I've been a bit preoccupied lately, so it has been a while since my last blog post. It will probably be another couple of weeks before I'm back in the swing of things.
In the mean time, check out this financial advice from fellow blogger Nicholas. This is one that deserves to be in everyone's blogroll. He boils investing down to three basic steps, and discusses some common investing misconceptions.
Nov 18, 2009
Aug 5, 2009
Securities lending: the next bubble?
So it goes something like this: you buy units of an ETF, which holds securities on your behalf. Then the fun begins: the ETF lends your securities to someone who wants to short-sell them, and the ETF charges interest. More money for the unitholder and for the ETF management. Everyone wins, right? Not so fast...
There have been several sobering posts lately regarding this practice of security lending by ETFs. By way of background reading, here are a few good articles by Larry McDonald:
While this is an obvious triumph of marketing, it scares me. Now, I am not an expert here; I don't know the ins and outs of the regulations surrounding these investment practices. But having said that, the main problem I see is that this scheme doesn't align the interests of the shareholder and management. Management's entire profit comes from security lending, and the profit of security lending can be boosted a few ways, such as, I dunno, lending at higher interest to those with a lower credit rating, or investing the collateral aggressively. Worst of all, while all the potential for profit goes to management, all the risk of loss is borne by the fund investor.
This is a scary situation. You've got a scheme that offers money for nothing with a plausible, if esoteric, explanation ("hey, we're not angels; we make our money from security lending, but don't worry your pretty little head about complicated details like that"); and it does so with a scheme that puts management's interest at odds with the interests of investors. Worse, the kinds of abuses that this scheme invites seem to be the same kind of aggressive lending and investing practices that led to this financial meltdown that some of of you may remember from a few months back.
As usual, Vanguard seems to have their act together on this one. They make their money from an explicit MER, and give all profits from the security lending to the unitholders. This way, the risks of profit and loss go to the same party--the unitholders--and investors know exactly how much they are paying management. I gather Vanguard's seemingly unwavering ethical behaviour stems from the fact that they are actually owned by their unitholders.
Next time you buy an ETF, you might want to consider what they do with the profits and collateral from their security lending operations.
(Please keep in mind that these are just the opinions of a relatively uninformed amateur. Also, I have no financial stake in Vanguard, nor any funds invested with them.)
There have been several sobering posts lately regarding this practice of security lending by ETFs. By way of background reading, here are a few good articles by Larry McDonald:
- Securities Lending Wake-up Call
- Two related blog posts here and here
While this is an obvious triumph of marketing, it scares me. Now, I am not an expert here; I don't know the ins and outs of the regulations surrounding these investment practices. But having said that, the main problem I see is that this scheme doesn't align the interests of the shareholder and management. Management's entire profit comes from security lending, and the profit of security lending can be boosted a few ways, such as, I dunno, lending at higher interest to those with a lower credit rating, or investing the collateral aggressively. Worst of all, while all the potential for profit goes to management, all the risk of loss is borne by the fund investor.
This is a scary situation. You've got a scheme that offers money for nothing with a plausible, if esoteric, explanation ("hey, we're not angels; we make our money from security lending, but don't worry your pretty little head about complicated details like that"); and it does so with a scheme that puts management's interest at odds with the interests of investors. Worse, the kinds of abuses that this scheme invites seem to be the same kind of aggressive lending and investing practices that led to this financial meltdown that some of of you may remember from a few months back.
As usual, Vanguard seems to have their act together on this one. They make their money from an explicit MER, and give all profits from the security lending to the unitholders. This way, the risks of profit and loss go to the same party--the unitholders--and investors know exactly how much they are paying management. I gather Vanguard's seemingly unwavering ethical behaviour stems from the fact that they are actually owned by their unitholders.
Next time you buy an ETF, you might want to consider what they do with the profits and collateral from their security lending operations.
(Please keep in mind that these are just the opinions of a relatively uninformed amateur. Also, I have no financial stake in Vanguard, nor any funds invested with them.)
Jun 4, 2009
"Nothing goes up forever"
I heard a market prognosticator on the radio at the start of June, claiming that the market was going to drop soon. Well, good for him; people make such predictions all the time, and they're right roughly half the time.
The interesting thing about this prediction was that this fellow made the argument that we're due for a big correction because "nothing goes up forever". I agree completely that the chance of having no down-days on the market approaches zero as your time horizon extends farther into the future, but that general argument, based on the law of large numbers, most certainly does not support his conclusion that the beginning of June was a good time to sell stocks.
It doesn't even matter that the stock market is down 3.8% from the day he made his call. He was still wrong.
If I toss a coin and get 10 heads in a row, I could make the statement "you can't get heads forever" and I would be entirely correct. If I went on to make the prediction that the next coin toss is now more likely than before to come up tails, I would be dead wrong, even if the next coin toss did in fact come up tails. You can't credit your pet theory for your own lucky guess.
The interesting thing about this prediction was that this fellow made the argument that we're due for a big correction because "nothing goes up forever". I agree completely that the chance of having no down-days on the market approaches zero as your time horizon extends farther into the future, but that general argument, based on the law of large numbers, most certainly does not support his conclusion that the beginning of June was a good time to sell stocks.
It doesn't even matter that the stock market is down 3.8% from the day he made his call. He was still wrong.
If I toss a coin and get 10 heads in a row, I could make the statement "you can't get heads forever" and I would be entirely correct. If I went on to make the prediction that the next coin toss is now more likely than before to come up tails, I would be dead wrong, even if the next coin toss did in fact come up tails. You can't credit your pet theory for your own lucky guess.
