Author: Mr. Cheap

Categories
Investing

Why Asset Allocation Works

People keep going on about how important asset allocation is. I left the party when they claimed that a stock & bond mix would perform better over the long-haul then an all stock portfolio. They acknowledged that the stocks would do better on average, but that the mix would somehow magically outperform the all stock.

This didn’t make any sense to me. If you leave two investments for 30 years and get the average stock return on the all-stock portfolio and the average bond return on the all-bond portfolio, how is the return greater if you mix them together instead of keeping them separate?

The only way I thought it could possibly make sense is the idea that you’d have funds available in the bond portion of your portfolio to use to buy stock after a crash. The primary advantage from this perspective would be that the bonds aren’t correlated with the stocks, so you could use one to buy the other. Asset evangelists don’t talk about this though, and since you’d have to actively capitalize on this, it seems like something they’d mention as a necessary step to get the good returns promised by asset allocation.

The realization finally hit me when reading “Four Pillars” this morning: The benefit comes from using the assets within your portfolio to determine when the other parts of your portfolio are cheap, then buying them. E.g. if you have a 90% stock, 10% bond portfolio, you’d expect that the stocks will outperform the bonds. If you’re re-balancing (say by adding money) and your portfolio has 85% stock, then clearly the stocks are selling cheap (relative to your bonds) and its worth buying more of them (which you’ll do to re-balance). When you add money, you’d normally expect to be buying more than 10% bonds (since on average the stocks will outperform the bonds and push them to a lower proportion of your portfolio), but if the stocks REALLY outperform the bonds, then you’ll buy even more then normal (and take advantage of the bonds being cheap relative to the stock).

Basically, asset allocation is just an easy way to determine when the investments you want to buy are cheap (relative to your other investments), then buy more of them. You could accomplish the exact same “benefit” from tracking when your investments are cheap or expensive and buying them directly, however this would be a lot more work. You could also just track the different assets within your portfolio and have the return for the last year and the return for the lifetime of the portfolio. When the last year’s return is lower then the lifetime return you’d put more of the money you’re adding to that portion – again not quite as easy but uses the same idea.

e.g.

Year 1 $90,000 stock, $10,000 bonds
Year 2 $96,300 stock (7% return), $10,300 (3% return)

Say we’re adding $1,000, in order to rebalance the asset allocation, we’d be putting $540 into stocks and $460 into bonds (bringing them back to 90/10).

Year 2 $96,840 stock, $10,760 bonds (after adding $1000 and re balancing)
Year 3 $96,840 stock (0% return), $11,082.8 bonds (3% return)

Say we’re adding $1000 again in order to re balance, in order to get back to the 90/10 split, we need to sell $192.52 of bonds and buy $1,190.52 of stock (we’re buying lots of stock since it had such an awful year that we now feel that its cheap).

Year 3 $98,030.52 stock, $10,892.28 bonds (after adding $1000 and re-balancing).

Part of me feels like “supporting” under-performing bond returns just for the information of when stocks are cheap doesn’t seem like the best approach, but maybe there’s more to it then I’m seeing. I’d be tempted to construct a portfolio and assign it the expected return for each asset class. When an asset doesn’t live up to expections, add money to it to bring it in line with where it “should be”. For example, in the above portfolio with 90% and 10% with an expected stock return of 7% and an expected bond return of 3%, after 10 years you’d expect the stock portion to make up 93.4% of the portfolio. *THIS* is what you’d use to re-balance, not 90%. This way you’d get the information that an asset class was under-performing and have the opportunity to buy it cheap, without unduly subsidizing the weaker portions of your portfolio.

Please correct me if I’ve missed the point. Given my current understanding, I’m far more convinced of the value of asset allocation.

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Categories
Personal Finance

The Financial Industry Preys on Inertia

Thicken My Wallet recently made the brilliant statement “The Financial Industry Preys on Inertia”. Tied in with Money Gardener’s Relationship Banking post I think this single statement summarizes a great deal of the problems of banking and personal financial management, and at the same time points out a simple solution.

