The “Hot Potato”

April 18th, 2016 by Potato

When talking about passive investing and diversifying across many asset classes, a common quip is that if you knew in advance which asset class would perform best, you’d just put your money there. Since you can’t, you diversify.

Well, in a recent issue of MoneySense, Norm Rothery delved into the “hot potato” that does exactly that (he also wrote about it in August of 2015). Using a momentum strategy, it goes all-in on whatever the hottest sector was over the previous 12 months. The extra return over a more vanilla, diversified approach is sweet — too much to ignore without some further thought.

Norm puts in a number of disclaimers at the end of the article, but before going ahead it’s worth thinking about those risks and more.

Firstly, I have to point out that going all-in on something (even something as diversified as a broad-market ETF) opens you up to blow-up risk. It didn’t happen in the recent past, but that’s not saying it couldn’t. That’s a fundamental risk of concentration — you could go all-in on the one asset class that goes down one year, then switch and catch the next loser.

It also looks to me like a strategy that’s possibly not very robust and vulnerable to execution risk. I don’t have data on returns with monthly resolution going back very far to test out how robust it may be, but it’s easy to get for the ETFs available to Canadian investors for the 2008 market crash and do a spot check. Norm mentions that the monthly rebalanced version of the hot potato only fell 10% in 2008 and recovered by 2009. Going into 2008 the hot potato had you do a few little dances between XIC and XBB. In August of 2008 it would have had you buy XIC, just to eat a 12.5% loss, and switch back to XBB the next month. If you went on vacation and missed that switch by two months, you were down 33%; if you missed by five months you were down 40%.

Momentum is a weird thing in the markets: it’s there, it looks to be exploitable, but it doesn’t have a “mechanistic” basis: controlling costs does, as does diversification — you can predict that those “should” work in the long term. But for momentum, even if there is some psychology or whatever to the momentum effect in general that makes it a real effect that may possibly form the basis of a successful strategy, what is it about trailing 12-month returns and monthly rebalancing that worked so very well for the historical check of the hot potato? Could that shift in the future to 6 or 24-month returns being the momentum sweet spot, and leaving someone using 12-month/rebalanced monthly strategies in the lurch? Are the features of momentum stable and exploitable enough to bet it all (or even compromise with dynamic sector weightings) on something like the hot potato? Or is this an accident of over-fitting historical data? Those question marks may make it a difficult strategy to stick to when a period of underperformance eventually comes along.

Larry Swedroe has an article looking at momentum in general that’s worth reading, in particular the line about how the strategy becomes less valuable as correlations between global markets increase.

I don’t know, and haven’t invested a tonne of time doing research here — hopefully Norm or someone else has a more data-driven answer. For now, I’m not brave enough to try it with actual dollars in the uncertain future — I’ll stay diversified and lazy.

Conjunction Fallacy and Real Estate

April 11th, 2016 by Potato

There’s a neat experiment in behavioural economics where people see a scenario that is more specific (and is actually less likely to happen) as being more likely to occur than a general case because it resonates better. The classic example (via Wikipedia):

Linda is 31 years old, single, outspoken, and very bright. She majored in philosophy. As a student, she was deeply concerned with issues of discrimination and social justice, and also participated in anti-nuclear demonstrations.
Which is more probable?
Linda is a bank teller.
Linda is a bank teller and is active in the feminist movement.

The first is more likely — it’s less restrictive and completely contains the second. Yet many people will choose the second option because it resonates better, or because it’s easier to visualize a representative example. Similarly people may pay more for insurance against a specific hazard they can visualize well (like dying in a terrorist attack) than more general insurance that also covers that specific case (dying from any cause).

So the watercooler gossip turned to the housing bubble today. I don’t usually say much when the conversation turns to real estate, as bearish views are not usually pontificated in polite company. I was especially restrained today, shocked into silence by the sudden agreement happening that all was not sunshine and roses — that in fact houses and condos were too expensive in the city.

For years I’ve been trying to say that the wise course is to rent because price-to-rent is out of kilter — but this has been a hard message to sell. Why is it cheaper to rent? Because of many factors, but the math says that’s what’s most likely the best course. When will it correct? Who knows but likely not tomorrow, a few years or so. You know nothing Jon Snow — I have an open house to hit. Those theoretical, general answers clearly didn’t cut it.

