An Object Lesson in the Dangers of Leverage

April 28th, 2021 by Potato

I have so much to say about the last crazy, lunatic, unprecedented year, and not sure how to say any of it — my own thoughts are still all muddled. Covid was just a part of that for me — we’re also coming up on a year since my dad died. I haven’t properly eulogized him, or told his story Speaker for the Dead style, and don’t know if I will ever be able to.

This may be a personal blog, but a big focus is on finances so let’s stick to that aspect. It’s easier to talk about, at any rate.

Doing taxes was painful this year, for lots of reasons. I had to prepare the final return for him, as well as a T3 return for the estate, which had quite the learning curve and lots of weird CRA idiosyncrasies. Some examples to delay us before getting to the meat of the post? Sure, why not. Let’s start with where to simply mail the form. It wasn’t a simple Ontario and East send it here, Manitoba and West, send it there — Ontario was spit up with some cities sending it to one tax centre, others to another. Why does that matter? It’s not on its own a complex thing to figure out, but it’s one more step of complexity in what was already a hard process, and one that most people only face under hard circumstances. And it seems like the sort of thing that makes no damned difference so why is the CRA making it needlessly harder? Oh, and there was also one page that got sent on its own to another tax centre in Quebec. Why? Who knows.

It was painful because it was the “final” return and well, that’s a reminder that he’s dead, that’s it. Things are final now, and there are feelings there.

But the other reason tax season was painful was that I had to go over all the financial losses from 2020 to report capital losses. For most people, 2020 wasn’t such a big deal, investing-wise — scary for a brief while, insanely bubbly in a few pockets of the market, but a buy-and-hold index investor ended the year in the positive. Not so for us.

I’ve said many times before that my dad was a good investor. He got me into investing at a young age, etc. etc. That was an understatement: he was a great investor. He didn’t want to be famous, but would give his head a little shake whenever someone else tried to proclaim themselves “Canada’s Warren Buffett”. He was Canada’s Warren Buffett, or at least it seemed that way for a long time.

But as Buffett said, a long string of impressive numbers multiplied by a single zero is still a zero. In the end my dad wasn’t Canada’s Warren Buffett: he was Canada’s Bill Miller or Hwang.

The problem was that he was so good for so long that he got over-confident. He was not afraid of leverage — indeed, he used a lot of it.

On an episode of Because Money (I can’t remember which one to link it now), I shared the tale of how he was in the hospital, sick from his cancer, and needed to check in on the market — because a drop of 5% would be enough to trigger a margin call.

We argued a lot about leverage after that.

I tried to tell him that he was taking too much risk — risk he didn’t even need to take. He tried to convince me that if I ever wanted to be rich, to do more than just get by on my public sector salary (which he also argued I could do much better if I just switched careers), I needed to use leverage.

So he gave me a two-part gift: the first was an amount of money, which here we’ll just call X, a large amount that was roughly a year’s salary for me. The second half of the gift was that he would manage it for me, including by using margin. When I was young he had taught me to invest, but he never really taught me how to invest, at least not like he did. Dad was not the teaching type — he had no patience for it. So this was a chance to finally pass along that knowledge, as I could see what he did in an account in my name almost in real time.

X went into a brokerage account, and he borrowed another 2.48X against it. All it would take would be a 28% market correction to completely wipe me out, which was terrifying. “Relax,” he said, “you need to get used to this. If I do lose you your money, I’ll just write you another cheque. But it won’t happen, and this is something you have to learn.”

Well, Covid-19 hit. I bought some puts on the S&P500 in the early days as a hedge — I briefly felt like a market genius when the virus escaped Wuhan and the market started to wake up to the risk. I sold those for a small profit as things got volatile and it reduced the margin a tad. But the market kept going down, violently. The overall markets were down about 30% by the end, but the highly concentrated active portfolio he was in was down even more, despite appearing more conservative. But all those staid dividend-payers suddenly looked like broken businesses in the wake of shutdowns, and the overall indexes were buoyed by tech stocks that we didn’t own. I threw more money from my savings at the account to try to stave off a margin call, but finally got margin called on March 22, and became a forced seller just a day before the bottom was in.

In the end, X became 0.1X — my inheritance was essentially gone. The market recovered over the rest of 2020, but I did not leverage back up, and even if I wanted to there are limits to how much I could have added.

