Asset Location Gets REALLY Complex

May 8th, 2018 by Potato

I’ve long been on record as saying that for many investors, trying to optimize their tax situation is not optimal for their overall strategy — worrying about asset location and moving to US-based funds can add significant levels of complexity for the sake of a few extra basis points. It’s confusing, hard to rebalance, and there’s no agreement on what “optimal” is in the first place (wait, should bonds be the first or last thing sheltered?). When the experts can’t even agree on what optimal is, then you know it’s not worth your time to worry about. If all of that throws you off your base game of saving and investing (e.g., if you defer investing your contributions for a year or two because you have to find a bigger block of time to plan out where everything goes, or if you ignore rebalancing because it’s too hard with everything in separate accounts), then it’s not worth the potential savings (this comes back to execution risk).

Just how many basis points or where to put things to be optimized is tough to say. Ben Felix of PWL recently had a white paper that tried to quantify the boost you can get from being efficient with your asset location. The paper uses a Monte Carlo simulation, which can sometimes be confusing to interpret, but broadly speaking, he found the potential boost from optimization to average about 0.23%/yr. Earlier, Justin Bender and Dan Bortolotti used past returns to estimate the boost from tax efficiency in the same range, about 0.3%/yr. And this is likely at the high end of the effect – this very long post is going to get into some very confusing additional factors, but ultimately I think the gain to be had from optimizing is even less than that for most people.

So if you want to stop here, it’s a fine place to stop: trying to tie yourself in knots with the asset location game is only going to save you at best a few dozen basis points per year and confuse your portfolio and make it harder to rebalance — people pay about the same to save complexity by moving to a robo-advisor or TD e-series and that’s totally worth it. I’m a big believer in just using the same allocation in all your potential locations.

TLDR: optimizing your asset location may only provide modest savings and not be worth the effort and complexity: my general recommendation is not to bother and to simply copy your desired asset allocation in each account.

A big part of the problem is that determining what is tax efficient depends on assumptions about future returns, differences in tax rates, and the behaviour of tax shelters. It all means dealing with added complexity. The Monte Carlo results in Ben Felix’s paper help illustrate this: in certain circumstances, what you predict will be optimal on average can actually work against you in a number of scenarios.

A further problem is that there are differences across the tax brackets: someone in the lowest bracket in Ontario has a negative marginal tax rate on eligible dividends, while at the top tax bracket dividends are taxed at a higher rate than capital gains. Most such analyses only use the top bracket. This helps simplify things for author in a few ways: your tax rates don’t move and you don’t get secondary effects (where higher returns cause the tax rate to increase). But then the “optimal” allocation derived from an analysis for the 1% might not fit the rest of us. Ben Felix is to be commended for including a run with lower brackets (which, TLDR, also found a much lower benefit to optimizing vs. just keeping a balanced portfolio in each account — so if your income is closer to $70k/yr than $200k/yr, then there’s even less potential savings on the table so again, just side-step the thorny issue of asset location entirely).

Another issue is that most such analyses don’t adjust the allocation for the after-tax exposure. So putting bonds in an RRSP comes out as better not because it is necessarily more tax efficient, but because it effectively lowers the after-tax bond allocation — the riskier portfolio will have higher returns in the first place, so the overall outcome is better from that rather than because of any tax savings.

This takes a bit of a conceptual mind shift: remember that the RRSP is filled with pre-tax money, so you can’t spend a dollar in your RRSP the same way you’d spend a dollar in your TFSA. Imagine that your RRSP is not just your money, but rather is jointly owned by you and the government — it is after all, pre-tax money that’s in there. The tax paid when you withdraw is just the government taking their portion back, and then it gets to grow tax-free in the meantime. This doesn’t affect your allocation when your allocation is the same across all your accounts: the government’s portion then neatly mirrors your own.

However, when you start putting parts of your portfolio exclusively in certain accounts, then you may want to factor this in (we talk more about this advanced topic in the course). So if a dollar in your RRSP is really only about half yours (at the highest marginal tax bracket), then you can think of the money you have as being the amount in your taxable and TFSA accounts, and part of your RRSP, with the government owning the rest of your RRSP. So your brokerage statement may say there’s $100 across those accounts, with $40 in your RRSP, but really your money is just $80,000, with $20 of it being the government’s portion of your RRSP.

Thus $40 in bonds in your RRSP and $60 in equities outside is not the same effective allocation as a 60:40 split in each account (for those in the course, recall the bunny infographic). In the first case, the government holds $20 in bonds, and you hold 20/60 (a 75:25 allocation), versus the 60:40 split for both you and the government in the second case.

