Financial independence without home ownership?

As Jonathan Chevreau says in his recent column: "a paid-for home is the foundation of financial independence". Or is it? Happily, this serves as the perfect lead-in to what is becoming a tradition for me: my annual rant on the topic of renting versus buying your home.

I rent. I always have, and unless something changes dramatically in the world of real estate, I always will. When it comes to the purely financial side of home ownership, the numbers just don't add up in Toronto, nor in most of the major Canadian cities. I rent because it saves me money.

It all comes down to the fair value of a house. If actual houses cost less, buying makes financial sense; otherwise, you'll save money by renting.

Real estate as an investment

Historically, real estate values just keep pace with inflation, making it equivalent to real return bonds, but with lower liquidity. This makes real estate one of the worst possible investments if you're looking for capital appreciation.

So why do people invest in real estate? There are two reasons.

First, just as bonds have their interest payments, real estate can generate cash flow. In the case of your own home, you do not actually see any positive cash flow, but you do get to avoid a negative cash flow in that you're not paying rent.

Second, real estate makes good collateral for a bank loan. Residential mortgages have among the lowest interest rates available to individual investors. That interest is not tax-deductible in Canada, and the idea of losing your home for defaulting on a loan is not a pleasant thought. Nonetheless, a mortgage is still a relatively attractive borrowing proposition.

Cash flow

Consider the 4% rule. It states that if you were to invest an amount equal to 25 years' rent in stocks and bonds, you could safely withdraw enough per year to pay your rent. Thus, no house is worth more than 25 years' rent. If your house can fetch a price worth more than 25 years' rent, you should sell your house, rent it back from the buyer, and pocket the difference!

The cash flows for owning one's home take three forms:

1. one large negative cash flow for buying the house;
2. recurring negative cash flows for mortgage interest, property taxes, and maintenance; and
3. one large positive cash flow for selling the house.

Because real estate values can be expected to track inflation, the net present value of cash flows #1 and #3 cancel, leaving #2. (For simplicity, I'll ignore transaction costs and moving costs.)

The recurring cash flows for home ownership are entirely negative, as they are for renting. In any given month, if renting saves money, we should be renting, since it would be more efficient to wait a month and use the money saved to increase the downpayment on an eventual house purchase.

Let's compute the break-even point between renting and buying.

For buying, most annual expenses depend on the value of the property. There are other expenses that depend on the house size, but to keep things simple, I'll express these too as a percentage of the property value.

Roughly speaking, house owners must pay the following costs that renters don't (mostly because they already included in rent):

• 2% mortgage interest. (We don't include the equity portion of the mortgage payment because that money has no impact on net worth.)
• 0.5% building insurance. (We don't include insurance on contents because renters must pay that too.)
• 1% property tax.
• 1% repairs and maintenance.
• 0.5% additional utilities.

TOTAL: 5%

At 5%, the house is costing you an amount equal to its value every 20 years.  This means if you buy a house with a mortgage worth more than 20 years' rent, you will waste money every month relative to renting. 20 years' rent in my current apartment is about $310,000. In my Toronto suburb, that means if I don't mind settling for a semidetached fixer-upper, and I have a decent downpayment, and I don't anticipate any increases in mortgage interest rates any time soon, I would save money each month by buying a house.

So why not buy a house then?

Because interest rates will not be this low forever. If you have a variable-rate mortgage, and rates increase, suddenly renting starts to look pretty good again.

Suppose rates increase by 3% to a more normal (yet still historically very low) 5%.  This brings the break-even mortgage to 12.5 years' rent, or under $200k in my case, which would price me out of the housing market in my area.

Ok, suppose instead we lock in at the current low rates by getting a fixed-rate mortgage. Guess what? The banks have thought of this. 5-year fixed-rate mortgages are going for right around 5% right now. This represents the same 3% increase we just considered a moment ago. No luck there.

All right, perhaps we can get a smaller condo instead of a house. Sorry, no luck there either: typical condo fees are also about 3% of the condo's value.

Any way you look at it, a realistic break-even mortgage is closer to 12 years' rent than 20.

But hey, you don't rent a house! You're comparing apples to oranges!

True. I rent a two-bedroom townhouse. Isn't it unfair to compare the rent on my apartment with the cost of a house, when the latter is much larger? Shouldn't I be using the rent on an equivalent house in my calculations?

No. Here's why.

