Short Takes: Problems with Risk Ratings, Rising CMHC Premiums, and more
Here are my posts for the past two weeks:
Pre-Suasion
What Do You Have to Show for Your Work
Comparing Your Investment Returns to a Benchmark
Here are some short takes and some weekend reading:
Dan Hallett has some thoughtful criticism of risk ratings of mutual funds and ETFs. Personally, I don’t think of risk as “low,” “medium,” or “high.” I think in terms of possible losses. Each asset class has some amount of loss I should reasonably consider to be possible. I usually think of the entire worldwide stock market as possibly dropping 50% for some period of time before eventually recovering. The possible percentage drop is much lower for fixed-income products. For any individual stock, the possible drop is 100% (with no recovery). Using these percentages, I look at my portfolio, imagine these drops happening and ask myself “will I be OK?”
Canadian Mortgage Trends reports that CMHC is raising premiums for high-ratio mortgages, making mortgage insurance more expensive for Canadians. They complain that these increases are “not well supported by any publicly available mortgage risk data (default rates, overall credit quality, equity levels, etc.).” This is a common logical error. The real risk is that future default rates will be much different from what they have been in the recent past. CMHC premiums need to reflect the risk looking forward, not default costs looking backward. I’m happy to listen to arguments about whether the new rates make sense, but those arguments have to be based on actual risk, not assumptions that the near future will look like the recent past.
Preet Banerjee uses his latest Drawing Conclusions video to explain that the costs you see on your upcoming account statements due to new reporting rules will actually be far lower than what you’re actually paying, if you invest in mutual funds.
The Reformed Broker explains to people trying to profit from trading on the reaction to Trump’s tweets why they need to give their heads a shake.
Canadian Couch Potato updated his model portfolios for 2017. He also goes over the 2016 investment returns in various asset classes as well as the performance of the model portfolios. Just in case that’s not enough, he has an interesting podcast featuring a hedge fund manager who advises people “to give up the dream of market-beating returns.”
Jessica Moorhouse interviews Dan Bortolotti in one of her Mo’ Money podcasts. One of the many interesting things Dan had to say was that part of the problem with advisors talking negatively about indexing is that their training includes little about indexing, so they often just don’t understand it.
Robb Engen at Boomer and Echo reviews a very interesting-sounding book How to Think about Money, by Jonathan Clements. You can also enter a draw to win a copy.
Big Cajun Man reports that the bulk of the job growth in Canada in 2016 was in part-time jobs.
My Own Advisor is giving away a copy of the book Victory Lap Retirement.
Pre-Suasion
What Do You Have to Show for Your Work
Comparing Your Investment Returns to a Benchmark
Here are some short takes and some weekend reading:
Dan Hallett has some thoughtful criticism of risk ratings of mutual funds and ETFs. Personally, I don’t think of risk as “low,” “medium,” or “high.” I think in terms of possible losses. Each asset class has some amount of loss I should reasonably consider to be possible. I usually think of the entire worldwide stock market as possibly dropping 50% for some period of time before eventually recovering. The possible percentage drop is much lower for fixed-income products. For any individual stock, the possible drop is 100% (with no recovery). Using these percentages, I look at my portfolio, imagine these drops happening and ask myself “will I be OK?”
Canadian Mortgage Trends reports that CMHC is raising premiums for high-ratio mortgages, making mortgage insurance more expensive for Canadians. They complain that these increases are “not well supported by any publicly available mortgage risk data (default rates, overall credit quality, equity levels, etc.).” This is a common logical error. The real risk is that future default rates will be much different from what they have been in the recent past. CMHC premiums need to reflect the risk looking forward, not default costs looking backward. I’m happy to listen to arguments about whether the new rates make sense, but those arguments have to be based on actual risk, not assumptions that the near future will look like the recent past.
Preet Banerjee uses his latest Drawing Conclusions video to explain that the costs you see on your upcoming account statements due to new reporting rules will actually be far lower than what you’re actually paying, if you invest in mutual funds.
