A Loonie Saved

Don't be fooled by a normalized line chart

2015-03-13T09:30:00.000-04:00

Often, two hypothetical investments are compared using a chart with two lines, one per investment, "normalized" so they start at the same point.

I urge you to pay no attention to such charts. It is far too easy to manipulate them to make whatever point you want to make.

Consider this chart showing the performance of the TSX Composite versus the NASDAQ over a two-year period:

These two lines are shown starting with the same value on the left so you can compare how they evolved from time onward. Clearly, NASDAQ in orange was the better investment in this time period.

Below is another chart of the same two indexes. Clearly, in this time period, TSX in blue was the better investment:

However, take a closer look. These two charts cover almost the same period. 80% of this second chart plots the same data as the first chart. The middle 80 weeks from July 2003 to January 2005 are included in both; only the 20 weeks on each end are different.

The trouble is that this type of chart is incredibly sensitive to the choice of starting date. Almost unbelievably sensitive. So sensitive that, in my mind, this kind of chart is practically useless as a tool to understand two investments. It is a simple matter to make a chart like this say anything you want it to say. (They can appear quite convincing; I think that may be because the mind gives too much weight to how much time one line spends above the other.)

Please don't rely on charts like this for any important decisions.

Occupying Bay Street

2011-11-15T12:18:00.000-05:00

You may not know this about me, but I'm an avid lacrosse fan. I have season tickets to the Toronto Rock at the Air Canada Centre on Bay Street. For those unfamiliar with the game, it's a rough, fast-paced game, a lot like hockey, except there's a net on the end of your stick you use to catch the ball, and you're running on turf, so you can turn on a dime. It's higher scoring than hockey, with a typical final score something like 12-8. In fact, the rules on scoring seem designed to make for one highlight-reel goal after another. Oh, and cross-checking is legal. It's pretty cool.

There are times, though, when the refs just seem to like to hear themselves call penalties. Play stops, and a team plays one, sometimes two, players shorthanded. Sometimes there seem to be more players in the box than on the bench (at least Rock players!) and you wish the refs would just lay off and let the players play.

But one thing I never wish for is that the game had no rules. If the rules are fair and balanced and not too onerous, and enforcement is fair and balanced and not too onerous, then you have the ideal situation where two teams of self-interested players compete with each other in a vibrant contest that benefits everyone from the players to the fans to the hot dog vendors.

Another thing I never wish for is that they'd stop keeping score. Sure, it's always disappointing to be on the losing team, but it's equally unfair to refuse to reward those who achieve excellence while playing by the rules, and it would be demeaning to the players to suggest that they can't cope with losing a game or two. Worse, it would undermine the very system that drives them to excel.

Money is also a way to keep score. This is surely not any kind of newsflash to anyone. What is less obvious is why lending money to a friend is so fraught with danger, but I think the reason is clear. When dealing with your circle of friends, you know these people intimately. You know when someone has been good to you and deserves your kindness in return. You know when a friend needs your help, and if they have been a true friend, you offer that help knowing that they would do the same for you. You don't need money for friends.

Money is for keeping score between strangers. In societies as large as ours, we must interact constantly with people we don't know. None of my friends happen to be able to provide me with Cheerios, or coffee beans, or gas for my car, on a regular basis. I get these from strangers, and we use money in an attempt to have everyone contribute their fair share to each other. When you lend money to friends, you are necessarily treating them as strangers, and that's why it feels so strange.

As a system to keep track of the value of the work people do for each other, money is imperfect—otherwise how is it that the best things in life are free?—but it works better than any other system we've tried, and we've tried a lot. Money is not a perfect measure of economic value, but it's not too shabby. However, money is a very poor measure of kindness, or of humour. It is a poor measure of justice. (Should we replace all prison sentences, court injunctions, and restraining orders with fines?)

Capitalism is a good scorekeeping system, but it's a lousy moral philosophy.

The debate over capitalism is confusing because the debaters don't recognize that they are arguing semantics. It's plain to see that a free capitalist economy has demonstrably produced more prosperity for more people than we've ever seen in history. It's also obvious that the profit motive is just greed, and greed is not the moral value upon which we want to pin our hopes for society. I think a lot of the folks arguing over the merits of capitalism might actually be surprised to find they agree with each other once the distinction is made between capitalist system and philosophy.

The true Big-C Capitalists (those who use capitalism as their primary moral compass) argue that there should be no regulation at all. That we should do away with rules and referees, and that profit should be the only motive. This is fine so long as you don't mind our economy being run by the Sean Averys of the world.

I think western society is supported on three great pillars: (1) democratic legislation, giving the people a say in the rules that govern them; (2) capitalist economy, giving the people a means to gauge the equity of their interactions; and (3) public education, giving the people access to the knowledge and skills they need to thrive. At their essence, the Occupy Wall Street protests cover all three of these areas. To the extent that the protestors are standing up against the undermining of these three pillars, I'm behind them.

However, much of the Occupy Wall Street debate seems to argue over more versus less regulation. This is just as absurd as clamoring for more versus fewer rules in lacrosse: if the rules are unfair, it doesn't matter how few there are. If the rules are unbalanced, their quantity doesn't matter: the game won't be worth playing. What matters is not how many rules there are, nor how strict they are, but how equitable they are, how fairly they are enforced, and how effective they are at making the game what we want it to be.

Preet at WhereDoesAllMyMoneyGo recently posted a video of Peter Schiff discussing economics with the Occupy Wall Street protesters. Take a look if you want to watch a debate that goes nowhere because the opposing sides don't recognize that they are not making opposing arguments.

Orders of wealth magnitude

2011-08-06T23:48:00.024-04:00

Born Rich is a 2003 documentary by Jamie Johnson, heir to the Johnson & Johnson fortune. In it, he interviews a number of other wealthy young people, and explores their taboos against discussions of money by doing the exact opposite: exposing intimate details of wealth in a documentary film. Ironically, he never gets a straight answer from anyone as to just why money is not to be discussed.

I think I've figured part of it out.

It came to me watching another of Johnson's documentaries, The One Percent. In one segment, Johnson talks to the director of an exclusive wealth management conference. The conference director estimates the average wealth of attendees at around $400M, with some in the billions.

Watching this scene, the thought occurred to me: what if you were a 400-millionaire at one of these conferences, sitting next to a family worth $10 billion? If this family invested their fortune conservatively in a broad basket of stocks and bonds, and followed the 4% rule, their investments would earn your entire life savings each year.

Imagine: would you really feel wealthy sitting next to someone who passively rakes in the fruits of your lifetime of business achievement plus inherited wealth every year with no effort? Such a person would belong to a whole different class of wealth, if such things were discussed in the open.

Being a big fan of logarithms, this led me to a rather novel notion: to use decibels to measure wealth. On this scale, a difference of ten decibels represents a ten-fold increase in wealth. Twenty decibels would then represent two ten-fold increases in wealth, for a total 100-fold increase. (If you're familiar with decibels from engineering applications, you'll also recognize that this means three decibels represents a doubling of wealth.)

Of particular interest to us is what happens at the 14-decibel mark. This represents a 25-fold increase in wealth. If your wealth is 14 decibels larger than mine, you are in the lucky position that you could invest your wealth very conservatively and spin off my entire life savings each year using the 4% rule.

To set the zero-point of the decibel scale, I wanted someone at zero decibels to be "just barely wealthy" in some sense. I chose $500k for this. At this level, the 4% rule provides for $20k each year, which corresponds to Canada's "Low-Income Cut-Off" for one person living in an urban center. (Statscan goes to great lengths to point out that the LICO is not a poverty line, but I'm going to use it as such anyway. So sue me.) Below zero decibels, attempting to live on your wealth alone would mean living in poverty, and therefore you don't quality as wealthy (barring Early Retirement Extreme, of course). Above zero decibels, your wealth passively spins off enough income to keep you out of poverty.

