Author Archives: Unassuming Banker

The simple formula to improve your decision making

I just watched The Big Short last night and became inspired to write this post. Having read the book years ago, I didn’t know what to expect, but I’m happy to say they’ve done an exceptional job. The movie offers the most accurate depiction of the years leading up to the 2008 financial crisis that I’ve seen. It doesn’t mean it didn’t take some artistic liberties, but far less so than many so-called “reputable” news outlets. I watched it with my wife and was impressed how it managed to keep her attention despite stories about my day job generally being her favorite natural sleeping aid. I highly recommend the movie to everyone, but I digress.

The Formula

I think the movie illustrates that we as people are very bad at estimating and properly weighting risk, both in our day-to-day lives, and in our investing. Therefore I want to introduce a simple and powerful way of thinking about risk through the following formula:

formula1

 

Beyond finance

I recently had a conversation with a friend about whether cycling in downtown Toronto is more dangerous than driving in downtown Toronto. His argument rested on the fact that there are fewer bike accidents than car accidents per year, making biking safer. He focused in on “# of times bad things happen” part of the formula.

Why is this incorrect? There are even fewer “accidents” resulting from getting trashed and trying to frogger yourself across the QEW.  It doesn’t mean it’s a safer thing to do.

In order to truly assess risk you need to know more than the number of accidents cyclists got into (# of times bad things happened). You also need to know how many total bike trips have been taken as well as how badly the cyclists were hurt when they got into accidents (impact of outcome).

Let’s say that cyclists get into accidents every 100 trips they take, but cars get into accidents every 50 trips taken. Which is safer?

Probability of bike accident = 1/100 =1%
Probability of car accident = 1/50 = 2%

Cars are riskier right? Actually the above tells us nothing about the relative riskiness of the two methods of transportation. We need to consider the impact of having an accident. Let’s say that cyclist’s get three times as badly hurt (on average) as car drivers when they do get into an accident, what is less risky in that case?

EVbike = 1/100 * 3 = 3%
EVcar = 1/50 * 1 = 2%

When taking into account and quantifying the impact, it is now cycling that appears to be the more dangerous of the two modes of transportation.

Before I get a bicycle helmet thrown at my head I just want to point out these are not real stats. I actually have no clue which mode of transportation is safer. In fact I doubt anyone really does because it’s hard to get a reliable estimate on the number of cycling trips taken. I’m just debunking the idea that comparing the number of accidents gives us any indication of risk.

Investing

While sometimes difficult to use in everyday life, this formula is a great starting point of any investment analysis. To illustrate let me go back to a scene in the “Big Short” movie when the Cornwall Capital guys decide to short (that means profit from the demise of) AA mortgage bonds (relatively stable) versus BBB mortgage bonds (far worse quality). They make this bet despite the fact that the latter are far more likely to fail. Why did they make a bet on the far less likely outcome, rather than take what seemed to be the sure thing? The movie does not address this well, but it comes down to the EV formula above.

The guys would get back 5 times their money if BBB bonds failed, but they would get 20 times the money if AA bonds failed. If the probability of BBB bonds failing was assessed at 90% and probability of the AA bonds failing at 40%, which bet would you take?

EVaa = 40% * 20 = 8
EVbbb = 90% * 5 = 4.5

According to EV logic you should actually take the AA bet, despite the fact that you are less likely to be right, because it has almost double the expected value of the alternative.

Investing with non-binary outcomes

The above analysis works because there are only two possible outcomes and one of them involves losing everything. If the guys are wrong about the mortgage market, and none of the bonds fail, they lose their entire investment regardless of the bet taken. This is what’s meant by a binary outcome, you either win or lose everything, but nothing in between. In reality most investments offer a fluid set of possibilities. However, in many cases an initial analysis can still be done using a multi-part EV.

EV of investment = EV of good outcome – EV of bad outcome

Let’s say you believe all the news stories about the housing market in Toronto flattening out. This means you would expect prices to start stagnating or rising very slowly for a number of years. In this scenario, after taking into account mortgage and other ownership costs, you should expect real returns on house investments to be somewhere between 0 and 1% a year. You assign this scenario a 95% probability.

EVgood = 95% * 1% = 0.95%

Let’s say that you also believe there is a very slight possibility that there is a bubble and it’s going to burst. Given that rates cannot go below 0 (at least not much), the Bank of Canada would be powerless to stop the decline of prices by lowering rates, likely leading to at least a 30% decline. You assign this scenario a 5% probability.

EVbad = 5% * -30% = -1.5%

You can then combine the two events to determine whether you should invest:

EV = 0.95% + (-1.5%) = -0.55%

Since the overall EV is less than 0 you should not make this investment even if you think there is no bubble and prices will not fall. The near certainty of modest returns in the future is more than offset by the small probability of a severely bad outcome.

While I used only two scenarios, you can use this same process to come up with as many as you like, and add them together to come up with an EV value for the investment you plan to make. You can also calculate EV values for a number of competing investment options to help you decide which offers the best risk/reward balance.

Conclusion

I know it’s hard or near impossible to accurately quantify the impact and/or probability of an outcome in many cases. This is why assessing risk is something that requires years of practice and a good intuition. However, making decisions without taking into account all the factors represented in the formula is extremely dangerous. The expected value formula is simple starting point to anchor my thinking. It is the minimum that I consider when making important decisions under uncertainty.

I hope the above is relatively clear and you’ll find it helpful in your decision making. I know it has helped me make the right decision many times when the choice that seemed superficially obvious was the wrong one. Not to mention, thinking this way also has the added benefit of completely frustrating my wife and friends. Can’t wait until my boys are old enough! They’re going to love this!


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What’s going on with the economy? part1 – oil

I got a text message from a friend recently asking me “soo should I be taking all my money out of the banks?” This was a response to the stock markets particularly nasty drop that day. I reassured my friend he need not convert all his money into gold bullion or stock up on guns or canned food.

