Michael James on Money

Short Takes: New Investment Option, Hedge Fund Disappointment, and more

noreply@blogger.com (Michael James) — Fri, 27 Jan 2012 05:01:00 +0000

Blue Hedge Investments are shaking things up in the Canadian investment landscape. I've had a few people express concern that I've either lost my mind or have sold out to scam artists. Click on "INVEST NOW!" to see what this is about.

Larry Swedroe reports that hedge funds had another lousy year.

The Blunt Bean Counter warns that new rules could lead to punitive taxes for incorporated contractors who are declared “incorporated employees” by CRA.

Larry MacDonald reports that most Boomers are still getting advice suitable for the accumulation phase of their lives rather than advice suitable for heading into retirement. Sadly for too many Boomers, this isn’t too much of a problem because they haven’t saved enough to retire yet.

Potato has some interesting thoughts on the debate about whether to prepare for financial emergencies with cash savings or a line of credit. He believes that it makes more sense to invest extra cash above one month of emergency savings. I think this depends on your situation in life. As many experienced tech workers with high-paying jobs found out a decade ago, your job can disappear and it can take years to find a new one at just 75% of your previous pay at the same time that your stock investments tank badly. I agree that emergency preparedness should be a combination of cash and a line of credit, but the appropriate cash amount can be very different from one person to the next. My cash buffer varies, but it is rarely under $20,000. When I was in my twenties, I considered a cash buffer of $1000 to be quite a lot.

Retire Happy Blog makes the case for low cost passive investing based on 20 years of experience in the investment industry.

Preet Banerjee reports that higher commodity prices are driving up food prices and we’ll see higher restaurant prices as well.

Big Cajun Man is trying to coordinate the federal government and his bank to sort out his pension and RRSP savings. He’s only been at it for a couple of years, so he’s probably got a while to go yet before things settle down.

My Own Advisor reports on the austerity measures planned for Greece including a 20% public-sector wage cut. This is some painful fallout from ignoring growing public debt.

Million Dollar Journey answers some investing questions from a new grad just entering the job market.

Second Look: Trying My Hand at Stock Picking

noreply@blogger.com (Michael James) — Thu, 26 Jan 2012 05:01:00 +0000

Writing this blog has taught me a lot about personal finance and investing. This is one of a series of articles where I argue with my former self by disagreeing with one of my previous articles. Unlike politicians, I’m allowed to change my mind as I learn more from my readers and my own research.

In a post on the costs of trading stocks I said

“I’m not against direct ownership of stocks. I happen enjoy tracking the progress of the businesses that I own, and I’m hopeful that I will prove to be slightly above average at stock picking.”

I followed up with my prescription for success in stock investing:

“Predicting the long-term future of a stock is best done by trying to predict the future success of the business rather than looking at wiggles in the chart of stock prices.”

I’m still not against direct ownership of stocks for highly skilled investors, and I still believe that fundamental analysis beats technical analysis. However, I’m no longer hopeful that I’m a good enough stock picker to be able to consistently beat the market averages. My record during my stock picking years beat the market, but only because of a couple of huge bets more than 10 years ago. Since then my results consistently lagged.

For stock traders, 80% to 90% of their competition is institutional investors. This is just not a game I want to play any more. Most individual investors who try to win this game will fail, but no doubt some have the skill to succeed. My guess is that the percentage of stock pickers who have the skill to consistently beat the market is extremely low.

I’d love to be able to go back to talk to my former self just after my last successful huge bet and convince myself to give up this game and just invest in indexes. Even better would be to give myself a stock recommendation, like Apple, but I don’t want to be too greedy.

On the Positive Side …

Here are a few of my older articles that I still quite like:

Insurance is not the same as protection even if it seems that way.

A game show illustrates an important lesson about the utility of money.

My visit to a doctor shows when insurance can be a bad deal.

When trying to transfer your long-term savings, it’s easier to pull than to push.

Locking in a Natural Gas Price

noreply@blogger.com (Michael James) — Wed, 25 Jan 2012 05:01:00 +0000

Rob Carrick says it’s time to lock in your natural gas price. He reasons that current prices are very low compared to previous highs. Buying a fixed-price contract for natural gas is like buying insurance against price increases, but for natural gas this insurance is quite expensive.

Carrick says that the current gas supply charge he pays is 12 cents per cubic meter. (He also points out that at this low price, the supply charge is only about half of what you pay. The other half is storage and distribution costs.) The peak price was 42 cents per cubic meter. The cheapest price he could find to lock in for the next 5 years is 19.7 cents.

To make these figures more real, let’s use my family’s consumption numbers. We used 4700 cubic meters of natural gas over the last year. This translates to a cost at current rates of $564 per year (plus roughly another $564 for storage and distribution). At the peak price, this would be $1974 (plus $564). At the best 5-year locked in rate, this would be $926 (plus $564) per year.

If natural gas stayed at 12 cents, the added cost of the fixed contract is $362 per year for a total of $1810 over 5 years. On the other hand, if rates were to suddenly shoot to 42 cents and stay there for 5 years, the fixed-price contract would save $5240 over 5 years. So, for an insurance premium of $1810, I could buy protection from big jumps in natural gas prices.

The difficult question to answer is whether this is a good investment. Are big price increases likely? If yes, then why are the suppliers dumb enough to supply gas at 12 cents right now? And why are fixed-rate suppliers willing to lock in 19.7 cents for 5 years? My guess is that like other forms of insurance, this is not a good deal strictly based on the expected outcome. After all, gas prices would have to rise steadily at 20.2% per year for 5 years for you to break even on this insurance.

The real value of insurance is protection from big losses. I buy liability insurance for my car because I don’t want to pay a million dollars if I’m at fault in a serious accident. In the case of natural gas, even in an extreme scenario where gas prices shoot up to 42 cents, it would cost me an extra $1410 per year for 5 years. I can handle this. I wouldn’t like it, but it wouldn’t devastate me.

