On MERs and Past Performance (Again)

March 1st, 2015 by Potato

A reader writes in, asking about a particular mutual fund manager. They’ve read The Value of Simple, but aren’t sure if they should switch to DIY index investing considering their particular funds have outperformed net of fees the past few years, and have won Lipper and Morningstar awards.

This was an interesting email to receive. The reader had four different ways of saying that past performance for the particular fund was good.

The Lipper and Morningstar awards are basically useless as indicators of a fund’s ability to out-perform their fees in the future. The Lipper awards in particular are completely focused on past performance, so winning one doesn’t tell you anything a screen of past performance wouldn’t already. The Morningstar award includes “style consistency” and “tax efficiency” as other criteria, but is again basically just a metric of past performance.

There are studies that show that past performance is not a criteria for finding winning mutual funds, so by extension, the Morningstar and Lipper awards shouldn’t have any bearing, either. Indeed, I went back and spot-checked the 2010 Lipper winner, and they badly under-performed in the subsequent ~5 years. Their 10-year average (including the out-performance that won them the award and subsequent under-performance) is now equal to the index. I then quickly checked all the 3-year winners in the Canadian equity category from 2007-2014 (the range data is available from Lipper), and all but one of them went on to under-perform the index. (I didn’t check all of the winners in all categories because they have dozens and dozens of categories to try to spread the love around)

So why is past performance not a good indicator of future performance, when it is for say, job performance for an engineer or a sales associate? There’s always a combination of luck and skill in performance and outcomes, but the proportions change for different tasks. The engineer’s outcomes might be mostly skill and a bit of luck, so a good one in 2010 will probably still be good in 2015. A sales associate might have an equal mix of factors affecting their past performance — finding the skill may not be too hard, but it may not be immediately apparent in past results. But for mutual funds the skill can be completely swamped by luck, so it’s quite hard to find, especially from the customer’s chair.

I’m not dogmatic about indexing and active management, but pragmatic: I think some people can out-perform due to skill, maybe even enough to beat their fees if they do it professionally. However, identifying that small percentage of managers is a task that’s comparable in difficulty to just being an out-performing active investor yourself, and that is very difficult in my mind. You have to have a good understanding of what skill looks like to be able to spot it amongst all the luck and marketing. And the MER acts as a huge hurdle: these guys might be very skilled, but out-performing by even 2% every year is quite an achievement, and that would be needed just get you back to even. In my opinion, going with indexing is the better bet.

Another consideration is what value you get for the MER paid. A big issue in the industry is that typical big bank/big firm advisors just sell funds and don’t provide the detailed plans, hand-holding, tax advice, or other services they claim in newspaper articles are reasons to avoid DIY investing. If you’re getting good service, then you have to decide whether it’s worth 2% — or whatever the fee difference is — to keep getting that level of service, or if you’d rather do it yourself and save on the fees and avoid the risk of their performance streak ending. If you’re not getting good service for what you pay, then paying the higher MER is purely a bet on their ability to out-perform, and historically that has not been a good bet to take. Demand better service to get your money’s worth, or take matters into your own hands (which may include paying fee-for-service for the expertise you need to supplement your own efforts in indexing).

The Toddler Morning Efficiency Curve

March 1st, 2015 by Potato

In all my years and all my learning, I have never quite got the hang of mornings. I used to be pretty good at sneaking up on them from the other side, staying up all night to get them when they least expect it, but waking up and facing a new day is just such an impossible concept. I know some people can basically just roll out of bed and be something called “chipper” and “alert”. I am not one of those people. I used to play snooze-button basketball with my alarm clock to gradually wake up over the course of an hour and a half, then search for caffeine before risking communication with other humans.

At several points in my life I have studied the evidence and become convinced of the utility of breakfast, and have woken up early to eat this mystery meal before leaving for work. Inevitably, after a few weeks of that I decide (consciously or not) to forgo breakfast in exchange for more time in bed, or less stress at cramming the rest of my routine into an unrealistically short period of time.