It seems that the meme unleashed by the Panama papers and stories of money laundering is one that resonates really well. Foreigners driving the cost beyond all reasonable affordability is a more salient reason for renting being a good move for now than a simple it’s too expensive for many possible reasons.

“We’re just Panama north!”
“There are so many empty condos in my building.”
“They’re not even playing the same game we are.”

I find it weird that a bubble described as high (and rapidly increasing) prices compared to moderate (and flat) rents was completely invisible — not even admitted as a low-probability possibility — but high prices plus alleged money laundering is immediately apparent as being an almost certain bubble, but that’s the conjunction fallacy for you.

There tend to be two camps on how to respond once people buy in to the predicate that hot money is behind prices increasing1:

  1. Greater fool/FOMO thinking, where the response is to buy now at any price while you still can, because you can sell later for even more because there’s no limit to the foreign money as long as we are cheaper than Tokyo/London/New York.
  2. Let the Grizzly have the fish thinking, where you stand clear of the explosive situation and see what shakes out — getting into a bidding war with a billionaire who’d be happy paying a 6-figure grease fee just to sneak money out is not a game you should be playing.

The conversation moved to the ironic feedback loop: foreign buyers buy for several reasons, but for capital flight it’s important that they can liquidate if needed. Even though they’re “clearly” responsible for driving prices up, they’re not the only market participants. Canadian buyers keep paying any price and are not suspicious of recent flips, reinforcing the idea that a GTA/GVA property can be liquidated at will.

Finally, another feature for the rental camp: price-to-rent is explained because hypothesized foreign capital is clearly not competing for rental space. They are not buying to have a pied-a-terre in Toronto or Vancouver — the prices paid are not for the usage of the property, as many are reportedly left empty.

Interesting changes in the small slice of the gestalt I can overhear.

1. Again for clarity: I don’t think hot money is the sole or even main reason, I’m more in the low rates/animal spirits/general cause camp. Prices are unsustainably high for many interacting reasons, and almost no matter what the underlying reason is the end conclusion is the same — managing your risk exposure and renting your shelter.

Value of Simple Updates

March 29th, 2016 by Potato

There are now a few updates for the Value of Simple on the errata page that have accumulated over the last year and a half since release. Now with some screenshots that need to be changed for the new Questrade system, I’ve decided to take those and roll them in to the e-book version, along with a few other very minor tweaks, which should be going live across all platforms as you read this. If you’ve already purchased the book you may be able to download a new version from your vendor of choice, and if not that’s ok — all the information you need is there in the errata. If you purchased directly from me just let me know and I’ll re-activate your download link within the store software and you can get the new version (but again, this is minor stuff — no need to re-read it if you’ve already put it away).

Updating the print edition is a bit trickier, in part because I really have to increase the price at the same time — the crash in the Canadian dollar does not play well with printing costs in USD (at this point the book is just a hair over break-even). Also because versioning is a bit more rigid in print: a second edition gets a new ISBN to track it, though there is some grey area around what constitutes a second edition. Minor corrections can be made without a new ISBN as part of a second printing without updating all that metadata. I really don’t want to release a 2nd edition over a few minor corrections, but I don’t want to let the e-book version get ahead of the print (even if everyone up until today had to get these changes through the errata page). Finally, updating print is trickier because (even with print-on-demand technology) there’s inventory. So even if I uploaded new files tonight, it may take a while for a new print run to hit the shelves. For now I have not pushed through an update to the print edition, but likely will soon (I just need more free time to make it happen).

So that is to say: if you want the print version, grab it while you can still get it for under $17 (based on the change in the exchange rate, the CAD price on a new print run will need to go up to near $20). As always, the e-book is natively priced in CAD.

Flat-Fee Robo-advisor Model

February 22nd, 2016 by Potato

For a little while now I’ve been thinking of doing a little comparison between robo-advisor models that spans a few years. The flat-fee model (exemplified by NestWealth) tends to work out better for people with more funds to invest, while the percentage model (e.g. WealthSimple) has the edge for investors starting out with smaller portfolios. However, small investors don’t stay small forever, and there’s a lot of inertia involved in investing: once you pick a service you’re likely going to stick with it for a few years or even decades, rather than starting with one model and switching to another once your portfolio gets big enough for it to become the winner. So there may be cases where it makes sense to go with a slightly more expensive option up front that will end up relieving you of the need to switch later, providing you with a better longer-term outcome.

