Blessed by the Potato

My mom and my aunts were quite concerned with my grandfather’s mental state as he aged. It was becoming clear that he was suffering from the onset of dementia and cognitive impairment (Alzheimer’s specifically), but nobody knew what to do. Most of the time he was fine: dementia isn’t a one-way slide into a mental fog, it’s got its good days and its bad. And living out in the country, just him and my grandmother, driving was an essential part of their lives. Yet clearly ensuring a 3,000 lbs guided missile was always safely operated was a priority for the safety of him and everyone else on the roads. Any discussion of selling the car or turning in his license was a major fight though, with nothing but hurt feelings all around as the girls found themselves up against an immovable object time and again, and not really being sure themselves how essential it was to “ground” him. Then one day while driving he merrily crossed to the other side of the road and sped along, completely oblivious to the fact that he was going the wrong way. Fortunately the lack of traffic on a PEI rural highway meant no one got hurt, and that incident galvanized my aunts and they made him give up his license. Since then, the issue of people being competent to drive has entered more prominently into the national consciousness, and Ontario for one changed its licensing so that seniors had to take regular renewal exams, and made it easier for physicians and family members to report a potentially dangerous driver.

Driving is so contentious because it’s so closely linked with a person’s sense of freedom and mobility; many even view it as a right. Yet it is also visible: you can tell when your parents are uncomfortable heading out at night or in the rain, and you might be in the car when you notice them run a red light, take long enough to get going at a green light that the queue behind them is honking angry, or cross over to drive on the left. Some new technologies like lane keep assist can help improve the margin of safety and keep them driving longer, but you know that one day the decision will have to be made.

Less discussed is what happens to a person’s finances. Even aside from being capable, do they have the interest in rebalancing funds in a passive portfolio? Are all the bills getting paid on time, or are some slipping through the cracks? It’s a much tougher nut to crack: we face significant societal taboos to not discuss finances or mental health, and unlike driving there are no innocent bystanders being run down nor are the problems visible. Also unlike driving, finances can be handled at your own pace, and you can wait until you’re having a good day to deal with them (and for the most complex investing decisions, one day per year may suffice).

Still, the major question is: when should you get help? A DIY approach saves fees and doesn’t require a ton of specialized knowledge, cat-like reflexes, or time invested. The right approach (keeping things simple, following evidence-based best approximations, controlling what you can and letting the market do the rest) can be successful and easy. But it still requires some attention, some decision-making, and some knowledge — and does leave you open for losses if mistakes are made. There will quite likely come a time when some help is needed.

I think a formal, painful process is the way to go. Decide, years in advance while tempers are cool and minds are sharp, what will be the criteria for needing help (family meeting, majority rules? Professional assessment*?). Identify what form that help will take (complete control, advice, double-checking) and who it will come from (relative/friend, professional advisory firm). Perhaps see a lawyer about a conditional power of attorney (IANAL). Yes, it will suck all the fun out of Christmas dinner this year, so maybe combine it with your other painful but necessary family talks that you’ve been putting off (organ donation: take ’em all; life support: trust the EEG and don’t save a vegetable; toilet paper: goes over the top).

While investing seems like the bigger risk — so unfamiliar and rarely encountered — regular monthly bills, credit cards, and chequing accounts can potentially be bigger sources of losses if ignored or mishandled. Systematic withdrawal plans can also simplify and remove execution risk on the investing side (as can automated bill payments on the household management side). Reducing leverage and transitioning to less-active styles are also good ideas (if you used those in the first place).

It’s also a helpful process to go through so you consider what will happen if you die. In that case I think it’s easier** — your non-DIY-investing spouse may need a plan or annuity to help them cope, but at least the situation is a little more cut and dry: you don’t start off arguing about whether or not you’re dead and capable of continuing to manage your affairs, and everyone will know to swoop in and offer to help in that case (and you’ll have a capable executor named to help out, right?).