While my friend’s reaction was over the top for comedic value I think many people are wondering the same thing. What the heck is going on with the economy, Canadian dollar and oil prices, and how is it all related? While my main focus on this blog is personal finance, I realize at times like these everyone, even people who could not care less about markets, start to pay attention. This sporadic attention is dangerous to their financial health, because if they haven’t been paying attention, and suddenly focus on the latest media hysteria, it’s easy to blow things out of proportion. This post needs to be split up into parts because of the complexity of the subject but I hope I can cut through some of the smoke screen and help you understand what is really going on.

Part 1 – Oil

Any discussion about what is happening in the world right now has to start with oil. Most of you know that oil prices have collapsed over the past year but maybe not everyone knows why they’ve collapsed or why it’s such a big deal for Canada.

You may remember from school that prices are set by supply and demand. If 10 people each want an apple, and there are only 5 apples available, then the price of the apple will be bid up until only 5 people can actually afford to buy an apple (or one really rich person buys all 5, but I digress). On the other hand if 10 people want to sell an apple each, but only 5 people want buy an apple each, then the sellers will keep dropping their price as far as they can, so that theirs is one of the 5 apples that actually gets bought. This is what people mean when they say prices adjust to balance supply and demand.

When demand exceeds supply prices go up until demand = supply

When supply exceeds demand prices go down until demand = supply

The following chart shows oil demand with a black line and supply with a blue line.


Do you see how the blue line gets far ahead of the black line around the middle of 2014? It is not coincidence that around the end of 2014 oil prices started their historic slide losing approx. 80% of their value. The green bars illustrate the difference between supply and demand to make it easier to see just how much supply exceeded demand from mid-2014 on. It’s this divergence with supply far exceeding demand that explains why oil prices had to fall.

Supply of oil increased far faster than demand for oil

Why did this happen? Aren’t we supposed to hitting “peak oil” and scavenging for energy left overs by now? The answer lies in something called “fracking” which, aside from damaging the environment, has made the US one of the biggest oil producers in the world.

The chart below shows how non-OPEC oil producers (that’s us, the US and Canada) drastically increased oil production since 2013 and how that coincides with the oil price (green line) falling.


It turns out technologies such as fracking and oil sand extraction have made the US and Canada some of the top oil producers in the world.


https://en.wikipedia.org/wiki/List_of_countries_by_oil_production

This may come as a surprise to you but the US is actually the top oil producer in the world and Canada is not far behind at #5.

Since 2011 this happened to US oil field production:


The production almost doubled in a span of 4 years. To put things in perspective the increase is equivalent to an entire new second Canada (the #5 largest producer of oil in the world) appearing out of nowhere and pumping oil full speed.

If the US is a larger oil producer, then why does Canada seem so much more affected by the oil price decline? Part of it has to do with the relative size of the economy. While we are producing only 30% as much oil as the US, our economy is also at least 10 times smaller. This means we are at least 3 times as dependant as the US on oil sales to drive our economy.

What about China and demand for oil? I’m sure you’ve heard dire warnings on TV that the Chinese economy is crashing and therefore oil demand is plummeting. As it turns out, if in fact the Chinese economy is slowing, it’s really not showing up in oil demand numbers and therefore not likely to be driving prices:


See that green line above? That’s how much oil the world is consuming per day. See that giant drop around the end of 2014? Neither do I, because it isn’t there. World oil demand is just fine, it’s the staggering size of increase in oil output in the US that is almost entirely to blame (or to thank for, depending on your point of view) for the oil price fall.

Compare the green line over the last 3 years versus the green line between 2007 and 2009. There is a definite drop in oil demand in the period leading up to the great recession signalling a severe drop in production and economic activity. The fact that this time around we are not seeing a similar drop in demand, but rather the drop appears to be entirely supply driven, is very good news for the world economy. It means we are unlikely to see a world wide recession and the fears of a repeat of 2008 are much overblown.

In summary

  1. Oil price is driven by supply and demand.
  2. Price declines can be either caused by increases in supply or decreases in demand.
  3. In general decreases in oil demand signal a slow down or problem in the world economy, while increases in supply can actually have many positive implications.
  4. Since we are looking at a supply driven oil price decline this time around, the decline is unlikely to be signalling an economic slow-down as many fear.

All well and good then, but how does that relate to the Canadian dollar and Canadian economy? Stay tuned for part #2 of the article coming soon. To make sure you don’t miss it subscribe to email alerts (on the top right of this page) or follow me on social media by clicking one of the buttons below. 


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How to take paternity and maternity leave at the same time

This summer, I am taking 2 months off work (paternity leave) to spend with my wonderful wife and our two beautiful sons. While fathers taking paternity leave is starting to become a bit more common, what surprises people is that I am taking this time off concurrently while my wife is also at home. Most people believe that if the father is taking paternity leave then the mother has to return to work, which might be why most Canadian fathers are still not taking advantage of this option. The reality is both parents are entitled to 37 weeks off work to take care of their newborns, it’s just that the language of the law is a bit confusing, and there is one somewhat important caveat.

To understand how the law works we need to first distinguish between the two different types of leaves.

Maternity/Pregnancy Leave

The first type of leave is called Maternity Leave by Service Canada (the people who handle EI payments) and Pregnancy Leave by the Ontario Ministry of Labour (similarly for other provinces, but I’ll focus on Ontario since that’s where I live). This leave is 17 weeks long and is only available to biological birth mothers. The leave can be taken up to 17 weeks before the child’s due date all the way up to the date of birth, but not after. This leave is often “topped up” by employers to a certain percentage of the employees salary.