And time is the big problem with mornings: it doesn’t behave or flow right. I can sit there at night, when everything is sparkly and sleek and working as it should, and time myself as I perform the necessary house-leaving preparatory tasks to plan when I need to haul my ass out of bed for the morning. I can put two poptarts in the toaster, determine that it takes 90 seconds to toast them, 25 seconds to slather them with peanut butter, and all of 195 seconds to shovel them into my food hole and wash them down. Practice run done: 310 seconds for breakfast, add it to the morning time budget, set the alarm clock back appropriately and we will be able to squeeze breakfast in. But then morning comes and time stops working properly. My carefully practiced and timed breakfast routine goes horribly awry. It’s going on 12 minutes and I still have half a pop tart to eat and somehow there’s melted peanut butter dripping on my pants.

I cannot accept that this is merely a subjective time dilation effect, caused by my severe case of night owlism. My toothbrush has a digital timer so that I brush for precisely 2.0 minutes. Yet in the morning, even though it still ticks up towards 2:00, it takes five minutes to get the whole process over with — the morning effect clearly affects even piezoelectric crystal-based time measurement.

Anyway, all this is to say that I am “morning challenged” and pretty much always have been.

Then into my life comes a wonderful bouncing baby, who becomes an amazing little toddler girl. Now instead of an alarm clock I wake up to the sound of “Daddy! Come pleeeeeeeeeeeeeease!” Bopping her on the head does not get me an extra 15 minutes to snooze so I pretty much have to get up at that point. For a long, long while she was waking up too late for me to even see her before I left for work, but then over the last year that has flipped so that she wakes up crazy early, following the ancient toddler urge to be up before dawn so that they can watch the sun rise and ask “why?”

And while to me it all sounds universally crazy early, there is a big difference to waking up at 5:30am and 7:00am, and incredibly it leads to a totally non-linear relationship in the time to be ready for work, a function I call the Toddler Morning Efficiency Curve. You would think that it would take about the same amount of time to do basically the same sets of things each morning, no matter when your wake-up call happened to come in. Indeed, if there was a non-linearity, you’d expect to become more efficient as the time to get out the door for work came closer and you started to hurry or cut non-essential things out of the routine — the hurry-up hypothesis. But it’s not so simple.

The Toddler Morning Efficiency Curve, showing that the amount of time needed to get ready is not a constant -- as you get up earlier and earlier it takes longer and longer, in a non-linear fashion. At some point -- about 5:30am or so -- the inefficiency becomes so severe that even though you have an extra hour and a half to get ready you still somehow end up being late for work.

If she wakes up at a “normal” time (normal for her, not for me), let’s say 6:30 to 7 am, then things proceed reasonably well. We can spend 10 minutes or so where I am just a useless bag of shambling meat, a zombie barely able to greet her and see if she needs a diaper change immediately or if it can wait a few minutes for the strength and dexterity to return to my hands. At some point shortly after waking up, I can go potty, tell her that I’m about to go potty, reassure her that I will be back in just one minute, and then go potty and listen to her wail for daddy to come back because this is a surprising and distressing abandonment and not something we do every. single. day. that daddy always comes back from.

Then we’ll get her dressed, maybe have some time to read a few books, play for a bit, or watch an episode of Mr. Rogers, then we go wake mommy up so I can have a shower and get dressed myself.

If she wakes up later, we can cut down on the playing or TV watching, but then have to deal with the whining that happens around the severe and unfair deprivation we’re causing through that action. The bigger issue though is that sleeping in just a bit seems to activate the lazy sunday lay-in region of her brain (the posterior cingulate? it’s got to be used for something, and seems to deactivate with any other active behaviour) and she no longer wants to get dressed. She wants to wear her PJs all day.

Even more inexplicable and fascinating is the phenomenon of waking up earlier. So many early theorists in parental dynamics predicted that if you had more time in the morning, you would at worst be finished everything by the same deadline — that the lateness barrier could not be breached from the left-hand side of the curve. How wrong we were.

Instead, we have the case where daddy is a nearly-immobile shuffling zombie, eyes 75% closed (often one closed entirely and the other largely closed against the harsh light of a 10 W night light), while the toddler draws unholy manic energies from the predawn night and tears circles around him. When it’s time to get dressed, she becomes and impossible squirming octopus of giggles, pleased as punch that she can so easily avoid having clothes put on her, free to live out her dream of running around the house naked.