Let’s see how this plays into asset location decisions. Let’s use a scenario of someone in the highest tax bracket, and assume that bonds will pay 2.7% in interest (fully taxed) and 0.3% in capital gains (deferred and tax-favoured) while stocks will return 2% in dividends and 6% in capital gains. The tax hit in dollars for each $1000 invested in a non-registered would be, using the top Ontario tax bracket:

Bonds: $14.45 + $0.80 (deferrable)
Stocks: $7.87 + $16.06 (deferrable)

I’m clearly paying more tax on the stocks: despite the lower tax rate on dividends and capital gains, the higher expected returns mean I’ll expect to pay more tax (in dollars). Therefore, I should prefer to used my limited tax shelter space to shelter my equities. So it seems weird and counter-intuitive that with basically the same numbers, previous papers on asset location have come to the opposite conclusion and suggest that bonds go into the RRSP first.

So let’s look at what happens when we shift the assets around, with and without adjustments for the government’s portion of the RRSP. Let’s assume there’s a $100,000 portfolio, with only $40,000 of RRSP room available. We’re aiming for a 40% bond/60% stock allocation (for simplicity I’m using just two asset classes with the return assumptions as above and assuming everything is liquidated after 1 year — further allowing things to compound should make the shelter space for the higher-return equities even more valuable).

Taxable

RRSP

After-tax value after 1 year

Effective allocation

Balanced

$36k stocks, $24k bonds

$24k stocks, $16k bonds

$82,076

60:40 stocks:bonds

Bonds in first, no adjustment

$60k stocks

$40k bonds

$82,510

76:24 stocks:bonds

Bonds in first, adjusted

$47,153 stocks, $12,847 bonds

$40k bonds

$81,979

60:40 stocks:bonds

Stocks in first, no adjustment

$20k stocks, $40k bonds

$40k stocks

$81,786

49:51 stocks:bonds

Stocks in first, adjusted

$28,565 stocks, $31,435 bonds

$40k stocks

$82,140

60:40 stocks:bonds

Balanced, 76:24

$45,600 stocks, $14,400 bonds

$30,400 stocks, $9,600 bonds

$82,621

76:24 stocks:bonds

If you imagine that you have a total of $60k nominal in equities and you just re-jig where you put it, then you get the result that bonds in your RRSP makes sense. But really, this is no longer the same after-tax portfolio. Remember, you have just $78,588 of your money — the other $21,412 is the government’s portion of your RRSP. So for a 60:40 portfolio you really have $47,153 in stocks to allocate, and the government has $12,847. If then you pull the government’s stocks out and make them all your stocks, while replacing the government’s share of the portfolio with all bonds, then your tax bill on withdrawal will be lower (the government’s portion will grow less), but your money in the portfolio will be riskier. Your after-tax allocation is now effectively 76:24, a much more aggressive portfolio than the 60:40 you were intending to use.

Now, whether to make this adjustment is a huge area for debate. Because what is the purpose of your asset allocation and risk tolerance in the first place? If it’s to manage your emotional response to nominal declines you might see in your account, then using the nominal amounts might be the right way to go about it even when you split up your asset location. After all, when you check in on your portfolio and are worried about inducing panic, you generally include the government’s portion of the RRSP as your money and look at declines in nominal (vs after-tax) terms. So seeing that the government is down along with you doesn’t really stop the panic attack in a market crash. Indeed, from this point of view it can make sense for an advisor to suggest putting their client’s bonds preferentially in the RRSP: they can get an effectively riskier, higher-returning portfolio without the client really noticing the volatility (because the changes in nominal dollars with volatility is the same). On the other hand, if you recognize that a dollar in your RRSP is not worth the same as a dollar outside, then you may wish to put an adjustment factor on your RRSP balances, which changes what optimal looks like.

So with that mind-set in place, the second row (the traditional optimum allocation) comes out ahead of a default balanced everywhere option not because of the tax inefficiency of bonds and the sheltering of the RRSP, but because the effective 76:24 portfolio has a higher expected return in the first place. We see that in the last row: if we just move to that same effective allocation but balance the location across the accounts, we actually get more money than in the so-called optimal, nominally 60:40 case. Also in the third row: keeping the same after-tax allocation to bonds and sheltering them first leads to a lower return than the balanced case. You also see it in examples like this post from Justin Bender, where sheltering bonds in the RRSP is optimal, but not in the TFSA (i.e., scenario 2 and 4).