Parental Leave

This leave can be taken at any time in the 52 weeks following the child’s birth and is between 35 and 37 weeks. It is available to both parents even at the same time. The Ministry of Labour website states:

Parental leave is not part of pregnancy leave and so a birth mother may take both pregnancy and parental leave. In addition, the right to a parental leave is independent of the right to pregnancy leave. For example, a birth father could be on parental leave at the same time the birth mother is on either her pregnancy leave or parental leave.

The leave is shortened from 37 to 35 weeks for the biological mother, if she already took the 17 weeks off for maternity/pregnancy leave, for a total maximum 52 weeks off. This leave is generally not topped-up by employers, something that catches many people by surprise in the second half of their leave. The drop in income from the topped up maternity leave to the EI-only parental leave can be very significant for many families.

How will taking paternity leave affect my prospects at my employer?

Some fathers may be afraid to take paternity leave in case it adversely affects their career. It’s important to know that fathers taking parental leave have the exact same rights as mothers taking maternity leave. This means:

  • The right to reinstatement – You have to get your job back , or a similar one if yours is no longer available, at the same salary or higher.
  • The right to be free from penalty – This means the employer cannot punish you in any way for taking the leave.
  • The right to continue to participate in benefit plans – Your employer must continue paying their own share of the premiums on your insurance.

Why doesn’t everyone do this?

Most fathers don’t know that it’s even an option. While splitting parental leave between the mother and father is gaining in popularity, most families don’t seem to be aware that they can take parental leave at the same time.

How do I get paid?

There is always a catch right?  While the Ministry of Labour allows concurrent parental leaves and protects both parents, Service Canada will not pay both parents EI. The following note can be found on the Service Canada website.

Can both parents apply for EI parental benefits?

Yes, but they have to share the benefits. In total, there are 35 weeks of parental benefits available to eligible parents of a newborn or newly adopted child.

There are many ways you can decide to use your parental leave. For instance, one of the parents can take the entire 35 weeks of benefits, or both parents can share them.

This means if you both want to stay home and take care of the newborn only one of you gets paid EI (Note: to clarify, it IS possible to both get paid EI at the same time, but the total of 35 weeks is shared between the two parents regardless, so it does not really make sense to do so unless you both plan to go back to work early). Since the maternity leave is often topped-up by your employer while the parental leave is not it’s best to have the mother claim the entire EI amount. This turns the fathers paternity leave into an unpaid leave.

In summary

While fathers are fully protected to stay home with their wife and newborn for up to 35 weeks after the baby is born, this is not a cheap option. Since only one parent can get paid EI at any one time, taking paternity leave requires some very careful financial planning. It’s important to save up not only for the paternity leave itself, but also for the reduced income after all the mothers employer top-ups run out.

I know it seems difficult to save up for a month or two off work and then have to deal with a reduced income afterwards. However, it’s the best decision I’ve ever made, and I’ve done it now twice, with both my sons. If you think about it, it’s really just a matter of making this time off a priority in your life. The EI that one of you will receive is worth $524 a week based on $49,500 a year salary. This means most people will get $2,270 a month from EI alone. Assuming a generous family budget of $5,000 a month, and no employer top up for the mother, this means you would need to save $2,730 per month off.

While $2,730 is not a trivial amount it is not more than a single week vacation to Mexico (2 people),  far less than even a minor house renovation, and probably the same amount as the delivery fees you pay when you pick up your new car. It might only require getting a bit creative on your baby room expenses and toys. What would you rather have, a quartz counter-top in your bathroom that will be out of style 2 years after you install it, or a once in a lifetime experience spending a summer with your family?

You know what I would choose each and every single time!

Spending time with my son on my paternity leave

Enjoying Paternity Leave at Lake Huron


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Something awesome has happened

Something amazing happened on June 25th, 2015. His name is Alexander and he is the reason why I haven’t had the time to write any new blog posts.

IMG_1555-6

I’ve been off work pretty much since the day he was born and it’s been a wonderful, but yet, incredibly exhausting time. I am savoring every moment, thinking how lucky I am to be able to spend all this time getting to know him, and helping my wife by taking care of our other 20-month old little terror.

Given how busy I am with both of the boys I keep wondering how other parents do this. Few couples have the kind of time and support my wife and I are blessed with. With both of us at home and both sets of grand parents close-by to babysit my older son 3 times a week, it still feels like more than a full time job. My full respect to all the mothers out there who somehow manage to juggle two little ones with their husband at work. Same goes for all the fathers out there who barely get any sleep helping their wives with the newborn, and still get up in the morning for a full day of work.

I fully realize that few parents have the luxury to take two months off when their babies are born. I do hope that reading this blog may help some of you planning to have a family prepare for this day financially, so you too can choose to spend the summer with your newborn. Believe me, your spouse or partner will love you for it!


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money, budgeting, spending, personal finance

The best way to curb the urge to splurge

We’re out and about somewhere and we see this amazing dress or a really fancy car, and we get an irresistible urge to splurge. We may be at a friends place and their newly renovated kitchen or porch makes us want to run out and hire a contractor. We’ve all been there.

There is nothing wrong with buying the things we like. The purchasing of items and services is, after all, the whole purpose of money. If we couldn’t exchange money for useful things it would be just worthless pieces of paper, or maybe just a meaningless number in a computer somewhere. However, we often get ourselves in trouble when we don’t fully visualize what it will cost to purchase this item we’re currently coveting.

The trouble is the cost in dollar terms is easily lost on us because we are not very good at visualizing numbers. Therefore, the best way to control the urge to splurge is to visualize the cost in terms of something else we really covet. 

This “something” else could be anything that we value very highly in our lives. In the case of my wife and I, we often use travelling as a point of reference. My wife will often joke about getting an expensive designer purse, but she immediately puts it in travel terms, and it makes the urge go away.  “It’s only enough money to backpack Asia for 3 months” is the best antidote to a bad impulse purchase. “That kitchen reno would be great! it’s just about enough money to finance a full year travelling around the world for the entire family.” Ehh, maybe we’ll skip it.

