Friday, June 18, 2021

Short Takes: Future of Cash Edition

Like many people, I’ve been enjoying the good weather as much as possible lately.  As a result, I haven’t done much writing, so I thought I’d reflect on the effect the pandemic has had on the use of cash.

Understandably, people have been nervous about handling cash through the pandemic.  Many people stopped using it, and some retailers refused to take it.  I’m curious about what will happen as we come out of the pandemic.

Will most people who sometimes used cash before the pandemic go back to it?  Will some retailers continue to refuse cash?  Banks would certainly like to see the end of cash so they can be assured of getting their cut of every transaction.  No doubt some retailers like the information they can gather about their customers when they use cards.

I’d like to see cash remain an option wherever I go.  Then those who prefer to use a card can do so, and those who want to use cash can do so.  In some contexts, I like the anonymity of paying cash, and at the end of the month, I prefer not to have a credit card statement riddled with small purchases.

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand
explains why it’s better to focus on total return rather than dividend yield.

The Rational Reminder Podcast brings us a sensible discussion of the decision to rent or buy a home.

Friday, June 4, 2021

Short Takes: Firing Your Financial Advisor, Measuring Returns, and more

As long as the pandemic feels like it has lasted, I’m amazed at how quickly we’ve reached the point we’re at today.  Early on, we hoped a vaccine would be ready by sometime in 2021, but maybe it would take longer.  Then once we had a vaccine ready, it seemed optimistic to hope that we’d be vaccinated by the end of 2021.  Then the Canadian federal government promised that every adult who wanted a vaccine would get it by September, and the general reaction was “sure, I’ll believe it when I see it.”  Now it’s starting to look like adults and children as young as 12 who want a vaccine may be fully vaccinated by the end of August.  I know it feels like this has all gone on forever, but our estimates for when it would end have been consistently getting earlier.  There is every reason to believe that the world’s reaction to the next pandemic will be even faster.

I managed only one post in the past two weeks:

How to Lie to Yourself about a Stock Crash with Statistics

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand lays out ten good reasons to fire your financial advisor.

Canadian Couch Potato gives a good overview of some different ways to measure your portfolio’s returns as well as some videos for those who want to dive in further.

The Blunt Bean Counter explains the various ways siblings can get into conflict over their parents’ estate.  Believing your own children would never squabble over your estate is seeing the world as you want it to be rather than how it is.

Preet Banerjee interviews Ben Rabidoux who analyzes what’s been happening in the Canadian housing market.

Justin Bender compares the global ex-Canada stock ETFs VXC and XAW in a recent video.  He has a stronger preference this time than in most of his other ETF comparisons.

Wednesday, June 2, 2021

How to Lie to Yourself about a Stock Crash with Statistics

Wouldn’t it be great if we could predict the future movements of stock markets so we could capture the gains and avoid the losses?  It turns out we can’t, but that doesn’t stop people from trying.

After a Twitter exchange with John De Goey, I ended up reading the article The Remarkable Accuracy of CAPE as a Predictor of Returns by Michael Finke.  He gives a chart that appears to show we can predict the coming decade of stock returns by calculating what is known as the CAPE (Cyclically Adjusted Price-to-Earnings Ratio).

For our purposes, we don’t need to know much about the CAPE other than that it is a measure of how expensive stocks are, and that it was invented by Robert Shiller who received a Nobel Prize in Economics in 2013.  In fact, we don’t even have to calculate the CAPE ourselves; it is freely available and updated daily.

Right now, stock prices are very high.  As I write this, the CAPE for U.S. stocks stands at 37.  The only time it was higher in the past century was during the tech boom and bust around the year 2000.  We seem to be repeating the boom part, and the fear is that we may soon repeat the bust part.

Here is my reproduction of a chart similar to Finke’s chart:

Finke’s chart used nominal U.S. stock returns rather than real (inflation-adjusted) returns, but they show the same thing: an apparently close relationship between the CAPE and U.S. stock returns over the subsequent decade.  Given the current CAPE, stock returns appear to be predictable to within +/- 3% per year.  That would be amazingly accurate if true.

Based on this chart and the fact that the CAPE is currently 37, we’d expect the average annual stock return in the next 10 years to be between inflation minus 4% and inflation plus 1.5%.  If true, this would clearly mean it makes sense to sell stocks.  De Goey made his position clear in an article titled Get Out!.

Sadly, there holes in this story.  Nobel Prize winner Shiller invented the CAPE, but he isn’t involved with Finke’s paper, despite De Goey’s implication when he defended Finke’s chart saying “Oh, and the guy who came up with the concept has a Nobel Prize.”

You might wonder how the chart above has so many points when we’re talking about 10-year returns and it covers only 25 years of stock market data.  The answer is that the chart uses 300 overlapping 10-year periods.  So, each point represents a starting month.  Two successive months are likely to have nearly the same CAPE and nearly the same 10-year annual returns.  So, we get lots of bunched up dots.

But the truth is that we have very little data.  We really only have two independent 10-year periods.  Despite the impressive correlation the chart shows, we’re extrapolating from little information.

To show the problem, let’s repeat this chart for another time period:

I didn’t choose this date range at random; I selected it to make a point.  If we were to devise a strategy based on this chart, we’d say not to worry if the CAPE gets high because you’ll still get decent returns.  But when the CAPE is in the 17 to 18 range, stocks are either going on a big run, or they’ll crash, and you have to be ready to get out.  This is obviously nonsense.  It’s dangerous to try to build strategies on too little information.

Here’s a chart using S&P 500 stock data from 1936 to the present:

This data still only covers seven independent decades, but we can see the real picture of the relationship between the CAPE and stock returns is a lot fuzzier than the first chart made it seem.  We can still reasonably guess that a higher CAPE reduces future expected stock returns, but the range of returns is still wide.

We might guess that the CAPE appears to have predictive value when it is above 30 because future stock returns are limited to a narrower range.  Again, this is because we have limited data and the periods overlap.  In fact, two overlapping decades a month apart are over 99% identical (119 of the 120 months).

To reduce this illusion of seeming to have more data than is truly available, here’s a chart of the same results back to 1936, but with overlapping decades spaced a full year apart:

Now we see how little information there is for the CAPE above 30.  But it gets worse.  Those five points are from consecutive years during the year 2000 tech boom and bust, so they all overlap by six to nine years.  Any strategy we develop based on high CAPE values is just guessing that the tech bust 20 years ago will repeat.

Does this mean we should blissfully assume a rosy future for stocks?

Absolutely not.  Stocks can crash at any time, and that last chart shows that we should assume lower than average expected stock returns over the next decade or more.  

Does this mean we should get out of stocks?

We don’t know the future.  Stocks may crash soon or they may not.  Nobody knows which.  The important question to answer is whether there is some investment other than stocks with a higher expected return right now.  Unfortunately, bonds and real estate (especially Canadian real estate) are expensive right now too.

If we really believed stocks would lose money over the next decade, we’d be better off with cash in a savings account.  But we can’t know if this will happen or not.  My own take is that stocks still have a higher expected return than other investments, so I am sticking to my investment plan.

However, I have lowered my expectations for future returns.  The main effect this has is to slightly reduce my family’s spending to preserve capital in case future stock returns really are poor.

If the CAPE continues to rise, I can’t say I’d stick to my current investment plan indefinitely.  I’m open to the possibility that it will make sense to taper my stock holdings if the CAPE gets to even crazier levels.  

One thing is certain though: I don’t believe it makes sense to make a radical change all at once.  For example, I wouldn’t suddenly sell all my stocks if the CAPE hits 50.  I’d devise some plan for my stock allocation as a function of the CAPE that would gradually reduce my stock holdings as the CAPE rises.  But I have no such plan for now.

De Goey’s call to get out of stocks will eventually look either prophetic or misguided.  But I won’t be among those who look back to judge his call to be right or wrong.  If you place a bet at a roulette table, you’ll either win or lose, but I’ll judge you by whether the bet made sense at the time you placed it.  For now, De Goey hasn’t made a case that convinces me, and I would never suddenly sell all my stocks anyway.  For now, you can count me among those concerned about high stock prices but unconvinced there’s a better place for my money.

It’s very easy to fool yourself with statistics, particularly when the amount of data is far short of enough to be statistically significant.  But, even in the absence of data, we have to make decisions.  To make a case for switching from stocks to some other asset class, we’d have to look somewhere other than past stock prices.

