Author: Mr. Cheap

Categories
Real Estate

The Fallacy of Return on Investment

Return on investment (ROI) is a popular, useful way to evaluate an investment. Simply, it’s the return you get from an investment, divided by how much it cost you. E.g. you buy a GIC/CD for $1,000, a year later they return your $1,000 and give you $50 in interest, you’ve got a 5% (50/1000) return.

I’ve posted before on my ROI from my condo (calculated at the 6 month mark – once I’ve done my taxes I’ll post about what it looked like at the 1 year mark). Going into the future, some of my expenses will drop (my mortgage is continually decreasing, I got a break on my insurance when I renewed) and my income (rent) SHOULD go up.

Will this mean that I have a continually increasing ROI? Many people would say yes and that’s part of the reason its supposedly great to invest in real estate, but I think there’s a problem with this line of thinking. I’ve wrote about this fallacy as it relates to stocks, but I think it’s broader than that.

Say I bought a condo for $100k 10 years ago and you bought an identical condo for $150k yesterday (which is the fair market value for both of our properties). Say we both rent our condos out for $1300 / month. My ROI is 15.6% (1300*12/100000) while your’s is 10.4% (1300*12/150000). We’ll ignore all expenses just to convince everyone that real estate is a magical, perfect investment vehicle.

Now say we both come across another investment offering a ROI of 13%. Using just ROI, rationally someone might say you should sell and move your money into the new investment, while I should keep my condo. But our condos and rents are the same, so how could it make sense for one of us to pursue an alternative investment but not both of us?

The problem with this thinking is that it’s considering my condo to be worth $100,000 when its not. Its now worth $150,000. The only reasonable way to think about this is to consider the CURRENT value of the condo (look at the opportunity cost). The purchase price is totally irrelevant (except perhaps for tax calculations and whatnot).

I’ve done various calculations on my condo return. Its looks great (over 7%) when I consider the purchase price (around $130k depending on whether you factor in the cost of renos and transaction costs). It looks pretty meager (around 4%) when you look at the ROI based on the current value of the condo (similar units are selling for an ASKING price of more than $160k – I don’t know what they’re actually selling for).

I got a good price on my condo when I bought. That transaction is finished however. I can’t claim that I keep benefiting from a good purchase price into the future as long as I own it (or I can claim this, but I’m fooling myself). I could have bought it, fixed it up and sold it (flipped it) and captured this increase immediately. The decision whether to sell or rent should be based on the market value NOT on the purchase price.

I came across a mistake in the opposite direction in a real estate book I was flipping through recently. The author claimed that you should base you ROI on your equity (current value – current mortgage) which I agreed with (the current value part anyway). However, he also considered positive cash flow as the income and reached an unusual conclusion. Say you bought a $100k property for 5% down ($5k) with a $1000 / year positive cashflow. His claim was that you start with a ROI of 20% ($1000 income / $5000 equity). Fair enough. He then speculated that a year later the property value AND the income went up 10% ($110k property, $1100 / year positive cash flow). His claim was that your ROI was now 7.3% ($1100 income / $15000 equity) and you needed to sell. The problem with this is that your leverage is massively affecting your ROI in a way that certainly doesn’t smell right to me (if you could get a property for 0% down with positive cashflow his calculation would claim that’s an infinite ROI). To my mind the investment is almost exactly the same as the day you bought it: the income and the value have gone up an equivalent amount, so why sell?

Personal yield on stocks, as I wrote before, is exactly this fallacy (one of the commenters on my previous post claims this fallacy is called “mental accounting”). Your personal yield is meaningless (for anything other than making you feel good about the investment). The dividend yield, based on the current stock price, is what is meaningful if you want to evaluate the ROI of an investment going forward (again: this is ignoring the tax drag, which should be included if you’re actually thinking about selling).

Just to be clear, I don’t think ROI is a fallacy, I think it’s a very important concept. However, I often read statements that make me worry that people are misapplying it.

Categories
Personal Finance

Savvy Consumers

I was surprised, when I first tried renting the condo I bought, at how savvy potential renters were. My initial rental price was *way* too high, and people would come, look around, then politely decline to fill out an application. I dropped the price and kept getting the same behaviour. Finally I dropped it again and suddenly half the people who saw the place wanted to fill out the application (and some of them wanted to rush through the application process – they were afraid of losing the place to someone else).

