The Automagical Financial Planning Ballparkinator

April 14th, 2014 by Potato

Update: Hi everyone, there’s a bug in the “backwards” calculation for early retirement scenarios. I’m going to work on it, and finish typing up the full instructions which should help explain the thinking behind it and why I think it’s neat.

I think hands-down the most common two questions I get related to finances are “how do I…” (for which I’ve written and am now revising a whole book) and “how much do I need to save, anyway?” There are a host of tools available on the internet to try to answer this, but they’re all fairly simplistic — as few as three factors are considered, with many hard-coded variables. If you’re still decades away from retirement then you really just need a ballpark number to get started, and for that those tools are pretty good — heck the “save 10% of your income” rule-of-thumb is not terrible, and it doesn’t even specify whether it refers to pre-tax or after-tax income, or to what age range it applies.

But of course I wanted something a little more detailed with more things to tweak. More importantly, I wanted to put up side-by-side comparisons of some important scenarios so people didn’t have to refresh their web browser a dozen times to get an idea of where to go. May I present Potato’s Automagical Financial Planning Ballparkinator. Available in Excel only for now, until I’m satisfied it’s debugged enough to also put on Google Docs Drive Docs.

There are many possible shapes to the future, so how much you need to save decades in advance will only ever be a rough estimate. This will help you figure out what the general ballpark estimate of that number should be. It’s based on my retirement planning spreadsheet calculator — I added a more robust tax calculation (including OAS clawbacks), and of course the whole soup-to-nuts saving through retirement component, but have removed some of the finer features (like non-flat budgets and personal inflation rates). It does include a separate field for your investing fees (MERs) so you can see the impact of those without having to directly adjust the returns in the scenarios (and more directly, to put that factor front-of-mind).

It calculates forward based on your current savings rate (and a bunch of other assumptions) to find out how long your money will last under that plan, and also estimates backwards from your budget needs to rough out how much you should be saving (annually). Note that the backwards calculation bundles all account types together for the calculation and guesses at a tax rate — a much rougher estimate and more similar to the simplistic web-based tools common on many bank websites.

The results for both methods are presented in a little table to examine three scenarios for future returns (a base, worst, and best case), which you can of course define yourself, and for four risk profiles/asset allocations: ultra-conservative (all fixed income), balanced (50/50), risk tolerant (mostly stocks), and all stocks. This is important as the rules of thumb like “save 10%” are based on having enough of a balance to get something close to equity-like returns on your savings. If you are like many people today, scarred by 2008 and unable to contemplate anything more volatile than a package of bonds, then you will have to cut your spending budgets and save substantially more every year to make up for that ultra-conservatism in your investments. Similarly, if you don’t start investing until you’re in your 50’s, then you’ll have to put away substantially more than 10% of your income.

Figuring out your future spending needs may be the most difficult part. For your future budget you can start with your current spending needs, and take your best guess as to how they will change in the future. More travel, but less commuting? No more mortgage payments, but added expenses for lawn care & snow removal that you used to handle yourself? The default in the spreadsheet is to take 75% of your current spending budget, but definitely put careful consideration into this figure — and try out a few iterations.

Note that this is not a full financial plan, not by a long shot. There’s nothing here about contingency plans, goals, motivations, asset allocation, rebalancing plans, insurance, emergency contacts1, taxes and tax shelters, short-term savings goals, or really much of anything else. I’m hoping one day Noel D’Souza will get around to showing us what a good, complete financial plan looks like. Until then: ballpark, get started, evaluate, adjust.

1 - no, not poison control. Who will calm you down when markets are roiling? Who will your family call if you’re dead or incapacitated, who has your will?

Update, April 16, 2014: Thanks to Spudd at CMF (no relation) for pointing out that there was a problem with early retirement scenarios and the RRIF table. I’ve provided rough guidance for that going back to age 20 — it might not be the right amount to start withdrawing from an RRSP right away, but it should be reasonably close and at least returns something for early retirement scenarios now. I’ve replaced the sheet on the site, the link remains the same.

Rebalancing Spreadsheet

April 4th, 2014 by Potato

Canadian Capitalist and Squawkfox have created rebalancing spreadsheets to help you when it comes time to rebalance your portfolio. They are somewhat simplistic and hard-coded with the funds — this is a good thing if you’re following the Sleepy Portfolio or one of the Couch portfolios: just enter the current value, the money you have to add, and see how to split your new purchase up.