When a bank offers a teaser rate, what they’re basically saying to you is “you’re so stupid and lazy, we don’t even need to offer you much of a deal. We’ll offer you a good deal for a short time, then milk you for the rest of your life. Ha ha, ha ha, ha ha”. The pathetic part is they’re right – we are stupid and lazy. Apparently bank’s love sending out mortgage renewal forms right before the end of a mortgage term (I’m not sure exactly how this works, I’ve never renewed a mortgage), so that you don’t have time to shop around. Most people sign the form, get the mortgage from the same institution again, and pay a higher rate then what that institution is offering new mortgage applicants!!! If you do this I hate you (as Ramit Sethi would say). Inertia makes the bank money (at your expense).

A buddy of mine is a teacher and didn’t even know what his salary was (he made two guess, $10K apart and said it was “one of those, I think”). I can’t criticize him too much, as I’ve lost checks a few times and discovered that I missed payment (once for around $1500). He didn’t bother contributing to his RRSP, because one of his colleagues had told him “it’s better not to”. I asked him what her reasoning was for such advice and he had no idea (the only thing I can think of is that their pension is so good they can rely on that for retirement planning – I’m not so sure about this myself, but I’m not a teacher). Its great when we work a job we love, and earn enough money that we don’t need to think about it, but we’re stupid and lazy beasts (things might change in the future, why not spend a bit of time planning for it).

We work very hard for our money (in most cases). It blows my mind how willing people are to throw away thousands of dollars (often many, many weeks of labour once you factor in taxes and living expenses) rather than think about something for a couple of minutes or make a 30 minute phone call.

The advantage to this is that if we’re willing to correct our behaviour: to take advantage of the teaser rates then move on to the best deal once its finished, to get pre-approval for a mortgage renewal 120 days before it comes due, and to keep track of our on-going finances, catch money that disappears and plan for retirement, you will be paid handsomely for your time – regardless of what you earn or your lifestyle.

Categories
Book Review

The Four Pillars of Investing: Ch 1, 2

Based on Mike’s Four Pillars blog, I decided I should grab a copy of Bernstein’s 4 Pillars and read through it (he named his blog after it, so how bad can it be? 🙂 ). There seems to be ton’s of good stuff in it already (I’m on chapter 2), that I decided I’d actually do a write up on chapters in chunks so that I don’t miss any of the big trends in this book (basically a good way to force me to use the knowledge I’m reading about).

While risk & reward going hand-in-hand is clichéd, there’s certain implications to this that are ignored by the investing community as a whole. Bernstein does an excellent job of presenting the idea, then pushing the implications into some interesting territory. He makes the assertion that its a bad idea to invest in “good” companies, since they will already have had their price pushed up to a level that will be tough for them to deliver ever increasing superior returns. With the possibility of bad fortune existing for any company, you’re often getting a meager return for the risk you’re accepting. He gives the example of Walmart being a “good” growth company and Kmart being a “bad” value company. Because investors aren’t interested in owning Kmart, those who buy it stand to do well if the company can get their act together and manage their business better (whereas, there’s not a lot of improvements or streamlining that Walmart can do). Another way to view this is with value companies, the bar is a lot lower for them to increase their performance, even if just by emulating the “growth” companies in their sector.

He also pushes this idea into the large-cap (big companies) versus small-cap (small companies) world, and provides convincing stats that although small-caps companies are far more volatile, the average return rewards investors for this volatility. Equally he shows how investors are rewarded for investing in riskier emerging as opposed to established markets.

He wryly points out that anyone who promises you large returns with total safety is very likely trying to scam you (which has certainly been my experience).

He lays out the grand goal of asset allocation such that portfolio volatility is minimized while returns are improved by accepting volatility from the components that make up your portfolio.