The same goes for putting money away for retirement or for time away from work. We try to fully visualize what that extra $3,000 spent on furniture means in terms of buying our time back. Would I rather buy new furniture for my basement, or take 2 months off work to spend with my newborn child, as I am doing this summer. To me, the choice is pretty obvious once it’s stated in this way.

This can also work for recurring purchases such as cable bills and gym memberships. What we usually do is multiply this monthly bill by 12 and put it in terms of vacations or plane flights. $1,500 a year for cable can buy two plane tickets to somewhere in the Caribbean, Central America or even South America.

The use of travel and time off as a comparison works for us because we value these things very highly. However, you may have entirely different priorities. Perhaps your priority is improving your home, or being able to go out to your own cottage every week, or to buy a boat. Whatever the priority is, the key is recognizing it, and then making the little daily decisions to get you there. Framing any impulse purchases in terms of delaying or preventing you from reaching those true priorities will help you control the urge to splurge. It will also help you achieve those goals much sooner.


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Retire 5 years earlier by ditching your mutual funds

Just imagine, retiring 5 years earlier than planned, simply by switching from mutual funds to exchange traded funds. The difference between retiring in 30 years, instead of in 25 years, can be all just due to mutual fund management (MER) fees.  How is that possible? Aren’t mutual fund fees something tiny like 1 or 2%?

Mutual fund fees need to be compared against the benchmark expected return

Mutual fund fees are always quoted based on the amount of money you have invested in the fund, not on the amount of money you are making from owning the fund.

The way mutual fund fees are presented is a bit like dividing maintenance fees on an investment condo by the full price of the condo. It’s a great way to make those fees look small, but not a very accurate way of measuring their true cost. If we want to assess whether the condo is a good investment, we would instead check how those fees compare to the rent charged to tenants.

Similarly, we need to compare the fees mutual funds charge to the investment returns they are likely to provide.

How much does an average mutual fund tracking the S&P 500 really charge in fees?

Let’s say we invest $10,000 in a mutual fund tracking the S&P 500 and charging a 2.11% management fee. This type of fund, if it does it’s job well, should return approx. 10% per year over the long term with dividends reinvested (before fees).

Therefore, in an average year we will pay 2.11% out of the 10% annual return or 21.1% of our expected return in fees

In dollar terms, that’s a potential return of $1,000 on the year being reduced by $211 to earn us only $789. That’s a huge difference!

What about the lower fee bond funds?

The news does not get better with lower fee funds because they also generally offer lower expected returns. For example this bond fund charges only a 1.47% fee, which might seem like a bargain compared to the one above, however the fund is also only expected to return 5.2%.

This means the fund fee is actually 1.47% out of 5.2% yearly return, or 28% of our expected return in fees.

In dollar terms, that’s a potential return of $520 on the year being reduced by $147 to earn you only $373. Despite this fund charging a lower fee on your investment, it’s actually more expensive than the S&P 500 fund when compared to it’s expected return!

How about over the long term?

I hope you can see, from the two examples above, that mutual fund management fees are actually far bigger than they first appear. The problem just gets worse over time though because of compounding.

Assuming a 10% annual return on the S&P500, here is a 3 year comparison between the mutual fund charging 2.11%, and a comparable exchange traded fund charging a 0.17% fee.

Per $10,000 invested

End of End of Year Balance  0.17% fee End of Year Balance 2.11% fee Additional fees paid for 2.11% mutual fund over 0.17% ETF
Year 1 $10,983.00 $10,789.00 $194.00
Year 2 $12,062.63 $11,640.25 $422.38
Year 3 $13,248.39 $12,558.67 $689.72

We can see that the total of additional fees paid after 3 years, is greater than 3 times the 1 year additional fee ($689.72 > 3 * $194). Why? The fee reduced balance after each subsequent year is smaller, which in turn means the same 10% return generates less money. This effect is called compounding and it greatly amplifies small differences over long periods of time.

After 25 years, assuming a 10% annualized return, a $100,000 mutual fund investment (2.11% fee) will turn into $667,621. That’s not bad, but the same $100,000 will be worth $1,042,376 if invested into the 0.17% exchange traded fund.

That “little” 2.11% fee ends up costing us around $330,000, or 30% of our total potential retirement nest egg!

Incidentally, it takes an extra 5 years before the mutual fund balance comes close ($975,969) to that of the exchange traded fund.

feechart

What would you do with an extra 5 years of retirement? 

Note sure where to start? See my article on how to set up an exchange traded fund (ETF) based retirement portfolio in 3 easy steps.

If you’ve enjoyed this article and would like to see more please use the “subscribe” option on the right or follow me using one of the social media buttons below. Thank you!


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Weekly Links – Keep it simple, slow and steady

Why do regular people always under-perform investment advisers, who in turn under-perform the market? It’s tempting to say it’s because the pro’s know more, are better educated, have more money, and/or better access to information. These advantages certainly make a difference, but really only on the margin. The real reason was identified back in 1949 by one of the founding fathers of modern security analysis, Benjamin Graham, who wrote “The investor’s chief problem, and even his worst enemy, is likely to be himself.”

This week’s theme is all about investing, and how keeping your emotions under control, ignoring whatever the hot investment of the day is, and sticking to your long term plan is the best way to ensure a prosperous future.

The Intelligent Investor: Saving Investors From Themselves (Wall Street Journal)
This article talks about how difficult it is to keep a level head when everyone else is losing theirs. Whatever the hot investment of the day, it’s very hard to stay away from it when everyone else is making money.

Five things I try to do on this Blog (The Irrelevant Investor)
The biggest danger an investor faces when investing in the stock market is not staying invested. Investors who try to time the market, sell at the bottoms, and buy near the tops. After repeating this pattern for a couple of cycles, they give up and label stocks “dangerous”. It’s when things look really bleak that keeping a steady head, and doing what at the time feels wrong, is most important.

