Michael James on Money

Some Index ETFs Understate Fees

noreply@blogger.com (Michael James) — Mon, 09 Nov 2009 05:01:00 +0000

Until recently, the leader in index ETFs for US stocks has been Vanguard. Their great reputation combined with rock-bottom MERs has made them the clear choice. However, Schwab has come out with several index ETFs with management fees matching or beating Vanguard with the added bonus of paying no commissions when trading in a Schwab account.

As Larry MacDonald points out, some ETF companies generate extra revenue through a practice called securities lending. This is the practice of lending stock to short sellers for a fee.

Some commentators are speculating that Schwab is keeping the proceeds from securities lending to augment the MER. The Schwab prospectus doesn’t seem to clear up the matter:

“When the fund lends portfolio securities ... the fund will also receive a fee or interest on the collateral. ... The fund will also bear the risk of any decline in value of securities acquired with cash collateral.”

So the fund gets a fee and the fund bears the risk. What do they mean by “fund” in this context? Is it the unit-holders or the management company?

In my opinion, because unit-holders own the securities they should keep the proceeds of securities lending (net of reasonable costs). If a management company keeps some or all of the proceeds, then they are essentially understating the fund costs.

Until Schwab makes it clear who gets the securities lending proceeds, I’ll stick with Vanguard. Vanguard has a clear policy:

“Unlike other firms that allocate a significant portion of lending revenues to their management companies, Vanguard returns all lending revenues, net of broker rebates, program costs, and agent fees, to the funds. Other securities lenders may divert up to 50% of the revenues derived from their securities lending programs.”

Debt Problems and the Dangers of Consolidation Loans

noreply@blogger.com (Michael James) — Sun, 08 Nov 2009 05:01:00 +0000

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

When people get into trouble with their debts, they usually have several different debts including credit cards, car loans, line of credit, and possibly student loans. The debts usually have different interest rates and different required monthly payments. Some debts are scheduled to be paid of quickly and others over a long period of time.

The idea of a consolidation loan is to borrow one large amount to pay off all of the other debts. For this to make sense, this loan would have to be at a low interest rate and amortised over many years to make the payments low enough for the debtor to handle.

To qualify for this type of loan at a low interest rate, the debtor might have to put up some collateral, and this collateral is usually a house. The consolidation loan then turns into a home equity line of credit (HELOC).

On the surface, this seems like a good strategy. A lower interest rate means that you pay less interest. What other considerations could there be? I can’t say that I ever thought about this much, but a HELOC seemed to make sense if you are in debt trouble.

However, Suze Orman is dead set against this strategy saying in her book Women & Money “never use home equity to get rid of credit card debt.” Her reasoning is that if you got into trouble once, then you are likely to run up your credit cards again. Then you will have credit card debt and the HELOC to pay off. And if you can’t pay them off you will lose your house.

My first thought was that I disagreed with Orman. A rational person would consolidate the loans and then bring spending under control. But a rational person probably wouldn’t have had debt problems in the first place.

It is possible for someone who manages money well to have some big expensive event occur that throws him into more debt than he can handle. But this is infrequent compared to the number of people who make poor choices that result in having debts spinning out of control.

So, Orman is right. Most people with debt problems probably should not consolidate their debts into a HELOC.

A Bonus Read on Bonds

noreply@blogger.com (Michael James) — Fri, 06 Nov 2009 14:44:00 +0000

If you’re a bond investor check out this roundup of articles on bonds from Rob Carrick, a personal finance writer for the Globe and Mail.

Okay, you caught me. I’m pleased because Rob included my article comparing bond ETFs to directly purchasing bonds in his roundup. I suppose it’s too unprofessional to put “Rob Carrick has heard of me” on a business card. Rob has done a great job explaining financial matters clearly and I’m happy to be included.

Short Takes: Defending ETFs, Garbage Collection, and Verbal Contracts

noreply@blogger.com (Michael James) — Fri, 06 Nov 2009 05:01:00 +0000

1. Canadian Capitalist looks at the numbers to refute Mackenzie Financial’s marketing campaign against ETFs.

2. Big Cajun Man isn’t too happy about the city of Ottawa’s plans to more than double garbage collection fees and charge for them separately. With the trend toward cities charging fees for services, eventually property taxes will pay for nothing but the bloated administration that adds nothing to the actual services delivered.

3. Ellen Roseman is concerned about the use of verbal contracts by telecommunications companies.

4. Rob Carrick reports that the Ontario government plans to start teaching money management to kids in grades 4 to 12. Hopefully, the government will be able to limit the influence of the mutual fund industry who will want to steer the curriculum in a favourable direction.

5. Apparently Warren Buffett and Larry MacDonald think alike in at least one respect: Burlington Northern railroad.

6. Gail Vaz-Oxlade has a collection of stories about parents and their spendthrift children. It’s heartbreaking to watch young people make terrible mistakes and not be able to convince them to change their ways.

7. Frugal Trader feels conservative for using excess cash to invest instead of increasing leverage. In my books that’s somewhat aggressive; using excess cash to pay off the leverage loan would be conservative.

8. Thicken My Wallet looks at “being nice” as a negotiation tactic.

9. Jonathan Chevreau reports that Visa has revised its financial literacy web site. Apparently, Visa thinks the 20-10 rule makes sense: “never borrow more than 20% of your yearly net income” and “monthly payments should not exceed 10% of your monthly net income.” I have a better idea: never borrow more on your credit card than you can pay off at the end of the month.

