Blessed by the Potato

CBC Marketplace recently ran an episode looking at financial “advisors”, sending a woman in to several with money to invest and a hidden camera that has made some waves. Some advisors were ok (which of course didn’t air), but there were some that were just atrocious. They provided shockingly bad advice, or couldn’t answer simple questions about how much they were paid and what fees would be.

I don’t know how the advisors were selected: the show gave the appearance of picking randomly from large firms, but they may have been tipped off about bad ones in advance. The industry has tried to couch this as just a case of running into a few bad apples, but as Sandi says, that’s a load of bull and lets them continue to get away with a broken model for the industry. Some of them were so bad that a bad apple metaphor doesn’t cut it, but rather one with a grenade in it. That should never have happened.

Yet such incredibly bad advice is not so unusual — the system and the major firms do not set a high bar for financial advice.

This is a major issue. Financial advice/planning has a large impact on people’s lives, yet conflicts of interest abound and problems take years to show up. Moreover, people who need advice largely do not have the ability to evaluate the quality of their advisors (even with the benefit of hindsight), so recommendations from friends are basically useless. Combine all that with hidden and confusing fees, and this is an industry that cries out for regulation. A we-can-do-better retreat and voluntary code of conduct is not going to cut it.

Regulation can come in many forms: the government can step in to regulate from the top down, or industry groups can self-regulate. Often a hybrid emerges, where the government will help legally protect a professional title, and members of that organization will self-regulate.

Right now, the conflicts of interest inherent to the existing salescritter-cum-advisor model are making it to the public consciousness. That erodes trust in the whole system, yet there’s very little in place to replace it.

Here is the central issue as I see it: the system needs to be reformed so that someone with no knowledge and no way to evaluate quality in advance can go to get advice from someone and trust in that advice (and get reasonable value for the fees that they pay while they’re at it). And really the best way to build trust for the lay public is to have a trustworthy expert give the thumbs-up — that is, regulation.

What does good regulation look like? There’s some kind¹ of quality standard set, with a mechanism to get it there in the first place (training, examinations). There’s a mechanism to maintain quality, through reducing conflicts-of-interest; ongoing training and continuing education; ongoing oversight, evaluation, and auditing; and even formalized specializations. And a way to make things right when the few bad apples inevitably get in: dispute resolution mechanisms, compensation funds. In return, a profession gets formalized and protected credentials and naming rights. Culture is important: a focus on ethics and client needs, on openness and honesty.

Not every element is required there. And government isn’t necessarily required: creating a brand that people can trust can also work. That can be a faster approach to get started, but doesn’t carry as much weight without the government behind it. In the next post I’ll look at some examples of professions that are out there now and how they are regulated. In the meantime, check out this week’s BecauseMoney podcast where I discussed this issue with hosts Sandi Martin, Jackson Middleton, and special guest Noel D’Souza.

1- actually the quality standard itself is important too — it should serve the right people (i.e. the public rather than the banks), have associated metrics, be achievable, consider structural issues and conflicts-of-interest, etc.

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.

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.

[Update: this post appears in the Carnival of Wealth, Dollars to Dollars Edition]

Here is how many people plan for retirement (and many similar activities that involve projections): come up with reasonable estimates of the relevant parameters. Plug it into an online calculator or spreadsheet to do the math. Have a cookie.

Yet you really can’t just say that the average investment return is 6%, your average spending needs are $40k/yr and inflation will hit 2%, plug that into a spreadsheet, and call your financial planning exercise completed. That might be your expected, most likely outcome and an excellent start. You can plot it for a nice, smooth exponential growth trajectory like this:

A very comforting graph: continually saving money, making steady returns, you move smoothly towards your retirement goal. While your future might have a good chance of looking something like that, it’s highly unlikely to be precisely like that. There’s a whole range of possible outcomes. So we don’t want to just plot the course that’s going to get us there. Take a few minutes and add a “95%¹ best case” and “95% worst case” projection. How would those scenarios affect your plans?

That’s a fair bit better: you have some idea of the range of future outcomes, and may even be able to say how those might compare to what you’re willing to accept, and set some limits and guidelines for your future course corrections. Maybe if by year 5 you’re closer to the bottom line than the middle one, you’ll increase your savings rate to compensate. But even that is not really capturing the uncertainty and more importantly the variability ahead. There’s a big cloud of probability around the outcomes, and this is just a small, simplified part of a projection to retirement.

