The Future Value Paradox

When planning your future, it seems self-evident that you should use the most accurate possible predictions. However, consider this:

When I consider a large purchase, sometimes it helps for me to think along the following lines:

I'm about three decades from retirement. The stock market roughly doubles every decade, so a dollar I spend now is worth $8 at retirement. Therefore, I shouldn't buy that $12k car because I'll be costing myself almost $100k at retirement!

This factor of eight multiplier really helps me build a visceral aversion to spending my money.

Now, if I'm careful enough with my money, my retirement could come much sooner than three decades. Suppose my frugal nature affords me a retirement in one decade. When planning for my future, I should strive to be as accurate as possible, so naturally I should frame my thinking in terms of a one-decade timeline:

I'm about one decade from retirement, so that $12k car will cost me $24k at retirement. Well, that's not so bad, so I should buy the car.

However, switching to this line of thinking would make me much less thrifty, and would greatly postpone my retirement. This leads me to what I'm calling the Future Value Paradox:

The longer the timeline I assume for my retirement planning, the more frugal I become, and thus the sooner I will retire.

So, the less accurate my prediction, the better my results!

Pessimism and the Risk Premium

The Dividend Guy has posted an article discussing market rebounds after downturns. This effect could be explained statistically by reversion to the mean, but this doesn't give any insights to the causes of the phenomenon, which I think is quite easily explained.

An investment with higher risk must, if fairly priced, give a higher expected return. This phenomenon is referred to as the risk premium. Now, in an efficient market, when some bad news comes to light, investors adjust their expectations for future earnings, and stock prices drop to maintain a fair P/E ratio. However, investors also conclude that risk has increased, causing them to demand a higher return, which implies a lower P/E ratio, so prices drop further.

When the bad news ends and good news starts to roll in, prices will initially grow along with higher expected future earnings; and then the perception of risk drops, causing the P/E ratio to grow again.

So, for example, suppose we learn that company ABC's expected earnings will be half what they were thought to be. For a fixed P/E ratio, this means that the stock price should be half what it was. However, this bad news also leads to increased perception of risk, so the P/E ratio drops, and the stock price can end up much lower than half of what it was.

Conversely, when the bad news ends and the expected earnings double, the stock price would merely double if not for the risk premium; but when the risk premium disappears, the P/E ratio increases, and the stock price can end up much higher than it was.

Without the risk premium, P/E ratios would remain fixed. Thanks to the risk premium, P/E ratios fluctuate with the market mood. This is a good thing for those with longer investment horizons: they are less risk-averse, and can pick up some good bargains during times of pessimism.

Lower P/E ratios during times of pessimism explain why returns would be higher during those times, causing overall stock performance to revert to the mean. This explains one small part of why Warren Buffet has had so much success being greedy when others are fearful.

Still renting?

A year ago, I posted my most popular article yet: Save money by renting your home. A lot has changed in the last year, but one thing that's the same as ever is that I'm perfectly content renting for the foreseeable future.

The the article hinged on a calculation of the largest mortgage I could carry and still save money every month:

I pay $1200 per month in rent, including my parking space. That rent includes a number of items that would come out of my own pocket if I owned a home, such as property tax, repairs, maintenance, and some utilities. All told, I get about $500 in value every month included in my rent. That leaves $700 that is truly "thrown away" just like mortgage interest.

How large a mortgage would cost $700 per month in interest? Today's variable-rate mortgages are going for about 4.6% per year. At that rate, a mortgage of $182k would have interest charges of $700 per month. That means if I could stop renting and move into a house with a mortgage of $182k or less, I would save money every month.

Here's what has changed:

• My rent has increased by $50/mth. That brings my "thrown away" money up to $750/mth.
• Variable-rate mortgages can now be had for 3.05% interest.

With these new figures, we find that the magic mortgage number is now about $295k. If I can find a buy a home with a mortgage of $295k or less, I would save money every month.

Here's what hasn't changed:

• Homes in my area still don't go for $295k. They're still up around $480k.
• Condos can be had for $295k, but the condo fees move the break-even point below $295k, so they're still not better financially.
• I still don't particularly want to own a home.

