Saturday, December 22, 2018

Short Takes: Dividend Investing, Investing Simply, and more

My short takes are a little late because I’m just back from a vacation. Apparently, I’m now on “island time.” Here are my posts for the past two weeks:

How Beneficial is the Dividend Tax Credit

Bad Arguments Against CPP Expansion

When Does Permanent Life Insurance Make Sense?

Deep Risk

Here are some short takes and some weekend reading:

Dividend Ninja interviews Dan Bortolotti to discuss index and dividend investing. From my point of view, Dan did a great job of explaining misconceptions many dividend investors have. Some of the dividend investors who commented saw it differently.

Preet Banerjee interviews John Robertson who explains how to keep investing simple.

Big Cajun Man has some trouble with a CRA request for documentation on expenses for his autistic son. This is a case where CRA shows it has a heart.

Canadian Couch Potato interviews Larry Swedroe to discuss challenges new retirees face with their portfolios.

Boomer and Echo looks at the various ways we kick debt down the road. We often have the best of intentions for the future, but just for now, we’ll do the easy thing. The problem is that life is only lived right now.

Monday, December 17, 2018

Deep Risk

When it comes to finances, the definition of “risk” is tough to pin down. We sometimes refer to portfolio volatility as risk, but this doesn’t line up well with what people mean when they talk about stocks or other assets being risky. William J. Bernstein brings us some clear thinking about risk in his 55-page book Deep Risk: How History Informs Portfolio Design, the third of four books in his Investing for Adults series.

Bernstein thinks of risk “in two flavors: ‘shallow risk,’ a loss of real capital that recovers relatively quickly, say within several years; and ‘deep risk,’ a permanent loss of real capital.” “Capital managed for near-term liabilities should be guided by shallow risk, while capital managed for very long-term liabilities should be guided by deep risk.”

This book “provides a framework for thinking about deep and shallow risk as essentially an insurance problem involving probabilities, consequences, and insurance costs.”

“The conventional ‘shallow’ risk of stocks is greater than that of bonds,” but when it comes to deep risk, “the reverse is true.” Inflation can permanently reduce the value of bonds, but the stock market tends to recover from losses. “Stocks protect against deep risk, but exacerbate shallow risk.”

Looking to history, Bernstein finds four sources of deep risk: prolonged hyperinflation, deflation from severe recessions and depressions, confiscation of assets as in communist takeovers or very high tax rates, and devastation from war. He then looks at the different ways of insuring against these types of deep risk.

The author judges inflation to be the most likely source of deep risk and the easiest to insure against. “Your best long-term defense against deep risk is a global value-tilted diversified equity portfolio.” He judges deflation and devastation to be least likely and hardest to insure against.

Past deflation and depressions were mainly due to being on the gold standard, “the result of placing control of the money supply in the hands of gold miners.” “Nations exited the Great Depression in the same order they went off the gold standard.”

An interesting quote: “Stocks, when looked at through a mathematical lens, become riskier with time; but swap out the math lens for a historical one and you get an entirely different picture.” I think that if the math doesn’t match reality, then you’re using the wrong math.

Overall, I highly recommend this short book for those interested in how to protect their wealth from permanent loss.

Friday, December 14, 2018

When Does Permanent Life Insurance Make Sense?

The vast majority of people who need life insurance are best off with term life insurance. Salespeople have tried to sell me permanent life insurance (universal life and whole life), but I never got a good feel for when this type of insurance might make sense. Recently, the Rational Reminder podcast interviewed Glenn Cooke, an expert in insurance who communicates very clearly. Glenn’s explanations allowed me to understand when permanent life insurance may make sense.

Before launching into my take on Glenn’s explanations, let me be clear that Glenn may not fully agree with me. In particular, he might find that the conditions I set out below are too narrow.

Permanent life insurance only makes sense to me when all of the following conditions are met:

  1. You have maxed out both your RRSP room and your TFSA room.
  2. You definitely have more money than you’ll ever need, and you want to leave a legacy (which might include cash to pay off capital gains taxes on a property, such as a cottage, that you want to stay in the family).
  3. You are satisfied that the tax advantages of permanent life insurance outweigh its high fees so that the insurance will likely outperform investments you make in a taxable account.

Explanations of these conditions

1. As Glenn explains, “your RRSPs and TFSAs need to be fully maxed out” because “the management fees inside a universal policy are almost always far higher that they would get outside of a universal life policy.”

2. The cheapest way to protect your family during your working years from the loss of your income is with term life insurance. Getting permanent insurance means you want an insurance payout no matter how long you live. Permanent life insurance “is not liquid and it’s not very flexible. Once you’re in, you’re in, which is why you don’t want any money going into an insurance policy that you might ever need.”

3. If you’re in the position of wanting to grow your legacy as large as possible, all that matters is whether some form of permanent life insurance is likely to outperform other investment options. I’d have to study the details of a universal policy to form an opinion on whether its tax advantages outweigh its high fees.

Some people might argue that condition 2 on its own would be enough to justify buying a universal life policy. Glenn says he has such a policy because he wants to “guarantee there’s an estate there for my kids.” However, if you’re actually running out of money, you’re likely to “cash in” a permanent life insurance policy, so I don’t see any guarantee that the kids will get much money. In fact, if using RRSPs and TFSAs produces better returns than permanent life insurance, then you’re less likely to spend your assets down to zero.

I’m satisfied that permanent life insurance never made any sense for my family. If I were helping a family member or friend with life insurance, I would use the three conditions above. But I’m open to changing my mind if I learn more about life insurance.

Wednesday, December 12, 2018

Bad Arguments Against CPP Expansion

The Canada Pension Plan (CPP) is set to start expanding in January 2019. Workers will begin contributing more of their pay to CPP, and those who contribute more will ultimately receive increased CPP benefits. There are sensible arguments for and against this change, but the most common argument I hear against it makes no sense at all.

I saw a version of this bad argument in an article by Charles Lammam at the Fraser Institute calling on Doug Ford to opt Ontario out of CPP expansion. Lammam calls CPP expansion “unnecessary” because “most Canadians adequately prepare for retirement.” He then goes on to quote statistics on the total dollar amounts Canadians have saved in different asset classes.

All this proves is that, on average, Canadians have enough savings for retirement. But averages are irrelevant in this discussion. Consider two sisters heading into retirement. One sister has twice as much money as she needs and the other has nothing. On average, they’re fine, but individually, one sister has a big problem. CPP expansion is aimed at those who can’t or won’t save on their own.

It’s tempting to ask why we should worry about those who refuse to help themselves by saving for retirement. There are numerous government programs that send tax money to low-income seniors. Three are the Guaranteed Income Supplement (GIS), the Age Amount Deduction, and the Senior Homeowners’ Property Tax Grant in Ontario. As a society, we’ve sensibly decided we don’t want to see seniors begging for food in our streets. An expanded CPP forces more Canadians to save for themselves rather than rely on free tax dollars in retirement.

So, why do we force all Canadians to contribute to CPP when it’s only a minority who won’t save on their own? If CPP were optional, too many of those who need it most would opt out. The only way CPP can serve its purpose well is if it’s mandatory for everyone.

Lammam complains that “Forcing Canadians to contribute more to the government-run pension will simply reduce the amount they save in private voluntary savings vehicles, resulting in little to no overall increase in total savings.” Good. We’re not expanding CPP to get everyone to save more. We just want everyone to save the bare minimum. It’s perfectly sensible for those who are saving well to reduce other savings somewhat and rely more on an expanded CPP.

It’s possible to have a sensible discussion about the merits of expanding CPP. But we should see arguments based on total savings of Canadians or average savings for what they are: a distraction from more meaningful discussion.

Monday, December 10, 2018

How Beneficial is the Dividend Tax Credit?

Many investors love Canadian dividends because they come with a tax break called the Dividend Tax Credit (DTC). Others look a little deeper and say that the DTC just prevents double taxation because the companies paying dividends already had to pay tax on their profits. They conclude that dividend income is no better than interest income, at least from a tax perspective. However, comparing the DTC to capital gains taxes gets more complex.

Dividend Taxation in Canada

The DTC is intended to prevent Canadian company profits paid to Canadian shareholders from getting taxed twice. Here’s an example to illustrate the idea:

Suppose a company earns one dollar in profit per share, pays 27 cents in income taxes, and pays the remaining 73 cents in dividends to each shareholder. Canadian shareholders actually declare the full dollar as income (called the dividend gross-up), but they get to deduct the 27 cents from the taxes they owe. The idea is that the total tax paid by the company and the shareholder is the same as if the shareholder had received a dollar of regular income.

In truth, the numbers don’t work out quite this perfectly. But the DTC does give Canadian shareholders a tax break that mostly covers the corporate income taxes.

