Monday, July 24, 2017

The Behavior Gap

The title of certified financial planner Carl Richards’ book The Behavior Gap refers to the gap between “what we should do and what we actually do” when it comes to financial decisions. The book identifies a great many of the mistakes we make, and almost all readers who are honest with themselves will identify with some of the mistakes.

Richards is well known for his napkin drawings, and there are plenty of them in this book. One says that the cost of your mistakes rises with your level of overconfidence. “Overconfidence is a very serious problem. If you don’t think it affects you, that’s probably because you’re overconfident.”

We know we shouldn’t buy high and sell low, but “we make investing decisions based on how we feel rather than what we know. Falling stocks scare us; rising stocks attract us.”

In a drawing offering investment advice, Richards says the chance that a fund will stink rises with its expense ratio. He offers more advice when he says our decisions about how much of our company’s stock to hold should be based on principles of diversification rather than “our feelings about what’s going to happen.”

On the subject of stock mania, Richards tells the story of how during the tech bubble in 1999, he resisted “the temptation to buy technology stocks” initially but eventually gave in and lost money. It’s the last people in before the bubble bursts who get hurt the most.

Richards believes that financial planning begins with life planning. “Find out who you are and what you want. Then you can stop wasting your life energy and your money on stuff that doesn’t matter to you—and start making financial decisions that will get you to your true goals.”

If we take action based on the latest news, we’re likely to do the wrong thing. “Try going on a media fast.” “When thoughts about the market arise, let them go. Go for a bike ride.”

I was surprised to see a financial planner write that “Financial plans are worthless.” However, he followed that up with “but the process of financial planning is vital.” A single static financial plan will become obsolete as life takes a few unexpected turns. Plans need to adapt.

We’re used to being told not to make overly rosy assumptions, but “pessimistic assumptions often discourage people from doing anything to improve their outlook.” I’ve known people who buy lottery tickets because they see winning as the only way to improve their lives. They just don’t understand or believe in the power of saving small amounts regularly.

“While making wise decisions about how you invest your money is important, it doesn’t have nearly the impact of working hard and saving more.” I’m all for encouraging people to save more, but a low-cost index investor could easily end up with twice as much money each month in retirement as someone who spends an investing lifetime chasing the latest hot mutual fund. This seems at least comparable in value to saving more money each month.

In one section, Richards describes so accurately the mood in a company whose stock is soaring that it seemed like he was talking about my employer back in the late 1990s. People had “visions of early retirement,” and they knew they “should sell some of the shares,” but they hung on anyway. Many of my colleagues saw 7-figure paper valuations evaporate.

I recall asking colleagues whether they would buy back the company’s shares if they were converted to cash right now. This only caused one of my colleagues to sell. I sold too few shares myself. Richards calls this the “Overnight Test” and asks if your portfolio went to cash overnight and you wouldn’t rebuild the same portfolio today, “what changes would you make,” and “why aren’t you making them now?”

“What makes us feel safe may be at odds with the numbers.” I’ve learned this truth when it comes to retirement. My wife and I need different things to feel it’s safe to retire. For me, it’s a set of spreadsheets that analyze all the numbers in a dozen different ways. I’d just be guessing about what would put my wife at ease.

We’ve heard that simple solutions are best when it comes to finances, such as saving diligently and choosing low-cost diversified investments. “We often resist simple solutions because they require us to change our behavior.” “We’d rather look for a magic bullet: something to save us from the day-to-day grind of simply doing the work that needs doing.” “It’s much easier to entertain ourselves with the fantasy of finding an investment that will give us a fantastic return than to save a little bit more money each month. But in the end, the fantasy will fail us.” Well said.

This book is both entertaining and helpful for readers prepared to admit to themselves that they’re guilty of some of the mistakes that create this “behavior gap.”

Friday, July 21, 2017

Short Takes: Reality Check for Novice Investors and Retirement Planning

Here are my posts for the past two weeks:

Are We Saving or Investing?