I'd like to leave you with one final thought. It is being claimed that now is the time to buy a home because of increasingly favourable interest rates and home prices. To my mind, the best time to make any investment is when the price is low and increasing. Right now, real estate prices are high and decreasing. As far as price is concerned, you could hardly choose a worse time to buy a home than right now (except perhaps six months ago).

The worst has happened. The sky has fallen. I've lost a gut-wrenching amount of money on paper in the stock market since September. But I'm as satisfied as I ever was in my asset allocation, my risk tolerance, and my decision to rent rather than buy.

Update, Apr 21: As of this week, you can get mortgage rates as low as 3.05%, so I have adjusted my calculations above to use this number instead of 3.3%.

Update, July 15: Looking at the same link given above, we see now that variable mortgage rates are as low 2.85%, so the break-even mortgage is up to $315k. This means I probably could buy a house in my neighborhood and, ignoring the buying and moving costs, I might save a few bucks every month starting on day one. But I still have no interest in buying a house just yet. For one thing, the moment the mortgages return to more historically normal rates, the mortgage's advantage over renting disappears, and I would be back to losing money every month relative to renting. I consider it unwise to bet against this happening in, say, the next five years. There are also non-financial considerations, like the freedom to change homes with just 60 days' notice at no cost, or my nearly complete protection from risk in the real estate market. A house would need to cost substantially less than my rent for me to take on the extra risk and responsibility of house ownership.

Update, November 3: Now rates are down to 2.25%, so the break-even mortgage is up to $400k. If I were convinced mortgage rates would stay this low indefinitely, and I liked the idea of skewing my asset allocation heavily toward residential real estate, and I didn't mind mowing my own lawn and fixing my own roof/furnace/toilet/whatever, and I was ok with losing the freedom to move with 60 days' notice, I'd buy a house right away!

Update, November 24: The neighbors just sold their house for $650k. It was a decent-sized 5-bedroom house, but it just goes to show that I wasn't being overly pessimistic by estimating $480k.

Protectionist frenzy over 22 cars?

Is protectionism ok when we do it?

Please, everyone, get a grip. We buy their cars; they buy our lumber, machinery, and energy (and cars!); and everyone wins. That's how international trade works.

It's not the job of Ontario Lottery and Gaming to stimulate the auto industry, and I think Smitherman is way out of line in his criticisms.

Update: The protectionism isn't over yet. Apparently MPs are now supposed to drive Ontaio-made cars only. Given the outrage we all heard over American protectionism so very recently, this hypocrisy is almost unbelievable.

Update 2: I'm glad I'm not the only one who feels this way.

Update 3: Here we go again. They're closing the barn door after the horse has left. They ought to ask themselves why Canada's manufacturing sector can't out-compete China in the first place.

The auto bailout: wrong in so many ways

Michael James hit the nail on the head today in his comments regarding the auto bailouts. I've made the same point about boosting EI rather than writing a vast cheque to a mismanaged company that makes inferior products.

It's importat to realize that the Canadian government is indebted to the EI system (at least morally, if not fiscally) to the tune of $51 billion anyway, so it seems perfectly fair for them to pay out an extra few billion in EI benefits to auto workers to tide them over until new jobs arise. It would also seem reasonable to fund re-training for the auto workers, and tax incentives for successful manufacturing companies (say, Japanese auto makers) to set up plants in Ontario.

All of this would seem more likely to succeed than to deliver billions of buckets to the crew of the Titanic.

I'd like to add that the way the Canadian bailout was determined also shows a startling lack of leadership. Queen's park decided ahead of time that they would pay 20% of whatever figure the US government arrived at, thereby abdicating our nation's fiscal sovereignty on one of its largest expenditures. This is just the latest in a string of actions since parliament was prorogued against all logic in December, all of which show that the current federal government is a rudderless ship.

ETrade's inactivity fees

I'm not happy with ETrade. I opened trading accounts there a couple of years ago, but until recently I only used the self-directed RRSP account. The regular trading account that you get along with the RRSP account sat idle.

Then, in October, Pizza Pizza (PZA.UN) shares dropped to the point that the distribution yield hit 14%. Now, the percentage yield is only interesting if it's a percentage of a large number, or if it's compounding; but at 14%, it meant I could buy 100 shares (for $640, which I had lying around) and the monthly distribution would be more than enough to buy one additional share every month. I transferred the cash, put in the order, activated the synthetic DRIP, and by the end of the year, the three distributions I had received had already covered the (rather pricey) $20 trading commission.