Not that I’ve actually done any of that with my parents, but I keep meaning to.

* – Note that this is not likely to happen promptly (avoiding the doctor, visiting on a good day, reticence on the part of the clinician to diagnose cognitive impairments)
** – Yes it sounds wrong.

I could fairly accurately define a mortgage as a loan that represents the very largest amount of money a person can possibly borrow and still expect to pay back. Though they are thought of as the safest kind of lending, when put in this light you can see that there is the potential for risk: the amounts are large and the timescales long.

If I were to try to create some way of predicting who would be a good credit risk, I would probably look at the household budget: how much money comes in, how much do they spend on what, and from there try to figure out how much that household could afford to put towards their prospective house purchase. Then, I’d have a few thousand potential scenarios with a number of important parameters — periods of unemployment, new children, interest rate changes, stock market returns, inflation in other spending categories, house price returns, etc., etc. — and run some Monte Carlo projections to see how likely this borrower would be to pay me back even if stressed.

That would probably give me a pretty good idea of who I could lend money to. But it is an absolutely ludicrous practice to think about for the real world. Firstly, there is going to be a lot of uncertainty: what if the borrower wanted to defraud me into giving them more money (or “soft fraud” so they could buy more house sooner) and under-stated how much they spent on food, vacations, and Halloween decorations so it looked like they could handle more mortgage than they really could? How would I ever collect and verify all the information they gave me to go into my model? Secondly, I will likely not be the one out vetting prospective borrowers and collecting their information, it will likely be someone who has a high school education (or a liberal arts bachelor degree) who has never heard of a Monte Carlo simulation working in the customer service part of my bank¹. My “mortgage specialists” likely couldn’t figure out their own detailed household budget, let alone audit a potential customer’s.

So I want something else that is going to be a pretty good predictor of ability to pay that will also be easy to verify and easy to apply by minimally skilled staff. And when you boil it down there are basically two things that are rather good predictors: how much money you’re making (income) and how much money you already have (down payment).

A larger down payment will mean that you’ll need to borrow less, but it also demonstrates that you have the ability to stick to a budget and save (or relatives who at some point did and liked you enough to give it to you). It gives you “skin in the game” — you’re much less likely to walk away from your house after a 20% downturn in prices if you put 20% of your own money into it. 20% is the cut-off, by the way, below which you must have mortgage insurance for a bank to lend to you

More income means of course that you have more money to pay the monthly bills to service your debt as well as keep the house properly maintained, etc. The question though is what criteria do I set for “more income”? There are many options, so we’ll have to think about what aspects of the problem to consider.

We could simply set a threshold of price-to-income: say you can get a mortgage for 5X your income. So if you had a $50,000 income you could only qualify for a $250,000 mortgage. But a mortgage is so long-lived that the interest rate that applies greatly affects your ability to afford it. At 10%, the mortgage alone would be over half your income, while at 5% it would be just over a third. At 20% it would take everything you had. Interest rates are one aspect to somehow build into our metric then.

So instead of comparing to the total mortgage amount, we could compare to something that more closely mirrored income: the debt service costs — which, if you’ve read ahead, you know is what banks currently do. There are some problems with using debt service costs: because they are interest rate sensitive, you might give out too much money during times of low rates. This was only recently (and only partly²) fixed by introducing the concept of the qualifying rate: your loan is tested against an interest rate of 5.4%, even if you’re able to borrow at 3%.

If we’re using the monthly cost, then we just need to come up with a rough average household budget, figure out how much money can go to the mortgage versus everything else, and we can set up a fairly simple multiple test for our front-line bank staff. But there are some wrinkles to iron out: there’s a big difference between how households split their budget. When I was in grad school, almost 80% of my income went to rent. Food, rent, utilities, and transportation were pretty much the only expenses I had — I was dependent on gifts for clothes and entertainment. Clearly, the average household can’t afford to allocate 80% of their income to housing expenses.