Friday, May 21, 2021

Short Takes: Investing Questions, CRA Oral Interviews, and more

My attempt to move the email delivery of my articles from Feedburner to follow_it has been anything but smooth.  Follow_it decided to require everyone to click a confirm link at the top of my Test post before they could get more articles.  My wife missed that and apparently many others did too.  I’m not happy with the inane ads follow_it places at the end of my articles, and I don’t like the tracking stuff they add to all links in my articles.  I’m seriously considering eliminating email subscriptions on my blog, but I’ll wait a while longer before making a final decision.

Here are my posts for the past two weeks:

What Might Have Been

Seeking Prophets

Here are some short takes and some weekend reading:

Tom Bradley at Steadyhand asks some very interesting questions.  One good one is “Who is going to buy the flood of low yielding government bonds being issued?”  Another is “Is the political risk around China fully reflected in securities prices?”  I won’t be buying the new bonds, and I’m wary of investing in China.

Anna Malazhavaya explains that CRA can now compel oral interviews.  This is a change announced in the 2021 Federal Budget.  If I understood correctly, they can even compel people to answer questions about a neighbour.  I guess that’s another good reason to get along with your neighbours.

Big Cajun Man continues to have difficulties making contributions to his son’s RDSP.  It seems that TD is trying to apply rules that make sense for RRSPs to RDSPs where they don’t make sense.

Boomer and Echo looks at reasonable expectations for future market returns.  Some investors expect the high stock returns of recent years to keep rolling.  The party has to end sometime, and making moves to try to keep it going likely won’t end well.

Wednesday, May 19, 2021

Seeking Prophets

It ain't so much the things that people don't know that makes trouble in this world, as it is the things that people know that ain't so. — Mark Twain.
Recently, I was reminded of how difficult it can be to help people with their financial decisions.  What they don’t know isn’t the problem so much as what they think they do know.

A young man I’ll call Lucas came to me wondering what to do with a modest sum in employee stock options.  He’s not sure which way the stock market is going, and he’s not sure where his employer’s stock is going.  Is now a good time to sell the options or not?

I started by explaining that nobody knows where the stock market or any individual stock is going, and that selling should be based on other considerations, like diversification and needing the money.  I tried to continue with how his best course of action depended on the stock’s price and the strike price as well as the amount involved, but there was little point.  As far as Lucas was concerned, I couldn’t help him and he’d have to ask someone else.  No doubt Lucas will find someone else who will confidently make random predictions about the stock market.

There are things Lucas doesn’t know that made it difficult to help him.  For example, he doesn’t know what a strike price is, so he couldn’t tell me how far into the money the options are.  He told me a dollar amount for the options, but I’m not sure if that’s the value of the stock or the net value of the options.  It’s even possible he doesn’t have options at all, but has some restricted stock.

The bigger barrier to helping Lucas is his mistaken belief that he needs help from some stock market prophet who can tell him the future.  I’ve had the experience before of having someone nod in agreement that such prophets don’t exist, and then immediately ask another question searching for predictions of the future.

Even when someone knows very little about investing, it’s necessary to first get them to unlearn things they think they know but are wrong.  Only then is it possible to help them.

Monday, May 17, 2021


This is a test post after I tried to fix my blog.  Feedburner is dropping email subscriptions, and I tried to switch them to  So, if this worked, emails will look different going forward.  If it didn't work and I broke my feed, I'll have some extra time on my hands.

Wednesday, May 12, 2021

What Might Have Been

I’ve let some very lucrative opportunities slip through my fingers over the years.  I won’t call them regrets as I’ll explain later, but I could have ended up with a lot more money than I have now.  Here I describe the top three potential paydays that got away from me.


I spent my career as a cryptographer, so it’s not too surprising that I took an interest in the workings of bitcoin when it first appeared.  I learned how it worked and appreciated the clever way it was designed to mimic mining for gold without the need for a central authority.  For a while, that’s as far as my interest went.

Later, some enthusiasts formed a group to work on mining bitcoins, and they wanted me to join.  I was tempted, but decided that I had other things to do with my time.  Given the way I tend to get obsessed with technical projects, if I had joined in those early days, I could have mined thousands of bitcoins.

When bitcoin prices were manipulated upward to spark the mania we’ve witnessed, I would have sold my bitcoins off a little at a time to avoid having too much of my net worth tied up in a volatile currency of questionable real value.  It’s possible that I could have ended up with around CDN$50 million after taxes.  But I’ll never know for certain what might have been because I didn’t join the group.

Apple Stock

I bought 3000 shares of Apple stock in October 2000.  They were only $20.54 each.  A little less than three years later, I sold them for a loss of about US$3000.  Since then, Apple shares have split 2 for 1, 7 for 1, and recently 4 for 1.  If I had held onto this stock, I’d have 168,000 shares now.  As I write this, these shares trade at $126.85, for a total of US21.3 million.

I would never have held on all the way to today without selling any shares.  To reduce risk, I would have sold small blocks of stock along the way.  My best guess is that I’d now have about CDN$10 million after tax from holding these Apple shares.  But I didn’t hold them, so I’ll never know for sure.


I had the good fortune to work for a tech company that had its initial public offering in the midst of the late 1990s tech boom.  I had no way of knowing what was about to happen, but the company’s stock price grew to 20 to 100 times any sensible valuation.  I did well with my allotment of stock options.

Leading up to the IPO, I had the chance to move into management but turned it down.  I decided I was happier doing technical work.  If I had embraced management for just a couple of years, I would have received substantially more stock options.  I could easily have ended up with a few million more dollars.  But, I chose reasonable working hours and work I liked better.


It’s tempting to look at these missed chances and draw some lessons like “when you see an opportunity, go for it” or “don’t be left with regrets,” but I think this is wrong.  None of these outcomes was foreseeable.

In the early days of bitcoin, there were believers in bitcoin as the future of transactions, but nobody was talking about getting rich from a crazy runup in bitcoin prices.  Bitcoin miners were geeks who liked the technology.  They weren’t young people seeking their fortune.

Fifteen to twenty years ago, Apple was just another small tech company that seemed sure to get crushed by the Microsoft behemoth.  Betting on Apple back then made no more sense than betting on several other tech companies.  But none of the others grew to what Apple is now.

My whole career I avoided management because I didn’t like the work, didn’t think I’d be good at it, and didn’t want to work the long hours management requires.  I had no way of knowing that enduring management for a small slice of a decades-long career would have a big payoff.

I’ve focused here on missed opportunities, but I’ve had a tremendous amount of good fortune in my life as well.  Some of the random choices I’ve made have paid off in unexpected ways.  The real lesson here is that life is unpredictable, and you’re destined to be fortunate sometimes and unfortunate other times.  There’s no point in mooning over what might have been.  Look to the future.

Friday, May 7, 2021

Short Takes: Leverage Losses, Financial Advice, and more

Speculation that we’re in a bubble is growing.  I don’t know how to identify bubbles while they’re happening, so the most I can say right now is that the prices of stocks, bonds, and real estate are high.  But let’s suppose for the moment that all three assets are in a bubble.  What are we to do with this information?  Maybe one or more of these assets will crash.  But what if they keep rising for quite a while longer before this crash happens?  What if the economy booms and we grow our way out of the bubble without a crash?  There’s no guarantee that selling assets and waiting for a crash will work out well.  Because I don’t know what’s going to happen, I’m sticking with my investment plan.  The only change I’ve made is to lower my expectations of future investment returns.  So, I haven’t changed the way I invest, but I haven't grown my spending as much as my portfolio’s growth dictates in case future returns disappoint.

I managed only one post in the past two weeks:

The “Explore” Part of a Portfolio

Here are some short takes and some weekend reading:

John Robertson
tells a deeply personal story about personal loss and financial loss due to leverage.  When it comes to investing with borrowed money, everyone is a genius until suddenly they’re not.

Ben Felix (video) explains what is and is not good financial advice.  He says that investing is largely a solved problem, but goes on to explain the ways that people need help.  He makes an excellent case that most people could benefit from an advisor who does a good job providing this help.  I have little doubt that he is able to do a good job in his practice.  However, after listening to many financial advisors of different types, including those who work with high net worth clients, I have my doubts that most of these advisors perform Ben’s list of tasks well.

Jason Heath answers a question about making spousal RRSP contributions in your 70s.

Monday, April 26, 2021

The “Explore” Part of a Portfolio

Many people advocate having a portfolio made up of mostly a core of low cost index funds along with a small “explore” part for taking concentrated risks on favourite investments.  This can work well enough if you’re realistic about it, but most investors cross the line to self-delusion.

