Another example of a bad deal is life insurance on children. In rare cases where a child actually has a substantial income that others depend on, it can make sense to take out life insurance on the child. But, in most cases, insuring a child’s life makes no sense; remember that the insurance offers no protection from death! I have had insurance agents try to talk me into insuring my children by arguing that I would need to cover funeral expenses, and that buying the insurance would guarantee future insurability. This was all nonsense. I can afford a funeral without the help of insurance, and if I couldn’t, I would choose something less costly than the standard funeral. The future insurability argument requires more explanation. When you buy term life insurance for, say, 10 years, it comes with or without the guaranteed right to renew the insurance at a particular price after the 10 years are up. If your insurance is renewable, then even if you develop a terminal illness in th...

Have you ever been to see a doctor who is obviously upset about something that has nothing to do with you? This has happened to me a couple of times where a doctor was complaining about something and I had little choice but to sympathize even though I was much more concerned about my own problems. Otherwise, why would I be seeing a doctor? One of these times the doctor was having a problem with her extended health coverage for topping up the basic Ontario government medical coverage. Her partners wanted her to go in with them on a plan that cost $400 per month for each doctor, but she saw in the fine print that the plan had a lifetime cap on all benefits of $25,000. She correctly figured out that she would pay $25,000 in premiums in just a little over 5 years. I asked her if she could afford to pay $25,000 right now if she had some sort of medical problem, and she said yes, which isn’t too surprising for someone with the income of a successful doctor. So, this means that the insura...

Some financial decisions, particularly about insurance, must take into account what is called the utility of money to get the right answer. Normally the concept of utility is explained in very mathematical terms, but it doesn’t have to be. Let’s take a fun example straight from a game show. You’re standing beside Howie Mandel playing a super-sized version of Deal or No Deal. You’re down to just two amounts left, 1 cent and $3,000,000! You get the following offer: take $1,000,000 now, or take a 50/50 chance at the $3,000,000. What should you do? If you got to do this many times, then on average, taking the chance you would win half the time and get an average return of $1,500,000. This is more than the million dollars you were offered, and so you should take the chance, right? Not so fast. Most people would correctly figure out that they should just take the million dollars. The reason is that the first million would make a huge difference in their lives, and an additional two mil...

In my last post, I discussed how insurance is a financial matter and doesn’t do anything to prevent accidents. So, if insurance is just about trading money back and forth, how can it be a good deal for both the insurance company and the person buying the insurance? When it comes to buying goods like food, it is easy to see why an apple is more valuable to a person buying one than it is to the farmer who owns an orchard full of apples. I’m quite happy to part with 50 cents for an apple when I’m hungry, and farmers are willing to take less than 50 cents for each of their apples. So, in this case, it is possible for both sides to win. When it comes to insurance, it isn’t as obvious that both sides can benefit. To keep things simple, imagine that a car insurance company has worked out that they will have to pay out an average of $600 per driver in claims for car accidents next year. If they charge each driver $1000 for the insurance, then they will make a $400 profit on each driver min...

A while ago during a temporary gap in my house insurance, some of my friends joked about coming over to my place and “having an accident” to make some big money. Of course they weren’t serious, and we all had a good laugh. Later on I thought about what had made the joke funny. If you think about it, a fraudster would have better luck getting a big settlement from an insurance company than from me. So, for a short while my house was probably the worst place to target for faking an accident. But my friends and I all got the joke instantly, even though it doesn’t seem to make much sense after some thought. What is going on? To answer this you need to look at how house insurance is marketed and sold. The best example is one insurance company that shows the image of a giant protective blanket enveloping your house. As long as you don’t think about it too much, you have the feeling that house insurance actually helps prevent accidents. The marketing promotes this subconscious idea. Of co...

In my last post, I discussed how stock price increases over the long term are possible. A reader, Steve, asks “If the value of stocks keeps on rising at a greater rate than inflation, wouldn't that mean that less and less people could buy stocks in the future due to lack of necessary funds?” This is a good question that points to the seeming paradox of the stock market creating value out of nothing. Let’s start with understanding inflation. Inflation is a measure of the increase in prices of the things we buy, like food, gas, and clothes. At the beginning of the year, a particular basket of items is selected as the typical things that people need, and the price of this basket of items is added up over the course of the year to measure the cost of living. If inflation is 3% one year, then the cost of this basket of items has risen 3%. Another way to view this is that the things we buy have constant value, and the value of money has dropped. Now, just because inflation is 3...

