Sometimes my grandmother surprises me. She is always up to date on the latest news, but I didn’t expect her to analyze the latest Canadian federal budget as carefully as she has. Here are her thoughts on what the tax-free savings accounts (TFSAs) mean to her. Unlike RRSPs that cannot be used past the age of 71, she is allowed use a TFSA. (I won’t give away her age, but her eldest daughter is on the verge of not being able to contribute to an RRSP either.) For my grandmother, investing means GICs at a bank, which is sensible at her age. I used to wonder if the bank took advantage of her by offering poor interest rates, but at the latest update, she left one bank to move to another where she negotiated a better rate than the best I was able to find with my discount broker. In one way the TFSA is good for her because it lets her shelter interest income that is usually highly taxed. However, the $5000 limit is a problem for her. The great interest rates she gets are partly due...

The Big Cajun Man over at Canadian Personal Finance has been calling for tax relief for single-income families for some time now. One way the government could do this would be to permit income splitting. Consider a hypothetical couple, Carol and Dan. Carol earns $80,000 per year as a software developer, and Dan stays home with the kids earning no income. Most people publicly praise Dan for taking on a non-traditional nurturing role while privately wondering what’s wrong with him. It takes a long time for attitudes to change, but that’s another story. Carol gets some tax breaks for supporting a spouse, but she still pays a lot in income taxes. If the Canadian government permitted income splitting, she and Dan could each declare $40,000 per year in income, and their overall tax bill would be quite a bit lower. We’ve heard that the Canadian government’s new tax-free savings accounts (TFSAs) provide income splitting opportunities. However, you will not get the same immediate benef...

The Canadian Federal Government introduced the tax-free savings account (TFSA) in yesterday’s budget. This is roughly the Canadian equivalent of the Roth IRA in the U.S. Canadians will be able to put up to $5000 per year into a TFSA. Any gains on investments inside a TFSA are tax-free. The TFSA is similar to an RRSP in that the income from investments within the account are tax-sheltered. The main differences are as follows. 1. TFSA contributions do not give you a tax deduction. RRSP contributions are deducted from your income to reduce taxes. 2. TFSA withdrawals are not taxed. With RRSPs, any withdrawal is treated as regular income and is taxed. A natural question is should you contribute to an RRSP or a TFSA? The answer depends on your tax rates. If your tax rate when you contribute money is higher than it will be when you withdraw money, then an RRSP is better. If your tax rate when you contribute money is lower than it will be when you withdraw money, then the TFSA is bette...

When people get into trouble with their debts, they usually have several different debts including credit cards, car loans, line of credit, and possibly student loans. The debts usually have different interest rates and different required monthly payments. Some debts are scheduled to be paid off quickly and others over a long period of time. The idea of a consolidation loan is to borrow one large amount to pay off all of the other debts. For this to make sense, this loan would have to be at a low interest rate and amortised over many years to make the payments low enough for the debtor to handle. To qualify for this type of loan at a low interest rate, the debtor might have to put up some collateral, and this collateral is usually a house. The consolidation loan then turns into a home equity line of credit (HELOC). On the surface, this seems like a good strategy. A lower interest rate means that you pay less interest. What other considerations could there be? I can’t say that I e...

It turns out that banks consider students to be great customers for their credit cards. I learnt this from James D. Scurlock’s book “Maxed Out: Hard Times, Easy Credit and the Era of Predatory Lenders,” which gives a fascinating look into the world of lenders and their hapless customers. The part of the book about students hit home with me. I have one son in university, and another will hopefully be going in a couple of years. So why are students good customers? When you think of the old style bank that only lends to people with steady income to pay off a loan, lending to students makes no sense. Students usually have little income, and many of them will run up bills on their cards that they can’t pay off. It turns out that students have something else that makes them great customers: parents. According to Scurlock, parents will almost always bail their children out of debt problems. And the attitude of banks has changed dramatically over the years. Students run up debts and pay intere...

Not to be too philosophical, but my experience has taught me that I’m best off to conduct myself as though there exists a single objective reality that applies to all of us rather than each of us having our own separate realities. What does this mean for the investing world? If several people all buy 100 shares of ABC stock at the same time for the same price, then they will all get the same return over a given period of time. Some of these people bought ABC stock for very smart reasons, and some might have bought it because they have the initials ABC. Some of the investors are smart, some dumb, some nice, and some mean, but they will all get the same return. This all seems obvious enough, but you have to keep it in mind when you read the come-ons for businesses that want to set you up with an account to trade stock options. Stock options are side bets between two parties on whether a stock will go up or down. A bet that the stock will go up is called a call option, and a bet tha...