Ben Carlson does a good job justifying the existence of explore-type investments in his article The Case for Having a Fun Portfolio.  After all, people are entitled to spend their money however they want.  Not every expenditure has to be part of a logical long-term plan.  We can buy a beer, or a motorcycle, or some favourite stock if we want.  So what if the long-term expectation is that the explore part of people’s portfolios will underperform indexes.

All the logic makes sense up to this point.  But just about every stock-picker I know can’t resist taking this a step further.  “Besides, the stock I picked is going to do great.”  In their hearts, they know their stock picks are going to outperform.  Past results don’t seem to deter them.  They wouldn’t bother with the explore part of their portfolios if they truly believed they would lose money over a lifetime of picking stocks.  All the evidence says that professional investors today set good relative prices so that individual investors who choose their own stocks are essentially making random picks.  The odds are against the small guy, but hope springs eternal.  I prefer to find hope in other pursuits.

Friday, April 23, 2021

Short Takes: Estimating Future Returns, Leveraged Blow-Up, and more

The email delivery of my blog posts is run through Feedburner, and Google has announced that they’re dropping this email service in September.  So, if my posts are to still get out to email subscribers, I’ll need to find some other way.  My first attempt to find a replacement came up empty.  Suggestions for an easy solution are welcome.

I managed only one post in the past two weeks:

If Simplicity in Investing is Good, Why is My Portfolio Complicated?

Here are some short takes and some weekend reading:

The Rational Reminder Podcast takes an interesting look at how to estimate future stock returns.  What they’re trying to do is harder than what I did.  I didn’t concern myself with what would happen in the near future.  I just used a conservative estimate of corporate earnings growth, and presumed that the market price-to-earnings ratio would decline to more typical levels by the time I get to be 100 years old.

Bill Hwang’s huge personal loss with his Archegos family office doesn’t seem very relevant to personal finance, but it does serve as a reminder of the dangers of leverage (borrowing to invest).  Warren Buffett says “Never risk what you have and need for what we don't have and don't need.”

Big Cajun Man reports on changes to the disability tax credit in the latest federal budget.

Wednesday, April 21, 2021

If Simplicity in Investing is Good, Why is My Portfolio Complicated?

My recent article on A Life-Long Do-It-Yourself Investing Plan describes a way to make investing uncomplicated while keeping costs to a reasonable level.  Reader reactions were very positive, but some of the questions I received are worth discussing.

“You’re advocating simple investing, but your own portfolio is complex.”

That’s true.  If the all-in-one exchange-traded fund VEQT had existed back when I was switching to index investing, I might have used it for all my stocks.  Unfortunately, it wasn’t around back then, and I settled on a mix of 4 stock ETFs.  In trade for this complexity, I estimate that I save approximately 0.29% per year in MERs and foreign withholding tax (FWT) compared to owning only VEQT.

As it happens, I’m well suited to building a spreadsheet to manage my portfolio, including automating rebalancing and following asset location rules.  Even so, if I were starting out today with no spreadsheet, I might forgo the savings and just buy VEQT for all my stocks.  However, given that I’ve already done the work to decide on a set of rules and have automated them all, I’m happy to save the 0.29% each year.

Much of my writing on portfolio details over the years has been aimed at investors like myself.  If you enjoyed your high school math classes, then maybe you have the temperament to manage a more complex portfolio.  However, I’m confident that the vast majority of people would be happier with something simpler.  It’s not just about a trade-off between effort and savings; there are many ways to mess up a complex portfolio.  You could end up doing a pile of work and saving nothing, or worse.

“Can I see a version of your spreadsheet with your personal details removed?”

I’ve started to make a public version of my spreadsheet several times.  Each time I despair at how hard it is to make such a spreadsheet generic enough to be widely useful, and simple enough to be understandable.  So, I doubt I will ever complete this task.

This may be rationalizing, but I’m not sure I’d really be helping my readers if I made a version of my spreadsheet available.  Maybe being willing and able to do the work of creating your own investing spreadsheet is a necessary condition for success at managing a more complex portfolio.

“You’ve got me thinking I should change my portfolio to match the simple portfolio you described.”

The biggest potential problem with making such a change is capital gains taxes.  If you have investments in a non-registered (taxable) account, you may have to realize capital gains to make a change.  Think carefully about adding a tax burden when making such a change.

If you’ve got a complex portfolio, it might make sense to simplify it, at least in your TFSAs and RRSPs/RRIFs.  However, if you already have a simple portfolio using one of the all-in-one ETFs that include bonds, the benefits of switching may be small.  The prospects for long-term bonds aren’t great right now, but your exposure to potential losses may be fairly low.  It pays to do some calculations before jumping on the latest investing idea.

If you’re already running a fairly simple low-cost portfolio successfully, there may be no reason to change.  If you want to change your portfolio because it will give substantial benefits, then go ahead.  But if you find your reason is an emotional need to seek perfection, then I suggest giving yourself permission to have a portfolio that isn’t quite perfect.  In my own portfolio, I sometimes have some fixed income in the wrong account because it was just easier to do it that way when I rebalanced.  The financial cost of doing this is trivial, and I’m not seeking perfection.

“There are other good ways to keep investing simple.”

That’s true.  I laid out one good way for someone to start an investment portfolio and then maintain it simply for a lifetime.  There are other ways, including many differences in the details.  Maybe you want an 80/20 all-in-one ETF, or you plan to buy an annuity with 25% of your portfolio when you retire.  We can debate the merits of these choices, but at a higher level, they just represent small differences.  The important things to focus on are simplicity, low costs, and avoiding mistakes.

Friday, April 9, 2021

Short Takes: Investing Simply, Income Tax Issues, and more

A big oversight of mine is that I never subscribed to my own email feed.  Like someone who donates to a charity to feel good about themselves without ever checking if the charity is doing good work, I made my articles available for free by email without ever checking whether the service was working well.  Fortunately, my wife subscribed and told me that sometimes there’s a day delay before an email arrives.  I’ve been working on fixing this.  I’ve now subscribed myself and noticed that the font was kind of small.  So I made it a little bigger.  Hopefully, with some periodic monitoring, I can make the experience better for everyone.

Here are my posts for the past two weeks:

Buy Now Pay Later Apps

Safety-First Retirement Planning

A Life-Long Do-It-Yourself Investing Plan

The Value of Monte Carlo Retirement Analysis

The Dumb Things Smart People Do With Their Money

Here are some short takes and some weekend reading:

Robb Engen makes a strong case for DIY investors to use a single asset-allocation ETF over more complex mixes of ETFs like Justin Bender’s Plaid Portfolio, Ben Felix’s Five Factor Model Portfolio, or my mix of VCN, VTI, VBR, and VXUS.  He’s right that few investors will manage these more complex portfolios successfully.  Complexity builds quickly when you’re managing multiple ETFs over RRSPs, TFSAs, and taxable accounts.  For my portfolio, I estimate my MER and foreign withholding tax (FWT) savings compared to just using VEQT for stocks is currently 0.29% per year.  This isn’t trivial, but you don’t have to mess up the plan much to lose these savings and more.  If I had to manage my portfolio by hand instead of having it automated in an elaborate  spreadsheet, I would gladly trade 0.29% per year for the simplicity of VEQT.  I recommend VEQT to my sons and other family and friends who ask.

The Blunt Bean Counter
is out with his list of common tax issues for the 2020 taxation year.

My Own Advisor makes a weak case that active investors shouldn’t bother benchmarking their portfolios.  I made a decision a while back to read fewer articles related to stock picking, but I still read some.  The main reasons not to benchmark your portfolio are 1) to avoid getting the bad news that your stock picks are losing to the market, and 2) to avoid the work required to figure out your portfolio’s return and to pick a benchmark.  Properly done, benchmarking begins with choosing in advance a mix of passive investments that roughly matches the allocations of your active portfolio.  Then at the end of the year, you can compare your portfolio’s return to that of your benchmark to see over the years whether your active picks are any good.  Most active investors don’t even know their portfolio’s return, so they’d be glad to hear that they don’t need to benchmark.  The few who do calculate their annual returns often find that their skills don’t look very good over the long term compared to a reasonable benchmark, and these investors are even happier to hear that they don’t need to benchmark.  My Own Advisor points to problems with finding a benchmark that matches your goals.  This isn’t actually very hard, but it usually requires blending a few indexes.  The key is to pick this mix in advance so you’re not tempted to choose a mix after the fact that makes your active portfolio look better.  My Own Advisor points to benchmarking being a lagging indicator.  However, the goal isn’t to go back in time and change your investments; it’s to find out whether you should keep picking your own stocks or abandon a losing effort.  It may be disappointing to find your efforts over a decade have lost you money, but it’s better to know the truth.  My Own Advisor suggests focusing on your life, health, and other more important things than benchmarking.  This advice applies much better to reclaiming the time you put into stock picking and just living your life while passive investments do their thing.  People are free to do as they wish with their money, including picking their own stocks and not checking their performance, but it’s not good to advise others to follow this path.