A friend of mine with quite a bit more experience commented on how this was very typical. He always knows that he’s overpriced a unit if less than half of the people who see it fill out the application (if they don’t fill out the application on the spot, they aren’t going to rent it – even if they promise to think about it and call later).

This is VERY different from how people often throw money around without a second thought. I’m usually amazed at how little thought and consideration people put into purchases, even major ones. People walk onto a car lot to have a look around and walk off owning a car they didn’t intend to buy. People hook up with a real estate agent who talks them into a buying a property that costs FAR more then the original “high end” they’d agreed to consider.

John T. Reed explained this behaviour in one of his books. People shop for an apartment differently than how they shop for most things. Typically people decide what price range they can afford for rent. They look at a bunch of apartments in that price range, and they rent the nicest one (or once they’ve got a feel for nice and bad apartments in that range, they start filling out applications for all the nicer ones). If you’ve got an apartment that SHOULD rent for $1200 / month, and the people coming to see it are looking for something in the $1500 / month range the $1200 apartment is going to look poor compared to the other places they’ve seen.

They aren’t really any more sophisticated than that (they just want to live in the nicer places they’ve seen), but an excellent buying strategy emerges from this. The end result is they become very savvy consumers for apartments in the price range they’re shopping in – just by picking a price, looking at a number of items in that range, and taking the nicest one. The wouldn’t be able to appraise other units or say what price they SHOULD be renting at, they just can find the nicer apartments at a specific price point.

Landlords rationally respond to this by either dropping their rent price until a unit is priced correctly, or they add things in (like free cable or more appliances) until the unit they’re rent is competitive for the rent “band” it’s competing in. This is a surprisingly efficient marketplace!

When people shop for a place to BUY, they look at places, fall in love with one, then try to get the best deal they can on it. When people shop for cars, they pick out the make and model they want then try to haggle with the dealer. If someone is buying a guitar, they try strumming them and pick out the one that has the look or sound that is appealing to them. These are all buying strategies almost guaranteed to get you a BAD deal.

So, an easy short cut to becoming a savvy consumer for something is to pick a price, view multiple items available for that price, then take the nicest one you see. E.g. decide you’re going to spend $14,000 on a car, go to dealerships and tell them that’s the EXACT price you’re willing to spend (after taxes and add-ons and everything) then tell them to let you test drive something they’d have available for that price (and have them tell you what extras you’d get). Do this at 5 dealerships, then buy the one that you liked the best – chances are you’ll get a good car for your money. Explain to each salesman what you’re doing, and if he has half a brain (big if) he should offer you a package that’s a good deal to increase the odds that you buy from him. If the dealership you choose tries to increase the price at the last minute, just go buy the car you liked second best.

Corporations perhaps approach the problem the wrong way when they put a project up for bids and then award the contract to the lowest bidder (who then does his best to provide the minimum amount of work while still fulfilling the contract and getting paid). Perhaps they should instead give a general outline of their problem, set the price they want to pay, then have companies’ bid by offering the services they could provide for that price.

Categories
Investing

Greedy Management and the Decline of Equity Returns

About a year ago I read Stephen A. Jarislowsky’s “The Investment Zoo” and the idea behind this post was stolen from it, and has been bouncing around in my head long enough that I feel like it’s my own. If you feel like reading a far better presentation of it (along with a bunch of other killer ideas), check out the original source.

Supposedly up until 20 years ago or so, upper management (CEOs and whatnot) were paid about 40 times what the average worker earned. High income without being obscene. People would work their way up the corporate ladder, have a very affluent lifestyle, and typically do the work they loved to do (run a large business).

As athletes commanded increasingly insane salaries, top CEOs started saying that as the “superstars” of the business world they deserved similarly extravagant salaries. Boards and shareholders bought in to this idea, and competition pulled up compensation packages for upper management to the nose-bleed inducing heights they’ve reached.

A favourite way of hiding how much they’re raping their business is for upper management to issue themselves stock options. Presented under the guise of “rewarding the management for increasing shareholder value” this lets the company buy back shares (pretending this is a good thing for shareholders), issue these shares to themselves (without having to dilute outstanding shares) and over time steal a major portion of the company from the owners (they’re buying shares for themselves with money that belongs to the shareholders). Apparently Jack Welch and his cronies went from owning nothing of the company to 30% of GE when he retired.