This is a simplified case (there’s no international equity, no US withholding tax issues, no multi-year compounding), but we see that the savings on offer is about 50 basis points when putting bonds in the RRSP without remembering to adjust the allocation — not too far off what the other papers get. Of course, going to an effective 76:24 allocation but without asset location would give an extra 66 bp. If you’re adjusting the allocation for the government’s portion of your RRSP, then putting stocks in the tax shelter first was the more optimal move, but all that added worry and complexity only saved you 8 basis points. Adding compounding over time and the withholding tax issue for US equities should further help make sheltering equities first the more optimal strategy when you expect low bond returns, and increase the potential benefit (which I still have yet to estimate well), but being in a lower tax bracket will likely reduce it. Again, the amounts involved are not huge, especially in comparison to the added complexity.

Interim Conclusion:

Adjusting your effective after-tax asset allocation can change your results of what an optimal asset location strategy looks like. Note that in any case, all these optimization games can bring is a few basis points of extra return — that may be worth the headaches of reading all these whitepapers for a few of you, but bear in mind the complexity involved versus the suggested default of just using the same portfolio in each account.

Optimizing in any case requires estimating future returns and tax rates, which can be difficult — post hoc, you may be worse off than a simple balanced approach if your estimates are wrong.

Engaging in asset location adds a lot of complexity to your portfolio for potentially minor benefit, and this benefit is likely even lower for people in middle tax brackets vs. those in the top bracket where such analyses usually focus.

Take-Home Message:

This is all very confusing and my default suggestion is that it’s best to just replicate the same allocation in all your accounts.

The Pros & Cons of Each Approach:

No asset location: repeat your asset allocation in each of your accounts (taxable, TFSA, RRSP).

  • Pros: You don’t even have to enter the argument about adjusting allocations for after-tax effects, and it’s very simple to do. Plus, you won’t ever run into problems with rebalancing as each account rebalances on its own, and you don’t have to predict the future in your optimization attempts.
  • Cons: However, you may not be able to shake the feeling that somehow you’re leaving a few basis points on the table, and you may pay more in commissions to repeat trades in each account.
  • Operating quick rule-of-thumb: decide on your asset allocation, then just do that in each of your accounts.

Asset location without adjusting for the tax effects of your RRSP: split your asset allocation up, using only nominal values (i.e. treat a dollar of bonds in your RRSP the same as a dollar of bonds in your TFSA or non-registered).

  • Pros: It’s much easier conceptually to see all the money as being equal no matter where it sits, and there are lots of resources to read that use this method so you’ll feel like you’re in good company and won’t get confused when you try to refresh your memory in a few years. You can trick yourself into accepting a higher risk portfolio, and asset allocation is only approximate at best (the difference may be behind the extra return seen, but really, is 60:40 meaningfully different from 76:24? …and the skew is even lower at lower tax brackets). You can save a bit on commissions by making fewer transactions because some asset classes won’t appear in all accounts.
  • Cons: However, with asset classes sitting in separate accounts rebalancing will be a pain, and it adds a lot of complexity and cognitive load to your investing. Plus if you put your equities in your non-registered account, your portfolio isn’t really set up to help add resiliency to your life, as you’d likely look to sell your bonds to cover any emergency spending that was larger than your cash emergency fund. You’ll treat your RRSP and TFSA as having quite different tax sheltering effects, which is odd given all the other reading you’ve done on how they both shelter gains from taxes.
  • Operating quick rule-of-thumb: put the asset with the lowest expected return in your RRSP. Put the one with the highest tax hit (expected return * tax rate) in your TFSA, which will likely be US & International equities. If your RRSP overflows with bonds, those go out to a non-registered account rather than TFSA. If your TFSA overflows with equities, then those go out to the non-registered (Canadian first).

Asset location with adjustments for the tax effects of your RRSP:

  • Pros: You more consistently apply your thinking of how RRSPs work, can maximize your tax savings, and will treat your TFSA and RRSP more consistently in asset location decisions. You can also feel like a pioneer at the forefront of your field, and can carefully explain why you do the crazy thing you do and watch as people’s brains ooze out of their ears at parties. You can save a bit on commissions by making fewer transactions because some asset classes won’t appear in all accounts. Plus, if you use similar low-interest-rate assumptions and bonds are the first thing in your taxable account, this allows your bonds to act as your second-tier emergency fund: already non-registered and ready to be spent if needed.
  • Cons: However, it is the most confusing option of all, adding the most complexity (though to be fair, asset location is already one of the most complex things you’ll inflict upon yourself as a DIY investor). Furthermore, the complexity keeps going: after adjusting your RRSP for the government’s portion, you may want to try to adjust your non-registered account, too, versus your TFSA (which is harder, though the factor will be much smaller). And with asset classes sitting in separate accounts rebalancing will be a pain. Also, while your portfolio may have the same real, after-tax risk as one you targeted when balancing across all accounts, the nominal amounts will look riskier — above, you had $68.6k nominal dollars in stocks when locating them in your RRSP with the pre-tax adjustment, versus just $60k nominal dollars in the all-balanced default approach and the non-adjusted asset location approach. In a market downturn, it will look and feel like you’re losing more money, and will take an extra effort off will to remember that you really only had $60k on the line and it’s the government that’s losing on their stock portion. In short, it adds a lot of complexity and cognitive load to your investing.
  • Operating quick rule-of-thumb: Bonds will be the first thing kicked out to non-registered, then likely Canadian equities. For most assets there isn’t a difference between the treatment of the RRSP and TFSA, except US equities held through US vehicles, which can save the withholding tax in the RRSP (and international equities gets complicated but let’s say a weak RRSP preference as well).

This seemingly pedantic debate about whether to adjust the RRSP amounts for the pre-tax nature of the tax shelter ends up changing the answer as to what you prioritize putting in your shelter when optimizing (given certain expectations about returns and tax rates), so decide and execute carefully.

Bonus Round:

There’s a legitimate debate for whether or not to adjust the amounts in your RRSP, and I just gave you some pros and cons for each way. Here are a few examples to help reinforce why I think you should use the method with adjustments (even though it’s complicated).

First, running an asset location optimization without adjusting the amounts in the RRSP tells you not to use your limited tax shelter space to shield the thing with the highest marginal tax hit, but rather to stick the thing with the lowest potential for growth in there. We can see this if instead of a 60:40 portfolio of stocks and bonds, we use an example of a portfolio composed of zero-yielding cash and stocks. It should be intuitively obvious that there is no benefit to putting something with zero yield (and thus zero tax) in your RRSP tax shelter, yet:

Taxable

RRSP

After-tax value after 1 year

Your effective allocation

Balanced

$36k stocks, $24k cash

$24k stocks, $16k cash

$81,499

60:40 stocks:cash

Cash in first, no adjustment

$60k stocks

$40k cash

$81,953

76:24 stocks:cash

Cash in first, adjusted

$47,153 stocks, $12,847 bonds

$40k cash

$81,232

60:40 stocks:cash

Stocks in first, no adjustment

$20k stocks, $40k cash

$40k stocks

$81,197

49:51 stocks:cash

Stocks in first, adjusted

$28,565 stocks, $31,435 bonds

$40k stocks

$81,677

60:40 stocks:cash

Yes, with no adjustment to the allocation, you would get the result that putting the zero-yielding cash in your RRSP was still the optimal thing to do (and would save you nearly the same 55 bp benefit as in the base case above with bonds). This strange result suggests to me that adjusting the allocation for tax concerns is the correct way to think about your RRSP in asset location exercises.

Second, we remember to make this adjustment in every other instance where we compare amounts in a non-registered account, or comparing TFSAs and RRSPs head-to-head. For example, one frequently asked question is whether it’s better to hold dividend-paying stocks in a non-registered account than an RRSP, because the withdrawals will be taxed at your full marginal rate while the dividends/capital gains will be taxed at a lower rate (e.g., the second myth in this column by John Heinzl in the Globe or this one). A naïve analysis would compare $1000 in a non-registered account and show that after say 200% capital growth you have $2465 left after paying a relatively light capital gains tax, while in a RRSP all the withdrawals (including the principal) are taxed at your full marginal rate, so you’d only have $1394 of your $3000 after paying 53.53% in tax. Of course, the flaw in that analysis is that you ignored the fact that pre-tax money goes into the RRSP — in a fair comparison, you’d really start with $2152 in your RRSP, which would then experience the 200% growth, and even after taxes on withdrawal would leave you with $3000, showing that the RRSP does indeed completely shelter gains from taxes when you account for the pre-tax nature properly.

Every time, the answer is that to fairly compare the RRSP, you have to recall that it’s pre-tax money so there should be more in there in the first place to be comparable to a TFSA/non-registered investment.

So really, I think we should be continuing to account for the fact that it’s pre-tax money in the RRSP (that is to say, part of what’s in there is the “government’s portion”) and adjust your asset allocation accordingly when you get into fancy asset location footwork. This is consistent with the way we treat amounts in the RRSP in any other analysis. Plus the idea of asset location is to try to get a bonus return through optimization with little added risk — the results from not adjusting (being worse off ~20% of the time) look like what happens when you add more risk.