The Four Pillars of Investing

The Dangers of Personifying the Stock Market

Things get quiet in the middle of summer, but I still have a couple of short takes:

Dan Bortolotti warns novice index investors that the bull market can’t last forever. When markets inevitably stumble, active managers will be quick to claim they could outperform during bear markets, even though the evidence doesn’t back up that claim.

Potato shows how to answer the question of whether you’re on track for retirement by going through an example case. As he shows, you can never know for sure that you’ll get the retirement you want, but you can find out if you’re way off.

Thursday, July 20, 2017

The Dangers of Personifying the Stock Market

Most people understand that the stock market reflects the collective actions of all stock traders, but we often personify the market, talking about it as though it has its own free will. This can lead to investing errors.

When we say that “stock markets struggled this week,” we don’t literally mean that there exists some sentient entity called the “market” that has the desire to rise, but was unable to do so this week. But thinking of it this way can create the illusion that you have only a single foe when you trade stocks.

It can also create the illusion that we can all somehow succeed against the market. When someone says that some past market event was easily predictable, such as the 8-year recovery from the 2008-2009 crash, many would agree. But it can’t be true. If we all knew stocks would rise so much, then buyers would have driven prices up right away.

When we see the stock market as the collective action of all buyers and sellers, it becomes clear that there had to be a lot of uncertainty among traders 8 years ago because stock prices just rose slowly instead of jumping all the way back up immediately. In fact, we must always be in a state where most traders are uncertain, because, if they weren’t, stock prices always shift up or down until they were uncertain.

If you’re trying to beat the market by getting higher than market returns, your real opponents are all the other stock traders, not just some single entity. Traders can’t all be winners. For every dollar of market outperformance, there has to be a dollar of underperformance.

So, when you try to beat the market, you have to ask yourself whose trading dollars you expect to take. Even worse, because almost all trading is done by professional investors these days, you need to ask yourself which investment pros’ dollars you expect to take.

None of this proves that you can’t beat the market. But it does show that the deck is stacked against anyone who tries, particularly after factoring in the costs associated with trying to beat the market.

Monday, July 17, 2017

The Four Pillars of Investing

While reading William J. Bernstein’s book The Four Pillars of Investing, I was unsure of how to summarize it. After finishing I’d say that it aims to give readers the right knowledge and expectations to become successful do-it-yourself investors. Without a solid grounding in each of the four pillars, investors are at risk of making expensive mistakes.

The first pillar, called “theory,” is less intimidating than it sounds. It teaches the link between risk and reward and that “high previous returns usually indicate low future returns, and low past returns usually mean high future returns.” This is particularly true of stocks because they show more mean reversion than you’d expect just from randomness.

We tend to think of money market funds as safe, but they get their returns in part from commercial paper that “does occasionally default.” There is no excess return without some risk.

Bernstein explains the Gordon equation, which states that the market return is equal to dividend yield plus the rate of dividend growth. He goes on to explain that to this we have to add the rate of stock buybacks and subtract the rate of new share issuance. One point I’d add is that companies can make their dividend growth appear higher for a few years by increasing the proportion of earnings they pay out in dividends. For this reason, one might substitute earnings growth for dividend growth. But this has its own problems for companies that game their earnings accounting.

An amusing bit was using Trump Casinos as an example of a business with a high risk of defaulting on loans. I doubt Bernstein had any idea that years after writing it, his book would come to seem political.

It’s not hard to see what Bernstein thinks of active management when he refers to a mutual fund’s advisory fees as “what the chimps get paid.” He also says “It should be painfully apparent by now that most of the investment industry is engaged in nonproductive work.” He sums up his arguments with “Stock picking and market timing are expensive, risky, and ultimately futile exercises. Harness the power of the market by owning all of it—that is, by indexing.”

Because of the possibility of high inflation, the author believes that “Long-duration bonds are generally a sucker’s bet.”

The second pillar is the history of investing. The main purpose of this pillar is to teach readers that market bubbles and crashes happen fairly regularly, and we need to keep our wits about us and stick to a plan. As George Santayana said, “Those who cannot remember the past are condemned to repeat it.”

I’ve written before about Bernstein’s distinction between investing and saving, and I won’t say any more about it here.