I wanted one with a bit more flexibility: one that would allow for a few broad categories of investments, with sub-investments. For instance, if I had small bits of cash left over at various points through the year I might throw them into a TD e-series fund, and as long as my overall Canadian/US/International split was ok I wouldn’t worry about rebalancing the e-series versus ETF splits. Or similarly if I had several sub-products to make up one sector, like counting BRK.B and VTI together for US exposure, but not caring too much whether that split was 50/50 or 60/40. Also rather than just entering the current value, the sheet lets you enter the price and the number of units in your various accounts. With the units entered, half the work is done for the next time you want to rebalance (just update the unit prices).

The sheet calculates and displays the variances (how much you are off by), and then also calculates how many units of each fund you need to buy to get back into balance. Note that you should generally round down so that you don’t over-spend the funds in your brokerage account. In the top row you can enter how much new cash you have to invest, or enter a negative value to withdraw cash from your portfolio.

The spreadsheet is available here in Excel, or through Google Docs* here. Enjoy!

* - Google can try to call it Drive, but Docs has stuck with me.

Regulatory Burden

March 30th, 2014 by Potato

In the comments to the first post on regulating financial advisors someone brought up the issue of regulatory burden: the extra paperwork and delays imposed on businesses. Nicole went so far as to call it “onerous” and “strangling” — and that’s just for the regulation already in place, which we’ve criticized as not providing enough protection.

There are lots of examples of regulatory burden out there, for many stakeholders. I regularly suggest that people go with TD Waterhouse to be able to invest in e-series funds over TD Mutual Funds because of the extra steps and forms needed to fill out and mail in to convert an account and the possible limitations of the KYC forms. I never got my CFP/CSC because it’s just not worth my time to take the courses and exam for what the designations would bring me; if something like that were to be a mandatory requirement to talk to clients about investing and their financial plans that would keep me and several other part-time educators/planners/coaches/DIY-support people out of business.

But a certain amount of form-filling, records-keeping, and education overhead should be expected in any business. The correct amount of regulatory burden is highly unlikely to be zero, and if it brings important consumer protections then that’s a good thing.

However, the way regulations and reporting are structured can have huge impacts on the eventual regulatory burden. Consider for example something I have some experience with: applying for a grant to do some medical research. You could apply to the US National Institutes of Health (NIH) and or to the Canadian Institutes of Health Research (CIHR). In both cases the basic document outlining the experiment you’re looking to fund would be say 13 pages. On top of that you’d have a detailed 5-year budget and a justification for the funds you were seeking, a half-page lay summary for the funding agencies to release to the press or the elected government representatives, and some kind of CV to demonstrate that you had the experience and ability to carry out the research you proposed.

Now both funding agencies take very seriously the protection of research participants and have fairly similar rules and regulations in place for that protection, but the implementation and regulatory burden is night and day in my mind. In Canada, your grant would now basically be complete: CIHR’s protection of research subjects rules are separate from the grant process, and all institutions sign on to it before they can enter a competition. They know that any research is going to be reviewed by a research ethics board that meets their standards, and will get a copy of the approval before releasing funds (if you’re successful in the first place). If the experiment calls for anything terribly out of the ordinary, then it’ll have to be explained in the proposal anyway. Compare this to the US, where the proposal part of the grant submission is almost like an afterthought to the stacks of appendices and tables that have to be filled out — including some that no one really seems to understand (including the NIH help staff I’ve spoken to), where you have to predict the racial breakdown for any proposed study (how many whites, blacks, asians, etc. will you recruit), but then also the “latino/non-latino ethnic breakdown” (how many latino asians vs non-latino asians will you include in your study??). It’s stressful and confusing (Spain and Portugal aren’t included in the countries of origin for people considered hispanic?) and totally bizarre (why do they care about this stuff? Will they really reject my grant over this?). For basically the same mandate and ultimate protection of research subjects, the regulatory burden is quite different between the agencies because of how they approach the problem and where they place the reporting requirements. By having so much paperwork up at the application stage it creates a lot of work for the ~80% of NIH applicants who will not get their grants funded because the scientific component wasn’t competitive enough for the severely limited funds.

