Standard financial theory treats us as though we are all perfectly rational people who make no mistakes in maximizing our utilitarian benefits with each of our financial choices. In reality, we’re emotional creatures who have desires outside of utilitarian needs. We have limited time and ability to evaluate choices, and we make lots of mistakes. Many books have been written about how people fail to make the best rational choices. What sets Meir Statman’s Finance for Normal People apart is his attempt to unify real human nature into a realistic theory of finance. “We want three kinds of benefits—utilitarian, expressive, and emotional—from all products and services, including financial products and services.” We’re used to focusing on utilitarian benefits such as maximizing portfolio returns. However, we also seek “the expressive benefit of high social status, as by a hedge fund; and the emotional benefits of exhilaration, as by a successful initial public offering.” Sometime...

Before launching into this biweekly roundup, our friend the Blunt Bean Counter played a role in a BDO Canada survey of business owners and non-business owners about retirement and wealth . Here are some of their findings: Business owners plan more for retirement than non-business owners but feel less on track. Almost one-third of business owners plan to work part-time after retirement – compared to 12 percent of the general population. More than one in three business owners plans to retire in the next five years. Financial support for children was more common among the business owners than among non-business owners. Here are my posts for the past two weeks: The Dividend Puzzle Portfolio Optimization The Annuity Puzzle The High Cost of Paying Property Insurance Monthly  Here are some short takes and some weekend reading: Mr. Money Mustache describes his experience driving for Uber and Lyft. He has a number of suggestions for making the system exploit drivers l...

Update: An anonymous commenter says that when a down payment is charged on property insurance, contrary to what our insurance agent told us, monthly payments end after 10 months and not 12.  The article has been updated accordingly. Recently, I was helping a family member switch property insurance companies. The last thing to arrange was paying the premium. The insurance agent was steering us toward monthly payments instead of paying for the full year in advance. At first I was just going to dismiss the idea of paying monthly, but I decided to ask the agent what interest rate they charged. I think his exact words were “there is a 4% service fee.” For the purposes of this article, I’ll scale all the numbers to an annual insurance premium of $1200 to keep the math simple. I took the insurance agent to mean that they take the $1200 premium, add 4% to get $1248, and divide by 12 to get $104 as the monthly premium. This turns out to be only partially correct.  In additio...

A big challenge in retirement is spending enough to be happy without running out of money. The main problem is not knowing how long you’ll live. This is called “longevity risk.” We are forced to plan for a long life whether we’ll live long or not. One way to eliminate longevity risk is with an annuity. The idea is to hand your money over to an insurance company, who then promises to pay you monthly, even if you live much longer than they expect. According to Meir Statman in his book Finance for Normal People , “people are reluctant to annuitize, a reluctance we know as the ‘annuity puzzle.’” Statman identifies a number of “behavioral impediments to annuitization.” We are averse to “transparent dips in capital.” Seeing your portfolio take a big drop hurts, even knowing that you’ll get lifetime income in return. Also, the “money illusion” makes “a lump sum of $100,000 seem larger than its equivalent as a $500 monthly annuity payment.” “Availability errors deter people from...

Deciding what percentage of your portfolio to allocate to bonds, domestic stocks, foreign stocks, etc. can be challenging. Any attempt to optimize this allocation is necessarily based on assumptions. It’s dangerous to blindly follow optimized allocation percentages without examining the assumptions built into the optimization process. In his book Finance for Normal People , Meir Statman tells the story of investment consultants choosing asset allocation percentages for a large U.S. public pension fund. The consultants used Harry Markowitz’s mean-variance portfolio theory to calculate an optimal portfolio for the pension fund. But then they modified all the percentages. Statman’s explanation for why the consultants changed the percentages is that the managers of the pension fund wanted more than the “utilitarian benefits of higher expected return”; they wanted “expressive and emotional benefits, including the benefits of conformity to the portfolio conventions of this pension fu...

The strong preference many investors have for dividends over capital gains is known among economists as the “dividend puzzle.” Meir Statman offers a solution to this puzzle in his book Finance for Normal People . Statman says that many investors incorrectly “frame the capital of a stock as a fruit tree and dividends as its fruit. In that frame, collecting dividends and spending them does not diminish the capital of the stock any more than picking fruits off a tree and consuming them diminishes its size.” “Rational investors know the correct frame for dividends and capital. They know that $1,000 in ‘homemade’ dividends from the sale of shares is identical in substance to $1,000 from a cashed dividend check, even if different in form, and they care about their total wealth, not its form.” Because the “price of shares of a company declines when a company pays dividends,” “payments of dividends do not affect the total wealth of investors.” All that said, dividends do offer some a...

I managed only one post in the past two weeks, a review of two books: The Smartest Investment Book and Portfolio Here are some short takes and some weekend reading: Tom Bradley at Steadyhand is almost as cynical as I am about Amazon’s long, drawn-out “search” for a second headquarters location. I hope this whole PR event backfires for Amazon. In another article he discusses the elements of academic behavioural economics that he sees in practice . Squawkfox has some sensible advice about extended warranties. Gordon Pape shares important things you should know about traveling to Florida for the winter. His advice on this subject is far superior to his investment advice. Big Cajun Man clarifies some of the rules surrounding Registered Disability Savings Plans (RDSPs).

There is little doubt that the vast majority of investors would be better off investing in low-cost diversified index funds than attempting to beat the market. However, the best writers explaining this fact, like Charles D. Ellis, tend to be calm and reasonable, while the loudest proponents of expensive active management say silly alarmist things like “index funds will destroy capitalism.” One voice on the index fund side that can take on hysterical active management proponents is Daniel R. Solin. His books The Smartest Investment Book You’ll Ever Read (Canadian Edition) and The Smartest Portfolio You’ll Ever Own pull no punches. While I prefer Ellis’s style, I like Solin’s chances of holding his own in a public debate. Solin refers to active portfolio selection as “hyperactive management.” He says “The securities industry adds costs. It subtracts value.” He devotes many pages to the numerous failings of the investment industry. While he overstates some of his points (e.g....