Book Review: The Canadian’s Guide to Investing

Authors Tony Martin and Eric Tyson have updated their book, The Canadian’s Guide to Investing, but it certainly does not seem very up-to-date.  Despite a few references to ETFs and some updated examples, most of the text seems decades old and no longer very relevant.  There are some good parts, but there are better choices for investment books.

The book makes reference to many things that used to be true.  Extensive discussion about “funds” is almost exclusively about mutual funds with little about ETFs.  Buying stocks is “costly unless you buy reasonable chunks (100 shares or so) of each stock.”  You can “call the fund company’s toll-free number” and invest by “mailing in a cheque.”  “A great deal of emphasis is placed on who manages a specific fund” – this is mostly a thing of the past.  “Invest in a handful of funds (five to ten).”  There is discussion of real estate “declines in the late 2000s.”

There are repeated references to MERs of 0.5% to 1.5% as being “low.”  Even the ETF discussion on this point says index ETFs “typically have MERs of less than 1 percent.”  I suppose 0.05% is less than 1%.

The authors advise people to avoid limit orders and use market orders when you intend to hold for the long haul.  They seem to consider limit orders as being only for trying to get equities for cheaper than the current ask price.  A good use of limit orders is to offer a price higher than the current ask price (or lower than the current bid price when selling).  This will usually give you the market price, but will prevent the trade from executing if markets move quickly against you just as you’re entering the trade.

The book advises people to rely on credit-rating agencies for bonds, which is interesting in light of the abject ratings failures leading up to the great financial crisis.

On asset allocation, “playing it safe” is to use your age as a bond percentage, “middle of the road” is age minus 10, and “aggressive” is age minus 20.  They go on to break down the stock allocation characterizing owning mostly Canadian stocks as “play-it-safe,” and having half your stock allocation outside of Canada as “aggressive.”  I don’t see anything safe about avoiding U.S. and international stocks.

The authors tell investors “who enjoy the challenge of trying to pick the better [fund] managers and want the potential to earn better than market level returns, don’t use index funds at all.”  Chasing star fund managers is an old and losing game.

At one point, the authors promise to help investors in “spotting a greatly overpriced” market so you can “invest new money elsewhere.”  It turns out that this method uses price-earnings ratios.  Shiller’s CAPE10 measure of U.S. stock market price-earnings has been above 20 since 2010, a period where U.S. stocks have grown by a factor of nearly 6 (including dividends).  This is not a good period to have skipped.

On the positive side, the authors advise against buying expensive cars: “set your sights lower and buy a good used car that you can afford.”  When it comes to index investing, “you can largely ignore the NASDAQ.”  “To find a home that meets your various desires,” taking “six months to a year [to find the right house and neighbourhood] isn’t unusual or slow.”  “Begin your search without [a real estate] agent to avoid … outside pressure.”

The authors have some interesting takes.  “One of the best tactics is to focus only on [retirement saving and paying off your mortgage] and ignore [saving for university or college]” until later.  They also offer extensive advice concerning owning a small business and determining if readers are suited to it.

The authors would need to put extensive work into this book to bring it up to date.  As it is, I can’t recommend it to others.

Tax Rates on RRSP Contributions and Withdrawals

Recent Rational Reminder podcasts (319 and 321) have had a debate about tax rates on RRSP contributions and withdrawals.  Most people agree that when you contribute, you’re lowering your taxes at your marginal tax rate.  The debate concerns withdrawals.  Some say that RRSP withdrawals come at your “average, or effective tax rates, not your marginal tax rate.”  Here, I address this question.

With Canada’s progressive tax system, the first part of your income isn’t taxed at all (or is taxed negatively when you consider income-tested government benefits), then the next part of your income is lightly taxed, and marginal tax rates increase from there as your income rises.

A question that comes up in my own portfolio accumulation and decumulation planning is what order to stack income each year.  Is it CPP and OAS that are taxed lightly and RRSP withdrawals taxed more, or should I stack the income in some other order?  What about other income from non-registered savings?  Maybe everything should be assigned the same average tax rate.

The truth is that this is only a struggle because we’re trying to assign tax rates to one strategy in isolation.  Whether a strategy is good or not cannot be decided in isolation.  It only makes sense to compare two or more strategies.  When we compare strategies, it becomes obvious how to handle tax rates.

Let’s try to create two strategies that isolate the RRSP as the only difference.  Strategy 1: no RRSP.  This strategy might include TFSA contributions or other elements, but it does not use RRSPs.  Strategy 2: everything from strategy 1 plus RRSP contributions while working, and RRSP withdrawals after retiring.

Comparing the two strategies during working years, we should think of RRSP deductions as coming off the highest part of the total income because that is the difference between the two strategies.  If we apply the deduction somewhere in the bottom or middle of the income range, then the other income (that is the same in both strategies) will be taxed differently in the two strategies.  We want to find the net difference between strategies, and that comes from treating the RRSP deduction as coming at the marginal tax rate.

During retirement years, we end up with a similar argument.  Both strategies will have the same income each year, except that Strategy 2 will have additional RRSP withdrawal income.  To isolate the differences in income and taxes between the two strategies, we must think of the RRSP withdrawal as being the last, most highly taxed part of the income.  So, it’s taxed at the marginal rate.

