All Debt is Bad

There is no shortage of debate over whether certain debts are good or bad or whether there is even such a thing as good debt. Million Dollar Journey says that good debts exist, and Big Cajun Man comes down on the all-debt-is-bad side. I think a large component of the disagreement is semantic.

Debt comes paired with something positive. Borrowing to go to school gives you an education and a debt. The education part is good and the debt part is bad. When people say that this is a good debt, they mean that you’re better off with both the education and the debt than you are with neither. But by itself the debt is still bad.

So am I just playing semantic games? I don’t think so. By getting the semantics right, we can change behaviour in a positive way. We should say that debt is bad, education is good, and that (most of the time) the advantage of education outweighs the disadvantage of having student loans. Phrased this way, it’s clear that minimizing the debt is desirable. We can still have the education with less of the associated bad debt by living frugally while going to school.

Instead of giving students a license to spend by declaring student loans to be good debt, we should call the debt what it is: a necessary evil for those who don’t have the savings to pay for school. Student loans are usually worth it in exchange for an education, but you can come out even further ahead by spending wisely while studying to minimize the size of student loans.

So, I say all debt is bad. It’s just that sometimes the thing we get in exchange for the debt is valuable enough that it makes sense to borrow.

GIS Clawback

Conventional wisdom is that the Guaranteed Income Supplement (GIS) is clawed back 50 cents for each additional dollar of income. However, with the GIS top-up introduced in 2011, the total clawback rose to 75% within a range of income. This makes it even more important to take into account the GIS clawback when helping low-income seniors plan their finances.

Service Canada provides a set of tables to help seniors determine their GIS and Allowance payment amounts. These tables apply only to seniors who are receiving the maximum Old Age Security (OAS) amount. Starting with your yearly income excluding OAS, GIS, and Allowance, you can look up your monthly GIS or Allowance. However, the tables won’t give you a simple picture of how GIS works.

The Service Canada tables make it easy for seniors to look up the GIS payments, but they’re cumbersome for planning out different scenarios. Rather than focusing on yearly income, I prefer to think about monthly income. And for couples, instead of looking at their individual GIS payments, I prefer to look at their combined payments.

Let’s focus on Table 2, which gives GIS payments (including top-up) for married or common-law partners both receiving maximum OAS payments. Here is a simple rule that gives the couple’s combined monthly GIS payments to within $2 given their combined monthly income:

Combined Monthly Income (excluding OAS, GIS, Allowance)	Combined GIS
$0 to $336	$983 minus 50% of Income
$336 to $624	$1067 minus 75% of Income
$624 to $1822	$911 minus 50% of Income

Expressed this way, it’s much easier to see the 50% and 75% clawback rates. (This rule only applies to the current quarter (until the end of March 2013) because GIS payments rise with inflation each quarter.)

People with low incomes are often better off saving in TFSAs rather than RRSPs. The reason for this is because income from RRSP or RRIF withdrawals triggers GIS clawbacks. In some cases it even makes sense to collapse an RRSP and move the net withdrawal (after income taxes) to a TFSA. This results in extra income taxes but increases future GIS payments. The table above can be helpful in determining whether such a strategy makes sense.

Housing Affordability Metrics

Despite the fact that I’m interested in the debate about whether we’re in a housing bubble and whether we’re headed for a housing crash that takes down our economy, I have no opinion myself. I care what happens, but I don’t know what will happen. Two of my favourite writers on this topic are Larry MacDonald, who likes to shoot down housing bear arguments, and Potato, who likes to shoot down MacDonald’s arguments. I won’t enter their debate except to make some observations about housing affordability metrics.

Housing bears tend to focus on debt-to-income ratios. They look at how many years of income your mortgage (and other debts) represent. Of course, you can’t spend all your income on debt repayment; there’s interest to pay, and you probably need to eat. So, the actual number of years needed to pay off a debt is much higher than the debt-to-income ratio.

If we focus on just the debt-to-income ratio, the situation in Canada seems dire. The average ratio in Canada keeps hitting new records. What is saving us is the current ultra-low interest rates.

This brings us to the other housing affordability metric: payment-to-income ratio. Because interest rates are so low, payments are low, and this metric doesn’t look so bad. In fact, we’re only slightly above the long-term average payment-to-income ratio. If we focus only on this metric, all seems right with the world.

So, which metric is right? In an interview with Preet Banerjee, Ben Rabidoux says that in most centers “we’re still above the long-term norm in terms of the percentage of income it takes to carry a mortgage and that’s with record low rates.” To those who say that we’re only marginally above long-term trends of affordability, Rabidoux says “I don’t see that as a good sign because we really don’t have a lot of downside in rates right now and so when they inevitably normalize that ratio or that reading is going to blow out quickly.”

Rabidoux is right that payment-to-income ratio doesn’t tell the whole story because interest rates are so low. If rates were to rise even modestly, this metric would rise very fast. On the other hand, debt-to-income doesn’t tell the whole story either because it ignores interest rates.

The truth is that the real picture is somewhere between these two metrics. If you read any argument that focuses on just one of these metrics without observing that today’s low interest rates make the metric somewhat misleading on its own, then you should be doubtful of the writer’s conclusions.

Wasting Paper

Guess what’s in this picture.

I’ll give you a hint. It’s not a board for either of the old games Bridge-It or Chinese Checkers. It’s also not your skin after seeing an allergy doctor. Another good guess would be an overhead shot of one of those man-made forests with trees all planted in a grid, but that’s not it either.

It’s a pie chart of my asset allocation in an RBC RRSP. This account holds less than a dollar and it’s apparently 100% cash. I got a 5-page statement of my account. My wife got a similar statement for her pennies.

Way back when banks used to pay interest on cash balances, my wife and I cleaned out these accounts, but there was a small rounding error due to interest payments. Now we get yearly statements along with a newsletter containing RBC’s market outlook. I sure hope things pick up soon. My returns for nearly 20 years have been zero.

I keep thinking that one of these decades RBC will contact us about closing these accounts. More likely they’ll switch me to eStatements. At least then we’d kill fewer trees.