Correlations aren’t Constant (The Reformed Broker)
This one is a bit on the technical side but the message is the same. Investors who patiently stay with their asset allocations over the long term, by buying “losers” and selling “winners”, tend to do very well. Everyone knows this but yet very few can actually do it. It’s extremely hard to sell that high flying fund that’s making you feel happy, and use that money to buy that dog that’s making you sick to your stomach every time you look at it.

The subprime mortgage crisis wasn’t about subprime mortgages (Fortune)
This article may seem out of place at first glance, but it very much belongs in this list. There was a time when the vast majority of people in the US truly believed that real estate could never go down, never-mind actually crash. This is the belief most Canadians have today. The arguments as to why this time is different are countless and eerily similar to the ones heard in the US. One argument heard a lot these days is how Canadian banks are far more responsible than US banks, and how the US crisis was caused by loans that are not even available in Canada, so no reason to worry. This article throws some cold water on that idea by describing exactly which mortgages caused the crisis. Real estate has a place in an investment strategy, just like any other asset class, but it needs to be kept within those limits. I know I won’t convince die hard wanna-be real estate magnates, but maybe I’ll give a pause to one or two people before they make some terrible mistakes.

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3 easy steps to a fully diversified retirement portfolio

I am always surprised how much confusion exists regarding various account types and investment options. The majority of people I talk to either do not have an investment account at all, or if they do, it contains some mutual funds that the guy or girl at their local branch recommended. I think what scares most people off is the financial industry’s love for acronyms and making simple things seems difficult.

I work in the financial industry and I can tell you it’s not coincidence that you’re finding it hard to understand. It is in the industry’s favor to make things seem difficult and confusing, so that you do not try to do anything yourself. This is what makes their revenue flow and profits grow, and it the end, it makes you that much poorer. While picking individual stocks and analyzing companies is in fact complicated, the approach I’m about to outline is not only easy, but is likely to work for you far better than paying for stock picking and analysis. (not convinced? See the most up-to-date analysis here)

In my previous posts I’ve already discussed why investing in the stock market over the long term is near risk free, but I’ve never really explained how to practically do it. Without further delay then, the 3 steps to a full diversified portfolio

Step #1 – Establish a self-directed investment account

There are plenty of brokers out there but the best option for simplicities sake is to go with whoever you already bank with. All the big 5 banks in Canada have what are called “discount brokerages” which offer self-directed accounts (RBC Direct, TD Waterhouse, BMO InvestorLine, CIBC Investor’s Edge and Scotia iTRADE) . The nice thing about going with your bank is that your account will be integrated with all your other internet banking and moving money between accounts will be very easy.

One thing to keep in mind is that an account is not an investment. Technically you do not invest into an RRSP or a TFSA but you contribute or deposit money into it. You then use that money to purchase investments. This is an important distinction because it underlines that you can choose the same investment regardless of which account you choose.

If you don’t already have a self-directed investing account you should set one up as soon as possible. There are 3 major account types for individual investors under the age of 65. I list them in the order of importance.

  1. RRSP (called an IRA in the US) – contributions to these accounts are deducted from your income for tax purposes. In other words the government gives you an interest free loan for somewhere between 30% and 50%  of what you contribute. Best of all this loan may never really have to be paid back, or at least not in full. It’s like getting an immediate return on investment between 30% to 50% and is the single most powerful way to build wealth for individual Canadians. In addition any investment returns you generate in this type of account are generated completely tax free.
  2. TFSA (called a Roth IRA in the US) – contributions are NOT tax deductible, however, you can withdraw the money tax free at any time. The investment returns in this type of account are mostly tax free. There are some exceptions but describing them goes beyond the scope of this article. These are best if you have either maxed out your RRSP contribution room or if know you will need the money before retirement.
  3. Regular/Margin – these are regular fully taxable investment accounts and should only be used if you have exhausted both your RRSP and TFSA room.

One note of caution on the RRSP. The amount you are allowed to contribute is cumulative, so if you have a Mutual Fund RRSP account or an RSP plan at work, you may have already used up some of your room. Talk to your HR department.

Step #2 – Figure out the allocation that is best for you

The 60/40 rule has been used for over 70 years as a default “balanced” stock/bond allocation. It means that 60% of your portfolio should be in stocks while 40% should be in bonds. Most financial advisers use this as a starting point but make various adjustments based on a number of factors. The most important adjustment is based on the age of the investor and how long they have until retirement.

The rule of thumb generally used is to take 100, 110 or 120 and minus your age to get at a stock allocation. This is an oversimplification because it fails to consider that one 30 year old is not necessarily in the same stage of life as another 30 year old. However it is generally a good starting point and will work well for the “average” investor.

The reason this simple rule works rather well is because, during the wealth accumulation phase of an individuals life, the exact allocation of their retirement savings is not all that important. This is because over a long enough period of time the stock market always ends up providing a solid return.  The purpose of the bond part of the portfolio is to reduce the volatility (ie. large swings up and/or down in the value) of the overall portfolio and help you stay on track. However, if you close your eyes, and wake up 25 years later, the best return is still achieved by going 100% stock.

The calculations are very different if you are either nearing or in retirement. In that case the primary purpose of an allocation is to provide you with a steady stream of income that can support your life style. Because life styles and incomes vary so much and because the consequences of not getting this calculation exactly right are far more serious I am going to stay away from suggesting allocations for anyone over 55. If you are near or in retirement I strongly advise you to hire a professional adviser to help you structure your portfolio.

