Friday, May 25, 2018

Short Takes: Trailer Class Action, Bogle Responds, and more

Here are my posts for the past two weeks:

Skin in the Game

Asset Location Errors

Here are some short takes and some weekend reading:

Salman Ahmed at Steadyhand explains a proposed class action lawsuit against TD’s asset management division over trailing commissions. These fees are supposed to be for advice, but discount brokers aren’t allowed to offer advice.

John Bogle responds to critics.

Jason Heath explains the potential problems with taking “dad’s money now to avoid probate.”

Big Cajun Man’s daughter ran into the same problems he’s had with investing in TD e-Series funds. She thought she opened a TD Direct Investing account, but it was actually a TD Mutual Fund account.

The Blunt Bean Counter explains rules for capital gains and losses on a terminal tax return. I wasn’t aware of some of the choices an executor can make.

Robb Engen at Boomer and Echo says he’s still on track to reach financial freedom at age 45. For most people, I tend to be skeptical that at age 40 or earlier they can predict their spending needs and desires in their 60s and beyond. However, in this case, Robb has proven he can create non-trivial alternative streams of income, and he intends to keep them going after he gives up his full-time job. Most people would be happier spending an extra year in their regular job instead of scrambling ineffectively looking for some sort of part-time income. Robb is an exception.

Robert McLister explains recent changes to mortgage rules that will help some borrowers get lower mortgage rates.

Wednesday, May 23, 2018

Asset Location Errors

Deciding how to split your stocks, bonds, and REITs across your RRSPs, TFSAs, and taxable accounts can be confusing. Even well-known authors and web sites such as Gordon Pape, Robert Brown, and 5iResearch make basic mistakes. The best way I know to prevent some fundamental mistakes is to think of your RRSP as partially belonging to the government. Recently, Canadian Couch Potato portrayed this way of thinking as not worth the complexity for a small additional return (see the sixth question here). I disagree. I think it prevents some larger mistakes.


5iResearch claims that you shouldn’t hold “High Growth Equity” in your RRSP, and that TFSAs are the best place for such assets. Their reasoning is that RRSP “gains withdrawn from the account are treated as ordinary income,” and that in TFSAs “Profits on the stock will not incur capital gains tax when realized, nor will there be tax on the appreciated capital when withdrawn from the account.” So, if you compare investing $10,000 in either your RRSP or TFSA in high growth equity, the TFSA will seem better, because you end up with more after-tax money.

This bad advice comes from failing to think of RRSP assets as partially belonging to the government. Suppose you’ll pay an average of 20% tax on all RRSP withdrawals. Then you should be comparing investing $8000 inside a TFSA to investing $10,000 inside an RRSP. In the case of high growth equity, the two investments will work out the same after tax, so there’s no reason to prefer one over the other.

Gordon Pape made a similar mistake in his book Tax-Free Savings Accounts – How TFSAs Can Make You Rich. He prefers to hold U.S. dividend-paying stocks in a TFSA where they will pay only a 15% dividend-withholding tax, instead of having to pay your full marginal rate in an RRSP.

When you understand that 20% of your RRSP belongs to the government, and you compare an $8000 TFSA investment to a $10,000 RRSP investment in U.S. dividend-paying stocks, you’ll come to the correct conclusion that the RRSP is the better place in this case.

Gordon Pape made another error of this type when he answered a question about whether to start withdrawing first from an RRSP or a TFSA. Once again, understanding that your RRSP is not all yours solves the problem.

In his book Wealthing Like Rabbits, Robert R. Brown made a mistake with some advice on whether low-income savers should put their savings in an RRSP or TFSA. Brown prefers RRSPs because “with RRSPs they get the tax savings now, when they are younger, lower income earners and they likely need it more.”

He is comparing equal-sized contributions to an RRSP or a TFSA, which is a mistake. For a 20% marginal tax rate, he should be comparing a $4000 TFSA contribution to a $5000 RRSP contribution. Assuming the low-income saver had $5000 available to save, both scenarios lead to being left with $1000 left, either immediately, or after getting a tax refund. If the low-income saver expects to have higher income in the future, the TFSA is actually the better choice right now.

Another type of mistake comes as we get closer to retirement. People try to calculate their “retirement magic number” based on the 4% rule or some other rule. To know when you have enough for retirement, you must take into account income taxes. This means reducing your RRSP assets by your expected tax rate and taking into account capital gains taxes in your taxable accounts.


