Reporters are running out of words to describe the drop in stock prices yesterday after the U.S. House of Representatives voted down the $700 billion bailout of the financial system: crash, plunge, carnage, bloodbath. Supporters of the plan said that the bailout is necessary to prevent further financial collapse. Others fear that even $700 billion would not be enough. What is usually left unstated in these discussions is what will happen if government doesn’t act. This part is usually left to our imaginations. In a more fearful moment, I tend to recall images I’ve seen of the homeless and hungry in the swirling dust of the great depression. Maybe others imagine burning buildings and widespread panic. The truth is that supporters of a bailout probably get more mileage out of leaving the consequences unsaid. We imagine much worse outcomes than most commentators would predict. I have little doubt that the U.S. government will ultimately have to do something fairly costly to li...

According to a sheet of paper stuffed in my mail slot, it’s “time to think about being paid what you’re worth.” Investors Group is taking on twelve new “consultants” in my area. This prompted me to poke around the Investors Group web site to look at their investment products. I didn’t much like what I saw. Presumably, Investors Group (IG) consultants would sell IG mutual funds among other things. The fund selector on IG’s web site showed 84 funds designated as “aggressive growth,” which seems to mean stock funds. The dollar-weighted average management expense ratio (MER) was 2.65% per year! This is staggeringly high. Most forecasters consider an estimate for the long-term compound return from stocks of 6% above inflation to be optimistic. IG stock funds take away nearly half of this return in MERs. Actually, it’s worse than the 2.65% I calculated. This percentage is for the back-end loaded version of the funds, where you pay a percentage upon leaving the fund if you leave too s...

There is no shortage of pundits who offer predictions of what will happen to particular stocks or the stock market in general. You’ll find them on television, radio, and innumerable blogs. I’m open to the possibility that some investors can guess the long-term success of a particular business, but I simply don’t believe any short-term predictions that I hear. Here is why: if these pundits actually get it right a significant fraction of the time, then they could make much more money investing based on their predictions instead of wasting their time as pundits. To prove this, I decided to run some Monte Carlo simulations. Suppose that our pundit Peter predicts whether the S&P 500 will beat inflation each month, and he gets it right 80% of the time. So, 20% of the time when he picks stocks to win, he is wrong, and 20% of the time when he picks inflation to win, he is wrong. This may seem like only a mildly impressive record, but I’ll show how Peter can make himself fabulously wea...

In his article about the new ban on short selling 800 US financial stocks , Larry MacDonald discussed some of the pitfalls of short selling. This reminded me of one of the more interesting ways that short sellers can come out on the losing end. Short selling is the practice of borrowing stock and selling it so that you effectively own a negative number of shares. Short sellers hope that the stock drops so that they can later buy the stock back at a lower price, pocket the difference, and return the borrowed shares. Until recently, this practice was perfectly legal. Now, short selling is banned on certain beleaguered financial stocks. As Larry said, the biggest reason why short selling is a difficult game is that stocks tend to go up. When you pick a stock to short, you have to have far better insight into the stock’s future than other investors just to break even. Using short sales to make more money than you could have made by simply owning an index is very difficult. Some ...

In his book, Twilight in the Desert , Matthew R. Simmons makes the case that Saudi Arabia’s oil production will soon peak as the most easily recovered oil is depleted. His extremely detailed analysis contrasts sharply with the Saudi assertion that they can satisfy world demand for another 50 years. Much of his technical information comes from Saudi technical papers that seem to contradict their public statements. Simmons provides mountains of technical information that amounts to circumstantial evidence that oil supplies are dwindling. However, as he points out, it is up to the Saudis to prove their claims about how much oil is still in the ground and how quickly it can be supplied to the world. Assessing the nature of oil fields and how much oil they contain is very difficult. As much as anything this could account for the seeming lack of reliable information about oil reserves. Even if we knew how much oil is in the ground, it’s not clear how much of it can be recovered economica...