Thursday, April 8, 2021

The Dumb Things Smart People Do With Their Money

Even smart people do some dumb things with their money, according to Jill Schlesinger, a Certified Financial Planner and media personality.  In her book, The Dumb Things Smart People Do With Their Money, she goes over thirteen common costly mistakes.  It’s an easy read that might change your mind about a few things.  The focus is on the U.S., and some detailed parts aren’t relevant to Canadians, but the broad themes are still relevant.

The parts of the book I liked best dealt with buying financial products you don’t understand, buying a house in situations that clearly call for renting, taking on too much risk, indulging yourself too much during your early retirement years, not having a will, and trying to time the market.

On the subject of buying investments we don’t understand, the author says “There just isn't any need to invest in gold,” and “It’s usually a crappy investment.”  On reverse mortgages, some predatory lenders “go to extraordinary (and sometimes illegal) lengths to foreclose on borrowers’ homes,” and “many people take out reverse mortgages without analyzing whether they really should stay in their homes.”

Schlesinger believes strongly in getting advice from fiduciaries.  It’s a mistake to take “financial advice from someone who is trying, first and foremost, to sell you something that will make him or her money, rather than help you.”

In an interesting twist, the author says you don’t need professional advice or a customized plan if “you have consumer debt,” “you aren’t maxing out your retirement contributions (presuming that you are in a high enough tax bracket for that to make sense),” or “you don’t have an emergency account with enough money in it to cover six to twelve months of expenses.”

The section on taking too much risk has an excellent discussion of recency bias.  I see this in myself every time I add new money to my portfolio, take money out, or have to rebalance.  These actions always call for either buying something that has performed poorly recently or selling something that has performed well recently.  I’ve learned to overcome my recency bias in these contexts, but the feeling of wanting to stick with an asset class that has been rising never goes away.  You need “to minimize how many direct investment decisions you make.  The fewer decisions, the less opportunity for your internal biases to wreak havoc.”

Schlesinger devotes an entire chapter to indulging yourself too much early in retirement.  This flies in the face of claims that overspending early in retirement doesn’t meaningfully contribute to the fact that the average retiree spends less with age.

In one section the author links the decision to delay taking Social Security with staying on the job longer.  Maybe that makes sense under U.S. rules, but in Canada, one can certainly benefit by spending savings while delaying CPP and OAS until years after retiring.

The author believes that the amount people can safely draw in retirement is “3 percent or so.”    This makes sense as a starting withdrawal percentage for someone age 60 or younger who pays investment fees above 1% per year.  Higher safe withdrawal amounts are for disciplined low-cost DIY investors or older retirees.

“The insurance industry wants you to think that you need permanent insurance, but most people don’t.”  Well said.

The section on not trying to time the market contains many excellent points.  Unfortunately, at one point the author quotes some DALBAR figures that supposedly illustrate investors’ poor market timing.  The DALBAR methodology for calculating investor returns makes no sense.  It’s true that individual investors aren’t good market timers, but DALBAR penalizes investors who buy into the market with new savings because they didn’t invest the money sooner (i.e., before they even had it).

Overall, this book is an easy read and makes many good points.  One of the downsides of being smart is that you can delude yourself at the same time you persuade others.  This can lead to excessive risk-taking and costly mistakes.

Tuesday, April 6, 2021

The Value of Monte Carlo Retirement Analysis

You may have heard of using Monte Carlo simulators to test your retirement plan.  It sounds impressively scientific to hear that your retirement plan has a 95% chance of success.  However, these simulators necessarily make assumptions about future returns, and the simulator outputs are very sensitive to these assumptions.

The term “Monte Carlo” refers to any algorithm that uses random samples to solve some problem.  Such methods are used widely in engineering, science, finance, and other areas.  In finance, Monte Carlo simulators are used to create many random sets of possible future investment returns, and we can test a retirement plan against these possible futures.  In particular, we can define success in some way, such as not running out of money or not having to cut back too far on spending, and see how often a retirement plan succeeds.

Monte Carlo simulators can work in many different ways.  They can just assume some expected return and volatility for stocks and bonds and generate random returns from what is called a “lognormal distribution.”  Alternatively, they could just start with a collection of past monthly or annual returns and select randomly from this collection.  Some simulators leave out the Monte Carlo part and just use actual return histories starting from various dates.

Unfortunately, the outputs of these simulators are very sensitive to the assumptions built into them.  If you use lognormal returns, you get to choose the expected returns and volatilities of stocks and bonds.  These are just 4 numbers, but they can make the difference between a retirement plan failing 5% of the time or 50% of the time.  

For simulators that use a collection of past returns, we can get very different outcomes depending on what range of historical returns we use.  For example, bond returns from the past 40 years can’t possibly be repeated in the coming 40 years unless interest rates can drop somehow to negative double-digit levels.  A Monte Carlo simulator can easily hide an assumption that we’re headed to interest rates of minus 10%.  Most experts don’t believe future stock returns can match average 20th century returns in the U.S., but a simulator can assume they will.

Another problem most Monte Carlo simulators have is that they assume future returns aren’t correlated to past returns.  We know that when the stock market is high, expected future returns are low and vice-versa.  In a past article I illustrated this effect in pictures.

Yet another problem is that most simulators assume inflation is some low fixed value.  This problem shows itself most with annuities and bonds.  Inflation only has to bump up a little to cut deeply into the value of annuities and long-term bonds.  If a simulator doesn’t allow for the possibility that inflation could tick up a percentage point or two, how can we take its output seriously when it declares a retirement plan successful 95% of the time?

It’s certainly possible for a conscientious and talented financial advisor to take all these facts into account and choose sensible assumptions to build into a Monte Carlo simulator.  However, it’s tempting to tinker with assumptions so that clients can appear to be able to safely spend more during retirement.  Few advisors would admit to doing this, but because experts disagree over what simulator assumptions are sensible, it’s fairly easy to come up with a plausible justification for a wide range of assumptions to build into Monte Carlo simulators.

In the end, simulators can be less of a scientific tool and more of a marketing tool to impress clients and give them comforting answers.  This may sound damning, but comforting clients matters.  It’s not good to misuse a simulator to comfort a client about a bad retirement plan, but it is good to make a client feel safe committing to a good retirement plan.

Wednesday, March 31, 2021

A Life-Long Do-It-Yourself Investing Plan

The financial products available today can make do-it-yourself (DIY) investing very easy, as long as you don’t get distracted by bad ideas.  Here I map out one possible lifetime plan from early adulthood to retirement for a DIY investor that is easy to follow as long as you don’t get tempted by shiny ideas that add risk and complexity.

I don’t claim that this plan is the best possible or that it will work for everyone.  I do claim that the vast majority of people who follow different plans will get worse outcomes.

Most of my readers will be more interested in the later stages of this plan.  Please indulge me for a while; the beginning lays the foundation for the rest.

Starting out

Our hypothetical investor – let’s call her Jill – is at least 18, currently earns less than $50,000 per year, and has a chequing account at some big bank.  She has a modest amount of savings in her account earning no interest.  It’s about time she opened a savings account to earn some interest on her savings, but big bank savings accounts barely pay any interest.

So, Jill opens an online non-registered savings/chequing account at EQ Bank.  She chooses it because it’s CDIC-protected, transactions are free, and it currently pays 1.5% interest even though it lets you do the things a chequing account can do.  If EQ Bank ever changes its policy on offering competitive interest rates or free transactions, Jill will just switch to somewhere else that offers better terms.  It’s not worth switching for a small interest rate increase or for a limited-time offer, but if she can ever get say 0.5% more elsewhere, she’ll go.  (I mention EQ Bank because it appears to be among the best available for savings/chequing accounts right now; I get no money or other consideration for mentioning them.)

For now, Jill probably needs to keep her chequing account at the big bank.  The EQ account has to be linked to some other bank account, and you can’t access a bank machine through the EQ account.  It’s also good to be able to talk to a big-bank teller the rare time you need a certified cheque, to make a wire transfer, or to pay some bill you can’t figure out how to pay online.