It’s certainly more complex to take into account taxes on RRSP withdrawals when managing your portfolio. That’s why I have a spreadsheet that does all the calculations for me. Even when rebalancing my asset classes, the spreadsheet shows me how much to buy and sell in each type of account factoring in taxes. I worked these things out once, and now I don’t have to worry about it.

One simplification I made was to treat my RRSP withdrawals as having a fixed tax rate. It’s possible that if my investments do very well, I’ll pay a higher tax rate. It’s also possible that the government will change tax rates. But I think it’s better to use an estimated tax rate than to implicitly use a 0% rate that is surely wrong.

On the subject of taking into account RRSP taxes, Canadian Couch Potato (CCP) says “we don’t manage portfolios that way because it is hopelessly impractical.” This is an overstatement. It would be difficult to do this properly if you had to do it yourself with a calculator for every client, but anyone running a financial advice business should be able to invest in some software or spreadsheets to get this stuff right. I’ve done it for my own narrow set of requirements. It should be possible for a business to cover a wider range of scenarios correctly with some automated tools.

CCP goes on to say he suspects that trying to take into account RRSP taxes in portfolio allocations “will defeat most DIY investors.” This is likely true. I think DIY investors are better off automating their portfolio decisions as much as possible, but few do this. They make essentially active decisions frequently, and adding the complexity of tax calculations increases the odds of making mistakes.


CCP sees little benefit to factoring in RRSP taxes. “If you lost half of the value of your RRSP, would it make you feel better to know that 30% would have gone to taxes in retirement anyway? I doubt it.” He quotes John Robertson as saying “all these optimization games can bring is a few basis points of extra return,” and CCP concludes that “the added complexity is not worth it.”

If these were the only benefits of taking into account RRSP taxes in asset allocation decisions and computing net worth, then I’d agree. But we need to avoid the bigger mistakes described above that are made by many including well-known figures in the financial world.

Note that I’m not talking about completely optimizing asset location decisions as discussed by John Robertson. He’s right that perfect optimization across all scenarios is very complex. However, each advisor or DIY investor uses some process to make “good enough” asset location decisions. Taking into account RRSP taxes with this good enough process adds only a modest amount of complexity to automated tools.

CCP says “For professionals managing portfolios for multiple clients [accounting for RRSP taxes] is close to impossible, and I am not aware of any firm that does so.” I don’t believe this is anywhere near impossible. All that is required is a one-time effort to include it in some automated tools. I think it’s about time for those selling financial advice to calculate portfolio allocations and net worth after subtracting estimated taxes.

Monday, May 14, 2018

Skin in the Game

We’ve heard that free advice is worth what you pay for it. In his latest book, Skin in the Game, Nassim Taleb takes this much further saying “do not pay attention to what people say, only to what they do, and how much of their necks they are putting on the line.” Most of his book is devoted to explaining the many contexts where the idea of skin in the game applies.

Like Taleb’s other books, this one is filled with many ideas worth thinking about along with many hurled insults at those he calls Intellectuals Yet Idiots (IYIs). There is even name-calling: “Hillary Monsanto-Malmaison, sometimes known as Hillary Clinton.” If Taleb’s accusations are accurate, then some of these people (but not all) deserve his insults and more, but they are tedious nonetheless. Despite all this, I’d rather read a book with a few good ideas and some unpleasant parts than read a pleasant book with nothing important to say.

I was unable to follow the logic of parts of the book, and some topics didn’t seem to have much connection to the concept of skin in the game. For the rest of this review, I’ll avoid these topics.

“Don’t tell me what you ‘think,’ just tell me what’s in your portfolio.” This is something I’ve tried to stick to on my blog when I discuss investing. I say how I invest, and explain why I avoid other investments, but I try to avoid recommending investments I don’t own myself. I’m suspicious of those who recommend investments they don’t own themselves.

Taleb extends this beyond just investing: “those who don’t take risks should never be involved in making decisions.” He doesn’t like it when government bureaucrats make decisions about wars or regulations when they have little to lose themselves. “Administrators everywhere on the planet, in all businesses and pursuits, and at all times in history, have been the plague.”

“The principal thing you can learn from a professor is how to be a professor—and the chief thing you can learn from a life coach or inspirational speaker is how to become a life coach or inspirational speaker.” He says the heroes of history weren’t library rats, but were “people of deeds [who] had to be endowed with the spirit of risk taking.”