So, I won’t be buying a fixed price natural gas contract. While it is possible that I’ll lose out by just paying market rates, I believe that the expected outcome is in my favour, and the worst case isn’t all that bad.

Hidden Costs in Private Investing

noreply@blogger.com (Michael James) — Tue, 24 Jan 2012 05:01:00 +0000

An acquaintance of mine I’ll call Carl mentioned that he invests with RBC’s private investing service where he pays a fixed percentage fee on his portfolio each year rather than paying management fees on all of his funds. I asked what other fees he pays and Carl’s reply was that there were no other fees. He said that he only pays the percentage fee and is pleased that he negotiated it below 1% per year on his sizeable portfolio. I just had to check into this.

It turns out that Carl’s portfolio is mostly invested in RBC’s Series O Private Pools. Carl was partially correct in that he does not pay any management fees on these funds. But, he does pay a management expense ratio (MER) and a trading expense ratio (TER) on each fund.

Many people think that management fees and MERs are the same thing because of the similar names, but they have differences. MERs contain the management fees plus a few other things like administrative costs and taxes. Outside of the MER are trading costs. So, in addition to his negotiated yearly fee, Carl pays administrative costs, trading costs, and taxes.

All of this was explained in the fund facts sheets. For example, the RBC O'Shaughnessy Canadian Equity Pool Series O has an MER of 0.11% and TER of 0.26%, for a total cost of 0.37%. Among the equity pools, the average added cost was 0.36%. Among the bond pools, the average added cost was 0.04%.

These costs may not seem like much, but remember that they are on top of the yearly fee that Carl negotiated. Adding 0.36% to this fee for the equity funds makes Carl’s negotiating skills look less keen. And while the added costs for bond funds are very low, the negotiated fee is quite high for fixed income investments.

Carl was quite surprised to learn all of this. While this information is available on the RBC web site and may well have been disclosed to him in documents he received, Carl’s understanding from talking to RBC representatives was that his only cost was the negotiated fee. This misunderstanding likely stems from not realizing that there are fees other than management fees.

Crushing Debt

noreply@blogger.com (Michael James) — Mon, 23 Jan 2012 05:01:00 +0000

David Trahair’s book Crushing Debt is subtitled Why Canadians Should Drop Everything and Pay Off Debt. This led me to believe that the primary focus of the book would be the need for individuals to reduce their debts. However, to get to discussions of personal finance and debt reduction, readers have to wade through the first half of the book which is about macroeconomic factors related to debt. The book has some interesting parts, but overall it is a little thin on useful content.

“A financially illiterate, disorganized client is a bank’s most profitable customer.” The thought of giving my money away to a bank is a great motivator to get me organized and seeking financial knowledge. Trahair even claims that he once arranged to give a series of free lectures at a university, but the university’s “Financial Partner” put a stop to his lectures because “it would be bad for their business.”

“Household debt levels are threatening the stability of Canadian banks.” The McKinsey Global Institute looked at 5 sectors in each of 14 countries and found that among the 70 sectors studied, Canada’s household debt made the top-ten list of those with “the highest risk of deleveraging.”

Trahair says that in some cases, those who “brag about never carrying a credit card balance” are actually “using a line of credit to pay off [their] credit card[s].” With large line of credit balances, these people may be in worse shape that those with a small credit card balance and no line of credit.

One of the better parts of the book was the explanation of why the goal of being debt-free is important. “In a severe recession, everything bogs down. Stock markets tank and ... real estate will plummet too.” Your creditors will try “to collect the money owed to them like starving dogs looking for a bone. You don’t want to be the subject of their hunt do you?” The message here is that you should not be evaluating the riskiness of debt in typical economic conditions, but rather in unfavourable conditions like a recession or when interest rates shoot up.

Trahair served 6 years on the Board of Directors of Credit Canada. This translates into quite a good section on the three choices for help getting out of personal debt: Credit Counseling Debt Management Plan, Consumer Proposal, and Bankruptcy. The strengths of this section are helping you decide what route to take and what to expect from each choice. I would like to have heard more about potential pitfalls. I’ve heard stories about unscrupulous credit counselors, but I don’t know the typical ways that the bad ones exploit their clients.

“The vast majority of Canadians ... have no idea where their money is going.” I think most people would get some surprises if they saw a pie chart of how much they spend in various categories. Trahair gives some very detailed instructions on how to collect your transactions from your bank’s web site and compile them in a spreadsheet. Even novice spreadsheet users would have a chance at following his directions.

Short Takes: ETF Uptake Disappointment, Endowment Effect, and more

noreply@blogger.com (Michael James) — Fri, 20 Jan 2012 05:01:00 +0000

Tom Bradley at Steadyhand reports on the underwhelming size of the shift from mutual funds to ETFs. Even as someone who competes against ETFs, he would like “these simple, low-cost products to have a bigger impact on the industry landscape.”

Canadian Couch Potato looks at our tendency to overvalue the things we own. This can actually makes sense in some contexts. For example, it makes sense to give a low value to a new type of laptop bag until you’ve used it for a while and discover it’s much better than your old kind. But this doesn’t apply to investing; you don’t have to own something to judge whether or not it’s a good investment.

Big Cajun Man is unimpressed by Suze Orman’s new debit card.

The Blunt Bean Counter raised $12,575 in his bloggers for charity drive.

Preet Banerjee explains why owning real estate may not be the best idea right now.

Canadian Capitalist compares currency-hedged vs. unhedged holdings.

Million Dollar Journey explains Health Spending Accounts and their tax benefits.

A Misconception about the Value of Bonds

noreply@blogger.com (Michael James) — Thu, 19 Jan 2012 05:01:00 +0000

Do you own bonds and are hoping for interest rates to go up so that you can make more money? You’re not alone. Many people are confused about what makes bonds go up and down in value. Once you own a bond, you should be hoping for interest rates to go down, not up.

