Friday, February 26, 2016

Short Takes: Bad Financial Products, Being Rich, and more

Here are my posts for the past two weeks:

Mouths to Feed in the Financial Industry

Avoiding Trudeau’s Tax Increase

Why Not Rent?

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand warns us about index-linked notes such as the BMO Growth GIC. These investments are so bad that Tom said “these products are an embarrassment to the wealth management industry” and “DON’T BUY THESE PRODUCTS!”

Give Me Back My Five Bucks explains that being rich is about how much you save rather than how much you spend.

Boomer and Echo tells a personal story of the pitfalls of prioritizing retirement savings above all else. At first I wasn’t sure where this was going, but it illustrates the problem of using the wrong type of account (RRSP in this case) as well as the illusion of saving when you’re really growing debt at the same time.

Preet Banerjee uses this video to explain when RRSP contributions make sense and when they don’t.

Million Dollar Journey lays out his investment strategy for his RESPs.

My Own Advisor muses about what his retirement will look like. It all looks quite sensible, but one part struck me: “getting more exercise.” I’m pretty sure that part of the plan should start now and not wait until retirement.

Big Cajun Man reminds us that spousal RRSPs are still useful. Income splitting past age 65 has reduced the need for spousal RRSPs, but they are still potentially useful if you retire before age 65.

Thursday, February 25, 2016

Why Not Rent?

I’ve been rolling around ideas for what my retirement will look like for some time now, and I like to look at what other people further along than I am have chosen to do. For some reason there is an overwhelming tendency to buy a second property instead of renting.

I’m most interested in the strategies of those who split their time between Canada during the nice months and somewhere warm in winter. The ones who avoid winter for only a month or less usually rent, but the ones who avoid the whole winter tend to buy.

When I run the numbers, renting makes a lot of sense. Buying requires a large initial cash outlay followed by ongoing property taxes, condo fees, and maintenance costs. Monthly rental costs may seem high, but I would only pay them for a few months per year. The costs of owning are year-round.

It’s possible that many retirees get the cost comparison wrong, but I suspect there are reasons other than costs that dominate. Renting has the advantage of flexibility. Owning gives greater stability. No doubt some retirees are willing to pay for this stability and do so with their eyes open. In other cases, I’m not so sure.

I’ve been told things like “there aren’t many good places available to rent where I want to stay.” My usual reaction to this is “how many places do you need?” However, most who say this just never considered renting. I guess they prefer to own for some reason.

I can certainly see the advantage of not having to arrange to rent a place each year. And I can see the advantage of having a subset of your stuff waiting for you at a place you own. The question is how much would I be willing to pay for these advantages in terms of money, lack of flexibility, maintenance effort, and time spent worrying about whichever of my properties I’m not currently occupying.

Another possibility is that I’m talking to a generation that looks down on renting. They think of renters as losers who live in crappy apartments. This isn’t true of all retirees, but it’s true of some.

In the end I don’t think I’m any closer to a decision, and I’ve still got time to decide.

Thursday, February 18, 2016

Avoiding Trudeau’s Tax Increase

If every Canadian changed nothing about their income from 2015 to 2016, Trudeau’s tax increase on high incomes would have brought in significant extra tax revenues. But things won’t stay the same. Some people find ways to adapt. I’m among these people.

For some time I’ve found my yearly vacation to be less than I wanted. This year is the first time I’ve done something about it. I’m a little past the midway point of an unpaid vacation. I wouldn’t say that the new higher tax bracket is the only reason I’ve taken extra time off, but it doesn’t hurt to know how much income tax I’m avoiding.

I certainly don’t expect anyone to feel sorry for me. And I don’t even have strong feelings about whether the new tax bracket is the right thing to do or not. But if my choice is any kind of example, we can expect some high earners to find ways to avoid the higher taxes. Some will use corporations and other tax manoeuvres, and others like me will just work less. No doubt many will change nothing at all.

In the end, the new higher tax bracket will bring in less money than one would expect naively based on 2015 tax filings. How much less is anyone’s guess.

Tuesday, February 16, 2016

Mouths to Feed in the Financial Industry

Among the many pitches I get for story ideas, one company promises a new approach to investing that will benefit everyone including investors, financial advisors, and fund managers. However, this just isn’t possible.

Very roughly speaking we can divide the investment industry into investors, advisors, and fund managers. Among advisors, fund managers, and their supporting consultants and other staff, there are a lot of mouths to feed in Canada. And the money they get comes out of investors’ pockets.