Starting Ch 2 he lays out the idea that some of the ideas require thinking about and suggests that the reader move through his book at a slow pace and think through the concepts. There’s something comforting about an author who says “this is going to be confusing, don’t worry about it, just take it slow”. When I reach a concept that doesn’t seem clear, I don’t feel stupid or that I’m missing something, since I’ve been primed for it. I just slow down (or plow through the section and plan to re-read).

It’s nice that he’s gentle with us.

He lays out the idea of a discounted valuation model for an ongoing income stream (basically how to determine the PRESENT value for something that will pay you in the FUTURE). After teaching the procedure and calculation, he shows how useless it is (what the hell?!?!) then shows us how to rearrange the formula and actually use it for something worthwhile (well, that’s ok then). Basically he makes a good case that the true return of a stock or a market is the dividend yield + dividend growth rate (and anything above or below this is the “speculative return”). This is known as the Gordon Equation.

So far I’ve really been enjoying this book, it seems to be packed with some really interesting ideas, and I’m looking forward to the rest of it.

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Categories
Book Review

The Intelligent Investor by Benjamin Graham

Reviewing “The Intelligent Investor” is a bit like deciding to review “The Bible”, people perk up a little and think to themselves “it should be interesting seein *this* guy embarrass himself”.

Apparently Ben had some really good ideas about investing. Not just kinda-good ideas, but REALLY good ideas. They made him rich, and apparently Warren Buffet got himself up to the 3rd richest man in the world by following them (so, potentially there are two other people who are following better ideas, but books aren’t available about there ideas, and even if they were available, one of those books would be in Spanish).

One of the early quotes is that Graham changed the securities industry from secretive guilds operating like medieval alchemists into a modern discipline that’s based on proper measurements. He claims by analyzing companies by the numbers that its possible to avoid the market excesses that have led to bubbles and make nice returns on your investments.

Its interesting reading books written even in the fairly recent past and comparing them to recently published books. I wanted to read Adam Smith’s “Wealth of Nations” but gave up on the first page (bleh! anyone have a nice abridged version? ;-). At certain points in the book Graham’s writing style gets overly convoluted and I would have liked him to write plainly. I read the new edition with commentaries on each chapter, which were certainly nice to get a “just the facts” version of what I’d just read.

Two chapters just got so bogged down in details that I gave up and skipped ahead (“Four Extremely Instructive Case Histories” and “A Comparison of Eight Pairs of Companies”). While Dividend Matter‘s write ups, which include the Graham’s number for the value of companies, always seems very interesting and useful, as I read the book I really didn’t think it was for me (all the background research he repeatedly demanded you to do for each company beyond the numbers just seemed like way too much work).

In the end there were two simple ideas that he suggested and I latched onto. At the beginning of Chapter 14 he suggests buying a broad number of stocks from the Dow Jones Industrial Average such that you track the market (a footnote comments that you can now do this far more easily just by buying a low-cost index fund). The plan I’m currently considering is to use my RRSP to buy equal amounts of an DJIA index-fund and a S&P 500 index fund and rebalance them every time I add money to my RRSP.

His other suggestion, which is made as a throw-away comment (sorry, I can’t find the page number) was that a decent return could be made from buying long-term dividend payers that are selling for low prices (and he makes the standard caveat to make sure they aren’t selling cheap because of very serious issues that are threatening the company).

The three things I gained from this book were a) I’m probably not cut out for individual stock analysis so I should probably steer clear of bargain hunting through the entire market b) stock indexes are probably my safest long-term bet – since I was considering this anyway I should push forward with Graham’s blessing and c) there are worse ideas than buying cheap dividend aristocrats for income.

Categories
Opinion

Absolutes

“You can’t lose money on real estate”.

“The stock market increases over time.”

“Build a better mouse trap and the world will beat a path to your door.”

“All rich people made their money with leverage.”

“It’s more lucrative to be self-employed then an employee.”

The world is a confusing place. Apparently the last person who was felt to “understand all human knowledge” was Francis Bacon (I couldn’t find a source for this – if I have the wrong guy please correct me). During his lifetime (he died in 1626) he was able to stay current on advances of all the sciences and follow every new discovery. Since his time, the amount of knowledge in the world has exploded (apparently doubling every 16 years or so) to the point where it would be impossible for any one person to follow all the discoveries in one large field, let alone multiple (which has pushed for ever increasing specialization). This bothers people.