If we look at some hierarchy of needs, shelter is up there, and if you don’t pay your mortgage you could lose your shelter. But it can take 120+ days for the bank to evict you if you skip your mortgage payment, and you’re hungry now. So food expenses, the transportation costs to get to work, and certain addictive vices (smoking, drugs, World of Warcraft) may get paid first. So if we say it takes about 15% of the household budget to cover that, then we can say that debt service costs can occupy the next tier of the budget. But not the entire rest of the budget — we want a household experiencing some stress (perhaps one wage earner out of the work force) to still be able to make those basic needs and service their debt — and an un-stressed household will still have other uses for money (vacations, saving, other discretionary spending), so there has to be headroom there.

Exactly how big that tier should be is a good question and I can’t really answer it from first principles. But the banks and CMHC have come up with 32% for debt servicing and that looks to be roughly in the right range.

Then the next question is what do we use to measure income? After-tax income makes a lot of sense: that is, after all, what you have to actually spend. However, it gets back to our initial problem of trying to make the model too good complex: how do we verify after-tax income? If you’re about to buy a house you might be putting as much as possible into your RRSP, with the intention of using the Home Buyer’s Plan. Those contributions make more of your income tax-free, making your after-tax income look bigger. But will that rate of RRSP contributions continue once you buy the house? What of all the other tax credits and deductions?

Gross income, on the other hand, is fairly easy to verify: an employment contract and/or T4 slip will do it. No fist-fights break out in the bank offices over what should be considered an eligible, sustained deduction, no shoe-boxes full of receipts to dump on the desk. Self-employed people will have trouble with either measure, so forget them for now.

Another advantage of using gross income rather than after-tax income is how it scales: people with higher incomes are able to put more of their budget towards a mortgage if they so choose, because the very basics (food, etc.) are covered by such a small part of what they make, so more of their salary is truly discretionary. They’re also taxed more. If the criteria is 32% of gross income, then someone making $40k and paying an average tax rate of 15% would be able to take on $12.8k/yr of debt servicing costs, and have an after-tax income of $34k to pay that — it works out to 37.6% of their after-tax income. Someone making $200k might have to pay 40% in tax, so their $64k in allowable debt servicing would be 53% of their after-tax income. A fixed ratio of gross income leads to a sliding scale for after-tax income.

Ease of verification, ease of calculation, some prediction of credit risk, and some modest scaling with income actually make the gross debt service ratio a pretty good choice for qualifying people to borrow.

There are still some weaknesses with it, in particular with how interest-rate sensitive it can be. Using a conservative qualifying rate helps mitigate that to a large extent, so I don’t know why there’s a loophole for the most popular kind of mortgage around (5-year fixed). Down payment is a little more straightforward. 20% is, roughly speaking, enough to weather a mild downturn and have enough capital to cover transaction costs if you need to bail. But providing mortgage insurance complicates things: being able to buy with no capital is an accelerating factor for bubbles, and is strongly predictive of default risk[3].

I’ve suggested some simple, easy to apply rules to modulate mortgage insurance: cutting back on the maximum price, scaling back on maximum loan-to-value or increasing the cost of insurance depending on price history, price-to-rent, or affordability metrics could help cool a bubble before it gets dangerously inflated⁴. However, that would require different rules for different cities depending on local economic conditions, and that doesn’t seem to be politically tenable for the CMHC, even though the rules could be made simple and transparent enough that it would be clear that no particular region was being targeted.

I don’t have a time machine or internal CMHC documents to explain it, but that’s my best guess for why GDS is used as the qualifying metric.

1. In this thought experiment I have a bank. I don’t really have a bank; I don’t even have bank stock.
2. A gaping loophole in the qualifying rate is that you get to side-step it if you lock into a 5 year mortgage (or longer), as most Canadians do. Then you get to use your contracted rate. These loans should also be tested against the qualifying rate for conservatism’s sake.
3. In all the research I’ve done, down payment/equity/LTV appears to be the second-strongest predictor of default after credit score.
4. And provide automatic, measured stimulus in a correction. Lean into the wind to introduce some negative feedback (negative is good).