Maybe describing it as a cone of probability is a better way of putting it. This helps visualize all the uncertainty that we face going into the future. Note that I made the bottom edge creep up over time; this works with some recent posts by Michael James about stocks becoming less risky over time. Next year the market could be down 50% in a repeat of 2008, but 30 years from now it’s very likely that the market will be up. Up less than your projected 6% real return perhaps, which could be a challenge to your initial plan, but up nonetheless.

Because the future is so inherently uncertain, I generally tell people with a lot of future ahead of them to not sweat the fine details: tweaking your asset allocation to the last half a percent really won’t matter when you can only guess at future returns to plus or minus 5% CAGR over 30 years. Control what you can (keep fees low, save some decent amount of your income, start early, don’t panic), and be prepared to be surprised and make adjustments. Get started in approximately the right direction, try to keep moving in the right direction through an iterative process, and try not to fear the uncertainty. Uncertainty is a fact of life. The future will — at best — only look approximately like how we imagine it will.

That’s a tough, uncomfortable concept for many. We demand rigidly defined areas of doubt and uncertainty! The unknown is scary and foreign and weird, and people just don’t like the unknown; uncertainty looks a lot like that with some kind of math mixed in (which is frightening and uncomfortable in its own right). As terrifying as this is going to sound: you can’t hide from uncertainty. That’s just the nature of life (and if it was less uncertain it would be boring).

A plan that includes a big cone of probability and uncertainty may actually be more useful than one that pretends there is no uncertainty in the future, though the single line, ever-upwards trajectory was a lot more appealing to our baser selves.

Podcast podcast podcast! In case you missed it, we talked about these issues (and I unveiled these terrible excel/photoshop hybrids) in the because money podcast earlier in January.

Footnote: pardon me for using photoshop to make the probability clouds. I should have used MATlab or something with an actual Monte Carlo simulation, but I don’t actually have it on any of my current computers — I’d have to go fire up my ancient Pentium 3 system as it’s the only one left in the house that still has MATlab and Maple. The consequence is that the clouds are not particularly accurate, and aren’t as much like cones as I would have liked. Hopefully the visual still works for you.

1 – By which I mean in a stats sense your 95% confidence interval — or in a more plain language sense — aside from a few extreme cases, the range your results will most likely fall within.

Preet Banerjee has a new book out called “Stop Over-Thinking Your Money!” (subtitled “The Five Simple Rules of Financial Success”). It’s at the pay-down-your-debt, balance-your-budget level of personal finance, so if you’re a regular reader here it may not quite be your speed. It is very approachable and light, so if you do need to find a first introduction to personal finance, this is a good choice. Preet starts off talking about what you need to get an “A” in personal finance vs an “A+”. I’m an academic so that kind of thing appeals to me, but from many of my students I think he maybe should have pitched it as what’s needed to get a “C+ and drunk”. And I do mean talking: he has a very conversational style, and encourages readers to tweet him as they go through the book. That’s also going to make it easy for a beginner to get into it.

I really liked this part on debt:

“Something to consider when you borrow money from a bank is that you aren’t ultimately borrowing money from the bank. You’re borrowing it from your future self. The bank is just the middleman between the two of you, and it charges interest for its services. […] Think of borrowing money as negotiating a pay-cut with your future self.” [emphasis as published]

Preet’s a car guy. Back when he had a regularly updated blog he’d often post racing videos, including a few of himself zooming around a closed track. This comes through in the book, as every other metaphor for life, spending, budgeting, or getting out of debt is related back to driving a car (or owning a car, or a car loan). If you are also a car guy then this is a great choice: you will find it extremely relatable, enjoyable, and relevant. If you are not a car guy, it will still be relatable — it’s not a terribly obtuse metaphor — though like me you may notice the prevalence of cars.

With a minimum of spoilers, the five rules break down to:

1. Disaster-proof your life.
2. Spend less than you earn.
3. Aggressively pay down high-interest debt.
4. Read the fine print.
5. Delay consumption.

In my book, I start off with a disclaimer that you should have these basics down (or something like them) before getting into the investing part I write about. Before I get into the more critical part of the review you should know that I’m going to add Stop Over-Thinking Your Money to the list of books to read before mine. So yes I liked it, but years of science and editing have hard-wired my brain into reviewing critically. Though Preet sent me a copy for free, it wasn’t to “blurb it”.