That’s the real danger of leverage: even if you have the psychological risk tolerance to ride out a volatile period in the market, a big enough dip can cause a permanent loss of capital as you’re forced to sell at the bottom to cover the loan. I should perhaps interject that while that non-registered account was actively managed, I do have registered accounts that are invested in passive index funds, which fared much better though the market crash and recovery, and which is my general recommendation for people — obviously active investing entails various risks, doing so with leverage even moreso.

The story sadly doesn’t have a silver lining, as I also didn’t learn much about his style of active investing — the cancer made him tired, and a little extra motivation to teach didn’t magically imbue him with the patience for it. “So tell me son, why did I do that trade?”
“I don’t know.”
“Well if you’re too fucking stupid to see it then I guess this family is doomed.”
“Thanks, Dad.”

He wanted to spend what little energy he had left on trading, not teaching.

In addition to learning a lot about leverage — or rather, strongly reinforcing my previous view — I also got an object lesson in risk correlation. Because part of this whole experiment was a compromise that stemmed from those arguments on leverage: I would have an account with more leverage to get used to it and see first-hand its power, and he would in turn take down the level of leverage on his own portfolio. Because even setting aside how nuts it was to run so close to the red-line that a 5% correction would make you start blocking the margin clerk’s number in good times, it was not good times. He had by that point had several run-ins with the hospital system for his cancer, and many more days where he didn’t want to get out of bed to trade. So he agreed that he was going to reduce his own leverage, begrudgingly. But “reduce” didn’t mean “eliminate,” and he too was margin called, almost every damned day through March, 2020.

The ability of an insurer to pay out insurance that was also tied to that very risk — risk correlation is not a good scene. So very understandably, Dad had to renege on his promise to insulate me from losses related to the leverage. In hindsight that was a completely obvious outcome, but it somehow never occurred to me when I let him go nuts with margin loans in my account.

That whole year was crazy in so many ways, and I want to try to be clear (I know I’m not, but I’ll try) that the human losses were the real tragedy… but those are hard to talk about, and this is in many ways a personal finance blog, and there are financial aspects to talk about.

Another aspect of the whole affair was a huge whipsaw in my own financial planning.

Back before we found out my Dad had cancer, before we found out it had returned and spread, before we knew that it was terminal, we did a Because Money episode on expecting vs *expecting* an inheritance. Basically, I never factored in receiving an inheritance into my own financial plans, at least not in a major way. My parents were definitely better-off than I was, so my standard-of-living in part is facilitated by gifts from them. While they don’t pay my rent or anything quite that co-dependent, a lot of my luxuries have come from gifts: plane tickets for vacations, curling equipment, or new video game systems. A good portion of my clothes I didn’t buy myself. So of course I was leaning on them in some ways (hashtag privilege?) but I also wasn’t factoring an inheritance into my long-term plans.

Suddenly that was changing. I was getting a rather large gift up front, and dad was dying — the prospect of an inheritance was becoming very real and updating my planning to take it into account seemed like the next step. In-between arguments over leverage and trading strategies, we also argued about frugality. I’m a pretty frugal person by nature, and over 8 years of grad school only reinforced that. I save a decent portion of my earnings, and have nearly zero affinity for conspicuous consumption. Dad tried to convince me to spend more, and live more in the moment. He didn’t want me to save that gift for the future — he wanted to grow it briefly, then have me plan to spend the dividends on the extra gas and insurance for a new showy gas guzzler to replace my Prius. He wanted me to spend 100% of my income — I already had enough saved up for the first few years of retirement, and I could count on an inheritance after that.

I wasn’t willing to go that far (I mean, I love my Prius), but hey, I can get greedy too. I was off work to take care of him, but was already imagining what it would be like to spend a few extra thousand per year once I had a paycheque again. I had started *expecting* an inheritance.

Then Covid hit and we got to be on a first-name basis with the margin clerk and it all went to hell. Whipsaw: back to planning to save the normal way.

Nest Wealth Fees Changed

April 25th, 2021 by Potato

Just a quick note that Nest Wealth has changed their fees. There are now 4 flat-rate tiers (vs. 3 before). At the low end, this makes them a little more cost competitive. At the high end though, they lose their cost dominance until a much higher portfolio size — from roughly a quarter of a million to roughly half a million now.

And of course there may be reasons you prefer one firm over another even if the costs are a bit higher one way or the other.