A few days ago I got some comments from a Rich Dad, Poor Dad follower who took exception to my Rich Dad, Poor Dad review of “the bible”. I tried to answer his question, but quickly gave up as I could tell he was stuck in that candy-sweet intellectual quagmire that is absolutism.

I did a science fair presentation when I was a kid, and my project was on insulation. I’d blown up a plastic bag, labeled it “Air” and had put it up on a board (air is a fairly decent insulator). Another kid walked by and asked how I’d filled the bag. “I blew in it” I responded, to which he sneered “then it’s not air, it’s carbon dioxide” and walked away. Clearly our young Darwin had learned that we consume oxygen when we respire and produce carbon dioxide (as a waste product). He took this as an absolute (so air must be 100% oxygen when I inhale, and 100% CO2 when I exhale) and proceeded to share his insights with those around him. The nuance to this concept is that we’re not perfectly efficient (by any means) and air is not a homogeneous gas (if you want to experience a different type of air, go to a Chili cook-off in an enclosed space). In grade 3 we learn “people breathe in oxygen and breathe out carbon dioxide”. In grade 7 we learn “people breathe in air, and breath out air with a lower proportion of oxygen and a high proportion of carbon dioxide”. Further on we learn the process in ever increasing detail including a related (and basically opposite) process in plants, how this relates to metabolism as a whole, and other biological waste products. You can go as far down this rabbit hole as you want.

I’ve always remembered this experience for two cliches. “A little knowledge is dangerous” and “blindly following information can be dangerous”.

A case could be made for any of the lead-in statements that began this post. Cases could be just as easily made against each of them. Where does this leave us? Is it impossible to know anything? How does one learn or make decisions?

My approach to acquiring new knowledge is to accept generalities for what they are, but to be open to understanding clarifications. My understanding of the stock market has evolved from “It goes up over time” to “It goes up over time, with cyclical fluctuations” to “It goes up over time, with cyclical fluctuations, but its very hard to predict where we are in a cycle”, to “It goes up over time, with cyclical fluctuations, but it’s very hard to predict where we are in a cycle, but the woman who wrote Juggling Dynamite thinks she can predict where we are in cycles, but a lot of people seem to disagree with her, so I should really look into this further before I base any important decisions on timing market fluctuations”. It’d sure be a lot easier to just live life (and invest!) according to the idea “it goes up over time”, eh?

Obviously if you accept that you never have complete knowledge on any subject (and you don’t. Accept this) you have three choices: 1) Become paralyzed and do nothing, 2) Do the best you can with the level of understanding you have and 3) Try to learn more.

Numerical analysis of stock seems quite complicated, and a good case has been made that prices already reflect this (and other valuation criteria) so I’m in position #1 with regards to this. I don’t even try to determine a “fair price” for a stock and whether or not its selling at a premium. I’d like to be able to go bargain hunting, finding undervalued stocks and buying them, then selling them once they’re over valued and laugh all the way to the bank but I don’t see how to get from where I am currently to this point (if it is even possible). I’ve therefore given up on trying to personally appraise stocks.

When I bought my condo, MANY people had a FAR greater understanding of real estate investing and the Toronto market then I did (and MANY still do). I was in position #2 when I made the purchase and still am as I make other decisions concerning it. If I had waited to achieve “perfect knowledge” I never would have bought, but if I’d bought without investigating the subject at all, I would have been putting BIG money into something I was very ignorant about (not a good scenario).

I’m quite interested in buying an apartment building at some point in the future, but am nervous about acquiring such an expensive piece of property with my current level of knowledge. Therefore I’m trying to pump Q from one million to my name for any information about his experience buying a building, talking to my real estate friend about his experience, and keeping my eyes open for good books on the subject (position #3).

