Rent vs Buy: Toronto Retrospective

January 27th, 2015 by Potato

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

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

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

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

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

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

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

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

Budgeting Processes

January 20th, 2015 by Potato

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

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

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

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

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

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

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

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

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

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

The Canonical Portfolio Part 2: Apocrypha

January 13th, 2015 by Potato

In the first post I discussed some of the philosophy underlying the Canonical Portfolio, and of course laid out the basic asset classes and default allocation suggestion. Remember that all asset classes with an ETF to make them investable have a compelling elevator pitch for why an investor should add them to their portfolio — if they didn’t, the ETF wouldn’t exist. So many other authors who pick these non-canonical classes for their suggested asset mixes tend to explain in those terms why they made it in… but that’s not quite enough for me. There are practical implementation issues to adding and rebalancing these different asset classes, in addition to explaining when and why someone would want or need them. Some are difficult to find, with only one or two illiquid or high-cost funds to choose from, others get such low recommended weightings even from their proponents that they’re not worth the effort of discussing, and there’s always the basic increase in complexity from adding more funds to the mix.

That said, it’s your portfolio and you can make it as complex as you like. Just remember that there is very little precision in investing, so just as I couldn’t come up with strong reasons for including these various alternatives, there isn’t really a strong reason why you shouldn’t. It’s not worth running into analysis paralysis over a few percentage points allocated to these more esoteric funds — go ahead if for whatever reason it really speaks to you, or you fell in love with the author of a particular alternative model portfolio — or just stick to the basics and be done with it.

Emerging markets are often included in the international diversification piece, and have been a bit of a hot topic with cutesy acronyms like BRICto describe them. Emerging markets add a lot of risk to a portfolio (both in the sense of volatility and chance of loss of capital). Yes, exposure to rapidly growing economies is sexy, but to some extent the profits from that growth will be captured by the multinationals already owned in the US and developed international indexes, and I am personally highly suspicious of some of them as long-term investments. My own feelings aside though, is it an asset class that should be included in the Canonical portfolio? My answer is no: even model portfolios that do like emerging markets only put a small allocation towards them — if it’s only worth 46% is it really worth the complication? If you want more risk, you could just turn up the knob on your existing three equity classes (indeed, this is partially done already through the age-10 guide). No, that would not be the same as getting broader diversification to these other markets, but emerging markets are not part of the TD e-series or Tangerine portfolios (though high-MER versions can be purchased at TD).

This last concern is very important for a book or resource laying out the Canonical Portfolio, because it creates pressure on a reader who might otherwise lean towards the simpler e-series or Tangerine choices: are these mutual fund options lesser or weaker because they lack these exotic asset classes? Does that mean the reader should push towards a more complete ETF portfolio1 with all these little slivers of allocation? And honestly, my answer was no, those are full and sufficient portfolios as they are. And if Tangerine is a satisfactory portfolio, then why should I add the complication of these other funds just because they’re available in ETF form? Especially when I could not come up with a guideline or simple rule on when someone might or might not need or want exposure to these alternative asset classes.

Here is a list of some of the other asset classes or ETFs that might be worth considering, but did not make my cut for inclusion in the book (or Tangerine’s cut for their funds, for that matter).

Preferred shares: these look like a blending of bonds and stocks, providing a higher, more tax-efficient return than bonds while being more stable than (common) stocks — and also sitting halfway between the two in the capital structure of a company. Able to provide a relatively high dividend even in a sideways market, preferred shares can be a nice addition and some people suggest adding them by chipping away a little bit of each of the stock and bond allocations. Indeed, Garth Turner is such a fan that he prioritizes preferred shares over international equities for an investor whose portfolio was on the smaller side, and in his more generic portfolio has a high allocation — as much as any other equity slice. But they suffer from a lack of sector diversification that’s even worse than the Canadian market in general. For those with really large fixed income accounts (e.g. those entering retirement), I think it can make sense to start to slice and dice that into regular bonds, real return bonds, and preferred shares… but ultimately I think it’s just not worth the complication for an interesting share class coming from a narrow slice of the economy.

Real return bonds: tied to measures of inflation, real return bonds have protection against one of the big risks to regular bonds. They’re also not highly correlated to stocks or regular bonds, which can be desirable in building a portfolio. However, their expected return is terrible (in part because they are so safe in other aspects); while the lack of correlation to the other “eigenvectors” is nifty, that argument absent some kind of expected return didn’t have much sway for gold, either. The main issue though is the practical reality that there is only one ETF in Canada offering real return bonds that I could offer up as a recommendation, and its MER is rather high at 0.39% (the iShares XRB — Vanguard does not have a real return bond offering, and while BMO does have ZRR in its library, with a market cap of just $37M it raises serious liquidity concerns for me so I wouldn’t include it in the book). Again, I don’t think the other bond funds are seriously deficient because they lack real return bonds, and while it’s not quite such a direct, perfect hedge, the big equity slice of the portfolio has the job of beating inflation. If equities are failing at that, a 5-10% allocation to real return bonds would help the stinging, but only so much.