Jill also opens a TFSA at EQ Bank.  It pays even higher interest, and she might as well earn the interest tax-free.  Sometime much later, Jill may want all of her TFSA room devoted to non-cash investments, at which time she can close this TFSA.  But for now her TFSA will hold some cash.

At this point Jill is learning about how TFSA contribution room works.  She’ll find that it’s best not to deposit and withdraw too often because you don’t get TFSA room back until the start of the next calendar year.  She should use her regular non-registered EQ account for more frequent transactions.

This plan will work well for Jill as long as she has fairly short-term plans for her savings, such as going to school.  As long as she will likely need her savings within 5 years, there’s nothing wrong with keeping it in cash earning as much interest as she can get safely and conveniently.

Let’s look at some potential distractions Jill faces on her current plan.

The bank teller says Jill should open a savings account and get a credit card.

Jill needs a good savings account, such as what EQ Bank offers, not a big-bank savings account that pays next to no interest.  If Jill gets a credit card, she should look for one that suits her needs, not take the conflicted advice of a teller.

All the cool kids are buying Bitcoin.

Jill is level-headed enough to know that she knows next to nothing about investing, never mind wild speculation in Bitcoin, or whatever is currently holding people’s interest.

Savings Start to Grow

At some point, Jill’s savings will grow beyond what she thinks she will need within 5 years.  Perhaps she has graduated, is working full time, and has no immediate plans to use all her savings as a down payment on a house.  She doesn’t carry credit card debt, has paid off her student loans, and has no other debts.  We’ll assume for now that Jill has no group RRSP at work and is making less than $50,000 per year, so that she’s not in a high tax bracket and has no reason to open a self-directed RRSP.  

Jill will still hold some cash savings she might need in the next 5 years in her EQ accounts.  Now it’s time to start investing in stocks with her longer-term savings.  Jill knows that stocks offer the potential for great long-term returns, but she has no idea which ones to buy.  Fortunately, she’s heard that even the most talented stock-pickers often get it wrong, so she’s best off just owning all stocks.  This may sound impossible, but the exchange-traded fund (ETF) called VEQT holds just about every stock in the world.  She can own her slice of the world’s businesses just by buying VEQT.  There are a few other ETFs with similar holdings, and it doesn’t matter much which one Jill picks.  (Once again, I mention VEQT because it appears to be among the best available stock index ETFs right now; I get no money or other consideration for mentioning it.)

Jill opens a TFSA at a discount brokerage.  It’s okay for her to have both this TFSA and the one at EQ Bank, as long as her combined contributions don’t exceed the government’s limits.  Any savings she adds to this new TFSA she uses to buy VEQT.  That’s it.  Nothing fancier.

The biggest lesson Jill needs to learn while her stock holdings are small is to ignore VEQT’s changing price.  Many people hope that their stocks won’t crash.  This is the wrong mindset.  Stocks are certain to crash, but we don’t know when.  We need to invest in such a way that we can live with a crash whenever it happens.  

Jill should just add new money to her VEQT holdings on a regular basis through any kind of market, including a bear market.  Trying to predict when markets will crash is futile.  She needs to accept that she can’t avoid stock crashes and that prices will eventually rise again.  This lesson is so important that Jill needs a different plan if she will panic and sell the first time VEQT drops 20% or more.  Learning that stock crashes are inevitable and calmly doing nothing different through them is critical for Jill's investment future.  Fortunately, in the coming years, Jill will focus on the safe cash cushion in her savings accounts when VEQT’s price drops.

What distractions could throw Jill off her plan now?

The bank says they can help Jill open a TFSA and invest her money.

The bank is just going to steer Jill into expensive mutual funds that will likely cost her at least 2% per year, which builds up to a whopping 39% over 25 years.  As incredible as it sounds, 39% of her savings and returns would slowly become bank revenue during those years.  It’s no wonder that bank profits are so high.  In contrast, VEQT’s fees are just 0.25% per year, which builds up to just 6% over 25 years.

The smart, sophisticated twenty-somethings are getting rich day-trading on Robinhood.

No, they’re not.  We only hear the stories about rare big temporary successes, not the widespread mundane losses.  Very few traders will outperform VEQT.  Over the long term, Jill will be ahead of more than 90% of investors and an even higher percentage of day traders.

Investing has to be harder than just buying one ETF.

In most endeavours, working harder gives better results.  With investing, you need to learn enough to understand the power of diversified, buy-and-hold, low-cost investing.  Beyond that, taking courses in stock picking will just tempt you to lose money picking your own stocks.

VEQT’s price is dropping! What should I do?

Inevitably, stock markets crash.  It’s hard to know how you’ll react until you experience a crash.  If Jill decides she really can’t handle a sudden VEQT price drop, her best course of action is to gut out this market cycle until VEQT prices come back up, and then choose a different asset allocation ETF that includes some bonds to smooth out the ride.  She can then stick with this new ETF into the future.

Rising income

Jill’s income is now enough above $50,000 per year that it makes sense to open an RRSP account at her discount broker.  She also has a group RRSP at work, and she contributes the minimum amount required to get the maximum match from her employer.  She would have participated in this group RRSP even if her income was lower because the employer match is valuable.

Jill figures out how much she’d like to contribute each year to her RRSP at the discount brokerage.  This has to take into account her RRSP contribution limit, her group RRSP contribution as well as the employer match, and the fact that there is little to gain from reducing her taxable income below about $50,000.  If she wants to add even more to her long-term savings than these RRSP contributions, she can save some money in her discount brokerage TFSA.

Next comes the decision about what to own in her self-directed RRSP.  Once again, she buys only VEQT.  Nothing fancier is needed, and most people won’t do as well as just owning VEQT.

When Jill looked into the details of her group RRSP, she was disappointed that the fees were so high; VEQT isn’t one of the investment options.  But she can’t get the employer match without choosing among the expensive funds.  So, her plan is to learn the vesting rules of her group RRSP, and once she’s allowed to transfer assets to her self-directed RRSP without penalties or losing the company match, she’ll make this transfer every year or two.  She’ll be careful to make these direct transfers from one RRSP to another rather than withdrawals.  However, when asking questions about the group RRSP rules, she’ll be careful not to reveal her plans to avoid the expensive fund choices.  The company operating the group RRSP may become less than cooperative if they know Jill has no intention of paying their excessive fees on a large amount of savings.

So, Jill now has VEQT holdings building in her RRSP and TFSA at the discount brokerage.  Her investment plan remains wonderfully simple.  But there are distractions ready to push her off this plan for easy success.

All the savvy thirty-somethings are talking about dividend stocks.

Most dividend investors are poorly diversified, but it’s possible to own enough dividend stocks to be properly diversified.  Does Jill really want to spend her time poring over company financial statements to choose a large number of dividend stocks?  Some people like that sort of thing.  Jill doesn’t.  She’s better off with VEQT.

Now that Jill’s savings are growing, surely she’s ready for a more sophisticated investment strategy.

Just about everyone who tries more complicated strategies won’t do as well as just owning VEQT.  Jill is best off just sticking with her simple plan.  She’s not keeping it simple because she’s not capable of handling something more complex.  It’s just that there’s no guarantee that a more complex strategy will perform better, and she’s not interested in doing the necessary work.  Jill used to be annoyed at people with more complex strategies because it made her feel dumb to have such a simple plan.  But now she just wishes these people well; she knows she has a smart strategy no matter what it sounds like to others.

Buying a home

Jill decides to buy a home in the next couple of years.  The cash she has in her EQ accounts isn’t enough for a down payment; she plans to use all of her investments in her discount brokerage TFSA as well as $35,000 of her RRSP investments through the home buyer’s plan.

Suddenly, money that she didn’t plan to use for at least 5 years has become money she wants to use sooner.  So, she sells the VEQT in her TFSA, and sells $35,000 of the VEQT in her RRSP.  This protects her home-buying plans in case VEQT’s price suddenly falls between now and when she buys her new home.

Jill still wants to earn good interest on her cash, so she checks out the options for cash interest at her discount brokerage.  Unfortunately, the interest rates are not nearly as good as what EQ Bank offers.  So, she opens an RRSP at EQ Bank, and arranges for TFSA-to-TFSA and RRSP-to-RRSP transfers from her discount brokerage to her EQ bank accounts.  She’s careful to make sure she isn’t making withdrawals, but direct transfers.