Short Takes: Tax Breaks for Disabled Children, and more

Big Cajun Man explains the steps to get tax breaks related to having a disabled child. Parents generally want the best for their children, including disabled children. Special schooling and other types of programs for these children can be very expensive. Taking advantage of all available tax breaks is important.

The Blunt Bean Counter looks at the important decision for small corporate business owners of whether to pay themselves salaries or to draw dividends. In part 2 he crunches the numbers, and in part 3 he explains further issues to consider.

Preet Banerjee interviews Ben Rabidoux in his latest podcast. The topic is the current state of Canadian real estate.

Retire Happy Blog gives some statistics to allow you to compare your financial position to averages, but goes on to explain the problems with this sort of comparison.

Jonathan Chevreau reviews the book Pound Foolish by Helaine Olen.

Casinos and Governments

Casinos are proof that governments love money more than people.

As the Ontario Lottery and Gaming Corporation (OLG) continues with plans to overhaul and expand their casinos and other gambling operations, I’m struck by how irrelevant it is to discuss whether this is good for the people. We debate the wisdom of making gambling available everywhere, but we always end up expanding more so governments can get more revenue.

I have no religious or philosophical objection to gambling; I enjoy a little gambling myself once in a while. But how many casinos do we really need so that people can satisfy their gambling itch occasionally? The answer is that this question is irrelevant. What matters is that expansion will bring in more money.

Never mind that casinos are a net loss to the country as a whole. Casinos cost money to operate, so government revenue is less than gamblers’ losses. Casinos create some jobs, but take away more jobs because gamblers buy fewer good and services. In the end, the net loss to the country is the diversion of human work from useful pursuits to running casinos. But none of this matters; governments need more money.

One of the most powerful arguments in favour of government-approved gambling is that without it gamblers will find ways to gamble illegally or in other countries. This argues for a modest amount of government-approved gambling to eliminate most of the gambling profits that would have gone to organized crime or other countries. However, if this were the real goal, then governments would run their gambling operations very differently and would advertise them much less.

Another common argument for government-approved gambling is that it supports hospitals. Who could be against hospitals? However, we could just as easily say that hospitals are funded from income taxes, and that gambling revenues fund less popular programs. The truth is that any difference between how gambling revenues and income tax revenues get spent is completely artificial.

Even municipal governments show their love of money over people. As an incentive to support the building of casinos, municipal governments are offered a slice of profits. The total amount of money leaving a city due to a casino far exceeds the slice of profits kicked back to the municipal government. But that doesn’t stop municipal governments from approving casinos; they want the money even if it hurts the city’s economy.

Government hunger for more money will not stop as long as they continue to run so inefficiently. Governments have bloated administrations in most areas and have too much duplication of effort. However, the biggest problem is the difficulty of firing people who are bad at their jobs. Unions present the image that their members are equal, but the truth is that some government workers are dedicated and competent, some are lazy and incompetent, and others have just had the desire to do good work drained from them by bureaucracy. The range is very wide.

If the problem of being unable to fire poor workers could be solved it would completely change the incentive structure of government and improve efficiency greatly. Governments would then be able to offer additional useful services or offer existing services at lower cost. A side benefit would be improved morale among government workers once they understood that competence is the best path to job safety. Despite the human tendency to be lazy, we are generally happier when we feel we’re contributing to an effort that matters.

Don’t hold your breath waiting for these problems to be solved. It would take a gargantuan battle with public-sector unions to make things better. Politicians have little appetite for such battles. It’s easier to just build more casinos.

Some Clarity for HST Complications

A few weeks ago, a reader I’ll call Jeremy asked a question about how to handle HST for a practice run with a partner I’ll call Sandy. Sales tax specialist Andrew Davis (contact details below) was good enough to help me sort out HST rules for Jeremy. Here is Jeremy’s situation:

Sandy runs a business in Ontario offering an HST-exempt service out of an office she rents. The service Jeremy offers is HST-taxable. Because Jeremy offers a different but complementary service to the public, Sandy suggested that Jeremy offer his service out of Sandy’s office space. To compensate Sandy for directing customers to Jeremy and providing office space, supplies, computers, etc., Sandy suggests that Jeremy pay her 40% of his revenues.

The complication comes with how to handle the HST. Jeremy must charge his clients the HST, but how should it be split between Jeremy and Sandy.

How to handle HST starts with exactly who is contracting with the customers. Here are some possibilities:

Case 1: Jeremy contracts directly with the customers in his own name. In this case Jeremy must collect and remit to CRA 100% of the HST payable.

Case 2: Sandy contracts directly with the customers for Jeremy’s services. In this case Sandy must collect and remit to CRA 100% of the HST payable.

Case 3: Jeremy and Sandy are in a partnership, and this partnership contracts with the customers. Then the partnership would be required to collect and remit 100% of HST payable.

The next level of complication comes when we consider the HST in the transactions between Jeremy and Sandy. Jeremy’s situation actually falls into case 1 above where it is Jeremy who contracts directly with customers of his service. So, we’ll focus on this case.

Although the arrangement is described as a revenue sharing arrangement, CRA would likely consider the revenue sharing as a payment by Jeremy to Sandy for a separate supply of the use of Sandy’s facilities. The supply of premises, administrative services, and other miscellaneous facilities are generally HST taxable. So, Jeremy must pay Sandy HST on these services, unless Sandy is a small supplier (definition here).

For this case, assuming that Sandy has no other HST-taxable revenue, she qualifies as a small supplier when she has charged Jeremy less than $30,000 in the past 4 quarters. If this is the case, Sandy is not required to register for HST but has the option of voluntarily registering. At this point, it’s useful to consider an example to see the implications of Sandy’s choice to register for HST or not.

An Example

Jeremy’s sales: $10,000
HST on those sales: $1300
Sandy’s cut of sales: $4000
Jeremy’s cut of sales: $6000

Scenario 1: Sandy does not register for HST

In this case, Jeremy collects the whole $1300 in HST and files an HST return declaring $10,000 in revenue and $1300 HST collected. He then either claims any HST input credits he has to reduce the HST owing, or he uses the quick method if he qualifies and remits 8.8% of the full $11,300 ($994.40).