Having said all that, assuming the following:

  • You are putting this money away for a minimum of 15 years and have no need for withdrawals
  • You are not already retired

Here are the approximate allocations based on a 120 – your age calculation:

Age 20-30 30-40 40-50 50-55
Stocks 100% 90% 80% 65%
Bonds 0% 10% 20% 35%

I chose 120 instead of 110 or 100 for the following two reasons

  1. Interest rates are near 0, therefore upside for bond investments is limited while downside is significant. A very minor move in interest rates can destroy decades of returns. Allocating a large percentage to bonds right now is the equivalent of picking up pennies in front of a steamroller.
  2. Volatility (up and down swings in value) of your portfolio is not an actual risk if you plan to keep your money invested for over 15 years. Why not get paid more to take this volatility on?

I am sure I will hear comments from various corners that the allocations I’m suggesting are too aggressive. The truth is there is no standard in the financial world and for every 10 people you ask you will get 20 answers. I think getting too hung up on whether someone should have 10%, 20% or 30% allocated to bonds makes people paralyzed with fear and prevents them from investing all together. Remember, in the grand scheme of things, the exact allocation matters far less than minimizing your fees and being in the market in the first place. Speaking of minimizing fees…

Step #3 – Use ultra-cheap ETFs to construct your balanced diversified portfolio

Exchange traded funds are similar to mutual funds except they are traded on stock exchanges. This gives them the following advantages:

  1. Since any financial institution can sell an ETF on the US or Canadian markets it means a much larger selection than your local bank offers in mutual funds.
  2. The huge number of investors and assets in ETFs means the management fees (MER) are kept ridiculously low. None of the funds I’m about to describe charge more than 0.2%. That’s not a typo, it’s less than one fifth of a percent.

The ETFs I suggest to build your quick fully diversified portfolio are all from Vanguard, a company that prides itself on having the lowest management fees in the world. The funds can be bought using your self-directed brokerage account, just like you would buy any other stock being traded on a US stock market exchange. The difference being that you’re not just buying a single stock but rather thousands of stocks and/or bonds that cover virtually the entire world of invest-able assets.

VT – Buying this ETF is equivalent to buying 7,137 different stocks/companies in 48 different countries across every sector of the world economy. This fund charges a 0.17% annual management fee. A similar mutual fund would charge around 2.3%. That’s a savings of $2,130 in fees over 10 years for every $10,000 invested.

BND – This ETF is the equivalent of investing in 6,512 different high grade bonds across the US bond market. 63.4% are classified as US government bonds and therefore can be considered default risk free. For this one you will pay a 0.07% annual management fee. A similar mutual fund would charge around 1.4%. That’s a savings of $1,330 in fees over 10 years for every $10,000 invested.

BNDX – This ETF is the equivalent of investing in 3,613 different high grade bonds across 98 different countries (outside of the US). This one charges a whopping 0.19% management fee. Once again a similar mutual fund would charge around 1.7%. That’s a savings of $1,510 in fees over 10 years for every $10,000 invested.

The following allocations would be excellent suggestions and cost you little to nothing in expenses.

Age 20-30 30-40 40-50 50-55
VT 100% 90% 80% 65%
BND 0% 5% 15% 25%
BNDX 0% 5% 5% 10%

Or if you hate percentages, the following per each $1,000 invested

Age 20-30 30-40 40-50 50-55
VT $1,000.00 $900.00 $800.00 $650.00
BND $0.00 $50.00 $150.00 $250.00
BNDX $0.00 $50.00 $50.00 $100.00

For example, if you have $10,000 to invest and you are between 30-40 you should buy the following amounts:

10 * $900 = $9,000 of VT
10 * $50 = $500 of BND
10 * $50 = $500 of BNDX

One note of caution is that all the above funds trade in US dollars. Therefore first convert your Canadian Dollars to US Dollars at whatever rate your bank is offering before calculating how many shares of each fund to buy (or you can use this handy little excel spreadsheet to calculate the # of shares to buy).

I bought the funds, now what?

Now you forget all about investing and NEVER check your account until you retire!

I’m actually only half joking as you’d be surprised how well this approach would work! The biggest risk to a long term investor is checking their portfolio too often.

Hyperbole aside, you should in fact re-align the allocation as you age and go into different age thresholds. Eventually you’ll move from your 30’s to your 40’s and as you do you should put more money into bonds. This is the only action I would strongly recommend for everyone.

If you want to do even better than this, you should check your portfolio no more than once a year, and re-balance it to the target allocations you chose when you first started. There are a couple of reasons why the portfolio will get misaligned over time without you changing anything:

  1. The prices of the funds fluctuate in different directions and by different amounts. This causes you to become over-allocated to the “winning” funds and under-allocated to the “losing” funds. Re-balancing forces you to buy a little of the “loser” fund while selling a bit of the “winner” fund to keep your allocation in-line.
  2. The funds pay you dividends which are cash payments that get accumulated in a cash balance in your account. This means your allocation to non-return bearing cash increases over time. This cash balance should be periodically invested using the same target allocations as the rest of the portfolio.

Once again if you choose not to re-balance regularly it does not mean you’ll do badly. You might do slightly worse than a regularly re-balanced portfolio, but still far better than letting your money sit in a savings account or pre-paying your mortgage. Therefore don’t let this stop you from putting your money to work.

In general there is really no need to check up on your investments or “watch the markets”. There are no tenants (real estate) here to check up on, no quarterly reports to read (individual stocks) to make sure management isn’t embezzling money, and no employees slacking off at work and alienating customers (small business). Since you are invested in literally the entire world economy you are protected against any particular part of it failing. If Tesla is a flop, then maybe GM and Honda will take over the market and make you rich, if Tesla ends up dominating the car industry that’s great for you too. If the car industry fails entirely and cars get replaced by Star Trek-like transporter machines, you will own the company that makes those transporter machines and benefit regardless.

The only risk you have is the entire the world economy imploding in on itself and everyone going berserk Mad Max style. Something tells me in that scenario your retirement portfolio would be the least of your worries!