Trying to Profit from the End of Oil

noreply@blogger.com (Michael James) — Thu, 05 Nov 2009 05:01:00 +0000

The world is running out of oil and according to Profit from the Peak by Brian Hicks and Chris Nelder, shortly oil production rates will begin their inevitable slow decline. The authors call the resulting scramble for energy sources “the greatest investment event of the century,” but is there a way for investors to profit?

Official sources paint overly-rosy pictures of the amount of oil still available. The biggest reserves are controlled by Saudi Arabia, but the Saudis severely limit access to scientific information about these reserves. The authors painstakingly go through available scientific evidence and conclude that peak oil production world-wide is near despite official claims that at least 50 years of oil remain.

Part of the problem with oil production is that as an oil field matures it gets progressively harder to extract oil, and the extracted oil has more impurities that take energy to remove. At some point, even if a field still has oil, it becomes unprofitable to extract any more oil. So, estimates of the amount of oil remaining are misleading; what matters is how much oil can be extracted.

This book is filled with detailed information about not only oil, but almost every other current and foreseeable source of energy. Here are some of the major conclusions:

– Oil production has peaked or will do so in the next three years.
– Natural gas and coal will peak some time in the next 13 years.
– Nuclear energy will peak in the next 10 years because we are running out of high-grade uranium.
– Wind energy is already competitive with coal and nuclear at 4 to 6 cents per kilowatt-hour.
– A hydrogen-based economy is highly impractical.
– In the future we will have an electric energy infrastructure with distributed electricity production and storage.

Another fact that puts Warren Buffett’s recent acquisition of a rail company in perspective: moving goods by rail is about 8 times more energy-efficient than trucking.

I give this book an A+ for technical content and clarity of explanations. However, investors are interested in profits. Interspersed throughout the book are “Investment Opportunities” sections that basically list companies involved in various energy-related ventures.

Despite the quality of information in the book, I can’t see how to profit. No doubt some of the companies mentioned will be wildly successful and many will fail. I can’t tell them apart. Even if I could guess which new energy source will prevail, such as wind or solar, there are so many companies working in these areas that I can’t predict which ones will dominate.

Federal Competition Bureau vs. CREA

noreply@blogger.com (Michael James) — Wed, 04 Nov 2009 05:01:00 +0000

The commission costs of buying and selling homes in Canada may be set to drop. The federal competition bureau has wrapped up a two-year investigation of real estate practices and they are pushing for big changes. They want the Canadian Real Estate Association (CREA) to open up its Multiple Listing Service (MLS) to discount real estate brokers.

Until now CREA has kept commissions on the sale of homes in Canada at artificial levels (usually 5-6% of the house’s sale price) by refusing access to MLS to any broker offering lower commissions. Because most homes for sale are listed in MLS, being denied access is a serious impediment for discount brokers.

For now CREA is sticking to its guns saying that they don’t plan to grant greater access to MLS. This may ultimately lead to a showdown before the Competition Tribunal. It seems that we can eventually look forward to lower real estate commissions driven by market forces rather than a monopoly.

Super Trader

noreply@blogger.com (Michael James) — Tue, 03 Nov 2009 05:01:00 +0000

The book Super Trader: Make Consistent Profits in Good and Bad Markets by Van K. Tharp is definitely not what I expected. I thought the aim would be to show me how to make consistent trading profits. Instead it assumes the reader already knows how to profit by trading and needs help sticking to a proven system.

Tharp paints a picture where profitable trading strategies are a dime a dozen, but the discipline to follow a system is the real key to success. A lack of discipline can certainly be harmful to investors’ returns, but Tharp offers no evidence that the consistently profitable trading strategies that he repeatedly refers to actually exist.

The book anticipates this criticism by ridiculing a “gentleman from England” who took one of Tharp’s courses and complained that it didn’t give him a profitable trading strategy. Tharp’s reply is that the course wasn’t designed to give a methodology; “it is about how to become a peak performance trader/investor,” and “psychology is far more important than methodology.” I’m with the English gentleman on this one.

Any failure to make 25%, 50%, or 100% return each year can be traced back to investor error, according to the author. This could easily be self-fulfilling; unless a trading strategy is described extremely precisely, a trader could look over the losing trades for a year and decide that many of them were mistakes.

God

Some of the subject matter of this book seems more suitable for athletes. Maintaining a positive attitude is good in most endeavours and feeling confident may help with tennis, but I’m not sure how it helps much with trading. Tharp takes this a step further by saying “it is time to open up the spiritual basis of trading.” Does this mean that we should pray for our stocks to go up?

More along these lines: “The opposite of joy is not necessarily sorrow; it’s unbelief in the true nature of your soul or the essence of God.” Thanks. Now my next trade is sure to be profitable.

Einstein

The author attempts to link his ideas to Einstein a couple of times. Apparently, the techniques for looking at things from multiple perspectives are “part of how he [Einstein] formed his great ideas about relativity.” I guess the idea is that disagreeing with the author is like disagreeing with Einstein.

Defusing More Potential Criticism

It’s simple math that the average trader gets the same returns as buy-and-hold investors, except that they pay more in trading costs. For very active traders these trading costs can be substantial. Tharp attempts to defuse this criticism of trading with a little story and a reader exercise:

Bill’s wife says “Trading is nothing but gambling. It’s a waste of time and has no redeeming value.” Bill then uses one of Tharp’s techniques aimed at solving the problem. It begins with Bill writing down some “statements” including “I married the wrong woman” and “She’s an idiot.” Of course, the real substance of the criticism is left unaddressed.