The return that you get from a bond is determined by prevailing interest rates. However, once you buy a bond, your interest rate is locked in not only for this year, but all future years until the bond matures. If rates go up, you don’t get to collect the higher rate next year. Instead, higher interest rates will make your bond then looks worse in comparison to new bonds and other investors won’t be willing to pay as much for your bond.

This is the basis for the inverse relationship between bond values and interest rates. Before you buy a bond, you’re hoping for higher rates, but after you’ve bought the bond, its value rises if interest rates go down, not up.

The Cost of Paying Bills Early

noreply@blogger.com (Michael James) — Wed, 18 Jan 2012 05:01:00 +0000

You’ve logged in to pay your credit card bill and you have to choose the date to transfer the money. Do you choose the actual due date, the day before, or some earlier date? What is the right balance between the risk of late fees and the opportunity cost of paying early?

Some people say they always pay bills on their due date and have never had a problem with late fees. Others claim that banks use dirty tricks like setting due dates on weekends and holidays and not recognizing payments until the following business day.

It can be difficult to gauge the risks of paying on or very close to a due date. But it isn’t too hard to figure out the cost of getting caught paying late if you can’t talk the bank or other creditor into waiving the late penalty. Many utility bills actually say explicitly what the cost will be if you pay late. With credit cards, the cost is retroactive interest back to the date of purchase on all outstanding items. The total penalties are often in the 2% to 3% range.

The opportunity cost of paying bills early depends on what else you would have done with extra money. It would not be a fair comparison to say that you are just losing bank account interest, unless you really just have all your savings in a bank account. If you had more money in your bank account, you’d probably use the excess for some other purpose such as paying down debt or investing for retirement.

I’ll use 8% per year as an opportunity cost on the assumption that this is a reasonable return expectation for retirement savings and that you’ll find some way to avoid paying higher than 8% interest on any debts.

On a $1000 bill, cost of paying late is about $20 to $30, and the opportunity cost of paying early is about ($1000 * 8% / 365) = 22 cents per day. In my household we tend to pay bills at least 2 days early, but occasionally as long as 2 weeks early for an average of about 3 days. On a yearly total of about $40,000 in bills, the total opportunity cost works out to $26 per year.

So, if this policy of paying early prevents just one instance of paying a $1000 bill late during the year, we’ve broken even. I’m no fan of giving money to banks needlessly, but I do like not worrying about whether our payments are made on time.

Don’t Mix Life Insurance and Investments

noreply@blogger.com (Michael James) — Tue, 17 Jan 2012 05:01:00 +0000

The top bid in the Bloggers for Charity initiative was Glenn Cooke at InsureCan Inc. He donated $100 to the Wilmot Family Resource Centre that provides affordable social, educational, and recreational services and programs.

What would you think if your car insurance broker suggested that you pay higher premiums for your car insurance in order to build up your RRSPs? You’d probably think that something was funny, and go looking for a real expert for your RRSPs.

Conversely is your investment advisor the first person you call for advice on the best car insurance rates?

Both of those situations smell a bit funny. Yet swap out the words ‘car insurance’ for ‘life insurance’ and all of a sudden many consumers find the idea more palatable. Why is that?

The answer lies with a bit of history and a bit of insurance product design. Car insurance premiums are priced on a year by year basis – risk is passed along in the form of premiums each year. For most life insurance products, though, premiums are levelled out across a number of years, sometimes even out to the entire lifetime of the insured. This levelling process means insurance companies build up a reserve of premiums inside the policy over time. That reserve is intended to cover some of the higher risk on life insurance as the insured gets older. The insurance industry, however, has taken that reserve and marketed it through the years as a saving plan or investment. And that has given us an environment where life insurance specialists are dabbling in different investments.

Hypothesis #1: You can find better investment options outside of the life insurance industry.

The standard sales technique goes like this: If I show you that you could invest in a product where the growth was tax deferred, wouldn’t this increase your investments substantially? Of course it would – when compared to an investment that isn’t tax sheltered. What got missed was that most Canadians have a variety of other tax sheltered investment options available to them. RRSPs are always a better option than investing in a life insurance policy, and how many Canadians have maximized their RRSPs? Few have.

Now some in the insurance industry will tell us that insurance investments become worthy after you’ve maximized your RRSPs. At that point, the tax sheltering seems to become comparable to other types of non-insurance investments. Unfortunately (for the life insurance industry) while the tax sheltering may be comparable, the investment options are not. Life insurance investments typically have hidden surprises like heavy back-end loads and high MERs. These two things mean your money is likely to be locked in place and provide you with a lower return than similar options available outside the life insurance industry.

It’s worth noting that there is a big push from inside both the insurance and investment industries (and the banks) to capture all of your business. There are a lot of benefits to the industry for you to deal with one place for both your insurance and investments – benefits that are not necessarily in your favour.

Corollary #1: Don’t use your insurance advisor for investments.

Insurance agents and brokers are licensed to sell insurance – we are not licensed to sell investments. The big world of investments, the billions (well, seems like that) of mutual funds available, are simply not available through your insurance advisor. So you are going to get an insurance product first and foremost, not a product that is primarily intended to be an investment.

Secondly, you’ve now purchased an insurance product that’s been repurposed for investments. What does that do to your insurance? Do you now have the proper insurance product? Or did you have to bend on the insurance in order to get the ‘right’ investment?

Corollary #2: Don’t use your investment advisor for insurance.

Some advisors are dual licensed – they are able to offer both investments and insurance. It seems like we have the best of both worlds. But do we?

I’d like to suggest that both the investment and insurance environments are so vast and complex that it’s virtually impossible for one person to be expert at both of them. In the field of insurance we have our own compliance regime, product changes, risk management, riders, ratings, product idiosyncrasies, and a slew of other minute details that can consume an advisor’s entire career just keeping abreast of them all. What’s the best company for someone who quit smoking six months ago? What’s the best company for someone with diabetes? Or for a pilot? Or for someone with 4 children? If an investment advisor is staying on top of the investment environment, how can they possibly also have the time to stay on top of the complex insurance environment as well?