Add to this the propensity for shuffling-sleep-zombie daddy to collapse onto any bed, couch, or other soft-looking surface “for just one more minute” of “inspecting his eyelids for holes”, and the whole thing becomes non-linear: the delays and funny effects on the flow of time from the early morning start using up more time than the extra head start provided in the first place, and everyone ends up late for school and work.

Book Pricing and CAD

February 28th, 2015 by Potato

The Canadian dollar has declined a fair bit over the past few months, making things produced in the US more expensive for us, including books like The Value of Simple. The CAD has dropped over 12% since I set the price of the book, and almost 9% from the release date. I wanted to set the price in CAD because the book is intended for Canadian readers, and I don’t want the price to fluctuate with every little move in the exchange rate — even if I have to absorb those fluctuations from my margin. So ideally this should all be invisible to potential buyers — the price stays at $16.95 until the exchange rate gets so painful that a price increase has to be passed along.

I do not know what happens behind the scenes in the book distribution chain, but Amazon and Indigo have never had quite the right price for the print book, and their price fluctuates over time. Just two weeks ago Amazon had a sale on the book, selling it for less than I do when I sell it at in-person events with no shipping costs. Now this week they have it at $1.50 over the list price (and $4 higher than the sale price). To try to fix this I’ve lowered the (hidden to the public, but existing in the distributor’s catalog) USD price on the book to reflect the new exchange rate, in the hopes that that’s the source of the new, higher price and that the price will get back to where it should be soon.

In the meantime, you can always order directly from me using the online store at the correct price if the Value of Simple is all you’re ordering — if you’re buying more and are eligible for free shipping, then even the erroneous Amazon/Indigo price may work out better for you on the whole (and their shipping with Canad Post is somehow magically faster than my shipments with Canada Post).

Speaking of the direct purchase option, my inventory from the first print run is getting low. In the store software the print book alone and the print and e-book bundle are treated as separate products with their own inventory counts, so I’m trying to balance the remaining units between the two options so you can choose what fits best for you — if one ends up sold out while the other still has stock then it’s quite likely you can order the out-of-stock option and I’ll still be able to fill the order immediately.

Note that I do have direct control over the e-book pricing, even at Amazon and Kobo, so those prices have not fluctuated at all with the exchange rate changes.

Notes on the Investor Education Business

February 26th, 2015 by Potato

It’s buried in the blogroll on the sidebar, but for a few years now I’ve offered consultation services for personal finance/investing matters over at Robertson Investment Services. I mention this now because of this recent article pointing that out, yet people landing here might not see that little wee link and be confused as to how I made it into that list. So hello and welcome — that is a thing that I do.

Deciding what to call my particular services was a bit of a challenge — I’m not a licensed salesperson or CFP, and I don’t really do a whole lot of detailed planning. “Coaching” kind of fits, but I have not aimed to get recurring coaching clients — I’ve specialized in a niche of helping people become do-it-yourself investors. Most of my clients just need one or two sessions to bounce some ideas off someone who’s well-read on the subject, trouble-shoot some nitty-gritty issues, and get over the hurdles of brokerage systems and spreadsheets to fly on their own. Given that I started as I was finishing my doctorate and had a long series of conversations on the meaning of that (to teach), I settled on “educator” and named the business accordingly1.

After working with a few clients over the years I thought I had figured out some of the most common issues and barriers, and set out to address those in the Value of Simple.

I was conversing with Ellen Roseman about it back in November, and said that I had hopefully made myself obsolete with the book — with only a few exceptions, most of my clients’ concerns have focused on the material in there. Ellen had a great response: “In my view, you never get obsolete if you offer a valuable service people don’t get elsewhere.” I figured I could help more people with a book hitting a wide audience than sitting down with people one at a time — I actually expected client flow to stop after the book came out as it could answer so many of these common issues; instead I’ve had more queries (the rest of you probably saw that coming).