I enjoyed a joke at the expense of the company “Yahoo!” where Bernstein asked if the name is an interjection “or was it simply a noun, meant to describe the company’s shareholders.”

The third pillar is the psychology of investing. People consistently make many types of investing mistakes. The first step in avoiding these mistakes is to understand them.

Some examples of mistakes are assuming “that the immediate past is predictive of the long-term future,” and our search for patterns that aren’t there. “The pricing of stocks and bonds at both the individual and market level is random: there are no patterns.”

Another mistake is seeking status through the types of investments you use. “Wealthy investors should realize that they are the cash cows of the investment industry and that most of the exclusive investment vehicles available to them—separate accounts, hedge funds, limited partnerships, and the like—are designed to bleed them with commissions, transaction costs, and other fees.”

The fourth pillar is the business of investing. This pillar is a warning about the financial industry. “The stockbroker services his clients in the same way that Bonnie and Clyde serviced banks.” “Under no circumstances should you have anything to do with a ‘full service’ brokerage firm.”

Most mutual-fund companies aren’t much better: “The primary business of most mutual-fund companies is collecting assets, not managing money.”

The sections of the book on the four pillars are strong, but the “assembling the four pillars” section isn’t as strong. A couple of the reasons for this aren’t Bernstein’s fault: the discussion of specific investments is getting dated and is too U.S.-centric for a Canadian like me.

My main criticism is that he ends up building portfolios that are too complex. For most people, the potential benefit of slicing up portfolios into ETFs or funds based on market caps, growth/value, geography, and other factors is too small to justify the extra work. No doubt some people could manage all this well, but many investors would make mistakes and end up spending too much on commissions, spreads, higher MERs, and realized taxes. Simpler is usually better.

The short section on investing with children is excellent. He advocates buying index funds for children, letting them watch the ups and downs once each quarter, and letting them spend some dividends. I tried to do something similar for my sons, but mostly failed. Bernstein’s approach would have been better.

Bernstein is very positive about an approach to investing called value averaging. It doesn’t work. I’ve discussed why here and here, and described some experiments I ran here.

The subsection on rebalancing places a lot of emphasis on which method gives the highest returns. This can be misleading for investors. When you own many stock funds based on various factors, rebalancing can give a small boost in returns. However, most investors just rebalance between stocks and bonds. The purpose in this case is to control volatility, not boost returns.

Overall, I found this to be an excellent book for steering investors toward making good decisions about the things they can control, and remaining calm about the things they can’t control. Readers who get through the whole book are likely to become better investors.

Wednesday, July 12, 2017

Are We Saving or Investing?

When we buy shares in a company, are we saving or investing? Most of the world would call this investing, but William J. Bernstein disagrees. In his excellent book The Four Pillars of Investing, he explains why he calls this saving:

“When you and I purchase shares of stock or a mutual fund, we are not investing. After all, the money we pay for our shares does not go to the companies, but, instead, to the previous owner of the shares. In economic terms, we are not investing; we are saving.”

He continues

“Only when we purchase shares at a so-called ‘initial public offering’ (IPO) are we actually providing capital for the acquisition of personnel, plant, and equipment. Only then are we truly investing.”

It’s certainly important to make a distinction between a simple change of ownership of shares and a company getting new money to run its operations. But I find the terms Bernstein uses very unsatisfying.

When I commit money to my trading account with the intent to leave it there for a long time, I am saving. When I choose to convert cash to shares, I’m not saving again. The word most people use for this activity is “investing.” If we wish to make the distinction Bernstein is making, then I think “trading” is a better word than “saving.”

But even this doesn’t describe the situation fully. It’s true that the net actions of buyer and seller provide no new capital to the company. But the buyer has aligned his economic outcome to the fate of the company. The buyer’s viewpoint is that he has invested in the company and the seller has withdrawn his investment, even if the company doesn’t see it this way.

The most troubling part of this semantic game is that it gives an opening for obnoxious types to derail any type of investment discussion with “actually, you’re not investing at all.” It’s amazing how often people in a narrow technical field think they can police the meaning of a word that has one meaning in the technical field and another well-established meaning among the broader public.