Between the Forbes Billionaires list and the highly scientific and authoritative Celebrity Net Worth web site, I cobbled together a list of some notable people (mostly Canadian) and plotted their wealth in decibels:

The vertical lines every 14 decibels divide these people into orders of "wealth magnitude", so you can tell at a glance that, for example, Warren Buffet's wealth could passively earn the entire fortune of Jim Balsillie each year. I think Isadore Sharp is pretty rich, but his entire fortune could be earned passively by David Thomson each year. And imagine Jim Carrey sitting down to have a chat with Stephen Harper, knowing that he passively earns Harper's total personal fortune each year.

This, I think, may be one of the reasons that the rich don't discuss their wealth, and it's a problem that middle-class peer groups never experience, because if one person's fortune can passively earn another's fortune each year, then at least one of those people is not in the middle class.

P.S. One other remarkable thing to note is that, by my definition of "wealthy", simply selling the average Vancouver house makes you instantly (barely) wealthy. The passive income from the price of a Vancouver house would be enough to keep you out of poverty without ever working again. This is what you give up to own a house in Vancouver. Houses in other large Canadian cities are just a few decibels behind.

The incredible benefits of house ownership

2011-04-23T08:23:00.020-04:00

The financial media, as always, are exuberant over the prospects of higher housing prices—an attitude I've never quite understood.

Housing is a basic human need. If the cost of bread were to rise 8.9% year-over-year, would the media proclaim a "bread boom" and paint a glowing picture of the strong bread market? If people viewed the cost of housing as they view the cost of gas, we'd all be talking about how we're being ripped off, and there would be calls for the government to intervene to keep prices lower. I've always found it rather puzzling that houses are given this special treatment.

Thankfully, a pamphlet from the National Association of Realtors arrived in my mailbox to explain the pro-side of house ownership. This is a document I must share with you. I found it very entertaining, and even enlightening (though probably not in the way the authors intended).

The first thing I learn from this pamphlet is that homeownership provides 5, count 'em 5, "substantial social benefits for families, communities, and the country as a whole":

Higher Academic Achievement
More Cohesive Communities
Better Connected Families
Improved Health and Safety
Stronger Economy

Under section 1, Higher Academic Achievement, they reference a number of rather esoteric statistical studies that I'm not capable of criticizing, though if I trust their motives and methods, their conclusions do seem to support a causal relationship between owning one's home and higher academic achievement for children. All I can say here is that in my own community of rented townhouses, we have about 30 school-aged children. In that population, one would expect to find 0.6 children in the 98th percentile, yet there are actually three children in the gifted program. It's hard to draw a conclusion from this one data point, but it's safe to say not all communities of renters are populated by academic underachievers.

However, my favourite part of section is the following chart:

As you can see by the axis labels, this chart clearly shows that the more Renter you are, the more Homeowner you are too!

Sections 2 and 3 describe More Cohesive Communities and Better Connected Families, using statistics from Cincinnati telling us that homeowners are "9% more likely to know who their school board representatives are" or "are less likely to have alcohol and substance abuse problems". These are clearly confusing correlation for causation, and so they'd bear no more thought if they weren't so entertainingly ironic or irrelevant in my particular situation.

For example, apparently homeowners are "28% more likely to repair or improve their home". I can tell you my odds of repairing my home are zero, because all I do is walk to the management office and fill out a work order, and the repair is done for me, for free. Likewise, they are "1.3 times more likely to read newspapers". I guess rentership explains why I never read newspapers. I suppose if I bought a house, I'd be more likely to stop getting my news online and order a subscription for a daily dead tree.

Homeowners are also "16% more likely to belong to parent-teacher organizations, book clubs, etc." My wife belonged to a book club at one time; I guess renting made her quit? And both my wife and I have belonged to our school council (which I currently co-chair) since the first year our older son started kindergarten, which doesn't particularly prove anything except that participation in such things is an individual choice.

The sizable Muslim population in our area may be alarmed to find that homeowners are "10% more likely to attend church". There's a rather narrow-minded implication there that we're all Christians, but homeowners are better Christians than renters.

My personal favourite is that homeowners are "59% more likely to own a home within 10 years of moving from parents [sic] household". Beyond the obvious reversal of causality in this statement, there's also an insidious circular argument that homeowners are better because they're homeowners. I've heard this a number of times in arguments such as "I don't want my kids growing up around renters", and I just don't know how to respond to that kind of statement.

Section 4, Improved Health and Safety describes how renters who buy a house suddenly experience higher self-esteem and perceived control over their lives. I'm sure taking up cigarette smoking would have a similar effect, but surely that doesn't make for a strong argument.

The pamphlet saves the best for last:

It's nice to think that the economy benefits from $60k out of my pocket when I buy a house, but it does tend to contradict the statistic in that green bubble that "a home owner's net worth is 45.9 times that of a renter's [sic]". Apparently, buying a house will reduce my net worth by $60k initially, and it will do very little (aside from forced saving) to help me recover that amount.

All in all, if I were a member of the National Association of Realtors, I'd be pretty embarrassed that this document is being used to represent the argument in favour of house ownership.

How to buy a car

2011-03-09T08:01:00.007-05:00

A recent post from Michael James reminded me of the car I just bought in August. The way we bought the car eliminated the problem he mentions and many others. I heartily recommend it.

Back in 2007, we decided we wanted a Honda Fit. We have no intention of ever buying a new car, but we went into a dealership anyway to test drive one, and the salesman worked out the numbers for us. The quote came out to $23k.

Instead of signing on the dotted line, we started pretending we had car payments, and setting aside the amount. (Yes, this early blog post of mine was nonfiction.)

I figured if I waited three years, we'd save about $6k in depreciation, and because we wouldn't be paying interest on a car loan, we'd save another $3k in interest, so we'd be spending $14k. So once we had saved up $14k, we just waited until the car we wanted reached that price.

That happened this past August: we saw a listing online for a 2007 Fit with low mileage for $14k. That week I went to the dealership and told the salesman that I wanted that car, and if he could make it work for $14k all-in, he had a deal.

Well, he made it work, so I bought the car.

The process was pretty much stress free for me. I got the car I wanted at the price I wanted, without any negotiation. Ok, it's true that the salesman might have shaved off a couple hundred bucks if I had negotiated harder, but in the big scheme of things, I saved $9k by waiting a few years, so I'm not going to try to stiff this guy for a couple hundred more bucks. In the end, we were both happy with the deal, so as far as I'm concerned, that makes it a good deal.

The most striking part for me was when it came time to sign the contract. He was explaining all the extra charges like taxes and whatever else. I can't even remember what the charges were because, well, I just didn't care. I had negotiated the bottom-line price, so in effect he was paying all these other charges, including the taxes.

And to top it all off, I didn't have to worry about financing rates, and I didn't even have to give the dealer my car insurance info. He didn't care because he had cash in his hands.

The only painful part was writing that bank draft for $14k. Man, that's a lot of zeros for a cheapskate.

Update: My wife would like me to point out that, while I may not be a world-class negotiator, I didn't just walk in and pay the sticker price on the car. They were asking $13,999 plus taxes, plus plus plus... We paid $14k all-in, which works out to almost 20% off the sticker price.