Scenario 2: Sandy registers for HST

In this case, Sandy charges and collects HST on the 40% revenue charge for the provision of facilities (13% of $4000 is $520). Sandy files an HST return and may claim HST input credits against any costs relating to facilities provided to Jeremy to reduce the $520 owing, or alternatively she may use the quick method if she qualifies. Jeremy is still required to declare $10,000 in revenue and declare the full $1300 HST collected. Jeremy is also entitled to claim HST input tax credits of $520 which is the HST cost Jeremy paid to Sandy on the $4000 cost of Sandy’s facilities. In the end, Jeremy’s HST return will be a net payable of $1300-$520=$780 less any other HST input credits he has. Using the quick method is not to Jeremy’s advantage for this scenario.  Whether Sandy should register for HST comes down to whether Sandy has any significant HST costs associated with the facilities provided to Jeremy.

Andrew Davis is a sales tax specialist who works on his own. He can be reached at Tel.: 416-441-0698 or Cell: 416-817-6675. 

Disclaimer:  There is no financial arrangement between Andrew and me. He was good enough to help me sort this out and I acknowledge that help.

How to Calculate Investment Returns

Recently, Million Dollar Journey had a post showing how to calculate investment returns using the spreadsheet function XIRR. After reading a few questions in the comment section of that blog post and thinking about how I compute my own returns, I realized that this is trickier than it seems. This post gives step-by-step instructions (with actual spreadsheets) for how to calculate your investment returns.

Throughout this post I’ll use the following fictitious example of an RRSP account opened in 2011.

2011 Feb. 22: Open account and deposit $10,000 cash.
2011 Mar. 11: Buy 400 ABC shares ($23/share + $10 commission).
2011 Aug. 17: Deposit $2500 cash.
2011 Sep. 12: Buy a $3000 bond paying 2%/year interest.
2011 Dec. 30: ABC pays 50-cent/share dividend.
2011 Dec. 30: Bond pays $60 interest.
2012 Jan. 16: Sell bond for $2960 (includes embedded commission).
2012 Mar. 20: Withdraw $3500 cash.
2012 Dec. 31: ABC pays 55-cent/share dividend.

To compute yearly returns, we need to know the total account holdings at the end of each year. We can calculate the cash balance from the data above, but we need closing prices for all investments. To compute quarterly returns, you’d need account holdings at the end of each quarter. Here’s the data we’ll use for this example:

2011 Dec. 30: Account holdings
– $550 cash
– bond worth $3000
– 300 ABC shares worth $24 each
Total account value $13,150

2012 Dec. 31: Account holdings
– $175 cash
– 300 ABC shares worth $28 each
Total account value $11,375

I’ve created a spreadsheet that captures the account transactions without doing anything yet to calculate investment returns.

Calculating Returns

To understand how we calculate returns, it helps to think of an account (or collection of accounts) as a black-box investment. Money goes into and out of the black box, but the goings on inside the black box don’t matter directly, except for how they affect the amount of money that ultimately comes out. We record the money flow from the point of view of the investor who is outside the black box.

So, the initial $10,000 deposit is money out of your pocket, so it counts as minus $10,000. The $2500 deposit gets recorded as minus $2500. The later withdrawal gets recorded as plus $3500. It’s very important to get the plus and minus signs right; your results can be way off if you get any of them wrong.

Here is the part that may be tricky to understand: the purchase of the shares and the bond, the sale of the bond, the dividends, and the interest are all internal goings on that don’t matter. That’s right – they don’t matter. Remember to think of yourself as outside the account’s black box. No money left your pocket or entered your pocket for any of these transactions.

If we stopped here with just the 3 cash transactions, we couldn’t get useful results because we wouldn’t be taking into account the final account holdings. The idea behind the black-box approach is that the box starts empty, finishes empty, and we see how it performed in between. To do this we add a fake transaction that basically drains the entire account of the $11,375 it had at the end of 2012.

So we only need to take into account 3 real transactions and the final account holdings to compute the investment return. The spreadsheet function XIRR computes the account’s Internal Rate of Return (IRR) for us. Here is a spreadsheet that calculates the annualized account return for our example.  To edit any of these spreadsheets, you need to go to the “File” menu and “Make a copy”.

The annualized return over the entire period turns out to be 11.70%. The XIRR function is based on a 365-day year, so it will report slightly smaller than expected returns for leap years. I included a check column in the spreadsheet above. If an account charges (or pays) daily interest at a rate that compounds to 11.70% in 365 days with same cash inflows and outflows as our example, it should start and end with zero dollars. This is the definition of internal rate of return.

Calculating Yearly Returns

To calculate returns for each year, we need to break the cash inflows and outflows into separate years. To do this we need to add “Account Balance” entries at the end of each year. In our example, the account balance at the end of 2011 was $13,150.

But we can’t just pretend to take all the money out of the account and leave it that way. We need to pretend to put it back. I just put in a fake re-buy to handle this. So each account balance statement has a corresponding “Starting Investment” entry for the same (but opposite sign) dollar amount on the same day. The following spreadsheet computes the annual returns for 2011 and 2012 for our example.

So, we made 6.93% in 2011 and 16.38% in 2012. Once again, I showed the check column.

Note that because XIRR gives annualized returns, we didn’t actually make 6.93% for all of 2011. Of course, the account balance jumped around many times throughout the two years and so we were making these returns on different account balances each day; a balance of zero prior to 2011 Feb. 22 is just a special case of this account balance variation.

Returns for an Entire Portfolio

I tend not to worry much about the returns in my individual accounts. I treat all of my accounts as one large portfolio. So, I just include all the cash flows to and from all my investment accounts in one spreadsheet. This gives me annual returns for my whole portfolio.

That’s pretty much it. I discuss a few technicalities below that don’t affect most people.

Some Technicalities

Quarterly Returns

To compute returns quarterly, add in “Account Balance” and “Starting Investment” entries on the last day of each quarter. Then use XIRR in each quarter. But remember that XIRR gives annualized returns. If you then want the quarterly return, take the return r from XIRR and calculate (1+r)^(1/4)-1.

Taxes

It can be tricky to account for income taxes when computing investment returns on a portfolio that includes a non-tax advantaged investment account. I’ve done this for my own portfolio, but I find it challenging to think through how to properly handle the built-in tax liabilities of deferred capital gains and other tax complications. So, I’ll leave it to the reader to work this out for his or her own account.