Implementation: How do you figure out what is the government’s portion of your RRSP? First, you have to figure out what the government’s share is — what the average tax rate of your withdrawal will be. For the case of the ultra-wealthy investor who is stuck fully in the highest tax bracket, it’ll be the highest tax bracket with no uncertainty. For someone more middle class, it may be your current marginal tax bracket, or a bit more or less than that. Your future RRSP withdrawals may span a few brackets.

Remember that you will never be able to peg this exactly. I suggest that using a round number that’s close enough — 30%, say — is likely a better way to go than to get lost in an exercise in trying to project it any more accurately than that, and certainly better than no correction at all. While the difference in effective portfolio ratios can be meaningfully far off if you don’t adjust, they likely won’t be if you use 30% as your correction factor and it ends up that you pay say 33% tax on withdrawal.

So you take that tax rate, t, and you say that much belongs to the government. Amount in RRSP (R) * t = government’s portion. To adjust your allocation, you can focus on just your part: (1-t).

So your portfolio may have a non-registered component (X) and a TFSA (Y). The total of your money (assuming we’re not going to go down the rabbit hole of also adjusting the non-registered amount) is X + Y + (1-t)*R.

Allocate based on that amount, then gross-up the RRSP with the government’s portion by dividing your after-tax RRSP amount by your tax adjustment factor (1-t) so you know how much to buy in the RRSP for each asset class.

So for example, if you’re sitting with $100,000 in your RRSP, $50,000 in your TFSA, and $35,000 in your non-registered, and you’ll use 30% as your close-enough tax rate:

Government’s portion of RRSP = 100,000 * 30% = $30,000
Your portion of RRSP = $100,000 * (1 – 0.3) = $70,000

Your portion of your portfolio = $70,000 + $50,000 + $35,000 = $155,000

Then if you want to aim for a 60:40 portfolio, you’d have 40% of $155,000 = $62,000 in bonds, the other $93,000 in stocks.

You’d start to fill your buckets:

Stocks in the TFSA = $50,000. Still have $43,000 of stocks to allocate, which go in the RRSP.

So now you have $43,000 of your money in stocks in the RRSP, and $70,000 of your money as total room in there. $27,000 of bonds go in the RRSP. Your RRSP is now 38.5% bonds — we’ll keep that in mind when we go to add back the government’s portion.

Finally, you have $35,000 of bonds for your non-registered account.

Before you can go and make the trades, you’ll have to gross up your RRSP again with the government’s portion (their $30,000). You’ll allocate it the same as your money in the RRSP, so 38.5% * $30,000 = $11,550 to bonds, $18,450 to stocks for the government portion. Or, same math a different way: RRSP_stocks_total = $43,000 [your money] / (1 – 0.3) = $61,450, RRSP_bonds_total = $27,000 / (1 – 0.3) = $38,550 [rounded to the nearest $50].

Your final, after-tax-adjusted asset-located portfolio is:
RRSP: $61,450 in stocks, $38,550 in bonds [$100,000 total]
TFSA: $50,000 in stocks
Non-reg: $35,000 in bonds.

Go make some trades and you’re done. (Or, you know, throw your hands in the air and keep each account as an undifferentiated copy of the whole, like a perfect atom because you’re not going to mess around with the subatomic physics nonsense that this involves: particle accelerators are for nerds and supervillains).

References:

I wrote the first draft of this before stumbling across these references (h/t Justin Bender), which have already trod the same ground:

W Reichenstein, Asset Allocation and Asset Location Decisions Revisited, The Journal of Wealth Management, 2001

“We argue that the traditional approach to calculating an individual’s asset allocation is wrong. The traditional approach fails to distinguish between the before-tax funds in deductible pension accounts and the generally after-tax funds in taxable accounts. Goods and services must be purchased with after-tax funds. Yet, the traditional approach treats $1,000 in deductible pension accounts as equivalent to $1,000 of after-tax funds in taxable accounts. I believe that the profession must first convert before-tax funds to after-tax funds, and then calculate the asset allocation based on after-tax funds… In Portfolios A and B, he could withdraw, say, $1,000 from the stock fund and buy $1,000 of goods and services. In Portfolio C, he must withdraw $1,538 from the stock fund held in a deductible pension account to buy $1,000 of goods and services; taxes consume the other $538… we can convert the $153,800 of before-tax funds to after-tax funds by multiplying by (1 – t), where t is his expected tax rate during retirement. The deductible pension account represents $153,800 (1 – 0.35) or $100,000 of after-tax funds.”