The market is over-valued

2011-02-27T17:21:00.009-05:00

I usually don't try to make predictions about the stock market, but a rather complacent post by Potato has led me to end my 6-month blog drought to explain why I think the market is over-valued, and why I'm not selling anyway.

I want to start by drawing your attention to this chart:

This chart, stolen from Wikipedia, is based on data from Robert Shiller, and shows the relationship between the P/E ratio of stocks (using the average earnings of the previous 10 years) and their performance over the subsequent 20 years.

The relationship is striking. The higher the P/E, the lower the returns over the subsequent two decades. This makes P/E the only reliable indicator I'm aware of for predicting future stock performance.

As I write this, the P/E of the S&P500 is 24. Based on the above chart, if historical trends hold, that means from this moment forward we can expect a 20-year return of approximately 0%. (In the market, historical trends seldom hold, but it's food for thought.)

Even if we we set aside Shiller's musings, and focus only on what the P/E ratio tells us directly, P/E=24 means annual earnings are just 1/24 = 4.2% of invested capital. This, plus earnings growth, is what we can expect to earn from the market whenever P/E=24.

(How much is earnings growth? Well, the nominal earnings of the S&P500 have roughly doubled every 30 years for the past century, which comes out to something like 2.3% per year, but with enormous error bars.)

4.2% nominal return is not an exciting number. The iShares Bond Index Fund XBB is paying 4% right now. The extra risk you're taking in the market rewards you to the tune of just 0.2% (plus earnings growth).

And if that's not bad enough, multpl.com has a chart showing the current P/E in relation to the historical values. Looking at the current value of 24, you'll notice the market has never had a P/E this high without crashing shortly afterward.

So... I find this is a scary time to hold stocks. As a net purchaser of stocks over the coming decades, I'm disappointed that the prices are so high, and if I were a market forecaster, I might even venture to guess that a correction is coming soon.

The question naturally arises, then: should I sell my stocks? Well, don't think I didn't consider it. However, I'm planning to hang on to my stocks for now for just one reason:

This is exactly the roller-coaster I signed up for.

I invest money I don't need soon, so I am largely indifferent toward fluctuations. Because I'm only interested in the highest expected returns, I stay invested in stocks.

I don't have the skill to time the market, nor to outsmart it. Yes, there's a good chance my stocks will some day be worth less than they are now, but that does not necessarily mean I should sell now. For example, if the 10% drop I fear were to be preceded by a 15% increase, on the whole I would regret selling now. And if I do sell now, there's a guy on the other side of that transaction buying my stocks, and who's to say he's the one who's wrong?

So, in the end, while I'm worried that my stocks will drop in value, I'm not going to start basing my investment choices on gut feelings. I must say, though, that as a net buyer of stocks over the next couple of decades, I do wish prices would drop to a more reasonable level!

And if the P/E rises another few points, I may be back here re-evaluating my position on this.

There's no such thing as marriage insurance

2010-09-13T14:22:00.001-04:00

Frank at Bad Money Advice has an article on marriage insurance. In this article, he goes to some lengths to determine whether marriage insurance is worthwhile. He does this by calculating the odds off a payoff and comparing with the amount of the payoff.

I think this analysis is misguided. I have a simpler one.

To begin with, you need to understand this: you never ever buy insurance on the hope that it will pay off. If you ever find yourself doing that, you've made a mistake, because then you're not buying insurance; you're making a wager, pure and simple. When you buy insurance, you should always be hoping it will never pay off. You should be hoping that your money will be wasted. When insurance pays off, it's because you rolled snake-eyes in the game of life and you could end up being ruined financially.

Insurance is meant to eliminate that risk of financial ruin. However, for this marriage insurance, the 1.63x payoff relative to the premiums makes this impossible. I can't think of anyone who can afford to pay $X for nothing, yet would be financially ruined by having to pay $1.63X during a divorce.

Therefore, this marriage "insurance" product is not insurance. It is gambling.

The penalty for saving

2010-06-05T07:26:00.010-04:00

Thicken My Wallet has a post on how the tax system discourages saving. In it, he mentions progressive taxes, the estate tax, and the high taxation of interest income among the reasons for this.

With all due respect, this seems to be a somewhat naive treatment of tax policy.

The estate tax prevents a hereditary aristocracy from forming. In Canada, death triggers a "disposition" which leads to capital gains tax, having a similar effect.
Dividend tax cuts take into account that the dividend-paying company has already paid some tax.
The flat tax is promoted as a way to simplify taxes, but in reality it's just a tax break for the rich. In Canada, our system's complexity doesn't come from its progressive nature, but from the multitude of obscure rules and deductions.

To me, what really penalizes saving is inflation. For some very loosely justified reasons, the central banks of the US and Canada aim for a 2% inflation rate. Deflation is deeply feared as some sort of bogeyman with scant explanation using terrifying terms such as "deflationary spiral" that call to mind the end of the financial system as we know it.

The fact is, before about 1900, deflation was commonplace in North America. Currency kept its average value over long periods because inflation and deflation alternated.

Targeting 2% inflation is just a 2% asset tax. It is analogous to a property tax, which would be fine, except for two very large problems:

Inflation doesn't just decrease assets by 2%; it also reduces debts by the same amount. Therefore, part of this "asset tax" is paid to debtors. The fairness and wisdom of this is debatable.
The beneficiaries of inflation are those who create new money. In our system of banking and fractional reserve, the money goes not primarily to the government, but rather the banks.

If you want to encourage saving, how about a prolonged period of gradual deflation?

The problem, of course, is that there's no way for the government to achieve this. Our government lost control of the money supply in 1935 with the creation of the Bank Of Canada, at which point monetary policy could be relied upon to favour the banks. Banks love debt; inflation favours debt; hence we have nothing but inflation after 1935:

(Source: Bank of Canada web site.)

To really encourage saving over borrowing, the government would need to take back control of the money supply from the banks. Well, good luck with that.

Don't overestimate the value of your leisure time

2010-06-02T16:27:00.003-04:00

Amber Bellaire has written a blog post that justifies spending money on maid services. This is a convenient post in that offers one-stop shopping for a variety of naive fallacies used in such arguments.

The logic goes like this:

Combined, their weekly before-tax income is about $2,000. At this rate, each partner is making about $24 an hour.

If both partners together spend six hours every other Saturday cleaning, that’s 12 hours out of their combined free time being spent on cleaning every two weeks. Multiply that by 24 (because each person is worth $24 an hour), and the couple is spending almost $300 worth of their free time hours cleaning biweekly. That’s $600 a month, or $7,200 per year.

The most striking flaw in this reasoning is that their time is not worth $24/hour. It must be worth less than that, of course, or else they would not be so eager to give an hour of time to their employers in exchange $24. Consider: if their employers were to cut their pay to $23.50, would they quit? If their time was worth $24/hour, they should!

This kind of reasoning is really nothing more than elitism practiced by people with well-paying jobs: if I make $24/hour, and you make $12, then my leisure time is worth twice as much to me as yours is to you. If that's the case, we should all be working around the clock to make sure Bill Gates gets all the leisure time he can.

A second important flaw occurs just a few paragraphs later:

For four hours of cleaning at $22 an hour, you’d be spending $88 to have your house cleaned by the company – saving you $212 worth of your own hours spent on cleaning (300 – 88 = 212) biweekly. That’s a savings of $424 per month, or $5,088 per year.

Here is the common fallacy that spending money is a form of "saving". Saving money means not spending it. It doesn't mean you've spent less than you could have. It doesn't mean earning yourself something that's "worth" money. Saving money is the opposite of spending money. The only way for the couple in this scenario to save money is to use cheaper cleaning supplies.