Preet over at Where Does All My Money Go recently discussed the importance of paying attention to investment fees. In a lighter moment, he had some fun with a fund screener and listed funds with yearly MERs above 8% ! To appreciate how ridiculously high this is, you need to see the effect over a long period of time. As I have discussed before, MERs are paid every year , and investors have to be cautious about comparing them to one-time costs. After one year in a fund charging an 8% MER you would still have 92% of your money. The next year, though, the fund would take 8% of your remaining 92% leaving you with 84.64% of your money. Over 25 years, an 8% MER would chew up 87.5% of your money. Suppose that your initial investment grows to $250,000 after 25 years. If you didn’t have to pay the 8% MER, you would have finished with $2 million! Things get even sillier with the worst fund Preet listed: “Dynamic Power Hedge Fund-F” with an MER of 13.94%. I’m not sure what this name ...

Suppose you’re given a chance to bet on the toss of a coin. If it comes up heads you win $20, and if tails you lose $10. Would you take this bet? Given a chance to do it 100 times in a row would you do it? This experiment was actually performed in a coffee shop in Westwood, Los Angeles, as explained by Jason Zweig in his book, Your Money & Your Brain . The average outcome is to win $5 every time you take this bet. But, if you do it only once, you could lose $10 instead of winning $20. What about doing it 100 times? The expected outcome is to win $500. The odds that you’ll actually lose money are less than 1 in 2000. The odds of losing $200 or more are less than one in a million. The odds of winning more than $200 are over 97%. This is an incredibly good bet. Amazingly, two out of three people accepted the one-time bet, but only 43% said they would be willing to repeat the bet 100 times. What are the possible explanations for the 57% of people who turned this down? ...

I stumbled across an excellent radio program (no longer online) where we hear from borrowers who didn’t have to show any credit worthiness, a broker who aggressively sought out borrowers without caring whether they could pay back loans, and other players up the food chain packaging mortgages into investments for the $70 trillion world-wide fixed income market that hungered for higher returns than US treasuries. Over the course of many steps, a half-million dollar loan to someone with low income was merged with other bad loans and transformed into an AAA-rated investment. This story is part stupidity and part greed. Unfortunately, both parts are extremely large. With stories like this it's easy to get discouraged. Are we all just greedy idiots? On the other hand, we still have too much food to go around and far more clothing for sale than we could possibly wear out. Life is pretty good whether we’re greedy idiots or not. For most of us, unhappiness is driven by envy of our...

Yet another mailing from the university I attended years ago arrived. It’s life insurance this time. In a burst of optimism, I think, maybe this will be a good deal because my alma mater will have trimmed the rates down as low as possible. I’ll get the benefits of a low cost group plan, and maybe university grads have slightly lower mortality rates. I decide to take a look. The first thing I see is a big picture of a smiling young woman. This is not a good sign. Advertisers know that men get looser with their money when they see smiling attractive women. I skip all the other mumbo jumbo and get right to the numbers. I’m a male non-smoker. I look up my age and desired coverage amount and find that the cost with the discount available to me is $67.50 per month. Is this good? I’m not sure. I could hunt through some paper files, but Google is right here at my fingertips. It took less than a minute online to get 12 quotes from the major insurers in Canada ranging from $46.40 to ...

Most of us have heard the phrase 20/20 hindsight. It refers to the fact that we tend to view past events as inevitable even though we didn’t see them coming in advance. Another name for this is hindsight bias. In his book, Your Money & Your Brain , Jason Zweig describes brain-scanning experiments that look for the biological basis for some of our human quirks. One of these quirks is hindsight bias. When we learn something new, we have a tendency to begin to believe that we’ve known it all along. When we buy a stock that later rises, we tend to think that we knew the stock would go up. We come to think that we bought the stock confidently knowing it would go up when the truth was that we were probably very uncertain and almost made a different choice. This tendency to believe that we were able to predict past events before they happened is very dangerous for investors. It makes us believe that the future is much more predictable than it really is. Hindsight bias can even kick ...

The banking crisis continues as Lehman Brothers files for bankruptcy . Most people seem to view banks failing as a sign that the financial crisis is deepening. You won’t be too surprised to learn that I see this differently. The damage to the economy was done when financial institutions made poor choices chasing short-term profits at the expense of the long-term health of their businesses. Lending money to people who can’t pay it back has to cause problems eventually. That banks are failing now is a logical consequence of their actions rather than a sign that things are getting even worse. To maintain a healthy economy, some businesses must fail. Everything would become stagnant if we were to prop up unprofitable businesses. Well-run businesses should see their market share increase as their poorly-run competitors fail. This doesn’t mean that government intervention is always wrong. However, the important test of whether government should step in is whether it is in the public i...