Investment Advice

“I’d recommend a good hedge fund over T-bills because you can get a much better rate of return.” You can also get a much worse rate of return as we’ve seen from recent hedge fund implosions.

Fantastic Returns

“I’ve known people with systems that can easily net 100% or more each year.” That’s great. A 30-year old starting with $10,000 could build it up to $10 billion by age 60 and $1 trillion by age 67. If the existence of such a system sounds implausible to you, you’re not alone. This book is filled with references to systems with incredible returns without giving any hint of how they work or any proof that they actually exist.

Advice for Prospective Hedge Fund Managers

“To have large amounts of money under management, you need to produce above-average returns with very little risk.” Most promises of high returns with little risk are scams as we’ve seen with the flurry of exposed Ponzi schemes.

Half-Way There

“Deciding on your objectives is about 50% of developing a trading system.” This reminds me of a joke about a clueless CEO. One day he announces that he has a great new idea: the company needs to double revenue while keeping expenses constant. This sounds great to the underlings, and one of them asks “that’s fantastic, what’s the idea?” The CEO stares back blankly and says “I just told you the idea.”

It takes 10 seconds to choose an objective of making at least, say, 40% return each year risk-free. The idea that the work toward meeting this goal is now half done is laughable.

Random Trading is Profitable

Tharp claims that choosing the right equity to trade isn’t important – what matters is the right exit. To prove this he devised a random trading scheme as follows. For each of 10 commodities toss a coin to decide whether to go long or short. Choose an exit point to cut losses equal to 3 times the trading range over the last 20 days. Otherwise, ride profits indefinitely.

After a trade is exited, flip a coin again to start a new position in that commodity. Tharp claims that this strategy made money consistently over a 10-year period. I’ll leave it to others to examine this more closely, but I’ll need a lot of evidence to believe that random trading can be more profitable than buy-and-hold.

An Example Trading System

“Let me present a simple trading system.” This got my attention. Maybe this is finally the part where the reader learns the secret to profitable trading! Sadly, the description doesn’t reveal how the system works. It just describes each trade’s results in terms of a dollar amount R:

– 20% of the time it makes 10R
– 70% of the time it loses 1R
– 10% of the time it loses 5R

On average, each trade makes 0.8R, although there is considerable volatility. The system is assumed to make 80 trades per year. Tharp claims that such a system is “not unrealistic” and that he’s “seen much better systems.” Let’s examine this a little.

If we set R to be 2% of our portfolio, then on each trade the portfolio makes 20%, loses 2%, or loses 10% with varying probabilities (see above). After 80 trades (one year), the average compound return is 156%! At this pace it would take only 20 years to turn $10,000 into over a trillion dollars.

Volatility is a factor here, and so I decided to run some Monte Carlo simulations. Out of a million simulations the starting $10,000 grew to at least $1 million 99.99% of the time.

If Tharp has seen trading systems with this kind of phenomenal potential, why is he wasting time writing books?

A Few Good Parts

There isn’t much I can recommend about this book, but there were a few good points. Tharp criticizes come-ons for trading saying they are designed “so that other people can take your money in fees and commissions.” There is no comment on the irony that this criticism can apply to this book as well.

There is extensive discussion of position sizing which more or less means controlling the size of trades to avoid doing significant damage to your portfolio if a trade works out badly. Tharp gives examples of profitable trading systems that can become money losers if the bets are too big. However the real value of this advice is that it will allow the typical trader with a money-losing strategy to lose money more slowly.

The best part of the book is the third of three biggest lies a cowboy tells:

1. The truck is paid for.
2. I won this belt buckle at the rodeo.
3. I was just helping that sheep over the fence.

Conclusion

Much of this book is self-help advice and exercises that have little to do with trading. For the parts that are related to trading, there is no evidence that they will help anyone trade profitably. This book definitely does not live up to its title.

Asset Allocation with a Twist

noreply@blogger.com (Michael James) — Mon, 02 Nov 2009 05:01:00 +0000

As regular readers of this blog know, I’m not a big fan of owning bonds for savings that won’t be needed for at least three years. It may not be for everyone, but I invest 100% of my long-term savings in stocks (with no leverage). For money I’ll need in less than three years, like University tuition for one of my sons, I buy bonds that expire close to the date I’ll need the money.

This means that I don’t get the advantage of rebalancing a portfolio between stocks and bonds. By trading to maintain constant percentages in stocks and bonds, investors are forced to buy low and sell high (as long as they actually do the rebalancing). Too often investors delay rebalancing when an asset class is priced low and the news is full of doomsday stories.

My latest idea is to change my portfolio to include fixed allocations to different stock asset classes. I’m sure that other people have thought of this before, but it’s the first time I have seriously considered committing my money to it.

My first thought is to include low-cost index ETFs for Canadian and US large and small cap stocks as well as possibly a few company stocks. I would define a percentage allocation to each stock class and rebalance whenever the percentages went outside of preset bounds.

All simulations I’ve ever done indicate that rebalancing gives a portfolio a small boost, but not enough to overcome the penalty of including an asset class with low expected returns, like bonds. Thus, I want to stick to stocks. I’m interested in reader feedback on this idea along with suggestions for which ETFs (and possibly individual stocks) make sense to use.