The proper way to evaluate a maid service is, of course, to compare the alternatives available, just as in any other purchase decision. Using Ms Bellaire's figure of $88 biweekly, the couple in her example would be spending $2288/year on housecleaning services. Here are a few ways to reason about that amount:

Using Ms Bellaire's figure of $24/hour, they would need to work an extra 8 hours overtime per month (or 5.3 hours at time-and-a-half) to pay for the maid service. If they're willing to do that, it may be worthwhile.
Using opportunity cost, consider that $2288 buys a pretty nice little vacation every year for two people. If you're willing to give that up, the maid service may be worthwhile.
Using investment opportunity cost, consider that $2288 spent on a maid this year could have been invested in stocks, where its real value could be expected to double each decade. If you have three decades until retirement, you've just spent over $18k of retirement money on the maid this year. To put this in perspective, note that amount would be greater than the couple's final RRSP contribution.
Using the 4% rule, that amount is equivalent by the income produced by an investment of $57,200. If you could imagine saving up that amount, and then cheerfully handing it over to someone for a lifetime of maid service, then it's worthwhile. (The trouble with this argument is that I don't think it will be very convincing to anyone who doesn't happen to have $57k sitting around, because it's too easy to spend imaginary money.)

If you can look at all four of these lines of reasoning and still feel comfortable spending that money on a maid, then go for it.

Financial independence without home ownership?

2010-04-28T17:21:00.005-04:00

As Jonathan Chevreau says in his recent column: "a paid-for home is the foundation of financial independence". Or is it? Happily, this serves as the perfect lead-in to what is becoming a tradition for me: my annual rant on the topic of renting versus buying your home.

I rent. I always have, and unless something changes dramatically in the world of real estate, I always will. When it comes to the purely financial side of home ownership, the numbers just don't add up in Toronto, nor in most of the major Canadian cities. I rent because it saves me money.

It all comes down to the fair value of a house. If actual houses cost less, buying makes financial sense; otherwise, you'll save money by renting.

Real estate as an investment

Historically, real estate values just keep pace with inflation, making it equivalent to real return bonds, but with lower liquidity. This makes real estate one of the worst possible investments if you're looking for capital appreciation.

So why do people invest in real estate? There are two reasons.

First, just as bonds have their interest payments, real estate can generate cash flow. In the case of your own home, you do not actually see any positive cash flow, but you do get to avoid a negative cash flow in that you're not paying rent.

Second, real estate makes good collateral for a bank loan. Residential mortgages have among the lowest interest rates available to individual investors. That interest is not tax-deductible in Canada, and the idea of losing your home for defaulting on a loan is not a pleasant thought. Nonetheless, a mortgage is still a relatively attractive borrowing proposition.

Cash flow

Consider the 4% rule. It states that if you were to invest an amount equal to 25 years' rent in stocks and bonds, you could safely withdraw enough per year to pay your rent. Thus, no house is worth more than 25 years' rent. If your house can fetch a price worth more than 25 years' rent, you should sell your house, rent it back from the buyer, and pocket the difference!

The cash flows for owning one's home take three forms:

one large negative cash flow for buying the house;
recurring negative cash flows for mortgage interest, property taxes, and maintenance; and
one large positive cash flow for selling the house.

Because real estate values can be expected to track inflation, the net present value of cash flows #1 and #3 cancel, leaving #2. (For simplicity, I'll ignore transaction costs and moving costs.)

The recurring cash flows for home ownership are entirely negative, as they are for renting. In any given month, if renting saves money, we should be renting, since it would be more efficient to wait a month and use the money saved to increase the downpayment on an eventual house purchase.

Let's compute the break-even point between renting and buying.

For buying, most annual expenses depend on the value of the property. There are other expenses that depend on the house size, but to keep things simple, I'll express these too as a percentage of the property value.

Roughly speaking, house owners must pay the following costs that renters don't (mostly because they already included in rent):

2% mortgage interest. (We don't include the equity portion of the mortgage payment because that money has no impact on net worth.)
0.5% building insurance. (We don't include insurance on contents because renters must pay that too.)
1% property tax.
1% repairs and maintenance.
0.5% additional utilities.

TOTAL: 5%

At 5%, the house is costing you an amount equal to its value every 20 years. This means if you buy a house with a mortgage worth more than 20 years' rent, you will waste money every month relative to renting. 20 years' rent in my current apartment is about $310,000. In my Toronto suburb, that means if I don't mind settling for a semidetached fixer-upper, and I have a decent downpayment, and I don't anticipate any increases in mortgage interest rates any time soon, I would save money each month by buying a house.

So why not buy a house then?

Because interest rates will not be this low forever. If you have a variable-rate mortgage, and rates increase, suddenly renting starts to look pretty good again.

Suppose rates increase by 3% to a more normal (yet still historically very low) 5%. This brings the break-even mortgage to 12.5 years' rent, or under $200k in my case, which would price me out of the housing market in my area.

Ok, suppose instead we lock in at the current low rates by getting a fixed-rate mortgage. Guess what? The banks have thought of this. 5-year fixed-rate mortgages are going for right around 5% right now. This represents the same 3% increase we just considered a moment ago. No luck there.

All right, perhaps we can get a smaller condo instead of a house. Sorry, no luck there either: typical condo fees are also about 3% of the condo's value.

Any way you look at it, a realistic break-even mortgage is closer to 12 years' rent than 20.

But hey, you don't rent a house! You're comparing apples to oranges!

True. I rent a two-bedroom townhouse. Isn't it unfair to compare the rent on my apartment with the cost of a house, when the latter is much larger? Shouldn't I be using the rent on an equivalent house in my calculations?

No. Here's why.

Consider this: suppose you were evaluating the cost of a car. If you don't own a car, you still need to get around, so to be fair you will have to calculate the cost of public transit, taxi rides, and the occasional car rental. But you do not need to calculate the cost of permanently renting an equivalent car. That option is not relevant unless you are seriously considering doing it! Most people without a car are content to take public transit and taxis.

Likewise, I'm content in the apartment I have. It's not my fault nobody will sell me a house this small anymore (though such houses were commonplace just a few decades ago). If they did, I could do a direct comparison, but they won't, so I must compare the options available to me. Apples-to-oranges is the way toward a rational decision.

Among the options available to me, renting is financially the winner, hands down. If someone gave me a house for free, I'd sell it and move back here.

Rebalancing: has John Bogle lost his mind?

2010-01-31T23:34:00.004-05:00

Larry McDonald's recent blog post discusses some critiques of dividend investing. I can't say I'm either for or against dividend investing, but one of the critics is John Bogle, who pretty much invented indexed mutual funds.

As blasphemous as this may seem, I tend to take Mr Bogle's advice with a grain of salt after reading his arguments against rebalancing. Saying rebalancing is unnecessary is essentially saying that asset allocation is unimportant.

This is clearly goofy. How does Mr Bogle justify this stance?

He justifies it by demonstrating that the additional returns from rebalancing are negligible. Well, as a believer in the efficient-market hypothesis, I could have told you that.

Rebalancing is not about maximizing returns. It's about managing one's exposure to risk. In fact, I'm actually mildly surprised that a rebalanced portfolio beat a non-rebalanced one at all. That means you are getting reduced risk at no cost! It seems to be one of the few free rides available in the investing world.

Capital-limited efficient market hypothesis

2010-01-20T10:52:00.004-05:00

Broadly speaking, I'm a believer in the Efficient-Market Hypothesis (specifically, the "semi-strong" form), due to the wealth of academic research backing it up. Yet it seems obvious that assets are mispriced regularly. How do I reconcile these two viewpoints?

