Monday, November 27, 2017

Finance for Normal People

Standard financial theory treats us as though we are all perfectly rational people who make no mistakes in maximizing our utilitarian benefits with each of our financial choices. In reality, we’re emotional creatures who have desires outside of utilitarian needs. We have limited time and ability to evaluate choices, and we make lots of mistakes.

Many books have been written about how people fail to make the best rational choices. What sets Meir Statman’s Finance for Normal People apart is his attempt to unify real human nature into a realistic theory of finance.

“We want three kinds of benefits—utilitarian, expressive, and emotional—from all products and services, including financial products and services.” We’re used to focusing on utilitarian benefits such as maximizing portfolio returns. However, we also seek “the expressive benefit of high social status, as by a hedge fund; and the emotional benefits of exhilaration, as by a successful initial public offering.”

Sometimes we make cognitive and emotional errors, but this is distinct from seeking expressive or emotional benefits. Feeling good has value. It is perfectly sensible to add up utilitarian, expressive, and emotional benefits when making a choice. It’s a cognitive error when we misjudge benefits.

For example, it’s sensible for a wealthy person to say “I have more money than I need, and I don’t mind sacrificing some returns when I pick my own stocks.” For almost all people, it becomes a cognitive error when we believe that our own stock picks will beat the market. “Investors who believe they can pick winning stocks are regularly oblivious to their losing records, recording wins as evidence confirming their stock-picking skills but neglecting to record losses as disconfirming evidence.”

Because we have limited time and attention, we use cognitive and emotional shortcuts to make decisions. This works well most of the time. “Cognitive and emotional shortcuts turn into errors when they take us far from our best choices.” Keep in mind that “best choice” is defined in terms of all types of benefits: utilitarian, expressive, and emotional.

One type of cognitive error we make is called a “framing error.” Stock traders who “frame the trading race as between them and the market” are making an error. “Traders possessing human-behavior and financial-facts knowledge frame trading correctly as against traders on the other side of the trades—the likely buyers of what they sell and likely sellers of what they buy.”

In everyday language, we use “rational” to mean roughly the same as “smart.” “Financial economists, however, use the term more narrowly” to refer to people who “want only utilitarian benefits from investments.” While there is no utilitarian benefit from buying your date a rose, it is perfectly rational in the everyday sense of the word.

Statman criticises those who advise us “to set emotions aside when we are making financial choices, and use reason alone.” He says that “we cannot set emotions aside,” and that “emotional shortcuts complement reason.” I think this apparent disagreement is mostly semantic. I suspect both sides would agree that it makes sense to think carefully about big financial decisions and avoid making a snap emotional choice. Those with less technical knowledge in behavioural finance than Statman has might compress this advice to “keep emotions out of it.”

Even optimism can lead to emotional errors. “Optimism enhances our daily life as we contemplate an enjoyable future, but optimism has downsides.” A study of Finns found that “Optimism can lead to excessive debt loads.”

On the question of whether financial advisers help investors avoid cognitive and emotional errors, Statman says “Evidence indicates that financial advisers improved the financial behavior and well-being of both working and retired people.” I scanned the four papers he references that offer evidence of financial adviser benefits. I suspect that the benefits are greatest for those with enough money to get advice from a fiduciary. Those getting “suitable” advice likely benefit less, if at all.

In an example of understatement, Statman says that many firms, including “banks, hotels, health clubs, mutual fund companies, and credit card companies” “choose to exploit their customers’ errors, such as by hiding information or shrouding it.” A good example of this is the 7-page confusing investment account statements I get that bury mandatory disclosures about fees near the end.

All is not lost. “We are susceptible to cognitive and emotional errors, yet can correct them by human-behavior and financial-facts knowledge.” So admitting we make mistakes and understanding them can help us make better choices in the future.

“Expected-utility theory and prospect theory are two theories that assess happiness and predict choices. Expected-utility theory was introduced by mathematician Daniel Bernoulli.” My assessment of Bernoulli’s paper is that he was not trying to predict choices. He was saying how people should make choices, not how they actually do make choices. It may be that later economists incorrectly claimed that people actually make choices based on expected-utility theory, but I’ve seen no evidence that we should pin this on Bernoulli.