May 25, 2009
Waiting until the market "calms down"
Michael James has updated his Market Timer Breakeven Date. This is an amusing way to measure the futility of selling the TSX index and trying to buy it later at a lower price. For anyone who did their selling later than October 6, their decision to sell has lost them money compared with staying invested. October 6 was fairly early in the Great Recession, so this kind of market timing would have required substantial clairvoyance foresight just to break even.
This is a concrete example of a case where market timing failed to produce any improvement over buy-and-hold. But, after all, it is only a single example. Isn't it usually a good idea to to sell stocks when they're crashing, and wait for the market to "calm down" before buying back in?
The answer is definitely no. This does not make sense, and if you feel the need to do this, you are either acting irrationally, or you have a poor asset allocation that does not match your financial needs or appetite for risk. The reason for this has to do with the concept of Risk Premium.
The risk premium means that, quite rationally, an investor will demand a better return from an investment with higher risk. If two investments have the same expected return, and one has lower risk, nobody buys the other.
Of course, the stock market as a whole will naturally seem riskier whenever stock prices drop. Therefore, we can expect stock prices during a crash to drop more than the fundamental value of those stocks. If economic conditions make it likely for a company's earnings to drop by 20%, we should expect the stock price to drop more than 20%: specifically, 20%+X, where X is the additional risk premium.
The risk premium makes it a particularly bad idea for investors to wait until the markets "calm down". If "calm down" means lower risk, then these investors are specifically waiting until the risk premium disappears! Combine this with the fact that the market's estimation of risk subsides only when stock prices rise, and you will find that waiting for markets to "calm down" is an ideal way to sell low and buy high.
So am I saying that people should not sell stocks while the market is crashing? On the contrary: if they need the money soon, and it's tied up in stocks, people most certainly should be selling them. The sooner, the better. What I'm saying is that, if they needed the money soon, that money shouldn't have been in stocks in the first place.
How does one avoid getting into such a mess? My own answer is, of course, more advice from Michael James. People who have several years' worth of expenses saved up in low-risk (and hence low-return) investments should find their paper losses in stocks inconvenient, but not alarming. Inconvenient, because of reduced liquidity: you don't want to sell stocks while they're cheap, so now you're stuck with them. But not alarming, because it has no impact on your standard of living, since you're not basing your standard of living on your stocks.
I've used an approach (which I christened bottom-up asset allocation) based largely on Michael James's advice. When the market crashed, I was not overly concerned with my deep paper losses; in fact, I bought more stocks. Why would I worry about a drop in the price of a commodity I hadn't planned to sell anyway?
Put money you need for anticipated expenses into stable investments and cash. The rest goes into investments with the highest expected chance of meeting your financial goals, which generally means a diverse basket of stocks. This approach should help you sleep at night while your stocks lose half their value, secure in the knowledge that your paper losses are unlikely ever to be realized.
This is a concrete example of a case where market timing failed to produce any improvement over buy-and-hold. But, after all, it is only a single example. Isn't it usually a good idea to to sell stocks when they're crashing, and wait for the market to "calm down" before buying back in?
The answer is definitely no. This does not make sense, and if you feel the need to do this, you are either acting irrationally, or you have a poor asset allocation that does not match your financial needs or appetite for risk. The reason for this has to do with the concept of Risk Premium.
The risk premium means that, quite rationally, an investor will demand a better return from an investment with higher risk. If two investments have the same expected return, and one has lower risk, nobody buys the other.
Of course, the stock market as a whole will naturally seem riskier whenever stock prices drop. Therefore, we can expect stock prices during a crash to drop more than the fundamental value of those stocks. If economic conditions make it likely for a company's earnings to drop by 20%, we should expect the stock price to drop more than 20%: specifically, 20%+X, where X is the additional risk premium.
The risk premium makes it a particularly bad idea for investors to wait until the markets "calm down". If "calm down" means lower risk, then these investors are specifically waiting until the risk premium disappears! Combine this with the fact that the market's estimation of risk subsides only when stock prices rise, and you will find that waiting for markets to "calm down" is an ideal way to sell low and buy high.
So am I saying that people should not sell stocks while the market is crashing? On the contrary: if they need the money soon, and it's tied up in stocks, people most certainly should be selling them. The sooner, the better. What I'm saying is that, if they needed the money soon, that money shouldn't have been in stocks in the first place.
How does one avoid getting into such a mess? My own answer is, of course, more advice from Michael James. People who have several years' worth of expenses saved up in low-risk (and hence low-return) investments should find their paper losses in stocks inconvenient, but not alarming. Inconvenient, because of reduced liquidity: you don't want to sell stocks while they're cheap, so now you're stuck with them. But not alarming, because it has no impact on your standard of living, since you're not basing your standard of living on your stocks.
I've used an approach (which I christened bottom-up asset allocation) based largely on Michael James's advice. When the market crashed, I was not overly concerned with my deep paper losses; in fact, I bought more stocks. Why would I worry about a drop in the price of a commodity I hadn't planned to sell anyway?
Put money you need for anticipated expenses into stable investments and cash. The rest goes into investments with the highest expected chance of meeting your financial goals, which generally means a diverse basket of stocks. This approach should help you sleep at night while your stocks lose half their value, secure in the knowledge that your paper losses are unlikely ever to be realized.
May 5, 2009
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:
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:
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!
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!
Apr 23, 2009
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.
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.
Apr 21, 2009
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:
Here's what hasn't changed:
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.
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.Here's what has changed:
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.
- 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.
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.
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.
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