Unlike most investing products, life annuities actually solve a problem that do-it-yourself investors have difficulty handling on their own: longevity risk. By controlling my own investments with low-cost index ETFs, I can beat most professionally-managed mutual funds. However, when it comes to my retirement years, it will be hard to decide how much money it’s safe to spend because I don’t know how long I’ll live. If you control your own investments, the only practical approach in your retirement years is to spend little enough that your money will last to the end of a very long life. Just because the odds are only, say, 50% that you’ll make it to age 80, that doesn’t mean that you can get away with saving only half a year’s worth of spending money for your eighty-first year. If you make it to age 80, you’ll need a whole year’s worth of money. Life annuities are an insurance product designed to solve this problem. The insurance company takes a lump sum of money from you and pa...

One of the concerns I have about my investing future is my own emotions. One day I may become bold or fearful and make some rash decisions. The resulting trades would probably work out badly. I consider my online trading account to be one of the things that increases my risk of doing something impulsive. Some people say that the solution is to work through a financial advisor who performs the trades for you. I have a much cheaper solution: I avoid logging in to my trading account unless it is necessary. Many people choose to read stock quotes and other investing news through their online accounts. When you do this, making trades is always just a few clicks away. I do my day-to-day financial news gathering anywhere but through my trading account. This small extra barrier of trying to remember my password and figuring out how to make a trade gives me a little more protection against impulsiveness. Usually, the people I mention this to think I’m a little crazy. Is anyone else conc...

A recent article at My Dollar Plan caught my eye: A Penny Saved is ... $6,977.03! This article points to the essay Every Penny Counts by Scott Bilker. Bilker shows that if you increase payments on a long-term high interest debt by just a penny each month, big savings result. Starting with a $10,000 loan at 1.5% per month, the interest is $150 per month. The minimum you can pay and still have the loan paid off eventually is $150.01. But this will take about 54 years. Increasing the payment to $150.02 saves you $6977.03 over the life of the loan. Just a penny per month makes a big difference. Now I understand the point these authors are making: small amounts can add up. Ignoring small amounts each day can seriously hurt your finances over the long run. I’ve made the same argument myself in Small Amounts Add Up, but Pennies Don’t . As you can guess from this article’s title, I argue that small amounts add up, but pennies are just too small to amount to anything important. ...

Let’s say you’re in a casino gambling and an employee walks up and says “I see you’re not having a good day. Here’s a voucher for you and your wife to have a free steak dinner. You can go right now. Enjoy.” This is a real possibility at Harrah’s casino in Las Vegas. This is a very kind gesture, but what is behind it? Yale law professor and economist Ian Ayres answers this question in his book, Super Crunchers . The ability of computers to gather vast amounts of data about our actions and choices has given rise to decision-making based on data analysis, called super crunching by Ayres. To see how super crunching works, let’s look at the case of Harrah’s casino. Like any business, Harrah’s would like to maximize profits. To use super crunching, Harrah’s began by collecting data about the gambling patterns of their “total rewards customers” who use swipeable electronic cards to identify themselves while gambling. Then Harrah’s used a method called regression on the data to see wh...

According to Jason Zweig in his very interesting book, Your Money & Your Brain , the wiring of our brains is responsible for some of the mistakes we make in our approach to investing. Zwieg covers a number of human tendencies that can be traced to brain activity, but I will focus here on what makes us want to keep chasing stocks that ultimately disappoint us. The new science of neuroeconomics involves scanning subjects’ brains while they take part in experiments. By seeing which parts of the brain light up and how intensely they light up, researchers can tell a lot about how we’re wired. It turns out that we’re more excited during the time leading up to a potential reward than we are to actually receive the reward. So, when a gambler plunks his money down on lucky number 7 at the roulette wheel, he’s more excited watching for the wheel to stop than he is to rake in his chips if he happens to win. The amount of excitement in the gambler’s brain increases with the size of th...

