Blessed by the Potato

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

Our first ever cherry-flavoured spring.

#PolarVortex
#CherrySpring

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

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

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

What’s new:

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

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

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

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