I don’t push the service much — as you may be able to tell by the link being buried below the fold on the sidebar. Somehow enough clients find me to keep me reasonably busy. Of course, I actually have a day job and a family, so an investor education side business that keeps me reasonably busy is not nearly as bustling as for someone who does it full time.


1. “Portfolio Doctor” was an awfully tempting runner-up.

Value of Simple RRSP Series Part 3: Over-Contributions

February 17th, 2015 by Potato

Inspired by recent real-life events1, let’s talk about what happens if you accidentally over-contribute to your RRSP.

Unlike for the TFSA, the government does track your RRSP contributions closely and will update you each year. Good thing too — RRSP contribution room accumulation is a good deal more complicated than asking how old you are and looking at your own activity, like with the TFSA’s across-the-board $5500 per year. Simply check the bottom of your notice of assessment for your contribution room for the year.

Your financial services providers will send you receipts to summarize your RRSP contributions at the end of the year, which makes it easy to report these on your taxes (which you do have to do).

There are penalties for over-contributing, but you get $2000 of leeway, so if you over-contribute by just a little bit you can carry it forward to use in a future year, without a penalty. If you over-contribute by more than $2000 there will be penalties, and you’ll want to pull it back out as soon as possible — though on that last point most people don’t find out about their over-contribution mistakes until the next tax year (at tax time in the spring), by which time they’ve earned enough new room to absorb them, so withdrawing to stop accruing penalties is often not necessary in practice2.

When you do have an over-contribution, you can only claim a deduction up to your available room, but you have to report all of the contributions — the difference will get carried forward. Do not edit the amounts on your RRSP contribution receipts to keep your reported contribution below your deduction limit.

In most (all?) tax software, if you enter contributions above your deduction limit, the excess will automatically be carried forward, so you may not need the previous instructions for dealing with Schedule 7, but be sure to have a look at your Schedule 7 to be sure.

If you’ve over-contributed beyond the leeway room, then you’ll be facing a 1% tax per month — and this form (T1-OVP) is where you calculate and report it.


1. The sad thing is, there’s going to be more than one RL friend saying “hey, this one’s about me!”
2. Be sure to check your own situation and take care of over-contributions as soon as possible if you’re over the $2000 allowance.

Value of Simple RRSP Series Part 2a: When to Defer

February 16th, 2015 by Potato

In the last post we talked about how to defer your deduction, but glossed over when that would make sense. A reader pointed out that there are actually few1 cases where it makes sense to do so.

The base case is where you have some money and are in a low tax bracket now, but will be in a higher one soon. I had suggested that this was where it would make sense to contribute immediately but defer the deduction, so as to avoid ongoing taxation of the funds if you simply waited to contribute. But this reader encourages us to look at those cases more closely.

Let’s say your money grows at 5%, and you get taxed on half the growth (like capital gains), and you start in the 20% tax bracket, and move to the 35% bracket the next year. If you contribute $100 to your RRSP and hold off to take the deduction, then you’d have:
Start in RRSP: $100
Refund from taking deduction at 35% bracket: $35
Tax-free growth in RRSP over year: $5
Total: $105 in RRSP, $35 outside, total of $140

If you wait to contribute, your $100 grows to $105, but then if you have to pay tax at 35% on half the growth (the gain is realized as you contribute) you’d only have $104.12 to contribute. But that extra contribution would bring you a slightly larger refund.
Total: $104.12 in RRSP, $36.44 outside, total of $141.14.

It’s tough to compare these outcomes because they’re not all in the same place — money in the RRSP is subject to taxes on withdrawal. So we can contribute a bit more to make the sheltered amount equal and the comparison easier: $105 in RRSP, $35.88 outside by contributing $0.88 and getting $0.31 back. So, a slight benefit to just paying the taxes and contributing the larger amount when you’re in the higher tax bracket — which you’ll have to weigh against the need to track and report the non-registered investments for taxes.