C Reed, Rethinking Asset Location – Between Tax-Deferred, Tax-Exempt and Taxable Accounts (2015). Available at SSRN.

Also, I deep-linked some PWL white papers above, because I don’t know how to link to a specific paper otherwise. Their collection of whitepapers is available here.

Future work: Using more realistic methods (portfolio with 4 components, withholding taxes, and compounding/deferring over multiple years), what’s the tax savings to be had with a stocks-sheltered-first, adjusted-for-taxes approach. And, how does it change if you’re not in the highest tax bracket?


Vanguard’s New All-in-One ETFs

April 1st, 2018 by Potato

Lots of people have been talking about Vanguard’s all-in-one ETFs that launched fairly recently. Dan @CCP talked about them in the back half of this podcast (and the first half is with me if you missed it :), and has a whole separate post on them, and likely will have another in the future as they’re generating a lot of discussion and questions.

In general, I like them: for a modestly higher MER, you get a one-stop investment portfolio.

One point I really like about them that hasn’t been talked about much is the fact that there is only one thing to look at for your portfolio. We talk a lot about the importance of having balance and diversification — so much in bonds, for example, to limit the losses you might experience in a market crash. However, in the moment people rarely look at their overall portfolio and say “Well, I’m only down X%, which I was prepared for, and my bond allocation is doing its job so all is good.” No, instead we tend to focus on the biggest, reddest number on the screen — and of course in a 3 or 4 fund portfolio, you’ll see each position individually, and have to do some math to see the portfolio as a whole.

With an all-in-one fund, you will only ever see the portfolio as a whole. You won’t second-guess your international fund during Brexit, your bond fund when interest rates are hiked, or your Canadian index fund when oil tanks. And there is a lot of investor behaviour management in the simple fact that in a diversified portfolio there is always at least one thing that is disappointing (under-performing the rest if not actually down). Not to mention in a crash — it’s hard to tear your eyes off the big red number on your losing-est fund and feel like the world is ending when that’s all that’s in the news, even if the rest of your portfolio is holding things together reasonably well. These funds will help avoid all that, and that’s the main reason I’m a big fan — all-in-one funds are best positioned to help actually match up that notion of risk tolerance for your overall portfolio and what you really see when you check in on your portfolio.

Now, these new funds do not mean that these ETFs are making Tangerine, TD e-series, or robo-advsiors obsolete. They do make investing in ETFs easier: just one thing to purchase, and no rebalancing. But you still have to deal with buying ETFs, which can’t be automated like Tangerine or TD e-series mutual funds can be. It does slightly complicate the nice one-dimensional relationship between cost and complexity that was the choice between Tangerine/robo-advisors/e-series/ETFs before. One-fund ETFs will be cheaper with automatic rebalancing, while e-series will have manual rebalancing but the ability to set up automatic purchases, and avoids the more complicated order entry of ETFs (rounding down to whole units, limit orders and bid/ask prices, worrying about market hours, etc.). I still think that overall I’d put one-fund ETFs to the right (i.e. more complex overall) than TD e-series — while rebalancing can be a pain and a bit confusing, you don’t have to do it often, while making regular purchases as easy as possible is more important to long-term success.

And if you are interested in these ETFs, you have to let the simplicity work. I mean, that’s what you’re paying extra for. I’ve seen hundreds of questions and thoughts since these launched in various blog comments and forums where people are trying to tweak the allocation to what they really want: buying VGRO and a bond fund for example, or buying both VGRO and VBAL to get an intermediate bond allocation. Just like with Tangerine’s funds a key point is to just round your desired allocation off to the nearest 20% or so to fall in to one of the choices on offer rather than trying to get lost in the details. Once you try to add more funds into the mix to get what you really want, you lose the whole benefit of the one-fund simplicity: buying more than one fund means it won’t automatically rebalance any more, and at that point you might as well buy a third (or fourth) fund and save the extra cost on bundling it up.

DIY Root Canal vs DIY Tax Stuff

March 19th, 2018 by Potato

Jason Heath pulled out a version of a quote I hate in this Ask MoneySense article on OAS clawbacks:

“Few people would think to Google how to perform a root canal, let alone try it themselves. But lots of people try DIY tax and financial advice.”

Now, it’s hyperbole, and I’m going to rant about it, but I don’t disagree with the main thrust of the article or the next part of that quote: “If you don’t have an accountant, contact one and buy an hour of their time. Bring a list of questions or send them beforehand, so you can get an income tax “check-up.” It may be well worth it even if you only do it once in your life or at least once in a while…” The last half of that paragraph, getting a check-up to have some common questions answered, is entirely reasonable and a good suggestion.

