute peak price.

We see that there is a huge gap between the peak and any of the selling patterns I examined. As shown in the chart, my actual share sales netted me about 22% of the peak amount. If I had set a maximum for this stock at about 50% of my net worth, I would have made 18% of the peak. (Putting 50% of your net worth in one stock is insane, but I actually had a much higher percentage in this stock for a while.)

None of the thresholds for a mechanical strategy would even have netted me as much as my actual sales. This speaks to just how lucky I was.

Whether it’s trading in one stock or market timing the entire stock market, expecting to sell at a peak price is just unrealistic. I’m a much more relaxed and realistic investor now that I’m an indexer.

The Consequences of Keeping Bad Employees

Most people do their jobs well, but there are some who can’t or won’t do their jobs adequately. The most obvious consequence of keeping bad employees is that paying them is a waste. But there are follow on effects that are much more serious. In the private sector, these problems tend to take care of themselves, but not so in the public sector.

There are many problems that come from allowing bad employees to stay in an organization:

1. They cost money but don’t produce their share of output.

2. They take up the time of other employees.

3. Some talented employees will become disgusted with having to work with incompetent employees and will leave.

4. Over time some bad employees will move up in management where they can cause more damage with poor leadership and bad hiring decisions.

5. An organization that goes too long without culling bad employees will eventually lose its ability to distinguish between weak and strong performers.

Of all these problems, only the first one (not producing enough output) has much of a hope of ever being measured. But the other four problems have a significant multiplying effect that is very difficult to measure.

Most companies in the private sector do a reasonable job of culling bad employees. The ones that fail at this important task increase their risk of failing entirely. So, one way or another, the problem of bad employees tends to be kept under control. It’s not that the private sector employees are all star performers, but the proportion of poor employees tends to stay under control.

It’s worth noting that a person is rarely inherently a bad employee. It matters a great deal what job they’re expected to do. There are some jobs I’m terrible at, and others I’m good at. The process of culling poor employees is in some sense a force that shuffles people out of jobs not suitable for them and into jobs they’re better at.

This reshuffling of people to different jobs sometimes happens within an organization and sometimes it involves getting fired and looking for a new job. It’s tempting to eliminate firing altogether and say that companies should always find a better fit for each employee. However, without the threat of getting fired, some employees will see no reason to ever really try. Some bad employees can’t do their jobs, but others just won’t do their jobs without the threat of being fired for poor performance.

In the public sector, firing employees is much less common than it is in the private sector. This leads to some very simple logic. Some hiring decisions are mistakes. If you don’t get rid of poor employees, they accumulate. This leads to the five problems listed earlier.

According to Statistic Canada, in 2011 there were 3.6 million public sector employees paid a total of $194 billion. If we conservatively estimate that 10% of these wages are wasted on bad employees, that’s $19 billion per year wasted. Of course, bad employees pay taxes, so let’s call the net waste $12 billion per year.

According to CRA, in 2012 the 9.5 million Canadians earning less than $20,000 per year paid a total of $1 billion in federal and provincial income taxes. So, cutting public sector waste would allow us to stop taxing people with incomes under $20,000 and we’d still have $11 billion left over. Just think of how much we could shorten wait times for medical scans and procedures.

Some readers will take this article as an attack on public employees and the services they perform for Canadians. This is not an attack on Canada’s public service. Our public service is vital. We need safe food and medical care just to pick two important functions. We need the millions of public servants who do their jobs well. What we don’t need is to pay the ones who can’t or won’t do their jobs. Many strong public servants would be thrilled to see their useless coworkers leave.

Don’t be fooled into treating public sector employees as a uniform group. There are good teachers and bad teachers. The good teachers are worth every penny we pay them and the bad teachers do damage to our pocketbooks and our children’s future. It’s not realistic to expect to eliminate all bad employees, but it would be great to deal with the most obvious cases of poor performance.

Short Takes: A New Father’s Financial Advice, Taking CPP Early, and more

Here are my posts for the past two weeks:

Credit Card Bill

Typical Spending vs. Average Spending

Contest Winners – Let’s Get Blunt about Your Financial Affairs

How Dividends Affect Stock Prices

Here are some short takes and some weekend reading:

Morgan Housel writes a brilliant piece offering financial advice for his new son. The high quality of his 10 points is in sharp contrast to the embedded ad made to seem like part of the article at the bottom.

Preet Banerjee explains how taking CPP early or late affects your monthly payments.