The point Bernstein was leading up to in his book is that IPOs have historically been poor investments, on average. So, investors would do well to avoid IPOs altogether. This is a good point to make, but we need better terms when discussing the distinction between IPOs and the secondary market than investing/saving.

Friday, July 7, 2017

Short Takes: Macroeconomics, Unlocking Phones, and more

Here are my posts for the past two weeks:

Payday Loan Information

Are Payday Loan Users Victims?

Enough: True Measures of Money, Business, and Life

Arguments Against Index Investing

Here are some short takes and some weekend reading:

Preet Banerjee interviews Luke Kawa, a Bloomberg reporter, to talk about macroeconomics. It was good to get some buzzwords explained, but this interview didn’t change the feeling I’ve had for some time that macroeconomics is wild guesswork.

Big Cajun Man reports that new CRTC rules will eliminate phone unlocking fees on 2017 December 1. He uses the example of Bell’s policies to show how onerous these fees can be.

Canadian Couch Potato reports on new index ETFs from Royal Bank.

Boomer and Echo ask whether your assets under management are really being managed.

Thursday, July 6, 2017

Arguments Against Index Investing

I’m accustomed to reading arguments against index investing. The valid ones tend to point out that few index investors actually stick to their plans. The “other” arguments make less sense but get repeated frequently anyway. Jack Mintz managed to bring a great many of these less sensible arguments together in a recent short article. Here I examine Mintz’s claims.

“What happens if the day comes that the entire stock market becomes solely made up of passive investors?”

This won’t happen. We’re not close to it now. If we ever got close enough to 100% index investing, active stock picking would become profitable.

“The lure of sharply reduced investment fees has enticed millions of investors to shift their portfolios to passive investments.”

Calling low fees a “lure” implies that index investors can expect to get caught somehow. Mintz offers nothing to back this up.

“There are problems with all this passivity.”

I got to the end of the article without seeing anything to back up this vague claim of problems index investors can supposedly expect.

“Much of the argument in favour of passive investment is based on the presumed failure of active funds to provide superior pre-tax returns on a consistent basis compared to index funds.”

The failure of active funds to keep up with index funds is extremely well studied and documented. There is nothing “presumed” about it.

“But passive investment works when market prices convey all the information about a security.”

The implication here is that passive investment doesn’t work when market prices don’t convey all the information about a security. This isn’t true. The fact that the average index investor gets higher returns than the average active investor is based on simple arithmetic, not some variant of the Efficient Market Hypothesis. Only a small minority of active investors can outperform the index. The more efficient the market is, the tinier the minority of active investors who can outperform the index over the long term.

“In the presence of informational inefficiency, there is value to research and hiring advisers.”

The vast majority of trading is done by investment professionals. They can’t all beat the index. After factoring in costs, only a small minority can beat the index over the long run. Average investors have no idea which advisors will help them outperform. Trying to guess this correctly is as hard as being a superior stock-picker.

“Passive investors freeload on active investors in the presence of informational inefficiencies. Through their research, active investors will reallocate capital from poorer-performing to better-performing assets, thereby increasing the overall value of an index, making passive investors better off too.”

This is true, but it’s an argument in favour of index investing, not against it. The work of active investors sets good prices that index investors enjoy. Perhaps we’re supposed to be embarrassed to be considered freeloaders. I think active money managers can be considered freeloaders for the huge fees they charge for a service that consistently produces poor outcomes for investors.

“It’s obvious that relying only on an index is absurd.”

So far we’re being lured, we have problems, we’re freeloaders, and now we’re behaving absurdly. Flinging around such characterizations is easier than making a logical argument.

“Nortel made up 36 per cent of the TSX in 2000 and went bust a few years later. Meanwhile, funds based on an index will often end up holding many unprofitable firms.”

On the other hand, index investors rode Nortel on the way up, and they own many profitable firms. The implication here is that active managers avoided Nortel’s implosion (as a group, they didn’t), and they can avoid companies that will be unprofitable in the future (as a group, they can’t).

“When the U.K. ended embedded commissions, the result was that lower-wealth investors would not or could not pay for advice, leaving them less well-prepared for retirement.”

