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.

Thursday, September 6, 2018

Where Retirement Income Plans Fall Down

Whether you use the 4% rule for retirement income or some other strategy such as my cushioned retirement investing, a fatal flaw lurks, threatening to undermine any sensible plan. This flaw is the number one reason why it makes sense to be conservative with the percentage of your assets you plan to spend each year.

I saw a good example of the problem when I helped a retired family member with her finances. I worked out a safe withdrawal amount each month and set up her portfolio to transfer this amount into her chequing account each month.

Within a year, she needed to make a large withdrawal from her savings. The reason doesn’t matter. It could have been for a car, a grown child who needed money, or something else. The problem was that she wanted to have her cake and eat it too. She wanted a steady income from her savings and to be able to dip into her savings when necessary. The problem is you can’t do both safely.

I don’t think the rest of us are much different. We can understand that we can’t double-dip, but faced with a problem that can be solved with money, it’s easy to decide that just this one time, it’ll be okay. Except that it will happen again and again. It seems that huge pots of money are irresistible.

So, when you’re reading about the latest ideas on how to spend 5%, 6%, or even 7% of your nest egg each year, keep in mind that such aggressive plans allow no room for special “one-time” lump sums. High withdrawal rates already increase the risk of running out of money; adding extra withdrawals makes financial ruin a near certainty. It’s better to have less aggressive monthly withdrawals and admit that occasional needs for lump sums are a possibility.

Tuesday, September 4, 2018

Avoiding the Stock Market

I used to think that the main factors that kept people from investing in the stock market were volatility and risk. However, a recent conversation with someone I’ll call Jim taught me that the difficulty of finding decent advice is a barrier as well.

Jim runs a successful small business in a rural area. He is at retirement age now and has turned over most of the business operations to his sons. He’d prefer to retire fully, but he still works enough out of his home to draw a minimum wage salary.

Jim’s retirement plan consists of continuing to work at his business and occasionally severing parts of his land to sell. He has some assets in an RRSP, but he’s not sure how much to trust the income he can draw from it. He had his RRSP at one of the big banks for many years, but his results were poor. Recently, he took a recommendation for another advisor who turned out to work for an insurance company. So, now Jim’s in expensive segregated funds, not that he’d heard of “segregated funds” before our conversation.

Jim is savvy enough in the ways of the world to understand that he hasn’t been treated well when it comes to his savings. But he can’t figure out what would be better. At least he understands that he must be paying fees somehow. He asked his new advisor what he pays in fees. The advisor deflected the question several times until Jim finally demanded to know what he pays. The advisor relented and told him. So, now Jim has confirmation that his savings have a huge leak that will severely reduce his retirement income.

If I were in Jim’s place, I’d just sell off the business and the land I don’t need, stop working, and invest the proceeds in mostly stocks. However, that’s because I know how to invest with total costs less than 0.2% per year. Jim’s alternative strategy of selling land in pieces and continuing to work makes sense given that he hasn’t figured out how to get a fair shake with his investments.

This story makes me wonder how many people out there choose investments like real estate or a business because it’s a world they understand. They avoid stocks not because they don’t believe in their long-term growth prospects, but because they understand their own limitations in figuring out how to get decent investment advice.