In almost all of my rent-vs-buy comparisons I have the renters invest their capital and ongoing savings, including in my most recent one about the three year condo holding (Toronto Condos: Best Case Scenario). Note that the renters didn’t have to in that scenario: the buyers lost so much to frictional costs¹ and higher ongoing costs² in their short foray into condo life that the renters could have left their cash in a chequing account and still come out ahead. But I had them invest it anyway because that is what you’re supposed to do. It didn’t hurt that doing so helped hammer the point home, making the spread in outcomes so large that you could be especially generous to the buying case (e.g. assume they were prescient about their mortgage needs rather than acting like a typical buyer) and still conclude that renting for 3 years is hardly throwing your money away — it’s the opposite. But that’s not why I chose to: it’s my default recommendation and assumption.

On Twitter, @barrychoi questioned the assumption that the renters would invest their capital. I wondered why you wouldn’t, to which he replied: “for time purposes. Is it worth risking your money if you might need that cash soon?”

Here is the thing, “need” and “soon” mean different things when you’re talking about housing. There are a lot of rules of thumb out there, but the general idea is that equities are volatile, while providing high return expectations. So you should invest money for the long term in equities, but not money you might need in the short term because you could be hit with a market down-turn just as you’re about to take your money out and spend it. The rules of thumb say money you need in about 5 years, or 10 if you’re really conservative, should be in something safer.

This is trying to take a heuristic shortcut to risk tolerance, but risk tolerance is made up of many components. The ability to recover is a big part of it, and it’s closely related to the time you have on your hands, which is where these rules of thumb are derived from. They’re also influenced by the history of the stock market and how long it may take to recover from a typical crash. If your timeline is too short, you could get unlucky and be caught in a crash just as you need your money, and have to eat the loss.

But when you’re talking about buying a house your timeline is not generally short: in the example David Fleming provided that inspired the previous blog post, the couple had been in a condo for ~3 years, and was looking to rent a slightly larger condo for another year or two before buying. Close enough to the 5-year rule of thumb to go investing the capital. In general, at the very least you’ll be signing a lease for a year, with a likelihood of renewing and maybe even having another rental stage before ending in your “forever house.”

Even if you’re not a housing bear³ and are just renting for a few years to avoid the ruinous transaction fees or until your career settles down enough that you have some certainty you won’t be packing your bags for the other side of the continent, you’re going to have a few years to play with. Just because the rule-of-thumb is 5 years doesn’t mean you’re insane to invest with a planned 3 ahead of you. Because if you are unlucky, you don’t need to buy a house on August 15th, 2016 like your plan says — you won’t vanish into a cloud of pixie dust and parental disappointment if you still have a lease on Tuesday — you can chill and rent for a few more years if you need to. Plans can be fluid that way, and that kind of flexibility is what gives you the risk tolerance to invest in equities.

Your plans are not set in stone, and the ability to defer your purchase date adds to your risk tolerance.

Aside from not needing to buy on a certain date, you don’t need a specific, immutable downpayment. If you invest a $100k nest egg, you expect that, with a 6% return, you’ll have $126k after 4 years when it might be time to buy. It could be better than that⁴, or it could be worse; uncertainty is something to deal with rather than fear. If you are unlucky and in four year’s time there is a terrible correction and you’re down 25%, well, you just lost $25k and it stings, but it’s not going to ruin your life. You take the reasoned gamble that you’re more likely to be up money by investing in equities for the next few years — and that, in advance, you’re not sure whether “next few years” will turn out to be 3 or 10. In many scenarios you will be proven right and be better off. But even if you do lose that bet, it’s not like you can’t buy a house at all, you just have to settle for less house or more leverage. Your original $100k (plus accumulated savings) might be enough for 20% down on a $500k place, but if you come to the table with only $75k you can still buy a house — with CMHC you can even still buy the $500k one from your twentysomething dreams. The risk to your life plans is not that large: it’s not a life-altering risk you’re taking, but a manageable financial one.