Over the last 100 years, the Dow Jones Industrial Average has gone from about 65 to 13,000, a factor of 200. But this is only about half of the return because it doesn't include dividends. So you can multiply this by another large factor to get the full returns. Of course stocks have had some major blips in the last 100 years, but this represents a relentless rise in stock prices. Even factoring out inflation, stocks have made an impressive long-term run. In the short term stocks rise because there are more buyers than sellers, and when demand outpaces supply, prices must go up. Over the long term it seems like the stock market creates wealth out of nothing. Science teaches us the law of conservation of energy, we often hear that there is no free lunch, and we talk of zero-sum games, but the stock market doesn’t seem to be bound by any such law. Over the long term, almost everybody who stays in the game seems to win. What makes stock prices rise over the long term? The short an...

This is the third post examining the arguments given by fund managers against leaving their funds and investing in an index . Argument #4: Over such and such a time period active funds beat index funds. It is true that over some periods of time, actively managed mutual funds give higher returns than index funds. When making this kind of argument, the fund manager has to select the time period carefully, because most of the time, index funds win out. Where actively managed funds tend to win is in periods where the stock market performs poorly. This is because most funds have to hold some cash (often around 10% of the money in the fund) to deal with the volatility of investors entering and leaving the fund. So over a period of time where stocks don’t do as well as interest on cash, a fund with 90% of its money in stocks and 10% in cash will beat an index fund with nearly 100% in stocks. However, stocks have been much better long-term performers than cash. The cash component of...

In the previous post , I started to examine some of the reasons fund managers give against leaving their funds and investing in an index . Here are a couple more. Argument #2: Our gains are more intelligent. Some of the arguments given by active stock pickers amount to saying that their returns are somehow better than the returns on an index fund because of some vague attribute like intelligence, precision, or global-mindedness. This raises an important question: would you rather make a 10% return intelligently or 12% mindlessly? I’m not advocating investing without thinking, but what matters ultimately to your financial future are results, not the process. Argument #3: Some people need their hands held. The argument here is that some people need advice, and if they try to manage their own money they might get nervous and sell at a bad time . There is a lot of truth to this. Many people do panic and sell near a market bottom when they would have been better off just holding on....

The investing strategy of indexing is a major threat to the mutual fund industry. (See some of my previous posts for an explanation of indexing , examples , and how to get into an index .) When you put your money in a low cost index fund, you are no longer paying the high fees charged by actively managed funds. Each investor with $100,000 in a mutual fund with a Management Expense Ratio ( MER ) of 1% pays $1000 per year in fees. Up that to the $500,000 you’re hoping to have one day and a 2% MER, and the fees are $10,000 per year. It is no wonder that the managers of these high cost funds are highly motivated to fight against indexing. Try typing “the case against index funds” into Google. You’ll get plenty of hits. The most amusing hit I saw was called “How to Market Against Index Funds.” At least the title makes the motivation very clear. I read through several of the articles I found while keeping an open mind about the possibility of learning about some real problems with indexing...

So you’ve been investing for a while, know some buzz-words, and now you’re a financial whiz. It’s time to start trading in and out of speculative stocks and stock options to make big money. Hold it right there! This could be a disaster. You could lose most of your money very quickly. There is nothing wrong with investing in individual stocks if you are truly knowledgeable and willing to put in the time to follow the companies you own. Following a stock price is not the same as following the company. If you own an individual stock you should have read its financial reports and have an informed opinion about the company’s prospects and whether the current stock price is high or low relative to those prospects. This is not true of the average investor. There is plenty of evidence that even most professional investors can't beat the market. Be wary of overconfidence. You may be better off sticking with the unexciting and low-action index fund strategy. Overconfidence can c...