Real estate investment trusts: this is the one that nearly got me. REITs are a particular weakness of mine in my active portfolio, and while they are not nearly the same thing as individual real estate holdings, I did have a simple justification for when you might want them (if you are a renter). They are nearly as common a selection as the major equity indexes and emerging markets, particularly for Canadian authors. But, like other sector-specific funds, the MERs are getting a touch high, and the diversification is not great (though there are many more quality REITs than there are banks). Though in some ways they look like fixed income or preferred shares, where most of the expected return will come from the steady payout and with some close relationships to interest rates, they are volatile and in terms of capital structure for the companies count as equity — thus if you do include them, you should be looking to count them as part of the equity portion.

Small cap tilts: I did prefer Vanguard’s total index to the S&P500 and the TSX Composite to the TSX60 for the added diversification, but did not mention getting small cap or value-tilted funds to increase this weighting. There are several to choose from for US and International, if you’re willing to go to a US exchange — but that’s a tough thing to recommend for the base Canonical portfolio (I’ve already received some flak over including Norbert’s gambit as an optional thing for getting VTI in RRSPs). The Canadian small-cap ETF from iShares has a relatively hefty MER of 0.6% and a really high weighting to the volatile junior materials sector.

Dow and NASDAQ: the Dow Jones Industrial Average is a collection of 30 companies that is popular largely for historical reasons — nonetheless, there are many funds available to invest in it if one wanted to (including e-series versions). Similarly, the NASDAQ has its own index that is quite technology-heavy. However, the main Dow and NASDAQ companies are also in the S&P500 (or VTI), so there’s no reason to slice-and-dice US exposure to include these other indexes.

Fundamental indexing: as an alternative to traditional market-cap-weighted indexes, FTSE has created indexes that weight companies on various characteristics of the investment. This is a really neat idea in theory, but the costs of implementing it are pretty close to the expected out-performance such an approach should bring — and in Canada they’re even less diversified than the already-tilted TSX Composite. Here’s a post from Y&T that Kyle put up after a short discussion with yours truly on the matter.

Bond fanciness: maybe it’s my bias towards a focus on equities, but I just did not want to get into the options for slicing and dicing the bond exposure into short term and long-term, government, corporate investment-grade, high-yield paper, real-return, or international bonds. In addition to the implementation problems facing the real return bonds, it could almost become a whole book on its own to discuss how and why someone would want to tilt their allocation — bond funds can be surprisingly complex.

Dividend and income funds: the dividend growth community loves dividends, and looking backwards dividend stocks do seem to be highly competitive with the broader markets. There are also many funds appealing to “yield-hungry investors” full of former income trusts — but when should someone be “yield hungry”? Focusing on payout also cuts out large swathes of the market.

Sector funds: whether it’s energy, biotech, utilities and infrastructure, or precious metals, many investors can’t help but have a preference for a particular sector, no matter how much they may otherwise believe in broadly diversifying and keeping things simple. These can then show up in their model portfolios, but then there is very little concordance between them — if you read enough they almost cancel each other out to form the broader indexes!

Berkshire Hathaway: though technically an individual stock and not an index fund at all, BRK does have some of the good properties an index investor would be looking for: they hold a diversified portfolio of businesses, keep turnover to a minimum, are tax-efficient, are highly liquid, and have effective management fees that are quite low. Michael James and Financial Uproar have written more about Berskhire Hathaway as an index-like investment, and in full disclosure, I personally hold some in my RRSP and count it as part of my passive portfolio. But it once again requires buying on a US exchange, so not appropriate for the book.

To sum up, there are lots of ways to build an index portfolio that is reasonably simple and stays true to the philosophy of diversifying and minimizing costs. As Michael James said in that last link “Most proponents of indexing strategies don’t quite manage to implement a pure index approach. They often come close to pure indexing, but they can’t resist adding some sort of twist,” and there are lots of possible twists. I’ve worked with people getting started with DIY investing, and seen the confusion that having multiple portfolio options out there can cause, especially when there is no clear reason for choosing one model over another. Hopefully the consensus that is the Canonical Portfolio will help — and that’s what I was aiming for in The Value of Simple — a good-enough portfolio that you can run out and get started with right away.

1. Indeed, this has been a major concern for people who come out confused by the MSGttPP — they see the cutesy name of “Uber Tuber” and worry that the “Complete” portfolio is a misnomer.