ABC stock has been rising steadily lately – is this a good time to buy? XYZ stock has fallen steadily lately – is this a good time to buy? Sadly, the answer in both cases is maybe. It turns out that you just can’t tell what is going to happen to a stock by just looking at what has happened in its price history. ABC might go up and it might go down. The same is true of XYZ. To understand this better, let’s look at an example that is much easier to understand: bananas. Suppose that bananas have been selling for a dollar per pound. Sometimes you buy a few and sometimes you don’t. Suddenly, banana prices jump to $1.50 per pound – should you buy them now? If the bananas seem the same as usual then probably not. But what if the bananas look unusually good, and you ate one and found it to be much better than the usual bananas? Then you’d probably buy them at the higher price. The next month, banana prices drop to 50 cents per pound – should you buy them now? If the bananas seem to be ...

Many people don’t like to talk about money, and so I try not to discuss money unless others show an interest. On a few occasions when the subject came up, I’ve encountered people who think that they don’t pay fees on their mutual fund investments. In a recent case, an acquaintance who I’ll call Rosie offered her reason for believing this. Rosie said that she knew that some people paid fees, but she checked her statements regularly, and she had never seen any fees listed. Of course she does pay Management Expense Ratios ( MERs ) and possibly front or back-end loads. I decided to have a look at some of my old statements from back in the days when I owned mutual funds. Sure enough, there weren’t any references to fees even though I know I paid them. How widespread is the mistaken belief that investors don’t pay any fees on their mutual funds? I’d be very interested in the results of a poll. Among those who know they pay fees, it would be interesting to find out how much they think t...

A major concern for many people is how old they will be when they can retire. This depends on a number of factors such as how much you save, how well your investments perform, how much you spend during retirement, and how long you live. Retirement calculators can figure this out for you based on a number of assumptions. However, most of them don’t give you a feel for how the final answer would change if your investment returns are volatile instead of perfectly steady. There was a good post over at the Canadian Financial DIY blog about using Monte Carlo analysis for financial planning. Monte Carlo analysis just means simulating possible outcomes many times to see how the final answer changes. I decided to use Monte Carlo to see how the mix of stocks and bonds in a portfolio affects when you can retire. I had to make some assumptions: - Stocks and bonds will have the returns and volatility as reported in the paper Portfolio Optimization by John Norstad (2002-09-11). - Retireme...

Part of my motivation for writing this blog is to pass on what I know to my children before they are on their own making financial decisions. Even though I make my choices carefully and put time into understanding how things work, I have made some financial mistakes and other people have taken advantage of me financially from time to time. People like to say that money isn’t everything, and this is true. Relationships, fun, interesting activities, and challenging pursuits lead to a full life. Money can’t give you these things, but it can give you more freedom to pursue them. Most of us trade our time for money by taking jobs. The jobs we have vary in how fulfilling they are, but very few of us can honestly say that we would do our jobs for nothing. Even the best jobs have unpleasant parts, and almost all of us do some fraction of our jobs only for the money. So, for most of us, to say that money isn’t important is to say that our time isn’t important, and this is wrong. Money represent...

I don’t normally go for hot tips on stocks, but I can’t help myself because I’ve come across a scorcher! Before I reveal the name of the stock, let me just say that this tip is a little different from most tips because it comes with a strategy that you have to follow to make money on this stock. The company is Questcor Pharmaceutical Corporation, trading under the symbol QSC in the U.S. This stock has been red hot. On Aug. 18th last year, QSC closed at 35 cents per share. Now it trades at about $4.70, a 1243% increase! With just three of these opportunities in a row, you could turn $1000 into over $2 million. The catch is that all this stock appreciation for QSC is in the past. So, to make money, you’ll have to travel back in time to Aug. 18th to buy this stock and then sell it now. The reason for the time travel is that I have no idea what Questcor Corporation does or what will happen to its stock price in the future. I’m not buying even a single share because I haven’t perfecte...