We’d like to think we’re not susceptible to trying to keep up the Joneses, but a study showed that lottery winners “increased visible assets, such as houses, cars, and motorcycles,” and this caused a “rise in subsequent bankruptcies among the close neighbors of these winners.”

I won’t repeat discussions of parts of this book I’ve discussed before about the dividend puzzle, portfolio optimization, and the annuity puzzle.

In a discussion of sustainable spending in retirement, Statman claims that “Older people in developed countries reduce their spending substantially starting at about age seventy and accelerating afterwards.” The reason, he says, is “physical limitations make them less able to spend, such as on travel, and because they are less inclined to spend for personal reasons.” He points to Fred Vettese’s work to justify leaving out what I think is the dominant reason retired people begin spending less: they overspent in their first few years of retirement. I wrote a critique of Vettese’s arguments in a previous article.

When investing, we seek more than just utilitarian benefits; we also seek expressive and emotional benefits such as “holding socially responsible mutual funds, the prestige of hedge funds, and the thrill of trading.” Unfortunately, investments with high expressive and emotional benefits “tend to be associated with high prices and low expected returns.”

Cognitive and emotional errors hurt our returns as well. Some examples are the “belief that stocks of admired companies are likely to yield higher returns than stocks of spurned companies, and that frequent trading is likely to yield higher returns than rarer trading.”

Statman goes through 5 possible explanations for the higher “factor” returns of value stocks and small-cap stocks. The first three explanations come from standard financial theory, and the final two come from behavioural financial theory. He concludes that behavioural financial theory explanations are more likely: “the evidence favors the emotional-errors and wants hypotheses over the data-mining, risk, and cognitive-errors hypotheses.”

To the growing list of investing “factors” such as value stocks and small-cap stocks, Statman adds some possible behavioural factors. One example is that stocks that rank low on social responsibility likely having higher returns.

In a discussion of three forms of the efficient market hypothesis (EMH), it struck me that the definitions seem to be based mostly on access to information and whether it is possible to profit from it with short-term trading. However, the best example of an investor who defies the EMH, Warren Buffett, made his billions with long-term investment. His advantage seemed to have less to do with having exclusive information and more to do with being better able to analyze how a company’s culture and strategy will play out over the long term.

Overall, I found this book to be very helpful at taking what I’ve learned elsewhere about human behaviours and mistakes and putting them in a useful context and framework. Our expressive and emotional needs aren’t mistakes; the mistakes come when we over- or under-value them. Statman says “I hope you see yourself in this book and learn to identify your wants, correct your errors, and improve your financial behavior.”

Friday, November 24, 2017

Short Takes: Driving Undercover in Uber and Lyft, and more

Before launching into this biweekly roundup, our friend the Blunt Bean Counter played a role in a BDO Canada survey of business owners and non-business owners about retirement and wealth. Here are some of their findings:
  1. Business owners plan more for retirement than non-business owners but feel less on track.
  2. Almost one-third of business owners plan to work part-time after retirement – compared to 12 percent of the general population.
  3. More than one in three business owners plans to retire in the next five years.
  4. Financial support for children was more common among the business owners than among non-business owners.

Here are my posts for the past two weeks:

The Dividend Puzzle

Portfolio Optimization

The Annuity Puzzle

The High Cost of Paying Property Insurance Monthly 

Here are some short takes and some weekend reading:

Mr. Money Mustache describes his experience driving for Uber and Lyft. He has a number of suggestions for making the system exploit drivers less.

Canadian Couch Potato interviews Nobel Prize winning professor of economics, Robert J. Shiller. I found Shiller’s remarks on real estate to be particularly interesting.

CBC Marketplace reports that car dealerships push long-term loans and disguise “negative equity,” which means the debt that results from owing more on your car loan than your car is worth.

Jason Zweig explains that not all index funds are run well and sometimes investors suffer.

Garth Turner found a real estate agent who makes it sound like the mortgage rule changes will make you lose money.

Big Cajun Man found that while he was ill, he let parts of his personal finances slide.