Disaster-proofing your life is a great place to start a book on personal finance. But in this initial a chapter on disaster planning, Preet spends 19 pages talking about insurance, and 5 pages on emergency funds. That’s a lot of focus on insurance, especially relative to emergency funds (and nothing on cash, lines of credit, or bottled water). This is something I should break off into its own post because I’m something of a bete noire of life insurance in personal finance blogging, so I will stop there. For all my quibbles on the relative emphasis of disaster-proofing components, Preet does an excellent job talking about insurance in this chapter. He goes into the issues with underwriting, with getting insurance at a young age and having the option to renew, and powers of attorney — all without it becoming a total snooze-fest (seriously!).

The other simple rules were inconsistent in the detail provided: Rule 4 was just 6 pages with one detailed example, and another brief one called up from Rule 1. I liked the discussions in Rule 5, particularly about renovations, but thought there was a lot of ground left to cover when it ended. In debt reduction he talked about methods like the snowball, but didn’t really go into much detail, just recommending Gail Vaz-Oxade’s book. He does mention the point he made in his TEDx talk about how people magically manage to run a balanced budget as soon as their ability to borrow more goes away, but it’s not made nearly as elegantly or persuasively as it was on the stage.

The 5 rules are just the first half of the book to get you ready for the investing part, which occupies the second half. I found the second half a little inconsistent in the level he was explaining things at. He fully explained the “all your eggs in one basket” metaphor (seriously: “If you have six eggs all in a basket and you drop that basket, then all your eggs are ruined. But if each egg has its own basket, then your chances of dropping and destroying all your eggs declines dramatically.”). But then he uses terms like standard deviation without defining them and only obliquely defines stocks and securities (several pages after starting to talk about them).

“Generally speaking, people put too much equity in their portfolio.” I haven’t really seen that myself, I’m usually trying to talk people into higher equity allocations — there’s so much risk aversion out there and stocks are tainted with the stigma of being unknown and weird. That might just be our different experiences: I tend to interact with young people just starting to learn about finances and investing, or else those from the research and health care fields, while his experience in the finance world (at Scotia with dimensional funds and Pro-Financial Asset Management) may have been with more serious investors. I loved his viewpoint on the investor risk questionnaires, how some people try to pick what they think the “correct” answer is to being a good investor, rather than what their actual risk tolerance is. Of course, it’s also just that you think you can tolerate a lot more risk when things are calm, only to panic when TSHTF.

A long chapter called “insurance 101” with graphs and percentages covering how payment leveling works and how the insurance company makes money off the arrangement concludes the book. I had trouble understanding why it was included — there’s already a really good, detailed section on insurance up front. Why so much granular detail on insurance, when nearly everything else is glossed over?

There are a number of comparisons to weight loss and dieting in the book. There is a lot of merit to that analogy: meeting a budget is fairly similar, whether it’s a calorie budget or a dollar one. The concepts and the math are not difficult, it’s just a matter of discipline. However valid it is, I don’t think it’s such a helpful comparison to make. Eating right and staying in shape are notoriously difficult in practice. I don’t think finances and saving are nearly as challenging — a point Preet himself makes on page 3 — so hammering on this metaphor may demystify finance but make many lose hope for actually managing to stick to the principles.

Preet makes the case that you don’t need to put in a ridiculous amount of work to get an A+ in finance if you can stop over-thinking your money to get an easy A. The book is a breezy read and hits the major points so it’s easy to recommend for beginners. But I’d say that “easy A” is a B- at best: many how-tos are missing, which is odd given the bang it started off with on insurance detail; core areas of personal finance like taxes, downpayments, RESPs are not mentioned at all; and Kerry Taylor gets as many mentions as retirement (pensions/CPP: not at all). There’s such a void in this segment of the personal finance education: there are a metric crapton of books for those who are in debt to their eyeballs, and even more investing tomes for those who have the basics figured out, but not much for those just starting out and needing a gentle introduction to getting their house in order (indeed, really the only other one I consistently recommend is The Wealthy Barber Returns). So despite all my (hopefully constructive) criticism above, there is a group of people out there who have an unmet need for a book like this.

Giveaway: Preet gave me a review copy, which I will pass along to someone in gently used condition. Between Feb 6 and 15, I’ll randomly select from comments below that:
1. Say which city and province they’re writing from [Canadians only; GTA-north or Discovery District-area people will get it hand-delivered because I’m too cheap to pay for shipping if I can avoid it and Preet didn’t bribe me even a little bit for the review].
2. Include a 20-200 word discussion on what state their finances and/or financial knowledge and/or that of their friends are in now and/or what simple rule of financial success you would have put in the book [this will be your skill-testing question and human filter].
3. Indicate whether they want the book for themselves or a friend.
4. Are received by 11:59pm on Wednesday February 5th, for whichever time zone my blog server decides it wants to be in that day.