Most investors don’t think about the corporate taxes paid and just focus on the tax they pay on the dividends they received. Ontarians in the 53.53% tax bracket pay 39.34% on their eligible dividends. Those in the 20.05% tax bracket actually pay a negative tax rate on their eligible dividends (-6.86%).

Comparing Dividends to Interest

Critics of dividend cheerleaders point out that dividends aren’t taxed any less than interest income once you properly account for corporate taxes. These critics are right.

This doesn’t mean that dividend-paying stocks are no better than fixed-income products. Taxes aren’t the only consideration. A company’s shares may appreciate even if it doesn’t retain any of its earnings. So, future dividends may be larger than interest payments on a fixed-income product even if neither type of income has a tax advantage. Of course, a company’s share price and dividends can go down as well.

Comparing Dividends to Capital Gains

Dividend cheerleaders look foolish when we compare dividend taxes to interest taxes, but what happens when we compare dividends to capital gains? To me, this is the more relevant comparison. Those who prefer dividend stocks to fixed income products can point to dividend growth as an advantage even if there is no taxation advantage. But when we compare stocks with different levels of dividends and capital gains, the tax difference is important in taxable accounts.

Suppose we are choosing between two baskets of stocks, both expected to earn a compound average return of 5% per year. We expect the dividend stock basket to pay 4% dividends and earn 1% capital gains. We expect the other basket to pay 2.5% dividends and earn 2.5% capital gains. So, the only difference is that with the dividend stocks we trade some capital gains for more dividends.

For both baskets of stocks, the companies have to pay corporate taxes, so we can just leave them out of the comparison. Now dividend cheerleaders don’t look so foolish for ignoring corporate taxes. For any money we withdraw to live on each year, we can just compare dividend tax rates to capital gains tax rates. In Ontario, dividend tax rates look better when our total income is under about $95,000.

But this ignores capital gains deferral. Suppose we spend less than 4% of our savings each year. With dividend stocks, we’d have to reinvest some dividends that we’ve already paid taxes on. With the other basket of stocks, we’d get the advantage of deferring some capital gains taxes to the future when we sell the stocks. Depending on how long we defer the taxes, this can give the capital gains the advantage over dividends down to total incomes as low as $48,000 in Ontario. Note that with the dividend gross-up, our actual received income can be even lower than this.

If we’re expecting our total income (including CPP and OAS) to be lower than $48,000 in retirement, it may seem like we should opt for dividend stocks. But keep in mind that all of this analysis assumes we have a taxable account. It only makes sense to have a taxable account if your RRSP and TFSA are completely full. This tends to be true only if we have large RRSPs that lead to high income in retirement. So, in most cases, capital gains taxes are lower than dividend taxes.


Those who like Canada’s lower tax rate on dividend income appear misguided when we compare dividends to interest income and properly account for corporate taxes. But when we compare dividend taxes to capital gains taxes, it makes sense to ignore corporate taxes and focus on the favourable tax rates for both dividends and capital gains.

Friday, December 7, 2018

Short Takes: Dividend ETFs, Dynamic Pricing, and more

I managed only one post in the last two weeks:

Smart Couples Finish Rich

Here are some short takes and some weekend reading:

Dan Bortolotti has a very sensible take on dividend ETFs.

Squawkfox tells us how to beat dynamic pricing where retailers change online prices based on what they know about you.

Ron Lieber attends a steak dinner annuity pitch and makes the salesman unhappy. A lot of complex financial products look good if you compare them to stocks without their dividends.

The Blunt Bean Counter explains the tax implications of renting out your property Airbnb-style. His explanation is more than enough to scare me away from becoming a casual landlord.

Jason Heath explains the details of how to defer RRIF income taxes when a spouse passes away. There are a number of different cases to consider.

Robb Engen lays out his financial goals for 2019. As usual, my favourite goal is “Don’t take on any new debt.” Without this goal, he could meet all the other goals painlessly by borrowing a pile of money.

Big Cajun Man didn’t hold back on his opinion of GM for closing their plant in Oshawa.

John Robertson reviews Passiv, a tool to automate the management of a do-it-yourself portfolio based on ETFs. It performs some of the functions I’ve built into my investment spreadsheet. It also does some things my spreadsheet can’t do such as sending trades to a brokerage account.

Monday, November 26, 2018

Smart Couples Finish Rich

We can all think of times when we wasted money on things that didn’t matter that much to us and were left without enough money to do things that truly bring us joy. The question then is how do we fix this problem? David Bach offers a step-by-step guide in his book Smart Couples Finish Rich. This book is getting dated, but it offers surprisingly concrete steps to the hard to pin down task of aligning your spending with your values and dreams.

This book is mainly aimed at people still in their working careers, so it’s tough for me to test out its ideas. However, I could imagine myself a decade or two ago being able to follow Bach’s nine steps. How much it would have helped me is hard to guess, but at least the steps are clear enough to go through the exercise.

Parts of this book won’t be too useful to Canadians with the talk of 401(k)s, IRAs, and health insurance. It wouldn’t be too hard for Canadian readers to skip these parts. Some of the examples are becoming quite dated with examples of much higher interest rates than we have now.

More troubling though is some bad advice. When it comes to choosing investments within a company plan, Bach suggests examining “a current list of investment options and a summary of how each of the investments has been performing recently.” Jumping to recent winners is a bad way to invest.

Here is some worse advice: “If you work for a terrific company and you know it’s well run, don’t be afraid to act on that knowledge. I currently have more than 50 percent of my 401(k) money invested in my company’s stock.” I wonder how many WorldCom employees thought their company was well run.

Less serious, but still somewhat troubling is the advice to put emergency funds in money market accounts because they are “incredibly safe.” There is some risk with money market accounts. The kinds of conditions that would put these accounts at risk are exactly the conditions where you’d be very glad to have cash at the ready. Higher returns always come with more risk.

One section does a good job of explaining the benefits of investing in low-cost index funds. But then Bach says index funds are just for the “getting started” phase before you have $50,000. He says to move to a portfolio of mutual funds. Why not stick with low cost investments instead of paying high costs?

Bach claims that with fee-based advice where you pay a percentage of your portfolio for financial advice has “no possible conflict of interest.” This just isn’t true. Commission-based advice may be worse, but fee-based advisors are incented to gather as many assets as possible and do as little as possible to retain clients’ money. Some advisors may do a great job despite this conflict of interest, but the conflict is there nonetheless.

One part I found curious was the claim that we won’t pay less in taxes when we’re retired. In my case, my income taxes dropped more than 90% when I retired. Perhaps this is a difference between being self-employed and being an employee. I paid very high taxes as an employee. Perhaps differences between Canadian and U.S. tax law are a factor as well.

People are too trusting of insurance company promises. Bach is very blunt: “Insurance companies will do just about anything they can to avoid having to pay out benefits—including hiring an investigator to check you out.” He’s not against getting sensible insurance; he is underscoring the importance of telling insurance companies the truth. Any lie you tell an insurance company gives them a potential way to avoid paying a claim.

People who have tried and failed to get control of their spending may be skeptical of yet another book on this subject. Bach begins with identifying your values, hopes, and dreams, and say “It’s my experience that people will do more, and act more quickly, with regard to their finances when they understand how their actions relate to their values.”

In conclusion, the best part of this book is the series of concrete steps designed to allow you to identify what matters to you in life and align your saving and spending with you values, hopes, and dreams. I suspect this approach is better than books that just urge us to spend less and save more. Delaying gratification sounds a lot less fun than making sure you get what you really want in life. But there are a few pieces of advice in this book readers are best to ignore.

Friday, November 23, 2018

Short Takes: Hedge Fund Blow-up, Getting Laid Off, and more

Here are my posts for the past two weeks:

The Value of Delaying CPP and OAS

Is it Worth it to Hold U.S.-Listed ETFs?

Rising Dividends in ETFs

Here are some short takes and some weekend reading:

James Cordier lost all his clients’ money and made this weepy apology video (that. He blames the failure of his option trading strategy on a “rogue” market. The problem is that markets go rogue in many different ways frequently. If you take on too much risk, a potential blow-up is just around the corner.

Doug Hoyes interviews the Big Cajun Man to talk about what it was like to get laid off from Nortel and the lessons he learned.

Canadian Couch Potato uses his latest podcast to take a swipe at investing courses that focus on price-to-earnings ratios, segregated funds, and stock options instead of the things DIY investors really need to know. Teaching beginning investors how to analyze stocks is like teaching a 5-year old to operate a chainsaw. For the purposes of this analogy, most experienced stock pickers are like 8-year olds with chainsaws.

Andrew Coyne is concerned that Canada is still running a deficit during such good economic times. So am I.

Boomer and Echo list some rip-offs to avoid. The worst one in this list, in my opinion, is credit card balance protection insurance.

Big Cajun Man had to destroy another credit card he didn’t want but was sent to him anyway. I’ve heard of this practice of sending credit cards to people without their having applied, but it has never happened to me.