There is definitely a place for professional advice — both planners and accountants. But there’s also a place for DIY-ing things.

The tired root canal analogy makes it sound like you have to be crazy to approach your taxes on your own. But just like with dentistry or medicine, there are lots of things that are totally reasonable to DIY (or Google-then-DIY). You would not go to your dentist every time you had to brush your teeth or floss, and you shouldn’t clog up your doctor’s office with every minor cold or papercut you get, even if you would go for a root canal or surgery. If you have a canker sore it’s totally reasonable to hit Google and gargle some warm salt water. Not everything is a root canal, not everything needs a professional to manage. And especially when it comes to taxes, there are too many people in the world who shrug and say “get an accountant” rather than helping people learn to DIY (which may be related to regulations and the fear of being sued).

This particular article also really highlights an important aspect of the issue: when we’re talking about mouths, people generally have enough background information to know what is at the totally-DIY-able level (like daily brushing) and what is at the I-need-a-professional level (like fixing a cavity or getting a root canal). When it comes to finances, lots of people don’t have the basic literacy to find the answers they need or use them appropriately. Here, finding the OAS clawback threshold is pretty easy, and planning around that is a decent edge case where it’s not unreasonable to do some DIY around it, but also not exploitative to suggest it’s worth getting a professional’s input. However, the person asking the question doesn’t seem to know that the threshold is about clawbacks, not reporting — you have to report everything. So they couldn’t find the answer because they didn’t know how to ask the question (or interpret the answers they likely did turn up). There’s some essential background knowledge missing that’s going to make DIY a challenge here — indeed, to know what can be done on your own.

What then is the answer? I really don’t like a blanket “this is like a root canal and you shouldn’t do it yourself” type approach — as someone who makes tools to help people DIY stuff, that is anathema. People shouldn’t be dependent on professionals; DIYing many things shouldn’t be construed as an impossible, whack-a-doodle notion. But at the same time, there is a financial literacy gap that makes it easy to point out the challenges in implementing DIY approaches. And people shouldn’t be afraid to get some help and pay appropriately.

“Adulting” help is becoming more important and more available. Indeed, the suggestion Jason makes after the hyperbole that I took so much issue with is good — I really like the suggestion to get a few hours of a pro’s time to get questions answered well. Not “get an accountant to manage all your money stuff because you’re hopeless” but “get a block of time and ask some questions to figure this out properly.”

Of course, the analogy to medicine or dentistry really breaks down in personal finance, because our own gaps in knowledge and ability vary. It’s not as clear-cut as this thing is only for professionals, while you’re out of luck if you need help with this basic everyday thing. Especially as paying by the hour for advice is a model that’s becoming more available: no longer is it that investing is the thing you need a pro for, in part because selling an investing product is the only way for them to get paid. Now money coaches and people like Chris are there to help with things like understanding your money and building a budget, while rarefied applications like investing are completely accessible to DIY-ers.

The Market Can Go Down?

February 6th, 2018 by Potato

Panic!

The US market was down about 4% today, following a ~2% decline on Friday. Everyone on the news and social media and forewords in their books seems to be reminding investors not to panic.

Forget that, let’s PANIC!

Look at your portfolio, and that loss. How many up days did it wipe out?1 Now is this it? Or could we have another week, another month of days like this? Where’s the bottom???

Now, with that fear feeling very real and sitting quite uncomfortably in the pit of your stomach, how comfortable are you with the way your portfolio is? Are you ready to ride out whatever the uncertain future has in store for us?

If you’re not feeling so good after today’s loss, well the reality is that this is what markets do sometimes. This is normal. If you’re having trouble handling this, then a few things may be at play:

  • You could have too much risk in your portfolio. Changing that to something more appropriate for the long term may be a good thing to do when the loss is still minor (just don’t time the market – don’t change it back “when things are more settled” – if you can’t handle risk now, you can’t handle risk).
  • You could be untested. This is your first test, there will be more – start getting used to it. Feel the fear and discomfort, then remind yourself that this is what all those books and articles were talking about, and learn to suppress it.
  • You may be paying too much attention to minor day-to-day moves – when it makes the front page it’s hard to tune out completely, but you may want to stop checking in on your portfolio if there’s nothing to be done.

There are various things you can do to try to handle the uncertainty, which I know is not easy, especially if this is your first real experience with volatility.