Also, some protection comes with virtually no on-going regulatory burden. The Residential Tenancies Act sets out many protections for tenants, but aside from modifying what you can put into a lease there is no paperwork for landlords or tenants to fill out in the regular course of business beyond what you’d need anyway. Indeed, you get some of that for better than free: by standardizing certain terms, responsibilities, and practices they don’t have to be separately negotiated and drawn up in a lease. Everything is handled on an enforcement basis: only after a problem arises does someone end up having paperwork to fill out. Now at that point it can be very onerous (dealing with the LTB is no picnic, especially for landlords), mostly due to the delays involved. But for most people most of the time, it’s reasonably strong regulation with little overhead cost.

So I think that implementing a better model for financial advice and regulation thereof can be done in a way that minimizes the regulatory burden. It’s something that can and should be kept in mind as a new regulatory framework is thought out (especially the implementation aspect), and kept in balance with the benefits.

He Asked For It

March 29th, 2014 by Potato

Sometimes being mean can be fun. No, that’s not right. Sometimes when I’m having fun I can come off as mean. I don’t aim to be mean, so this is a tough blog post to approach because that is just about all I have to offer. Let us pretend that I have been possessed by Greg McFarlane and this is a guest post FRotM: Book Edition.

A little while ago I got a piece of email that I ignored as being basically spam: a request to review and blurb a new book (actually titled: “A Free Investment Book for You”). Pitched as “a “How to” guide to obtaining compound returns of 20 percent, 30 percent, or more annually from investing in stocks and to do so in a manner that’s worry-free for the investor.” and “The Sane Approach to Investing in Stocks for Insane Profits.” I decided to be nice and junk it. That kind of pitch turned me right off: it looked like it was either not refined enough to know it’s contradictory, or a scam.

Then he followed-up. Clearly this was a real person and not a robot emailing me, so I wanted to put him out of his misery. This is what I sent back:

“I don’t think I would be a good choice for you as a reviewer/blurber. I don’t think 20-30%+ returns and “worry-free” can be put together like that, so seeing it as the central part of your message is troubling. I work as an editor so my reviews tend to be critical in the first place, and starting off on a bad foot already might not lead to a review you would like.”

He still wanted to send me a book, calling me “an excellent candidate for reviewing my book… my desiring your participation at this stage is a testimonial to the respect that I have for you and your work.” Ok kid, flattery will get you everywhere. I got the book. I read the book. I was open to having my mind changed: maybe it was a good investing book and he just needed to work on his email marketing. Alas, it was about as bad as I feared, shy of not advocating that readers borrow money from friends or remortgage their houses to invest.

Rather than tearing into it wholly, I just want to pick on one specific part: those worry-free 20-30% returns. In the book he lays out the 10-stock portfolio that brought him a 128% return in under 5 years. He compares that to just 45% on the S&P500. But that is a mistake. This is basically a giant case of getting a little bit lucky with stock picking, and a lot lucky with timing. He bought in 10 chunks through the end of 2008 and the beginning of 2009 — yes, he just happened to start investing at a generational low in the market that was followed by a massive, unrelenting bull market. No wonder he thinks 20% returns are worry-free. Anyway, it looks like he’s comparing his portfolio purchased across several time-points that span the market lows to a single time-point for the S&P500 from before the Lehman Bros event. It was easy enough to look up the S&P500 total returns and compare an index portfolio that made purchases on the same dates as he did, and the actual comparison would then be 104%. Yes, his picks out-performed, but it’s not nearly as impressive. Oh, and most of those same picks were hit way harder in 2008/2009 than the index was, so if there’s a repeat then so much for the “worry-free” part.

Then he lays out a second 16-stock portfolio that only has a bit over a year of tenure. He boasts a 29.6% return versus the S&P500 at 26.3% [figures not audited]. Yet that portfolio includes one position that just so happened to return 243% in a year. Exclude just that one outlier, and the portfolio underperformed. By a lot. Sure, sometimes that’s how investing works, but that’s not the kind of track record you base a book around (and again, hoping for a single lottery-ticket-stock to pay off while almost half your portfolio declines in an amazing bull market year is not my definition of “worry-free”).

I cannot in any way recommend this book — I haven’t even mentioned the title because I feel bad for the kid, and I don’t want this to be the only review that comes up in Google. But I warned him, and he asked for the review anyway.

Now he did start off by thanking his editors (amongst others), and on a micro level it’s a fairly tight text. With my own self-interest in mind paying for a few editing passes can help make a book more digestible (especially a self-published one). Unfortunately, the over-arching shortcomings cannot be saved by layout and grammar. It really needed a peer review — and some robust back-testing — before being sent off for a copy edit as the basic premise appears to be flawed, based on a mistaken return comparison and a great deal of luck. Though mentioned often in how the book was presented, the issue of worrying and freedom thereof was not covered.