The Marriage of Grossman-Stiglitz and Dunning-Kruger

February 7th, 2021 by Potato

With passive index investing, there’s a bit of a concern from some corners that if too many people become indexers, then there won’t be anyone to do security analysis. The market will stop being efficient, and the free ride that passive investors enjoy will be over. While it’s a “paradox” in that passive investing only works if there are active investors to make the market efficient, in practice, most of us aren’t too worried about it — there will always be some active investors to help determine prices.

I’ve seen the argument (not that I can find it now to link to it) that the weakest active managers will be forced out first (the ones who were basically closet indexers but charging 2.4% for the privilege). The remaining good managers may make some pre-fee alpha, and help keep prices rational for the passive investors. So as active managers continue to broadly under-perform index funds net of fees, and more investors move to passive funds, the ones who were least able to generate alpha will be the ones forced out of the industry.

But watching the chaos of the markets over the last little while, I also remembered the Dunning-Kruger effect: those who are least skilled are also not generally able to accurately assess their skill. So as passive continues to prove to be a good strategy, the ones who don’t switch are not just the most skilled (still generating alpha) but also the least (who may not know the risks they take or that they’re not generating alpha). And professional managers are not the only ones in the market — there are a lot of retail traders out there. On the whole they’re dwarfed by institutional money, but they can certainly move a few sectors and specific names. And so they have.

And social media in some ways fuels it — most people would never trade on a tip made in a video, tweet, or forum post. But the world’s a big place, and there are lots of people who do. And the algorithms are good at serving up more and more of that if you engage with it.

The last little while has seen some market moves that are just plain hard to call “efficient”. The weak-form efficient market hypothesis still applies — no matter how crazy it is, it’s still unpredictable enough that you can’t reliably profit from it, so just stick with index funds. Looking at the Gamestonk run-up and crash, calling the top never looked like a sure enough bet that I wanted to do it. Tesla, a niche, money-losing maker of electric vehicles (with a money-losing solar panel division that’s shrunk significantly since its related-party bailout, I should add, before the comments section fills with wails that it is also “an energy company”) somehow became the world’s most valuable automaker. And if you tried to short it at the point that it passed Toyota, you got destroyed as it continued to go straight up and become the most valuable automaker by such a margin that it’s worth more than all the global brands you recognize combined.

But even then, you just have to look around and shake your head at the stuff people are buying. An electric — no, hydrogen! — truck company with no working trucks, no plan to make any, and an executive chairman who left in disgrace is worth $9B, with $500M in shares traded on a given day. Weed companies went up and up and up ahead of legalization in Canada, even as the sector became way bigger than the most optimistic projections of post-legalization market size, and you could not escape the hype. Space is a cool idea, but is Virgin Galactic really worth $13B (and 3X what it was a year ago?).

I’ve read a lot of stuff on active investing, and many articles make points about second-order, third-order thinking — how will the market react, what’s already priced in, etc. Lately it seems like that stuff will get you killed. There seems to be a lot of people in the meme trades, but there’s no way to go and become an active investor and profit from it: all I can do is rant on my blog about how crazy some of this stuff seems.

The K-Shaped Recovery (or the Perfect Storm that Missed)

January 27th, 2021 by Potato

In the clouds of the pandemic, a perfect storm was brewing for Toronto real estate. The units stolen from the residential market by AirBNB were coming back online, at the same time that immigration was suspended and a massive wave of unemployment and economic uncertainty swamped the economy, oh and the city was warning that the lost TTC revenue and extra costs might lead to a huge property tax hike (spoiler: they got a bailout and chose to cut services rather than increase taxes if it gets worse). In a sane world those should have been a handful of pins popping an already frothy real estate market, with an epic, sharp crash to bring us back to sensible price:rent and price:income levels — or at the very least an Alberta-style soft landing that takes the froth out.

But we don’t live in a sane world, and instead we have a K-shaped recovery. Except unlike the K-shaped recovery people talk about for people and the jobs market, where one group is having a really bad year with no light at the end of the tunnel yet (e.g., anyone whose livelihood revolves around music festivals, conventions, or personal services), while another has virtually uninterrupted income and lower expenses (e.g., many people who work primarily on a computer and who only had to go into the office in the first place because of a lack of imagination and will from their corporate overlords), in the real estate market it can be the same property with two divergent outcomes.