Rob Carrick gives us one of his short videos explaining the Liberals’ tax plans. He hits the high points clearly, but I’m not sure why he refers to “high net worth earners.” I think he just means “high earners” because you get hit with this extra tax on high incomes whether you’re a millionaire or you owe a million. The most amusing part of this video was the preceding ad touting active management in investing. Apparently, the “power of active management” “can protect capital long term,” “can tap global insights,” and “can seek to outperform.” Envious passive investors should rest assured that they can protect their capital long-term as well, that tapping global insights is highly overrated, and that seeking to outperform almost always ends in long-term underperformance.

Million Dollar Journey explains the virtues of the new Tangerine credit card. I’m normally not at all excited about credit cards, but Tangerine’s new card looks quite good.

Big Cajun Man tells the cautionary tale of how his mother became unable to get insurance on her home.

The Blunt Bean Counter explains the tax implications when Canadians sell U.S. real estate.

My Own Advisor asks Frugal Trader at Million Dollar Journey about his approach to dividend investing. Frugal Trader is one of the rare stock pickers who actually reads company annual reports. I have my doubts about his or anyone else’s ability to beat the market, but I have little doubt he’ll roughly match the market’s return over the long term. I have more doubts about the ability of other investors to match his approach.

Boomer and Echo tell us where first-time home-buyers are getting their down payments.

How Dividends Affect Stock Prices

A few times now I’ve seen dividend investors claim that paying dividends doesn’t make stock prices drop. The claim is that investors know the dividends are coming and they are already built into the price of the stock. This isn’t true, but perhaps the reason isn’t obvious. After all, this type of reasoning does make sense with other types of news about stocks.

This is best explained with an example. Consider two companies:

Company A
– will be paying a $1 per share dividend tomorrow

Company B
– won’t be paying a dividend
– will be paying a fine tomorrow that works out to $1 per share

In both cases, we assume that investors have known about these facts for a long time. In company B’s case, when tomorrow comes and they have to pay the fine, their stock price changes no more than usual because investors have known about the fine for a long time and have already factored it into company B’s share price.

So, the question then is why doesn’t this logic apply to company A? After all, their situations look quite similar. But, when company A’s shares trade ex-dividend (meaning that the share buyer won’t get the dividend), the share price drops by $1. Why the difference?

The answer comes from examining exactly what investors are buying today versus tomorrow. In company B’s case, if I buy today and hold until tomorrow I’ll have the same thing as if I wait until tomorrow to buy. In both cases I’ll have shares of a slightly poorer company B.

In company A’s case, if I buy now and hold until tomorrow I’ll have the slightly poorer company A plus a dollar per share. If I wait until tomorrow to buy company A’s shares, I won’t get the dollar per share. So, company A’s shares are more valuable to me today than they will be after the dividend gets paid.

A factor that makes this difference less obvious is that dividends amounts are usually small compared to stock prices. The natural volatility of stock prices masks the share drop caused by paying the dividend.

Another factor masking this effect is that most dividend-paying companies have enough earnings to justify their dividends. So their profits make their shares more valuable over time. This means that share prices tend to build up through each quarter as profits are earned.

If we could remove the market’s volatility, we’d see a saw tooth pattern with share prices rising steadily for 3 months and then dropping suddenly when the dividend is paid. But market volatility and investor behaviour mask this pattern.

Don’t get caught up in magical thinking. You can’t take money out of a piggy bank and expect it to still hold the same amount.

Contest Winners – Let’s Get Blunt about Your Financial Affairs

The winners of the draw for copies of Mark Goodfield’s book, Let’s Get Blunt about Your Financial Affairs (using a pseudo-random number generator of my own design) are

Murray D. and
David R.

Congratulations to both winners who I have already contacted by email. The interest in this book was high judging by the large number of entries. Thanks to all who entered and for the kind words many included with their entries.

Typical Spending vs. Average Spending

The gap between your typical monthly spending and your average monthly spending is what gets many people into financial trouble. I collected my family’s monthly spending since 2010 to illustrate how it’s human nature to get into financial trouble if you’re not wary.

My family’s monthly spending is shown in the chart below. I’ve omitted the grid-lines for privacy reasons and because the absolute dollar numbers aren’t important to the points I’m making. (You may wonder about that very low month near the middle of the chart. In cases where I made a purchase and was reimbursed, I treated the reimbursement as a negative amount spent. That month my employer reimbursed me for travel expenses I had in the previous couple of months.)

The main thing to see with this chart is the amount of variation from month to month. My family’s spending variation may be greater than most, but everybody’s spending varies somewhat. Some people are dedicated to using equal billing plans and paying for cars and other large items with loans. Even these people have unexpected big expenses from time to time.