Predatory Lenders and Students

noreply@blogger.com (Michael James) — Sun, 01 Nov 2009 04:01:00 +0000

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

It turns out that banks consider students to be great customers for their credit cards. I learnt this from James D. Scurlock’s book Maxed Out: Hard Times, Easy Credit and the Era of Predatory Lenders, which gives a fascinating look into the world of lenders and their hapless customers.

So why are students good customers? When you think of the old style bank that only lends to people with steady income to pay off a loan, lending to students makes no sense. Students usually have little income, and many of them will run up bills on their cards that they can’t pay off.

It turns out that students have something else that makes them great customers: parents. According to Scurlock, parents will almost always bail their children out of debt problems. And the attitude of banks has changed dramatically over the years.

Students run up debts and pay interest for as long as they can. When things finally fall apart, their parents pay off the debts. The situation is perfect for the bank: they charge high interest rates with very little risk of default.

Other great customers are people who can’t handle money properly, but have a valuable asset such as a home. The strategy here is to offer this person some unsecured credit, and when they become unable to make payments on the debts they run up, get them to reorganize the debt with the home as collateral. As the debt continues to grow, and the borrower can’t make the payments, the bank can seize the home.

In this scenario, the bank’s goal isn’t so much to seize the home as it is to collect interest on its loans. The home serves as protection against default making the loan safe. Profitability comes from maximizing interest rates and minimizing the risk of default.

When you think in generalities about debt, it is hard to argue with the idea that people should be responsible for their debts and should pay them back. But, when confronted with the particular case of an illiterate woman being forced from her modest trailer home over a snowballing small debt combined with some papers she signed, but didn’t understand, things become less clear.

I’ve done my best to educate my sons about the problems with debt. I’ve also tried to convince them to talk to me before the first time they get a credit card or borrow money in any other way. But, I don’t have any particular insight into the best way to protect young people from the debt trap.

Short Takes: Dark Pools, Technical Analysis, and Flat Tax

noreply@blogger.com (Michael James) — Fri, 30 Oct 2009 04:01:00 +0000

1. Jason Zweig wades into the dark pools where hedge funds trade large share volumes at lightning speed. How can the little guy hope to compete with these shadowy figures that purportedly trade on inside information? The answer turns out to be by trading very infrequently.

2. Larry Swedroe reports on a new study finding that technical analysis is a waste of time.

3. Larry MacDonald published ideas from two proponents of a flat-tax system. Unfortunately, I can’t make the numbers add up. It seems that the government would be pulling in significantly less tax money with either plan. If that’s what these flat tax advocates have in mind, then they need to explain how we will do away with big chunks of government spending.

4. Million Dollar Journey has some advice on how to handle collection agencies.

5. Canadian Financial DIY has opinions about the new ability for Canadian retail investors to trade in Contracts For Difference (CFDs). Buyers beware. Remember that whenever you enter into a financial transaction where you don’t fully understand what you’re buying, there is a good chance that it won’t end well for you.

6. Preet wonders what the point is of having an ETF with only a few holdings when it can be cheaper to just buy the individual holdings yourself.

7. Canadian Capitalist found a use for prepaid credit cards for xenophobes: safer online purchases.

8. Big Cajun Man explains why debt is like fat.

RRSP and TFSA Strategies

noreply@blogger.com (Michael James) — Thu, 29 Oct 2009 04:01:00 +0000

In an ideal world we would all make our maximum RRSP and TFSA contributions each year and look forward to being a millionaire in retirement. However, people who are able to do this are in the minority. Most Canadians have more combined RRSP and TFSA room than they will ever be able to use.

But don’t despair! Having excess room gives us some tax-saving strategies:

Income Smoothing

If your income is highly variable from year to year, you can smooth it out by making RRSP contributions in a high income year and withdrawing some RRSP money in a low income year. This reduces the tax burden if your top marginal rate is higher in the contribution year than it is in the withdrawal year.

One disadvantage of this approach is that the RRSP room will be lost permanently, but this is of little consequence if you have more room than you can use. There used to be another disadvantage before we had TFSAs: any gains on the money withdrawn from the RRSP in the future would be taxed. However, you can now put this money in your TFSA to avoid any future income taxes on your gains.

Tax Reduction for Low-Income Retirees

We’d all like to think that we’ll retire in comfort, but the truth is that many retirees have very low incomes. These people collect the Guaranteed Income Supplement (GIS). In a particular income range, this GIS gets clawed back 50 cents for each dollar of income, an effective additional tax of 50%.

For low-income retirees with a modest RRSP (converted to an RRIF), the required withdrawals each year can be 50% clawed away plus the regular income tax rate. So, some Canadians have more than 50% of their RRSP withdrawals taxed away.

In some cases, it makes sense to withdraw a large amount from the RRIF in one or more years. Part of each large RRIF withdrawal will be clawed back, but once the GIS is fully clawed back, the remainder of the withdrawal is taxed at a much lower rate. The result is that you get to keep more of your retirement money. The downside of this strategy used to be that any future returns on the withdrawn money would cause GIS claw back. But, now, the money can be moved into a TFSA to avoid this problem.

BMO’s New Bond ETFs

noreply@blogger.com (Michael James) — Wed, 28 Oct 2009 04:01:00 +0000

As Canadian Capitalist reported, BMO has come out with several new exchange-traded funds, including some bond ETFs. Any investor considering these bond ETFs should check whether it is cheaper to buy a bond directly.