  • First, try talking yourself through it. This is normal, it’s happened before, it’ll happen again. Etc.
  • Second, try reminding yourself that stocks going down while you still have money to save and put to work is a good thing for you.
  • Third, try using it as a lesson to check in less often.
  • And finally, go watch Bridge of Spies and ask yourself “would it help?”

gif from the Bridge of Spies – ‘You don’t seem alarmed.’ ‘Would it help?’

So yes, ultimately I’m giving the same “Don’t Panic” message as everyone else, but if you are feeling emotional about the markets then try to use that fear to learn something — either about your risk tolerance, or how to manage fear when markets are erasing years of gains instead of weeks.

1. Not that many, actually – this only took us back to ~mid-Dec.

DIY vs Robo Quick Challenge

January 11th, 2018 by Potato

I was challenged a while ago to figure out if DIY investing is really worth it for regular people when you factor in the value of the time and effort spent — should I even be putting time into things like the book and course to help people learn to invest when robo-advisors are the future?

And of course the first defense is that even if a robo-advisor is doing the work, you still need to do some reading so you’re prepared for the risks and uncertainties inherent in investing, etc. But the point is still there: are the savings of DIY worth the extra time it takes now that robo-advisors exist?

I decided to do a quick back-of-the-envelope comparison. Though there’s no way to know for sure that I didn’t tweak the assumptions to get an answer I liked, I assure you that these are the first reasonable estimates that came to me as I was trying to be fair — we are “doing it live” so to speak.

So do-it-yourself investing requires a bit of time and effort, and the question is how do you value that time and effort to figure out when it makes sense to DIY vs. just pay a robo-advisor? For this I’m going to assume that we’re only talking registered accounts, so no ACB and other tax reporting headaches of a non-registered account (and besides, if the robos aren’t tracking it for you then a more complex robo portfolio may be more work than a simple DIY one).

First, you have to learn about your risk tolerance to make sure you’re ready to invest at all, come up with a rough plan, figure out whether to prioritize your TFSA or RRSP, etc. But that’s a wash as even if a robo-advisor is handling the day-to-day aspects of your investing, you still have to deal with that.

There will be more up-front costs to learn how to invest as a DIY-er. You’ll have a bit more learning to do for DIY investing, like the mechanics of making trades and rebalancing, choosing a model portfolio to follow, as well as some investment in learning to control bad investor behaviour. The Practical Index Investing Course is $299 $169 and a one-stop resource, with another ~15 hr required to work through it — so the total cost depends on what you value your time at. Let’s use $25/hr and call it $544 in up-front investment (more if you’re going to go with the library card and time method – the course will save you lots of research time, which is the point of it /self-promote).

Then on-going effort is small but not nil. For the TD e-series route you may have to spend 2 hours/year or so on tweaking your automatic contributions and rebalancing; for ETFs it might be more like 4 hours/year. Plus the ongoing MERs of the funds (and the robo-advisor’s fee for that option).

Element DIY e-series DIY ETFs Robo-advisor
Time: learning about risk tolerance, planning Same – this is table stakes for investing Same – this is table stakes for investing Same – this is table stakes for investing
Learning how to trade and manage portfolio $544 (one-time) $544 (one-time) 0
Annual cost of funds 0.45% 0.2% ~0.7%
Annual effort to maintain $50 $200 0
Total cost for $10,000 for 5 years $1,019 $1,644 $355 (*)
Total cost for $100,000 for 5 years $3,044 $2,544 $3,275 (*)

* – includes “first $5k managed free for a year” offer calculated with real all-in costs.

Now I am a fan of robo-advisors and they do have their place — lots of people will be well-served by going to one and not everyone wants to be a DIY investor. That’s important so I’ll repeat it: regardless of the potential savings of DIY, not everyone will want to (or should) do it all on their own. Plus there are other potential benefits, for instance a robo-advisor may help prevent bad investor behaviour (and read Michael James’ comment to further reinforce that — any savings can be swamped by bad investor behaviour).

But it looks like even if you give a decent value to your time ($25/hr here) and assume that there’s a big up-front commitment required to learn it, that DIYing can still make sense and be worth the time and effort for moderate-sized portfolios. I picked 5 years out of the air as a reasonable amount of time to amortize those up-front costs — the longer you think that’s good for, the more DIY will pull ahead (at least where the portfolio is large enough to make sense in the first place). For smaller portfolios, the time might not be wisely spent on DIY efforts, though small portfolios do grow into large ones and there is some value to just sticking with one method.

Note that putting a value to your time also reinforces the traditional wisdom that you need a ~5-figure portfolio for ETFs to make sense over TD e-series — even with commission-free purchases, the MER savings may not outweigh the effort with smaller portfolios.