The Reformed Broker explains to people trying to profit from trading on the reaction to Trump’s tweets why they need to give their heads a shake.
Canadian Couch Potato updated his model portfolios for 2017. He also goes over the 2016 investment returns in various asset classes as well as the performance of the model portfolios. Just in case that’s not enough, he has an interesting podcast featuring a hedge fund manager who advises people “to give up the dream of market-beating returns.”
Jessica Moorhouse interviews Dan Bortolotti in one of her Mo’ Money podcasts. One of the many interesting things Dan had to say was that part of the problem with advisors talking negatively about indexing is that their training includes little about indexing, so they often just don’t understand it.
Robb Engen at Boomer and Echo reviews a very interesting-sounding book How to Think about Money, by Jonathan Clements. You can also enter a draw to win a copy.
Big Cajun Man reports that the bulk of the job growth in Canada in 2016 was in part-time jobs.
My Own Advisor is giving away a copy of the book Victory Lap Retirement.
I wrote as much on my site as well Michael, I think of risk as a "loss" - the combination of severity of that loss and the probability that loss will occur. When it comes to money, I'd rather not lose anything.
ReplyDeleteHave a great weekend and thanks for the mention.
Mark
@My Own Advisor: I'm no fan of investment losses, but the possibility of loss and the potential magnitude the of loss goes hand-in-hand with higher expected gains. So, you take the bad with the good.
DeleteThe fact that the economy creates Part-time jobs is fine, but if the millennial are forced to have multiple jobs throughout their "career" they had better be doing some extra financial planning so they can pay for it all. The other problem being most part-time jobs don't have benefits.
ReplyDeleteThanks for the inclusion this week!
"I usually think of the entire worldwide stock market as possibly dropping 50% for some period of time before eventually recovering. For any individual stock, the possible drop is 100% (with no recovery). Using these percentages, I look at my portfolio, imagine these drops happening and ask myself “will I be OK?”
ReplyDeleteDo you really do that?! How do you calculate the probabilities of those events?
If, as I think I’ve read, your portfolio is comprised exclusively of index funds and ETFs, then why would you even consider such events? If the global markets “eventually recover” and you own no individual “no recovery” stocks…it seems like a moot exercise.
@SST: Yes, I do that. Probabilities are a factor in deciding on a plausible size of price drop. But once I've picked a price drop percentage (50%), probabilities don't enter into it. I just imagine that the big drop happens, and decide if the results are tolerable.
DeleteIf I were further from retirement age, I wouldn't have much to worry about and this "exercise" would be very brief. However, I'm old enough that if the company I work for had financial trouble and I lost my job, I might consider retiring. My current plans involve finding other work if I have to and waiting out a stock crash. But when I come to the point where I decide I'd rather not find other work, I'd have to consider immediately selling a block of stock while it's priced high and shifting the proceeds into fixed income as a precaution against a stock crash so that I'd be OK to retire immediately.
"Probabilities are a factor in deciding on a plausible size of price drop. But once I've picked a price drop percentage (50%)..."
DeleteThis is confusing to me. Are you letting true probabilities decide a plausible price drop or are you randomly picking the percentage?
To me, a 50% price drop, while technically plausible, doesn't have any where near the frequency of occurrence a 20% or 30% drop does. Spanning the last 200 years*, there's been only a single instance of a -50% annual return to the S&P. What data did you use to calculate a -50% drop to "the entire worldwide stock market"?
(That's not to say more 50% cuts didn't happen, but the drop and recovery within the year resulted in a >-50% return.)
You also build "eventually recovering" into your calculations, but if you are seeking the same plausibility as you are in 'size of price drop', shouldn't you also include "never recovering" as a plausible probability? The NIKKEI index, for example, is still down ~50% 35-years after its price drop.