The safest of the new bond ETFs are ZFS (0.2% MER) which invests in Canadian 1-5 year bonds, and ZPS (0.25% MER) which invests in provincial 1-5 year bonds. These MERs are a huge improvement over the typical bond mutual fund MERs, but they can still be high for large investments.

An alternative to these ETFs is to simply buy a bond directly. Discount brokers allow investors to buy bonds that make periodic payments, or buy another type of bond called a coupon that just pays a fixed amount at a given end date. The safest of these bonds are backed by the Canadian government or provincial governments.

Let’s suppose that you want to invest $20,000 in Canadian bonds for 5 years. You could buy ZFS and pay 0.2% each year for a total of about 1% after 5 years. The total fee would be around $200 plus the trading commissions. Or you could buy a bond directly.

Discount brokers don’t make it obvious what commissions you pay on a bond trade. You need to figure out how many bond units you can buy with your $20,000 and look at the gap between the buy and sell price for that number of units. The total cost of buying and then selling the bond will be equal to this gap. Of course, if you keep the bond to maturity, you won’t have to pay the selling half of the commission. With this information you can compare costs and decide on the cheaper approach.

Many investors are unaware that they can buy bonds directly. An advantage of this approach is that the final bond value is guaranteed. With a bond fund or ETF, you get no guaranteed future value.

Pension Reform Promised Soon

noreply@blogger.com (Michael James) — Tue, 27 Oct 2009 04:01:00 +0000

Finance Minister Jim Flaherty has said that pension reform is coming soon. Unfortunately, it may not be what many Canadians are hoping for. With existing company pension plans underfunded by a total of about $50 billion, many Canadians who are retired or near retirement are justifiably worried.

One of the more notable company pension plans in trouble is Nortel’s. Without any reasonable prospect of further contributions to Nortel’s pension plan, pensioners would like to see the government back the plan with financial guarantees.

The same is true for those hoping to draw from other pension plans that are in financial trouble. But the Harper government hasn’t given any sign that it intends to pony up the massive pile of cash that would be necessary to back these pension plans.

All indications at this point are that Flaherty intends to change the rules going forward to encourage companies to be more conservative in their pension funding. For example, the surplus cap of 10% may be increased.

However, none of this will help people whose pensions are threatened right now. Nortel pensioners want government backing, but should taxpayers be made to pay for this? Even if the government relents and decides to back pension plans, it is likely to have various restrictions and caps that would leave pensioners receiving less money than they were promised by their employers.

Why is Investing Different from Other Endeavours?

noreply@blogger.com (Michael James) — Mon, 26 Oct 2009 04:01:00 +0000

I’ve argued in the past that trying to time the market is a near impossible game for most of us to win over the long term. This prompted the question “why should we bother trying to do anything like becoming a doctor or a lawyer – there will always be someone else who is better.”

It’s certainly true that we can’t reasonably expect to be the very best doctor, lawyer, programmer, or poker player in the world. However, doctors don’t have to compete against every other doctor in the world. It might be tough if the world’s best doctor has the office next door, but under typical circumstances, a doctor merely needs to be in the middling range among his peers to run a successful practice.

In the case of a poker player, he just needs to find a game where he is an above average player. The fact that better players exist in the world is of no concern if they aren’t seated at the table.

However, when it comes to market timing, you can’t choose your opponent. Equity trading is essentially a world-wide game where everyone must compete against the very best players all the time. When trying to decide whether now is a good time to jump in or out of the market, an army of professionals with much better access to relevant information than the typical trader are competing in the same game.

To Win with Stock Options, Someone Has to Lose

noreply@blogger.com (Michael James) — Sun, 25 Oct 2009 04:01:00 +0000

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Not to be too philosophical, but my experience has taught me that I’m best off to conduct myself as though there exists a single objective reality that applies to all of us rather than each of us having our own separate realities.

What does this mean for the investing world? If several people all buy 100 shares of ABC stock at the same time for the same price, then they will all get the same return over a given period of time. Some of these people bought ABC stock for very smart reasons, and some might have bought it because they have the initials ABC. Some of the investors are smart, some dumb, some nice, and some mean, but they will all get the same return.

This all seems obvious enough, but you have to keep it in mind when you read the come-ons for businesses that want to set you up with an account to trade stock options.

Stock options are side bets between two parties on whether a stock will go up or down. A bet that the stock will go up is called a call option, and a bet that the stock will go down is called a put option.

Descriptions of stock option strategies usually go something like this:

“If you think ABC stock is poised for a big move upward, buy call options. When ABC stock rises, you will make a lot more money than if you just bought the stock instead of the options.”

Statements like this are true because they start with “if”. But what happens if ABC stock doesn’t go up? You’ll lose your money, that’s what. For every bet you make with stock options, there is someone on the other side betting the opposite way. You can’t both win; the stock can’t go up for you, but down for the other guy.

One of you will win the bet and the other will lose. This is what is called a zero-sum game. Across everyone who plays, the total wins and losses add up to zero. Actually, it’s worse than this because of trading commissions when you buy or sell options. So, in reality, the average person involved in stock options loses money.

When you trade in options you are making bets ON the stock market, but you’re not invested IN the stock market. Because of this, you’re not taking advantage of the fact that the average stock market investor makes money over time. This means that stock option trading has a built-in disadvantage when compared to investing in stocks.