Pundits, friends, and acquaintances confidently drone on about interest rates, the balance of trade, commodity prices, and the impending doom in the stock market. History tells us that when stock prices have been falling, the negative predictions increase. There is no reason to believe that these people know any better than anyone else whether stocks will go up or down in the short term. Anyone who could actually predict where the stock market was going in the short term could easily make a fortune fast. Some successful investors say that one of the best times to buy is when the masses agree that stocks are doomed. This barrage of negative news about the stock market leads to a common problem for nervous investors: selling when prices are low. If the stock market then rallies, these investors lose out. I’m not advocating waiting with your cash until the world seems to be crashing down and then buying in either. This kind of market timing works for few people. If your investments ar...

The idea of indexing is to put money that you won’t need soon into one or more low cost index funds for a long time. There are pitfalls with handling your own investments that might cause you to deviate from your strategy. One such pitfall is making quick decisions about your investments. It is very easy to place stock market trades with a web browser. While connected to your broker’s web site to look at your investments, the trade button is sitting right there on the screen. In a moment of weakness, you might make some trades you later regret. Fortunately, North American markets are only open from 9:30 am to 4:00 pm eastern time, and not too many people are making trades after a beer or two. When you pay the fees to work with a financial advisor, the advisor usually has to be contacted to make investment changes. One of the good things that most financial advisors do is to talk people out of doing anything rash. In the coming posts , I will discuss other potential pitfalls of st...

To those who have opened a self-directed brokerage account and have bought and sold stocks, this might seem like a trivial question. However, this whole business can be quite bewildering to the uninitiated. To start with, you need to choose a broker. I won’t recommend any particular broker, but the following surveys may help. U.S. Brokers. In a survey by SmartMoney, the top brokers in the premium category were E*Trade, Fidelity, and Charles Schwab. The top brokers in the discount category were TradeKing, Scottrade, and Firstrade. Canadian Brokers. In a survey by the Globe and Mail, the top Canadian online brokers were Qtrade Investor, E*Trade Canada, TD Waterhouse, and BMO Investorline. Opening an account. After choosing a broker, follow the instructions on the broker’s web site for opening an account. This process is similar to opening a regular bank account except that the brokerage account can hold stocks, bonds, and mutual funds in addition to cash. There are several types...

Low-cost index funds are a great way to own a very broad range of stocks without paying high fees. Of the many index funds to choose from, two are described in the table below. If some of the table entries don’t mean much to you, don’t worry because I’ll explain them. Country U.S. Canada Fund Name Vanguard Total Stock Market iShares Canadian Large Cap 60 Stock Ticker VTI XIU Description 1200 large U.S. companies 60 large Canadian companies MER 0.07% 0.17% MER25 1.7% 4.2% These two funds are called Exchange-Traded Funds (ETFs) meaning that they can be bought and sold like stocks in the stock market. Other mutual funds are bought directly from the mutual fund company or through an intermediary like a financial advisor who deals with the fund company. The stock ticker listed in the table above is the symbol that is used to identify the stock (or ETF) when making a buy or sell order. Low MER An important attribute of these funds is that they have very low Management Expense R...

I have been talking about the dangers and high costs of investing in typical mutual funds, which is useful to a point, but you may ask “well then, what should I do with my savings?” Of course, this is a question that everyone has to answer for themselves, but one possibility to consider is a strategy called indexing. An index is a measure of prices among a particular set of stocks. For example, the Dow Jones Industrial Average (DJIA) measures stock prices of 30 of the largest public companies in the U.S. When you hear that “the Dow is up 100 points today,” the commentator is referring to the index of these 30 stocks. Other familiar indexes in the U.S. are the Nasdaq and the S&P 500. In Canada, the main index is the S&P TSX, often abbreviated as the TSX. Each of these indexes is reported as a number that gives us a sense of whether stock prices have gone up or down. If an index goes from 10,000 to 10,100 one day, then stock prices have risen by an average of 1%. The investme...