The next chart shows the average and median spending amounts for my family. “Average” here means adding up all the amounts and dividing by the number of months. “Median” means the amount where half the months are above and half are below. I’ve expanded the chart and cut off the big months to better see the average and median.

The main thing to see with this chart is how much higher the average is than the median. This happens because there are many months with a little below average spending, but a few months with much higher than average spending.

Over a long period of time, you need to earn enough money to cover your average expenses. But over short periods of time, an income that covers your typical month’s expenses can seem to work. This means that inattentive spenders who let their lifestyles rise to cover their incomes will float along okay for a while, but will get hit hard by big infrequent expenses.

In some ways, those who try to smooth out their monthly costs as much as possible with equal billing plans and car loans or leases are even more vulnerable. These people can go several months with almost exactly the same monthly expenses before they’re hit with a big unexpected cost.

The remedy for this problem is to have some sort of savings buffer or emergency fund. Just having an emergency fund isn’t enough, though. You also have to carve out a periodic amount from your income to fill the emergency fund back up after you’ve had to dip in.

Some people prefer to have access to a line of credit instead of having emergency savings. But this only works if you have enough slack in your budget to cover the line of credit payments. And if you have this slack available, why not build up some emergency savings now instead of going into debt later? The truth is that too many people who rely on lines of credit for emergencies end up just continually building their debts.

When I think about how much money my family needs monthly, I look at our actual spending, but that’s just a start. Then I look at big, infrequent items, like a new roof, a new car, etc. Then I take those items out of our actual spending, and add back an average figure.

So, for example, if I’ve looked at our spending for one year, and we installed new flooring that year, then the results are skewed because we won’t be fixing the flooring again next year. So, I take the floor costs out of the spending and add back in an average monthly figure. So, if I expect to spend $15,000 every 25 years, that’s $600 per year, or $50 per month. Then I add in monthly costs for all the other infrequent items I’ve identified. The final result is my family’s estimated monthly cash needs.

If you go through this same exercise, it will give you an idea of how your income compares to your true long-term average spending. The scary scenario is where your estimated average spending exceeds your income. Too many people are in this situation and don’t know it.

Credit Card Bill

Credit card companies seem to be losing their patience with some of their less profitable customers:

THE ESTIMATED TIME TO REPAY THE CURRENT STATEMENT BALANCE IS 0 YEAR(S) AND 0 MONTH(S) AND 6 DAY(S) BECAUSE YOU’RE ONE OF THOSE JERKS WHO PAYS THEIR BILLS IN FULL EVERY MONTH.

Short Takes: Don’t Know and Don’t Care about Stocks, Unrewarding Credit Cards, and more

Here are my posts for the past two weeks:

Irrationally Yours

Giveaway – Let’s Get Blunt about Your Financial Affairs

Here are some short takes and some weekend reading:

Jason Zweig brilliantly explains why it is important for investors to stop caring about the future of stocks. One good quote: “One functional definition of a bear market is that it is simply a period that separates the people who don’t care from those who merely say they don’t.”

Preet Banerjee uses one of his great Drawing Conclusions videos to explain when credit card reward programs aren’t rewarding.

Big Cajun Man came to the realization that his biggest purchase in life was not his house.

The Blunt Bean Counter has a guest expert explaining the top reasons why people and corporations get audited by CRA related to GST and HST.

Boomer and Echo explains why he dumped his dividend stocks in favour of a simple indexed portfolio. His investing path mirrors mine quite closely except that it took me 12 years to figure out that I shouldn’t be picking stocks instead of only 5 years.

My Own Advisor is encouraged by analyses saying we may not need as much savings as some experts say to retire comfortably, but gets stuck on the requirement to work until age 65. That sounds tough for me too.

Giveaway – Let’s Get Blunt about Your Financial Affairs

Mark Goodfield, known as The Blunt Bean Counter, is an accountant who knows his stuff and can explain things clearly. He’s written a book, Let’s Get Blunt about Your Financial Affairs, that collects some of his best writing together into a range of areas that matter to Canadians. I’m giving away two physical copies of his book (see below for details of the giveaway).

Some of the topics Goodfield covers are executors, wills, audits, taxes, RRSPs, RRIFs, retirement, and cottages. Goodfield draws from his extensive experience working with his clients to give insights about human nature to go along with solid accounting information.

The book’s style is very conversational, which makes it much easier to read than you’d expect from an accountant. It’s tempting to say it could use more editing. One of the more amusing parts talks of the tail wagging the “dodge” instead of “dog”. However, the meaning remains clear, and these little things give a feeling of authenticity.