If you do want to stay with one firm for loyalty reasons, some larger firms have both investment and insurance reps that will refer business between each other. This allows you to get the best of both worlds while sticking with one company.

In summary, if you’re using an advisor for investments, find yourself an expert on investments and stick to investments. If you’re looking for life insurance, find yourself an expert life insurance advisor and center the conversation around insurance. Use two different people for these services.

Too late? Have you already intermingled these two products? While the life insurance industry has traditionally trained its reps to never replace a life insurance policy, I’ve provided some strategies over at Financial Highway on How To Replace a Life Insurance Policy.

Glenn Cooke is a life insurance broker and president of InsureCan Inc. He is happy to provide a second opinion on your life insurance options and does not offer investment advice to his clients. He can be reached at (866) 662-5433.

Economics in One Lesson

noreply@blogger.com (Michael James) — Mon, 16 Jan 2012 05:01:00 +0000

The central theme of Henry Hazlitt’s book, Economics in One Lesson, is that one must look beyond the primary effects of economic policies to see the secondary effects. Under such scrutiny, many policies lose their lustre. Hazlitt delivers on the promise of a useful lesson in economics in just over 200 pages. Originally written in 1946 and then updated in 1978, the topics in this book are still very relevant today.

“The art of economics consists in looking not merely at the immediate but at the longer effects of any act or policy; it consists in tracing the consequences of that policy not merely for one group but for all groups.”

Hazlitt begins with a story of a vandal breaking a window. Superficially, this seems to create work for glass makers and window installers, but upon tracing through all the effects, the world on balance loses more employment than it gains from the broken window. It makes sense that vandalism would have a net negative effect on the economy, but this isn’t apparent if you focus on those who are paid to make repairs.

The book continues with lessons in many areas including government spending, taxes, credit, automation of work, shortening work hours, tariffs, fixing wages and prices, saving industries, rent control, minimum wage, unions, profits, inflation, and saving. Each sub-lesson is explained clearly for the reader to understand and accept or try to refute.

A common theme is that attempts to help one group often hurt other groups. What this says to me is that we should be very selective about which groups we choose to help. Shifting tax money to the less fortunate is a luxury of wealthy societies. However, we have to be careful about determining exactly how much such help we can afford. And we should not waste our limited capacity for helping the less fortunate by helping those who don’t need help.

For the rest of this review, I’ll discuss specific parts of the book that struck me as interesting.

Credit

Some believe that credit is something a banker gives to you. In fact, credit is something you already have. Your “character and past record have earned it. ... The banker is not giving something for nothing.”

Government Loans

Private lenders “are selected by a cruel market test.” They “are rigidly selected by a process of survival of the fittest.” Government lenders are those who produce “the most plausible explanations of why it wasn’t their fault that the loans failed.”

Unemployment

Many schemes for solving unemployment problems rest “on the false assumption that there is just a fixed amount of work to be done. There could be no greater fallacy. There is no limit to the amount of work to be done as long as any human need or wish that work could fill remains unsatisfied.” Some policies are based on the idea that there is a fixed list of available jobs “which has to be spread over as many people as possible so as not to use it up too soon.” On the contrary, “work creates work.”

Rent Control and Slumlords

When rent controls keep rents artificially low, landlords have little incentive to invest in their properties because they cannot get a sufficient return on such investments. “Where rent controls are particularly unrealistic or oppressive, landlords will not even keep rented houses or apartments in tolerable repair.”

Unions

Hazlitt points out many of the negative effects of unions, but has some positive things to say about them as well. “In some trades they have insisted on standards to increase the level of skill and competence. And in their early history they did much to protect the health of their members.” I suspect that the author would not find much positive to say about modern unions.

Inflation

Inflation is a consequence of many misguided policies intended to improve our welfare. However, we cannot consume more than we produce. Inflation restores “a workable relationship between prices and costs of production.” However, people fail to properly account for inflation when judging their salaries and raises. “Inflation is the opium of the people.”

Saving

Many argue that when people save money the economy suffers. However, saving “is another form of spending” because money saved in banks is lent to businesses for projects to increase production. Saved money creates just as much employment as spent money. Some believe that saving “is the cause of depressions” when it is really “the consequence of depressions.”

Short Takes: Slow RRSP Transfers, Rule of 40, and more

noreply@blogger.com (Michael James) — Fri, 13 Jan 2012 05:01:00 +0000

Tom Bradley at Steadyhand rants about how long it takes some large financial institutions to transfer out RRSP accounts.

Wealthy Boomer explains the rule of 40 to figure out how long it takes for a mutual fund MER to consume one-third of your portfolio. This is a variant of the rule of 72 for figuring out how long it takes your money to double.

Carol Goar at The Star explains a new scheme by tax preparers to exploit the poor.

Larry Swedroe reports that 2011 was another bad year for actively-managed U.S. stock funds.

Rob Carrick interviews Gordon Pape about his new book Retirement’s Harsh New Realities.

Canadian Couch Potato is positive about BlackRock acquiring Claymore. Any reduction in competition makes me nervous as a consumer, but Vanguard’s entry into the Canadian ETF space should keep up the pressure to keep costs down.

My Own Advisor makes some financial goals for 2012. I like the approach he has taken to put dollar figures on each goal. Personal finance is not a pass/fail game. You get part marks for coming close.

Preet Banerjee explains how to save on different types of goods with off-season shopping.

Money Smarts tries to raise awareness about Canada Learning Bonds (CLBs), which are government contributions to RESPs of low income families. They don’t even have to make a contribution to get a CLB.

Big Cajun Man has an amusing rant about telemarketers.

Million Dollar Journey explains why he buys dividend stocks directly rather than using a dividend ETF.