As long as the investment industry continues to employ as many people as it does now, investors must continue to pay the same high fees they pay now, on average. In kindergarten we learned that 5 blocks are still 5 blocks when they are moved around. Similarly, no amount of rearranging costs can keep all the financial helpers employed while lowering investors’ costs.

The only way the average investor can get lower costs is for the fees going to helpers to shrink. This means lower salaries, fewer helpers, or both. If we manage to bring significant cost benefit to investors in the future, it will come at the expense of advisors, fund managers, or both.

It is this basic fact that has much of the financial industry doing whatever they can to maintain the current high-fee model. Don’t expect anyone to give up their paycheque without a fight.

Saturday, February 13, 2016

Short Takes: Knocking DIY Index Investing and more

It’s easy to lose track of the days while on vacation. But a day late is better than never. Here are my posts for the past two weeks:

The (Honest) Truth about Dishonesty

The Way I Think about Insurance

Understanding Bank Profits

Portfolio Turnover

Here are some short takes and some weekend reading:

Boomer and Echo comments on the things advisors say to discourage people from pursuing DIY index investing.

Big Cajun Man talks about the brain drain that happens when baby boomers retire. I’ve seen this effect where I work due to people leaving the company for new jobs. Suddenly there is nobody left who knows how certain systems work.

The Blunt Bean Counter updates us on the latest patterns in CRA audits for individuals and corporations.

Preet Banerjee has a video explaining the basics of RRSPs.

Million Dollar Journey explains how capital gains taxes apply to currency conversions.

My Own Advisor lays out some resolutions for dividend investors. These resolutions illustrate how focusing on dividends helps some investors stay invested during market turmoil.

Wednesday, February 10, 2016

Portfolio Turnover

We know that true couch potato investors who just buy and hold indexes are rare. One indicator of deviation from couch potato investing is the percentage of a portfolio invested in individual stocks or other non-index securities. Another such indicator is portfolio turnover.

High portfolio turnover can be a sign of market timing. Even investors who think they are just changing their minds about asset allocation percentages may be doing it so often that they are effectively making active market timing decisions.

I decided to look back at my own trading history to examine my portfolio’s turnover since I switched to mostly indexing nearly six years ago. It turns out to be surprisingly difficult to decide how to measure portfolio turnover for this purpose. To show what I mean, I’ll go through the different categories of trades I’ve made.

1. Adding new money

By far the most common trade I’ve made is to buy more of the index ETFs I own with new money I’ve saved or with dividends. However, it hardly seems fair to count this as deviating from passive investing. In each case, I added money to ETF positions that were below their target percentages.

At the very least, for someone like myself still in the accumulation phase, I should probably just focus on selling transactions to measure portfolio turnover.

2. Currency exchange with Norbert’s Gambit

A few times over the years I’ve needed to exchange Canadian dollars for U.S. dollars or vice-versa to make an ETF purchase. Most brokerages hide high fees in their exchange rates. To save money, I use Norbert’s Gambit to exchange currencies. This involves finding a security that trades in both Canadian and U.S. dollars (I’ve used DLR and RY in the past), buying the security with one currency, and then selling it in the other currency.

Technically this is portfolio turnover, but it hardly seems reasonable to count it as active investing. It just happens that using Norbert’s Gambit for large currency exchanges usually costs less than hidden brokerage currency exchange fees.

3. Rebalancing

Occasionally, my portfolio tracking spreadsheet emails me to indicate that 2 or more of my ETFs have deviated by enough from their target percentages that I need to sell an ETF that is too high to buy and ETF that is too low.

Again, this is technically portfolio turnover, but should it count as active investing? If I was tinkering with my asset allocation percentages or chose the timing of the rebalancing then it should count as active investing. But if the rebalancing is triggered by a purely mechanical set of rules, it’s hard to see why it’s not part of a sound passive strategy.

4. Selling individual stocks

Now we’re getting to some real portfolio turnover. After I sold off my 20 or so stocks nearly six years ago, I hung onto two of them (BMO and BRK). A couple of years later I sold all the BMO stock to buy more ETFs. Over the years, my wife and I have been leaking out the BRK stock as well. The problem in this case is that we had substantial capital gains in taxable accounts, and we didn’t want to recognize all the gains in one year. But it’s still portfolio turnover.