Consider this: suppose you were evaluating the cost of a car. If you don't own a car, you still need to get around, so to be fair you will have to calculate the cost of public transit, taxi rides, and the occasional car rental. But you do not need to calculate the cost of permanently renting an equivalent car. That option is not relevant unless you are seriously considering doing it! Most people without a car are content to take public transit and taxis.

Likewise, I'm content in the apartment I have. It's not my fault nobody will sell me a house this small anymore (though such houses were commonplace just a few decades ago). If they did, I could do a direct comparison, but they won't, so I must compare the options available to me. Apples-to-oranges is the way toward a rational decision.

Among the options available to me, renting is financially the winner, hands down. If someone gave me a house for free, I'd sell it and move back here.

Rebalancing: has John Bogle lost his mind?

Larry McDonald's recent blog post discusses some critiques of dividend investing. I can't say I'm either for or against dividend investing, but one of the critics is John Bogle, who pretty much invented indexed mutual funds.

As blasphemous as this may seem, I tend to take Mr Bogle's advice with a grain of salt after reading his arguments against rebalancing. Saying rebalancing is unnecessary is essentially saying that asset allocation is unimportant.

This is clearly goofy. How does Mr Bogle justify this stance?

He justifies it by demonstrating that the additional returns from rebalancing are negligible. Well, as a believer in the efficient-market hypothesis, I could have told you that.

Rebalancing is not about maximizing returns. It's about managing one's exposure to risk. In fact, I'm actually mildly surprised that a rebalanced portfolio beat a non-rebalanced one at all. That means you are getting reduced risk at no cost! It seems to be one of the few free rides available in the investing world.

Capital-limited efficient market hypothesis

Broadly speaking, I'm a believer in the Efficient-Market Hypothesis (specifically, the "semi-strong" form), due to the wealth of academic research backing it up. Yet it seems obvious that assets are mispriced regularly. How do I reconcile these two viewpoints?

Hindsight

The first thing to realize is that many of the so-called "mispricings" that people observe are just hindsight at work. The dot-com bubble, for example, is widely cited as an obvious failure of EMH. The logic usually employed looks something like this:

1. Semi-strong EMH predicts that prices reflect all publicly-available information
2. Prices during the bubble were too high, given what we now know
   
3. Therefore semi-strong EMH didn't apply during the bubble
   

The obvious unstated assumption here is that everything we know now was known during the bubble. Since this is patently false, the argument doesn't hold.

Capital limitations

But what if we replace #2 with this: "Prices during the bubble were too high, given what we knew at the time". While this assertion is far from proven, I concede that it's possible.

To explain this, I employ a modified version of EMH that I refer to as the Capital-Limited Efficient-Market Hypothesis:

While fair prices reflect all known information, actual market prices reflect only the information known to those with the capital and willingness to drive prices toward their fair value in search of profit.

Thus, one way to explain an asset mispricing would be to demonstrate how investors are deficient in at least one of three areas:

1. Knowledge
2. Capital
3. Willingness
   

If you reject the notion that the dot-com bubble was a shortage of knowledge, then it can be argued to be a shortage of capital and willingness as follows:

• The dot-com bubble was characterized by a dramatic increase in capital invested according to market momentum and wildly optimistic guesses of future performance.
• The relatively few investors who knew stocks were overpriced could drive stock prices down only by short-selling them.
• Short-selling carries the risk that the investor will lose a great deal of money (more than invested) should prices continue to climb. This reduces investors' willingness to risk a lot of capital.
• Therefore, the inefficiency was able to persist because market was unable to eliminate it.
  

This framing allows for an inefficient price level to persist for some time, but only to the extent that investors are unwilling to profit by correcting it.

Corollaries

This rule is a lot more "fuzzy" than the original EMH rule. I wish I could evaluate this hypothesis more rigorously, but I lack the expertise to do so. I think it would stand up well. I also worry that it is so vague as to be meaningless, but I don't believe it is.

Does this capital-limited EMH make any actual concrete predictions? I think so.

The first prediction would be that bubbles crash more quickly than they rise. This would be because investors are always less willing to short a stock than to invest in it. Is there evidence of this? Not being a statistician, I'm not even sure how to check, but it does "seem" right.

A second prediction would be that Warren Buffet, an investor who excels in identifying mispriced assets, must necessarily become less effective as his available capital becomes so much that he becomes more effective at canceling the very inefficiencies he notices. This is borne out by the long-term price trends of Berkshire-Hathaway stock, and I don't think this would be a surprise to anyone.