Leap Years

You may want to adjust your returns in leap years for the fact that XIRR is based on a 365-day year. The difference is small and can be ignored for most purposes, but here is how to adjust for it: Take the return r given by XIRR and compute (1+r)^(366/365)-1.

A Rant about Dates

I found a misfiled receipt in the folder hanging next to my tax folder. It might have been there for a while – I’m not sure. I’m no fan of overpaying my taxes, so I looked for the transaction date to see if it’s from 2012 and I can use it in my next tax filing, or if I messed up on a previous year’s tax filing. A few seconds of scanning revealed

11/01/12

Seriously? Somebody thinks this string of characters conveys useful information. Or maybe this person just hates other people.

There are 6 possible ways to reorder the year, month, and day in a date. Fortunately, 3 of these orders are not in widespread use. The ones that are widely used are

year-month-day
day-month-year
month-day-year

So the plausible dates for my receipt are

2011 January 12
11 January 2012
November 1, 2012

So, either I messed up my 2011 taxes and can file an adjustment request, or I can use this receipt on my 2012 taxes. Great. Maybe I’ll try to invent some parallel-universe technology, try both approaches, and see how it all works out.

I know there are people who have strong opinions on the “correct” order for the year, month, and day. I care much more about clarity than some idealistic argument for the correct order. That said, here’s my pitch for year-month-day. We have a well-established standard for hours, minutes, and seconds. It goes from biggest (hours) to smallest (seconds). So, I like the following format going from years all the way down to seconds.

YYYY/MM/DD HH:MM:SS

Yes, yes, I know I used “MM” twice. But you know what I mean.

Let me repeat that while I like this format, I could live with just about anything that is clear. And by clear, I don’t mean a format that is unambiguous to a computer; I’m not trying to solve the upcoming year 2100 or year 10,000 problem. I want a person who knows the commonly-used date formats to be able to look at a date and read it unambiguously.

A starting point that helps a great deal is to use 4 digits for the year. I know this takes extra space, but there seems to be space on my receipt for 4 lines of text begging me to enter some idiotic contest. I could win cash prizes and all I have to do is give them a name, email address, phone number, and implicitly agree to endless email and phone spam.

When we use 4 digits for the year, the only possible ambiguity is with the month and day. We can resolve this using letters for the month. All of the following are quite clear.

2011 Jan. 12
11 Jan. 2012
Nov. 1, 2012

However, writing letters for the month and a 2-digit year is not good enough: 11 Jan. 12 is not clear. If someone insists on using numbers for the month, then the only order that is unambiguous is

YYYY/MM/DD

Many people don’t like this format. They are used to Nov. 1, 2012 or 11 Jan. 2012. That’s fine. Use one of these if you like. But unless you hate people, use 4 digits for the year and write letters for the month. Otherwise you’re making baby Jesus cry.

Short Takes: Reduced Spending in Retirement, Novel Mutual-Fund Marketing, and more

Rob Carrick discusses the fact that our spending tends to drop throughout retirement in a video interview with Fred Vettese, Chief Actuary at Morneau Shepell, Inc. Vettese quoted studies in Germany and the U.S. showing that our spending at age 75 is 20% lower than at age 65, and our spending at age 85 is one-third less than at age 65. Unfortunately, he did not give enough information to locate the studies. I wonder whether these studies took into account that people’s pensions decline with inflation and some retirees simply run out of savings. Declining retiree spending would hardly be surprising if the main reason were that their income declines.

Tom Bradley at Steadyhand considers a new marketing strategy based on how Steadyhand treats clients when they choose to leave.

Million Dollar Journey explains how to easily and accurately calculate your portfolio return using the XIRR() spreadsheet function.

Potato gives us some clear thinking on Canada’s high debt-to-income ratio.

Big Cajun Man explains the idea of cost-per-use of exercise equipment as a way to motivate you to use it more.

The Blunt Bean Counter suggests a number of things to consider in your will to prevent problems with the inheritance of your belongings. He also explains some of the ways an executor can deal with distributing belongings not specifically mentioned in a will.

My Own Advisor lays out his financial goals for 2013. I was happy to see that he included the goal to not take on any new debt.

Where Does All My Money Go? has some cool graphs showing that even while the U.S. debt has been rising quickly, the interest cost on that debt has been falling.

Larry Swedroe reports that hedge funds had yet another bad year in 2012.

High Debt-to-Income Ratio Dangerous Even for the Young

Much has been made of the fact that the family debt-to-income ratio has hit 164.6%. In a funny off-colour joke, Preet Banerjee made the point that this is an average and that young people tend to have a higher debt-to-income ratio than older people. Boomer and Echo made a similar point that young people tend to have large mortgages and that their debt-to-income ratio is misleading. I think there is truth in these arguments, but that young people need to be very careful using these arguments to justify taking on enormous debts.

An important goal is to eliminate debt before retirement. Not everyone will succeed, but we can expect the debt-to-income ratio for retirees to be low. Young people buying a house tend to start with large mortgages and smaller incomes than they will have later in life. It’s normal to expect that debt-to-income ratios will be higher among the young than the old.

So, young people whose ratio is higher than the national average can relax. But don’t relax too much. Today’s low interest rates make it far too easy to build huge debts on a modest income. Boomer and Echo use the following example.

“If you’re the median Canadian household who brings home $5,500 a month, you should keep your monthly debt payments under $2,200. This sounds pretty reasonable.”

Let’s assume that the debt payments in this example are split 80/20 between a 3% 25-year mortgage ($1760/month) and a line of credit ($440/month). This corresponds to a $371,900 mortgage, and if the LOC payments are 2% of the balance per month, the LOC balance is $22,000.

This household has a total debt of $393,900 and a yearly income of $66,000, for a ratio of 597%! I think this is crazy. A household in this position should be worried about possible interest rate increases, job loss, or a drop in their home’s value if they need to move.

It’s true that the national average debt-to-income level isn’t a good yardstick for young people, but being too far above this average figure is dangerous. Instead of trying to have everything at once, try easing slowly into a higher-consumption lifestyle. It’s possible to be happy with a modest home and a used car.