Wednesday, November 21, 2018

Rising Dividends in ETFs

Reader ML asks the following good question (edited for length):

I am relatively new to investing for dividends. Currently my strategy is to invest in high quality stocks and hold them for a long time. You are one of the bloggers who switched from buying individual stocks to buying ETFs. I get the strategy of ETFs in that it’s hard to beat the market with individual stocks.

My question: Over years the dividend you receive from an individual stock continues to grow. If ETFs switch over their portfolio would they not miss out on this increase in dividends, year over year? It seems to me that the dividends stay pretty steady in the ETFs. Is that not a big chunk of money to miss out on?

The short answer is that ETF dividends do grow. The dividends that low-cost index ETFs pay are mainly the dividends collected from all the individual stocks held within the ETF. There is a small deduction for the costs of operating the ETF and possibly a small increase from securities lending, but for the most part, you’re just getting the collected individual stock dividends.

If you follow blogs and Twitter accounts of dividend enthusiasts, you’ll see frequent reports of companies increasing their dividends. This focus on dividends can be a good thing in that it helps some investors keep holding their stocks through market crashes. But celebrating each dividend increase can also create the illusion that dividends are rising faster than they really are. If three stocks have dividend increases of 3%, 5%, and 7%, this feels like a total increase of 15%, but collectively, the annual dividend increase for holding all three stocks is 5%.

Whether your collection of individual stocks produces faster rising dividends than an ETF’s dividends depends on the fortunes of the companies you own. If your companies grow their profitability faster than the index average, then your dividends will grow faster. If their profitability grows slower, your dividends will grow slower.

In the end, it comes down to whether you’ve chosen better stocks than the average. Stocks that pay high dividends can go in and out of favour over the decades, so dividend investing will have good and bad periods. If you’re sufficiently diversified, you’ll likely get about the same results as an index biased to value stocks. However, it can be challenging to own enough individual stocks to be properly diversified.

I’m not sure what you mean by “ETFs switch over their portfolio.” Index ETFs tend to have very little turnover of stocks. Perhaps you’re referring indirectly to the idea of “yield on cost.” Some dividend investors like to calculate their annual dividend divided by what they paid for the stock. So, a stock might be paying a 4% dividend, but this looks like a 12% dividend to someone who bought the stock a decade earlier for one-third the price. This may feel good, but it has little meaning. I’ve owned some ETFs long enough that my dividend yield on cost is getting high, but yield should be thought of based on current prices, not what you paid in the past.

In summary, ETFs aren’t missing out on a big chunk of money. Their dividends tend to rise over time. It’s important to look through any type of “container” like low-cost stock index ETFs to see that under the covers they hold many individual stocks. Whether you hold an individual stock directly or hold it indirectly in an ETF, you get the same results of rising or falling dividends and capital gains.

Thursday, November 15, 2018

Is it Worth it to Hold U.S.-Listed ETFs?

Index investors in Canada who own Exchange-Traded Funds (ETFs) have a choice to make with their U.S. and international stock holdings. They can either buy an ETF that holds U.S. and international stocks but trades in Canadian dollars (such as Vanguard Canada’s VXC), or they can buy U.S.-listed ETFs that trade in U.S. dollars. This choice is a trade-off between cost and complexity.

It’s certainly a lot simpler to own VXC. With U.S.-listed ETFs, you need to find an inexpensive way to exchange Canadian for U.S. dollars, such as Norbert’s Gambit. But, as Justin Bender explained, the cost of VXC is higher than the cost of owning U.S.-listed ETFs. This higher cost comes from a higher Management Expense Ratio (MER) and U.S. dividend withholding taxes.

For the mix of U.S.-listed ETFs that I own (VTI, VBR, and VXUS), the blended MER is 0.09%, which is 0.18% lower than VXC’s MER. Less obvious, as Justin calculated, is the fact that U.S. withholding taxes of 0.35% cannot be recovered for VXC. This tax is not charged to VTI, VBR, and VXUS when they’re held in an RRSP. There are international dividend withholding taxes that apply to both VXC and VXUS.

From this total of 0.53% in lower costs for U.S.-listed ETFs, we need to subtract the added costs of currency exchanges. In my case, this averages about 0.01% per year using Norbert’s Gambit. However, this cost would be higher for smaller portfolios and much higher for investors who don’t use Norbert’s Gambit. In total, my costs would be about 0.52% higher each year if I owned VXC.

I plugged this higher cost into my retirement spending spreadsheet and found that my estimated lifetime retirement income derived from my portfolio declined by 5.6%. So, for example, if my portfolio was going to produce $50,000 per year, this would drop by $2800 per year if I owned VXC instead of my U.S.-listed ETFs.

Now that I’m comfortable managing a portfolio that includes very infrequent Norbert’s Gambit currency exchanges, I find the added complexity of dealing with U.S. dollars to be worth it for the extra income, but your mileage may vary.

Monday, November 12, 2018

The Value of Delaying CPP and OAS

Few people realize that you can delay receiving CPP and OAS until age 70 in return for permanently higher payments. Among those who know this is an option, very few choose to wait. I went through the exercise of calculating my safe level of annual spending when taking CPP and OAS at different ages and found that I can start spending more today if my wife and I wait until age 70 for our pensions.

You can start CPP anywhere from age 60 to 70, and OAS can start anywhere from 65 to 70. I created a spreadsheet that calculates our CPP and OAS payments for chosen starting ages of these pensions. Then the spreadsheet calculates our estimated safe annual spending level throughout retirement.

Consider two scenarios:

Scenario 1: We both take CPP at 60 and OAS at 65
Scenario 2: We both take CPP and OAS at age 70

In both scenarios, we’re both retired now with no expectations of earning income in the future. The results were that Scenario 2 allows us to spend $3920 more per year (starting right now) compared to Scenario 1. This breaks down as $3100 per year extra for delaying CPP and $820 per year for delaying OAS.

To be clear, the $3920 per year is not how much the pensions increase due to taking them at age 70. In fact our total annual pension payments are $16,900 higher (in today’s dollars) in Scenario 2 than they are in Scenario 1.

Delaying our government pensions has two main effects:

1. We will dip more heavily into our savings during our 60s.
2. We’ll need to spend less of our savings after age 70.

Because we have to make our savings last in case one of us lives to be quite old, the total extra we spend from our savings in our 60s is less than the total of the boosted pension payments we’ll enjoy after age 70. This is what leads to being able to spend $3920 more per year (adjusted for inflation), starting right now.

It’s paradoxical that delaying receiving money leads to being able to spend more this year and every year going forward, but that’s what happens. Knowing that sizeable pensions are coming at age 70 makes it safer to spend more today.

Our circumstances don’t apply to everyone. Delaying government pensions won’t work if you don’t have enough savings to live on comfortably until age 70. If you’re so sure that you’ll die before you’re 80 (and your spouse will die young as well) that you’re willing to spend all your savings before you’re 80, then delaying taking government pensions doesn’t make sense.

However, the most common reason I hear from people for why they want to take their pensions early is that they want to spend some money while they’re young enough to enjoy it. But as I’ve explained, my wife and I get to spend more while we’re younger because we’re delaying our pensions. Your mileage may vary.

Friday, November 9, 2018

Short Takes: Retirement Income, Credit Card Balance Protection, and more

Here are my posts for the past two weeks:

Retirement Income for Life

Bonds can Outperform Stocks for Very Long Periods

The Problem with Bootstrapping

Here are some short takes and some weekend reading:

Dan Bortolotti answers a question from 60-year old Jerry W. about how he and his wife can generate $35,000 per year from their savings (combined $400,000 in RRSPs and $180,000 in TFSAs). Dan makes a number of excellent points, and concludes with “it would be worth considering whether it makes sense for you to take your CPP benefits before age 65.” We don’t know enough details about Jerry’s situation to make specific recommendations, but most people in this situation would actually be better off delaying CPP and OAS until age 70. It seems counterintuitive, but by shifting some longevity risk to the government, retirees who decide to take larger pensions at age 70 can safely spend more money when they’re 60.

SquawkFox explains why you should stay away from credit card balance protection insurance. CBC goes undercover to show that banks will do what they can to get you to buy this insurance.

John Robertson reports that there are new options for where to open an RDSP, including a robo-advisor.

Big Cajun Man has another angle on the benefits of eliminating debt. I get the feeling that he has debt on his mind.

Thursday, November 8, 2018

The Problem with Bootstrapping

If you’ve ever had someone run simulations of your financial plan, the whole process looks wonderfully scientific. Some software takes your financial plan and simulates possible future returns to see how your plans work out. But what assumptions are baked into this software? Here I use pictures to show the shortcomings of a technique called bootstrapping.

With monthly bootstrapping, simulation software chooses several months at random from the history of actual market returns to create a possible future. The simulator repeats this process many times to create many possible futures.

