Monday, September 28, 2015

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.

Friday, September 25, 2015

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.

Thursday, September 24, 2015

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.


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.

Monday, September 21, 2015

The Little Book of Common Sense Investing

The average return earned by stock investors (before expenses) must exactly equal the average return of the stock market. This is the “humble arithmetic” founder of Vanguard, John Bogle, writes about in The Little Book of Common Sense Investing. Collectively, we can’t be above average because we are the average. To be above average, you have to take money away from someone who ends up below average. However, stock trading is dominated by sharks looking to take your money.

Bogle’s simple advice is to give up trying to beat the professionals who dominate stock trading and just buy and hold broad-based index funds. The best index mutual funds and ETFs give you the market average returns at extremely low cost. To beat the market, you have to outsmart professional traders by enough to cover the much higher expenses of active investing. This is a fool’s errand for all but a few of the best investors. Even most professionals can’t succeed at this game.

So, why do we try? It seems to be human nature. Through selective memory we tend not to admit to ourselves that we fail at active investing. Bogle understands that we have a hard time accepting that simple index investing is the best approach for almost all of us. So, he looks at it from many angles and shoots down arguments for active investing.

In an attempt to make us accept market returns, Bogle says “the index fund is indeed the only investment that guarantees you will capture your fair share of the returns that business earns.” The message is simple. Don’t be greedy. Accept your fair share with indexing.

There are many ways investors seek to get around Bogle’s “humble arithmetic,” including finding winning fund managers. “Fund investors are confident that they can easily select superior fund managers. They are wrong.”

Bogle makes a strong case that a critical factor in fund selection is fees. He drives this home with a play on the “you get what you pay for” expression saying “We investors as a group get precisely what we don’t pay for. So if we pay nothing, we get everything.”

“The winning formula for success in investing is owning the entire stock market through an index fund, and then doing nothing. Just stay the course.” Even those who accept indexing as the right strategy often sell after market declines. It may seem counter-intuitive to just hold on through a crash, but most investors who try to avoid losses end up avoiding gains instead.

A quote from Jonathan Clements explains why we should think well of active investors. “We shouldn’t discourage fans of actively managed funds. With all their buying and selling, active investors ensure the market is reasonably efficient.” Active investors lose money so the rest of us can index.

Mutual funds report returns that are higher than the returns earned by their investors. This is because investors pile into last year’s winning fund only to be disappointed. So some funds perform well while they are small, and tend to perform poorly after swelling. In one extreme example from 1996 to 2002, a group of 10 funds had a net reported gain of 13%, but their investors lost 57%.

At one point, Bogle lost some of his patience with investors who are oblivious to costs. “Why would investors pay more than a 0.50 percent annual cost for a money market fund? The answer is beyond me. (They should probably have their heads examined.)” That bit in parentheses is Bogle’s, not mine.

Bogle isn’t much of a fan of ETFs because “Their use by long-term investors is minimal.” He allows that broad-based index ETFs can work well for long-term buy-and-hold investors, but the truth is that ETFs are traded hyperactively.

In a harsh quote, David Swensen, chief investment officer of Yale University, says “The mutual fund industry is a colossal failure.” This is a fair criticism given that a typical mutual fund’s fees consume more than half of investors’ money over a lifetime.

Recognizing that people just can’t stay away from active investing, Bogle allows that investors can carve off a small slice of their portfolios for some fun, “but not with one penny more than 5 percent of your investment assets.” He goes on to list what he thinks are acceptable ways to invest this 5%. He’s okay with individual stocks, actively managed mutual funds, ETFs, and commodity funds. But he says no to closet index funds (high-fee funds that are close to owning an index) and hedge funds.

“We know that neither beating the market nor successfully timing the market can be generalized without self-contraction. What may work for the few cannot work for the many.” We’d all like to think we’re the special flower who can beat the market, but in almost all cases, we’re not.

Bogle uses deceptively simple but relentless logic to demonstrate why indexing is the way to invest. Anyone with the active investing itch should read and understand this book before risking a single penny trying to beat the market.