Well, before I even had a chance to start a spreadsheet to examine it, Sandi Martin rings me up to say that she’s just implemented exactly that kind of feature in the latest version of the Canadian Online Investment Fee Calculator. Synchronicity.

So for example, if you have $50,000 to invest today (and no interest in DIY-ing with e-series or ETFs), you might go to the calculator and see that WealthSimple is the cheapest option for you right now. But if you’re diligently saving $15,000/yr, you’ll quickly get up to the point where a flat-fee model like NestWealth or ShareOwner (now owned by WealthSimple) will work better for you. According to the calculator that point will be hit around year four or five for this example, with the ten-year overall fees being a pretty tight race (though the flat-fee model will continue to be better into the future from that point). So maybe you’ll decide to go with one of those options over a percentage-based model even if it costs a bit more now because it’ll work out in the long term and you won’t have to move your investments in a decade to save a little bit of money then.

Now of course I have to end by reminding everyone that cost isn’t everything, and that the advice or other convenience factors can create value for money (e.g. if one best lets you stick to your plan and avoid behavioural pitfalls, that will be worth more than the pretty thin difference in costs with these providers) — and if a robo-advisor will help you stay on track better than going it alone, then that may be worth the increased costs over the DIY route.

Freelancers Guide Part 5: Stormageddon Editorial Example

February 4th, 2016 by Potato

This is part 5 of a series, click here for part 1 and the table of contents.

One night, Potato was at a party when he heard a friend say that she was writing a book and needed recommendations for an editor. “Hey,” he said, “I edit stuff. What do you need?” Seeing the customer need, he became a freelance editor and was open for business in that moment. They agreed on a price, and after the party Potato sent an email to confirm the work and the terms so the expectations were clear on both sides.

Dear Author:
As discussed tonight, I will do a developmental/substantive edit of your book The Rings of Jupiter. I will [specifications of the work to be done].

This will be for a flat rate of $1100, payable in 3 installments of $100, $500, and $500. I will send you a sample edit of the first few chapters for the first installment, at which point you can cancel the contract if you’re not satisfied with the work. The second installment will be due after I complete a first-pass through the whole book and detailed edits to chapter 10. The final installment will be due upon final delivery. Edits will be in the form of tracked changes and comments within the MS Word. Please expect the work to take approx. 4 weeks.

Acknowledging the editorial contribution in the final published copy would be appreciated but not required.”

Potato then sends a basic invoice for the first installment, using his legal personal name.

Before the final installment, Potato realizes that there’s a demand for this kind of work from all kinds of authors and organizations, and that it could be a viable side business. He dreams up the name Stormageddon Editorial and registers the name with the province of Ontario. The final invoice has the Stormageddon branding on it.

To really get Stormageddon Editorial off the ground, Potato creates a website, and orders a new laptop to be dedicated to the business. He clears off a table in the den to be a dedicated workspace. Over the next few months he gets a few more contracts and records them (along with associated expenses) in a simple ad hoc spreadsheet, and racks up a few more general business expenses, including visiting a conference to learn more about freelance editing and build his network.

Click here to see the spreadsheet created for internal purposes (i.e., on a cash, common-sense basis).

Now to translate this into the form the CRA expects it (the T2125).

Revenue maps to revenue, so far so good. It’s a service business with no employees, and a small supplier so no HST, and the first page rolls by pretty quick.

The expenses will have to be categorized, some of which will become capital cost allowances (depreciation) rather than straight expenses. We’ll also get to throw in the personal use of home, which for my own internal understanding of how the business was doing I wasn’t really considering.

Here are my sample expenses:

  1. 1. Postage, Canada Post
  2. 2. Envelopes, Staples
  3. 3. Laptop, Dell
  4. 4. Website hosting, Dreamhost
  5. 5. Dinner with Client 1, Classy Pizza Joint
  6. 6. Business name registration, Province of Ontario
  7. 7. Conference Registration
  8. 8. Parking for conference
  9. 9. Consult – WordPress

I’ll pull up my T2125 and the CRA’s guide for this — of course, that’s a 58 page monstrosity, which is why I’m writing this blog series in the first place.

Ok, so #1 and #2 look to fit neatly under office expenses.

The computer, #3, is a capital cost item, class 50, and so will go down in that section.