Instead of monthly bootstrapping, some simulators choose annual returns at random. Other simulators collect blocks of consecutive years. All these methods have their problems. Here we show the problem with monthly bootstrapping, but this problem applies equally well to annual bootstrapping.

I started with Robert Shiller’s online return data for total monthly returns of U.S. stock from July 1926 to September 2018 (1107 months). I then built 30-year portfolios with 2 methods:

1. Monthly bootstrapping
2. Rolling 30-year periods

For the bootstrapping, I simulated one billion 30-year returns. For each rolling period, I just started at a particular month in stock return history and collected 360 consecutive months of returns. To eliminate bias against months near the beginning and end of the historical data, I used “wrapping,” meaning that some 30-year periods began near the end of the historical data and wrapped about to July 1926 to complete the 30 years of returns.

So, while there were a billion bootstrapped returns, there were only 1107 rolling returns. This is part of the appeal of bootstrapping; you can create as many different possible futures as you like.

The following chart shows what the distributions look like. The distribution of rolling returns is very coarse because there are so few of them available in our stock market history. The bootstrap distribution also has bars, but they are so fine, we can’t see them.

The big thing to notice is that the two distributions don’t match well at all. Both curves have the same area under them, but historical returns are more bunched near the center. In fact, the rolling period results were within one percentage point of the mean return 47% of the time, but the bootstrapping results were within one percentage point of the mean only 28% of the time.

Why is this a problem? Because bootstrapping results are supposed to be realistic possible futures. If bootstrapping results don’t look much like the past, what makes us think they are a realistic model of the future?

Much of the theory of finance is built on a foundation of thinking in terms of annual returns. I repeated the process above for annual returns rather than 30-year returns. The next chart compares the bootstrapping and rolling distributions.

This time, the distributions match reasonably well. Someone who looks at just this chart could be forgiven for thinking that bootstrapping matches reality. But the small difference shown in this annual chart grows to the large difference we saw in the earlier 30-year chart.

Some will defend bootstrapping and claim the difference shown in the 30-year distribution chart isn’t enough to negatively affect portfolio simulations. This isn’t true. Actual 30-year returns are much less volatile than bootstrapping says they are. Testing financial plans with bootstrapping pushes people to higher bond allocations at too young an age.

What accounts for the difference we see in the 30-year distribution chart? It turns out that stock returns from one year to the next have correlations that bootstrapping eliminates. After stocks have had a good run, there is a tendency for them to have a below-average year. Similarly, stocks tend to have a good year after a poor run. This effect is too weak to exploit with market timing, but it does build up over the course of decades.

Does this mean we should be doing simulations using returns from rolling periods? Perhaps, but this method has its troubles too. There just aren’t enough rolling periods in history to draw statistical conclusions. The future likely won’t look exactly like any one period from the past.

But this isn’t an excuse to use bootstrapping. Actual returns show correlations over time. Bootstrapping strips away these correlations. There is a good quote William J. Bernstein attributes to Ralph Wagner about returns being like “an excitable dog on a very long leash.” For our purposes, the dog’s owner represents the collective fundamentals of U.S. businesses, and the dog represents stock prices. Fundamentals have volatility, but not as much as stock prices. Over one year, the dog can take you anywhere. The longer you own stocks, the more your returns follow the owner rather than the dog. We’re all still affected by the dog’s wanderings, but bootstrapping is like cutting the dog’s leash and letting it run wild.

None of this is any guarantee that stock market returns will take you where you want to go. There is no perfect way to peer into the future. Simulations that use bootstrapping have the appearance of scientific rigour, but their outputs have more decimal places than anyone can reasonably justify.

Tuesday, November 6, 2018

Bonds can Outperform Stocks for Very Long Periods

It’s widely believed that over 30-year periods, stocks have always outperformed bonds. However, recent research says this isn’t true. U.S. bonds beat stocks over the 30 years ending in 2011, and it happened many times in the 1800s according to retired professor Edward McQuarrie at Santa Clara University. However, the important question is what should we do with this information?

Jason Zweig at the Wall Street Journal reported on this research in his 2018 Nov. 2 article Sometimes, It’s Bonds For the Long Run, a play on the title of Jeremy Siegel’s excellent book Stock for the Long Run. It’s doubtful that Zweig is recommending that investors consider whether bonds are the best source of long-term returns, but his readers could be forgiven for thinking this.

The next chart shows McQuarrie’s data on 30-year rolling periods. This means that the return shown in a given year is actually the average returns over the previous 30 years. So, near the end of the chart where it shows the bond return higher than the stock return, this means that bonds beat stocks from 1982 to 2011 (by a whopping 0.15% per year).

It’s hard to get much of a feel for this information when we talk of average returns. So, let’s switch to dollars. Suppose an investor makes two equal-size investments in stocks and bonds, and lets them ride for 30 years. At the end, what is the ratio of the ending value of the stocks to the ending value of the bonds? The next chart shows this.

Consider our hypothetical investor who made two equal investments in stocks and bonds from 1982 to 2011. If the bonds had finished at $100,000, the stocks would have finished at $95,900. If we repeat this experiment for any other 30-year period in the past century, we get a much different story. The most extreme case is 1942 to 1971 where if bonds ended at $100,000, stocks ended at $2,130,000! For all 30-year periods ending between 1948 and 2001, stocks always more than doubled bonds.

The older data tell a different story. During much of the early 1800s, bonds beat stocks over 30-year periods. Most of the time, stocks lagged by less than 1% per year, but there was one period where bonds outperformed by a cumulative 94%. That would have been a good time to own bonds, but it’s nothing close to the dominance of stocks during most of the past century.

Zweig warns that history may repeat itself, possibly “in a way that investors who have all their money in stocks should hedge against before it’s too late.” Unfortunately, while hedging improves worst-case returns, it hurts long-term expected returns.  Perhaps Zweig's warning is at least partially a commentary on how the bull run in stocks since 2009 has to end in a crash at some point.

So, what should investors do? Should we be increasing our portfolios’ bond allocations? Should we be ready to switch to bonds if we see a repeat of the conditions that led to bond dominance in the early 1800s? For my own portfolio, my answers to the latter two questions are no and no. I already have sufficient fixed income in my portfolio.

Nothing has changed. Stocks are a better bet than bonds over the long run. Bond allocations remain a useful way to control a portfolio’s volatility. For any money I won’t need for a long time, I’d rather ride out stock market volatility than give away expected returns by owning bonds. Your mileage may vary.

Tuesday, October 30, 2018

Retirement Income for Life

If you don’t have a defined-benefit pension, odds are you’re losing some sleep worrying about saving enough money during your working years to retire well. You might even have a retirement savings goal in mind. With all this to worry about, you probably don’t think much about how to spend that money during your retirement. Probably something like the 4% rule will be good enough, right? Well, the 4% rule is better than no plan at all, but you can do a lot better.

Frederick Vettese explains solid strategies for the “decumulation” phase of your life in his excellent book, Retirement Income for Life: Getting More Without Saving More. He starts off showing how the 4% rule can fail, and then makes a sequence of 5 enhancements that improve the decumulation strategy significantly.

The five enhancements
  1. Reducing investment fees
  2. Deferring your CPP pension to age 70
  3. Buying an annuity with about 30% of your savings
  4. Being prepared to adjust your annual spending if markets boom or crash
  5. Taking out a reverse mortgage late in life if necessary

Many people will object to some of these enhancements. There is a very good chance that whatever objections you have, Vettese discussed them in the book and explained convincingly that you’re not right. It’s no fun to be proven wrong, but the upside is getting more income out of your retirement savings.

Enhancement 1: The benefits of reducing investment fees are obvious, except for those who don’t even realize they are paying huge fees on their mutual funds.

Enhancement 2: “Only 1 percent or so of all CPP recipients postpone the start of their CPP payments until age 70,” even though doing so can be so advantageous. And Vettese jokes that he’s not sure “if they started their CPP pension late by design or accident.”

Getting people to defer their CPP payments is a tough sell, as I’ve discussed before. If you think that wanting to spend money in your 60s while you’re still young enough to enjoy it is a winning argument, I’m sorry to say that this idea doesn’t hold water for people with at least $100,000 in savings (double that for a couple). The truth is that planning to delay CPP makes it possible to spend more in your 60s safely.

The arguments for delaying CPP to age 70 apply nearly as well to delaying OAS payments to age 70. However, Vettese worries that getting people to delay CPP is a hard enough sell without asking them to delay OAS too.

Enhancement 3: Annuities are another tough sell, but the proof that they help when markets give poor returns is in Vettese’s well-explained simulations. My trouble with annuities is that the market for them seems so opaque. There is limited information available to compare payouts of standard annuity types. I’m interested in annuities whose payouts rise by 1% or 2% each year, and I’ve never found a way to get payout information online. I’ve seen elderly members of my extended family negotiate GIC rates with their banks, and still end up with rates more than 1% below what was available elsewhere. I’m afraid that will be me with annuities because I don’t know how to find the best payouts.