Crashing a Stock-Picking Contest

I have a habit of sticking my nose into a stock-picking contest several bloggers have been running for the past 4 years. Fresh from working out my 2012 return of 8.03%, I’m ready to crash their 2012 contest. Each year my actual portfolio return has been above average among the contest entries and this year is no different. (For discussion of the 2011 results see the last paragraph here, and for 2010 see here.)

The big winner this year was Preet Banerjee at Where Does All My Money Go? with a 35.6% return! In fact, Preet has the best 4-year record by far among all the bloggers in the contests. This is amusing because Preet seems to take it the least seriously. In one contest he “picked some three letter words at random and then found the ticker symbols to match those words.” With FUN, HAT, ADD, and CAR in 2010, Preet came in second place. His disclaimer tells people considering buying his picks to “RAISE YOUR RIGHT HAND BEFORE PLACING THE ORDER AND REPEAT, ‘I AM A NUTBAR’.”

So, how have my actual portfolio’s returns compared to the bloggers’ picks in these contests? Here are my rankings and comparison to the average blogger return:

2012: 4 above me, 6 below me, 5.3% above average
2011: 3 above me, 6 below me, 8.7% above average
2010: 4 above me, 5 below me, 4.3% above average
2009: 3 above me, 6 below me, 10.7% above average

Starting with $10,000 at the beginning of 2009 and dividing it equally among the blogger picks each year, the bloggers would have held $12,984 at the end of 2012. This same $10,000 in my portfolio would have grown to $16,869.

Does this make me a great stock picker? Absolutely not. My portfolio has been mostly in index ETFs. I was lucky that the few individual stocks I hadn’t got around to selling happened to outperform the index. The bloggers in the contest collectively failed to match either the S&P 500 or the TSX.

The funniest results come from a blog called Beating the Index (the web page on this blog discussing the results has disappeared, presumably out of embarrassment). This blogger has been participating for 2 years with the following results.

2012: -51.6%
2011: -44.1%

Beating the Index blames the poor results on the rigid contest structure that does not permit trading mid-year. About the type of stock he chooses, he says “This is a sector where you HAVE to be pro-active: cut losses and take profits.” We can only imagine what the results could have been like if trading were permitted. Instead of losing a cumulative 73% in 2 years, perhaps trading to a few other stocks in free-fall would have lost 90% or more!

All this brings to mind a variant of an old joke:

Q: How can you make a million dollars?
A: Start with a billion dollars and spend 10 years trying to beat the market.

Index investing may not be much fun if you happen to like analyzing stocks, but for most investors, sticking with indexing is more profitable.

My 2012 Portfolio Return

It’s important for active investors to carefully measure their portfolio returns periodically. If you don’t compare your results to an index, how can you know if you’re wasting your time or not? Mental accounting allows many investors to lose to the index but think they’re actually beating it. The only trading I do now is to add new money to my portfolio and occasionally rebalance my holdings to my chosen target percentages. But, I like to calculate my yearly returns anyway.

My 2012 portfolio return was 8.03%. This is less than you’d expect from an index portfolio given 2012’s asset class returns. My portfolio is 100% in stocks and is actually only just over 90% in index ETFs. So, you might suspect that the non-indexed part must have performed poorly this year. But, this isn’t the case. The only individual stock I own is Berkshire Hathaway which returned 16% in 2012 measured in Canadian dollars.

So, what happened? To start with, some of the best asset classes for 2012 were real estate, but I have no real estate in my portfolio. I have a mortgage-free home that has increased in value substantially in recent years, but I don’t track its value in my portfolio. Another effect that hurt my returns a little is that I have a modest small-cap tilt in my ETFs, and Canadian small caps actually lost a little money this year. A third effect was that I happened to add new money to my portfolio at a stock-market high point in the year.

None of these effects were large by themselves, but they resulted in a modest return this year of only 8%. Just to be clear, I did no active trading during the year. I just kept my portfolio percentages in line with rebalancing, reinvesting dividends, and adding new money. Holding Berkshire Hathaway stock counts as active investing, but I just held the shares through the year.

After my 2012 results, you may wonder: am I going to pile my money into real estate? Nope. Am I going to sell off my small-cap ETFs? Nope. Am I going to try to time my entry of new money into my portfolio better? Nope. I’m going to stick with my current plan and just add new money whenever I have money to add.

For many years I was an active investor. Have a look at my results from 1995 to 2011 compared to an index benchmark to see how I performed. I believe my results were just luck, which is why I now spend my time on more interesting pursuits than scrutinizing annual reports.

Market Outlook

Is there any phrase in the title of an article or a speech that signals useless content with higher probability than “Market Outlook”? No doubt clever readers could come up with some worse phrases. Hopefully, I’m not adding to the poor track record of “Market Outlook” with this brief article.

People worry about the future of their investments, their jobs, and the interest rate on their debts. When someone promises to predict the future, people listen. It doesn’t seem to matter that so many previous prophets got it all wrong; people listen to the next one anyway.

We’re wired to see patterns. The sun comes up each morning at a predictable time, and we expect this to continue. The problem is that we see patterns that aren’t there as well. When gamblers start winning money at a craps table, they think they’re on a “heater” and start betting more. But this is a case where patterns don’t really exist; past dice rolls tell you nothing about the future.

The movements of planets and stars are very predictable, but the economy and stock prices are not. If stock prices were predictable, then investors would already know which stocks are destined to rise, and they would have bid up their prices already.

The only way to get an edge is to know something that other people don’t know. Do you really think the market outlook section of your investment newsletter is going to tell you something that nobody else knows? Not likely.

I see little point in reading anything that starts with “Market Outlook” ... unless I wrote it :-)

Short Takes: Straight Talk on Mutual Funds, Advertised Mortgage Rates, and more

Rob Carrick gave us an excellent perspective on how the mutual fund fee structure was formed. One quibble I have with his prescription for the future is that I don’t see why trailing commissions should be replaced “with a fee that is set by the adviser as a percentage of the client’s assets.” Separating out the fees for advice makes a lot of sense, but I don’t see why these fees should be directly proportional to the size of the client’s portfolio. It isn’t 10 times more work to provide advice on a million-dollar portfolio rather than a $100,000 portfolio. Some costs are variable, such as potential liability for mistakes, and richer clients may have higher expectations. But, many costs are fixed. Rather than a fixed percentage advice fee, it makes more sense to charge a fixed dollar amount plus a smaller percentage. Advisors aren’t likely to think much of this idea much because dollar amounts sound big to their clients and percentages sound small.