Continuing, if your total portfolio is comprised of funds and not individual stocks, then why even consider a "possible drop is 100% (with no recovery)" scenario? First, if that does happen, the index, through its active management will replace said company with another component. Second, what data did you use to determine 'stocks going to zero with no recovery'? Yes, it's plausible, and we can all think of many examples, but in the global marketplace of perhaps 50,000+ issues, how many of those have eroded completely? Third, you seem to discount your own fear in the 100% drop scenario. Would you actually wait around and do nothing until the stock hit $0 before you "sold"? A stock's final return may very well be 100%, but what would your net losses be?
It seems as though you also omit any social security stop-gap functions from your calculations. If you lost your job, what degree of buffer would employment insurance provide against you having to sell assets? I don't know the particulars, perhaps if you are a contractor you can't apply for EI, etc.
Perhaps these are just easy to work with imagined worst-case scenario numbers? Perhaps I'm over/under-thinking?
*(this is actually a practice which I loath to participate because of the many changes in variables and data, but it serves its purpose here.)
@SST: You have a way asking your questions that seems designed to offend, but perhaps it's not deliberate. On the other hand, you bring up important issues.
Delete"Are you letting true probabilities decide a plausible price drop or are you randomly picking the percentage?"
True probabilities about future returns are not knowable. All we have as a rough guide to the future is the past. I use 50% because it's close the the largest drop in the world-wide stock market that has happened since decent data has been collected. This choice isn't random, but it's hardly important whether we use 48% or 52%.
"To me, a 50% price drop, while technically plausible, doesn't have any where near the frequency of occurrence a 20% or 30% drop does."
If a 50% drop in world-wide stocks leaves me OK, then so will a lesser drop. This isn't an optimization exercise; I seek to determine what effect a big investment loss would have on my life.
"The NIKKEI index, for example, is still down ~50% 35-years after its price drop."
Japan isn't the whole world. Many terrible futures are possible. I've chosen a 50% drop with a recovery within 10 years as the worst outcome worth planning for. Significantly worse outcomes could result from nuclear war or other calamities. But, I question whether the concept of individual ownership would even have meaning in sufficiently bad outcomes.
"Why even consider a 'possible drop is 100% (with no recovery)' scenario?"
I have options in my employer. When I consider a bad outcome, I assume these go to zero. Otherwise, I don't use this scenario.
"What data did you use to determine 'stocks going to zero with no recovery'?"
In the past some stocks have gone to zero. It can happen again. Many people believe they'd be smart enough to sell well before zero. However, how can you tell the difference between a company that will made a big rebound and one that will fail completely? The truth is that almost all of us can only take a guess.
"You seem to discount your own fear in the 100% drop scenario."
I've invested through two boom-bust cycles now and didn't flinch. This is in part because I think through how a crash will affect my life before any crash happens. That's the point of the exercise of imagining a 50% drop.
"If you lost your job, what degree of buffer would employment insurance provide against you having to sell assets?"
If my unemployment lasted long enough, EI would make a difference. But, as long as I'm healthy, I would have little problem finding a job paying much more than the EI clawback limit. My real concern is how a market crash would either extend the years where I have to work, or would reduce my spending through retirement.
"Perhaps I'm over/under-thinking?"
Perhaps. If I look at my portfolio of $X now and imagine median returns, I can project a likely future life for myself, including how long I have to keep working and how much I can spend monthly (scenario 1A). If I then imagine a drop to $X/2 with a recovery to $X in a decade, I can then see I'd require more years of work and have lower monthly spending (scenario 1B). Alternatively, I could imagine moving $Y into fixed income right now, and repeat this exercise. The scenario with median returns would look somewhat worse (scenario 2A), but the market crash scenario (scenario 2B) would look better than 1B. If I decide I really don't want to risk 1B, then I could choose to give up a shot at 1A (and accept a likely 2A) so that the bad scenario becomes the more tolerable 2B. So far, I haven't chosen to move any money to long-term fixed income, but when I decide I'd really rather not have to work too much longer, I probably will.