This is all assuming that you have the contribution room to contribute more later. However, RRSP contribution room is finite, and can be quite limited if you’re in the situation of having lower employment income (e.g., a grad student on scholarship) and non-registered investments. RRSP contribution room carries forward, but it does not grow or get inflation adjustments. So in the case where you can only contribute $100 no matter which point in your life that is, would it make sense to contribute right away and then defer taking the deduction? Again, the comparison gets tricky because we’ll have different amounts inside and outside the RRSP, so it’s hard to compare head-to-head. If you figure that the RRSP is money good (you’ll be able to pull it out completely tax-free) then the contribute immediately and defer the deduction plan wins; it looks like the break-even is where the rate on RRSP withdrawals is the same on the rate applied to the non-registered investments.

Reality is a bit messier because you wouldn’t be immediately pulling the RRSP money out again, you’re hoping for it to keep compounding into the future. Using your room as soon as possible and deferring the contribution gets you more in the shelter, versus having more in your non-registered account to face the drag of taxes over time. I haven’t figured out the math to get an analytical formula, but from playing with a spreadsheet it does look like it does generally make sense to contribute and defer the deduction if your room is finite and your tax drag is about a quarter to a third of your marginal rate (which is the case, even for dividends, for people with incomes over ~$45k).

Ok, that was a bit confusing and not especially conclusive. There are cases where it makes sense to contribute and defer taking the deduction, mostly when your contribution room is limited (where you’ll end up with non-registered investments no matter what), but it’s not as hands-down beneficial as I thought when I did it as a grad student, or quite as simple as I implied in the previous post looking only at the value of the deduction (and ignoring that the contribution will likely grow over time even if left in a taxable account).

Still, the previous post on knowing how to defer is still useful because we don’t have perfect knowledge of the future. There are situations where you may contribute in a lower tax bracket and want to defer taking the deduction, and that’s when you contribute without knowing what your tax rate for the year will be in advance. For instance, if you make regular contributions in the first half of the year, but then find yourself unemployed in the last half, you may wish to defer taking the deduction for those contributions until you’re back up to speed; or where you work one job and make contributions but then get a big raise towards the end of the year or early in the next. Yes, it may have been even better to hold off on making the contributions in the first place, but that would have required an impossible ability to predict the future.

1. Actually the word used was “never”.

Value of Simple RRSP Series Part 2: Deferring the Deduction

February 14th, 2015 by Potato

Putting money into your tax-sheltered accounts (RRSP, TFSA) is great: not only are the gains on your investments not taxed, tracking the gains and distributions becomes totally optional because the CRA does it for you (or more properly doesn’t care, and treats it like a black box where only what goes in and comes out matters).

While using your TFSA right away can be a good move for almost everyone, the RRSP can be trickier: if you’re young and not making much now, you may want to wait until you are closer to your peak earnings (or at least a few tax brackets higher) before you start contributing and taking the deductions. You can of course hold on to your contribution room — it will carry forward until you’re ready to use it.

However, a neat feature is that the contribution and taking the deduction are separate steps: you can contribute to your RRSP to get tax-free compounding and a freedom from paperwork and hold on to the tax deduction until a higher-income year. I did this towards the end of grad school, maxing out my meager RRSP room while deferring the deduction until last year when I was working full time. Indeed, this is one of the classic examples of where such a move is the way to go. Another case where you may want to defer taking your deduction is when you have a new job or big raise that starts partway through the year, and won’t hit that next tax bracket until the year after.

When should you consider deferring the deduction? [edit: please see the next post for when deferring might make sense.] I don’t have a precise formula or spreadsheet ready for you. You do need to consider the time value of money: a tax deduction (refund) now will be more valuable than one a few years from now. There should be a reasonable chance of getting to a higher bracket soon — and the bigger the projected shift the more you may be willing to wait. Waiting 3-4 years to move from a 20% tax bracket to a 31% one was a no-brainer for me — the tax refund was worth 50% more in just a few years. Deferring for a decade in the hope you’ll move from 31% to 33% or 35% may not make sense for you. If you still have TFSA room, use that first — you can always pull from your TFSA to contribute to an RRSP later. But if your TFSA is full and you’re starting to build non-registered investments while you wait for your salary to increase to use your RRSP room, then contributing and deferring may make sense.

I’ll just note that some cases make sense for deferral (like mine in grad school), but for many people out there in the middle class, the climb through the tax brackets is gradual enough that it usually will not make sense to defer taking the deductions — if you’re not sure, you’re probably one of the many who will be just as well off taking the deduction immediately.