Tuesday, September 15, 2015

Reader Question: Leveraged ETFs

A reader, J.H. asks the following thoughtful question about leveraged ETFs (edited for length):
I am familiar with the decay factor of leveraged ETFs over the long term. However, it seems that using 50% cash, 50% 2X ETF, rebalanced say annually, mirrors the underlying 1X ETF very closely. In fact it is a bit better on a risk adjusted basis.

Blue portfolio: 100% SPY (an S&P 500 index ETF)
Red portfolio: 50% SHV (short-term U.S. bonds), 50% SSO (a 2X leveraged S&P 500 ETF)

These two portfolios gave nearly identical returns from 2008 to the present. I found this to be contradictory to everything I read about leveraged ETFs. A six year back-test should be enough to unveil the presumed decay, but I don't see it.

I am particularly interested in this way of investing as it provides a way to beat SPY without taking all the risk of being all-in. If on the cash component one can earn more than what SSO pays to borrow to buy stock (these days, one can make 2.3% or so using a GIC ladder), then I would say this approach can provide an easy 0.5 - 1% premium over a traditional all-equity portfolio. In essence, the 50% cash deleverages the leverage and can add alpha.

But I do know there is no free lunch in the investment world so I must be missing something. It cannot be that easy. A backtest using synthesized 2X returns that go back to as far as the S&P500 would be an interesting test to validate the theory.
Here is a chart of the comparison from J.H.’s backtest at Portfolio Visualizer:

As we can see, the two portfolios end up at the same place, but with somewhat different paths. Unfortunately, this is a side effect of the powerful bull market we’ve seen for 6 years and not a sign that J.H. has found a way to make an extra 1% on his money for free. I can explain this without resorting to math.

A 2X-leveraged ETF takes its cash, borrows an equal amount and uses it all to buy an index (the S&P 500 in this case). The leveraged ETF may actually use derivatives rather than borrow, but that isn’t important here.

Every day, the leveraged ETF rebalances so that it remains 200% exposed to the S&P 500. This means that if the S&P 500 goes up, the leveraged ETF borrows more and buys more stock. If the S&P 500 goes down, the leveraged ETF sells some stock and reduces its debt. On a day-to-day basis, this is essentially a momentum strategy. Unfortunately, the markets tend to revert to the mean; leveraged ETFs buy high and sell low. I gave a more detailed explanation of this effect in a past post.

If leveraged ETFs tend to leak, then how do we explain J.H.’s backtest in the chart above? The answer is the 6-year bull run in stocks. During a strong year for stocks, the leveraged ETF (SSO) maintains 200% exposure to stocks, but SSO grows to be more than 50% of the red portfolio. So, the red portfolio’s exposure to stocks grows above 100% from beginning to end of the year.

On average during a good year, the red portfolio is more than 100% exposed to S&P 500 stocks. So, the reason the red portfolio has kept up since 2008 is that this has been a great period to be more than 100% exposed to stocks. This extra exposure exactly offsets the inherent leakiness of the leveraged ETF.

To test this explanation, we can check to see what happens if we eliminate the annual portfolio rebalancing. We should expect the red portfolio to perform much better because its exposure to stocks will keep climbing above 100% instead of getting reset to 100% each year. Here is the chart without rebalancing:

As we can see, the red portfolio won easily. But this only happened because we are focused on a great period of time for stocks. Averaged over all conditions, the 50/50 portfolio with a leveraged ETF will not keep up with the plain vanilla index portfolio. So, there’s no free lunch.

Friday, September 11, 2015

Short Takes: Cyclical Investing, Market Crashes, and more

Here are my posts for the past two weeks:

How Much Diversification Do You Need?

Should You Take a Variable Rate Mortgage? 

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand explains how the wealth management industry encourages investors to follow cyclical shifts even though such behaviour harms returns.

Boomer and Echo guarantee that the stock market will crash but aren’t saying when.

My Own Advisor updates us on his progress toward financial goals. The one thing not clear to me is that I thought he filled his TFSA from older savings, which may be a good idea if you haven’t got new savings, but doesn’t represent much progress.