The Blunt Bean Counter explains how Canadian CPP/OAS and U.S. Social Security are harmonized with a “Totalization Agreement” between the two countries. See the first post on this topic as well.

Boomer and Echo review Dollars and Sense by Dan Ariely and Jeff Kreisler. It’s worth taking a chance on any book written by Ariely.

Wednesday, November 22, 2017

The High Cost of Paying Property Insurance Monthly

Update: An anonymous commenter says that when a down payment is charged on property insurance, contrary to what our insurance agent told us, monthly payments end after 10 months and not 12.  The article has been updated accordingly.

Recently, I was helping a family member switch property insurance companies. The last thing to arrange was paying the premium. The insurance agent was steering us toward monthly payments instead of paying for the full year in advance.

At first I was just going to dismiss the idea of paying monthly, but I decided to ask the agent what interest rate they charged. I think his exact words were “there is a 4% service fee.”

For the purposes of this article, I’ll scale all the numbers to an annual insurance premium of $1200 to keep the math simple. I took the insurance agent to mean that they take the $1200 premium, add 4% to get $1248, and divide by 12 to get $104 as the monthly premium. This turns out to be only partially correct.  In addition to the monthly charges, the insurance company wanted a $200 “down payment.”

This is where the uncertainty comes in.  Although we were told the payments would last for 12 months, it seems plausible that our agent was wrong and that they would end after 10 months.

So, the $1200 premium led to a total of $1448 in payments if paid monthly for 12 months. After doing some figuring, I said “that service fee of 4% is more like 4% per month.” The agent’s reply was a simple “yes.” Needless to say, we just paid the full annual amount of $1200.

Later on when I had time for more accurate calculations, I worked out the internal rate of return on these payments to be 3.58% per month, which compounds to 52.6% per year!

However, if the payments were only going to last for 10 months, then the total paid would be $1240, and the annual interest rate charged would be 9%.  It's misleading to characterize 9% interest as “a 4% service fee,” but this is a long way from charging over 50%.

I recommend trying to find out the total of all payments you'll make when paying monthly and compare this total to the annual premium.  This will give you some idea of the cost of paying monthly.

Tuesday, November 21, 2017

The Annuity Puzzle

A big challenge in retirement is spending enough to be happy without running out of money. The main problem is not knowing how long you’ll live. This is called “longevity risk.” We are forced to plan for a long life whether we’ll live long or not.

One way to eliminate longevity risk is with an annuity. The idea is to hand your money over to an insurance company, who then promises to pay you monthly, even if you live much longer than they expect.

According to Meir Statman in his book Finance for Normal People, “people are reluctant to annuitize, a reluctance we know as the ‘annuity puzzle.’” Statman identifies a number of “behavioral impediments to annuitization.”

We are averse to “transparent dips in capital.” Seeing your portfolio take a big drop hurts, even knowing that you’ll get lifetime income in return. Also, the “money illusion” makes “a lump sum of $100,000 seem larger than its equivalent as a $500 monthly annuity payment.”

“Availability errors deter people from annuitizing further because images of outliving life expectancy are not as readily available to people as images of many kinds of death that might befall them soon after they sign an annuity contract.” Regret aversion is also involved because of the possibility “their heirs would receive only pennies on the annuity dollar.”

Finally, we get to the easiest-to-understand reason for avoiding annuities: they have a “smell of death.”

All these behavioural reasons that people avoid annuities sound perfectly plausible. However, there are also rational utilitarian reasons for avoiding the annuities available to people.

First, let’s consider a simple fixed payout life annuity. The return on such annuities is a mixture of long-term bond rates, mortality credits, and embedded fees. This forces people who prefer the higher expected returns of stock investments to give them up to get mortality credits. One good solution might be to take just your bond allocation and buy an annuity if the embedded fees aren’t too high. But, it can be quite reasonable to prefer to keep a significant allocation to stocks.

There are annuities available whose variable payouts are related to stock investments. However, the investment fees buried inside these products are extremely high.