Hindsight

The first thing to realize is that many of the so-called "mispricings" that people observe are just hindsight at work. The dot-com bubble, for example, is widely cited as an obvious failure of EMH. The logic usually employed looks something like this:

Semi-strong EMH predicts that prices reflect all publicly-available information
Prices during the bubble were too high, given what we now know
Therefore semi-strong EMH didn't apply during the bubble

The obvious unstated assumption here is that everything we know now was known during the bubble. Since this is patently false, the argument doesn't hold.

Capital limitations

But what if we replace #2 with this: "Prices during the bubble were too high, given what we knew at the time". While this assertion is far from proven, I concede that it's possible.

To explain this, I employ a modified version of EMH that I refer to as the Capital-Limited Efficient-Market Hypothesis:

While fair prices reflect all known information, actual market prices reflect only the information known to those with the capital and willingness to drive prices toward their fair value in search of profit.

Thus, one way to explain an asset mispricing would be to demonstrate how investors are deficient in at least one of three areas:

Knowledge
Capital
Willingness

If you reject the notion that the dot-com bubble was a shortage of knowledge, then it can be argued to be a shortage of capital and willingness as follows:

The dot-com bubble was characterized by a dramatic increase in capital invested according to market momentum and wildly optimistic guesses of future performance.
The relatively few investors who knew stocks were overpriced could drive stock prices down only by short-selling them.
Short-selling carries the risk that the investor will lose a great deal of money (more than invested) should prices continue to climb. This reduces investors' willingness to risk a lot of capital.
Therefore, the inefficiency was able to persist because market was unable to eliminate it.

This framing allows for an inefficient price level to persist for some time, but only to the extent that investors are unwilling to profit by correcting it.

Corollaries

This rule is a lot more "fuzzy" than the original EMH rule. I wish I could evaluate this hypothesis more rigorously, but I lack the expertise to do so. I think it would stand up well. I also worry that it is so vague as to be meaningless, but I don't believe it is.

Does this capital-limited EMH make any actual concrete predictions? I think so.

The first prediction would be that bubbles crash more quickly than they rise. This would be because investors are always less willing to short a stock than to invest in it. Is there evidence of this? Not being a statistician, I'm not even sure how to check, but it does "seem" right.

A second prediction would be that Warren Buffet, an investor who excels in identifying mispriced assets, must necessarily become less effective as his available capital becomes so much that he becomes more effective at canceling the very inefficiencies he notices. This is borne out by the long-term price trends of Berkshire-Hathaway stock, and I don't think this would be a surprise to anyone.

A third prediction would be the existence of the risk premium. Higher risk reduces the amount of willing capital available to drive a price up, thereby leaving it lower than the fair price. Again, I'm no statistician, but I think it's fair to take "implied volatility" as a proxy for risk, and if you look at this chart comparing NASDAQ "implied volatility" versus price, to me it's clear there's an inverse relationship.

As a software developer, I see the market as a kind of debugging exercise in which efficiencies can continue to exist only until they are noticed by someone with enough capital to cancel them. Benjamin Graham gives several examples of these inefficiencies that got "debugged" out of existence:

In 1949 we could present a study of stock-market fluctuations over the preceding 75 years, which supported a formula—based on earnings and current interest rates—for determining a level to buy the DJIA below its “central” or “intrinsic” value, and to sell out above such value. It was an application of the governing maxim of the Rothschilds: “Buy cheap and sell dear.” And it had the advantage of running directly counter to the ingrained and pernicious maxim of Wall Street that stocks should be bought because they have gone up and sold because they have gone down. Alas, after 1949 this formula no longer worked. A second illustration is provided by the famous “Dow Theory” of stock-market movements, in a comparison of its indicated splendid results for 1897–1933 and its much more questionable performance since 1934.

Conclusions

I started writing this post in November, hoping to support the hypothesis with additional evidence and reasoning, but since I seem to have neither the time nor expertise to achieve this, I've resigned myself to posting it in its current half-baked form.

By and large, I no longer try to pick stocks. I don't have the advantage over the general market in any of the three required qualities: knowledge, capital, or willingness. Following Graham's advice, and being unwilling to become an "enterprising investor", I have no option but to become a "defensive investor", and my life is much less stressful for it!

Portfolio fraction averaging

2009-12-15T10:39:00.009-05:00

In the last couple of days, Michael James has been exploring variations of the 4% rule, and has proposed his own modified version, which simply states that you should spend 4% of your portfolio per year, and allow the resulting income to fluctuate.

Though this strategy as stated leaves some important questions unanswered, it does have a fundamental advantage over William Bengen's original 4% rule, which advises a constant withdrawal (in real terms) in dollars every year.

Bengen's advice amounts to dollar cost averaging in reverse: rather than periodically buying a fixed dollar value of assets, you periodically sell a fixed dollar value of assets.

The name "dollar cost averaging" refers to the fact that the average price you're paying for assets is determined by spending a fixed dollar cost for each purchase. The average price paid for the assets equals the total paid divided by the total units purchased, and in the case of dollar cost averaging, this works out to the harmonic mean of the purchase prices (though I'll spare you the mathematical details). This kind of mean makes DCA attractive while buying, and much less attractive while selling.

For example, consider just two purchases using dollar cost averaging, buying $1 of assets each time. For the first purchase, the asset cost 20 cents per unit, and for the second purchase, it cost 5 cents per unit. The first purchase gets 5 units, and the second gets 20, for a total of 25 units costing $2, which is 8 cents each.

Michael's plan, on the other hand, advises you to sell a fixed fraction of your portfolio each time period. This "portfolio fraction averaging" is, to a first approximation, much like selling a fixed number of asset units each time. (The diminishing number of units held is offset by new units purchased by reinvested dividends, so let's ignore both of these things for now.) The average price for each unit in such a scheme is the arithmetic mean of the individual sale prices.

Using the same example asset as before, consider just two sales using portfolio fraction averaging, where 4% of your portfolio amounts to one unit. The first sale would earn 20 cents, and the second sale would earn 5 cents. The two units together netted 25 cents, for an average of 12.5 cents each. Note that this is more than the 8 cent average we paid for these units. The arithmetic mean is always greater than the harmonic mean!

So, when you sell your assets, would you prefer to earn an average of 8 cents per unit, or 12.5 cents?

I thought so.

Is the 4% rule good advice?

2009-12-11T11:00:00.006-05:00

If you've spent any time reading personal finance blogs, you must have come across the "4% rule". It is quoted with impressive regularity, yet it is rarely explained, and even more rarely questioned.

What is the 4% rule?

Many would summarize the 4% rule as follows:

You can safely withdraw 4% of your retirement savings each year in retirement without risk of running out of money.

This statement is not only vague; it's inaccurate. It doesn't say anything about how the retirement savings is invested, or how to cope with inflation, or just how much risk there is of running out of money.

The 4% rule was first developed in a paper by William Bengen. Here is the 4% rule from the horse's mouth:

For a client just beginning retirement, determine first the "safe" withdrawal rate. … For a client of age 60–65, this will usually be about 4 percent. The withdrawal dollar amount for the first year (calculated as the withdrawal percentage times the starting value of the portfolio), will be adjusted up or down for inflation every succeeding year. After the first year, the withdrawal rate is no longer used for computing the amount withdrawn; that will be computed instead from last year's withdrawal, plus an inflation factor.

So this is not a withdrawal rate of 4% per year. It's a withdrawal rate of 4% in the first year, adjusted for inflation thereafter.

What is Bengen's advice for asset allocation?