“Beware of the person who gives advice, telling you that a certain action on your part is ‘good for you’ while it is also good for him, while the harm to you doesn’t directly affect him.” This applies in many areas, one of which is financial advice. Typically, advisors get a percentage of your assets, not a percentage of your gains and losses.

“Behavioral economics [fails] to give us any more information than orthodox economics (itself rather poor) on how to play the market or understand the economy, or generate policy.” I see behavioral economics having two purposes: a positive one to try to help people make better personal financial decisions, and a negative one to help retailers and other sales organizations better exploit their customers’ weaknesses.

Taleb criticizes Thomas Piketty’s book, Capital in the Twenty-First Century. On Picketty’s method of measuring inequality: “Static inequality is a snapshot view of inequality; it does not reflect what will happen to you in the course of your life.” For example, the 25-year old version of me had much lower income and assets than the recent version of me. Measured statically, inequality seems bigger than it really is.

Measures of income inequality are dominated by the wealthiest people (the “tail” of the wealth distribution). This tail is a “fat tail” and the standard mathematical tools used by economists assume thin tails.

I suspect that Piketty wouldn’t be overly concerned with these criticisms. Even if we correct the way inequality is measured, Piketty would likely still call for huge tax increases. I’ve written before what I think of these proposed taxes. Taleb says “Any form of control of the wealth process—typically instigated by bureaucrats—tends to lock people with privileges in their state of entitlement.” He would rather have inequality with turnover among the wealthiest.

“Academia has a tendency, when unchecked (from lack of skin in the game), to evolve into a ritualistic self-referential publishing game.” I’ve seen this happen in my own field to some extent. However, the best researchers don’t engage in publishing games; it’s the next tier down who do these things because are struggling for survival as researchers. A field or subfield faces problems when the best researchers abandon it to those most concerned with getting publications.

“Consider that a recent effort to replicate the hundred psychology papers in ‘prestigious’ journals of 2008 found that, out of a hundred, only thirty-nine replicated.” Because human nature was “available to the ancients,” “everything that holds in social science and psychology has to ... have an antecedent in the classics.” I agree that we should be skeptical of new findings, but I reject the idea that it’s impossible for us to learn something new about human nature.

“Executives are different from entrepreneurs and are supposed to look like actors.” I’ve certainly seen a lot of this in my business career. Whether an executive has genuine skill at running an organization effectively or not, he or she almost invariably acts the part.

I’ve often wondered about the apparent gap between grocery store prices and what farmers get paid. According to Taleb, “close to 80 to 85 percent of the cost of a tomato can be attributed to transportation, storage, and waste (unsold inventories), rather than the cost at the farmer level.”

There is a posh area a few kilometers from my home with huge houses on big lots. I see few people when I walk through the area on a sunny Saturday afternoon. The few children I see look lonely. Taleb observes “nobody today will come to console you for living in a mansion—few will realize that it is quite sad to be there on a Sunday evening.”

On “The Ethics of Disagreement,” Taleb says “You can criticize either what a person said or what a person meant.” I’ve certainly had my fill of critics who deliberately take statements out of context. Politics consists of little else.

The book contains criticism for the ideas of risk aversion and loss aversion. I write about this part of the book in a piece called Does Loss Aversion Exist?

On the subject of Genetically-Modified Organisms (GMOs), Taleb believes that by making sudden genetic changes rather than making gradual changes with conventional breeding, we risk creating an organism that grows out of control and destroys our ecosystem. He believes that no benefit we get from GMOs could outweigh this potential loss.

Overall, I’m glad I read this book. Some parts were tedious, but the few parts that made me think about a subject in a different way more than compensated.

Friday, May 11, 2018

Short Takes: Investment Returns, Minimizing Portfolio Taxes, and more

Here are my posts for the past two weeks:

Money = Human Work

Does Loss Aversion Exist?

Here are some short takes and some weekend reading:

Tom Bradley explains where investment returns really come from. The answer is different from what most people think.

