Money Smarts Blog

 As far as the financial debate goes between buying vs renting, it’s all about assumptions.Anyone who bought in the last 10 years in the various real estate hotspots (in Canada at least) will have done well and can use that as proof that home ownership is a great investment.However, nobody knows how much houses will go up in the future.The reality is that if they only appreciate by their long term increase of inflation + 1, then they are not such a great investment.

Dividend stocks are the same thing – they have done so well over the last ten years that everyone (including myself) is buying them now convinced that we can’t lose with them.Again the reality is that if the dividend increases over the next 10 years are more in line with their long term average of about 5% and the stocks are currently priced for more than that, the stocks won’t be such a great investment.Admittedly not a bad investment either, but anyone trying to do a Derek Foster starting now is almost sure to be disappointed.

The fact is that a lot of investments such as real estate and dividend stocks tend to do at least reasonably well over the long term in that they tend to go up in value.The problem is that we tend to think of “good investments” in relative terms so they are investments that do better than the average investment.Over the long haul, “investing” in your house probably won’t do as well as investing in the stock market and likewise, Canadian dividend stocks probably won’t outperform the market over the long haul, but that is real hard to believe given their history over the last ten years.

And finally a quote from Bernstein who is referring to the tendency of investors to look at recent history and conclude that it will continue forever, “Ignore the last ten years!”.

One of the benefits of an rrsp in that any capital gains or dividends are sheltered from tax as long as the money is in the rrsp. Investors who are doing a Derek Foster Maneuver or someone who just isn’t convinced of the benefits of an rrsp might be in the situation where they have unused rrsp room and securities outside the rrsp which are generating dividends and/or capital gains.

I’ve read in a number of books (including Four Pillars) that mention how the drag on performance from any kind of ongoing taxes such as dividend tax can be significant so I decided to see for myself how much effect dividend taxes have over 20 years.

To set up my spreadsheet I’m assuming that an investor has $100,000 of gross income which they can either put directly into an rrsp (no tax deducted at the source) which will result in a portfolio of $100k or they can choose to receive the $100k as income which will result in a portfolio of $60k after their 40% income taxes are paid.

I’ve made up a stock in which the purchases will be made. This stock will have 4% capital gains each year and pay a 4% dividend which will be reinvested. The dividend will be taxed at 20% in the taxable account.

At the end of 20 years, the investments will be sold in both portfolios, taxes will be paid and then the final amounts will determine which is the best way to invest. I’m assuming that when the securities are sold that the person is still working and will pay 40% income tax on the rrsp and will pay 20% on the capital gain in the taxable account (50% of capital gain * 40%). Note that neither situation is all that likely to occur in practice since good tax planning would dictate that you should wait until retirement to cash in the rrsp or sell the securities in the taxable account. However this method will allow us to isolate the effect of the tax on the dividends since all other factors will be equal.

In my spreadsheet, the first few columns are the rrsp account, this is a simple calculation – I basically add 4% cap gain + 4% div to the balance each year which results in total of $466,096 after 20 years. I’m assuming the dividend is paid at the end of each year. The income tax will be 40% of $466k which will leave $279,657 for the rrsp holder.

The taxable account calculation is a lot more complicated since I need to deduct the tax on the dividend each year (it gets paid from the dividend) as well as calculate the adjusted cost base of the investment (hopefully I’ve done this correctly) for the purpose of knowing how much capital gain there is. In this account the investor ends up with a total of $204,813 which is less than the rrsp account.

In summary the rrsp investor ends up with 37% more money at the end of 20 years which is quite significant. The investment rate of returns are 8.0% for the rrsp investor and 6.3% for the taxable account investor which is a big difference considering the only difference between the two scenarios is the tax on the dividend which doesn’t seem like a lot of money on an annual basis.