At one point, the author admits to being surprised when his simulations showed that delaying CPP and buying an annuity weren’t “a net drag on retirement income when investment results are good.” I’m not surprised because both enhancements shift longevity risk away from the retiree to either the government or an insurance company. The book’s simulations assume a long life where you win at life but lose at longevity risk.

Enhancement 4: The benefit of being prepared to adjust your spending is that you don’t have to leave such a huge margin of safety. “The idea behind dynamic spending is that a voluntary, controlled reduction in spending made early enough might enable you to avert a more drastic and involuntary cut later on.”

Enhancement 5: Vettese calls reverse mortgages “the nuclear option.” They’re not a core part of his plan. But if markets perform badly for many years, and you’re safety margin wasn’t enough, starting a reverse mortgage late in life can make sense.

With a reverse mortgage “You cannot be forced to move out. You do have to maintain the house, however.” These statements seem to contradict each other. If you don’t maintain the house well enough, can you be forced out? From experience, I can tell you that old people often stop maintaining a house properly once they have physical or mental problems or run short of money.

Your spending pattern

“The traditional advice for middle- and high-income earners is to shoot for a retirement income target of 70 percent of final average earnings.” The book goes through the numbers to show that this is too high for most people. In retirement, your income taxes go down, you don’t need to save any more, you probably finished off the mortgage, and your kids probably cost less. Few people need 70% of their former income to end up with the same standard of living.

Academic studies consistently show that our inflation-adjusted spending declines, on average, through retirement. Based on this finding Vettese’s simulations assume that your inflation-adjusted spending will be flat in your 60s, decline 1% each year in your 70s, decline 2% each year in your 80s, and remain flat thereafter.

It makes intuitive sense that you slow down and spend less as you get older, and academic studies support this idea. However, as I’ve argued before, I see problems with planning for your retirement spending to decline this much as you age.

My main objection is that some people start to spend less because they overspent early in retirement, and now they have no choice. I’m not saying this applies to everyone, but it does apply to a nontrivial number of people. Few people will admit to this easily, though. I had a long discussion with my neighbour about how he works part-time in retirement. It began with talk of needing something to do, but he eventually got around to admitting indirectly that he needed the money.

Vettese’s model of declining spending has your spending dropping by 26% from age 70 to 90. This is a big drop. Things like property taxes, house insurance, and house repairs won’t decline that much, so everything else has to drop by even more. I can believe that people do spend this much less, on average, but for some the decline is forced rather than a choice.

The book argues that “couples aged 75 and over either saved or gave away as cash gifts an average of 16.1 percent of their income. Couples 85 and older saved or gave away even more. Saving so much ... showed that the drop in spending had little to do with insufficient income.” This shows the problem with trying to reason with average figures. The saving and giving away of 16.1% of income is a mix of people giving away more than this, some giving away less, and some giving away none. You can’t then conclude that nobody is short of income. This just isn’t true.

A UK study reported that “most of the 80-year-old respondents said that their spending was not constrained by a lack of money.” Most is not all. The existence of people whose spending declines due to lack of money skews the study’s results.

Ideally, we’d like to base our retirement spending plans on the experiences of people who make the choices they want rather than those who are forced to spend less due to running out of money. It would be nice to go back to the academic studies and ask the researchers to remove data from people whose spending was forced to decline. Then we could see what happens when people do what they naturally want to do. If we could do this, there might still be a spending decline with age, but I’m guessing that the decline would be less than what Vettese uses in his simulations.

All that said, though, I still find the book’s 5 enhancements very interesting. I suspect that using lower spending decline percentages would make some difference, but that the enhancements still make sense.

Some good quotes

“You have to invest in stocks if you want a decent return over the long run.”

“I don’t see any good reason to adopt a stock weighting as low as 50 percent in your RRIF or RRSP, apart from wanting to avoid a lecture from your financial planner.”

“I used to do market research on my own and trade individual stocks. It was hubris to think I was smarter than the crowd.”

A salesman trying to choose the right size of fridge in a sitcom asks “How many cubic feet of food does your family consume in a week?” In figuring out whether you’ve saved enough, Vettese doesn’t want to make the same mistake and says “I’m not going to ask you how many cubic feet of money you will consume in retirement.”

Using DSCs “is one of the most odious practices a fund salesperson can perpetuate on an innocent investor.” “The salesperson might say it is for your own protection—so you don’t jump from one investment to another too often—but this is like a third-world employer saying that he locks in his migrant employees at night ‘for their own protection.’”

Online Calculator

The author generously makes a retirement income calculator available free online. This calculator never asks for your name or email address, and you get a pdf file of your results.  It tells you how much you can spend in retirement under different scenarios.  Seeing the benefit of Vettese's enhancements for my own situation is very interesting.  The first time I tried the calculator, there were a few hiccups, but they appear to have been fixed.


This is an excellent book that will challenge your preconceived ideas about retirement spending. Anyone with 6-figure or better savings will face difficult choices about how best to spend this money during retirement. Few financial advisors are knowledgeable enough to help much. This book is a good starting place for making these important decisions.

Friday, October 26, 2018

Short Takes: Securities Lending, Pot Stocks, and more

Here are my posts for the past two weeks:

Beat the Bank

Getting Even by Owning Big Business Stocks

Here are some short takes and some weekend reading:

Dan Bortolotti discusses the “catch” with zero-fee index mutual funds. Dan says “there is no catch here,” but I’d like an expert opinion on the securities-lending practices of different index mutual funds and ETFs. Who gets the interest the funds collect from short-sellers who borrow stocks? How much hidden risk is there for investors?

Dan Hallett analyzes the price levels of pot stocks.

Squawkfox explains how social media and FOMO can make you unhappy and cost you money.

The Blunt Bean Counter explains clearance certificates from CRA for a deceased person’s estate. Without one, the executor(s) could be held personally responsible for any taxes CRA comes looking for after a reassessment. This is timely for me because I’ll be filing tax returns for an estate next spring. I’m still on the fence about whether a clearance certificate is needed in my case, but now I understand the issues better.

John Robertson makes a convincing argument that we need to keep our investment plans as simple as possible.

Thursday, October 25, 2018

Getting Even by Owning Big Business Stocks

Common advice to make up for high bank fees is to buy bank stocks to get your money back in dividends. We could extend this to the big telecommunications companies as well. I decided to look at how I stand in collecting dividends from these companies vs. what I pay for their products.

On the dividend side, it’s not a good idea for your portfolio to be too concentrated. I own Canadian stocks through Vanguard’s Canada All Cap Index ETF (ticker: VCN). The part of VCN’s dividends that come from the six big banks plus Bell, Rogers, Telus, and Shaw amount to about 34 cents per share each year.

So, suppose you add up what you pay to these businesses and it comes to $1000 per year. As I write this, you’d have to own $90,800 worth of VCN to collect $1000 per year in dividends. Of course, these businesses don’t pay all of their earnings out in dividends, so you could own a little less VCN than this to have the total profits cover your costs.

You could also argue that these businesses do provide some value, and we shouldn’t say the entire $1000 is lost to insufficient competition. Prices might be only triple what they would be with meaningful competition. In the end, you might decide that $50,000 worth of VCN is enough to cover your costs deriving from our uncompetitive markets.

On the other hand, most of us will find that we give more than $1000 per year to these businesses. For the telecommunications companies, we should include mobile phone plans, home phones, cable, and internet access.

Assessing bank costs is trickier. If you haven’t figured out that there are free chequing accounts, these fees are easy enough to add up. Bank deposits are typically paid about 2% less interest than current short-term bond yields. Credit cards make almost everything more expensive whether you pay by credit card or not. Net of credit card rebates, I’m guessing I pay an extra 1% on almost everything I buy. Then there’s the cost of unreasonably high interest rates on all forms of debt.

In the end, I was surprised at how much I pay to Canada’s big, bloated, government-protected businesses. Fortunately, what I get back in dividends from these companies is a little higher. That’s good for me, but the vast majority of Canadians end up on the wrong side of this comparison.

Wednesday, October 24, 2018

Beat the Bank

It can be frustratingly difficult to get the masses to understand how important it is to control investment costs. Ex-banker Larry Bates does an excellent job of explaining what he calls Simply Successful Investing in his book Beat the Bank. Canadians who hand their savings over financial advisors at banks or elsewhere need to read this book.

Bates knows that people don’t want to become investing experts. “There are countless things about investing you don’t need to know: this book focuses on the few things you do need to know.” You don’t have to “listen to the daily tsunami of utterly useless media chatter about the financial markets.”