Lower-wealth investors in Canada are already very poorly served. Most of the time, salespeople sell them expensive mutual funds without providing meaningful advice. Quality financial advisors are almost exclusively available to investors with substantial portfolios.

“Instead of favouring passive investing over active investing, policy should instead remove barriers that make financial planning costly. Ottawa charges GST on financial-management fees.”

It’s not clear to me that removing the GST from financial-management fees would lower investors’ costs. Costs are unreasonably high now. What would stop fund companies from raising fees to fill the GST gap? If you think of the GST as an extra cost for investors, you probably want to remove it. If you think of the GST as taking a slice of fees away from fund companies and advisors, then you probably want to keep it (unless you work for a fund company or advisor).

“Fans of ETFs and the companies that market the funds insist that active investing can never beat passive investing, since no human can consistently outperform the market.”

Few people claim that no human can consistently outperform the market. After all, most of us have heard of Warren Buffett. What index investors claim is that the average index investor gets higher returns than the average active investor after factoring in fees.

“The overwhelming number of studies that test the difference between active and passive funds are deficient in some respects.”

To back up this claim, Mintz cites nitpicks about benchmarks and observes that some studies found that active management beat passive in certain time-frames or under other circumstances. The truth is that the overwhelming majority of studies clearly back up the simple arithmetic argument that active managers as a group cannot beat indexes.

It’s hard to know the real motivation of those who make arguments like this. One plausible guess is that while the arguments are easy to refute, they give advisors something convincing to say to their clients in a one-on-one setting with nobody there to offer counterarguments.

One point to be clear about here is that active investing is not the enemy. For one thing, active investors help to set good prices. Investors’ real enemy is high costs. In the U.S., Vanguard offers active mutual funds with low costs. These funds serve investors well.

The best criticism of index investing is that so many investors fail to stick to their plan. Some bail out when stock prices fall. Others tinker so much with their allocations that they’re effectively market timers. Some are poorly diversified.

The passive versus active debate isn’t going away any time soon. There are too many people who make their livings from expensive mutual funds to expect them to just give up.

Wednesday, July 5, 2017

Enough: True Measures of Money, Business, and Life

John Bogle thinks there should be more to investment management and business in general than maximizing profit. In his distinguished career, he has put his money where his mouth is by creating a structure for Vanguard that strongly incents employees to minimize investor costs. In his book Enough: True Measures of Money, Business, and Life, Bogle describes Vanguard’s history and explains his business philosophy.

The book opens with the story of Joseph Heller being told that a hedge fund manager “had made more money in one day than Heller had earned from his wildly popular novel Catch-22 over its entire history. Heller responds, ‘Yes, but I have something he will never have ... enough.’” Bogle believes there are more important goals once you have enough money.

Vanguard began amid a business dispute and it was “barred from assuming responsibility for investment management and marketing.” This proved to be a happy result for investors because it helped make Vanguard the investor-friendly organization it is today. Vanguard eliminated the need for investment management by forming “the world’s first index mutual fund.” Without marketing, it converted “to a no-load, sales-charge-free marketing system.”

Keeping investor costs low is very important to Bogle. “On balance, the financial system subtracts value from our society.” He doesn’t want to add to this problem. He also shares Charlie Munger’s “concerns about the flood of young talent into a field [fund management] that inevitably subtracts so much value from society.” “Today, if fund managers can claim to be wizards at anything, it is in extracting money from investors.”

Some investors have a hard time accepting low-cost index investing approach that Bogle advocates because it seems too simple. But Bogle says that “Financial institutions operate by a kind of reverse Occam’s razor. They have a large incentive to favor the complex and costly over the simple and cheap, quite the opposite of what most investors need and ought to want.”

Canadians may be surprised to learn that Bogle is leery of ETFs: “I have serious questions about the rampant trading of most ETFs.” While Vanguard offers low-cost mutual funds, they are not available to Canadians, and we tend to look to ETFs for low costs. Bogle does “admire the use of broad market index ETFs that are held for the long term.”