To win with stock options by enough to beat the strategy of simply buying and holding a stock index there have to be enough others who are losing money with stock options.

Short Takes: Estate Summary, Rare Financial Plans, and Bell Problems

noreply@blogger.com (Michael James) — Fri, 23 Oct 2009 04:01:00 +0000

Short Takes: Estate Summary, Rare Financial Plans, and Bell Problems

1. Canadian Capitalist tells us from personal experience the importance of keeping a one-page account summary to help family sort out your finances after you’re gone.

2. Larry MacDonald and Million Dollar Journey reveal that financial advisors rarely create proper financial plans for their clients.

3. Ellen Roseman has an unbelievable collection of bad Bell customer experiences. My own experience with Bell over the decades has been problematic as well.

4. Thicken My Wallet does a great job of explaining the dilemmas involved in trying to treat Madoff’s investors fairly.

5. Potato makes the case that while market timing in stocks is near impossible, it may be possible to time the real estate market.

6. Big Cajun Man has a funny illustration of the importance of having a target for your finances and ... uhh ... other things.

7. Preet explains why over the long run stocks have to give better returns than guaranteed investments.

8. Gail Vaz-Oxlade has a good rant about the need to save for retirement. One thing I would add is that it’s not enough to save a specified amount of money. You have to save more than your neighbours. The cost of having young people fill jobs to service your needs in retirement will rise if there are a lot of retirees with the money to pay for them.

9. Canadian Financial DIY reviews the book The Secret Language of Money.

TFSA Rule Changes Likely Helpful to Investors

noreply@blogger.com (Michael James) — Thu, 22 Oct 2009 04:01:00 +0000

The Canadian government’s planned TFSA rule changes have been described as needed to prevent sophisticated abuses by savvy investors, but on closer examination, the biggest effect may be to protect investors from themselves.

The penalty for over-contributions to a TFSA used to be 1% each month, but this has been changed to taxing any return on the excess amount at 100%. Apparently, some investors were deliberately over-contributing looking for short-term gains that would then be tax-free, except for the 1% each month.

However, most investors who chase short-term gains lose money. This new rule will have the effect of saving many reckless investors from following a strategy that has a built-in 12% per year drag on returns. This is almost like borrowing on a credit card to invest.

The new rule against swaps between RRSPs and TFSAs is designed to prevent a scheme to shift money from an RRSP to a TFSA as I explained previously. For an investor who tried this and failed to execute it well, the result was just paying a bunch of fees to a brokerage for shifting stocks around.

Canadian Capitalist observed that one could achieve a cash for stock swap between an RRSP and a TFSA by just selling stock in one and buying the same stock in the other. This begs the question, why ban swap transactions? I have three possibilities:

1. The government hasn’t thought of this.

2. The new rules will actually cover this kind of dual activity in an RRSP and TFSA.

3. The government thinks that the costs of commissions and spreads will make it impossible to profit from this strategy.

UPDATE: A 4th potential reason: investors may be able to play games with the fair market value on a swap by picking either end of the day's trading range after the fact. This would not be possible if the swap is accomplished virtually by buying and selling stock in the two different accounts.

Overall, the new rules may prevent some sophisticated investors from exploiting TFSAs, but for most investors who try such games, the rules will save them from themselves.

TFSA Abuse

noreply@blogger.com (Michael James) — Wed, 21 Oct 2009 04:01:00 +0000

There seems to be no limit to the number of clever schemes that tax experts come up with to avoid paying taxes. The Canadian government is planning to make some changes to the rules governing Tax-Free Savings Accounts (TFSAs) to close some loopholes.

The most interesting tax avoidance scheme involves swaps between RRSPs and TFSAs. Before now I wasn’t aware that such swaps were permitted without any tax implications. The idea is that if you have $5000 in cash in one account and $5000 worth of stock in the other, you can swap the cash for the stock without it counting as a withdrawal or contribution.

This makes some sense. After all, the total value in each account doesn’t change. It’s like one account bought the stock from the other account at fair market value. However, this swapping idea led to an amusing scheme to shift assets from an RRSP to a TFSA. I’ll explain it with an example.

Suppose that Tammy the tax avoider is nearing retirement with $100,000 in an RRSP and $5000 in a TFSA. Tammy is facing the prospect of having to pay income taxes on the $100,000 as she withdraws it from her RRSP over time. She’d much rather have the money in a TFSA where it can be withdrawn tax-free.

Tammy begins by buying 500 shares of (hypothetical) ABC shares for $10 each:

TFSA: $0 plus 500 ABC shares
RRSP: $100,000

Suppose that ABC stock goes up to $12. Then Tammy swaps the TFSA shares for $6000 cash in the RRSP:

TFSA: $6000
RRSP: $94,000 plus 500 ABC shares

Then the stock goes back down to $10, and Tammy swaps them back for $5000:

TFSA: $1000 plus 500 ABC shares
RRSP: $99,000

Since the stock went up then back down, Tammy hasn’t made any money, but notice that she has managed to shift $1000 from her RRSP to her TFSA. If ABC stock cooperates by continuing to bounce up and down, Tammy can keep shifting money from her RRSP to her TFSA.

The proposed new rules for TFSAs will apply a 100% tax (ouch!) to TFSA amounts that can be attributed to such a scheme. Tax avoidance is all fun and games until your money gets confiscated.