As a career banker, Bates understands the harm that bank mutual funds do to people’s savings. This harm became personal after a conversation with his sister. He was left embarrassed and ashamed after learning that she was taken in by his employer’s high-fee mutual funds. “Fees are stealth wealth killers.”

The book refers to “top banks, insurers, and mutual fund companies” as Bay Street, the downtown Toronto street where many of these companies are headquartered. “Bay street fees continue to quietly strip away 50 percent or more of the lifetime investment gains of millions of Canadians.” When I tell people this, they typically react with disbelief. Maybe they’ll believe it coming from a former banker.

Bates has a web site where you can get your “T-Rex score,” which is a measure of “how much of your investment return you will actually get to keep.” T-Rex is short for Total Return Efficiency Index. The catch is that you have to know what you pay in annual fees to get your T-Rex score. This is a challenge for the blissfully-ignorant investors who think they don’t pay any fees.

The book lists the T-Rex scores for many of the biggest mutual funds in Canada. The average score is a pathetic 45%. The missing 55% is what Bates calls “true fees.” “Freedom 55? I think not. More like 55 percent of your money is gone.”

The biggest mutual fund providers don’t care which of their funds you invest in, as long as they get your money. That’s why they “operate hundreds of mutual funds at any given point in time. This means the big players will almost certainly have at least some four-star and five-star ranked funds.” This is true even if the good results in a few funds are just blind luck.

According to Burton Malkiel, “A blindfolded monkey throwing darts at a newspaper’s financial pages could select a portfolio that would do just as well as one carefully selected by experts.” Bates continues with the monkeys asking us to “imagine a mutual fund provider named Simian Fundco employs eight monkey to select stocks.” After a year, four outperform. After another year, two outperform again. After three years, one monkey has outperformed three straight years. This monkey “is anointed as Simian’s new star.” No actual skill is required to advertise a star money manager.

In a call for action, the reader is asked to “Choose One: 1. Make Bay Street Rich 2. Make Yourself Rich.” Unfortunately, most Canadian investors have unwittingly chosen option 1.

To entice readers to learn a little about investing, he distinguishes between a do-it-yourself (DIY) investor and an assemble-it-yourself (AIY) investor. DIY investors devote much of their time to following individual stocks and reading annual reports. AIY investors just choose some low-cost index funds and ignore their portfolios most of the time. The book gives examples of good index funds for building a complete AIY portfolio. By these definitions, I was a DIY investor for a while; I had a good year followed by a bad decade. Now I’m a happy AIY investor.

One barrier to becoming an AIY investor is the fear of doing something wrong when making online trades with a discount broker. Even though I’ve been doing this for almost two decades, it still makes me nervous to make 5- or 6-figure trades. I wasn’t aware that most discount brokers have practice accounts “to get familiar with buying and selling processes before you consider doing the real thing.” This sounds like a great idea to dispel fear of the unknown.

For those who still find AIY investing more than they want to take on, robo-advisors are an option that Bates includes in his definition of Simply Successful Investing. Robo-advisor fees are higher than teh MERs of low-cost index funds, but they are still far lower than typical Canadian mutual fund fees.

In a discussion of DIY investing (stock-picking), Bates tries to put stocks into categories: Blue Chip, Moderate Risk, and Speculative. However, these categories are illusory, as the author later admits. Any stock can fall to speculative status before you figure out you should sell. Nortel “is a particularly prominent and painful Canadian example.” Bates credits stock-pickers with near 100% T-Rex scores, but invisible losses from competing with pros on stock selection make stock-picking a bad choice for most investors.

“Long-term business ownership through the stock market is a bet on the continued ingenuity, dynamism, growth, and prosperity of today’s North American businesses and tomorrow’s budding entrepreneurs.” It pays to be optimistic about the future as long as you protect yourself adequately from short-term paper losses. “Today’s bonds are virtually useless at building wealth,” but they “can be highly effective at protecting wealth.”

“Canadians love ‘balanced’ mutual funds.” However, the fees are stripping away almost all of the bond returns as well as too much of the stock returns. “High-fee balanced mutual funds are conveniently lucrative for Old Bay Street and simply awful for investors.”

You’re better off being a bank owner than a customer. “If you think Bay Street banks overcharge, earn enormous profits, are protected by the government, generally get away with murder, and will continue to do so, there is a perfect way for you to address the ‘inequity.’ Include bank stocks in your portfolio. Make bank profits work for you.” This is good advice to a point, but don’t miss the book’s message about diversification. Unfortunately, many Canadians have portfolios dangerously concentrated in Canadian bank stocks.

One piece of advice I don’t agree with is to make trades at the market price. Limit orders are safer. Just pick a price a few cents worse than the current bid or ask. So, if the market says you can buy at $20, you can set a limit of $20.05. If all goes smoothly, you’ll get the $20 price. If the market price happens to run away at that moment, you’ll pay at most $20.05 per share or trade won’t execute. In addition to protecting you from major market movements, limit orders help you avoid spending more than the amount of cash you have in your account.

Among the investments Bates thinks you can safely ignore are gold, preferred shares, corporate bonds, and Bitcoin. Sounds sensible to me.

A nitpick is the two quotes about compound interest attributed to Albert Einstein. Fact checker Snopes finds this attribution “dubious” because “Einstein died in 1955, but the earliest mention we could find of this item was in a 1983 New York Times blurb.”

This book delivers on its promise to stick to the few things you need to know about investing. I highly recommend it for any Canadian who has or expects to have enough savings to invest.

Friday, October 12, 2018

Short Takes: Killing Mutual Fund Reforms, Taxing the Rich, and more

Here are my posts for the past two weeks:

Managing a GIC Ladder in Retirement

More Money for Beer and Textbooks

My House vs. My Stocks

Here are some short takes and some weekend reading:

Gordon Pape takes Doug Ford and Vic Fedeli, Ontario’s Finance Minister, to task for “dumping cold water” on Canadian Securities Administrators’ mutual fund reforms “that would significantly benefit investors.” This position “flies in the face of everything the Premier claims he stands for.”

The C.D. Howe Institute reports that the 4% increase in the top federal income tax rate didn’t produce the hoped-for $3 billion increase in tax revenues. Instead it resulted in a slight decrease in combined federal/provincial tax revenues. My own retirement made a small contribution to reducing tax revenues in the future.

Canadian Couch Potato interviews Larry Bates who is trying hard to explain to Canadians just how much of their investment gains are getting consumed in fees. Check out his “T-REX Score” calculator.

Preet Banerjee interviews Ben Rabidoux for an interesting discussion of real estate across Canada from the points of view of both owners and renters.

Robb Engen at Boomer and Echo answers questions from a reader considering borrowing money to invest. Robb does his best to offer the alternative of not borrowing, but just investing available cash from income. However, I’ve never had much success in talking people out of using leverage to buy stocks.

Wednesday, October 10, 2018

My House vs. My Stocks

My wife and I bought our house in mid-1993. We’re at the young end of the baby boom, but we bought our house when we were fairly young. As a result, we’ve lived through the huge run up in house prices older boomers have enjoyed. In 25 years, the price of our house has gone up about 160%. So, how has this compared to our investment portfolio?

Well, in that same period of time, our portfolio has had a cumulative return of 1030%. That might seem to end the comparison, but real estate is typically a leveraged investment. We paid off our home quickly, so we didn’t get much advantage from the leverage. But what if we had used leverage?

The average discounted mortgage rate over that period was about 5%. Suppose we had put 10% down and made payments on a 5% mortgage for 25 years. The Internal Rate of Return (IRR) on our investment works out to 5.8% per year or a cumulative return over the 25 years of 307%.

It might be tempting to add in a return from not having to pay rent, but it’s doubtful that the rent on a comparable house would have been more than we’ve paid in property taxes, insurance, maintenance, repairs, and upgrades.

We figured out early that it didn’t make sense to pay high mutual fund fees on our investments. If we had paid an extra 2% each year, our cumulative investment return would have been 580% instead of 1030%. This brings the 307% real estate return closer, but our investment portfolio still wins.

What’s the point of all this? Even though we owned a home during one of the best periods in history for real estate, our other investments performed better. There may be some people whose homes outperformed stocks, but far fewer than most would guess. When we think about our homes being worth a couple hundred thousand dollars more than we paid, it’s easy to forget about the costs of ownership and the long period of time it took to get that return.

Looking forward, real estate can continue to appreciate, but certainly not at the same pace it did for baby boomers. For now, young people are better off financially renting rather than owning. This is true even if they choose to rent a single-family dwelling rather than an apartment. To get full advantage of the lower cost of renting, they need to sock away some of their monthly savings to invest.

Tuesday, October 9, 2018

More Money for Beer and Textbooks

When I headed off to university, I was pretty naive about money. It’s safe to say that this is true of most kids starting post-secondary education. There are lots of ways to get yourself into financial trouble at school. This is where Kyle Prevost and Justin Bouchard come in with their book More Money for Beer and Textbooks. These authors offer Canadian students and their parents solid information that I wish I had back when I was in school.