Fans of diversifying with commodities will get only blunt words from Bogle. “Commodities have no internal rate of return. Their prices are based on supply and demand. That is why they are considered speculations, and rank speculations at that.”

Bogle worries that professions, including financial services, that should be worthy of trust are being undermined by profit motives. “Profession by profession, the old values are clearly being undermined. ... Unchecked market forces not only constitute a strong challenge to society’s traditional trust in our professions, but in some cases these forces have totally overwhelmed normative standards of professional conduct, developed over centuries.” “Over the past half-century-plus, the fund business has turned from stewardship to salesmanship.”

Bogle is critical of the practice of paying CEOs with stock options. This drives short-term thinking, but measuring “CEO performance should be based on the long-term building of intrinsic value.”

Convincing people to pursue more than just money can be a tall order. He quotes Descartes on this point: “A man is incapable of comprehending any argument that interferes with his revenue.”

Bogle sacrificed a great deal of personal wealth when he created Vanguard to strongly incent its employees to keep costs low. “In comparison to nearly all, if not all, of my peers in this business, I am something of a financial failure.” But he is “doing just fine, thank you.” He has enough and measures his success with a different yardstick.

Tuesday, July 4, 2017

Are Payday Loan Users Victims?

In a recent post about payday loans, reader Paul had the following (lightly edited) comment:

“You know I used to feel sorry for people who get caught up in this money cycle. But when most people would rather just watch Dancing with the Stars or an insane reality program and not spend 30 seconds on improving any aspect of their financial lives, I just can’t.

“One’s financial problems seem to always be ‘someone else’s or some fat cat banker’s fault.’ No one is responsible for themselves anymore. For the poor who struggle to make ends meet and this is the only option, yes I agree that is bad; for the rest, you get what you deserve if you can't pay for that non-essential ‘toy’ or latest iPhone you purchased you just had to have.”

There definitely are many people who deserve Paul’s criticism. But many who get caught up in a vicious payday loan cycle had plenty of help getting there. When I’m asked to referee a dispute, I like to say that we shouldn’t overlook the possibility that everyone is wrong.

Before looking at the causes of debt troubles, it’s important to recognize that on a pragmatic level, it doesn’t matter whose fault it is that you’re stuck in debt. If nobody else will help you, then you have to help yourself. So, don’t take any part of the rest of this post as an excuse to throw up your hands and declare your debt troubles to be someone else’s fault; that won’t help you.

Most of us start off young and clueless about money. It’s easy to begin a descent into debt trouble without realizing the path you’re on. These people aren’t blaming others for their problems because they don’t know they’re in trouble yet. As they begin to recognize the signs of trouble, they react in different ways. Some take positive actions to climb out of their financial hole and some blame others, but many just bury their heads in the sand for as long as possible pretending nothing is wrong.

The financial industry has great skill when it comes to promoting debt and helping people maintain their lifestyles while building debt. When your debt is split across multiple credit cards, lines of credit, car loans, and a re-advanceable mortgage, it’s very easy to lose track of whether your debt is rising from one month to the next.

If tobacco companies were to hire attractive 21-year olds to give free cigarettes to kids on their 18th birthdays, parents would riot. We react much less to banks hiring attractive people to push credit card applications on young adults. However, for many debtors, getting into a vicious payday loan cycle is the end of a descent that began with mishandling a first credit card.

Student loans are no help in teaching people to avoid debt. Tuitions have risen so high that it’s very difficult to get an education without a loan. Starting your adult life owing $20,000 normalizes being in debt. How could it hurt to add another $1000 on a credit card? At this point, the debt cycle is well established.

Any time I’m inclined to judge debtors harshly, I wonder what effect today’s debt-pushing machine would have had on me. I was turned down for student loans because I went to school in a different province, and fortunately for me, being in debt didn't seem like a normal state when I was young. If I were growing up today, I probably would be able to get student loans. Without the strong push I got toward frugality, perhaps I might have got an early taste for a more expensive lifestyle.

When it comes to Canadians’ debt problems, there’s a lot of blame to go around. But we can’t wait for banks, universities, and government to grow a heart and stop contributing to the debt cycle. The only person you can count on to get you out of a debt spiral is you.