People like to say that the expected nominal return from stocks is 10% over the long term. Whenever the market exceeds this and they say “the rules are different this time” a correction hits and brings us back down to Earth. Any time you hear that phrase or get stock tips from a shoe shine boy it’s time to sell.

I wonder if this time the rules ARE different, and we’re having part of our 10% return stolen from us by the people we’ve entrusted to grow it?

Categories
Frugal

Life Without Wheels

Quite a while ago I was planning a post on living without owning a car, and a bunch of posts on the subject hit the blogosphere. Enough time has passed that there might be interest in kicking the topic around again.

I’m in my early 30’s, have had my driver’s license since I was 16, and have never owned a car.

People who have been drivers for a while can’t comprehend the possibility of life without continuous access to their own vehicle. Even in big cities where there are a number of options to get around, it just doesn’t seem like living if you can’t be like R. Kelly and say “I’m about to take my key ‘n’ Stick it in da ignition” (although I suspect their may be a subtext involving more then driving an automobile in this song).

I get around by:

  • Taking the subway / buses – I get a monthly pass when I’m going somewhere every day, and use tokens when I’m working from home for an extend period – $2.75 / trip here in the GTA is an excellent value
  • I fly if I travel long distances, and rent a car if I’m travelling a shorter distance
  • I take a cab when / if I want to go somewhere that isn’t easily reached by public transit (which is VERY rare)

When I consider taking a new job or moving somewhere new, I make sure I can get to the place I need to go by walking or public transit. Paying $50 or $100 more for a place near work or campus is MUCH cheaper then getting a car.

When calculating the cost of owning a car, don’t forget issues such as:

  • finance charges
  • maintenance
  • gas
  • insurance
  • parking
  • having to give rides to deadbeat friends like Mr. Cheap

These can add SUBSTANTIALLY to the sticker price of a vehicle.

Some time ago on Wooly Woman’s blog I answered a question a woman had about cutting her expenses by suggesting that her and her husband’s financial problems would disappear if they got rid of their two cars. I never got a response from her.

During my Masters most of my friends were grad students from China, and they were often able to live very frugal lives in Canada. The one thing most of them were willing to splurge on was to get a car (which they told me would be VERY expensive back home).

Ultimately, as much as getting rid of a car would probably make drivers’ financial lives easier, it’s the sort of thing you just can’t give up. Kind of like asking someone to not have sex: it may work for virgins, but good luck getting someone to stop after they’ve started.

I’m hoping to stay a car owner virgin for life.

Categories
Real Estate

Raising Rents

My tenants are coming off of the end of their first year’s lease, and happily they’re going to stay. Landlords always have strong opinions on the subject of rent increases (and rent decreases – most are dangerously, stupidly opposed to them).

One school of thought is that property is an investment, and in order to maximize the investment you need to always be charging the maximum rent. John T. Reed discusses this in “How to Manage Residential Property for Maximum Cash Flow and Resale Value” and makes a very good case that you should always be charging the maximum possible rent. For multi-unit properties, his view is that if you have less than a 5% vacancy rate you’re leaving money on the table. His points include the ideas that:

  • Current tenants can become problem tenants as easily as new tenants could
  • New tenants might be LESS troublesome then current tenants, there are a lot of good people out there in the world, there’s no reason why they’ll be worse then what you currently have
  • Getting top rental dollar is necessary for justifying a high property value
  • If you aren’t raising rents and moving in new tenants often you’ll have no idea what the market rate actual *IS*

The counter-argument is simply that good tenants are gold and you shouldn’t give them a reason to leave. One place I was living raised my rent from $650 to $700 and I promptly gave notice (there were a bunch of reasons I wanted to move, this was just “the straw that broke the camels back”). The place sat empty for 2 months until they could find another tenant (losing them $1300 – it’d take over two years at the increased rental price to make up for this loss). Once a landlord is covering his expenses, PITA factors (“pain in the ass”) become more annoying and it becomes easier to accept less money if people don’t bug you.

So what did Mr. Cheap do? I left my tenants’ rent as it was. I promised them when they moved in that if they didn’t call me for minor issues (such as changing light-bulbs), I wouldn’t raise their rent. I’ve been delighted with them as tenants (no bounced checks, no problems). I like to joke with my father that the hardest part of renting out my condo is walking to the bank to cash the check each month. So even though my condo fees have gone up, and inflation means I’m earning less each month from their rent, I don’t need potential aggravation from new tenants while I’m applying for my PhD (if I raised my rent and the current tenants moved out).