People can be split into two groups: 1) those who spend carefully, save money, and invest wisely, and 2) those who, to varying degrees, do not do these things well. For convenience, let’s call these two groups savers and spenders. Some of the spenders’ wages get transferred to the savers, primarily in the form of interest on debts. Most interest paid by spenders becomes the profits of banks and other companies, which then gets distributed to shareholders who happen to be savers. Of course, people don’t really fit into just two groups. Most people fall somewhere between the best of savers and the worst of spenders. You can think of people being lined up the side of a mountain based on how well they handle money with the worst spender at the top of the mountain. Now imagine money rolling downhill from the spenders to the savers. Although I have called the two groups savers and spenders, limiting spending is not enough to make someone a saver. A saver must invest wisely as well. Imagine s...

Most commentators agree that we should include some bonds in our long-term investments. My quest for a reasonable analysis to support this conclusion continues. Previously, I have discussed the ideas of Gordon Pape and Morningstar on this subject. I’m starting to feel like I’m in some sort of boxing match. So, let’s do it right: “In this corner ... Roger C. Gibson, esteemed author of ‘Asset Allocation: Balancing Financial Risk’ now in its fourth edition. He’s a well-respected expert whose ideas have been endorsed by Sir John M. Templeton and Don Philips, Managing Director, Morningstar.” “And in this corner ... some guy who figured out how to use Blogger.” Oh well. I lose on the credibility meter. My only chance is that people actually think about the arguments. Gibson does an impressive amount of analysis and explains many important concepts clearly. When it finally comes time to figure out an optimal asset allocation, he tosses in an interesting assumption about our tolera...

Well-known financial author Gordon Pape seems to agree with Morningstar that investors tend to be very conservative. (See this post for a discussion of Morningstar’s views on investor conservatism.) For example, in his book “Sleep-Easy Investing”, Pape recommends against owning stock index ETFs . He observes that by early 2003 stocks had declined, and “many people would have bolted at that point, thus defeating the basic strategy of owning ETFs.” He is right that it is a bad idea to sell low and miss out on a subsequent run-up in stock prices. But stock index ETFs have given good returns for people who have stuck with them calmly through declines. The good times with stocks more than make up for the declines. Pape’s book is one of the best financial books I’ve read. It includes useful information and practical advice explained clearly, but I’m not the least bit interested in his model portfolios. They are filled with fixed income products, and the target returns are far too low....

Everything I read about asset allocation says that investors are very conservative and must put a significant fraction of their money into fixed income investments like bonds even though stocks have historically given much higher returns. All of these commentators may be right about their assessment of investor psychology. Of course, this says nothing about what would be best for investors; it is just a reflection of how investors think. Morningstar has formalized this view of investors in a formula for assessing investments. This formula calculates what they call the Morningstar Risk-Adjusted Return (MRAR). I spoke about this somewhat in a previous post . Morningstar describes it in more detail in a 4-page write-up that is no longer available online, but that's okay because all the math in their expanation tends to obscure what is going on. Let’s look at a simple example. Suppose that each year a particular investment returns either 50% or -20% with equal probability. A si...

What a great sounding idea: unlocking the value of your home. Whenever I hear this phrase, I picture piles of cash stored in my walls. What could be more reasonable than taking some of this cash out to make my life better? I usually hear advice about unlocking my home’s value from a bank that wants to sell me a loan or a financial advisor who wants to sell me mutual funds. But, so what? Do I really need to have so much of my money tied up in real estate? Some financial advisors even talk about the dangers of investing too heavily in just one asset class: real estate. For the sake of safety and diversification, do we need to take some money out of our houses and buy some stocks and bonds? To begin with, the idea that you can take some money out of your home without selling it is just a trick. You own 100% of your home regardless of how much you owe on your mortgage. If your house drops in value, the loss is yours, and the bank will still want the same mortgage payments. So, “using home ...

This is the last part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here . On the positive side, this book contains a wealth of useful and unbiased information about investing and saving for such things as college and retirement. The authors are thorough and knowledgeable. Not counting differences of opinion, I found only one error in the book: at the top of page 113, the return in the example is actually 43.4% rather than 24.9%. On the negative side, the book heavily stresses investing in I Bonds, which are safe, but give low investment returns. I fear that most people will not be able to save enough money each year to meet their goals if they stick to I Bonds. These people need to take some calculated risks to get what they want. It’s better to have a 90% chance of achieving your goals with stocks than having a 0% chance with I Bonds. Even though I disagree with the authors’ main point that stocks are too risky, it’s a goo...