Despite advice you may have heard to the contrary, the historical record supports an allocation of between 50-percent and 75-percent stocks as the best starting allocation for a client. For most clients, it can be maintained throughout retirement, or until their investing goals change. Stock allocations below 50 percent and above 75 percent are counterproductive.

And just how safe is this strategy? Bengen back-tests the strategy using market performance and inflation numbers between 1926 and 1992. With a 50/50 split between stocks and bonds, Bengen concludes:

Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe. In no past case has it caused a portfolio to be exhausted before 33 years, and in most cases it will lead to portfolio lives of 50 years or longer.

Of course, the merits of conclusions based on back-testing can be questionable, but at least we know exactly where the 4% rule comes from.

Does this make sense?

The main problem I have with this advice is that it breaks what I consider a very reasonable soundness test: two people in identical situations should be given the same advice. However, consider Allan and Barney, both 65 years old with $1M in 50/50 stocks and bonds, and both with the same actuarial risks (both married, non-smokers, living in the same part of the country, etc.). Suppose inflation is 3%.

Allan is retiring in March 2009. Barney retired in March 2008. At the time, Barney's nest egg was $1.3M. He dutifully withdrew $52k for the year.

What advice do we give these two men in March 2009?

We advise Allan to withdraw $40,000 (which is 4% of his portfolio), but we advise Barney to withdraw $53,500 (the previous withdrawal adjusted for inflation) despite being in precisely the same financial situation. To me, this is inherently irrational, but it's hard to offer better advice to poor Barney, who would be understandably upset at the prospect of decreasing his annual income by 20%.

Can we do better?

A subsequent paper by Scott, Sharpe, and Watson addresses the question of whether Bengen's strategy is the most cost-efficient way to ensure you get a reliable cash flow during retirement. They identify two sources of inefficiency: one is a relatively minor one that they address using option trading; I find that one fairly uninteresting because it only amounts to 2-4% of your savings, and recouping that requires some fairly esoteric financial maneuvering. However, the more interesting inefficiency is fairly straightforward and accounts for 10-20% of the portfolio's value.

To understand this inefficiency, first consider that if you kept your nest egg as cash under your mattress, you could safely withdraw 4% per year for 25 years with zero risk of running out of money during that time. Suddenly, investing in a mix of stocks and bonds to achieve a probable 33 years of withdrawals is not so impressive anymore.

Of course, your mattress doesn't compensate you for inflation, but this is easily fixed using inflation-protected government bonds. With a typical real return of 2%, Scott et al argue that the retiree could finance 30 years of guaranteed inflation-adjusted withdrawals for the price of just 22.4 years. This amounts to a withdrawal rate of 1/22.4 = 4.46%!

What gives? How could stogy old inflation-protected bonds offer a withdrawal rate 11% higher than that of the stocks-and-bonds portfolio?

The answer is that choosing the bonds over the market portfolio gives up both the potential upside and downside of the market. Because the market generally increases over time, the upside over a 30-year time frame is much higher than the downside risk, and the market values this at approximately 11% of the withdrawals per year.

The bond investor has also accepted the certainty that his money will be gone after year 30. The stocks-and-bonds investor likely still has money left to continue his withdrawals indefinitely, and extremely likely still has enough at least for years 31-33.

This is what the inflation-protected bond investor has given up in exchange for a 11% higher withdrawal rate and zero risk.

So what should we do?

The best course of action may be a combination of the two. Buy inflation-protected bonds to fund 30 years of living expenses based on your budget, and use the remainder of your portfolio to invest in stocks and bonds, which could improve your standard of living, fund your expenses after 30 years, and leave an inheritance for your family.

Time-tested financial advice

2009-11-18T00:00:00.002-05:00

I've been a bit preoccupied lately, so it has been a while since my last blog post. It will probably be another couple of weeks before I'm back in the swing of things.

In the mean time, check out this financial advice from fellow blogger Nicholas. This is one that deserves to be in everyone's blogroll. He boils investing down to three basic steps, and discusses some common investing misconceptions.

Securities lending: the next bubble?

2009-08-05T08:28:00.006-04:00

So it goes something like this: you buy units of an ETF, which holds securities on your behalf. Then the fun begins: the ETF lends your securities to someone who wants to short-sell them, and the ETF charges interest. More money for the unitholder and for the ETF management. Everyone wins, right? Not so fast...

There have been several sobering posts lately regarding this practice of security lending by ETFs. By way of background reading, here are a few good articles by Larry McDonald:

Securities Lending Wake-up Call
Two related blog posts here and here

Finally, as of a couple of years ago, someone has done the obvious, offering an ETF with a nominal expense ratio of 0%, with management making all their money from security lending.

While this is an obvious triumph of marketing, it scares me. Now, I am not an expert here; I don't know the ins and outs of the regulations surrounding these investment practices. But having said that, the main problem I see is that this scheme doesn't align the interests of the shareholder and management. Management's entire profit comes from security lending, and the profit of security lending can be boosted a few ways, such as, I dunno, lending at higher interest to those with a lower credit rating, or investing the collateral aggressively. Worst of all, while all the potential for profit goes to management, all the risk of loss is borne by the fund investor.

This is a scary situation. You've got a scheme that offers money for nothing with a plausible, if esoteric, explanation ("hey, we're not angels; we make our money from security lending, but don't worry your pretty little head about complicated details like that"); and it does so with a scheme that puts management's interest at odds with the interests of investors. Worse, the kinds of abuses that this scheme invites seem to be the same kind of aggressive lending and investing practices that led to this financial meltdown that some of of you may remember from a few months back.

As usual, Vanguard seems to have their act together on this one. They make their money from an explicit MER, and give all profits from the security lending to the unitholders. This way, the risks of profit and loss go to the same party--the unitholders--and investors know exactly how much they are paying management. I gather Vanguard's seemingly unwavering ethical behaviour stems from the fact that they are actually owned by their unitholders.

Next time you buy an ETF, you might want to consider what they do with the profits and collateral from their security lending operations.

(Please keep in mind that these are just the opinions of a relatively uninformed amateur. Also, I have no financial stake in Vanguard, nor any funds invested with them.)

"Nothing goes up forever"

2009-06-04T07:54:00.003-04:00

I heard a market prognosticator on the radio at the start of June, claiming that the market was going to drop soon. Well, good for him; people make such predictions all the time, and they're right roughly half the time.

The interesting thing about this prediction was that this fellow made the argument that we're due for a big correction because "nothing goes up forever". I agree completely that the chance of having no down-days on the market approaches zero as your time horizon extends farther into the future, but that general argument, based on the law of large numbers, most certainly does not support his conclusion that the beginning of June was a good time to sell stocks.

It doesn't even matter that the stock market is down 3.8% from the day he made his call. He was still wrong.

If I toss a coin and get 10 heads in a row, I could make the statement "you can't get heads forever" and I would be entirely correct. If I went on to make the prediction that the next coin toss is now more likely than before to come up tails, I would be dead wrong, even if the next coin toss did in fact come up tails. You can't credit your pet theory for your own lucky guess.

Waiting until the market "calms down"

2009-05-25T11:53:00.008-04:00

Michael James has updated his Market Timer Breakeven Date. This is an amusing way to measure the futility of selling the TSX index and trying to buy it later at a lower price. For anyone who did their selling later than October 6, their decision to sell has lost them money compared with staying invested. October 6 was fairly early in the Great Recession, so this kind of market timing would have required substantial ~~clairvoyance~~ foresight just to break even.

This is a concrete example of a case where market timing failed to produce any improvement over buy-and-hold. But, after all, it is only a single example. Isn't it usually a good idea to to sell stocks when they're crashing, and wait for the market to "calm down" before buying back in?