Hey, what can I say? I’m Mr. Cheap, not Mr. Greedy!

Categories
Personal Finance

Role Playing Games and Personal Finance

“I didn’t spend all those years playing Dungeons and Dragons without learning anything about courage” – U.F.O. geek on X-Files

Growing up, I got pulled into “Dungeons and Dragons” (D&D) at a fairly early age, and played role playing games (RPGs) of one sort or another until I left for university. For those who haven’t encountered them, RPGs are games where a group of people sit around a table with dice and tons of rule books. One player is typically the Dungeon Master (DM) and the others are players. What proceeds is a form of collaborative storytelling where the DM creates an adventure for the players, who each control one of the main characters in the story. The story will be played over a number of nights, often stretching into years for dedicated groups.

The ultimate goal is for everyone to have a fun time, and it’s typically not competitive: the DM isn’t trying to “beat” the players. Instead, the players tend to work together to achieve goals (often called Quests). The dice and rules are there to provide a framework to resolve “risky” actions within the world. Say you get in a bar fight, the rulebooks provide guidelines on how to model the situation, then the dice help you figure out the resolution (who wins, and how badly each side is hurt). With a few rulebooks and a DM who can think quickly on their feet, anything can be ATTEMPTED within the game (although attempts can and will fail).

At the start of the game, the players are usually very wimpy. A wizard (called a “Magic User” in D&D) might be able to cast one spell a day, and a fighter may have trouble beating a couple of farmers in the above mentioned bar fight. As the game progresses, the players accumulate items (like a +3 Long Sword of Goblin Slaying) which make them progressively more powerful and more likely to successfully deal with challenges they encounter. They also gain “experience points” (XP) and gain levels, which make them inherently more powerful, allowing the magic user to cast more spells of greater power, and the fighter to kill entire villages of farmers (if that’s your bag baby). As you get further in the game, the players can fight and beat dragons, giants and even gods (often RPGs take place in a fantasy setting – think J. R. R. Tolkien and Lord of the Rings).

This has evolved into computer RPGs, and more recently into Massive Multi-player On-line Role-playing Games (MMORPGs) like World of Warcraft.

The compounding nature of finance and investing, as well as the risk element, always struck me as somewhat familiar to RPGs. As you get more “powerful” (wealthier), you have more options, and it becomes easier to deal with challenges (including the challenge of building more wealth).

The risk element is also present. As much as you may have a good understanding of the rules, as soon as you start rolling the dice, there’s no guarantee what will happen. Having the right equipment to deal with unforeseen emergencies (such as a potion of healing in case it looks like you’re going to lose) is vital. Monitoring the risk and status of your investments, and having contingency plans is also vital. Deciding whether to buy something to deal with a potential problem is similar to decisions about buying insurance.

The fact that you’re “playing” with other people is also important. If there’s a disagreement within your party, it might cause more problems then the “official” challenges of the game. The DM might interpret the rules differently then you expect, and this can throw a wrench into your plans (the DM is the ultimate authority in the game). No matter how well you understand an investment, other investors are playing with you. In situations like the tech bubble or the sub-prime meltdown, their perception of the situation can cause problems for you. Dealing with problems from personally misunderstanding an investment is probably a problem most of us don’t like to admit to.

I’m not necessarily advocating RPGs as a way to teach investing to children, but I think there are certainly elements that will lay the foundation for similar concepts that may appear in finances later.

Categories
Personal Finance

The Danger Of Being Too Conservative

For out non-Canadian readers, GIC stands for Guaranteed Investment Certificate, and its pretty well the same as an American CD. You put the money in for a fixed length of time at a fixed interest rate, then at the end of the term, you get your money back plus the interest (or you can get the interest paid out over the term of the loan). They’re guaranteed by the government, so are a very safe, very conservative investment. They’re typically referred to a “fixed income”.

Most of my family and friends are VERY conservative investors. We’re talking GICs, Canada Savings Bonds and savings accounts conservative investors. My mom won’t touch mutual funds because they’re too volatile and she wouldn’t be able to weather the market fluctuations. While I’m certainly sympathetic to taking a conservative position with investments, there’s a price and a danger when this is how you invest.