If you’re a housing bear like me and have recognized that with crazy price-to-rent metrics it just makes more sense to rent, then you’ll be doing so for as long as it takes. Housing corrections take years to play out. And a housing bust is almost never a “V-shaped” event, where you only have a few weeks or months to swoop in on cheap prices: once the excess comes out (which itself will be a multi-year correction event even in a crash with numerous accelerating factors like in the US), the market will very likely stay in “fair value” range for a few years. As a bear you may be living in a rental house that would sell for⁵ $500k in today’s bubbly climate. One day, if prices make sense, you might like to own a similar house, but it’s 30% over-valued. So you rent, invest, and get on with your life. But if the conditions have changed so that it’s time to buy then that house has likely come down over $100k in price — you’d still be way ahead even if you were unlucky in equities and lost $25k of your downpayment. And, if you want, you can keep renting for another few years to see if equities recover, knowing the house likely won’t. And conditions might not change: in which case your “downpayment” fund is really your “retirement fund” in a soft-landing world for renters.

Of course you invest it if you’re a housing bear.

So when you’re talking housing, you generally have some long timescales to play with. Maybe not the 10+ years needed for the chance of a negative outcome to go to nearly zero, but enough that investing in equities is not some wild, undisciplined gamble. Even a 3-year holding period has something like an 80% chance of beating cash. I think too many people are too afraid of uncertainty, particularly young people who have a lot of ways to recover from loss at their disposal⁶. Risk tolerance comes from many sources: you can be flexible with your timelines if needed, or adjust your expectations/budget. And you need a downpayment, not the downpayment you started with — ending up unlucky and losing a portion of your downpayment is generally a survivable event.

My dad taught me at a young age that you only put in the stock market what you can afford to lose. But the market doesn’t go to zero even in a bad crash, and the amount you can afford to lose is generally not zero even when you’re house-horny. So with that in mind I take acceptable risks to try to invest my money in a way that maximizes my expected value.

Plus I know that the risk I’m taking as a renter with equity investments is way smaller than the risk a buyer in today’s market is taking (both financially as well as to my future lifestyle and mobility options).

1: Realtor commissions, CMHC premiums, mortgage break fees, and possibly land transfer taxes (or the burning the opportunity to use the first-time buyer exemption later on a more expensive property), legal fees, inspections, and the inevitable over-spend on customizing (or as is often the case for new condos, finishing the job the developer botched).
2: The higher monthly costs to own (condo fees, interest, property tax, etc) that add up to more than rent, a renter can save in this market.
3: Why are you not a housing bear? Have you seen my spreadsheets? You must live in Hamilton… or non-waterfront Gravenhurst.
4: Indeed, I was more confident being fully invested in 2009/2010 coming out of a huge crash — with the valuations and recovery it seemed unlikely that a second major crash would take us yet lower. If, as in the previous example, someone had listened to me then but with $100k they’d have hit the $125k mark in just three years. Also, I’ll add down here in the footnotes that if you’re close to the CMHC threshold then the potential gain of going over the 20% mark might provide an added incentive — though the downside is there as well.
5: I refuse to say “worth”.
6: Again those are dodge, dive, duck, dip, and dodge… er… Wait, it’s: defer, earn, save, change expectations, leverage, and run crying to mommy.

A reader recently emailed me saying that he liked my investing book so much he was going to read it again after letting everything percolate for a few months. He wanted to know if I had a second edition coming out soon. It has been two years now since I wrote the book, so perhaps a revision is due.