John Robertson tackles the complexity of optimizing how you spread your bonds, Canadian stocks, and foreign stocks across your RRSPs, TFSAs, and non-registered accounts. In my experience, trying to come up with a set of rules to cover all possible situations is very difficult, but most individual cases are easy enough to sort out. For example, I know what tax rate I’ll likely be paying on RRSP/RRIF withdrawals, I own no bonds (I have a cash/GIC allocation instead), and I understand that my RRSP contents partially belong to the government (which eliminates certain behavioural errors). These facts greatly simplify the analysis to determine which accounts should hold each of the asset classes I own.

Canadian Couch Potato interviews Ben Carlson for an interesting discussion of the challenges investors face despite the wide array of low-cost choices we have today. As a bonus, you’ll get a clear and accurate skewering of technical analysis.

Boomer and Echo takes a look at how online mortgage brokers are changing the mortgage business.

Thursday, May 10, 2018

Does Loss Aversion Exist?

We’ve long been told that we feel losses more than we feel gains; that losing $1000 will make us more unhappy than winning $1000 will make us happy. Many experiments point to the existence of loss aversion, although recent experimental results have caused skeptical researchers to question its existence or at least claim that loss aversion is more complex than we first thought.

Nassim Taleb criticizes the ideas of risk aversion and loss aversion differently from the sceptical researchers. In his book, Skin in the Game, Taleb says “I believe that risk aversion does not exist: what we observe is, simply, a residual of ergodicity. People are, simply, trying to avoid financial suicide and take a certain attitude to tail risks.”

Taleb also says “Rationality is the avoidance of systemic ruin.” He rejects the idea that we are loss averse; we are simply avoiding things that could lead to financial ruin, death, or other permanent loss. “In a strategy that entails [a possibility of] ruin, benefits never offset risks of ruin.”

So, let’s apply these ideas to a simple experiment. We offer a subject, Stan, a chance to toss a fair coin to either lose $100 or win $200 on the coin’s outcome. Suppose Stan rejects the offer. What are his possible reasons?
  1. Humans are wired with simple heuristics for avoiding ruin, and this offer triggered one of Stan’s avoidance heuristics.
  2. Stan doesn’t believe the coin is fair.
  3. Stan doesn’t believe he’ll be paid if he wins.
  4. Stan has a moral objection to gambling or some other reason that gambling even once has high cost, such as having a gambling addiction.
  5. Stan has other financial risks in his life that combine to make a $100 loss potentially very painful right now.
  6. Stan is so poor that the cost of a $100 loss is greater than the gain of a $200 win.
Suppose Stan is then offered the same coin toss to lose $100 or win $300 and he accepts. Suppose further that he had no idea rejecting the first offer would bring a more lucrative offer. This eliminates reasons 2, 3, 4, and 5 above for rejecting the first offer. Reason 6 affects so few people (in the first world) that we can safely assume it doesn’t apply to Stan. This leaves reason 1, mental heuristics for avoiding ruin.

Whether we call this “risk aversion,” “loss aversion,” or something else, it’s clear that the vast majority of subjects who reject a 100/200 coin toss but would accept a 100/300 coin toss are making a mistake in the 100/200 case. Even though mental heuristics for avoiding ruin serve us well and served our ancestors well, Stan applied them in this case to reject a beneficial opportunity.

Taleb doesn’t like labeling Stan “irrational,” but no matter what label we choose, he made a choice against his own interests. This doesn’t mean that Stan isn’t well-served on the whole by his mental heuristics for avoiding ruin; it’s just that they didn’t serve him well in this case.

The cost of this mistake is quite low (less than $50), but similar mistakes have much higher costs. One example is portfolio allocation. Many people live in poverty in old age because of a lifetime of avoiding any investment riskier than bank deposits. It’s certainly possible to achieve better returns on savings without incurring the risk of ruin.

Friday, May 4, 2018

Money = Human Work

We often hear people say “money isn’t everything” or “it’s just money.” There are times when this is a healthy attitude to have, but more often it’s not the right way to think about money.

Money represents human work. With money you can get other people to do work for you, such as making houses, food, clothing, cars, and computers. If we change the familiar sayings to “human work isn’t everything” or “it’s just human work,” they don’t ring nearly as true.

Few of us would want to get by entirely on our own, living in the wild, finding our own food, and making our own clothes. We buy the work of others in just about every aspect of our existence.

There are those who make their lives worse by spending less than they should. But more often the person who says “money isn’t everything” works to get an income and gives too much of it away in foolish ways.

We shouldn’t focus on money to the point of worship. But we shouldn’t think that money is somehow separate from real life either. Human work matters, so money matters.