This book isn’t purely about finances. Just because one choice is more expensive than another doesn’t necessarily make it a bad choice. The authors discuss cost differences and weigh them against other advantages and disadvantages.

They start with how much school will cost and the relative costs of being on and off campus. They also offer a number of tips on finding one or more of the scholarships and bursaries available, many of which never even have one student apply. You’re not likely to find many other books that even devote a section to partying on a budget.

Other sections include RESPs, student loans, summer jobs and part-time work, cars, credit cards, saving on textbooks, and choosing in-demand careers. Throughout, the writing style is clear and (mostly) fun. No matter how hard you try, the details of RESPs may be important, but they’re not fun.

There’s not much negative to say about this book. They made a joke about unclaimed scholarships that made a reference to taxes on lottery winnings, but Canada doesn’t tax lottery winnings. A few details about tax credits have changed since this book was printed in 2013.

The authors don’t pull any punches in their discussion of banks: “many parents are extremely confused about how any sort of registered plan is used, because bank employees and investment advisers make a lot of money on this confusion.”

Few people truly understand how expensive cars are, but these authors get it. They go over the various costs and conclude “The truth is that owning a car is an absolute money pit.” That said, though, they go on to give practical advice for those who want a car despite the costs.

Despite the fact that both authors have liberal-arts degrees, they are quite blunt about the poor job prospects for new graduates with liberal-arts degrees. “Many scholars and post-secondary institutions believe that the goal of a liberal-arts education is simply to give people a well rounded education after high school. Many students believe that the goal of a liberal-arts education should be to provide them with the skills and credentials to succeed in the job market. There is a fundamental contradiction here.”

A problem with our education system is that “More and more [teachers] swam the liberal-arts streams to get there (go ahead and walk in to an elementary school and see how many teachers there have any math background at all).” Among other problems, this leads to “an overall deficit of enthusiasm and knowledge surrounding skilled labour in our academic system.”

I recommend this book to post-secondary students and their parents. It’s a wealth of knowledge about how schools work. It will answer important questions many students never would have thought to ask.

Friday, October 5, 2018

Managing a GIC Ladder in Retirement

The following good question about managing a GIC ladder during retirement came from AT in Calgary (edited for length and privacy):

I’m 100% FIREd and have no regrets about this. After working for 30+ years, I was just done. I spent the better part of a year learning about money, and your articles have been particularly helpful.

I have put 3 years into GICs (1,2,3) and the '1' comes due 2019 May 1. Assuming I stick with the 3 year model, do I roll that one into a new 3 year GIC and then continue as before?

That seems to make sense but here is my question that I can't quite wrap my head around. If I lock it in on May 1st, then what happens if the market crashes on May 2nd? Somewhere there has to be a cash cushion for that year unless I just have to bite the bullet and draw down my registered money. What do you think?

First of all, congratulations on retiring! I know I felt great about retiring to my personal projects rather than doing what other people wanted me to do. I’m glad you like the blog. I’ve learned a lot about finances writing it.

I’ll describe how I handle the cash and GICs part of my portfolio, and you can decide for yourself whether you want to apply it to your own portfolio. I began retirement with 5 years’ worth of spending in cash and GICs, and have the rest of my portfolio in stocks. One year of cash was in a High-Interest Savings Account (HISA) at EQ Bank paying 2.3% interest. The other 4 years were in GICs of duration 1, 2, 3, and 4 years. Note that I don’t have a 5-year GIC.

During my first year of retirement, I spent the cash in the HISA. At the end of that year, my 1-year GIC came due. Because nothing bad had happened in the stock market, I rolled the GIC cash into a new 4-year GIC, and sold stocks to refill the HISA. So, I started the year with 5 years of cash and GICs, but this dwindled to 4 years before I topped it up again.

Suppose the stock market had crashed so severely that I decided to reduce my annual spending. To make this more concrete, suppose my planned annual spending from my portfolio had dropped from $50,000 to $45,000. With $50,000 in cash and $150,000 in GICs, I would only have needed to sell $25,000 worth of stocks to get to 5 years’ worth of cash plus GICs. $45,000 would then have gone into my HISA, and I’d have bought a $30,000 4-year GIC.

There are plenty of minor complications in all this. One is reducing the amount in the HISA and GICs to account for dividends in non-registered accounts that you could spend instead of reinvesting. Another is that a buying a small GIC could lead to being short of cash in the future. This is easy enough to handle by just keeping a little extra cash in your HISA. Of course, you have to stay on top of your spending level. You can’t start spending more just because there’s extra cash in the HISA.

The important part of all this is that I always have enough cash in the HISA to maintain my planned spending level until the next GIC comes due. So, I’m never in a position of having to draw down my stocks during a short-term mid-year stock market crash.

So, AT, you can compare your approach to mine and decide whether there is anything you want to change. Good luck.

Friday, September 28, 2018

Short Takes: Dumb Ideas, Financial Crisis, and more

Here are my posts for the past two weeks:

Interest Tax Deduction When Borrowing to Invest

What Does FIRE Mean?

Here are some short takes and some weekend reading:

James Clear explains why we cling to dumb ideas.

Tom Bradley at Steadyhand draws five lessons from the financial crisis. My favourite: “In the depths of despair, I heard many investors say they no longer expected much from their stock portfolio. This couldn’t have been further from the truth.”

The Rational Reminder Podcast interviews Robb Engen who has sensible takes on a number of investment issues.

The Blunt Bean Counter has a lot of dealings with CRA on behalf of his clients, and he shares his recent experience with delays and CRA areas of focus for information requests.

Boomer and Echo dig into Vanguard and Horizons single-ETF solutions.

Wednesday, September 19, 2018

What Does FIRE mean?

The hugely popular term FIRE stands for Financial Independence, Retire Early. There are countless articles and blogs devoted to the FIRE movement. But what does FIRE mean? The answer is different from what many would guess.

Financial Independence

Let’s start with the FI part of FIRE: are those who say they’ve FIREd financially independent? Here’s my definition:

You are financially independent if you have enough money or other assets to cover the costs of living the life you want for the rest of your life without having to earn more money along the way. You can be financially independent if you depend on truly passive income such as dividends, capital gains, interest, or a business you own but where you don’t work. However, there should be sufficient margin in your assets and passive income to cover possible market crashes or increased spending needs with reasonably high probability.

Based on this definition, few people who have FIREd are financially independent. Some still depend on a spouse who works. Others work part-time, or they work full-time at something they like much better than their former job. Others stripped down their spending drastically to make their spending match the income their assets produce. This doesn’t preclude being financially independent if their assets have some margin and their spending level is sustainable. Unfortunately, ultra-low spending that you can handle in your 30s may not be sustainable in your 60s or 70s, even after adjusting for inflation.


Next, let’s look at retirement. People have many definitions of retirement. Mine depends on how much of your time you spend earning income. So, if you’ve quit your full-time job and now spend a few hours a week making some money on the side, I’d say you’re “mostly retired.” Working full-time on a blog to earn income makes you “not retired.” There’s a whole continuum from not retired to fully retired. Based on this definition, few of those who have FIREd are fully retired. Most aren’t even half-retired because of how much they work.

So, what does FIRE actually mean?

The most broadly applicable definition of FIRE I can come up with is it has come to mean quitting the job you hate. I can relate to this. The older I get, the less interested I am in doing what other people want me to do. Those who have FIREd have found a way to get by without working at the soul-destroying job they came to hate.

If they’re not financially independent or retired, were they wrong to FIRE?

Not at all. It’s perfectly sensible to pursue happiness. Why work at a job you hate until you reach true financial independence if it’s possible to get along fine doing something else? If you do quit the job you hate at a young age, why is it important to be fully retired?

The main problem with FIRE is that it is completely misnamed. As long as FIRE enthusiasts call themselves financially independent and retired, critics won’t go away. I don’t have a better name, though. It’s hard to beat the marketing power of screaming FIRE, even if the words making up this acronym apply very poorly.

My case

I guess I FIREd a little over a year ago. I didn’t hate my job, and I did wait until I was solidly financially independent. I was tempted to leave earlier, but I knew I could never get a job at the same pay again if my skills got stale for 5 or 10 years. By age 70, I doubt I could get a job at one-quarter of what I used to make. So, I stayed with my job until I had a large safety margin of financial independence.

Whether or not I’m retired is debatable. I don’t blog for money; it’s a hobby I enjoy. My blog’s income is now solidly in the 3-figure range. I’ve discussed consulting work a few times in the past year, but haven’t done any work yet. I don’t see any point in deciding now whether I will ever work again. I’ll do what I want when the time comes.