A third prediction would be the existence of the risk premium. Higher risk reduces the amount of willing capital available to drive a price up, thereby leaving it lower than the fair price. Again, I'm no statistician, but I think it's fair to take "implied volatility" as a proxy for risk, and if you look at this chart comparing NASDAQ "implied volatility" versus price, to me it's clear there's an inverse relationship.

As a software developer, I see the market as a kind of debugging exercise in which efficiencies can continue to exist only until they are noticed by someone with enough capital to cancel them. Benjamin Graham gives several examples of these inefficiencies that got "debugged" out of existence:

In 1949 we could present a study of stock-market fluctuations over the preceding 75 years, which supported a formula—based on earnings and current interest rates—for determining a level to buy the DJIA below its “central” or “intrinsic” value, and to sell out above such value. It was an application of the governing maxim of the Rothschilds: “Buy cheap and sell dear.” And it had the advantage of running directly counter to the ingrained and pernicious maxim of Wall Street that stocks should be bought because they have gone up and sold because they have gone down. Alas, after 1949 this formula no longer worked. A second illustration is provided by the famous “Dow Theory” of stock-market movements, in a comparison of its indicated splendid results for 1897–1933 and its much more questionable performance since 1934.

Conclusions

I started writing this post in November, hoping to support the hypothesis with additional evidence and reasoning, but since I seem to have neither the time nor expertise to achieve this, I've resigned myself to posting it in its current half-baked form.

By and large, I no longer try to pick stocks. I don't have the advantage over the general market in any of the three required qualities: knowledge, capital, or willingness. Following Graham's advice, and being unwilling to become an "enterprising investor", I have no option but to become a "defensive investor", and my life is much less stressful for it!

Portfolio fraction averaging

In the last couple of days, Michael James has been exploring variations of the 4% rule, and has proposed his own modified version, which simply states that you should spend 4% of your portfolio per year, and allow the resulting income to fluctuate.

Though this strategy as stated leaves some important questions unanswered, it does have a fundamental advantage over William Bengen's original 4% rule, which advises a constant withdrawal (in real terms) in dollars every year.

Bengen's advice amounts to dollar cost averaging in reverse: rather than periodically buying a fixed dollar value of assets, you periodically sell a fixed dollar value of assets.

The name "dollar cost averaging" refers to the fact that the average price you're paying for assets is determined by spending a fixed dollar cost for each purchase. The average price paid for the assets equals the total paid divided by the total units purchased, and in the case of dollar cost averaging, this works out to the harmonic mean of the purchase prices (though I'll spare you the mathematical details). This kind of mean makes DCA attractive while buying, and much less attractive while selling.

For example, consider just two purchases using dollar cost averaging, buying $1 of assets each time. For the first purchase, the asset cost 20 cents per unit, and for the second purchase, it cost 5 cents per unit. The first purchase gets 5 units, and the second gets 20, for a total of 25 units costing $2, which is 8 cents each.

Michael's plan, on the other hand, advises you to sell a fixed fraction of your portfolio each time period. This "portfolio fraction averaging" is, to a first approximation, much like selling a fixed number of asset units each time. (The diminishing number of units held is offset by new units purchased by reinvested dividends, so let's ignore both of these things for now.) The average price for each unit in such a scheme is the arithmetic mean of the individual sale prices.

Using the same example asset as before, consider just two sales using portfolio fraction averaging, where 4% of your portfolio amounts to one unit. The first sale would earn 20 cents, and the second sale would earn 5 cents. The two units together netted 25 cents, for an average of 12.5 cents each. Note that this is more than the 8 cent average we paid for these units. The arithmetic mean is always greater than the harmonic mean!

So, when you sell your assets, would you prefer to earn an average of 8 cents per unit, or 12.5 cents?

I thought so.

Is the 4% rule good advice?

If you've spent any time reading personal finance blogs, you must have come across the "4% rule". It is quoted with impressive regularity, yet it is rarely explained, and even more rarely questioned.

What is the 4% rule?

Many would summarize the 4% rule as follows:

You can safely withdraw 4% of your retirement savings each year in retirement without risk of running out of money.

This statement is not only vague; it's inaccurate. It doesn't say anything about how the retirement savings is invested, or how to cope with inflation, or just how much risk there is of running out of money.

The 4% rule was first developed in a paper by William Bengen. Here is the 4% rule from the horse's mouth:

For a client just beginning retirement, determine first the "safe" withdrawal rate. … For a client of age 60–65, this will usually be about 4 percent. The withdrawal dollar amount for the first year (calculated as the withdrawal percentage times the starting value of the portfolio), will be adjusted up or down for inflation every succeeding year. After the first year, the withdrawal rate is no longer used for computing the amount withdrawn; that will be computed instead from last year's withdrawal, plus an inflation factor.