My favourite section covers investment talk and how most people exaggerate their investing success. We lie to others and also to ourselves. Becoming honest with myself is what stopped me from picking my own stocks and switching to indexing.

One of the sections that is heavy on the human nature side of things is where he discusses the personality types among children in line for an inheritance. He labels them loving children, waiters, and hoverers. He sees examples of people at their best, but in one case of an adult child impatient to get access to money he says, “I just felt sick to my stomach.”

In one very practical section, Goodfield gives step-by-step instructions for how to go about tax-loss selling to minimize your capital gains taxes. Many writers tell us we should do this, but this book gives a detailed procedure to follow.

Goodfield’s experience has been that “people consider their RRSPs holy and try their best to never withdraw from them.” However, he observes that this seems to be at odds with Jamie Golombeck’s assertion that “80% of all RSP withdrawals are made by individuals under the age of 60.” I don’t see a contradiction here because most withdrawals come after the RRSP is turned into a RRIF. The majority of RRSP money comes out during retirement, but it is technically not from an RRSP but from a RRIF.

One chapter’s title is a good example of Goodfield’s personality: “Retirement: How to Avoid Eating Alpo.” This chapter contains a 6-part series on trying to figure out how much money you need to retire. In an otherwise great series, at one point he assumes “your returns are at least market after accounting for your management fees.” He includes the prediction that “Michael James is flipping” with this assumption. I’m not exactly flipping, but it got my attention. We can’t all be above average. If some of us beat the average by 2% to make up for fees of 2%, somebody has to lose to the market average or else the market average won’t really be average.

Overall, I think almost all readers will find useful tidbits in this book that they can only get from someone with experience as extensive as Good field’s.

To enter the book giveaway:

Just send an email with the following things:
– Subject: Book Giveaway
– Answer to the following skill-testing question: (6 x 9) + 7 – 4
– 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.)
– I will follow up with winners to get a postal address for shipping. This will be limited to Canadian addresses because the book’s contents are specific to Canadians.

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 Thursday, October 15th 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!

Irrationally Yours

I love reading Dan Ariely’s blog where he answers reader questions about human behaviour. His answers are very entertaining in addition to giving insight into our irrational responses and giving us ways to compensate for our irrationality. Ariely has collected many of his best questions and answers into a wonderful book, Irrationally Yours. Not much of the book is directly related to personal finance, but understanding your own irrationality is important in investing.

On the subject of deciding whether your financial advisor’s services are worth the cost, Ariely recommends imagining sending a cheque every month instead of having the money taken away without your notice. Picturing yourself in the painful position of having to write that cheque, you’re in a better position to “ask yourself if you would pay your financial advisor directly for these services.”

When Ariely answers a question about making sure people have enough retirement savings, he makes a joke with a commentary on American lifestyles. “There are basically two [approaches]. The first is to get people to save more money, and to start saving at a younger age. The second approach is to get people to die at a younger age. ... By allowing citizens to smoke. By subsidizing sugary and fatty foods. By limiting access to preventive health care, etc. When we think about retirement savings in these terms, it seems we’re already doing the most we can on this front.”

On the subject of sticking to a financial plan, Ariely recommends trying to limit your opportunities to make changes. This reduces the odds you’ll make an impulsive choice when you’re being irrational. “You can ask your financial advisor to prevent you from making any changes unless you have slept on the decision for seventy-two hours.” Another approach is “not looking at your portfolio very often.”

Here’s some advice for a situation I’ve been in a few times. A man finds himself “walking behind a woman at night in a somewhat unsafe pace, going in the same direction.” He “can feel the doubt and worry in her mind.” Ariely’s recommendation: “Simply pick up your cell phone, call your mother, and talk to her in a slightly loud voice. In a world of suspicion, nobody who calls his mother at night could be considered a negative individual.”

When asked about clearing your mind by taking a run, Ariely makes it clear what he thinks of running in a way I found amusing. “I suspect that running while thinking about work is a recipe for designing products and experiences that enhance agony, misery, and pain.”

I highly recommend this book to all my readers, but especially those who insist that they don’t act irrationally.

Short Takes: Blunt Bean Counter Book, ETF Trading Volume, and more

Here are my posts for the past two weeks:

Reader Question: Leveraged ETFs

The Little Book of Common Sense Investing

Personal Finance Election Issues

Here are some short takes and some weekend reading:

The Blunt Bean Counter, our favourite accountant, has written a book. It’s too late to enter his giveaway, but look for a review and giveaway on this blog in the next couple of weeks.

Canadian Couch Potato explains why your ETF’s trading volume is likely higher than it appears.

Tom Bradley at Steadyhand explains why the Steadyhand team is strongly incented to generate good returns for their clients.