Some people get stuck in position #2. Rather then trying to learn more about the subject, they attack people who disagree with them. The fallacy with this approach is that the universe doesn’t change how it operates because you won an argument (unless you believe that we have a subjective universe based on a consensus perspective, in which case this might be a good approach to life). Running around brow-beating people into agreeing with you that your approach is without flaw and guaranteed to make you rich, successful and attractive to the opposite sex isn’t productive or effective. The joke is that it makes position #3 harder to achieve as the people who might have been willing to enlighten you probably won’t want to talk to you any more.

Thank you to all my readers (and especially those who leave comments or write me e-mails). My every interaction with you puts me into position #3 and makes me a better person. Those who challenge me and get me to look at things from a new perspective (like Mike and Q’s responses to my income post that didn’t include taxes, Money Gardner and Mike’s clarifications of my living expenses in my about section, Jason’s inspiration of this post and Quietrose’s off-line challenge that I was spending more on food then I needed to): Thank you, thank you, thank you! You’re my own chorus of personal Jesus Christs!

Those poor Christians who only get one!

Categories
Opinion

What I Mean By Early Retirement

Telling people you want to retire soon when you’re in your early 30’s really bugs people.

I’ve been spending a fair bit of time these days getting my financial house in order and making plans for the future. One of the ideas I’m investigating is to “retire” in 3 years. The most common reaction when I’ve tried to talk to people about this is outrage (“how dare a guy in his early 30’s even THINK about retirement!!!”).

Part of this comes, I think, from our society’s protestant work ethic and the idea that its just plain wrong for someone not to want to toil for 40 hours a week to secure the necessities of life. Working hard is placed on a pedestal in Western society, with near universal contempt for those who inherit wealth and decide not to work (or that super-small, ultra-minute, potentially-imaginary subset of homeless people who just decide not to work without having an inheritance).

Another part of it probably comes from jealousy (“Why should I have to work hard when you don’t?”) and part of it comes from the expectation that you follow the proscribed path through life in a Western country (high school in your teens, university in your early 20’s, crappy jobs as you start working leading to ever higher quality/paying jobs and eventual retirement at 65). Shaving a few years off of any one of these stages is noble, but forging your own path is viewed with great suspicion.

A while ago a woman called in to Suze Orman and said that her parents had retired young (at around 40), blown through all their savings, and at 65 were basically impoverished. They then told their daughter that she had to support them in their golden years (since they’d raised her). The woman asked Suze what she owed her parents. Suze’s response, which I agree with, is that the parents behaved quite foolishly, and the daughter has ever right to tell them they have to get by on social security if they don’t want to get part-time jobs.

The unfortunate aspect of all this hostility is that I think people misunderstand what I’m after. I’m not planning to spend the next 70 years wearing a wife beater and watching Matlock (which is what, I’m lead to believe, retirement mostly entails). My goal is basically to escape wage slavery (I’m a capitalist who believes in wage slavery – go figure!) and to be able to live life on my own terms without having to feel dependent on anyone else for the necessities of life (or for a large enough pay-check to purchase the necessities of life). I hate to feel beholden to anyone (I’d make an awful trophy wife) and most 9-5 jobs and contract work makes me feel exactly this way (“if I upset this person they may fire me and make my life unpleasant”). Basically I want to have a “welfare-eque safety net” of monthly cash payments that will cover the necessities of life that I’ve provided for myself rather than relying on that provided by society.

If I get to the point that I can cover my cost-of-living from passive investments, my first action would probably be to put on a wife beater and spend the next 2 months watching every episode of every Star Trek series, in order (see, I’m not going to waste my life!!!). After that I’ll probably spend another 2 months drinking coffee and reading. Once I’m bored of that, I expect I’ll spend the rest of my life alternating between three things:

1) Working short-term, interesting work (this could be doing things like preparing tax returns, working as a barista and letting hot women pick me up, becoming a grad student again, etc) in order to purchase luxuries (travel, a nicer place to live, materials for some hobby, etc) or increase my standard of living by increasing my passive income

2) Pursuing knowledge for its own sake and enjoying the process (go get a PhD, spend 6 months in Buenos Aires learning Spanish and how to surf, etc)

& 3) Starting new businesses (probably with low capital requirements) and get them running such that they can operate with minimal over-site (such as rental properties, a franchise with a more active partner, writing a book, selling copies of software that I’ve written, etc) or selling them outright (same as any of the earlier ideas but with no ongoing commitment or royalties)

Not the worst way that I can imagine spending the rest of my life, but (almost) everyone else seems to disagree.