Second Look: Investing in Individual Stocks

noreply@blogger.com (Michael James) — Thu, 12 Jan 2012 05:01:00 +0000

“There is nothing wrong with investing in individual stocks if you are truly knowledgeable and willing to put in the time to follow the companies you own.”

I used to believe that smart people willing to put in the work to pore over annual reports and financial statements could beat the stock market averages. Former self, I think you are wrong. I no longer believe that intelligence and hard work are enough. There are too many brilliant people trying to do the same thing. Unless you are a true financial genius or have access to inside information, I’m pessimistic about your likelihood of keeping up with average market returns over the long run.

Sadly, I know too many small investors who think that following stock prices and calculating dividend yields qualifies them as stock experts.

On the Positive Side …

Here are a few of my older articles that I still quite like:

What is a mutual fund? Here I tell a story designed to explain the different players involved in mutual funds and their motivations.

Why does my financial advisor seem to work for free? This is the story of how years after investing in mutual funds I came to understand how my financial advisor was paid.

What is an MER? Aimed at novices, this article explains management expense ratios and why small percentages matter.

Some Economic Predictions for 2012

noreply@blogger.com (Michael James) — Wed, 11 Jan 2012 05:01:00 +0000

I routinely get asked for market predictions. Friends and colleagues ask questions like what will interest rates do this year? My attempts to say that I don’t know and that I don’t think anyone else knows either are usually met with something like “yes, but where do you think the stock market is headed?”

So, I decided to have some fun and give people the predictions they want. These predictions will be random. I didn’t toss any coins, but I’m just going to write down the first thing that comes to mind without any serious thought.

Random predictions for the next year:

1. Interest rates will go up a little.
2. Housing prices will come down a little.
3. Canadian and U.S. stock markets will have an above average year.
4. Bonds will have a below average year.
5. RIM won’t drop 75% again.
6. Berkshire Hathaway will have a strong year.

If you rely on these predictions, you’re crazy. If they prove to be uncannily accurate, I will refuse to take any credit.

Humans seem wired to believe that with enough thought we can somehow predict the future. To some extent we can. We know when the sun will come up each day, and we can predict tomorrow’s weather with some accuracy. However, financial markets already reflect a consensus of predictions. Trying to out-predict the world consensus view is largely futile.

Investing Skill

noreply@blogger.com (Michael James) — Tue, 10 Jan 2012 05:01:00 +0000

We often hear that while most investors are better off with passive investing in index funds and ETFs, skilled investors should try to beat the market. The problem here is that the word “skill” here has a technical meaning that is quite different from its everyday use.

The technical meaning of investing skill is more or less synonymous with having better than 50/50 odds of beating the market. So, if the odds are that you’ll beat the market (after costs), then it makes sense to try. But this meaning is very different from the ordinary use of the word “skill”.

Just because you know more about investing than your friends and neighbours doesn’t necessarily mean that you’re likely to beat the market, even though your superior knowledge makes you skilled in the ordinary sense of the word. If I use “skill” with its everyday meaning, here is how I would state the conditions under which it makes sense to be an active investor:

“Active investing makes sense when you are significantly more skilled than the dollar-weighted average active investor.”

Let’s break that sentence down starting from the end and working back.

Why should you compare your skills to only other active investors rather than everyone?

When you are an active investor you can only succeed when you take money away from someone else. You can’t take money away from people with nothing to invest or who are passive investors. You can only succeed when other active investors fail. If you’re not better than your competitors, then you will lose.

Why should you dollar-weight the active investors you compete with?

If some investor is only playing with $500, even if you out-trade him for his entire portfolio, you’ve only made $500 (less costs). When you make a trade, the person on the other side of the trade is much more likely to be someone controlling a huge portfolio than a small one. Your main competition is big players, not other individual investors.

Why do you have to be ‘significantly’ more skilled?

Active investing generally has much higher costs than passive investing. Active traders as a whole pay more in commissions, spreads, and taxes (for non-registered accounts) than passive investors pay. If you achieve average results among active investors, then you’ll still get lower returns than passive investors. You have to clearly beat the (dollar-weighted) average active investor.

Getting back to the technical meaning of investing “skill”, it may be that skilled investors exist. Warren Buffett demonstrated skill over his investing lifetime. Some argue that modern efficient information flow and the increasing number of talented people who analyze markets has made it harder to be a skilled investor. If skill still exists, it must be rare. The next time someone talks about investing skill, keep in mind that this means much more than just being smarter than your brother-in-law.

The Illusion of Low Financing Rates

noreply@blogger.com (Michael James) — Mon, 09 Jan 2012 05:01:00 +0000

Recently, a car ad trumpeting 0% financing caught my eye. Sounds great! I’ll take it. Just give me a 25-year amortization at 0% and I’ll drive off in my new car. Fat chance. The car company would never agree to this arrangement because the financing isn’t really at 0%.

If I could get this deal for a $30,000 car, the payments would be $100 per month for 25 years. At 4% inflation, the last payment would have the purchasing power of $38 in today’s dollars. That would be a very sweet deal, especially if $30,000 was the final price after negotiation rather than the inflated asking price.

In reality, we get to choose either a price discount (cash back) or a low financing rate for just a few years. This proves that the real financing rate is much higher than advertised. No doubt car marketers know how to avoid breaking the law, but why is this type of advertising permitted?

This reminds me of the deal my parents were offered when they bought their first house. They could get the house for one price, but if they paid a few thousand more, they would get a free car as well. This is a curious use of the word “free”.

Even for people who understand that the financing rate is really much higher than stated, the effect of these games is to confuse the consumer. One way to sort things out somewhat is to check what loan terms you can get from a bank to compare them to the car company’s financing terms.

Take the car’s price (after negotiating it as low as you can) less the cash back and talk to your bank about what the payments would be. Compare this to the car company’s payments (for the same number of years of payments). This will give you an idea of how the car company’s real financing rate compares to the bank’s rate.