The answer is definitely no. This does not make sense, and if you feel the need to do this, you are either acting irrationally, or you have a poor asset allocation that does not match your financial needs or appetite for risk. The reason for this has to do with the concept of Risk Premium.

The risk premium means that, quite rationally, an investor will demand a better return from an investment with higher risk. If two investments have the same expected return, and one has lower risk, nobody buys the other.

Of course, the stock market as a whole will naturally seem riskier whenever stock prices drop. Therefore, we can expect stock prices during a crash to drop more than the fundamental value of those stocks. If economic conditions make it likely for a company's earnings to drop by 20%, we should expect the stock price to drop more than 20%: specifically, 20%+X, where X is the additional risk premium.

The risk premium makes it a particularly bad idea for investors to wait until the markets "calm down". If "calm down" means lower risk, then these investors are specifically waiting until the risk premium disappears! Combine this with the fact that the market's estimation of risk subsides only when stock prices rise, and you will find that waiting for markets to "calm down" is an ideal way to sell low and buy high.

So am I saying that people should not sell stocks while the market is crashing? On the contrary: if they need the money soon, and it's tied up in stocks, people most certainly should be selling them. The sooner, the better. What I'm saying is that, if they needed the money soon, that money shouldn't have been in stocks in the first place.

How does one avoid getting into such a mess? My own answer is, of course, more advice from Michael James. People who have several years' worth of expenses saved up in low-risk (and hence low-return) investments should find their paper losses in stocks inconvenient, but not alarming. Inconvenient, because of reduced liquidity: you don't want to sell stocks while they're cheap, so now you're stuck with them. But not alarming, because it has no impact on your standard of living, since you're not basing your standard of living on your stocks.

I've used an approach (which I christened bottom-up asset allocation) based largely on Michael James's advice. When the market crashed, I was not overly concerned with my deep paper losses; in fact, I bought more stocks. Why would I worry about a drop in the price of a commodity I hadn't planned to sell anyway?

Put money you need for anticipated expenses into stable investments and cash. The rest goes into investments with the highest expected chance of meeting your financial goals, which generally means a diverse basket of stocks. This approach should help you sleep at night while your stocks lose half their value, secure in the knowledge that your paper losses are unlikely ever to be realized.

The Future Value Paradox

2009-05-05T10:58:00.005-04:00

When planning your future, it seems self-evident that you should use the most accurate possible predictions. However, consider this:

When I consider a large purchase, sometimes it helps for me to think along the following lines:

I'm about three decades from retirement. The stock market roughly doubles every decade, so a dollar I spend now is worth $8 at retirement. Therefore, I shouldn't buy that $12k car because I'll be costing myself almost $100k at retirement!

This factor of eight multiplier really helps me build a visceral aversion to spending my money.

Now, if I'm careful enough with my money, my retirement could come much sooner than three decades. Suppose my frugal nature affords me a retirement in one decade. When planning for my future, I should strive to be as accurate as possible, so naturally I should frame my thinking in terms of a one-decade timeline:

I'm about one decade from retirement, so that $12k car will cost me $24k at retirement. Well, that's not so bad, so I should buy the car.

However, switching to this line of thinking would make me much less thrifty, and would greatly postpone my retirement. This leads me to what I'm calling the Future Value Paradox:

The longer the timeline I assume for my retirement planning, the more frugal I become, and thus the sooner I will retire.

So, the less accurate my prediction, the better my results!

Pessimism and the Risk Premium

2009-04-23T22:10:00.006-04:00

The Dividend Guy has posted an article discussing market rebounds after downturns. This effect could be explained statistically by reversion to the mean, but this doesn't give any insights to the causes of the phenomenon, which I think is quite easily explained.

An investment with higher risk must, if fairly priced, give a higher expected return. This phenomenon is referred to as the risk premium. Now, in an efficient market, when some bad news comes to light, investors adjust their expectations for future earnings, and stock prices drop to maintain a fair P/E ratio. However, investors also conclude that risk has increased, causing them to demand a higher return, which implies a lower P/E ratio, so prices drop further.

When the bad news ends and good news starts to roll in, prices will initially grow along with higher expected future earnings; and then the perception of risk drops, causing the P/E ratio to grow again.

So, for example, suppose we learn that company ABC's expected earnings will be half what they were thought to be. For a fixed P/E ratio, this means that the stock price should be half what it was. However, this bad news also leads to increased perception of risk, so the P/E ratio drops, and the stock price can end up much lower than half of what it was.

Conversely, when the bad news ends and the expected earnings double, the stock price would merely double if not for the risk premium; but when the risk premium disappears, the P/E ratio increases, and the stock price can end up much higher than it was.

Without the risk premium, P/E ratios would remain fixed. Thanks to the risk premium, P/E ratios fluctuate with the market mood. This is a good thing for those with longer investment horizons: they are less risk-averse, and can pick up some good bargains during times of pessimism.

Lower P/E ratios during times of pessimism explain why returns would be higher during those times, causing overall stock performance to revert to the mean. This explains one small part of why Warren Buffet has had so much success being greedy when others are fearful.

Still renting?

2009-04-21T23:13:00.009-04:00

A year ago, I posted my most popular article yet: Save money by renting your home. A lot has changed in the last year, but one thing that's the same as ever is that I'm perfectly content renting for the foreseeable future.

The the article hinged on a calculation of the largest mortgage I could carry and still save money every month:

I pay $1200 per month in rent, including my parking space. That rent includes a number of items that would come out of my own pocket if I owned a home, such as property tax, repairs, maintenance, and some utilities. All told, I get about $500 in value every month included in my rent. That leaves $700 that is truly "thrown away" just like mortgage interest.

How large a mortgage would cost $700 per month in interest? Today's variable-rate mortgages are going for about 4.6% per year. At that rate, a mortgage of $182k would have interest charges of $700 per month. That means if I could stop renting and move into a house with a mortgage of $182k or less, I would save money every month.

Here's what has changed:

My rent has increased by $50/mth. That brings my "thrown away" money up to $750/mth.
Variable-rate mortgages can now be had for 3.05% interest.

With these new figures, we find that the magic mortgage number is now about $295k. If I can find a buy a home with a mortgage of $295k or less, I would save money every month.

Here's what hasn't changed:

Homes in my area still don't go for $295k. They're still up around $480k.
Condos can be had for $295k, but the condo fees move the break-even point below $295k, so they're still not better financially.
I still don't particularly want to own a home.

I'd like to leave you with one final thought. It is being claimed that now is the time to buy a home because of increasingly favourable interest rates and home prices. To my mind, the best time to make any investment is when the price is low and increasing. Right now, real estate prices are high and decreasing. As far as price is concerned, you could hardly choose a worse time to buy a home than right now (except perhaps six months ago).

The worst has happened. The sky has fallen. I've lost a gut-wrenching amount of money on paper in the stock market since September. But I'm as satisfied as I ever was in my asset allocation, my risk tolerance, and my decision to rent rather than buy.

Update, Apr 21: As of this week, you can get mortgage rates as low as 3.05%, so I have adjusted my calculations above to use this number instead of 3.3%.

Update, July 15: Looking at the same link given above, we see now that variable mortgage rates are as low 2.85%, so the break-even mortgage is up to $315k. This means I probably could buy a house in my neighborhood and, ignoring the buying and moving costs, I might save a few bucks every month starting on day one. But I still have no interest in buying a house just yet. For one thing, the moment the mortgages return to more historically normal rates, the mortgage's advantage over renting disappears, and I would be back to losing money every month relative to renting. I consider it unwise to bet against this happening in, say, the next five years. There are also non-financial considerations, like the freedom to change homes with just 60 days' notice at no cost, or my nearly complete protection from risk in the real estate market. A house would need to cost substantially less than my rent for me to take on the extra risk and responsibility of house ownership.