UPDATE: Some have suggested that when performing a swap, there is the opportunity to select any price in the day's trading range. This means that when stock moves out of the TFSA, a high price can be chosen, and when it moves back into the TFSA, a low price can be chosen. This makes this scheme much more effective.

The Future of Bonds

noreply@blogger.com (Michael James) — Tue, 20 Oct 2009 04:01:00 +0000

Rob Carrick wrote a provocative piece about the effect of rising interest rates on the bond market called Latest horror flick: Attack of the bond market. This made me take a look at how bad the carnage would be if interest rates rose.

Poking around at my online brokerage, I found a $100,000 Canadian strip bond coming due 2029 Dec. 1 that they would sell to me for $43,818. When you own a strip bond you don’t get any periodic payments; you pay for it, and in this case you get your $100,000 when it comes due, unless you sell it first.

The return on this bond works out to 4.19% per year for just over 20 years. However, according to the Bank of Canada, the average return on long-term Canadian bonds over the last 10 years is 6.38%. This begs the question, what happens to my strip bond if interest rates return to the average level?

Suppose that in just over 5 years, the yield on my bond rises to 6.38%. By this time, it would be a 15-year strip bond and would sell for $39,546. This price is calculated so that the 6.38% return would make the bond worth $100,000 over the 15 years from 2014 to 2029.

So, my bond’s value would drop from $43,818 to $39,546, a loss of 9.75% in just over 5 years. This is roughly a 2% loss per year before considering inflation. If I owned long-term bonds in a bond mutual fund, the loss would be more like 3% to 3.5% per year because of the added fees.

These potential losses if interest rates return to average levels aren’t devastating, but investors usually choose bonds for safety, not to lose a few percent every year.

Swine Flu Dividend

noreply@blogger.com (Michael James) — Mon, 19 Oct 2009 04:01:00 +0000

Even though the swine flu hasn’t caused the devastation that some predicted, it has still harmed many people. Widespread concern over this flu has had a curious financial side effect that I didn’t know about until my wife pointed it out to me.

A couple of nights ago my family enjoyed a large pork roast that fed four hungry people and left enough for lunch for two. I wasn’t too surprised to find out that the roast cost only $5.50 because my wife routinely finds good deals on meat.

But this wasn’t a case of a pork roast that was a day from its expiration date. My wife tells me that pork is almost always on sale now and that this roast would have cost more than $10 a year ago.

Many factors go into the pricing of goods, but the dominant factor for pork right now is the swine flu. For some reason, people are avoiding pork because of this new flu. This makes no sense at all; experts say that you can’t catch swine flu from eating pork, but people are avoiding pork anyway.

So there you have it. A combination of a new flu and widespread ignorance has a small silver lining: cheap pork. Of course, pork producers won’t see this as a silver lining. That’s why they would rather call the swine flu the H1N1 virus. I’m not too optimistic about the new name catching on soon.

Hidden Mutual Fund Fees?

noreply@blogger.com (Michael James) — Sun, 18 Oct 2009 04:01:00 +0000

This is a Sunday feature looking back at selected articles from the early days of this blog before readership had ramped up. Enjoy.

Many people don’t like to talk about money, and so I try not to discuss money unless others show an interest. On a few occasions when the subject came up, I’ve encountered people who think that they don’t pay fees on their mutual fund investments.

In a recent case, an acquaintance who I’ll call Rosie offered her reason for believing this. Rosie said that she knew that some people paid fees, but she checked her statements regularly, and she had never seen any fees listed.

Of course she does pay the Management Expense Ratio (MER) and possibly front or back-end loads. I decided to have a look at some of my old statements from back in the days when I owned mutual funds. Sure enough, there weren’t any references to fees even though I know I paid them.

How widespread is the mistaken belief that investors don’t pay any fees on their mutual funds? I’d be very interested in the results of a poll. Among those who know they pay fees, it would be interesting to find out how much they think they pay.

Disclosure rules are supposed to prevent this sort of confusion. Each mutual fund has a document called a prospectus that discloses fees, and investors have to be given a copy of the prospectus. However, I suspect that people read the prospectus about as often as they read the 16-page manual that comes with a new toaster. (Do not use in bathtub. Do not sue us ...)

Maybe the disclosure rules need to be changed to require fees to be shown prominently on statements. This would be similar to the way that credit card statements have to include information about the amount of interest charged and the interest rate.

Because MERs are so high in Canada, let’s take a Canadian example. Suppose that Howard and Cindy are in the early fifties and have been saving in their retirement savings plans (RRSPs). As of a year ago, between them they had $200,000 split across the three biggest actively-managed Canadian equity mutual funds. (The following figures are based on real fund results.)

Here is the summary part of their collective investments including a fee disclosure that doesn’t normally appear on statements:

Total Assets one year ago:
$200,000

Total Assets now:
$197,247

Total investment return over the past year:
-$2753

This investment return takes into account the following MER fees paid:
$4647

Howard and Cindy would definitely pay more attention to the exorbitant fees charged by mutual funds if they were disclosed this way. Switching to index funds would save Howard and Cindy about $4000 per year in MER fees.

Don’t hold your breath waiting for this kind of disclosure. There would be huge opposition to it from the mutual fund industry.

Short Takes: Bond Yield Fantasy, Money Delusions, and Alternative Minimum Tax

noreply@blogger.com (Michael James) — Fri, 16 Oct 2009 04:01:00 +0000

1. Larry MacDonald explains the difference between a bond’s nominal yield and its yield to maturity. If any fixed income product such as a bond or preferred share is paying a rate that seems too good to be true, check whether it will be redeemed soon for less than its current price.