Short Takes: Explaining Investing Costs, Portfolio Rebalancing, and more

noreply@blogger.com (Michael James) — Fri, 06 Jan 2012 05:01:00 +0000

Preet Banerjee answers some questions from a financial advisor not happy with his Globe and Mail column, Would you give up 44 per cent of your investment over 25 years.

Larry MacDonald asks several experienced investors how they handle portfolio rebalancing.

Larry Swedroe shows that when it comes to investing, what you don’t understand can be very expensive.

Canadian Couch Potato explains how ETF units come into and out of existence and how this process keeps them trading at the value of the underlying assets.

Potato analyzes his performance as an active investor and explains his struggle to decide whether to be an active or passive investor.

The Blunt Bean Counter explains 5 popular CRA audit targets.

Big Cajun Man writes about the magic dancing monkeys that may be standing (dancing?) between him and his son’s Canada Learning Bond.

Canadian Capitalist summarizes the 2011 returns for various asset classes.

Gail Vaz-Oxlade explains that the best way to change your behaviour is to focus on what you really, really want rather than focusing on what you should stop doing. I see the power of this with one friend of mine who has set a target date to retire into a life of daily golf. He is laser-focused on his goal and this makes it easier for him to save a high percentage of his income. Without this goal it would he harder to avoid expensive temptations.

Million Dollar Journey and Money Smarts announce their results in a 2011 stock-picking contest. The average result of the 9 participants was a loss of 14.57%. My pick of the Canadian and US stock indexes would have been well above average.

PRPP Costs

noreply@blogger.com (Michael James) — Thu, 05 Jan 2012 05:01:00 +0000

So far I have more questions than answers about the new Pooled Registered Pension Plans (PRPPs) and a big question is what the costs will be like for participants. The Department of Finance has a framework document that lays out the basic idea of PRPPs, but it is the details that will determine if this approach is beneficial for Canadians or not.

PRPPs will be administered by “regulated financial institutions that are capable of taking on a fiduciary role in order to act in the best interests of plan members.” The investment choices will allow participants to create portfolios consistent with their “investment objectives and risk preferences including a low cost option.” This seems to imply that high-cost options may be offered as well.

Because it will be employers who will decide which financial institution to choose as a PRPP administrator, and we can reasonably believe that employers can evaluate costs better than the typical Canadian, there is some hope that PRPP administrators will compete on costs, but this is not guaranteed.

If the PRPP legislation doesn’t prevent administrators from “refunding” part of the investing costs back to employers, then competition on costs could be undermined. (See the update below that explains why this is not permitted.) If one administrator’s costs are 0.5% of plan assets and a second administrator’s are 1.5% with a 0.5% “refund” back to the employer, which one do you think the employer will choose? Note that both the administrator and the employer are better off with the second plan as long as employees don’t revolt.

I have (had) no idea whether the PRPP legislation or the required fiduciary role of administrators is likely to prevent such a scheme to give incentive payments to employers. However, if PRPPs take off, there will be huge amounts of money at stake. I’d be interested to hear from anyone with an expert opinion on whether any type of direct or indirect “refund” scheme is likely to be possible with PRPPs.

Update: That was quick. Thanks to Shawn Patton who commented below on finding a section of Bill C-25 that prohibits an administrator from giving kickbacks to employers:

"24. Subject to the regulations, an administrator must not give, offer or agree to give or offer to an employer an inducement to enter into a contract with the administrator in respect of a pooled registered pension plan."

Hail Mary Argument for Active Investing

noreply@blogger.com (Michael James) — Wed, 04 Jan 2012 05:01:00 +0000

Canadian Couch Potato recently posted a thoughtful criticism of Gordon Pape’s argument in favour of active investing. Pape’s reasoning strikes me as another example of what I call the ‘Hail Mary’ argument.

Passive index investors receive market returns less modest costs. Active investors also receive market returns, but their costs are much higher. So, on average, active investors get lower returns than passive investors. This is true whether market returns are high or low.

Despite this argument, which is based on simple math, we often hear people say that when the markets give poor returns, you have to become a stock picker to get decent returns. On the surface this is true. The only way to beat the market is with some active investing approach; passive investors will never beat the market.

However, the average active investor will still lose to the market. A few will beat the market, and most will get less than market returns, even when market returns are poor. For most investors, trying to beat the market is a Hail Mary approach. It probably won’t work, but passive investing is guaranteed to not beat the market.

So, what’s wrong with a Hail Mary? Football teams try them all the time. They’re exciting and occasionally they work. Unfortunately, there is a big difference between football and life. Football teams only try a Hail Mary when it’s the last hope before all is lost. There is no difference between losing with a conservative play and losing with a failed Hail Mary. But, in real life, there is an important difference between getting a cumulative passive return over a decade of 25% and getting an active return of 0%.

The only way it makes sense to use active investing is when there is a reasonable expectation of outperforming passive investing. The investor has to be correct in his belief that he is so much better than other active investors that he will overcome higher investing costs to beat the market. Just hoping to outperform by luck is little better than gambling at the roulette table.

The Wealthy Barber Returns

noreply@blogger.com (Michael James) — Tue, 03 Jan 2012 05:01:00 +0000

I do my best to explain things as clearly and simply as possible, but David Chilton, author of The Wealthy Barber Returns, does a better job. Years of seeking financial strategies that work and explaining them to people has clearly paid off. It’s nearly impossible to write a financial book aimed at a broad audience that is useful, understandable, and entertaining, but Chilton has done it.

A major focus of the book is recognizing human weaknesses and finding financial strategies that work despite these weaknesses. Temptation is everywhere and “one of the biggest reasons that it’s so difficult to save is that no one out there really wants you to,” from your kids and friends to bankers and governments. Chilton says that learning to say “I can’t afford it” is liberating and “frees you from the pressures to live beyond your means.”