TD Bank recently announced record earnings for the third quarter this year. This sounds a lot more impressive than it really is. If I leave some money in a savings account that pays 3% interest every year, I can expect to make “record earnings” every time I get paid interest. By leaving each interest payment in the account, the next interest payment will be larger than all the previous ones. So, a new record is set every time. Warren Buffett explained this in his 1977 letter to shareholders . Pay raises tend to be very small these days, but by the standard of financial press releases, you can trumpet a new record income even if all you get is a 1% raise. I’m not making any claims about whether TD Bank had a good quarter or not. But, you shouldn’t be impressed by any announcement of record earnings. It’s always necessary to dig further into the details to find out what is really going on.

I was recently pointed to a fascinating book called Predictably Irrational , by Dan Ariely. Among other things, I learnt that when ordering food in a restaurant, I should try to order first to maximize the odds that I’ll enjoy my meal. Huh? In a series of experiments, Ariely determined that many of us have a tendency to order something different from everyone else at our table to show our individuality. Other people have a tendency to order the same food as others to show solidarity. Either tendency leads to ordering a sub-optimal choice. Ariely’s experiments showed that when people write down their orders without knowing what others at their table ordered, they enjoy their meals more. In the ordering out loud case, only the first person to order enjoyed his meal as much as those who wrote their orders down. This is just one of the many ways that people are consistently irrational in a predictable way. I would say that being too afraid of short-term investing losses is anot...

Most people are happier to see the price of the equities they hold rising rather than falling. But, is this sensible for people who are in a phase of their lives when they are saving money and buying equities? Isn’t it better to buy things at lower prices instead of higher prices? I think that your feelings on this subject say something about you as an investor. Warren Buffett has consistently said that he would be pleased to have the stocks he holds drop by 50% so that he could buy more cheaply. The reason he thinks this way is that he believes he has a good sense of the intrinsic value of the businesses he owns. You can think of stock prices as estimates of intrinsic value that may or may not be accurate. Buffett is confident that if a stock price drops way below the intrinsic value of the business, the price will rise to meet the intrinsic value eventually. So, for him, low stock prices are a buying opportunity. However, most people can’t estimate the intrinsic value of a bus...

Last week, Frugal Trader over at Million Dollar Journey wrote a provocative article about 4 reasons why index investing may not be for you . This article generated a lot of interesting discussion. Instead of giving my own opinion on the subject, I thought I’d search out views from a recognized expert. Enter Warren Buffett, or at least a 15-year younger version of him. In his 1993 letter to shareholders , Buffett wrote “[A] situation requiring wide diversification occurs when an investor who does not understand the economics of specific businesses nevertheless believes it in his interest to be a long-term owner of American industry. That investor should both own a large number of equities and space out his purchases. By periodically investing in an index fund, for example, the know-nothing investor can actually out-perform most investment professionals. Paradoxically, when ‘dumb’ money acknowledges its limitations, it ceases to be dumb. “On the other hand, if you are a know- ...

One of the quirks of human behaviour is that we value things more highly if we own them. When selling your house, you remember the good times, but prospective buyers notice the cracks in the walls. One of the places where this effect can give you trouble is on ebay. Suppose that you are searching for an item on ebay and are pleased to find it. You then make a bid. But the bidding won’t close for another three days. Two days later you see that there aren’t any higher bids. At this point, you begin to mentally treat the item as partially in your possession. The rest of this story is familiar to frequent users of ebay. In the last minutes of the auction, a higher bid will come in and anger you. This newcomer has a lot of nerve! After all, this item has been nearly yours for three days. Now you’re tempted to enter bids higher than the upper limit you decided upon three days earlier. I don’t have any grand ideas for how to combat this tendency. Maybe just being aware of it can he...

Canada’s Gross Domestic Product (GDP) rose 0.3% in the second quarter of this year, which means that we’re not in a recession. This should be good news, but it’s actually mildly annoying. We all know that the economy hasn’t been great lately. Even if unemployment is low, we know people who have lost jobs and have been forced into lower paying jobs or part-time work. Stock prices are dropping. Housing prices are dropping. To say that we’re not in a recession is like denying that there are any problems with the economy. But the numbers don’t lie. GDP shrank in the first quarter and rose in the second quarter. The definition of a recession requires two consecutive quarters of dropping GDP. So, we’re not in a recession. The emotional response to this news was captured nicely in the headline “Canada skirts recession on a technicality.” The implication is that we all know that things have been rough and we should be calling it a recession, but some number cruncher found some w...