Canadian Mortgage Trends reports that RBC and TD are competing a little harder with their advertised mortgage rates. The big banks tend to advertise mortgage rates well above competitive rates. I can see two advantages of this. One is that some people wander into a bank and actually pay the posted rate. I did this when I was young. Another reason is that tinkering with posted rates affects some interest rate differential formulas the banks use to decide how much they’ll charge you to break your mortgage. Hopefully, Canadian Mortgage Trends is right that today’s competitive pressures will force big banks to post more competitive mortgage rates.

Canadian Couch Potato explains how to compute your U.S. ETF returns in Canadian dollars. It’s nice to see writers show the correct way to “add” percentages when they need to be compounded.

Big Cajun Man has some fun with some sarcastic New Year’s resolutions.

Preet Banerjee explains why he mentioned the male appendage to Peter Mansbridge in his Mostly Money Mostly Canadian podcast.

The Blunt Bean Counter explains the value of maintaining separate credit cards for business and personal purchases.

Million Dollar Journey explains some of the ways that pension schemes calculate your starting benefits. Commenters added more useful insights into pension levels.

My Own Advisor is making steady progress toward his goal of earning $30,000 per year in dividends. I suspect he will have to increase this figure over time to compensate for inflation.

Some Economic Predictions for 2013

Fresh from my near random performance in 2012, here are some predictions for 2013. I’d prefer to convince people that economic predictions are useless no matter who is making them, but that seems mostly futile.

Without any serious thought and no confidence whatsoever, here are some random predictions.

1. Interest rates will go up a little.
2. Housing prices will come down a little.
3. Canadian and U.S. stock markets will have an above average year.
4. Bonds will have a below average year.
5. The U.S. government deficit will be less than the 2012 deficit of $1.1 trillion.
6. Berkshire Hathaway will have a strong year.

You might notice that 5 of these 6 predictions are the same as the ones I made last year. To that I say quit complaining – it’s not like this blog is behind a paywall.

Remember that financial markets already reflect a consensus of predictions. Trying to out-predict this world consensus is largely futile. Do not rely on my financial predictions or those of anyone else.

Evaluating My 2012 Economic Predictions

To start the year I made some random economic predictions with confidence level zero. Keeping in mind that you should ignore all economic predictions whether they are mine or anyone else’s, let’s take a look at how well I throw darts blindfolded.

1. Interest rates will go up a little.

Fail. The Bank of Canada target rate stayed at 1% throughout 2012.

Score: -1

2. Housing prices will come down a little.

Fail. According to the Teranet - National Bank Composite House Price Index, as of November house prices had risen 3.46% so far this year. I’ll concede that it’s unlikely that December will wipe out all of those gains.

Score: -1

3. Canadian and U.S. stock markets will have an above average year.

Using XIU as a proxy for Canadian stocks, the 2012 return with dividends was 8.0%, or about 6.3% above inflation. I’m not sure I’d exactly call that an above-average year, but it seems acceptable.

Using VTI as a proxy for U.S. stocks, the return with dividends was 16.4%, or about 14.8% above inflation. This is definitely an above-average year.

Score: +0.75

4. Bonds will have a below average year.

Using XBB as a proxy for Canadian bonds, the 2012 return with dividends was 3.0%, or about 1.3% above inflation. This is only slightly below average. I’ll only take half a point on this one.

Score: 0.5

5. RIM won’t drop 75% again.

Success! RIM shares went from $14.80 to $11.80, a drop of only 20%. Of course, dropping 75% or more is quite unlikely, and I deserve little credit for this correct prediction.

Score: +0.01

6. Berkshire Hathaway will have a strong year.

Success! Berkshire A-class shares went from US$114,755 to US$134,060, an increase of 16.8%, or about 15% above inflation. Of course, Warren Buffett would measure the success of the year by Berkshire’s business performance rather than the movement in its stock price. But we’re talking about pointless predictions here and we might as well use a superficial measure of their success.

Score: +1

Total Score: +0.26 (out of a possible range of -6 to +6)

So, my overall score is extremely middling. Keeping in mind that a score of zero corresponds to a blindfolded monkey throwing darts, my predictions are nothing special. It’s a good thing that I made no concentrated bets on these predictions. You shouldn’t have either.

With a little luck, I could just as easily have made a bunch of predictions that all turned out to be right. But these would have been just as worthless as the predictions I did make because you can’t know in advance if I’m going to be right or not. And even if I get them right one year, I might be totally wrong the next year.

Simple Interest is Too Complicated

The only virtue of simple interest is that it is easier to calculate the amount owing than when we use compound interest. However, in today’s world, computers do our calculations for us and this advantage means very little. Despite its name, I’ll show that simple interest is far more complex than compound interest in important ways.

A Basic Example

Let’s start with an easy example to illustrate the difference between simple and compound interest. You borrow $10,000 from Uncle Jack to be paid back in 10 years. Uncle Jack isn’t a very loving uncle and knowing you have no other options he charges you 10% interest each year.

If Uncle Jack charges simple interest, then your debt rises by $1000 each year for a total of $20,000 after 10 years. The 10% interest is always charged “simply” on the original principal amount. To put this into a formula, if the interest rate is r=0.10 per year, the number of years is t=10, the initial loan amount is M=$10,000, and the future value after t years is F, then we have

F = M(1 + tr).

This formula works even if the time t is not a whole number. If you pay back Uncle Jack after two and a half years, it makes sense to use t=2.5 so that you would owe a total of $12,500.

If Uncle Jack prefers compound interest (compounded yearly), then your debt still rises by $1000 the first year to $11,000, but in the second year the 10% interest is calculated on the $11,000 debt. So, the interest is $1100 for a total debt after two years of $12,100. Each year your debt is multiplied by (1+r)=1.1. After 10 years, you owe $25,937. Expressing this as a formula we get

F = M(1+r)^t.