From now until she buys the home, she directs all new TFSA savings to cash in her EQ Bank TFSA to build her down payment. But she won’t use all her cash on hand as a down payment, because there will inevitably be expenses with a new home.

After buying the home, she plans to direct new savings to paying down the mortgage.  She’ll still participate in her group RRSP, but she won’t contribute to her TFSA or self-directed RRSP for a while.  She wants to get the mortgage down to a less scary level in case mortgage interest rates rise.  Once the mortgage is somewhat tamed, she’ll resume adding to her TFSA and self-directed RRSP, and she’ll invest in VEQT.

New distractions as well as the old ones are ready to push Jill away from her simple plan.

Isn’t it better to invest than pay off the mortgage while rates are so low?

This is good reasoning to a point.  It comes down to how stretched you are.  A quick test is to calculate what your mortgage payment would be if interest rates rise 5 percentage points.  If this payment would cause you serious problems, you’re probably best to pay extra on the mortgage for a while.  With her life ticking along so well, Jill sees no need to add risk.  Once the mortgage principal is down to a more comfortable level, she’ll resume adding to her investments.

Surely it’s finally time for a more sophisticated investment strategy.

Jill’s simple investment strategy is working well, and she’s busy with her new home, her job, and the rest of her life.  There’s no reason to believe a different strategy will work better for Jill.  As we’ll see later, there are ways for Jill to cut her investment costs, but her portfolio still isn’t large enough for the reduced costs to give significant savings, and she’s definitely not interested in doing the extra work necessary to get these savings.

Approaching retirement

Thoughts of retirement are entering Jill’s mind, but she’s not ready to stop working yet.  She’s amazed at how seemingly modest monthly savings have turned into large balances in her investment accounts.  She’s married now, and together with her husband they have 8 investment accounts including non-registered (taxable) accounts, TFSAs, RRSPs, a spousal RRSP, and a LIRA.  Across all these accounts, all they invest in is VEQT.  It couldn’t be simpler for DIY investors.

Jill still has a regular non-registered high-interest savings account (HISA); her only TFSA now (at the discount brokerage) holds only VEQT.  The HISA still holds cash she thinks she might need in less than 5 years.  This includes emergency savings and cash for anything expensive she anticipates buying.  Over the years she considered investing some of this cash in GICs, bonds, and other possibilities, but the interest rate on her account remained competitive with these other options, and having the cash ready at a moment’s notice is comforting.

Jill is starting to think about building her fixed-income investments anticipating retiring in less than 5 years.  This fixed-income allocation will include her HISA and some short-term bonds; she’s not interested in taking on the inflation risk and interest-rate risk of long-term bonds.  She chose the ETF called VSB for her bonds.  She plans to build her fixed income holdings slowly until it’s 5 times her annual spending by the time she retires.  All her stock holdings will remain in VEQT.

The family’s stock portfolio is now roughly a million dollars.  Even VEQT’s low 0.25% management expense ratio (MER) costs Jill $2500 per year.  She pays another cost as well: foreign withholding taxes (FWT) on the dividends of non-Canadian stocks.  This impact of this tax burden varies between registered and non-registered accounts and totals $2000 per year for Jill.

It’s possible to reduce Jill’s MER and FWT costs.  For example, there are U.S.-based ETFs that have lower MERs, and when they’re held in RRSPs/RRIFs, the U.S. doesn’t withhold dividend taxes.  Justin Bender has a portfolio he calls Plaid that cuts costs compared to VEQT.  My personal portfolio cuts MER and FWT costs by 0.29% per year compared to VEQT.  Benjamin Felix takes a different path to higher promised returns with his Five Factor Model Portfolio that seeks to give investors higher returns through exposure to known investment factors.  What all three portfolios have in common is their increased complexity compared to Jill’s plan.

So why shouldn’t Jill try to cut costs or get higher returns?  $4500 per year isn’t cheap.  Robb Engen made a compelling case for sticking with a simpler portfolio based on a single asset-allocation ETF, such as VEQT.  I’ll save further comment for the first distraction Jill faces below.

C’mon, don’t be a chump.  It can’t be that hard to run a portfolio that saves costs or boosts returns.

Running a portfolio with multiple ETFs and many accounts is a lot more work than it appears to be.  The complexity apparent in theory grows tenfold in practice.  Every decision we have to make is another opportunity for the recency bias baked into our brains to cause us to buy high or sell low.  Unless Jill would enjoy building a spreadsheet to automate a complex portfolio, it just isn’t worth her time and effort to try to save some of the $4500 she pays per year.  Many people who try to run a more complex portfolio will end up making costly mistakes that outstrip the savings they’re trying to achieve.  I run a somewhat complex portfolio with my big spreadsheet and scripts to send email alerts, but I tell my sons to just buy VEQT.

Why not pick your own stocks and do away with MER costs altogether?

For all but the best stock-picking professionals in the world, people are essentially picking stocks randomly.  Devoting countless hours to researching stocks ends up being no better than throwing darts.  To be adequately diversified, you must own many stocks.  The risks of owning too few stocks can be more costly than the small MER on VEQT.  Jill isn’t interested in devoting her life to researching stocks for what could turn out to be worse results than owning VEQT.

What about gold as an inflation hedge, or real estate for more diversification?

Unlike businesses, gold produces no earnings.  In fact, it costs money to guard gold.  Over the long term, gold returns have been dismal compared to stocks.  The array of businesses held by VEQT have vast real estate holdings.  Jill doesn’t need to buy more real estate.  There will always be investments that come with some sort of story, but Jill doesn’t need them.  She doesn’t need hedge funds, commodities, or IPOs either.


Jill’s thoughts have turned to how best to spend from her retirement savings.  She is maintaining her fixed income allocation in a HISA and the ETF VSB for a total of 5 years’ worth of her family’s spending.  The rest of her portfolio in all discount brokerage accounts is still in VEQT.  She spends from her HISA, and each year she sells some VEQT to replenish her fixed income allocation.

She has decided what percentage of her portfolio she can safely spend each year.  This percentage rises with her age, similar to mandatory RRIF withdrawal percentages.  In the years before she starts collecting CPP and OAS, she actually spends more so that she can live as well now as she’ll live after getting these government pensions.

Jill considered buying an annuity for more income certainty, but the lack of inflation protection in available annuities put her off.  She might consider buying an annuity later in her retirement when inflation will have fewer years to erode fixed payments.

Jill has been following her plan successfully for some time now, but she still faces distractions.

Stocks are sure to crash soon.  Jill has to protect her portfolio now that she’s no longer earning an income.

People are always making scary predictions.  The truth is that nobody knows when stocks will crash or when they’ll shoot up.  Jill has her fixed income allocation to buffer stock volatility.  If a stock market crash would devastate her finances, she probably should have begun retirement with a fixed-income allocation of more than 5 years of spending.  Selling stocks when she’s nervous and buying stocks when she’s comfortable is unlikely to work out well.

An insurance guy has this great variable annuity with guaranteed minimum lifetime withdrawals.  Your money gets invested inside the annuity and if it performs well you get higher payments.  But you always have your guaranteed minimum payments.

Insurance companies invent lots of products that make it seem like you can have your cake and eat it too.  Somehow, rising markets will make you rich, and with falling markets you get your guaranteed income.  To complete the magic, the insurance guy gets a fat commission for selling the variable annuity, and the insurance company makes money too.  All the children in Lake Wobegon are above average.  

Reality isn’t so wonderful.  Commonly, the fees applied to your investments within the variable annuity are very high, which significantly reduces the odds that they’ll perform well enough to give you higher payments.  Further, the guaranteed income typically isn’t indexed to inflation.  Decades of inflation crush the buying power of fixed payments.  It isn’t impossible for a variable annuity to be a good deal; I’ve just never seen one.

This pre-construction condo project pays 12% interest on a second mortgage.  That’s way better than the pitiful 1.5% interest on a HISA.

This is another example of an investment few people really understand.  If the borrower was likely to make the payments, someone who understands this business well would already have invested.  Whoever is selling this to Jill is hoping for a fat commission.  It’s dangerous to chase higher yield on money that’s supposed to be safe.


Jill’s plan was simple and she followed it successfully.  Her most difficult challenges were avoiding distractions and sticking with her plan.  There are many other plans that can work out well too, but constantly switching to shiny new plans won’t work out well.  More complex plans can seem sophisticated, but most people who follow such paths will get worse results than Jill got.