Note: This article does not mean to imply hiring a financial adviser is a bad idea. There are plenty of wonderful girls and guys out there helping to keep people on track to reach their financial goals. The service a good adviser provides minimizes your costs, stops you from making emotional decisions, tweaks your allocation to better suit your risk profile and helps you with tax implications and planning. They are also very likely to use ETFs similar to the ones I’ve described in this article when constructing your portfolio. However, if your financial adviser thinks their primary job is to “pick the best stocks”, run as fast you can!


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Weekly Links – Senators, Astronauts, Millionaires and Travel

I have been a bit busy with my wife getting oh so very close to giving birth to our second son. However, I am working on a new original article and will be publishing it early next week. In the meantime please enjoy the following round up of great articles I’ve read recently.

It appears that being a United States Senator does not mean you have to be particularly good with your money. You can lecture people on their finances and get paid to give speeches on being fiscally responsible, while yourself binging on debt by buying multiple properties and luxury cars you cannot afford. Who knew? OK — not exactly an earth shattering surprise that a government official can’t manage finances, but the degree of fiscal irresponsibility is more than I would have expected.

However, let’s start with some positives examples of making good choices regardless of income and/or wealth.

Good lifestyle choices don’t change much whether you’re rich or poor

  • One family’s downsizing strategy to live within their means (Globe and Mail) – I like this story because it really illustrates how important the choice of where to live is to a families financial health. The biggest difference, between this family and the struggling family I mentioned in one of my previous articles, is that this family chose a place to live that matched their budget and their actual needs. No amount of saving on anything else can fix the monumental mistake of buying too much house.
  • Millionaires Who Are Frugal When They Don’t Have to Be (New York Times) – The habits that make you sustainably wealthy do not just disappear as soon as you hit some particular wealth level. There is no number at which a frugal person turns into a Marco Rubio (more on that below). It’s amazing how much self-made financially secure people have in common with each other.

On the other hand bad choices lead to financial ruin regardless of income

  • Marco Rubio’s Career Bedeviled by Financial Struggles (New York Times) – maybe Marco isn’t exactly financially ruined but he does remind me a bit of a ponzi scheme. The more money is given to him the more he needs to keep going. I believe his situation is actually very similar to many middle and upper middle class families, which is why I started this blog. Still, the level of ineptness here is epic, I just couldn’t help hearing the Benny Hill Show music in my head as I was reading this article.

So where does travel fit in?

  • How we quit our jobs to travel (BBC) – I am certainly not advocating this as a career strategy for everyone, however, it illustrates the importance of understanding your goals. Too often people focus on the progression of their careers and ticking off all the proverbial life-achievement boxes dictated by mainstream society. Others focus on achieving financial independence or a comfortable retirement without a good idea of what they’ll do when they get there. It’s critical to clearly understand why you are pursuing your goals, and what you plan to do once you achieve them, as early on as possible. You may realize you can actually “retire” to your dream activity right now.
  • Why I love the world (BBC) – The more I learn about Chris Hadfield the more I like him.  On the surface this may not appear to have anything to do with personal finance, but I believe there is a very important message here. It goes back to the myopia that drives us to pursue things simply because others around us think they’re valuable. Travel opens your eyes to ways of living that you would have never imagined or thought possible. It reminds you that a large number of concerns everyone in your community is so obsessed with, are actually very specific to the time and place you happen to be living in. They are just distractions that keep you off course. There are values that are universal (same across cultures and geographies), and there are values that are fleeting, and knowing the difference can be extremely positive for your finances.

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Providing for your kids does not have to be expensive

As my wife is getting closer and closer to her due date we are starting to get really excited about meeting our new little guy. We are packing all our hospital bags and making sure everyone knows “the plan” when the day finally arrives. We are also preparing ourselves mentally for the long months with lack of sleep. One thing we are not particularly worried about is the additional costs of having another baby.

In fact I can’t wait to take my two months of paternity leave when my son is born! I will be able to spend time with both of them during the summer months and help my wife with the first 2 months of having our 2 boys under 2.

How are we able to afford a second baby without any worries? It’s because we make boat loads of money of course!

OK, just kidding, I’m guessing you already know that I turn to the income side of the equation only as a last resort. In fact, my wife has only been working part-time since returning from maternity leave after our first son was born, and I took a sizeable pay cut in order to have a job within a shorter commuting distance.

Yet, we bought a new house last year and I took last July and August off to spend with my son. We’ve even managed to somehow increase our total savings over the course of last year. How is that possible?

Sometimes a picture is worth a thousand words so I’ve decided to show you guys what we’ve been able to give my son at little to no cost.

Vintage Glider Chair

Cost: $0
Comparable Retail Cost: $400 – $1,100 (or maybe infinity)

Vintage glider

Vintage glider

Gliders are EXPENSIVE!!! You can really spend a ridiculous amount of money on these.

This baby found its way into our hands through our awesome friends who saw a neighbour throw it out on the curb. It squeaked a bit initially but we WD40’ed it and cleaned the crap out of it, while my mother in-law sewed up those cushion covers. Since she’s retired she loves little projects like this. This glider would command a serious price at a “Vintage” furniture store in a hipster neighbourhood.

Chest

Cost: $0
Comparable Retail Cost: $200 – $1,700 (I’m just googling West Elm <insert item> to get the highest possible price)

Awesome free chest

Awesome free chest

This is where we keep our baby supplies. You can see there is a little work that needs to be done on the bottom drawer to make it look completely respectable, however, I think it has a very nice modern look. We inherited this from my brother in law as we bought our in-laws house and he eventually moved out. Thanks Andrew!

The best part is it has a friend…

Dresser with mirror

Cost: $0
Comparable Retail Cost: $500 – $2000

Free dresser with mirror!

Free dresser with mirror!

These drawers are where we keep the majority of my sons clothes. Again thank you uncle Andrew! This piece is actually in an even better shape than the chest. Score!