So this is not a withdrawal rate of 4% per year. It's a withdrawal rate of 4% in the first year, adjusted for inflation thereafter.

What is Bengen's advice for asset allocation?

Despite advice you may have heard to the contrary, the historical record supports an allocation of between 50-percent and 75-percent stocks as the best starting allocation for a client. For most clients, it can be maintained throughout retirement, or until their investing goals change. Stock allocations below 50 percent and above 75 percent are counterproductive.

And just how safe is this strategy? Bengen back-tests the strategy using market performance and inflation numbers between 1926 and 1992. With a 50/50 split between stocks and bonds, Bengen concludes:

Assuming a minimum requirement of 30 years of portfolio longevity, a first-year withdrawal of 4 percent, followed by inflation-adjusted withdrawals in subsequent years, should be safe. In no past case has it caused a portfolio to be exhausted before 33 years, and in most cases it will lead to portfolio lives of 50 years or longer.

Of course, the merits of conclusions based on back-testing can be questionable, but at least we know exactly where the 4% rule comes from.

Does this make sense?

The main problem I have with this advice is that it breaks what I consider a very reasonable soundness test: two people in identical situations should be given the same advice. However, consider Allan and Barney, both 65 years old with $1M in 50/50 stocks and bonds, and both with the same actuarial risks (both married, non-smokers, living in the same part of the country, etc.). Suppose inflation is 3%.

Allan is retiring in March 2009. Barney retired in March 2008. At the time, Barney's nest egg was $1.3M. He dutifully withdrew $52k for the year.

What advice do we give these two men in March 2009?

We advise Allan to withdraw $40,000 (which is 4% of his portfolio), but we advise Barney to withdraw $53,500 (the previous withdrawal adjusted for inflation) despite being in precisely the same financial situation. To me, this is inherently irrational, but it's hard to offer better advice to poor Barney, who would be understandably upset at the prospect of decreasing his annual income by 20%.

Can we do better?

A subsequent paper by Scott, Sharpe, and Watson addresses the question of whether Bengen's strategy is the most cost-efficient way to ensure you get a reliable cash flow during retirement. They identify two sources of inefficiency: one is a relatively minor one that they address using option trading; I find that one fairly uninteresting because it only amounts to 2-4% of your savings, and recouping that requires some fairly esoteric financial maneuvering. However, the more interesting inefficiency is fairly straightforward and accounts for 10-20% of the portfolio's value.

To understand this inefficiency, first consider that if you kept your nest egg as cash under your mattress, you could safely withdraw 4% per year for 25 years with zero risk of running out of money during that time. Suddenly, investing in a mix of stocks and bonds to achieve a probable 33 years of withdrawals is not so impressive anymore.

Of course, your mattress doesn't compensate you for inflation, but this is easily fixed using inflation-protected government bonds. With a typical real return of 2%, Scott et al argue that the retiree could finance 30 years of guaranteed inflation-adjusted withdrawals for the price of just 22.4 years. This amounts to a withdrawal rate of 1/22.4 = 4.46%!

What gives? How could stogy old inflation-protected bonds offer a withdrawal rate 11% higher than that of the stocks-and-bonds portfolio?

The answer is that choosing the bonds over the market portfolio gives up both the potential upside and downside of the market. Because the market generally increases over time, the upside over a 30-year time frame is much higher than the downside risk, and the market values this at approximately 11% of the withdrawals per year.

The bond investor has also accepted the certainty that his money will be gone after year 30. The stocks-and-bonds investor likely still has money left to continue his withdrawals indefinitely, and extremely likely still has enough at least for years 31-33.

This is what the inflation-protected bond investor has given up in exchange for a 11% higher withdrawal rate and zero risk.

So what should we do?

The best course of action may be a combination of the two. Buy inflation-protected bonds to fund 30 years of living expenses based on your budget, and use the remainder of your portfolio to invest in stocks and bonds, which could improve your standard of living, fund your expenses after 30 years, and leave an inheritance for your family.

Time-tested financial advice

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.

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:

• Securities Lending Wake-up Call
• Two related blog posts here and here
  

Finally, as of a couple of years ago, someone has done the obvious, offering an ETF with a nominal expense ratio of 0%, with management making all their money from security lending.

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.)