I’ve given very nearly zero thought to a second edition: I have an errata page to catch the very few corrections and changes that cropped up, and other than updating the historical results for the past two years there really isn’t anything fundamental to change. That’s the beauty of a simple, passive approach. I might give it another round or two of editing/polish, and maybe add a graph or two, but nothing so major that I would go to the trouble of doing a new edition — it was intended to be timeless (also: sales have dropped to zero, removing motivation).

Reader feedback has been universally positive — it’s actually freaking me out. Most people (as expected) don’t write a review or pester the author, but a few have written back with brief notes of thanks or praise. No one has suggested changes, said that a part confused them, or that something obvious was missing. It makes me wonder if Wayfare wakes up early every morning to clear the inevitable negative ones out of my email and comment queue to spare my ego, as there’s no way nobody has wanted to complain that it was a waste of their $5, the world just doesn’t work that way. It may be due to the small sample size: even after two years I’ve still only sold a few dozen copies.

So an open question: what would you like to see in a second edition?

I cut a few chapters from the initial outline: I wanted to finish before my PhD thesis defense prep picked up again, and more importantly, thought it was vital that the book be short and approachable (unlike my blog). I figured there were numerous sources on the whys of investing and the indexing choice, and on budgeting, so I could focus on the missing component of the hows. One I’ve been thinking about has been expanding the single page on planning, in large part because I’ve had a few decent blog posts on the matter for material (including a rather important spreadsheet) that came out after the book was published. However, there are whole books on planning — whole careers on it — and it could rapidly grow on me to become a book in its own right, not to mention that it’s not really my specialty (maybe I can convince Sandi to co-author it and do most of the work?).

But maybe you think less is more: is there something that should be cut? Have other, newer books on the market supplanted the need for my book entirely?

Let me know what you think, what you want, what you never knew you needed until this one perfect moment of comment section inspiration seized you.

As an aside, PSGtDIYI (wow that’s an ugly acronym, no wonder I just call it the book) is self-published in electronic-only formats (though with a letter-sized PDF version for easy printing at home). That was in part to test the market before committing the time and resources to finding a publisher or making print versions — and the response was not strong enough for me to look into that further. But my dad at least thinks that this material would be better-suited to a print version, and suggested I do a small print run for it. Though I doubt a serious publisher would be interested in it (the format is too weird), that route might lend it some additional credibility. If nothing else, a print version is something I can give away to people who need it and they might actually read it. Very roughly speaking, I would likely need to charge closer to $10 for a print edition, even for a quick copy shop spiral-bound deal (and bear in mind it is a very thin book printed out, and many people value their books by weight). Thoughts on that?

Not so long ago, I read an article refuting efficient market theory, using the example of Tanzanian Royalty Exploration as a case of an obvious inefficiency. It’s a strange example to pick, because it doesn’t actually support the thesis.

A quick refresher: just over two years ago Sino-Forest was exposed as a fraud (at the time, alleged to be fraudulent). It plunged in price, losing some 75% in the first few days. Sino-Forest traded on the TSX under the symbol TRE. At the same time, a company called Tanzanian Royalty Exploration fell about 8% in a few days. It happened to have the same ticker symbol — TRE — but on a different stock exchange. The story was that in the panic to dump Sino-Forest, some people were entering the wrong exchange for the TRE symbol and accidentally selling off Tanzanian. Ha ha, crazy market, what a clear inefficiency! Tanzanian even went out of their way to change ticker symbols to avoid the confusion/stigma.

As cute as that narrative is, it hasn’t panned out: here we are almost two years later and Tanzanian has not come anywhere close to its May 2011 high. The drop co-incident with the Muddy Waters report on Sino-Forest could perhaps have been an inefficiency, but given the continued slide (now down 55% in two years) it appears as though it might have been a true, “efficient” decline after all. Perhaps the close timing and similar tickers are merely one of life’s funny coincidences. Nobody who identified the coincident ticker symbols and price drops at the time and assumed it was a market inefficiency made any money trying to play it. And I don’t think anyone using the example a year or more later is making a very strong case for active investing.