This is the sixth part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here . Chapter 1 of this book begins with the sad story of John and Joan Parker who in March 2000 were planning to retire when John turned 62 at the end of 2002. Their retirement savings were in stocks and the recent big stock market gains made it look like they would have a comfortable retirement soon. Sadly, stock prices dropped, and this couple had to plan on working longer to make enough money to retire. If only they had their money invested in safe investments, right? What if they had put their retirement savings entirely into regular bonds and I Bonds for the past 30 years? Then the Parkers would not have participated in the long bull market that ended in the early 2000’s. As we saw back in part 4 of this review, stocks have beaten the I Bond strategy in all 30-year periods since 1926. Had the Parkers invested in bonds, their savings would have bee...

Here is a bonus post today in case you’re not following the book review. Your reaction to a game show scenario can reveal important information about your attitudes as an investor. It can even tell you what mix of investments are appropriate for your portfolio. Let’s get right to it. You are playing Deal or No Deal and you are down to two amounts: one penny and a million dollars! What is the minimum offer you would accept from the banker? For those not familiar with this game show, here is the situation. You are about to toss a coin. If it comes up tails, you get nothing (and lose nothing). If it comes up heads, you get a million dollars. Just before you toss, someone offers you a sum of money to give up your chance to toss for the million dollars. What is the minimum such offer you would accept? It turns out that your answer depends on how rich you are. Bill Gates would likely accept an offer of half a million dollars, but not much less. However, someone in a despera...

This is the fifth part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here . In Chapter 7, the authors outline a strategy for investing primarily in inflation-protected bonds (I Bonds) along with a small amount in stock options. Before discussing this strategy any further, let me give a brief primer on stock options. The simplest kind of stock option is a call option. When you buy a call option, you are buying the right to purchase stock at a particular price. Suppose that Microsoft currently trades at $34 per share, and you decide to buy 1000 call options for $1 each that give you the right to buy Microsoft shares for $40 each sometime in the next 6 months. If Microsoft stock never gets to $40 per share within 6 months, then you lose the $1000 you spent. If the stock goes to $45 per share, then you can exercise your right to buy 1000 shares for $40 each and then sell them for $45 each. In this case you make a profit of $5 pe...

This is the fourth part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here . In part 3 of this review I showed that the authors’ justification for disliking stocks based on simulations is misleading. Instead of doing 30-year simulations, what about looking at actual 30-year returns in the data we have from 1926 to 2000? The worst 30-year period for stocks was from 1965 to 1994 (inclusive), where the average real compounded return was 4.3%. This means that if I Bonds had existed then, and you could get one that paid 4.3% above inflation, then it would have done just as well as stocks. But, I Bonds don’t usually pay this much. In every single 30-year period, stocks beat I Bonds. But what about the big stock market crash after the year 2000? Even taking the 30-year period ending at the bottom of the crash, average yearly compounded real returns were above 4%, which beats I Bonds. One of the points that the authors repeat is ...

I’m interrupting my book review to continue an interesting discussion over at Canadian Financial DIY ( post 1 and post 2 ). The posts and follow-up comments make good points about investor psychology, but I’m more interested in getting the right answer for rational investors. A quick search turned up the useful paper Portfolio Optimization by John Norstad (2002-09-11). This paper describes all the math I needed to calculate optimal portfolios, and it provides information about stock and bond returns in the U.S. from 1926 to 1994. The paper assumes that you can borrow at a rate that is 0.83% above inflation. Based on all this, I worked out the optimal mix of borrowing, stocks, and bonds to maximize the expected compound return. Let’s assume that you have $100,000 to invest. Drum roll, please! The optimum portfolio has you borrowing $180,000 (for a total of $280,000 to invest now), and investing $196,000 in stocks and $84,000 in bonds. This mix gives you a boost of 2.45% per year...

This is the third part of a review of the book “Worry-Free Investing”, by Zvi Bodie and Michael J. Clowes. This review began here . The main theme of this book is that stocks are too risky for most investors. The authors repeatedly claim that stocks are too risky even in the long run and that most people should avoid them completely or have only a small percentage of their money in stocks. Curiously, the justification for this claim doesn’t come until Chapter 6. The authors give some useful historical investing information for the period from 1926 to 2000, including the real returns investors received in U.S. stocks, bonds, and treasury bills (Figures 6.1 and 6.2). By “real returns” we mean the investing returns after subtracting inflation. This makes for better comparisons because we are comparing dollar amounts that have equal purchasing power. This information was then used to simulate possible outcomes of stock investing over 30 years (Figure 6.6). These simulations were base...