5. Changing ETFs

At different times I’ve held Canadian ETFs XIU, XCS, and VCE. I’ve since sold them all to buy VCN. But how much of this is actual portfolio turnover? VCN has a large overlap in underlying stocks with both XIU and VCE. It only makes sense to count the degree of change in the underlying stock holdings as portfolio turnover. However, pretty close to all of the XCS sales are portfolio turnover.

On the U.S. side, at one point I decided to trade U.S. small cap stocks in the form of ETF VB for U.S. small cap value stocks in the form of ETF VBR. Roughly have of these trades should count as portfolio turnover.


Initially I intended to report my portfolio turnover each year since I started mostly indexing, but I’ve decided now not to do this. This is because some of the thinking I explained above seems too close to rationalizing.

If I go back to a stricter definition of portfolio turnover that counts all stock sales except for Norbert Gambits, my 2015 turnover was about 8%. Add to this the less than 5% I still have in BRK, and we get some sort of measure of my active investing in 2015. Most other years were higher than this (except 2011 where I had zero turnover).

I hope to keep my active investing at lower percentages than this in future years. If you think of yourself as a passive index investor, you may find the exercise of calculating your portfolio turnover illuminating.

Monday, February 8, 2016

Understanding Bank Profits

Every 3 months we get to hear again about how Canada’s banks made billions of dollars in profits for the quarter. Most Canadians are disgusted by it all. But there are a few simple things we need to know to understand why banks behave as they do.

Suppose a normal person, call her Jen, comes into a large inheritance, say $500,000. Jen would likely use the money in some way to try to improve her life. If she’s near retirement, she might retire a little earlier. She might change to a more fulfilling job that pays less. Whatever she does, it will likely consume the money over time.

Few people like Jen would react by trying to find a way to get even more money the next year. We tend to carry this thinking over to banks. If banks made so much money this year, why don’t they give us a break on interest and fees? Why do they need even more money?

The answer is that almost all of those bank profits get paid out to the bank’s shareholders as dividends. And shareholders want more dividends every 3 months. In fact, they want those dividends to rise over time. Whatever the banks earned this year, their shareholders want more next year.

While a big windfall for Jen reduces some of the pressure in her life, big profits for banks just create pressure to earn even more next year. You’d think bankers would be doing high fives and taking a break after earning $10 billion in a year, but this just makes them desperate to find ways to earn $11 billion next year. And if they don’t, they’ll be seen as failures.

Does this mean we should feel sorry for the banks? Absolutely not. The most important takeaway is that it’s a waste of time to wait for banks to grow a heart. The never ending new fees, fee increases, and debt promotion isn’t meanness; it’s desperation.

The cost of delivering banking services just keeps dropping as technology keeps improving. This should translate into cheaper banking and much lower bank profits. So far, it hasn’t worked out this way for the average Canadian, but the pressure remains on the banks to keep profits rising.

My response to all this is to expect banks to try just about anything to extract more fees and interest from me and my family. But I plan to pay as little as possible.

Wednesday, February 3, 2016

The Way I Think about Insurance

There are a tremendous number of different types of insurance. It can be difficult sometimes to decide which types to buy. Here I describe the way I think about insurance and how it guides my choices. I encourage my readers to come up with their own ideas to guide them when it comes to insurance.

The core of my thinking about insurance is that it is a way to protect myself and my family from low-probability events whose costs would be devastating to our finances. This means I specifically exclude high-probability events and low-cost events.

An example of a high probability event is needing dental work. As it happens, my employer gives me “insurance” to cover this, but I don’t consider it insurance because it is capped at a low level. It’s just extra pay because it’s not protecting me against a large loss.

After I retire, I would never buy typical dental or health insurance. Insurance companies employ smart people. They would never let me buy coverage that costs less than the expected benefits I would get. They’d also add extra to the cost for their own overhead and profits. I’ll be better off just paying directly for dental work. If I could get insurance that covered high-cost dental work or health costs, that could be useful to me.

An example of a low-cost event is when some consumer item like a television breaks. I never buy extended warranties. For one thing, retailers often find a way to avoiding honouring them. But, even if retailers did honour warranties, I wouldn’t buy them because I can afford to replace a broken item. I was once even offered an extended warranty on a $5 battery! What a waste of time.

So, what kinds of insurance make sense? Liability insurance for your car and home come to mind first. Getting sued for a couple of million dollars would certainly be devastating for almost all of us.