Given that the ending is not that realistic, I wouldn’t rely too much on these findings, however they certainly point to the conclusion that holding investments inside an rrsp is better than outside even if those securities have special tax considerations outside the rrsp such as dividend stocks. Active traders should also take note – they might be better off having their trading stocks inside their rrsp and their bonds outside their rrsps!

p.s. I’m working on a more complicated spreadsheet which will do the same scenario except that it will involve a more realistic scenario of collapsing the portfolio over five years. I’m not going to promise to finish it since it’s turning into a monster but I’ll see if I can at least figure out if the results will be different than the simplified scenario above.

The Bank of Montreal (BMO) raised their dividend to $0.70 today from $0.68 which is up from $0.65 that was paid out earlier in the year. This stock is the only stock in my leveraged portfolio and since one of the cornerstones of my leveraged plan is dividend increases, I was pretty pleased. In 2007, BMO has raised their dividend by 7.7% which is above my long term assumption of 5% annual dividend growth. The current yield based on today’s closing price is 4.26% which is pretty good especially if you are doing a leveraged plan like I am and need some dividend income to cover the interest costs.

An excellent website called Dividends Matter has an analysis on BMO which is worth checking out.

Now they did have a bit of an earnings drop but considering it was mostly from a trading problem which has ended (although they keep reporting losses from it) so I’m not worried about it.

Yesterday I posted a review of chapter one from Richard Bach’s book “Smart Couples Finish Rich”. Coincidentally, Brip Blap is hosting a book giveaway with Bach’s book as the main prize – so head on over and leave a comment and you might win this excellent book.

In other news I entered the latest Carnival of Personal Finance hosted by Free Money Finance so go check it out! I haven’t actually read any of the other posts, other than the ones from blogs I normally read so if you find any good ones, please let me know.

This is a “part II” for my original post called “How to Deal With Market Volatility” which I posted last week. I wanted to try to make a spreadsheet to show the effects of someone who “panics” when the market goes down and then later on gets back into the market when it starts going up. Please note that I’m not referring to investors that have specific buy and sell scenarios and follow their own investment plans, but rather people who don’t really have a plan and react to events in the market.

I’ve created a spreadsheet in which I created a rather contrived example of a market that goes up 17% per year for two years and then drops 10% in the third year. This repeats over and over again for a long term return of 8.1%.

I’ve also created three types of investors:

1. “Buy and hold” has 100% equities and never changes their portfolio.
2. “Market panicker” has 100% equities when he/she is in the market and a high interest account paying 4% when not in the market. This investor only gets into the market when it’s doing well and sells when it’s doing poorly. When the market drops he switches all his money to a low cost money market mutual fund halfway down, then he sits in cash until the market goes up for a year and then gets back in.
3. “Conservative buy and hold” has 65% equities and 35% cash and never changes their portfolio except to rebalance once a year.

I started all three of my investors off with $100,000.

According to my calculations:

The buy and hold investor ends up with $478,700 for a return of 8.1% which matches the market (let’s assume no fees).

The market timer investor starts off ok by participating in the first two up years but then after that he continually switches all his money to money market halfway down the crash (so he gets -3% for those years since his equities go down -5% and then he gets half a year of interest), then he sits out the first year of the up market and only get 4% when he could have gotten 17%, then he gets back in the market and enjoys the 17% the next year before the cycle repeats. As a result of this market timing he only gets 6.8% return which gives him $370,100 after 20 years.

The more conservative buy and hold investor has 65% equities and 35% cash which pays 4%. He gets 12.5% in the good years and loses 5.1% in the bad years. This person ends up with $377,600 which works out to a return of 6.9% which is slightly higher than the market timer.

In the end, the buy and hold investor who has 100% equities has an investment account which is worth 23% more than the market timer.

The point of this example is to show that you don’t need to have 100% equities to do well in the markets and that if you are going to panic every time the markets drop and then buy on the way up, you are better off picking a more conservative mix which will reduce your volatility and quite possibly improve your returns by allowing you to stick with your investment plan and stay invested.