2. Gail Vaz-Oxlade is in a unique position to see the financial mistakes made by many people and she lists the big mistakes people make in their attitudes toward money.

3. Million Dollar Journey explains the Alternative Minimum Tax (AMT). The AMT exists to prevent high income people from driving their income taxes to zero with certain types of deductions. If you’re old enough to remember NDP politicians thundering about the number of millionaires who pay no tax, you’ll see the motivation for having an AMT that gets wealthy people to pay some tax each year. AMT can be a pain if it applies to you, but the difference between the AMT and the amount resulting from the regular tax calculation becomes a deduction in a future year.

4. Canadian Capitalist shows that Scotiabank’s online store ScotiaMocatta is an expensive way to buy gold and silver.

5. Thicken My Wallet finds that dividend ETFs are redundant because of their significant overlap with broad-based stock indexes.

6. Big Cajun Man has a take on the great debate of whether you should contribute to your RRSP or pay down your mortgage.

7. Preet explains why investing in managed futures over the last couple of decades would have reduced portfolio volatility.

8. Jonathan Chevreau reports that Invesco Trimark is travelling the country pushing an asset mix that would have performed better over the last couple of years than the traditional mix of stocks and bonds. Of course, there is no guarantee that adding commodities, real estate, and other exciting assets to your portfolio will help over the next two years. I’ll be following Trimark’s advice as soon as I perfect my time machine.

9. Ellen Roseman helped some Sears Canada customers get satisfaction after the company’s call centre moved overseas causing delays and frustration.

Canadian Investors Lose Sight of the Real Prize

noreply@blogger.com (Michael James) — Thu, 15 Oct 2009 04:01:00 +0000

In a recent survey of investor attitudes reported on here by the Financial Post, “Canadian investors are more influenced by soft issues such as their relationship with their investment advisor than by hard-core financial factors such as portfolio performance.”

It’s amusing to see portfolio performance described as just one of the “hard-core financial factors.” Portfolio returns should be the main concern of an investor. Instead, “investors are desperate for relationships with investment advisors that help them feel more comfortable.”

It’s hard to know for certain why people focus on less important issues, but I’ll try a guess. Maybe most investors have no idea what returns they should expect, but they know how they feel and they know whether they like their advisor as a person. So, the judge their experience by the things they understand.

In a perfect world, people would be able to examine their portfolios to determine their asset mix and then compare their returns to a similar mix of index returns. This comparison would expose sky-high MERs most of the time. Unfortunately, few investors can do this.

Draw Results and More Money Emotions

noreply@blogger.com (Michael James) — Wed, 14 Oct 2009 04:01:00 +0000

The giveaway winners of 4 copies of the book The Secret Language of Money by random draw are Aaron, Gene, Nora, and Adrian. The winners have been contacted by email. I accidentally jumped the gun and held the draw too early. Because I contacted the winners too early as well, I would have done a second draw for a fifth book for any last-second entries, but there weren’t any.

Thanks to all who entered the draw. For another chance to win this book, check out Thicken My Wallet’s giveaway.

Here are a few more interesting tidbits from the book.

Affinity Bias

Apparently, we tend to overestimate the value of things we like, such as familiar stocks and favourite sports teams. This explains why I always found so many willing Torontonians to take my bets against the Toronto Maple Leafs during the 1980s.

Compulsive Spending Cycle

I have always found the tendency for some people to buy things they don’t really want or need to be baffling. According to the authors, buying things makes some people feel good in powerful ways. Unfortunately, this immediately leads to shame for having spent money they can’t afford to lose. Then they need to spend again to feel better and the cycle continues.

Senior Citizen Vulnerability to Scams

This one is likely to be controversial. “The prefrontal cortex – the home of logic, level-headed decisions, and long-range planning – is the ideal resource for debunking a scam or outing a con.” But scams promise big returns quickly and this fires up the limbic system and bypasses the prefrontal cortex. But higher brain functions “tend to wane with advancing age” and the “very old are very prone to this sort of emotional hijacking.”

Politicians

No great insight here, but quite funny:

“Politicians seem to fulfill various roles in our lives. They watch out for the common good; they attend to all manner of logistics in the managing of the social order; and they lead us in times of trouble. And they do one more thing: Now and then, they flame out in entertainingly spectacular fireballs of scandal and self-destruction.”

What Follows a Lost Decade?

noreply@blogger.com (Michael James) — Tue, 13 Oct 2009 04:01:00 +0000

Commentators bemoan the lost decade for stocks. In Canada, returns were positive, but low over the last decade, but in the US, returns of the S&P 500 were actually negative. According to Larry Swedroe, this is the first time since the great depression that this has happened over 10 or more years.

However, if we subtract out inflation, returns look even worse. As Larry shows, there have been three periods of at least 10 years since the depression that the S&P 500 has failed to beat inflation. These periods ended in 1947, 1983, and now (at least we hope it doesn’t continue).

This is all very depressing, and can make us want to give up on stocks altogether. However, I wondered what happened after these bad times. Here are the S&P 500 total returns (including dividends) for the decade after these “lost decades”:

1948 to 1957: 14.4% above inflation
1984 to 1993: 10.7% above inflation
2010 to 2019: ?

As you can see, those first two decades were spectacular! There is no guarantee that the upcoming decade will match these impressive results, but it does give us some hope.