Tuesday, March 30, 2021

Safety-First Retirement Planning

An alternative to managing a portfolio of stocks and bonds through retirement is to use insurance company products such as annuities and whole life insurance to get more predictable outcomes.  Mixed approaches are possible as well.  Wade Pfau, a professor of retirement income, makes the case for income guarantees in his book Safety-First Retirement Planning.  The book is a dry read, but it’s thorough in its explanation of insurance company products.  Pfau’s intent is to persuade the reader that annuities and whole life insurance can help build a better retirement, but the book had the opposite effect on me.

Any reader looking for a deep understanding of income annuities, variable annuities, fixed-index annuities, and whole life insurance along with the vast array of bells and whistles available on these products will find it in this book.  Income annuities are simple enough, but the other insurance products have so many small variants that it seems impossible to compare the products of different insurance companies without a retirement researcher at your side.  “Prospectuses about variable annuities can be hundreds of pages long.”

With so much variation in available products, you may wonder how the author is able to make any general claims about how to use these products well.  The answer is that he made many simplifying assumptions.  The biggest assumption is that the insurance products are “competitively priced.”  This assumption is so at odds with some practices in the real world that the chapters on variable annuities and fixed index annuities begin with disclaimers.

Pfau limits his discussion to “good” variable annuities whose “fees are not excessive” and whose complexity is not used to “hide a lack of competitiveness in the pricing.”  He limits his discussion of fixed-index annuities similarly and further assumes they are “not being sold by an unscrupulous financial advisor only to generate a commission.”

My personal experience with variable annuities and fixed index annuities is limited, but I have waded through the rules for a few of them.  In every case, it was clear to me that the products were not “good.”  They were overpriced and their income guarantees were highly vulnerable to inflation, even if inflation stays at low levels.  I’m not optimistic about finding a “good” variable annuity or fixed index annuity of the theoretical types described in this book.

The only insurance product I’ve ever seriously considered is an income annuity indexed to the Consumer Price Index (CPI), but these seem not to be available in Canada.  I might consider an income annuity without inflation protection late in life when I’m less concerned about inflation uncertainty over decades.  The author hasn’t given me a reason to change my mind on these points.  But this isn’t so much a problem with the book as it is a sign that Pfau’s presentation is thorough and unbiased.

One of the side effects of considering theoretical versions of insurance products showed itself in one example comparing a simple income annuity to managing a portfolio of stocks and bonds.  The conclusion was that the annuity allowed higher retirement spending, but this conclusion depends on being able to buy an annuity for the price Pfau calculates.  I don’t know if that is possible in the real world.

For anyone considering whole life insurance, Pfau makes it clear that you should think of it as a replacement for the bonds in your portfolio.  Further, the main value of whole life insurance is the tax deferral, so it makes most sense for someone who has already maxed out tax-advantaged retirement accounts, but still wants more fixed-income investments.

My expectation before reading this book was that it would cover how to decide on portfolio allocation to stocks, bonds, and annuities based on annuity prices and stock and bond future return expectations.  However, the final chapters on pulling everything together didn’t really cover this.  Any rational means of deciding how much to spend on an annuity would be sensitive to the annuity’s price.

Pfau admits that his “discussion has been based on a simplified model in which future inflation is fixed and known.  There was no possibility for unexpectedly high inflation.”  This is why his analyses don’t call for using annuities whose income guarantees are CPI-adjusted.  But in the real world, decades of inflation uncertainty make annuities with fixed income guarantees much riskier than they appear.

The author attempts to partially justify the lack of focus on inflation-protected income guarantees by observing that “inflation-adjusted spending for many retirees can be expected to decline with age.”  The implication of observing that the average retiree spends less with age is that we should plan our retirement assuming we’ll do the same.  This is like observing that the average adult carries a few thousand dollars in credit card debt, so we should all do the same.  Why should we emulate the behaviour of the average retiree when we know that some retirees overspend early and later have to cut spending?

Overall, this book gives a thorough, unbiased explanation of retirement insurance products.  I’m left with a much better understanding of annuities and life insurance.  In theory, retirees could benefit from certain types of fairly priced annuities and life insurance.  In practice, what I learned only solidified my reasons for avoiding most insurance company retirement products.

Monday, March 29, 2021

Buy Now Pay Later Apps

If your financial life is going well, you’ve probably never used a Buy Now Pay Later (BNPL) app and may not have ever heard of them.  Here I look at what return they make on their money, and who pays them this return.

For a good explanation of BNPL apps, see Preet Banerjee’s video where he covers what they are and why you should avoid them.  In a typical case, if you are online buying a $100 item, you might encounter an offer to pay $25 now, and then $25 more in 2, 4, and 6 weeks.  From your point of view, this looks like an interest-free loan, but the BNPL company might only pay the retailer $94.  So, the BNPL company makes $6 over 6 weeks.

BNPL Returns

For this example, Preet calculates the BNPL company’s return as $6 on $94 invested over 6 weeks (42 days).  This works out to an annual uncompounded rate of (6/94)*(365/42) = 55%.

However, the BNPL company didn’t wait 6 weeks for the whole $100.  In fact, it got $25 of this money right away.  So, we could say that their investment was only $69 for 6 weeks.  This works out to an annual uncompounded rate of (6/69)*(365/42) = 76%.

But this still doesn’t account for the fact that the BNPL company got $25 in 2 weeks and another $25 in 4 weeks.  If we calculate the internal rate of return on investing $69 to get back $25 in 2, 4, and 6 weeks, it works out to 4.29% every 2 weeks.  Compounding this annually gives a whopping 199%!  This assumes that all returns get reinvested.

But what if we want to calculate the uncompounded return where the BNPL company makes a single investment and never reinvests returns?  The easiest way to think of this is to imagine the BNPL company entering into a series of $100 purchases where they invest $69 on each purchase to get back $25 in 2, 4, and 6 weeks. We will treat $2 from each payment as profit, and the remaining $23 as a return of the BNPL company’s working capital.

Suppose the BNPL company starts with $138 to invest.  They immediately invest $69 in one online purchase, leaving $69 of their capital uninvested.  Two weeks later, they get back $23 of their capital (and a $2 return), and they invest another $69 in a purchase, leaving them $23 of capital.  Two more weeks later, they get back $46 of their capital (and a $4 return), and they invest another $69 in another purchase (with no leftover capital).

From here on, every two weeks the BNPL company gets back $69 of their capital to invest in another purchase, and they get a $6 return.  They can continue this indefinitely having 3 purchases on the go at all times, all with just the initial $138 of working capital.  If we constrain the BNPL company to winding up all transactions by the end of the year, their total return on $138 is 26 payments of $2, $4, $6, $6, $6, …, $6, $6, $6, $4, $2.  This is a total return of $144, and an annual uncompounded return of 144/138 = 104%.

If we just focus on the steady-state condition where the BNPL company makes $6 every 2 weeks on a $138 investment, the uncompounded return is (6/138)*(365/14) = 113%.

So, which return value is correct?  I’d say the uncompounded return is 113%, and the compounded return is 199%.  Either way, this is well over the usury level of 60%.  However, it’s not at all clear who, if anyone, is being charged this interest.  The deal looks interest free to the consumer, and it looks like a 6% fee to the retailer.

Who Pays for BNPL Returns?

If we look at the retailer and customer as a single entity, they accept $94 from the BNPL company and return $100 spread over 6 weeks.  So the retailer and customer as a combined borrower are paying usurious interest rates in this example.  But it’s not easy to define how they are treated as individuals.

Ultimately, the high cost of the BNPL “service” has to be paid by some combination of consumers and retailers.  Who pays depends on how much the retailer is able to increase prices to cover this cost.  Sadly, it’s not just the consumers who use BNPL apps who pay this price.  When retailers raise prices, everyone pays more no matter how they pay.

Friday, March 26, 2021

Short Takes: CRA Accounts, Asset-Allocation ETFs, and more

I enjoyed Nassim Taleb’s take on Bitcoin (below).  He doesn’t hold back.  There’s a huge difference between pricing Tesla cars in Bitcoin vs. asking for the Bitcoin equivalent of the car’s price in U.S. dollars.  He also says those who believe Bitcoin is a store of value are “ignorant.”  In a different tweet, he says that if you return your car, Tesla has the option to refund you the Bitcoin you paid or the dollar equivalent Bitcoin amount (whichever is less, presumably).  This doesn’t sound like much of a commitment to Bitcoin by Tesla.