How do you engage in this magical deferral? The contribution step is the same as always: move money into your RRSP (and once it’s in there, invest in something). You’ll get a contribution receipt, which you will report on your taxes — even if you plan to defer taking the deduction you must report the contribution, and you must have enough RRSP contribution room for it. Your tax software will likely then try to automatically use all of your contributions for deductions right away to maximize your current refund. If instead you want to defer them, search for a form called Schedule 7. If you follow along in the PDF/paper version of the form, it’s divided into parts:

    Part A — Contributions
    Part B — Repayments under the HBP and the LLP
    Part C — RRSP/PRPP deduction
    Part D — RRSP/PRPP unused contributions available to carry forward

Part C is where the magic happens: you just tell the CRA how much of your contributions you want to use for a deduction this year. If you contributed $5000, but want to carry-forward that whole amount, just override line 13 with $0 (you want to use none now). Or you can enter a partial amount if you want to use some now and some later (useful if you’re just over a marginal tax bracket break).

An image of the CRA's Schedule 7 for deferring your RRSP contribution.

To do this in TurboTax, click on the forms button at the bottom of the screen, and then the “form lookup” option. Start typing “schedule 7″ and you’ll see it pop up. Once you open it, it will look almost identical to the CRA form above. If you try to change line 13, it will take you to a special TurboTax “worksheet” where you can enter the amount you want to carry-forward, which saves you a step of subtraction. Note that you can also go directly to the worksheet from form lookup (just look for “RRSP”), but it makes more sense to me to look for schedule 7 than some special TurboTax thing.

In StudioTax, you can adjust this right from the initial wizard when you’re entering your RRSP contribution information: uncheck the “maximize RRSP claim” option. I’m a little less familiar with Studiotax, but it appears that if you want to defer your deduction after you’re past this wizard step, you have to click on “forms” at the top to ensure Schedule 7 is in the “added forms” category, then click on “federal forms” at the bottom of the screen. Double-clicking on line 13 will bring the wizard screen below back up so you can adjust how much you want to claim this year.

An image of the CRA's Schedule 7 for deferring your RRSP contribution.

Once you’ve deferred your deduction, you’ll see it show up on your notice of assessment. If you use the same tax software year to year, it will pull that deferral forward for you next year; if not, you’ll have to enter it from your notice of assessment, and you’ll see it show up in the very first line of Schedule 7 as unused RRSP contributions. Every year your tax software will try to automatically use your deferred contributions and any new contributions for you, so if you’re trying to defer for more than a year then you’ll have to make the adjustment to line 13 each year until you’re ready to take it.

Value of Simple RRSP Series Part 1: the Deadline

February 10th, 2015 by Potato

“I love deadlines. I love the whooshing noise they make as they fly by.”

February is usually better known as “RRSP season” as the deadline approaches — this year that deadline is March 2, 2015.

But a deadline for what, exactly?

The deadline for RRSP contributions to count against the previous years’ taxes — due to a quirk in the rules, contributions made the first 60(ish) days of the the year can count to the current year or the previous one — so this is a last chance to make a contribution and reduce your 2014 taxes owing.

Yes, there is time value to money, and you don’t want to go a lifetime without contributing to your RRSP, but this is the least important deadline there is. If you don’t log in to your online banking to make a contribution until March 3rd this year, it just means you have to wait a year and two months for your refund instead of just two months. When you’re 75 and spending that money you’ll care whether it’s there at all far more than whether the tax deduction was taken a year later. Plus for many people, the TFSA is a better choice to prioritize anyway, so this RRSP and refund stuff is just noise. Oh, and implicit there is another fact about the deadline: you can contribute at any point during the year, not just during this special “RRSP season.”

But no, you will not lose your contribution room — you carry it forward and accumulate it until you’re ready for it. The consequences of missing the deadline are very minor, so if you’ve procrastinated this long on putting together a financial plan and starting to invest, another few weeks or months is not going to kill you — though please do commit to getting it done sometime this year.