This formula also works if the time t is not a whole number. Such calculations are difficult to do by hand, but spreadsheets have no trouble with them.

So far, based on the formulas, I seem to be proving that compound interest is more complicated than simple interest. But that’s going to change.

A Simple Interest World

Imagine a world where all banks structure their loans with simple interest rather than compound interest. Suppose that there are two competing banks called Bank-5-5 and Bank-7-25. Bank-5-5 only offers 5% simple interest loans for 5 years, and Bank-7-25 only offers 7% simple interest loans for 25 years. Suppose that these banks will offer these same deals indefinitely (interest rates never change).

You need to borrow $100,000 and not pay it back for 25 years. Should you take the 7% loan for 25 years or a series of 5-year 5% loans? The first impression is that the 5% deal is better because the interest rate is lower. But all is not what it seems.

Let’s start with the 7% loan. Using our simple interest formula with M=$100,000, t=25, and r=0.07, we get a final debt after 25 years of $275,000.

Now let’s look at a series of five 5-year loans to cover the 25 years. After the first 5 years, the simple interest formula says the debt grows to $125,000. Now we have to roll that debt into a new 5-year loan. The new value for M is $125,000, and after 5 more years the debt becomes $156,250. Continuing this way until the end of the 25 years, the total debt comes to $305,176.

So, it turns out that the single 7% loan is actually better than the series of 5% loans. This calculation might not seem too bad, but suppose the loans are structured like a mortgage where we make monthly payments along the way. Which deal is better in this case? I had to break out a spreadsheet for this one. It turns out that the series of 5% loans is better with monthly payments of $556.50 instead of $577.70 for the 7% loan.¹

This interplay between simple interest rate, duration of the loan, and timing of payments makes it difficult to figure out which deal is better. This is analogous to trying to describe the motion of the planets. If you view the Earth as stationary, then the motion of the other planets seems very complex. But if you see the Earth as just another planet moving around the sun, then the paths of all the planets can be described simply as (roughly) ellipses. Just as simple interest is superficially simpler than compound interest, treating the Earth as stationary is only superficially simpler than treating it as though it moves around the sun.

Bank Incentives in a Simple Interest World

Let’s look at things from the bank’s point of view after 20 years into a 7% simple interest 25-year loan. Each dollar of the initial loan that hasn’t been paid off already has grown by 20x7%=140% to $2.40. Over the course of the twenty-first year, each dollar of initial loan still outstanding will grow from $2.40 to $2.47. This is an increase of only 2.9%.

If the bank could persuade you to pay your debt off right now, it could put the money to work in a new loan that would make 7% initially instead of the paltry 2.9%. In a simple interest rate world, banks would always prefer shorter loans if they could lend the money out again at the same simple interest rate.

In fact, with a laser-focus on profitability, banks would think in terms of compound interest. Consider a loan at 10% simple interest for 10 years. Each dollar of the initial loan that remains outstanding would become a debt of $1.10 after year 1, $1.20 after year 2, and so on until it is $2.00 after year 10. Viewed in compound interest terms, the interest rate for each year is as follows:

Year 1: 0.10/1.00 = 10%
Year 2: 0.10/1.10 = 9.1%
Year 3: 0.10/1.20 = 8.3%
...
Year 10: 0.10/1.90 = 5.3%

To judge the profitability of their loans, banks would need to think in compound interest terms like this. Once we see the declining compound rates, it becomes quite obvious that banks in a simple interest world would prefer shorter loans to longer loans.

Compound Interest Makes Comparison Easier

In the real world where banks offer loans with compound interest, consumers can make a simple comparison between loans by looking at the interest rates charged. Other factors such as prepayment terms can make a difference as well, but as long as these other factors are not materially different between two loans, the loan with the lower compound interest rate is usually better. The various factors that go into comparing simple interest loans don’t matter much with compound interest loans.

One thing that can be tricky is determining the actual compound interest rate you’re being charged. It’s important to work this out before comparing loans. That’s the subject of the next section.

Advertised Loan Rates Versus Actual Compound Interest Rates

If your credit card interest rate is 20%, you’d think this means that each $1000 of the balance not paid off through a year would grow to $1200, but this isn’t true. It actually grows to about $1219.39. So, the compound interest rate is actually almost 22%.

When the interest rate is lower, the effect is smaller. For example, an 8% car loan with monthly payments actually has a yearly compound interest rate of 8.3%.

This happens because of a little game that is played with simple interest. You’d think that if simple interest is involved, the interest charges would be lower than they are with compound interest. But this isn’t the case the way that banks play it.

Banks introduce a compounding interval that changes the effective compound interest rate. For most personal loans in Canada the compounding interval is monthly. This means that they take the advertised yearly interest rate, pretend it is simple interest and divide it by 12 to get the monthly interest rate, and then compound it anyway. Neat trick, eh? So, 12% per year compounded monthly is really 1% per month, and this compounds out to 12.7% per year.

With most mortgages in Canada, the compounding interval is 6 months. This is called semi-annual compounding. A 4% mortgage of this type really means 2% interest every half-year. This compounds out to 1.02x1.02 – 1 = 4.04%. This isn’t too bad, but back in the early 1980s when mortgage rates reached 20%, the compounded rate was 21%.

To get to the monthly rate for a mortgage, banks take the semi-annual rate and find the monthly rate that compounds out to this semi-annual rate. Starting with the advertised rate r, the semi-annual rate is r/2, and the monthly rate is

(1 + r/2)^1/6 – 1.

So, it’s not as though the banks don’t know how to work with compound rates; they’re just allowed to stick with this peculiar approach that makes them more money than just using compound interest rates.

To make a meaningful comparison between loans with different compounding intervals and different interest rates, you need to work out the actual yearly compound rates.

A Simpler World with Only Compound Interest Rates

If everyone only advertised compound interest rates, the world would actually be a simpler place. We wouldn’t have to worry about compounding intervals at all. There would be no such thing as dividing an annual rate by 2 to get a semi-annual rate or dividing by 12 to get a monthly rate. Starting with the annual rate r, the only way to compute the monthly rate would be as follows:

(1 + r)^1/12 – 1.