Here are my posts for the past two weeks:

Pre-Construction Deals Create a Dishonesty Option

How to Account for High Stock Prices in Retirement Spending

TurboTax Gets Medical Expense Optimization Wrong

Mutual Fund Deferred Sales Charges are Designed to Hide Bad News

How Much Savings Do You Need to Delay Starting CPP and OAS Pensions?

Here are some short takes and some weekend reading:

Rishi Maharaj has a sensible take on the security problems with online CRA accounts that have left nearly a million Canadians locked out.  “The CRA should be commended for surveilling which usernames and passwords are being sold by fraudsters and proactively freezing those accounts. But that’s where the plaudits end.”

Boomer and Echo answers reader questions about asset allocation ETFs and their fees.

Ben Felix explains the elements of good financial advice on the latest Rational Reminder podcast.  Spoiler: it’s not picking stocks or investment managers.  As usual, his ideas are well thought out, but the hard part is quantifying the value of the advice, which will be different for each investor.  Even if Ben’s advice is superior to your own choices in more ways than just portfolio size, the question is whether his advice is enough better to overcome its cost.

Wednesday, March 24, 2021

How Much Savings Do You Need to Delay Starting CPP and OAS Pensions?

Canadians who take their CPP at age 60 instead of 70 “can expect to lose over $100,000 of secure lifetime income, in today's dollars, over the course of their retirement,” according to Dr. Bonnie-Jeanne MacDonald in research released by the National Institute on Ageing (NIA) and the FP Canada Research Foundation.  However, those who retire before 70 need savings to tide them over until their larger CPP pensions start if they want to live at least as well in their 60s as they do later in retirement.  Here we look at the amount of savings required by a retired 60-year old to be able to delay CPP and OAS pensions.

We’re used to thinking of CPP and OAS pensions as just a few hundred dollars per month, but a 70-year old couple just starting to receive maximum CPP and OAS pensions (but not any of the new expanded CPP) would get $61,100 per year, rising with inflation for the rest of their lives.  If the same couple were 65 they’d only get $43,700 per year.  If this 65-year old couple had taken CPP at 60, their combined CPP and OAS would be $32,700 per year now.  The incentive for delaying the start of CPP and OAS is strong.

We can think of the savings needed to delay the start of CPP and OAS pensions as the price of buying larger inflation-indexed government pensions.  This price is an absolute bargain compared to the cost of buying an annuity from an insurance company.  Those in good health but worried about “losing” if they delay pensions and die young can focus on the positives.  Delaying pensions allows retirees to spend their savings confidently during their 60s knowing that their old age is secure.  Taking small pensions early can leave retirees penny-pinching in their 60s worried about their savings running out in old age.

The table below shows the amount of savings a retired 60-year old requires to delay starting CPP.  This table is based on a number of assumptions:

  1. The current maximum age 65 CPP pension is $1203.75 per month.  Before you take your CPP pension, it grows based on national wage growth as well as an actuarial formula, but after you take it, it grows with “regular” inflation, the Consumer Price Index (CPI).  We assume wage growth will exceed CPI growth by 0.75% per year.
  2. We assume the retiree is entitled to the maximum CPP pension.  Those with smaller CPP entitlements can scale down the savings amounts.  For example, someone expecting only 50% of the maximum CPP pension can cut the savings amounts in half.
  3. We assume the retiree holds savings in an RRSP/RRIF so that withdrawals will be taxed in the same way that CPP pensions are taxed.  Retirees using savings in non-registered accounts won’t need to save as much because they only need to match the after-tax amount of CPP pensions.
  4. The retiree is able to earn enough on savings to keep up with inflation.  (Online banks offer savings account rates that put the big banks to shame.)  The monthly pension amounts in the table are inflation-adjusted; the retiree’s savings will grow to cover the actual CPP pension payments.
  5. We assume the retiree doesn’t have a workplace pension whose bridge benefits end at age 65.  This bridge benefit replaces some of the savings needed to permit delaying CPP and OAS.
CPP % of  Inflation-Adjusted  Months of Savings
 Start   Age 65 CPP  Monthly CPP Spending from  Needed at 
Age Pension Pension  Personal Savings  Age 60
60 64.0% $770 0 0
61 71.2% $863 12 $10,400
62 78.4% $958 24 $23,000
63 85.6% $1054 36 $37,900
64 92.8% $1151 48 $55,200
65 100.0% $1250 60 $75,000
66 108.4% $1365 72 $98,300
67 116.8% $1481 84 $124,400
68 125.2% $1600 96 $153,600
69 133.6% $1720 108 $185,800
70 142.0% $1842 120 $221,000

Unlike CPP, you can’t start your OAS pension until you’re at least 65.  But you can delay it until you’re 70 to get larger payments.  The table below shows the amount of savings a retired 60-year old requires to delay starting OAS.  The table is based on a number of assumptions:

  1. The current maximum age 65 OAS pension is $615.37 per month.
  2. We assume the retiree is entitled to the maximum OAS pension by living in Canada for at least 40 out of 47 years from age 18 to 65.
  3. We assume the retiree won’t want to live poor before age 65, which means spending from savings from age 60 to 64 to make up for not receiving OAS.
  4. We assume the retiree holds savings in an RRSP/RRIF so that withdrawals will be taxed in the same way that OAS pensions are taxed.  Retirees using savings in non-registered accounts won’t need to save as much because they only need to match the after-tax amount of OAS pensions.
  5. The retiree is able to earn enough on savings to keep up with inflation.  The monthly pension amounts in the table are inflation-adjusted; the retiree’s savings will grow to cover the actual OAS pension size.
  6. We assume the retiree doesn’t have a complex tax reason (e.g., OAS clawback) that makes it better to take OAS early.

OAS % of  Inflation-Adjusted  Months of Savings
 Start  Age 65 Monthly OAS Spending from  Needed at 
Age  OAS Pension  Pension  Personal Savings  Age 60
65 100.0% $615 60 $36,900
66 107.2% $660 72 $47,500
67 114.4% $704 84 $59,100
68 121.6% $748 96 $71,800
69 128.8% $793 108 $85,600
70 136.0% $837 120 $100,400

An example of how to use these tables

The Harts are 60 years old and recently retired.  They have $400,000 combined in their RRSPs.  Their CPP contribution histories entitle them to a 70% CPP pension each, and they’re both entitled to a full OAS pension.  They’ve decided to hold back $100,000 of their savings as a reserve or emergency fund, but are willing to spend the remaining $300,000 during their 60s in exchange for much larger guaranteed, inflation-indexed CPP and OAS pensions for the rest of their lives.  They’re tempted to reserve even more of their savings, but this would mean lower guaranteed income.

The Harts don’t want to live poor now just so they can have more income later.  So, we first go to the age 65 row of the OAS table to see that they need to spend $36,900 each from 60-64 to make up for OAS not starting until 65.  This leaves $226,200 of their savings to “buy” more CPP.  We began with OAS because starting OAS at 60 isn’t permitted.  We then focus on CPP because delaying CPP boosts pensions more than delaying OAS.  Only if we can delay CPP to 70 do we go back to the OAS table to choose a later OAS start age.

Because their combined CPP entitlement is 140% of a single maximum CPP pension, we divide $226,200 by 1.4, to get $161,600, and look up this amount in the right column of the CPP table.  We find that the Harts can delay CPP until they’re about 68.  So, the plan is to spend one-eighth of the $226,200 each year for 8 years (so CPP can start at 68) plus an extra one-fifth of $73,800 each year for the first 5 years (because OAS will start at 65).

So the Harts now have a plan.  But their lives might not play out exactly as they expect.  As they approach 65, they will apply for OAS, but they might apply for CPP before or after age 68, depending on how much they spend in the coming years, their portfolio returns, and changes to their needs for a savings reserve or emergency fund.  They will be guided by watching their RRSP balance to make sure it doesn’t drop below a sensible reserve amount.

The maximum savings required by a 60-year old to delay pensions to age 70 is $221,000 for CPP and $100,400 for OAS, for a total of $321,400.  This doubles to $642,800 for couples. Those with at least this much saved are able to maximize guaranteed inflation-indexed government pensions that will last as long as they live.  Those whose CPP or OAS pensions are less than the maximum won’t need to have as much saved.  Those who retire before age 60 will need to use more savings to tide them over until CPP and OAS pensions begin.

Although Canadians have many reasons for taking their CPP and OAS pensions early, the only reasons that stand up well to scrutiny are very poor health and lack of savings.  Here we showed how much retirees must have saved to tide them over to the start of enlarged CPP and OAS pensions.