Indeed, you don’t have to contribute in a lump sum right at the end and can ignore the deadline by starting a regular contribution plan now, and even fill out a form get your employer to stop taking the tax off at the source so you get the money working for you right away (and then you don’t get a refund in the spring — which also takes away the temptation to spend it). So despite the media and advertising blitz that happens every February, RRSP “season” isn’t really a big deal.

So, let’s not stress out over this deadline: if you miss it, the consequences are pretty minor. The last few weeks of February are the worst time to try to go to a bank to open an account or meet with your planner. But if you do want to get your contribution in before the deadline you can do so and let it sit in cash (or a money market fund — the equivalent for a mutual funds account), as Sandi points out in this post, and make a plan at your leisure, and invest it when you’re more prepared (though seriously, it only takes one weekend to burn through the Value of Simple).

Rent vs Buy: Toronto Retrospective

January 27th, 2015 by Potato

As a housing bear I often get the recency bias retort: bulls rule, bears drool, look how much housing was up over the past few years; how can you even show your face after being “wrong” for so long?

Looking in the rearview mirror is not a good way to make decisions, and in cases where random chance has a large role, a particular outcome working out does not necessarily mean the course chosen was actually the best one. Today let’s just say “whatever” to all that logic. People like history and anecdotes so let’s take a look at how “wrong” renting turned out.

Yes, the past three years have been unbelievable for Toronto real estate. Absolutely blow-the-doors off amazing couple of years for detached houses (condos less so, but still), even the bulls didn’t see it coming that “good”. Low rates that got lower, bidding wars, HGTV and animal spirits. But you know what? It hasn’t exactly been terrible for the rent-and-invest-the-difference crowd, either: rent inflation was basically nothing, and the stock market was on fire. To take my case as an example, from late 2011 (when we last moved) to now, an equity index portfolio was up over 15%/yr, and actual rent inflation was 1.1%/yr. The average Toronto (416) detached house was up 9%/yr according to TREB figures, and that more-or-less meshes up with sales in the neighbourhood that we’ve been watching over the years.

While the rent vs buy calculator was built to look at the future based on estimated rates and figures, we can over-ride the future estimates in the calculations with the actual historical figures to see how the comparison played out. And as you might expect, buying a detached house would have been better in the recent past… but perhaps by less than you would think. In fact, if you had bought in 2011 and wanted to sell now to lock in the amazing gains you made over renting, you’d only come out with about twenty-two grand more# in your pocket after the transaction costs despite seeing the sticker price on your house swell by $228,000. Still you may fairly say, that’s a win for detached houses.

What’s more amazing is how segmented the Toronto market has become and how dependent that result was on picking a detached house. If instead you had bought a semi-detached, townhouse, or condo* — which about 65% of the people buying in the Toronto market did at the time — the equivalent renter would have come out ahead, despite the complete absence of a crash, correction, or soft landing. Far, far ahead in the case of the average condo buyer who only saw appreciation of 3.2% and would be likely to be facing a move after just 3-4 years.

Now, it’s just as unfair to put 15% in for stock returns going forward as it would be to put in 9% for house price appreciation — the future is looking much bleaker for both asset classes, and just given how much faster it moves we’ll likely see a stock market correction before a housing one (though we’ll also see the recovery first in equities). Using some reasonable estimates for what will come, it’s hard to make the case for owning unless you believe this incredible luck will strike twice. In beta right now, Preet has a new spreadsheet that will do a Monte Carlo simulation of multiple outcomes for the rent vs buy comparison in case you need a second opinion.

Looking back, I still think I made the right choice given what I knew at the time, and the situation looks even more skewed towards renting now so it’s nice to be able to stay put. And that opportunity cost came with a lot of convenience and freedom. So that makes it very easy to be comfortable staying with the choice to rent going forward, because I really don’t think we’re going to see another three years of 9% annual price growth in Toronto RE.