When I checked the account in January, I was in for a surprise: they had charged the account a $25 "inactivity fee". I thought at first there was some sort of mistake, but it turns out they charge regular accounts (not registered accounts) $25 each quarter in which you make fewer than two trades. There is an incredible irony in charging me an inactivity fee the very first time I used this account.

I was not impressed. At this point, I think my letters to ETrade speak for themselves:

Hello,

You have charged my cash trading account a $25 "low-activity admin fee". I would like it to be refunded immediately please. My account ID is XXXXXX.

I find it absurd and infuriating that you charge me $25 specifically for providing me with no service. Your trading fees and currency exchange rates are already among the costliest in the industry, and they are only tolerable because I don't trade frequently. If you insist on charging me $25 per quarter to do nothing for me, I will be closing my accounts, transferring my holdings to a brokerage with a sane fee structure, and publicizing my displeasure as widely as possible.

I don't mind paying for service, but I refuse to pay for a lack of service, and I suggest you take a moment to reflect on the wisdom of surprising your customers with this mean-spirited, punitive fee.

Out of respect to the service agent, I won't name him or post his reply, but perhaps you can infer what was said from my response:

Dear Xxx,

Thank you for your reply, but I'm afraid it doesn't stand to reason. Why does ETrade need to charge this fee if I make one trade, but not if I make two? Why does ETrade encounter these back-office expenses if I have $4999 in my account, but not if I have $5000? It is absurd. I think the real explanation is that ETrade wants to guarantee themselves a minimum revenue stream from each customer regardless of the level of service provided. This is what happens when you let accountants run your business.

More to the point, other discount brokerages don't charge this fee. I would rather part with $125 for closing my account than get hit with this infuriating fee every quarter, or pay $160 every year for trades I don't want to do.

I think ETrade needs to consider carefully whether they want to lose people like me as customers. Certainly, my account balance is tiny now, since most of my assets are elsewhere, and I am at the start of my investing career; but I'm looking for a broker to use for the next three decades until my retirement, and I'm not going to choose one who charges me for nothing.

I will not pay this fee again. It is up to you whether that is because you have waived it, or because I have closed my account.

As expected, they did not waive the fee, and the service agent seemed to become somewhat personally affronted by my emails, which prompted me to say this:

Dear Xxx,

I didn't mean to accuse you personally of setting the policy. I made an effort to refer specifically to "ETrade" separately from yourself, but if I wasn't clear enough, I apologize.

Nonetheless, the inactivity fee is unacceptable to me. I am aware of a number of discount brokerages that have no such fee, so charging me a fee for no service is not only unethical: it also puts ETrade at a disadvantage relative to its competitors. I will be exploring my options before the time comes that ETrade can charge me that fee again.

I do not want to switch brokerages (partly because I don't want to pay the $125 ransom to get my assets back) so I would sincerely appreciate it if you could find a way to help me get this "fee for nothing" waived.

Naturally they were unable to waive the fee. What I have done is open a TFSA at ETrade and move my shares there. The TFSA is a registered account and is not subject to the inactivity fee. With any luck, that $25 fee is the last money I'll be paying ETrade for a very long time.

What do you think? Am I being unreasonable?

Thanks, Larry!

On October 27, Larry McDonald posted an article on saving money by defending yourself against traffic tickets, rather than paying an agent several hundred dollars to represent you.

The following evening, I was pulled over by a policeman and given a number of tickets for administrative matters. I can't be too specific, but it was a pretty expensive evening. Worst of all, the convictions would disqualify me for my current hallowed status with my car insurance provider, and would lead to increased premiums for years to come. This seemed manifestly unfair to me, since I believe my poor administrative skills have no bearing whatsoever on my actuarial risk.

My first thought was not to take chances: to hire an agent to represent me and get the convictions dropped; but after reading Larry's article, I decided to go it alone.

Early in January, I attended my appointment with the prosecutor, and with a wave of her pen, my life got a whole lot easier.

I saved myself four convictions, three demerit points, and over $500 in fines, all at no cost besides my time.

Thanks, Larry!