The book points to home-renovation expenses as a major factor in people getting into trouble with their lines of credit. As for credit cards, the cycle is “See. Salivate. Swipe. Rationalize. Rinse. Repeat.”

Banks usually determine how much debt you can afford based on your gross income. Chilton advises using your income after taxes and after proper savings. When lending you money, banks don’t care if the interest payments keep you from saving in your RRSP or RESP.

Tracking all your expenses for a few months is tedious, but the author says that it’s important to see where your money is really going. The areas where people most underestimate their costs are “(1) cars; (2) dining out; and (3) little things.”

“CPP, QPP and OAS may become stingier. If you can survive without them, you just might have to.” This seems to imply that Chilton believes that these benefits may be clawed back (or clawed back more in the case of OAS) from higher-income earners in the future.

“Spend more on experiences and less on stuff.” I whole-heartedly agree.

On reverse mortgages, Chilton thinks they are expensive (fees and high interest rates), but that they “are, on occasion, a viable solution.” I don’t know a lot about reverse mortgages, but I’ve heard proponents say that your debt can never exceed the value of your home and you can’t be forced out no matter how long you live. This makes me nervous because old people are often forced out of their homes for health reasons. If the debt grows to consume the house, then a forced-out senior would have nothing left to pay for another place to live. I would have liked to read Chilton’s take on this issue.

The author is no fan of people using index ETFs to “time the market or play the hot sector.” These people aren’t “just sitting back, they’re making things happen. Things like commissions, higher taxes and below-average returns, for example.” That line cracked me up.

Predicting which investments will outperform in the future is very difficult. “I’ve met a phenomenal number of people, however, who can pick past outperformers with uncanny accuracy.” When he meets advisors who think that can pick future outperformers, Chilton likes to ask them “Do you recommend the same funds now that you did three, five and ten years ago?” Of course, the answer is usually no, which means that the previous recommendations didn’t perform well.

A very interesting statistic about stock market volatility: since 1926, “the S&P 500 has risen between 0 and 20 percent in only one-third of the years.” However, Chilton is positive about stock investing: “I strongly believe in human ingenuity and creativity, and I want a piece of the action.”

Chilton says that more than 80% of the people he asks have no idea how much they pay their advisors or how well their portfolios have performed. Despite this, he predicts that “the costs of financial products and financial advice are going to go down significantly.”

The frequent humour and wise advice make this book a pleasure to read. The world is full of investing books, but this one also addresses the challenge of saving enough money to make investing worthwhile.

A Vivid Illustration of an Over-Priced Extended Warranty

noreply@blogger.com (Michael James) — Thu, 29 Dec 2011 21:33:00 +0000

One of the computers in my house came to the end of its useful life recently. In my house, that means ordering a new computer from Dell. Since I’m a tech guy and have techie friends, I’ve heard time and again how I can save money by buying cheap components and putting the PC together myself. But I’d rather leave it to Dell to put the system together and pay a little extra, but not too much extra.

I prefer to buy online, but the Dell web site didn’t allow me to make all the choices I wanted. This meant having to make a call to Dell. This also meant having to turn down all the high-margin items available as add-ons.

I was pleasantly surprised when the salesperson didn’t press me on an extended warranty after I turned it down; she just went on with the list of other choices. However, when we came to the end, she began a script: “You know sir, you’re buying an expensive computer...”.

For a mere $119 I could extend the standard warranty from 1 year to 2 years. After I turned down this offer a miracle happened and the extra year of warranty dropped to $79 in 10 seconds. After I refused again, it took only 10 more seconds for it to drop to $60. Yet another refusal by me didn’t create any further drops in price.

I don’t know what an extra year of warranty costs Dell, but I’m guessing that it’s much less than $60. This makes the original price of $119 seem like a big gouge.

Train Your Brain to Get Rich (or not)

noreply@blogger.com (Michael James) — Tue, 27 Dec 2011 14:12:00 +0000

I’m a victim of marketing. The title of the book Train Your Brain to Get Rich by Aubele, Freeman, Hausner, and Reynolds caught my eye, but the title is misleading. The additional words on the cover, “the simple program that primes your gray cells for WEALTH, PROSPERITY, and FINANCIAL SECURITY,” just add to the misdirection. This book isn’t really about money.

As I read through the first quarter of the book, I kept waiting for the financial aspects to begin, but by the hundredth page I suspected that they never would begin, and as I finished the last page, my suspicion was confirmed.

This book is really about brain health and the benefits of such things as a positive attitude, meditating, exercise, sleep, and healthy eating. The superficial financial parts of the book could just as easily be replaced with “train your brain to play better tennis.”

The financial references actually seem as though as though they were added after the fact by a different writer. It’s as though someone took a completed book and added variants of “to get rich” and “your way to wealth” to all the chapter titles. The financial references inside the book are equally superficial.

There are many examples of this financial superficiality within the book, but I’ll give just one. A section that discusses the brain benefits of dreaming is titled “Dream Yourself Rich”. I would have preferred “Dream Yourself to Killer Abs”.

In an effort to say something positive, I found two things. In one section the authors recommend a focus on buying experiences rather than material things, which seems like very good advice. They also quoted studies showing that while caffeine boosts simple mental processes, it does not seem to help with creative pursuits or “thinking beyond the basics.”

Don’t get too positive about what you might learn, though. The reader is also treated to the following claim: “When you’ve identified an intention, focused on it, and made a clear, committed decision to act upon your intention, your mind will open up the universal floodgates, bringing all the resources you need, sometimes in seemingly mysterious or impossible ways.” Thanks for that.

I can imagine a whole series of books about different subjects: “train your brain to make people like you,” or “train your brain to find a girlfriend.” The great thing is that it would probably take only 15 minutes to replace the financial buzzwords to create each new book.