I wish all those who have FIREd well. I worry about some who count on maintaining ultra-low spending for the rest of their lives. Expenses have a way of creeping up as you age. That said, I’m a supporter of finding a way to get away from work you don’t like.

Tuesday, September 18, 2018

Interest Tax Deduction when Borrowing to Invest

Last week’s article on Smith Manoeuvre risk sparked reader RS to ask the following thoughtful (lightly-edited) question:

Have a mortgage and have non-registered investments (mostly in XIC) that can cover a significant portion of my outstanding mortgage. Wondering if it will make sense to pay off the mortgage using non-registered investments and take a HELOC and buy the same (or similar to avoid attribution) assets. I will be in the same position as I am now, but now I will be able to write off interest (which will be about 25% more in HELOC). My marginal rate is 50%, so I guess it might be advantageous. I will also need to factor in any capital gains taxes (25% of gains) that I will incur now against the savings. But this thinking sounds too simplistic. Not sure if I am missing something here.

I don’t think you’re missing much. Given that you have had a mortgage at the same time as building non-registered investments, it would have been better to have set things up to make your interest tax-deductible from the beginning. But that’s water under the bridge now.

If we take it as given that you will maintain your leverage, then whether to proceed with the change depends on the numbers. You can project a likely outcome over whatever period of time you plan to maintain your leverage, calculate your costs and savings in each scenario, and choose a winner. I’m guessing the numbers will favour making the change to make your interest tax-deductible, but I’d have to see all the numbers to be sure.

Keep in mind that CRA has a number of requirements you have to meet before they will allow you to deduct interest costs. Be sure you understand them before you proceed.

The purpose of my original article was to make people think about whether they want to leverage their stock investments at all. So, in addition to possibly making the change you’re contemplating, you should consider whether to just pay off your mortgage to reduce risk and not get a HELOC.

Whether this lower-risk scenario makes sense can’t be determined by running numbers on most likely scenarios. You choose to de-risk based on the possibility of a very bad scenario. Would a crash in stock prices, house prices, and widespread layoffs leave you devastated, or would you be okay? This is the right way to think about the level of risk you take on.

My personal choice years ago was to pay off my mortgage before I started building non-registered investments. Only you can decide how much risk you want to take on.

Friday, September 14, 2018

Short Takes: Pain of Spending, Condos, and more

Here are my posts for the past two weeks:

Avoiding the Stock Market

Where Retirement Income Plans Fall Down

10 Ways to Stay Broke Forever

Smith Manoeuvre Risk Assessment

Here are some short takes and some weekend reading:

Joe Pinsker has a very interesting article about lowering spending by increasing the pain of spending. In the end, I’m suspicious that making yourself feel pain about all spending isn’t sustainable. Somehow we need to feel fine about sensible spending and feel pain for dumb spending.

Condo Essentials has a list of signs that will allow you to spot a bad condo before you buy it. I’m not a big fan of buying overpriced condos, but you should at least check for these problems before diving in.

Canadian Couch Potato compares bond ETFs to GICs for retirees.

Big Cajun Man explains why you might want to open an RESP for your disabled child instead of using an RDSP only.

Boomer and Echo review Larry Bates’ new book, Beat the Bank: The Canadian Guide to Simply Successful Investing.

Thursday, September 13, 2018

Smith Manoeuvre Risk Assessment

The Smith Manoeuvre is a tax-efficient way to borrow against your home to invest more in stocks. This increases your potential returns, but also increases risk. Periodically, it makes sense to evaluate whether you can handle the potential downside.

It’s clear that if you can follow the Smith Manoeuvre plan through to near retirement without collapsing it at a bad time, you’ll end up with more money than if you hadn’t borrowed to invest. The important question is how likely you are to be forced to sell stocks to pay your debts at a bad time.

It’s easy to decide you’re safe without really considering the risks. I find that employees, particularly in the private sector, underestimate the odds of getting laid off. Most of the time, they’ll say it can’t happen. But it can. You can lose your job, stocks can fall, real estate prices can fall, and all 3 can happen at once.

In fact, a single event could trigger all 3 bad outcomes. Anything that could cause stocks to drop 30% could easily cause sky-high Canadian real estate prices to drop significantly as well. The resulting pressure on businesses could lead to layoffs. This isn’t a prediction; it’s just one possible outcome out of many. This raises the following question.

Could you keep your financial plan going if the total value of your house and stocks dropped below your total debt at the same time as you’re unemployed for a few months followed by employment at a lower salary?

A gut feel isn’t really an answer to this question. A real answer comes from looking at numbers, including your essential spending, available cash, and the amount of reduced cash flow.

If your answer is that you couldn’t survive a scenario like this without selling stocks or your house to make payments on your debt, then you should consider reducing your leverage now (which is just a fancy way of saying you should sell some stocks now to pay off some debt while stock prices are high).

If your answer to this question is that you’d be fine in this scenario, or at least you could come out of it with minimal damage, then good for you. If your answer is that such a bad scenario can’t happen, then I wish you luck because it did happen in the U.S. in 2009.

Tuesday, September 11, 2018

10 Ways to Stay Broke Forever

One starting point for improving your personal finances is to look at what doesn’t work. This is the approach Laura J. McDonald and Susan L. Misner take in their book 10 Ways to Stay Broke Forever. The authors offer many suggestions for changing negative spending habits, but the book also contains a number of parts that make me question the authors’ numeracy.

Financial education “tends to be technical, overly complex and written in obscure, jargon-filled prose. As a result, it often fails to reach the very people for whom it is designed.” This book is quite easy to read. However, some attempts to lighten the subject matter seem forced, such as starting an explanation of liquid assets with “This always makes us think of the bottle of PatrĂ³n Gold tequila stashed in our freezer.”

Positive aspects of the book include discussions about cars. Rather than leasing, if you save up before you need a car “you could go buy that sweet ride outright, with cash.” Another section has some creative ideas for carless alternatives.

If we’re having financial troubles, the authors recommend a “personal finance reboot” to “shift us from a bad pattern into a better one.” One step is to “Check your bank balance online every day to gain awareness of your cash flow levels at all times.” Another is to “Give the plastic a rest and use cold hard cash for awhile.”

On dining out, some tips for saving money include having “a long, leisurely weekday brunch or lunch rather than a dinner,” and “eat dinner at home and then head [out] for dessert and a glass of wine.”

One piece of advice I don’t agree with is to “Buy instead of rent” your home. Too many young people are digging themselves big holes and would be better off renting until home prices are more affordable.

In one baffling section, the authors steer readers to investing “with your friendly neighbourhood bank.” “The personal financial representatives at the bank are trained to help beginner savers and investors understand their options through the use of plain language and straightforward advice.” Either that or they’re heavily-pressured salespeople steering their customers into ridiculously expensive mutual funds.

There were several parts of the book that had me questioning the authors’ numeracy. They claim that Total Debt Service Ratio (TDSR) is also known as “Debt-to-Income Ratio.” It isn’t. TDSR is the payments you have to make on your debt divided by your income, not debt divided by income. Typically, to get a mortgage, your TDSR must be below about 40%. Knowing this “it might shock and appall you to learn that the average Canadian household’s debt-to-income ratio is a whopping 163 per cent. So, yeah, this is a problem.” Because these are different measures, comparing the 40% TDSR limit to the 163% debt-to-income ratio is meaningless.

A survey “found that 61 per cent of Canadians believe they have less debt than the average Canadian. Since that is statistically impossible, it seems we might have just found our common national characteristic: debt denial.” It’s not statistically impossible. In fact, their next paragraph includes “the average credit card debt is $3277.33. Forty-one per cent of Canadians have credit card debt of more than $3,000.” So, 59% have credit card debt under $3000, and even more have credit card debt under the average amount ($3277.33). It’s important to understand the difference between average and median.

In a list of the components of the purchase prices of a car, the first entry was “Price of your car ÷ monthly payments.” This formula gives some number of months, which obviously isn’t part of the purchase price of a car. Perhaps they meant “payments times number of months.” It’s bad enough that someone wrote this, but apparently all the book’s proofreaders either didn’t see it was wrong or just glossed over anything that looked mathematical.

A “BMO report found that 43 per cent of Canadians sometimes spend more in a month than they earn.” That sounds bad until you try to figure out what it means. I sometimes spend more in a month than I earn. Over the years, I’ve paid for a pool, a deck, new windows, new flooring, a new fence, and other big-ticket items. In each case I spent more that month than I earned. I’m willing to bet that 43% should actually be over 99%. So what was this statistic actually measuring? Your guess is as good as mine.

These innumeracy problems may not affect the bulk of the book that is intended to give people practical ideas for breaking out of self-destructive spending patterns. However, when I see authors get things like this so wrong, it makes me doubt other parts of the book. Many things I already knew, but how much trust should I put in the parts I didn’t already know? I can’t recommend this book.