Page distribution:
Completely blank, not even page numbers (colouring fodder for your young daughter!), 10%.
Small investing nuggets not even fleshed out enough for a blog post (e.g. 431 words on coattail investing does not blow me away with content), 30%.
Specific information* on companies found in a stock screener that will be instantly out-of-date in book format, 25%.
Index (the kind to look stuff up, not the S&P500), 4%.
Drivel, 7%.**
The purported approach/method/secret, 2%.***

* - Includes estimated future EPS growth rates to two decimal places, though all the percentages round precisely to X.00% so I don’t know why the digits were necessary in the first place.
** - Harsh but accurate summary.
*** - Totals may not add to 100% because math is hard and fact-checking is for losers who don’t have insane profits to chase. Also, yes, depending on how liberal you want to be on what counts as part of the approach versus general rehashing of Warren Buffett quotes, just ~2% on that topic. Spoilers: use PEG, buy when below 0.75-1.

Regulation Examples

March 24th, 2014 by Potato

In the last post we talked about the importance of regulation: to create an environment where a non-expert, without the ability to independently evaluate an expert, can come to trust a complete stranger because of the regulations and mechanisms in place to create and maintain quality and ethics. There are lots of examples of industries and professions with varying degrees of regulation that we can learn from.

Car salesmen are regulated (OMVIC in Ontario). The regulations set some minimum standards for disclosure and how prices can be advertised: it’s not especially strong legislation (for instance, the dealer does not have an obligation to work in the best interest of the customer), but then the general public understands explicitly that the car salesperson sitting across the desk from them is in a sales role. They don’t couch themselves as “transportation advisors”, and if you went to one you would know that they would try to sell you a car (and you would not walk away with a recommendation for a bicycle and transit pass even if those might suit your situation better). They might be able to help you pick a particular car that’s suitable: compact over a truck, but even then you know that if you walk into a Chrysler dealership with a need for something fuel efficient you won’t be driving out in a Prius or Leaf: the best they could do is a 4-cylinder gasser that their dealership sells. To my mind, this is most analogous to the current MFDA designation in the financial sphere, but without the universal, mutual understanding of the sales and commission-driven nature of the role.

Some trade organizations exist more to protect their members and a monopoly than to protect consumers and build trust with the public. Since it’s been a while since I’ve done so, let’s pick on realtors: there are minimal barriers to entry, and no formalized processes to manage conflicts-of-interest (except for those set up at individual brokerage offices). There is a dispute mechanism, but from casually looking at cases and allegations, they seem to take realtor-on-realtor aggro way more seriously than allegations of misleading or mistreating the lay public. In other words, CREA/TREB is not a model I would want to copy: the initial quality standard is not rigourous, there’s no continuous improvement, there’s next to no policing or efforts to maintain the public trust: it appears to be a trade organization out to serve its own interests.

In cases where the decisions are literally life-or-death the regulatory body tends to take a more active role. Medical physicists for instance are responsible for calculating radiation doses in cancer therapy and ensuring that the machines are accurately delivering the doses prescribed. Over-dosing can kill through radiation effects, underdosing can allow cancer to proliferate. The Canadian College of Physicists in Medicine requires a graduate degree in one of several related fields, a fellowship program (education), examination, continuing education, periodic re-certification, and practice reviews.

Banking, at least the deposit-taking part, is a highly regulated industry. Not just anyone can rent out a space with marble pillars and a vault and call themselves a bank. Because trust is essential to preventing a run on the banks, a government-backed insurance scheme (CDIC) is in place to guarantee that if all of the regulations and oversight somehow still manages to fail, depositors will get their money back (up to a limit of $100,000 per account). Now, that’s not to say that a bank won’t ding you with service charges or sell you services you don’t need — they walk a fine but well-defined line of trust and conflicting interests for sales.

Franchises are not something handed down by the government or enshrined in law, yet by building strong brands people know that stopping at McDonald’s or Subway for a meal will provide a fairly uniform meal experience — they can trust that even in a strange city far from home that they’re going to get what they expect. It’s a way of accomplishing the end goal of letting someone with no easy way of independently evaluating quality to walk in off the street and know that they’ll be in good hands.