Big Cajun Man has noticed that just the act of examining his spending seems to automatically cause him to spend less.

My Own Advisor takes a look at some of the things wealthy people do better than he does.

Boomer and Echo gives a real life example of how leveraged investing can go horribly wrong.

Personal Finance Election Issues

Recently, Mark Seed at My Own Advisor called on Canadians to turn three personal finance issues into election issues. It certainly makes sense to take personal finance policies into account when you vote. Unfortunately, I mostly disagree with Mark on all three of his points.

Here are Mark’s preferences in bold followed by my thoughts.

1. Keep the Tax Free Savings Account (TFSA) contribution limit at $10,000.

On the surface, the choice is between a $5500 TFSA limit and a $10,000 limit. But that misses a crucial point. When the government increased the limit, they eliminated inflation indexing. So, the real choice is between $5500 with automatic cost-of-living increases or a fixed $10,000 limit whose value declines each year with inflation.

It can be difficult to imagine that $10,000 will become a much less valuable amount of money at some point in the future, but it will happen. Just 5 or 6 decades ago, $10,000 could buy a nice house. Now it’s not much of a used car. Far enough into the future, it will be a month’s rent in a typical apartment. Cost of living adjustments matter.

Another thing to consider is that generally only the wealthiest Canadians can afford to put $10,000 annually into their TFSAs today. Don’t be fooled by the many claims that large numbers of low-income Canadians max out their TFSAs. The numbers are very skewed by parents filling up their children’s TFSAs and retired Canadians transferring existing savings into their TFSAs.

So, in the short term, the $10,000 limit benefits wealthier Canadians, and in the long term, the lack of indexing will make the TFSA limit dwindle in real terms. While the $10,000 limit will benefit me, it’s worse for my sons. I prefer to choose a reasonable limit and have it rise automatically with inflation. The old rules of a $5500 limit with indexing make sense to me.

2. Abolish the Registered Retirement Income Fund (RRIF) minimum withdrawal requirements.

This was a big issue before the government made changes to the minimum RRIF withdrawals. It used to be that your RRIF portfolio had to earn a return of 6% over inflation to keep your RRIF payments matching the cost of living. It is unrealistic to expect to earn an average return this high over the years, particularly after accounting for investment costs.

With the latest RRIF changes, you only need to earn a return of about 3% above inflation to keep up with the cost of living. This is much more realistic. Now there is much less need to change RRIF withdrawal rules.

You may ask why we need RRIF withdrawal rules at all. Why not just leave people alone to manage their RRIFs their own way? Let’s look at who benefits if there are no minimum RRIF withdrawals. Lower to middle class Canadians need income from their RRIFs in retirement, so they won’t benefit from scrapping minimum withdrawals.

Middle to upper income Canadians are often better off tax-wise if they start drawing down their RRSPs and RRIFs after retiring rather than waiting until they turn 71. This only leaves people so wealthy that they don’t want to draw down their RRIFs at all. They’d rather defer taxes all their lives. They’d like to pass their RRIFs tax-free to a spouse or even to the next generation if they could.

RRSPs were designed to allow Canadians to defer taxes until they retire. Why should we allow wealthier Canadians to continue deferring taxes throughout their retirements as well? Scrapping the new lower minimum withdrawals will benefit the wealthiest Canadians, and the rest of us will have to make up for the reduced taxes collected by the government.

3. Stop OAS payments entirely to wealthy seniors over the existing “clawback” threshold.

Currently, OAS payments get clawed back by 15% of your income over $72,809. Once your income gets to about $117,000, the entire OAS is clawed back. The suggestion here is to just take all the OAS payments back (or never send them) for those whose incomes are over the $72,809 threshold.

The problem with this proposal is that it creates a huge difference for just an extra dollar of income. Someone making $72,808 gets to keep all of their OAS payments for the year, and someone making a dollar more gets nothing from OAS.

This would lead to tax-planning strategies in retirement where people with high average incomes keep their income to $72,808 or less in most years. If they have to go over the threshold, then they make sure to go over it by a lot, such as by draining a RRIF.

It is much better to have the current smooth tax policies. Once you hit the threshold, the clawback takes 15 cents out of every additional dollar. This is much better than falling off a cliff and having to give back all of the OAS. We can debate whether the threshold should be higher or lower, or whether 15% is the right clawback percentage, but a smooth transition is highly desirable.

Conclusion

Unfortunately, I have to disagree with Mark on all three of his points. The old TFSA limit was better with its automatic inflation increases, and the RRIF minimum withdrawals and OAS clawback rules are just fine as they are.