Big Cajun Man sees his line of credit interest rate increasing and tries to get it reduced.

Wednesday, September 9, 2015

Should You Take a Variable Rate Mortgage?

A fellow financial blogger asked my opinion about his upcoming mortgage renewal. He faces the same choice as many of us do: should you take a fixed-rate mortgage or go for the lower variable rate? The risk with the variable rate mortgage is that rates might rise. The answer requires surprisingly little math.

If rates stay the same for 5 years, then the lower variable rate will save you money compared to a 5-year fixed-rate mortgage. If rates go down, you’re even further ahead. Averaged over all possibilities, the average outcome is that you save some interest on a variable-rate mortgage. The worry, though, is the possibility that rates go up.

You can’t fully protect yourself against rising rates even with a 5-year fixed rate, because you’ll have to renew at a new interest rate after 5 years. But you might hope to get your balance down enough that you could absorb an interest rate increase in 5 years.

The real test of what you should do comes with looking at a terrible outcome. Suppose you could get a 2% variable rate today. What would your payment be if the variable rate shot up to 7%? This isn’t a prediction. We’re just looking at what happens in a scary scenario. It’s your reaction to this scenario that should drive your decision.

After calculating your mortgage payment at 7% interest, did you throw up? Did you look at it and know for certain you’d lose the house and everything else you own? Then a variable-rate mortgage isn’t for you.

Instead, did you look at the 7% payment and think that it would be no fun to pay this higher amount, but that you’d be okay? Then you can go ahead with a variable-rate mortgage.

A curious thing about this piece of advice is that I don’t know of anyone who has followed it. Some say it makes sense to them, but they never actually calculate the payment based on 7% interest. They just imagine a higher payment and declare whether they can handle it. This is useless without actually calculating the payment based on the much higher rate.

One explanation for not following this advice is laziness. Another possibility is pain avoidance. It’s no fun to imagine a much higher payment, and not calculating the higher payment avoids the pain. Whatever the explanation, deciding if you can handle a higher payment without actually calculating the higher payment amount is not helpful.

Wednesday, September 2, 2015

How Much Diversification Do You Need?

Some investment experts advocate maximum diversification, which others deride it as “di-worse-ification.” In Ben Carlson’s recent article, he is somewhere in the middle saying you need to find the “right balance between eliminating unsystematic risk (risk that’s specific to single securities or industries) and di-worsification by adding too many overlapping funds.” Who is right? Your answer depends on your views on active investing.

At one extreme, suppose you knew for certain you’ve identified the one stock that will go up most in the next year. You’re not 90% sure or 99%. You’re 100% sure. Then you’d be crazy not to invest everything you have in that one stock. Of course, you’d also have to be crazy to be this certain about the stock.

As our crystal balls become cloudier, the need to diversify arises. Maybe you decide to put some of your money into other stocks, even though you have less confidence in these other stocks. You’ve decided that the protection against possibly being wrong about your top pick is worth the risk that your lesser picks will make less money.

Those who argue that you’re di-worse-ifying are saying that you’re diluting the potential returns from your top pick with lesser ideas. How far it makes sense to go with diversifying depends on how confident you are that your top stock picks will work out well.

At the low end of the confidence continuum, we have those who have no idea which stocks will perform well, have no idea if markets are going to go up or down, have no idea which money manager will perform well, and have no idea which financial advisor might beat the markets for us. These people are indexers.

Diversification is simple for indexers like me. We own all stocks for as low a cost as possible. There is no such thing as di-worse-ification because we have no opinions about one stock being better than others. There is no reason to fret over active mutual funds because index funds are cheaper and cover the same asset classes.

Another thing to consider when it comes to diversification is that all evidence points to very few people having stock-picking skill. Even among money managers you might choose to manage your money, very few have enough stock-picking skill to make up for their fees and expenses. And very few individual investors have the skill to identify these winning money managers.

So, almost everyone who thinks they can beat the market either with their own picks or by finding the right helper is wrong. Not everyone, but almost everyone. I had the stock-picking bug for about 12 years, but a careful study of my results beat that nonsense out of me. I’m a happy, diversified indexer now.