#4, the annual website hosting and domain registration bill, is a bit tricky, because now I have to decide if I want to live in CRA pedant-ville or not. All that stuff in the legalese preamble says that I have to account for expenses as they’re accrued, so the year of webhosting I purchased in August will have to be split up into the portion used in 2015 and 2016, and each part claimed in the appropriate tax year. This makes a good case for arranging to have annual costs come up in January/December. Anyway, $144.74/12 = $12.06/mo, times five months used in 2015 = $60.30. There isn’t a spot for web hosting, so I’ll add it to “Other”. The rest of that cost will be carried-over to 2016.

#5 is covered in the guide — entertainment is allowed, but only 50% of the cost, so only $33.50 goes into line 8523.

#6 I’ll put under line 8760, business licenses.

#7 will also go under “Other”, but because the conference included a day of meals that weren’t itemized separately, I need to take off $50 for the personal use for meals — but half of that ($25) I can add back as an expense under meals and entertainment, so that’s now $58.50 under meals and entertainment, and another $148.50 for other.

#8 Parking: there’s a line for motor vehicle, but it’s for everything but parking. I’m not going to claim anything for the business use of my personal car — it’s a massive headache to keep a mileage log, and I know it’s a miniscule amount. However, the parking receipt I can directly tie to a business activity, so I’m claiming that, but apparently under “Other” ($12).

#9 Consultation: This is another head-scratcher. It’s not quite a “professional” fee, but maybe? I figure there’s too much grey zone there so I’ll stick it under “Other” as well ($120).

So you can see that even in a fairly simple example there’s some confusion, grey zones, non-obvious things, and complication. There are clear lines for things like rent, telephone and utilities, and property taxes, but these are not the spots for your business-use-of-home expenses — those go down below. These lines are only if you’re snazzy enough to have a separate office space (like in a commercial/industrial building). And the “Other” category gets a pretty good workout.

Next I go down to part 8 and fill out the business use of home expenses part. I start by entering the total that I paid for the various categories (in this case for just 7 months as I started fictional Stormageddon Editorial part way through the year, but for subsequent years I’ll use the full 12 months that it was operating as a side business out of my home). What’s really weird is that the form is not set up with rent as a line here (which adds to the confusion when there is a line for it above). So rent, along with phone and internet, will go under “other”.

Now I have to figure out what portion of those expenses would be for my own personal use, and which can legitimately be counted as part of operating my business. I use a basic square footage calculation, detailed in the spreadsheet, and figure that 6% of the house has become dedicated to Stormageddon Editorial. So 94% of those costs are personal, and $949.74 is added to my expenses.

There is a bit of weird up and down action on the form here, as I have to go down to CCA (next paragraph), back up to the basic net income calculation, get the net income to figure out if I’m allowed to claim business-use-of-home expenses (if you make very little, you can’t have your business-use-of-home expenses create a loss, you can only carry those expenses forward until your business shows a profit), then back up to the net profit calculation to enter those expenses. Phew, I’m tired after all that up and down scrolling (your tax program will do this for you if you use one).

Finally, I go down to the capital cost allowance section and plug in the details for my computer purchase. Doing this by hand is a bit of a chore: adding the new equipment, figuring out how much of it to claim this year versus carry-forward (which involves reading the guide a lot). Thankfully, most tax programs will take care of this from the additions stage onward. So, I’ve put down in area B that it’s a class 50 item (computer), a description no one but me will read, the total cost, and the business use part (in this case, 100%). Then that gets brought up to area A under column 3. For column 6 I have to make an adjustment for the fact that the equipment was added this year (I can’t claim a full year of depreciation yet), so half that cost comes off. Then I take the rate for computers (class 50 = 55%) and that’s how much of the amount I take this year. Next year, I’ll take 55% of the value left on my laptop as an expense, and so on until it’s all written off or I dispose of it.

My bookkeeping got a bit more complicated: not only did I have to translate my very quick and straightforward cash-based internal tracking to the tax form, I now need to track which things I paid for in 2015 will count as expenses in 2016. My tax program will automatically handle the computer (capital equipment), but I’ll have to track the web hosting and any other partially allocated costs.

And while it’s not quite as simple and straightforward as we might wish, that is it — we’ve launched a business and reported it on our taxes!

I hope that’s been a helpful series, and will help orient you to the CRA guides. As a final disclaimer, remember that I am not an accountant, and I am especially not your accountant. The onus is on you to ensure you’re doing your taxes correctly.