This will be the last discussion of the ugly side of mutual funds for a while. After this post I will be talking about an alternative to the standard mutual fund . I have always liked Will Rogers’ advice about investing: “Don't gamble; take all your savings and buy some good stock and hold it till it goes up, then sell it. If it don't go up, don't buy it.” There is a slight temporal problem with this strategy, but it is clear that if you could look into the future, investing would be easy. Another way to look at this quote is that you should wait until a stock goes up and then buy it at the old price. But who would be foolish enough to let you do this? Late Trading Back in 2003 there was a big scandal where some mutual funds allowed their preferred clients to do what is called late trading. Generally, mutual funds set the day’s price of their units when the stock market closes (4:00 pm eastern) and any trades (buying or selling of mutual fund units) during the day ...

Suppose that you have found a mutual fund called XYZ with a good track record of strong returns and an honest manager who has not closed and renamed losing funds and has not incubated funds as discussed in my last post . Hurray! XYZ fund manages $50 million making it small by mutual fund standards. The fund manager is very skilled at investing in small companies that are about to grow big. So, you switch out of your current mutual fund and switch into XYZ. This is going to be good! The herd is with you. It turns out that you weren’t the only person with this idea. Literally thousands of other people pile into XYZ chasing those high returns. Assets under management at XYZ swell to $2 billion, a 40-fold increase. This is great for the fund’s managers; they will collect 40 times the management fees. But, what are they going to do with all that investor money? XYZ fund was successful at finding a handful of small companies that give big returns. These companies aren’t big enough t...

My last post discussed how mutual fund managers close, rename, and merge mutual funds with a history of low returns to hide their poor record. To counter this, investors are advised to choose funds with a long history of good returns. Typical advice is to focus on 10-year returns. Investors do tend to choose funds with a history of high returns. However, they often focus on just the past 1 or 3 years of returns, rather than looking at longer periods. Not surprisingly, mutual fund managers are aware of this. Because mutual fund managers are paid a percentage of their fund’s assets each year, they are motivated to attract as many investors as possible to the fund to drive up its total assets under management. This has led to an interesting practice among some mutual fund companies to drive up reported returns. Incubation Some companies start up several mutual funds with small amounts of private money and run them aggressively. After a while, the poor performers are closed ...

I used to hold mutual funds in an employee savings plan. The first time that one of the funds I held changed its name, I was puzzled. Was I switched to a different fund? Why was this done? I asked the representative of the firm that managed our savings plan about this. He said I shouldn’t worry because the name change was inconsequential, and this seemed to be true. The number of units I held and their approximate value didn’t change. What was the point of all this? After comparing my last two statements, I did find one seemingly small difference. The part of my most recent statement with the 1-year and 5-year performance of my fund was blank. The previous statement listed these returns for the old fund name, and the returns weren’t very good compared to other mutual funds. Erasing History The purpose of the name change was to erase an unpleasant history and start over. Because of this little trick, mutual fund lists are purged of their poorest performers. There are definitely funds th...

The second financial advisor I actually invested money with was a pleasant woman who used to work at my bank branch handling my mortgage and had moved out on her own. I won’t use her real name; let’s call her Gina. Initially, my wife and I each invested a small sum with Gina in some mutual funds. We were contemplating moving the rest of our investments over from our first financial advisor, but Gina had an idea for something even bigger. The Pitch Based on our income and lack of debt, Gina said that we should be borrowing a large sum of money and investing it. Interest rates were low, and when it came to taxes the interest could be deducted from the big gains we were sure to make on our investments. At the end of 5 years, we would have big profits with “no money down”. Gina worked on us for quite a while with this pitch. Fortunately, the borrowing made us nervous, and we decided not to go for it. This all took place just before the high-tech bubble burst. We would have lost a l...

A few years after I began investing with a full service brokerage firm, my advisor Mike seemed excited to be offering me the chance to get in on a new type of account. For 1% of my assets each year, a professional money manager would handle my account making investments specifically suited to my needs. I misunderstood how this would work at first. I thought that this money manager would be picking individual stocks for me and running my account like its own little mutual fund. It turned out that my account would actually hold several mutual funds with the mix of funds shifted around once in a while as I got older. At the time I was just starting to understand mutual fund management expenses and financial advisor fees, and the rest of the conversation with Mike went something like this: Me: “So, each year I would be paying the MER on the mutual funds plus another 1% to you guys?” Mike: “Uh, yeah, but ...” followed by a bunch of confusing reasons why this was a good idea anyway...