Short Takes: Long-Term Effect of Fees, Cutting Back, and more

noreply@blogger.com (Michael James) — Fri, 23 Dec 2011 05:01:00 +0000

This will be the last regular post until next year. I may write one or two before then if the mood strikes. To all my readers, I wish you happy holidays and all the best in the new year.

Where Does All My Money Go? breaks down the effect of mutual fund fees on a 25-year investment. Check out the spreadsheet that lets you enter your own inputs to see how much of your money goes to your advisor, the dealer, and the fund company.

Gail Vaz-Oxlade conducted a poll to find out how much people could reduce their monthly expenses if they had to. The most striking thing about this poll is that the highest category is “15% or more”. I could reduce my expenses by 50%. If I absolutely had to, I could go further by moving my family somewhere cheaper. I think people have a misguided sense of the distinction between necessities and wants. Necessities are food, simple clothing, shelter, education, and not much more.

Canadian Couch Potato interviews Vanguard representatives about their entry into Canadian ETFs and what new ETFs may come in a second wave. I’m particularly interested in U.S. and foreign stock ETFs without currency hedging. See part 2 of the interview as well.

The Blunt Bean Counter shows that there is no advantage to earning income in a corporation because of the way that dividend taxation is integrated with personal taxes. I wonder if maybe there are certain narrow situations where using a corporation can be used to smooth personal income between years. One strange situation would be two people who run a company by each working every other year. They would prefer to declare $75,000 every year rather than $150,000 every other year.

Retire Happy Blog reviews Andrew Hallam's book, Millionaire Teacher.

Tom Bradley takes on the claims that the world's financial troubles are “different this time”. Ironically, one of the ways that things remain the same is that people tend to think that present conditions are different from the past.

My Own Advisor had some fun making a financial version of Christmas poetry.

Larry MacDonald reviewed Dan Bortolotti’s book MoneySense Guide to the Perfect Portfolio.

Million Dollar Journey says that cash is king. Many readers weighed in on how much cash they keep around for emergencies and opportunities.

Big Cajun Man makes the case for giving cash as a Christmas present.

Looking Forward to a January 1st Raise

noreply@blogger.com (Michael James) — Thu, 22 Dec 2011 05:01:00 +0000

Come January, I’m expecting a huge raise. Most workers get a huge raise at the start of a new year, but they don’t realize it. In the last days of the year, you are taxed at your top marginal rate, but in January the slate is clean and your income is untaxed for a while.

You won’t see any of this on your pay stub, though. Payroll taxes are designed to smooth out the effect I’m talking about by predicting your final taxable income and taking equal amounts of tax off each pay. But your real taxes are based on your actual income using progressive percentages.

For a person earning $100,000 per year in Ontario, after-tax pay at the end of this year is $28.92 per hour, but will rise to $51.11 per hour starting in January (based on 37.5 hours per week and 365.25 days per year). Of course, it will then drop off over the course of 2012.

For most of us who collect a regular income for the whole year, none of this makes much difference, but for those who work irregularly of for irregular pay rates, this effect can be important.

For example, if you’re planning to quit your job to live off your savings for a few years and see the world, it’s better to wait until March than to quit in December. This way you’ll get paid during the high-income period at the start of the year.

If you’re planning to do something that will cause a big change in your income, it pays to understand our progressive tax system and how it affects your final tax bill.

The War on Loyal Customers

noreply@blogger.com (Michael James) — Wed, 21 Dec 2011 05:01:00 +0000

A friend I’ll call Jerry recently complained about his Maclean’s magazine subscription:

"I see via your magazine insert I can order a year's subscription for Ontario for $53.62 (tax included) whereas I just recently paid $70.86 to renew mine! While I can understand the ‘bonus gift’ difference, I am quite upset that you are gouging (over 30 %!) a long time subscribing customer (over 30 years)."

Jerry went on to demand a refund of the difference, and Maclean’s promised he would get it in 4 to 6 weeks. Of course, the other loyal customers who don’t bother to complain won’t get this refund. Most people believe that loyal customers deserve to be well-treated, but companies seek profits. Apparently, Maclean’s magazine has decided that the most profitable approach is to draw people in with low prices and hope they keep subscribing at higher prices. My guess is that they are right.

This doesn’t mean that I think loyal customers deserve poor treatment; I just don’t think that discussions of what we deserve are relevant (except as a way to extract a refund). Businesses must seek profits to survive. If enough Maclean’s customers stop subscribing because they don’t like paying more than new customers, then Maclean’s will change its practices. The same is true of Maclean’s parent company, Rogers. However, my guess is that more people are willing to give up a magazine for a principle than are willing to give up their television and internet.

Unless more people start to vote with their wallets, expect loyal customers of most businesses to continue to pay higher prices than fickle customers who pay attention to prices. In the mean time, people like Jerry can get lower prices by complaining.

Pay Parity

noreply@blogger.com (Michael James) — Tue, 20 Dec 2011 05:01:00 +0000

We often hear of unions seeking pay parity with other workers. Invariably, a pay raise and possibly some back pay are required to right the supposed unfairness. No doubt there are legitimate cases, but I suspect that most are not.

My direct experience is mostly with programmers. Organizations have different philosophies when it comes to paying programmers. Some seek the best talent they can find and give them above-average pay. Most offer average pay and get average talent, and still others offer low pay and try to get by with whoever will work for them.

It is too easy for programmers at one company to look at another company’s pay scales and complain. The truth is that most complainers would be rejected if they tried to get a job with the higher-paying company. Superficially, all programmers do similar work, but when we get down to details it is normal for one company’s programmers to be far superior to another company’s programmers. When this is true, demands for pay parity make little sense.

With this experience as a backdrop, I tend to be skeptical of any claim that one group of workers does the same work as another and deserve pay parity. If this were true, why aren’t members of the lower-paying group leaving to get jobs with the higher-paying group? The answer is often that the better workers actually do this and thus create a meaningful difference in talent between the two groups.