So what would I like to see? I think good regulation will be stronger and faster* than building up a brand/franchise, though the end result might be better that way as an organization shooting for excellence doesn’t have to play to the lowest common denominator. Either way, I think getting rid of embedded commissions and their inherent conflicts-of-interest and obfuscation is the first step: it’s an uphill battle for education and standards if that basic component of the business model isn’t fixed first. We could follow the UK and Australia in that direction, and it will be interesting to see how their experience plays out over the next few years.

Either way, training and examination requirements at the start, including an ability to explain how fees work, the impact of fees, cash flow planning, and managing behavioural issues. Explaining risk at some level is necessary but is tough because even experts have trouble defining it precisely — perhaps just understanding that there are aspects of risk. Levels or specializations of certification, and an understanding that some situations should be kicked up the chain. Re-examination, auditing of practices, and other systems to keep quality high. And a correction mechanism: some way to feed back new or unresolved problems back through continuing education, to arbitrate disputes, and compensate customers who were wronged.

The regulatory body should ideally be separated from the body that looks to maintain a monopoly or promote the profession so that it can be client-serving and not self-serving. Because it can be confusing as to what the responsibilities of the advisor are (especially if a term like “advisor” is used), someone (who?) should make it clear to the public what the relationship is, possibly disclosed up front (”Hi, I’m a salesperson and I do not have a responsibility to do what’s best for you, just to make my commission and not recommend something egregiously bad. Let’s look at a 7-seater, shall we?”).

Unfortunately I still haven’t had a chance to read the private member’s bill in Ontario so this might all be covered already.

* - from implementation to helping people. It will likely be slower to be crafted and passed in the first place.

I Don’t Understand Twitter

March 24th, 2014 by Potato

A little while ago a social media guru in our pubic affairs team said that you had to maintain a “presence” on Twitter by posting at least three times a day. We just wanted a place for people to get updates on a new project, which with lecture announcements might mean one quantum of content per month.

John Scalzi said that he was culling his follow list by removing the people who rarely tweeted.

I don’t get it. I check my Twitter feed about once a day, and though I only follow 36 people my screen is always full. Those accounts are carefully curated so that I usually want to read to the end of a day’s updates — but the general signal-to-noise on Twitter is atrocious. What finally got me to write this rant was friend of the blog @barrychoi tweeting about a new post on his blog eleven times in a single day! When people have really active Twitter accounts, especially with high levels of noise (like live-tweeting just about anything in depth, or just seeing half a conversation) it really turns me off. Following a couple dozen accounts like that and unless I just camped on the Twitter app I would start missing content — even at a miserly 140 characters the tweets add up.

And maybe that’s the problem: so many people are so swamped by the uproarious nature that they just sample their Twitstream at random intervals, which forces people to re-post their tweets again and again hoping to catch the eyeballs of their so-called subscribers, which exacerbates the high noise level. Ugh, that’s just not a game I can play.

Maybe it’s because I use the default web-based interface rather than a 3rd-party app with more capabilities (i.e., doing it wrong). I believe the way people use Twitter is to politely follow anyone who follows them first, then mute them with the list functions of the 3rd-party apps. Or else there’s something I’m just not understanding about the whole thing — which is likely given how incredibly difficult I find expressing anything in 140 characters. Seriously, my whole stream is basically poor-man’s-RSS announcement of new posts, and tweets full of [1/3] multipart markers.

As long as I’m ranting: hashtags are really annoying. When used sparingly they can be used to tag tweets, particularly when trying to tag that tweet to something in particular that might not show up in a general search (such as #becausemoney for questions and commentary directed at the podcast). But just adding the symbol in the middle of a sentence makes it harder to read and doesn’t help at all with the intended function — no one is out there searching for highly generic terms like #money or #Canada… and if those words were in the tweet anyway a search would pull them out without wasting a character and reducing readability. Without careful, conscious application, hashtags just become more noise. Oh, and “via” means “by way of; by means of” and is usually used to indicate who sent you a link you’re passing along to your followers — putting via [yourself] is like talking about yourself in the third person, it’s weird and off-putting.

Regulation of Financial Advisors

March 20th, 2014 by Potato

CBC Marketplace recently ran an episode looking at financial “advisors”, sending a woman in to several with money to invest and a hidden camera that has made some waves. Some advisors were ok (which of course didn’t air), but there were some that were just atrocious. They provided shockingly bad advice, or couldn’t answer simple questions about how much they were paid and what fees would be.