* - at the same price:rent and rent inflation, which is a bit harder to verify as I didn’t live it.
no marker - “good” in scarequotes because higher prices are not intrinsically good.
# - for clarity: the difference is relatively small because the renter also sees their net worth increase by over $150,000 through those amazing equity returns and the ongoing cost savings. [note added after publication]

Budgeting Processes

January 20th, 2015 by Potato

Sandi asked me for some thoughts on budgeting and methods to control or track spending for a recent Because Money episode, and right now I’m staring at over a year’s worth of receipts that I just can’t seem to find the time to go through, so it’s probably a good time to talk about the history and evolution of my budgeting process.

A massive box full of receipts from the past two years.

When I was a grad student things were tight and budgeting and frugality really mattered. My entertainment budget was often around $30/mo, which is really easy to blow through if you forgot about the movie you went to see three weeks ago or go out with friends a lot. But I’m really bad at the forward-planning money-in-jars kind of restrictive budgeting — I’m much better about adapting to fit the total budget than hitting it on every category. Though that said, I was just bouncing back a few years in my calendar for something else, and saw where I had mapped out which days I could treat myself to pizza so I was paying some attention to my category limits.

So my method was to gather up all my receipts1 and bills every month and lay them all out on a piece of paper (and eventually, a spreadsheet). I’d group them: food, rent, eating out, entertainment, car, utilities, other. Then all the receipts would be stapled to a piece of paper and filed away (in case I needed more detail than the summary). I started by just tracking things — I came in fairly frugal even from living with my parents — which also helped give me an idea of the irregular expenses that I had to try to amortize. After a while I saw where I needed to put in some more effort, and just made a vague effort to do better. I know, this is the dieting version of “I just eat whatever I want and never feel hungry and end up naturally thin” but there you have it. It didn’t take too long before I came in on-budget most of the time. I never stressed too much about big expenses in one month or another, like car repairs or blowing entertainment out of the water in October and December, or having the categories come out different than I planned: as long as it all averaged out over the year.

Once I had those unconscious frugality muscles built up and a fairly natural sense of my set-point, I started to slack off on the budgeting process. It went from being a monthly ritual done as soon as possible after the month end, looking at each line item on each receipt, to a quarterly and then semi-annual check-up and review process. I found that the medium-length time periods were better for smoothing out the month-to-month noise, but it was still a task I could do in a reasonable amount of time. Pushing out to semi-annual just encouraged more and more procrastination.

After Blueberry was born I only did two more budgets, and now find myself with this massive pile of receipts and notes to go through. And it’s really hard to find the time. I thought I’d get around to it over Potatomas break, with two full weeks off and no natural disasters forcing an evacuation this year. But I didn’t — I just have so much to do now, and it’s really hard to prioritize a budget review because I know that I’m doing more-or-less all right: I’m sending the right amount of money from my chequing account to my investment accounts and Blueberry’s RESP to hit my savings goals, so however it’s happening, it’s all working out.

I know that my savings rate gives me a bit of a cushion to be sloppy with my budgeting — if I slip I might miss out on a year of savings, which would suck, but if something unexpected comes up or I spend over budget I’m not going to be instantly facing credit card debt or the poor house. But I’d still like to know how I’m spending my money, and going through my budgets does give me a nice picture of my personal inflation rate. So I’m thinking I’ll toss most of those old receipts and instead sample my budget for just a month or two to double-check that I’m on track, then go back into unconscious frugality mode again.

In terms of this kind of review-and-try-harder process, I should note that I was naturally frugal before starting my budgeting adventure, and just needed to tweak things a bit. Then once I found my stride, it’s been fairly effortless to stick to it. For many people out there a more rigid budget (with jars or the digital equivalent) might work better, as might be paying yourself first on every paycheque to save (I do not save evenly through the year — most of my contributions to long-term investments are in the front half, and Oct/Nov/Dec are usually negative, drawing down a chequing/savings account balance built up a bit in Jul/Aug/Sep).

So to try to sum up: what works for me is to not stress about it, and just try to be generally balanced and frugal, without focusing on any particular expense. Though my income is now pretty smooth (depending on freelance and consulting jobs), my spending is not, so I look out at the annual averages. If I ever get too sloppy though, that’s going to take a long time to spot and correct the problem.

1. I make notes for some purchases without receipts, and estimate others like “~$20 at Tim Horton’s over the last month.”