And compounding the monthly rate 12 times would always take you back to the yearly rate r rather than some higher interest rate.

This would eliminate one way for banks and other lenders to advertise lower rates than the actual compound rates they charge. But there are many other tricks that some lenders use, such as adding service fees that don’t count as interest or charging large penalties for paying off a loan early.

Conclusion

Simple interest isn’t very simple. If we actually used simple interest, comparing loans would be a complex endeavour involving calculations with the interest rates, loan duration, and timing of repayments. Even the small use of simple interest in computing monthly interest rates introduces the needless complexity of compounding intervals. Compound interest is far simpler than simple interest.


¹ The formula for the monthly mortgage payment P on a t-year mortgage at yearly simple interest rate r and mortgage principal M is  P = M/[∑_n=1,...,12t (1/(1+nr/12))].

Financial Guilt for the New Year

In my quest to critique everyone else’s financial goals (an example here), I move now to the Big Cajun Man who recently tossed out a few financial resolutions. Here is a paraphrase of his list (you’ll have to click through to his blog for the funny parts I left out):

1. Stop spending so much.
2. Be more honest about our money.
3. Stop being so hard on myself about money.
4. Write down every purchase.

I would call this a guilt list rather than financial goals. Many people have guilt lists like this about money, their weight, working out, and other areas of their lives. The problem is that all this guilt doesn’t help people very much.

For financial goals to actually help you handle money better, you need to begin with a clear picture of where you are financially and where you want to be. Numbers must be attached to this picture. Then you can define specific goals (again with numbers) that take you from where you are to where you want to be.

The goals are likely to be related to spending, saving, debt levels, and income. Here are some examples:

1. I will limit my spending on restaurants to $100 per month.
2. I will save $250 per month in my TFSA.
3. I will reduce my line of credit balance by $300 per month and not increase any of my other debts.
4. In addition to my regular pay at work, I will earn at least $400 per month doing odd jobs in my neighbourhood.

Without the specific times and dollar amounts attached to the goals, you’re just making yourself feel guilty with little benefit.

Short Takes: CMHC Real Estate Valuations and more

Potato explains why the pressures on CMHC’s automated housing appraisal system push it toward systematically over-valuing real estate.

Money Smarts Reports his 2012 investment returns. All investors should work out their overall portfolio return each year. This is particularly important for active investors who try to beat the market themselves or by following the advice of an advisor. If your active investing isn’t beating the market, maybe you should try low-cost index investing.

Where Does All My Money Go? was the big winner in the 2012 blogger stock-picking contest, which is funny because he seems to take it the least seriously.

Million Dollar Journey announced the winners of the big giveaway that included some investment newsletters. I’ve had my fill of investment newsletters; hopefully the winners will find them more useful than I did.

Investor Skiing

Skiing can be fun, but heading downhill is no fun for investors. So, why do so many of them do it anyway? The following chart shows how performance chasing can turn into investor skiing.

Most investments are volatile, which means they go up and down. Whenever an investment like a mutual fund is at its peak, it has a great recent track record and is considered “hot”. The blue fund above jumped from $25 to $39 in only 3 months. It doesn’t get much hotter than this.

Our skier poured $39,000 into 1000 units of the hot blue fund, but the party was over by then. He rode it down to $23.50 by April. But, fear not! A new hero has emerged. The red fund doubled in only 3 months. The skier switched to the hot red fund at exactly the wrong time and rode that down to $12. A final switch to the high-flying green fund in July gave disastrous result, too.

By October, our skier had only $3000 left. So much for hot funds. This is an extreme example, but it illustrates what happens to those who repeatedly jump to the latest fund with good recent returns.

Does this mean we should look for funds with poor recent returns? Nope. It’s better to get out of the fund-skiing game altogether and learn about diversified low-cost investing strategies.

Financial Goals and Debt

I’ve never really set financial goals for myself, but I do find the goals others set for themselves interesting. I used to make projections about future savings based on my income and spending to see when I’d have enough money for a house down payment or a car, but this is different from setting goals. One thing that is usually missing from people’s financial goals is a goal related to overall debt.

My day job is related to online security. I spend a lot of my time looking for ways to get around security systems so that we can make them better. So, when I look at someone’s financial goals, I immediately look for easy ways to achieve the letter of the goals without meeting the true spirit of the goals. Once we see the problems, it’s possible to make the goals more robust.

Krystal Yee at the blog Give Me Back My Five Bucks posted her 5 financial goals for 2013. Her first goal to “earn $85,000 to $90,000” isn’t easily gamed. The fourth goal to “diversify my investments” away from TD’s e-series mutual funds is more about learning than financial sacrifice, and deciding if she has met this goal is a personal matter. One thing I would say, though, is that she is misusing the word “diversify”. Many of the e-series mutual funds are wonderfully diversified. Buying other funds that invest in the same asset classes won’t improve diversification much, if at all.

The remaining 3 goals to “Put an extra $2,500 onto the mortgage,” “Save $16,000 in my Retirement Portfolio,” and “Start contributing [monthly] to charity” can be met trivially by just borrowing $20,000 or so on a line of credit – no real financial sacrifice required.

Of course, when I say it like that, it’s easy to object. Who would be foolish enough to just borrow the money for their financial goals and then delude themselves into thinking that they’ve met the goals? Certainly not Krystal. When the cheating is this blatant, I agree that almost nobody would be this foolish.

However, as David Chilton points out in his excellent book The Wealth Barber Returns, “Even some of my financially responsible colleagues have built up huge balances on their lines of credit, half the time without fully realizing it was happening.” It is very easy to not notice a line of credit balance creeping upward.

Maybe Krystal won’t make the mistake of meeting her financial goals with borrowed money, but many people do. When people set their goals, I think they should explicitly include one related to overall debt. Some examples are “keep my line of credit at zero and don’t create any new debts” or “reduce my line of credit balance by $3000 and don’t create any new debts.” (You might have noticed a pattern in those two suggestions.)

Dealing with debt can be like trying to crush a balloon with your hands. When one debt shrinks, another one pops out somewhere else. Only by carefully monitoring debts as well as assets can we know if we’re making financial progress in our lives.

Happy New Year

At least dealing with a hangover isn’t too expensive :-)