Crib

Cost: $100
Comparable Retail Cost: $80 – $1,100

Splurgy Crib

This is the most expensive thing I’m going to list in this post. It was bought for a crazy $100 on sale at IKEA. It wasn’t even the cheapest IKEA crib. Horrors! However, we are going to use it for at least 4 years, and we really wanted to spoil ourselves with a brand new crib. So there!

As I’ve mentioned a few times on this blog my philosophy is not to cut costs down to the bone. Sure we could have found a cheaper second hand crib, but we could have also spent $1,100 on some hard-wood Pottery Barn monstrosity. Because, you see, it’s worth the $1,100 because it’s going to last forever and even has storage! Never mind that your kids are not some baby vampires that will stay 2 years old for eternity. Or maybe they are and that’s why this crib even exists?

Toddler Tricycle

Cost: $5 (including delivery to my door!)
Comparable Retail Cost: $60 – $160

wpid-20150603_120838.jpg

One of my sons first words was car. It wasn’t dada or mama or please or thank you. It was CAR!

He absolutely loves anything on wheels that makes a  vroom sound or that he can mount. Leads to some pretty funny scenes when he tries to ride his one-foot long fire truck.

I was biking down to the local Shoppers Drug Mart when I saw this beauty sitting on the curb at a garage sale. I didn’t stop because even if I liked it I couldn’t strap it to my back and bike it home. However, on the way back I stopped and inquired about the price. I immediately liked the home owner, good guy, and after a little banter he answered “Whatever you think is good, we just want it gone”. I told him I can give him $5 but I’ll have to go home and drive over first. “We’re going to be packing up soon. Do you live nearby? My car is right there, would you like me to drop it off at your house?” he inquired. How could I say no? A $5 tricycle with delivery included!

Toddler Wagon

Cost: $0
Comparable Retail Cost: $70- $200

Toddler Wagon

Toddler Wagon

I take my son everywhere in this thing. I think it’s his second favourite form of transportation after my coupe. It makes getting to all 4 neighbourhood playgrounds a breeze without having to worry about him falling out, and it gives me some exercise in the process. Who needs a gym membership?

Yes, I actually walk to the playgrounds, I was shocked to discover this is not the normal thing to do around here. People I spoke with were apparently equally shocked that I actually walked the 5 minute walk rather than take out my car to get there.  One conversation went like this:

Them – “You took the wagon here?”
Me – “Yes, he loves riding in it!”
Them – “So you must live near the playground?”
Me – “Yes, not too far away, on street abc, where do you live?”
Them in an awkward tone – “I live on cba street” – which happens to be closer than my house
Me – “Ahh I see”

More awkwardness and eye contact avoidance happens later when they take their kids into their gigantic SUV to drive them home.

OK sorry about the rant. Where was I again? Oh right, the wagon came to us courtesy of my wonderful frugal parents who overheard a neighbour saying they wanted to throw it out.

Playroom full of toys

Cost: $0
Comparable Retail Cost: ????

Playroom full of toys

Playroom full of toys

Nothing you see in the screenshot above cost us any money. Some of these toys are old toys that my wife and my brother in-law used to play with as kids. Other toys are gifts from family and friends, and often things that their own kids have grown out of. There is one particular item that deserves extra special mention though.

Matthews Playhouse

Cost: $0
Comparable Retail Cost: $150 – $400

matthews clubhouse

This piece of art is truly magnificent! It is the brain child of my extremely talented sister and my ridiculously frugal dad. The whole thing is made of discarded cardboard boxes which means its light and therefore very safe. My boy loves to run in and out of it and I can’t count how many times he has smacked his head right on the top of the door way. Thank goodness its cardboard!

I’m lucky because my sister is an amazing artist which you can see through the attention to detail and level of personalization of this play house. It is not something everyone can do but it is something that we are taking full advantage off.

Thank you Ciocia Sylvia and Dziadek Janusz!

Note: If you have any art or graphic design work you need done don’t hesitate to contact sylviat.design@gmail.com for a quote!

What does this all add up to?

Let’s do some quick math here, this is after all a personal finance blog.

Our total cost for all 7 items: $100
Comparable retail cost – Low end: $1,460
Comparable retail cost – High end: $6,600

Overall savings: $1,360 to $6,500

My personal feeling is that most people fit somewhere in the middle of the above range. They buy some things high end, some low end and most mid-range. This means we saved approx. $2,500 over the average family on just these 7 items! 

If we invest this $2,500 into the stock market at the average 10% total return for 25 years we will have $27,000 more in our retirement account for virtually nothing!

Obviously these items are not all the costs associated with having a child. The post would be much too long if I tried to list everything we saved money on. It’s the right mental approach when making purchasing choices across the board that makes the big difference.

The thing is we are not even actively trying to be frugal. We are not going out of our way to clip coupons or scour garage sales or check every flyer for a sale. You could do much better than us if you did! All we do is take advantage of all the opportunities that fate provides us with instead of passing them up for silly superficial reasons.

You can say were lucky to have awesome friends to pick up the glider for us, to have a brother in-law who decided to leave his furniture behind, or to have such a talented sister. I agree completely! Yes, we’re lucky, but we try to take advantage of all the opportunities we are presented with. Have you grabbed a hold of and taken advantage of all the opportunities you’ve been presented with? 

Look around you and try not to get tunnel vision as to what is you need to get. When it comes to chance there are the things you can control and the things you can’t. You cannot control what opportunities will present themselves. What exact brand or type of item will become available to you free or at a ridiculous discount.  I could have easily decided that my brother-in-laws furniture wasn’t quite the right color or style and purchased an entire new baby room furniture set. What you can control is whether you take advantage of the opportunities that do present themselves to you.

Focusing on the part that you can control, rather than worrying about what you can’t, applies equally well to savings money on kids items as it does to everything else in life.


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