I don’t know how the advisors were selected: the show gave the appearance of picking randomly from large firms, but they may have been tipped off about bad ones in advance. The industry has tried to couch this as just a case of running into a few bad apples, but as Sandi says, that’s a load of bull and lets them continue to get away with a broken model for the industry. Some of them were so bad that a bad apple metaphor doesn’t cut it, but rather one with a grenade in it. That should never have happened.

Yet such incredibly bad advice is not so unusual — the system and the major firms do not set a high bar for financial advice.

This is a major issue. Financial advice/planning has a large impact on people’s lives, yet conflicts of interest abound and problems take years to show up. Moreover, people who need advice largely do not have the ability to evaluate the quality of their advisors (even with the benefit of hindsight), so recommendations from friends are basically useless. Combine all that with hidden and confusing fees, and this is an industry that cries out for regulation. A we-can-do-better retreat and voluntary code of conduct is not going to cut it.

Regulation can come in many forms: the government can step in to regulate from the top down, or industry groups can self-regulate. Often a hybrid emerges, where the government will help legally protect a professional title, and members of that organization will self-regulate.

Right now, the conflicts of interest inherent to the existing salescritter-cum-advisor model are making it to the public consciousness. That erodes trust in the whole system, yet there’s very little in place to replace it.

Here is the central issue as I see it: the system needs to be reformed so that someone with no knowledge and no way to evaluate quality in advance can go to get advice from someone and trust in that advice (and get reasonable value for the fees that they pay while they’re at it). And really the best way to build trust for the lay public is to have a trustworthy expert give the thumbs-up — that is, regulation.

What does good regulation look like? There’s some kind1 of quality standard set, with a mechanism to get it there in the first place (training, examinations). There’s a mechanism to maintain quality, through reducing conflicts-of-interest; ongoing training and continuing education; ongoing oversight, evaluation, and auditing; and even formalized specializations. And a way to make things right when the few bad apples inevitably get in: dispute resolution mechanisms, compensation funds. In return, a profession gets formalized and protected credentials and naming rights. Culture is important: a focus on ethics and client needs, on openness and honesty.

Not every element is required there. And government isn’t necessarily required: creating a brand that people can trust can also work. That can be a faster approach to get started, but doesn’t carry as much weight without the government behind it. In the next post I’ll look at some examples of professions that are out there now and how they are regulated. In the meantime, check out this week’s BecauseMoney podcast where I discussed this issue with hosts Sandi Martin, Jackson Middleton, and special guest Noel D’Souza.

1- actually the quality standard itself is important too — it should serve the right people (i.e. the public rather than the banks), have associated metrics, be achievable, consider structural issues and conflicts-of-interest, etc.

The Absurdity of Index Investing

March 13th, 2014 by Potato

Many people don’t believe in index investing, looking instead for ways to beat the market and eke out those last few percentage points of return.

I get it: index investing is an absurd concept. Most popular indexes were never intended to be investment products: they were simply a way to try to get an average figure for the stock market so journalists could succinctly report what was happening on Wall/Bay St. when filling the paper and TV screens with non-actionable noise (…I mean news). That such an arbitrary collection of companies should end up being the most highly recommended way to invest seems to stretch credibility.

“Surely,” the argument goes, “out of 500-some companies I can find 10 that are obviously going to do worse than the average and exclude them, and find 10 that are obviously going to out-perform and over-weight those, and then I’ll out-perform indexing.” And I don’t know — maybe you can. But likely not, at least not without so much work (or paying someone else to put in the work) that the costs undermine the gains. And if you can maybe get the extreme outliers, the temptation is to keep going with the tweaking until long past the point where any move you make is more likely to be wrong than right. It’s a losers’ game.

Still, the mind rebels against the concept.It can’t be that indexing works, after all, there’s a whole profession created around the idea of investing through active management. If the argument that the active investors are the market — so the average active investor gets the average market return less fees — were true then a whole industry by rights should not exist. But it does, therefore there must be something better than active investing, QED. The studies exist though: the best data is on mutual funds, which by a very large margin do not beat their indexes net of fees.