If we had an annuity option that resembled a well-run shared-risk pension plan, then it would certainly make sense for people to use it to get the advantage of mortality credits. Until this is available, expect this annuity puzzle to persist.

Monday, November 20, 2017

Portfolio Optimization

Deciding what percentage of your portfolio to allocate to bonds, domestic stocks, foreign stocks, etc. can be challenging. Any attempt to optimize this allocation is necessarily based on assumptions. It’s dangerous to blindly follow optimized allocation percentages without examining the assumptions built into the optimization process.

In his book Finance for Normal People, Meir Statman tells the story of investment consultants choosing asset allocation percentages for a large U.S. public pension fund. The consultants used Harry Markowitz’s mean-variance portfolio theory to calculate an optimal portfolio for the pension fund. But then they modified all the percentages.

Statman’s explanation for why the consultants changed the percentages is that the managers of the pension fund wanted more than the “utilitarian benefits of higher expected return”; they wanted “expressive and emotional benefits, including the benefits of conformity to the portfolio conventions of this pension fund and similar pension funds.”

Statman may be correct in this assessment, but there is another reason for rejecting the recommended percentages from mean-variance portfolio theory. This reason is based on strictly utilitarian benefits and not expressive or emotional benefits.

The basis for mean-variance portfolio theory is that investment returns follow what is called a lognormal distribution. This model does a decent job for most of the range of possible investment returns, but it vastly underestimates the chances of extreme events. Unfortunately, making sure you can survive extreme events is a very important part of portfolio allocation.

If returns really conformed to mean-variance portfolio theory, then rational investors would be using a lot of leverage (investing with borrowed money). To compensate for the tendency of mean-variance portfolio theory to recommend risky portfolios, we usually choose a low value for the standard deviation of portfolio returns we can tolerate. This helps but isn’t a perfect solution.

There are other stable distributions that do a better job of modeling extreme investment returns. Unfortunately, they are harder to work with. In fact, their standard deviations are infinite.

Statman may be right that the primary reason why people deviate from portfolios optimized by mean-variance portfolio theory is that they seek expressive and emotional benefits. However, trying to protect portfolios against extreme events is another good reason.

Tuesday, November 14, 2017

The Dividend Puzzle

The strong preference many investors have for dividends over capital gains is known among economists as the “dividend puzzle.” Meir Statman offers a solution to this puzzle in his book Finance for Normal People.

Statman says that many investors incorrectly “frame the capital of a stock as a fruit tree and dividends as its fruit. In that frame, collecting dividends and spending them does not diminish the capital of the stock any more than picking fruits off a tree and consuming them diminishes its size.”

“Rational investors know the correct frame for dividends and capital. They know that $1,000 in ‘homemade’ dividends from the sale of shares is identical in substance to $1,000 from a cashed dividend check, even if different in form, and they care about their total wealth, not its form.” Because the “price of shares of a company declines when a company pays dividends,” “payments of dividends do not affect the total wealth of investors.”

All that said, dividends do offer some advantages when we consider “expressive and emotional benefits” rather than just utilitarian benefits.


“Young investors bolster their self-control by setting separate mental accounts for income, including salary and dividends, and capital, including stocks. They add a rule—‘spend income but don’t dip into capital.’” Investors who create homemade dividends are more likely to succumb to temptation and “turn a 3 percent homemade dividend into a 30 percent homemade dividend.”

Sticking to a rule of not spending capital “also benefits older investors who draw money from their portfolios for retirement expenses and worry that self-control lapses would turn” their intended 3% home dividend into larger withdrawals.

Mental prohibitions against spending capital are so strong that when a company is forced to suspend its dividend, some shareholders living off dividends do “not even contemplate creating homemade dividends by selling [some] shares.”

Hindsight, Regret, and Pride

“Compare John, who buys a laptop computer for $1,399 with dividends received today from shares of his stock, to Jane, who buys the same laptop today with $1,399 homemade dividends from the sale of shares of the same stock.”

If the stock later goes up, Jane will feel regret for not having waited to sell, but John won’t feel this regret. Of course, if the stock later drops, Jane would feel pride for selling when she did, and John won’t feel this pride. “Consistent with loss aversion in prospect theory,” Jane would feel regret stronger than she would feel pride. So, on balance, John comes out ahead.