At this point, we should comment on what we mean by marginal rate.  It is usually defined as the tax rate on the last dollar earned.  However, we usually aren’t discussing amounts as trivial as a single dollar.  Larger amounts can easily span multiple marginal tax brackets.  So, it’s possible for your RRSP deduction to give part of its tax savings at one rate and part at a lower rate.  

So, when we say that RRSP contribution tax savings occur at your marginal rate, this might actually be a blended rate, not to be confused with your overall average tax rate.  For example your marginal tax rate might be 43%, your tax savings rate on RRSP contributions might be partly 43% and partly 38% for a blended rate of 40%, and your average tax rate might be 25%.

This effect becomes larger for RRSP withdrawals, because the withdrawals tend to be larger than the contributions.  If your income consists of CPP, OAS, and RRSP withdrawals, your RRSP withdrawals may be the bulk of your income and may span multiple marginal tax brackets.  So, even though we say you pay tax on the RRSP withdrawals at your marginal tax rate, this is actually a blended rate that may not be too much higher than your average tax rate.

So, when comparing the strategies that differ only in RRSP contributions and withdrawals, the argument that RRSP withdrawals come at your average tax rate might be sort of true in the sense that they will likely be at a blended rate, but we get the correct answer when we think of RRSP deductions and income as coming at the top of your income.  We can only answer such questions properly when comparing two or more accumulation and decumulation strategies rather than analyzing one strategy in isolation.

Picking Up Nickels in Front of a Steamroller

Suppose a casino offered the following bet.  You roll six fair dice.  If anything but all sixes shows up, you get $20.  But if all sixes show up, you lose a million dollars.  There are a number of practical problems with this game.  The casino would demand a million dollar deposit in advance, and the odds are way too sensitive to imperfections in the dice and to player skill at not throwing sixes.  But this is a thought experiment designed to shed light on real world financial events.

Initially, few people would play this game, because losing a million dollars is too scary.  But if you watched someone playing, even all day, you’d likely never see a loss.  You’d just see the player collecting $20 every 10 seconds or so building up to many thousands of dollars.  The fear of missing out (FOMO) would set in for some and tempt them to play.

Over the long haul, the casino expects to pay out $933,120 for every million dollars it wins.  So playing this game is good for the casino but a bad idea for the player.  However, it’s easy to forget about the losses if you only see everyone winning $20 every play.  Games like this are referred to as “picking up nickels in front of a steamroller.”  The $20 payoffs are the nickels, and the million-dollar losses are when you get flattened by the steamroller.

The yen carry trade

So what does this have to do with real life?  There are many “games” in real life that resemble this hypothetical game more than people would like to admit.  When interest rates were much lower in Japan than they were in the U.S., it seemed profitable to borrow yen at a low interest rate, convert it to U.S. dollars, and collect high interest on U.S. dollar deposits.

This sounds quite profitable, so why did I say it only “seemed profitable”?  Well, all was well as long as interest rates and the exchange rate between yen and U.S. dollars were stable.  However, a rise in the value of the yen and higher Japanese interest rates (the steamroller) could more than wipe out any profits from the interest rate spread (the nickels).

Unlike the hypothetical dice game where the potential loss of a million dollars is prominent, it’s less obvious with the yen carry trade.  You might convince yourself that the value of the yen and Japanese interest rates would change slowly enough that you could exit your positions profitably.  However, many others would be trying to unwind their positions at the same time, each one trying to be among the first to get out.

Excessive leverage

Rather than just invest a fraction of your wages in stock markets, you could borrow extra money to invest more.  The stock markets may gyrate, but they keep rising.  If you can just wait out the gyrations, you’ll be sure to eventually make more money (the nickels) than if you didn’t borrow.

The problem is that if you borrow too much, and your creditors see that you’re in danger of becoming insolvent, they may demand their money back or impose high interest rates that eliminate your profits.  A sudden stock market crash (steamroller) could wipe you out before you get a chance to wait out the market decline.  Modest leverage can be reasonable, but it takes some skill to determine how much you can borrow safely.

The great financial crisis

Many Wall Street firms made apparent profits selling insurance against mortgage defaults in the form of exotic financial instruments like credit default swaps (CDSs) and collateralized debt obligations (CDOs).  In this case, the nickels were the insurance premiums they collected, and the steamroller was the wave of mortgage defaults across the U.S.

It’s tempting to say that everyone involved was naive or incompetent, but employees of a firm have different interests than the firm itself does.  While the party was ongoing, the apparent profits piled up, and employees collected their share in the form of huge bonuses.  When the steamroller crushed their firms, these employees didn’t have to return their bonuses.  It was like playing the dice game with someone else’s money.  The employees would take a cut of each $20 win, and let others deal with the million dollar loss.

Long-Term Capital Management

The LTCM hedge fund employed Nobel Prize winners to beat the markets, and it seemed to work for a few years.  They used complex models of how markets work to squeeze out profits (the nickels).  Unfortunately for them and their investors, markets eventually stopped working the way the models expected (the steamroller) for long enough to wipe out past profits.

Conclusion

There are many financial schemes in the real world that resemble picking up visible nickels in front of an obscured steamroller.  If you think you've found a way to beat the markets, try to figure out where the steamroller is.