Categories
Opinion

The Magic of Positive Thinking

In case you haven’t seen the movie (or read the book) “The Secret” I’ll give you the condensed version: positive thinking improves your life, negative thinking worsens your life. For example, Bill Gates is the richest man in the world because he believed he would be (his business instincts and impeccable timing were trivial details) and everyone who has ever been the victim of a crime deserved it (for thinking negative thoughts that caused their victimization).

Yes, I agree its trash but I’m going somewhere with this.

In “The Dilbert Principle” Scott Adams’ discusses how he wrote “I am a world famous cartoonist” 5 times per day until he was a world famous cartoonist. He also played monopoly for an entire summer with a bunch of Irish kids and never won once (because the lousy potato eaters were convinced of their “Irish Luck”). He writes about an objective reality (where things happen because they happen) and a subjective reality (where things happen because we expect them to happen).

He’s a smart guy and I like him, but still kinda wonky reasoning.

Positive thinking actually works though. How it works is based on psychology rather than mysticism. We all have limited resources (time, money, energy, etc) and competing internal needs and desires. As much as economists believe we’re purely rational beings, often we make poorly considered decisions because of resource constraints (salesmen would be unnecessary in a purely rational world). Thinking about something (positive or negatively) increases its “priority” during the limited resource consideration cycle our tiny brains go through, and increase the chance that we’ll take action towards that goal.

For example, every day Mr. Adams wrote out the 5 lines. Later, when he was debating whether he should practice drawing, have a nap or take his girlfriend out for lunch 2 hours later, it was easier for him to practice drawing, because he’d recently put a priority on that activity. If you have a goal (say becoming famous or being rich) that you don’t think about very often, the chance of taking actions that will lead towards it are very small. Any action that gets you thinking about it (writing lines, talking to friends about it, dreaming about it before bed or in the shower) will increase you commitment to the goal and the chance that the next time you have a decision to make, you’ll work towards this goal (instead of a competing goals – such as watching the next episode of “Hell’s Kitchen”).

Recently I was told I’m consumed by money (ouch!). While I don’t agree with this 100%, in part I think it means I’m on the right track to sorting out my finances since I’m spending time thinking about them (to the point that other people are aware of it and thinking I’ve gone too far).

Categories
Personal Finance

Are you saving too much for retirement?

The CEO of Vanguard posted a rebutal to allegations that financial services create a climate of fear in order to encourage over-saving.

I’m a saver, so I think I’m in the same camp as him that the risk of saving too much money isn’t the worst threat in the world. On the flip side, I think some people spend time in real fear and anguish worrying about eating dog food in their golden years, and preying on those fears (especially to make a buck) isn’t the most noble of sales techniques.

I think the ideal situation would be rather than give people fixed answers (“you need 1 million to retire”) or roughly-customized answers (“you’ll need 60% of your pre-retirement income”) it would be better to educate them on what they’ll need. Encourage them to track their consumption, realistically plan how it will change in retirement, provide some easy-to-use monte-carlo simulation software and help them input their variables, and help them explain what the numbers mean (your savings will have a 90% chance of lasting you until you’re 90 years old).

This might make a good workbook too, you read through, follow the exercises about tracking and estimating your expenses, use some bundled software and come out with some truly customized, realistic retirement goals.

Obviously this would be a lot more work then telling people they need to save a million dollars (and many people wouldn’t be willing to go through the process), but I think it would be a great way for the financial planning industry to serve their clients.