Of course, we live in a crazy, irrational world. The lure of the possibility of doing better (and rubbing your peers’ noses in it), of finding that fund manager who’s secretly the next Buffett, Lynch, or Soros is irresistible to many. We’ve all heard of those guys who made it big by just having the right idea at the right time — whether it was a tech company, a mining stock, or shorting the housing market — and we’ve all got ideas of our own. We’re greedy, and there’s a driving need to be better, even if it means taking risks to get there. Setting out to be average is a tough nut to swallow, even if doing so actually makes you an above-average investor who can more easily avoid the emotional foibles of the masses.

Or maybe your salescritter moves the goalposts and instead of promising better returns instead breaks out language regarding absolute returns or lower volatility. That can be shockingly persuasive: even though human drivers can make all kinds of deadly errors, nobody wants a robot car on the road. The thought that some human agency is driving your portfolio — even if they’re driving it into the ground — can seem more reassuring than the thought that you have turned everything over to a passive sampling of global capitalism.

And even when you’ve heard about how “fees matter”, the fees sound so very small — single-digit percentages or even “basis points” — that it’s hard to believe the effect is so profound. Surely paying 1% to this really smart-sounding guy will be worth it when he out-performs, right? It was to the people who invested five years ago…

Yes, past performance is no guarantee of future results, but — aha! — doesn’t that also apply to index investing being the way to go? And looking at past results is so important as it’s one of the few pieces of data accessible, and we have to look at something — investing should be work. That’s a law of nature or something, right? No: it’s hard to accept, but making things easy and uncomplicated is a virtue. If it makes it easier to stick to your plan and not panic or screw things up through human error, then that’s a further way that indexing is a good approach to take (and to recommend). Rather than procrastinating on a hard method that’s likely going to underperform, it’s really easy — and satisfying — to push someone just getting started towards indexing.

Then, after all the absurdities and cognitive biases have been stripped away, you see that indexing isn’t quite so absurd after all. A cap-weighted index minimizes the amount of rebalancing that has to happen on an ongoing basis as valuations fluctuate. Big indexes are well-diversified, and even if they were meant for reporting more than buying, they work quite well if there’s some scale involved (which Vanguard, Horizon, BMO, TD, Tangerine, or iShares can easily provide). Because there’s nothing else to compete on (the vendors want to track the same thing as closely as possible) the fees get cut as close to zero as possible.

Even after accepting that indexing is the way to go, that urge to outperform and make it into work can remain. We all know someone who uses ETFs to invest, but is not in any sense a passive index investor. They may try to time the market, or just over-fit their asset allocation model, digging up ever more specific sector and individual country funds to own, with their portfolio allocated down to fractions of a percent. There are some who acknowledge the happenstance origins of indexing, and who try to create better indexes (fundamental, value-tilted, etc.) that still embrace the core principles of broad diversification and fee minimization.

Though no matter what path led to the indexes we have, in the end it’s the best strategy available for the vast majority of people investing for the long run.

Cherry Coke Zero Project Part 2

March 12th, 2014 by Potato

This has been an absolutely awful winter for much of North America. Unrelenting cold — actually, it relented on Tuesday but one day of relenting is still craptacular — snow that just piles up and up and up, broken only by the ice falls. You can blame random fluctuations and poor luck in weather, shifts in the climate from global weirding, but we all know the answer: the Polar Vortex. But what can we blame the Polar Vortex on? Simple:

The Obstinate policy of the Coca-Cola Company of Canada to deny Cherry Coke Zero to Canadians.

You may recall in my last plea to the company that I pointed out how they were exploiting Canadian icons (polar bears, Santa, happiness) — that Canada was their muse, and yet we were getting the short shrift on flavour selection. I took a carrot and stick approach: I asked very nicely for them to bring Cherry Coke Zero to Canada, with a promise to buy a lot of it if they did, and backed that with a threat to unleash a progression of plagues: memes, cats, and ultimately polar bears.

Now it turns out it’s really difficult to arrange for the release of polar bears with the explicit purpose of setting them loose upon downtown Toronto to terrorize the regional executives of a certain global beverage company. I mean, the paperwork is just the beginning: you have to wait for a slot in front of the Zoo’s board of director’s semi-annual meeting to pitch your case, and of course really the only approach is to use my scientist credentials to call it a research project, so that means I have to apply for a grant and ethics approval, which is another two-year-long timeline. I mean, at that point infiltrating my way into Coke’s ranks, working my way up the corporate ladder, and just making the decision myself is starting to sound easier.

So I kind of let the project slide for a little while.