The Canonical Portfolio

January 4th, 2015 by Potato

Making the case for investing is relatively easy — investing is what gives you growth beyond your own savings, so that you can save at a reasonable rate and meet your goals. Investing through index funds is also not a hard sell: control your costs, get the market return, keep it simple. Where people sometimes get stuck though is deciding which indexes they should invest in. There are, after all, numerous indexes to follow (and funds to invest in), especially if you include sector funds.

In The Value of Simple I present a simple portfolio of just four funds1 that will meet the needs of pretty much any investor out there, with a simple rule-of-thumb to determine the main split:

  • Bonds (your age less 10), e.g. 25% if you’re 35 years old (which could be for example TDB909, VAB, XBB, or XQB)
  • And three equity classes, split roughly evenly with what’s left:

  • Canadian Equities (e.g. TDB900, XIC, or VCN)
  • US Equities (e.g. TDB902, XUS, VUN, or VTI)
  • International Equities (e.g. TDB911, XEF, or VIU). [Or, use VXC to cover US and other International in one step — especially helpful for those who pay commissions to buy/sell ETFs]

And that’s it. This is the Canonical Portfolio, a generally agreed-upon mix that will serve you well2,3.

However, there are lots of different points of view and thoughts on what should be in an index fund portfolio, and I had to do a fair bit of thinking on the various options when writing the book. Everyone has their own thoughts on what a passive index-based portfolio should look like (or even multiple such portfolios), and what rules of thumb should help determine the asset allocation (with many using fixed allocations and the usual “adapt as needed” disclaimer), and how fine the distinctions and allocations should be cut.

My guiding principle was that I wanted it to be easy to follow, simple, and not confuse readers while still capturing the kinds of investments that it needed to. Basically, to make it as simple as possible but no simpler. It’s also important to be able to explain in clear, simple terms why someone should pick one option over another when there are choices to be made. So in the case of covering the spectrum of Tangerine through TD e-series to Questrade I could do this: there is a clear trade-off between complexity and cost. But for asset classes beyond the basic four I could not come up with such a rule, and did not feel that the Tangerine or e-series methods were lesser portfolios for their lack of emerging markets or other asset classes4.

The top categories in investing — the unanimously agreed-upon eigenvectors of investing — are the ur-classes of stocks (risky stuff) and bonds (safe stuff). There are many sub-divisions and combinations of these, which we’ll get to, but clearly having some of each is a vital part of a decent portfolio. Precisely how much is a tricky, individual question of risk tolerance and time horizons, but the simple age-based rule-of-thumb should get you close.

Then for risky stuff the first complication is that we need to get international diversification: nearly5 everyone writing from a Canadian point-of-view agrees on this point. How much to weight the US, rest-of-world, and Canada is again tough: some home-country bias makes sense, but we are only a tiny part of the global economy. An even split is a compromise that’s easy though, so that’s what I recommended, and some Vanguard research seems to back that up as coming within a reasonable range (and still more broadly diversified than the typical Canadian investor).

The US is an obvious choice for international diversification, with the rest of the developing markets tracked by the FTSE Developed Ex-North America (formerly MSCI EAFE) index as well-accepted options. And this is indeed what I have included, and products to invest in each of these categories are available through each of the methods I cover in the book: Tangerine, TD e-series, and ETFs.

Beyond that it gets increasingly grey.

In the next post, we’ll go through a few of the other asset classes I considered mentioning in The Value of Simple but ultimately decided that they would not sufficiently serve the readers to include.

1. Or just one fund at Tangerine with the four classes contained within. And Vanguard also introduced it’s all-in-one ETFs.

2. This is not a rigid prescription, and as unhelpful as it is to say, you will have to adapt it to your own circumstances and inclinations: for instance, you may be more or less conservative than the age-based bond allocation would suggest.

3. Coming up with a clever name is apparently de rigueur: CC did it with the Sleepy Portfolio and (similar to the Canonical Portfolio), and CCP did it with his array of 7 model portolios (also found at the end of the singularly titled “MoneySense Guide to the Perfect Portfolio” or MSGttPP). I had originally called this the Doctor’s Portfolio, but no, that’s a rubbish title, forget that title… and it’s not about making it eponymous. Canonical, for those who don’t use the word as regular parts of their vocabulary in reference to sci-fi plots or physics, means standard, accepted, etc.
Edit: CCP has updated the model portfolios in 2015 (a week and a half after this was published) to remove much of the confusion and cutesy names — all of the model portfolios are now very closely aligned with the Canonical Portfolio.

4. This is a real concern: I don’t want people to feel pressure to move up to a more complicated ETF portfolio because of fear that they’re missing something major with TD e-series or Tangerine.

5. Larry MacDonald being the main Canada-only holdout.