There is another emotional advantage to dividends that comes from the way that capital gains are framed with and without an associated dividend. This topic is somewhat technical, and so I’ll leave it to those who choose to read Statman’s book.

So, even though rational investors focus on total returns rather than over-valuing dividends, normal investors get some expressive and emotional advantages from dividends.

Friday, November 10, 2017

Short Takes: Amazon Nonsense, Extended Warranties, and more

I managed only one post in the past two weeks, a review of two books:

The Smartest Investment Book and Portfolio

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand is almost as cynical as I am about Amazon’s long, drawn-out “search” for a second headquarters location. I hope this whole PR event backfires for Amazon. In another article he discusses the elements of academic behavioural economics that he sees in practice.

Squawkfox has some sensible advice about extended warranties.

Gordon Pape shares important things you should know about traveling to Florida for the winter. His advice on this subject is far superior to his investment advice.

Big Cajun Man clarifies some of the rules surrounding Registered Disability Savings Plans (RDSPs).

Friday, November 3, 2017

The Smartest Investment Book and Portfolio

There is little doubt that the vast majority of investors would be better off investing in low-cost diversified index funds than attempting to beat the market. However, the best writers explaining this fact, like Charles D. Ellis, tend to be calm and reasonable, while the loudest proponents of expensive active management say silly alarmist things like “index funds will destroy capitalism.”

One voice on the index fund side that can take on hysterical active management proponents is Daniel R. Solin. His books The Smartest Investment Book You’ll Ever Read (Canadian Edition) and The Smartest Portfolio You’ll Ever Own pull no punches. While I prefer Ellis’s style, I like Solin’s chances of holding his own in a public debate.

Solin refers to active portfolio selection as “hyperactive management.” He says “The securities industry adds costs. It subtracts value.” He devotes many pages to the numerous failings of the investment industry. While he overstates some of his points (e.g., “Nobody Can Consistently Beat The Market”), most investors would do well to assume his absolutes are correct.

The 2006 book, The Smartest Investment Book You’ll Ever Read (Canadian Edition), is starting to get a little dated, but is still very useful. Many Management Expense Ratios (MERs) for index funds are now much lower, and there are more Exchange-Traded Fund (ETF) choices than there were back then. On the positive side, this Canadian edition really does have meaningful Canadian content.

The 2011 book, The Smartest Portfolio You’ll Ever Own, covers some of the same ground as the first book, but covers new ground as well. It offers several model portfolios. One ETF-based portfolio is essentially the same as the one recommended in the first book. Another portfolio is based on index mutual funds. A third is based on Vanguard target-date funds.

Solin calls these three model portfolios the “smartest portfolios.” To distinguish a fourth model portfolio from these three, he calls it “The SuperSmart Portfolio.” This portfolio is based on ETFs and is designed to capture size and value factors based on the Fama-French three-factor model. All four portfolios are intended for Americans, so Canadians will have to try to adapt them to investment choices available to us.

Here are a few interesting quotes:

“Wall Street is not completely lacking in skill. It takes considerable skill to convince you it has an expertise that doesn’t exist and that you should pay for this nonexistent skill.”

“Just say no to: Market timing; Buying individual stocks and bonds; Actively managed mutual funds; Alternative investments; Variable annuities; Equity indexed annuities; Private equity deals; Principal-protected notes; Currency trading; Commodities trading.”

“The true secret of giving advice is, after you have honestly given it, to be perfectly indifferent whether it is taken of not and never persist in trying to set people right.—Hannah Whitall Smith”

“If you are using a broker or adviser who claims to be able to beat the market, withdraw your money and close your account.”

Toward the end of the 2011 book, Solin gives somewhat of a commercial for Dimensional Fund Advisors (DFA), and he admits to being an advisor offering their funds. However, this comes after the bulk of the book that offers advice suitable for do-it-yourself investors.

Overall, I find these books useful for giving readers the indexing side of the active vs. indexing debate. Academics might cringe at the repeated absolutes, but the impact on readers is likely to be positive.