The rental market has taken a big hit in the downtown core, especially the microcondo segment that was most ghost hotel-y and the least fun to quarantine yourself in. Yet prices to buy those units have barely budged. In the burbs, rents are flat-ish, while prices have exploded higher.

And hold on to your butts, because the early indicators are making it look like the first half of 2021 is going to be an absolute ripper. Whether its low rates, or spending so much time at home that makes people want a house, or the freedom to look a little further afield if daily commutes may be off the table for a while, demand is surging, while the deferral cliff (that was one of the elements of the perfect storm that missed) turned out to not be such a big deal.

Now, if you’re just looking for a long-term place to live, then this likely doesn’t concern you — one more blip up on the chart of craziness, while renting continues to be a predictable expense. But if you’re in the FOMO game, or are looking to take a big risk on flipping a place this year, this is a big deal. It’s also so confusing and so hard to see coming, especially if the pandemic has left your own financials in shambles.

Where are people getting the money? How do they even have the energy to go rage-buying houses when things are so terrible?

Well, the upper leg of the “K” is doing just fine, if not even better than before, and they’re the only ones who buy houses anyway. So of course the market would be ripping, why didn’t I see it before?

Buuuuuut, immigration is still down. Tourisim is still down. Employment is still down. The perfect storm may have passed us by for now, with the upper leg of the K doing fine and dandy and as focused on real estate as ever, yet the storm clouds still look to be brewing out there, and are even weighing on the rental sector. If rents are down, why isn’t it affecting the purchase prices of the same units? Will this so-called fundamental stuff eventually matter?

Though rents are a big factor in the value of housing, a part of that to consider is the gearing involved: as rents race ahead, the added rent is essentially pure profit for the landlord (the beauty of a fixed-cost business), allowing a disproportionate increase in the price of the unit. As rents fall, the same should hold true in reverse: the price should fall by more than the decline in rents. However, investors can also speculate on future rents, while the rental market is basically a spot price. So if you believe that all the factors currently holding rent down are temporary, it may be rational to not cut your price by much, or even to down a big ol cup of FOMO FlavorAid. Conversely, if all the demand factors are down for the foreseeable future, and rent inflation may be muted for a long time, then prices should drop a lot — first to catch up with the lowered rent, and then to reverse the expectation for rapidly rising rent that had already been baked into prices.

As always, I look around and renting looks to be the smart move. The price:rent is IMHO more likely to be fixed in the long term by prices coming down than rents going up. But the market can stay irrational for a long, long time, and based on how the spring is setting up, a while longer still.

There’s a parallel in the Gamestop (GME) mania: with a long-term view, you may see a mostly bricks-and-mortar retailer with limited profit potential, worth nowhere near the current price. But short-term supply-demand imbalances (a mania combined with short covering, and options fuckery*) can drive the price up far beyond that, and it’s impossible to know the precise moment it will turn.

* – I believe the technical term is gamma squeeze but I don’t want to have to try to explain it.

Bank Phone Systems and Scheduled Calls

January 19th, 2021 by Potato

I’ve been quite unimpressed with the big banks’ phone systems during the pandemic. Not just the long wait times (nearly two hours the other night with TDDI) which is somewhat expected (it was regularly 45+ minutes in the before-times, and more has to be done remotely these days), but their schedule-a-call services have been particularly disappointing.

My first attempt at a scheduled call was with RBC… who completely ghosted me at the appointed time. That was set up in the first place because the regular phone staff couldn’t answer an estate question after the first hour-on-hold wait. I gave up on trying to resolve it remotely at all, and sat on the issue for a few months until I could deal with it in-branch.

When I went to set up a new youth account for Blueberry, TD wouldn’t let me do it self-serve online — it required an appointment. Fortunately they offered the option of a phone appointment so I could avoid an unnecessary trip out of the house (and the accompanying covid exposure). Which was my second experience with a scheduled call. They did call on time… only to tell me they couldn’t open a youth account over the phone and I had to go into the branch. Someone should tell the web team so the website scheduling the calls doesn’t waste everyone’s time — I got to the schedule a call in the first place from choosing to open a youth account within the website. And while some banking services are essential, I wasn’t going to worry that much about setting up an account for Blueberry that I’d go out to do it during a stay-at-home order.

Anyway, Blueberry now has her very first bank account at Tangerine, which we were able to set up completely online — I didn’t even need to call! How is this still so hard for the big banks?