The price you’ll pay is that your return is going to be about equal to inflation, so you’ll lose whatever you make.

If you were getting 5% on your GIC, it may seem pretty good until you take away 40% for taxes (this puts you down to 3%), then take 3% away for inflation (this puts you down to 0%). In real terms, you’re just preserving your capital. This isn’t unnecessarily a BAD idea (your capital is VERY safe), but the problem is that your money isn’t working for you. All your savings will simply be what you’ve earned and stashed away: it won’t grow.

“But Mr. Cheap” you protest, “what about times when there are high interest rates, like when it was 12% back in the 80’s?” Well, back in the 80’s when we had high interest rates inflation was very high as well. What fixed-income giveth, inflation taketh away.

Inflation isn’t too big of a worry, since with high inflation, interest rates will go up, so if you set up laddering (where different GICs come due at different times), you’ll get pretty close to the average interest rate. What inflation taketh away, fixed-income giveth.

The real danger with this is simply that you won’t be able to save enough money to live off of in retirement. Compounding won’t be working for you, so even if you’ve been saving since a young age, it will be hard to accumulate enough to be comfortable in retirement. Of course, if you put the money into a RRSP, you won’t be taking the tax hit mentioned above, but at 2% compounding it’s going to be quite meager. This can work if you live well below your means, and save aggressively, but I think there are better options.

When you allow a little more volatility in an investment (give up the absolute guarantee of GICs), the market rewards investors richly for taking on this risk. If you earn the average nominal return on equities, 10%, you’ll lose 4% to taxes (40%), and 3% to inflation, leaving you with 3% to compound (7% if its in your RRSP). Certainly better than treading water.

Something like the couch potato portfolio is an easy way to set up a very diversified equities portfolio. You don’t have to put all your savings into it (start small, maybe with 10 or 20% of your savings until you get your sea legs). If you can set it up, re-balance once a year and ignore it the rest of the time, you’ll do fine. The danger is if there’s a correction and you’re tempted to sell and flee back to GICs (don’t do this!). It may be a good idea to keep your investment small until you have gone through a real dip to make sure you have the stomach for it. Over time you’ll see that you’re getting a lot more growth from the equities compared to your fixed income (the GICs) and hopefully will become comfortable with the idea of exchanging a bit of volatility for dramatically higher returns.

Categories
Opinion

Living the Good Life as a Custodian

Throughout my undergrad I lived in residence for 4 of my 5 years (I changed majors half way through and extended my program). By a strange twist of fate, the same custodian ended up working in every building where I was living, so we got to know each other pretty well by the end of my studies.

Towards the end of my final year, he was good enough to invite me over to his house for dinner. After a couple beers too many he became quite morose and shared with me how much he hated his job, primarily from how servile it felt to him and how he was treated by his supervisors and the students.

To put this in perspective, he had:

  1. A nice house in a good area of town
  2. A wife who was VERY attractive (notice that I put this AFTER the real estate)
  3. Two healthy, active, engaged children
  4. Plenty of food, and a wife who was a good cook (we had an amazing feed)
  5. An active social life (life can’t be too bad if you’ve got Mr. Cheap coming over to drink your beer)
  6. A good brain in his head (he used the word servile to describe his life, and I like to have intelligent conversation while I’m drinking someone’s beer)
  7. Good enough health that he was quite active in a competitive recreational hockey league
  8. A great life experience, having moved around and lived all over
  9. Two cars
  10. An active spiritual life with his whole family involved in the faith

I told him at the time, and believe to this day, that his life would be the envy of 99% of the world. Literally. Seriously.

If you wanted to look back in time, his modern life would be the envy of 100% of the world (he’s living better then any 16th century monarch – we can eat meat EVERY DAY if we want to). We live in a world where a writer can go from being on welfare to being richer than the Queen of England.

I think it’s easy to focus on negatives in our lives, but it’s also important to occasionally sit back and realize how good we have it. This is a GREAT time to be alive. Roger Williams (the author of the incredible The Metamorphosis of Prime Intellect – if you start reading it, don’t stop after the first chapter) makes a point in a podcast interview about how a medieval peasant seeing our modern life would probably take the view that people would be happy all the time (think medical advances, consumer goods and improved working conditions). Our worries and fears about the obesity epidemic, a looming recession and the sub-prime meltdown would be bizarre and incomprehensible to him.