Update, November 3: Now rates are down to 2.25%, so the break-even mortgage is up to $400k. If I were convinced mortgage rates would stay this low indefinitely, and I liked the idea of skewing my asset allocation heavily toward residential real estate, and I didn't mind mowing my own lawn and fixing my own roof/furnace/toilet/whatever, and I was ok with losing the freedom to move with 60 days' notice, I'd buy a house right away!

Update, November 24: The neighbors just sold their house for $650k. It was a decent-sized 5-bedroom house, but it just goes to show that I wasn't being overly pessimistic by estimating $480k.

Protectionist frenzy over 22 cars?

2009-03-10T16:48:00.012-04:00

Is protectionism ok when we do it?

Please, everyone, get a grip. We buy their cars; they buy our lumber, machinery, and energy (and cars!); and everyone wins. That's how international trade works.

It's not the job of Ontario Lottery and Gaming to stimulate the auto industry, and I think Smitherman is way out of line in his criticisms.

Update: The protectionism isn't over yet. Apparently MPs are now supposed to drive Ontaio-made cars only. Given the outrage we all heard over American protectionism so very recently, this hypocrisy is almost unbelievable.

Update 2: I'm glad I'm not the only one who feels this way.

Update 3: Here we go again. They're closing the barn door after the horse has left. They ought to ask themselves why Canada's manufacturing sector can't out-compete China in the first place.

The auto bailout: wrong in so many ways

2009-02-23T08:00:00.009-05:00

Michael James hit the nail on the head today in his comments regarding the auto bailouts. I've made the same point about boosting EI rather than writing a vast cheque to a mismanaged company that makes inferior products.

It's importat to realize that the Canadian government is indebted to the EI system (at least morally, if not fiscally) to the tune of $51 billion anyway, so it seems perfectly fair for them to pay out an extra few billion in EI benefits to auto workers to tide them over until new jobs arise. It would also seem reasonable to fund re-training for the auto workers, and tax incentives for successful manufacturing companies (say, Japanese auto makers) to set up plants in Ontario.

All of this would seem more likely to succeed than to deliver billions of buckets to the crew of the Titanic.

I'd like to add that the way the Canadian bailout was determined also shows a startling lack of leadership. Queen's park decided ahead of time that they would pay 20% of whatever figure the US government arrived at, thereby abdicating our nation's fiscal sovereignty on one of its largest expenditures. This is just the latest in a string of actions since parliament was prorogued against all logic in December, all of which show that the current federal government is a rudderless ship.

ETrade's inactivity fees

2009-02-01T18:51:00.005-05:00

I'm not happy with ETrade. I opened trading accounts there a couple of years ago, but until recently I only used the self-directed RRSP account. The regular trading account that you get along with the RRSP account sat idle.

Then, in October, Pizza Pizza (PZA.UN) shares dropped to the point that the distribution yield hit 14%. Now, the percentage yield is only interesting if it's a percentage of a large number, or if it's compounding; but at 14%, it meant I could buy 100 shares (for $640, which I had lying around) and the monthly distribution would be more than enough to buy one additional share every month. I transferred the cash, put in the order, activated the synthetic DRIP, and by the end of the year, the three distributions I had received had already covered the (rather pricey) $20 trading commission.

When I checked the account in January, I was in for a surprise: they had charged the account a $25 "inactivity fee". I thought at first there was some sort of mistake, but it turns out they charge regular accounts (not registered accounts) $25 each quarter in which you make fewer than two trades. There is an incredible irony in charging me an inactivity fee the very first time I used this account.

I was not impressed. At this point, I think my letters to ETrade speak for themselves:

Hello,

You have charged my cash trading account a $25 "low-activity admin fee". I would like it to be refunded immediately please. My account ID is XXXXXX.

I find it absurd and infuriating that you charge me $25 specifically for providing me with no service. Your trading fees and currency exchange rates are already among the costliest in the industry, and they are only tolerable because I don't trade frequently. If you insist on charging me $25 per quarter to do nothing for me, I will be closing my accounts, transferring my holdings to a brokerage with a sane fee structure, and publicizing my displeasure as widely as possible.

I don't mind paying for service, but I refuse to pay for a lack of service, and I suggest you take a moment to reflect on the wisdom of surprising your customers with this mean-spirited, punitive fee.

Out of respect to the service agent, I won't name him or post his reply, but perhaps you can infer what was said from my response:

Dear Xxx,

Thank you for your reply, but I'm afraid it doesn't stand to reason. Why does ETrade need to charge this fee if I make one trade, but not if I make two? Why does ETrade encounter these back-office expenses if I have $4999 in my account, but not if I have $5000? It is absurd. I think the real explanation is that ETrade wants to guarantee themselves a minimum revenue stream from each customer regardless of the level of service provided. This is what happens when you let accountants run your business.

More to the point, other discount brokerages don't charge this fee. I would rather part with $125 for closing my account than get hit with this infuriating fee every quarter, or pay $160 every year for trades I don't want to do.

I think ETrade needs to consider carefully whether they want to lose people like me as customers. Certainly, my account balance is tiny now, since most of my assets are elsewhere, and I am at the start of my investing career; but I'm looking for a broker to use for the next three decades until my retirement, and I'm not going to choose one who charges me for nothing.

I will not pay this fee again. It is up to you whether that is because you have waived it, or because I have closed my account.

As expected, they did not waive the fee, and the service agent seemed to become somewhat personally affronted by my emails, which prompted me to say this:

Dear Xxx,

I didn't mean to accuse you personally of setting the policy. I made an effort to refer specifically to "ETrade" separately from yourself, but if I wasn't clear enough, I apologize.

Nonetheless, the inactivity fee is unacceptable to me. I am aware of a number of discount brokerages that have no such fee, so charging me a fee for no service is not only unethical: it also puts ETrade at a disadvantage relative to its competitors. I will be exploring my options before the time comes that ETrade can charge me that fee again.

I do not want to switch brokerages (partly because I don't want to pay the $125 ransom to get my assets back) so I would sincerely appreciate it if you could find a way to help me get this "fee for nothing" waived.

Naturally they were unable to waive the fee. What I have done is open a TFSA at ETrade and move my shares there. The TFSA is a registered account and is not subject to the inactivity fee. With any luck, that $25 fee is the last money I'll be paying ETrade for a very long time.

What do you think? Am I being unreasonable?

Thanks, Larry!

2009-01-06T22:57:00.004-05:00

On October 27, Larry McDonald posted an article on saving money by defending yourself against traffic tickets, rather than paying an agent several hundred dollars to represent you.

The following evening, I was pulled over by a policeman and given a number of tickets for administrative matters. I can't be too specific, but it was a pretty expensive evening. Worst of all, the convictions would disqualify me for my current hallowed status with my car insurance provider, and would lead to increased premiums for years to come. This seemed manifestly unfair to me, since I believe my poor administrative skills have no bearing whatsoever on my actuarial risk.

My first thought was not to take chances: to hire an agent to represent me and get the convictions dropped; but after reading Larry's article, I decided to go it alone.

Early in January, I attended my appointment with the prosecutor, and with a wave of her pen, my life got a whole lot easier.

I saved myself four convictions, three demerit points, and over $500 in fines, all at no cost besides my time.

Thanks, Larry!