Then the Olympic messaging started up, and I realized: we are winter. Right after that moment of clarity the ice storm hit and I was without power for 7 days — over Christmas. Santa saw I was in a funk and stopped by to have a good chat about the whole ordeal, and I mentioned that what would really cheer me up is a Cherry Coke Zero. The mad plan came together in that instant: rather than polar bears, Santa would use his Christmas Winter Miracle Weather Machine (CWMWM) to help his fellow Canadians put a little pressure on the company. And thus, the Polar Vortex. He even managed to send snow all the way south to head office in Atlanta.

For three months the Polar Vortex has raged and blown and blustered, freezing innocent and culpable alike.

It’s time for spring, Coke. But Santa won’t relent until all Canadians — from Windsor to the Workshop at the North Pole — can enjoy Cherry Coke Zero without having to snowshoe down to one of the few Freestyle machines sprinkled around or smuggle one across the border. George RR Martin has given us a glimpse into a world of winter without end, and it’s not pretty — anyone you get remotely attached to is at constant risk of gruesome death. Don’t take us down that road: be the hero to the people you’ve always wanted to be and bring back spring.

Our first ever cherry-flavoured spring.


Updated Rent-vs-Buy Calculator

March 8th, 2014 by Potato

Thanks to some discussions with people (and Redditors) I have updated the rent-vs-buy investment method calculator (aka the ultimate rent-vs-buy comparison tool for Canadians). You can see the spreadsheet in Google Drive here (and save a copy to your own Google Drive or download in various spreadsheet formats) or click here to download it in Excel format.

Please see the original page for instructions, and the follow-up discussions: part 1 on things to consider and discussion questions, and part 2 on the sensitivity to various inputs changing.

If you haven’t seen this before, it’s a very detailed and customizable rent-vs-buy calculator. It assumes that all else being equal, you can compare apples-to-apples options for your shelter. If buying costs more, the renter will save the difference in monthly cash flow and invest it. It allows you to model a change in interest rates over time (specifying a rate for years 1-5, 5-10, and 10+), includes the effect of transaction fees, house price appreciation, taxes on the renter’s investments, and most importantly: investment returns that compound over time.

What’s new:

  • The default mortgage rate is now 3.49%, the lowest big-bank 5-year fixed rate my rate-comparing friends at were able to find. With the move to a 5-year fixed (the most common option chosen) I’ve updated the back-end mortgage calculations to account for the bizarre 6-month compounding of fixed mortgages in Canada.
  • The CMHC charges have been updated for the recently announced changes (though those won’t take effect for another month).
  • The summary box (scroll over to the right) now also says how much the buying case wins by (in the event that it does) so you don’t have to look down at the full results table.
  • The default comparison has been updated. I’ve just spent a quick half hour searching for comparable listings and found many exact — same unit — apples-to-apples comparisons, and Toronto’s price-to-rent is easily over 240X right now1.

I have been asked about creating a space for fudge factors (in particular, to model the case where the owner gets a roommate or rents out a basement/secondary suite2) and I have not included that and do not feel persuaded to. Having such a field would just invite non-comparable comparisons (like comparing renting a full house to owning half of one with a call option on the rest). It’s a spreadsheet, so it’s not hard to account for such cash flows (for instance, just over-write the maintenance fee column with a combination of increased maintenance fees from being a landlord and a negative cash cost item for the rent income), and I would much prefer you think deeply about it by doing it manually than just jumping ahead to the fudge cell to justify buying.

1. I was overly fair to the buying case before and renting was still better — a point that was lost on many. The comparison now starts with one such matched pair (in North York). Renting now totally blows buying out of the water. I don’t want to belabour the Toronto housing bubble issue too much (I’d rather people focus on the usefulness of the tool and try it out for their own purposes without getting distracted by my situation), but it’s not even close guys. And I’m still being too fair by being at the bottom of the range — many of the condos that were “only” 240X had maintenance fees of ~1.4-1.5%, vs the sheet’s default of 1.1%, and those condo fees don’t even cover all maintenance/upkeep needs.
2. I already had a short post on this topic, but in brief: if it doesn’t make sense to rent out a whole house, how does renting out half of one suddenly become financial genius?

Update: Etienne (who was featured by Garth Turner recently) emailed me with the fix for a minor bug: the CMHC premium was being applied to the whole house value rather than just the loan value. Fixed as of March 15, 2014. The magnitude of the error depends on the downpayment; for example with 5% down it made the mortgage 0.15% too large, for 10% down it was 0.24% too large.