Insurance against damage to my home also makes sense. I wouldn’t want to have to pay for a rebuild if my house burned down. However, I choose a very high deductible. I wouldn’t make a small claim anyway, so paying a higher premium for a low deductible makes no sense. The same applies to deductibles for collision insurance on cars. I don’t even bother with collision insurance on my car once it’s worth less than $10,000, but I do keep the liability insurance.

Life insurance makes sense to protect anyone who depends on your income. However, I look for the cheapest term life insurance I can find that has the term length I need and is convertible and renewable. I’m not interested in the various forms of permanent insurance such as whole life and universal life because they just bolt an expensive investment component on top of term life insurance.

Disability insurance makes sense as well. Most of us are more likely to become disabled than we are to die. However, this is a tricky area. It can be difficult to determine whether a plan has reasonable coverage for its cost.

Many of us have various types of insurance through our employers. Health insurance is just extra pay because it won’t pay for anything truly expensive. Disability insurance through an employer can work well, but life insurance may not. If you get cancer and decide you don’t want to spend your last reasonably healthy days working, you may find it difficult to convert your employer life insurance to an individual plan because you’ve become uninsurable. Some employer plans offer convertibility, but there are deadlines and the insurance company is motivated to make such a conversion difficult for anyone with an elevated chance of dying.

I never link insurance to a financial product like a mortgage or credit card. Few people realize that the underwriting for mortgage life insurance doesn’t take place until there is a claim. This means the insurance company doesn’t check whether you’re covered until you die. You can bet they’re willing to put some effort into finding a reason to deny your coverage.

So, there you have my personal philosophy on insurance. I look for ways to protect my finances from devastating losses. I ignore all forms of insurance that cover losses I can handle. Your mileage may vary.

Monday, February 1, 2016

The (Honest) Truth about Dishonesty

We know people lie and cheat sometimes, but can we predict when and why? Dan Ariely has researched this question and reports the results in his entertaining and enlightening book The (Honest) Truth about Dishonesty—How We Lie to Everyone—Especially Ourselves. This book is very accessible, yet gives deep insights into dishonesty.

The most important thing to understand about cheating is that it involves a tension between our self-image and the benefits of cheating. “We are all capable of cheating, and we are very adept at telling ourselves stories about why, in doing so, we are not dishonest or immoral.” “We cheat up to the level that allows us to retain our self-image as reasonably honest individuals.”

I would have thought that lying and cheating involved conscious evaluations of trade-offs at least some significant fraction of the time, but Ariely says this isn’t so. “There are rational forces that we think drive our dishonest behavior—but don’t. And there are irrational forces that we think don’t drive our dishonest behavior—but do.”

Ariely’s experiments show that “it is very difficult to alter our behavior so that we become more ethical.” A consequence is that he suspects “that this ineffectiveness also applies to much of the ethics training that takes place in businesses, universities, and business schools.”

In one amusing section, Ariely “studies” the link between his students writing exams and “Dead Grannies.” He finds “that grandmothers are ten times more likely to die before a midterm and nineteen times more likely to die before a final exam.”

Something I’ve noticed before is that my self-control is a limited resource, similar to my ability to focus on tasks, or my physical endurance. “Simple, everyday attempts to keep our impulses under control weaken our supply of self-control, thus making us more susceptible to temptation.” So, the chocolate bars and cupcakes constantly available to me at work are making my life worse, even if I never eat them.

The ability to lie to ourselves is an important component of our dishonest behaviour. “We are all very good at rationalizing our actions so that they are in line with our selfish motives.”

In one interesting experiment, women were asked which of four nightgowns they preferred. Most subjects picked the one on the far right and gave their reasons why it was best. The most interesting part of the experiment came when the subjects were told that the nightgowns were identical. They insisted this wasn’t true.

In another experiment, the researchers found that more creative people cheat more. “Creativity can help us tell better stories—stories that allow us to be even more dishonest but still think of ourselves as wonderfully honest people.” So, more creative people are more dishonest, but they would deny this fact.

There were a great many factors found to increase dishonesty, but two surprising factors that had no effect were the amount of money to be gained and the probability of getting caught. Factors that increased honesty included making a pledge, signatures, moral reminders, and supervision.

Overall, this book is a fairly easy read, but gives deep insights into the nature of lying and cheating. I highly recommend it to anyone who wishes to better understand the actions of others, and more importantly, to better understand yourself.