A Canadian's random thoughts on personal finance

Sep 13, 2010

There's no such thing as marriage insurance

Frank at Bad Money Advice has an article on marriage insurance. In this article, he goes to some lengths to determine whether marriage insurance is worthwhile. He does this by calculating the odds off a payoff and comparing with the amount of the payoff.

I think this analysis is misguided. I have a simpler one.

To begin with, you need to understand this: you never ever buy insurance on the hope that it will pay off. If you ever find yourself doing that, you've made a mistake, because then you're not buying insurance; you're making a wager, pure and simple. When you buy insurance, you should always be hoping it will never pay off. You should be hoping that your money will be wasted. When insurance pays off, it's because you rolled snake-eyes in the game of life and you could end up being ruined financially.

Insurance is meant to eliminate that risk of financial ruin. However, for this marriage insurance, the 1.63x payoff relative to the premiums makes this impossible. I can't think of anyone who can afford to pay $X for nothing, yet would be financially ruined by having to pay $1.63X during a divorce.

Therefore, this marriage "insurance" product is not insurance. It is gambling.

Jun 5, 2010

The penalty for saving

Thicken My Wallet has a post on how the tax system discourages saving. In it, he mentions progressive taxes, the estate tax, and the high taxation of interest income among the reasons for this.

With all due respect, this seems to be a somewhat naive treatment of tax policy.
  • The estate tax prevents a hereditary aristocracy from forming. In Canada, death triggers a "disposition" which leads to capital gains tax, having a similar effect.
  • Dividend tax cuts take into account that the dividend-paying company has already paid some tax.
  • The flat tax is promoted as a way to simplify taxes, but in reality it's just a tax break for the rich. In Canada, our system's complexity doesn't come from its progressive nature, but from the multitude of obscure rules and deductions.
To me, what really penalizes saving is inflation. For some very loosely justified reasons, the central banks of the US and Canada aim for a 2% inflation rate. Deflation is deeply feared as some sort of bogeyman with scant explanation using terrifying terms such as "deflationary spiral" that call to mind the end of the financial system as we know it.

The fact is, before about 1900, deflation was commonplace in North America. Currency kept its average value over long periods because inflation and deflation alternated.

Targeting 2% inflation is just a 2% asset tax. It is analogous to a property tax, which would be fine, except for two very large problems:
  1. Inflation doesn't just decrease assets by 2%; it also reduces debts by the same amount. Therefore, part of this "asset tax" is paid to debtors. The fairness and wisdom of this is debatable.
  2. The beneficiaries of inflation are those who create new money. In our system of banking and fractional reserve, the money goes not primarily to the government, but rather the banks.
If you want to encourage saving, how about a prolonged period of gradual deflation?

The problem, of course, is that there's no way for the government to achieve this. Our government lost control of the money supply in 1935 with the creation of the Bank Of Canada, at which point monetary policy could be relied upon to favour the banks. Banks love debt; inflation favours debt; hence we have nothing but inflation after 1935:

(Source: Bank of Canada web site.)

To really encourage saving over borrowing, the government would need to take back control of the money supply from the banks. Well, good luck with that.

Jun 2, 2010

Don't overestimate the value of your leisure time

Amber Bellaire has written a blog post that justifies spending money on maid services. This is a convenient post in that offers one-stop shopping for a variety of naive fallacies used in such arguments.

The logic goes like this:
Combined, their weekly before-tax income is about $2,000. At this rate, each partner is making about $24 an hour.

If both partners together spend six hours every other Saturday cleaning, that’s 12 hours out of their combined free time being spent on cleaning every two weeks. Multiply that by 24 (because each person is worth $24 an hour), and the couple is spending almost $300 worth of their free time hours cleaning biweekly. That’s $600 a month, or $7,200 per year.
The most striking flaw in this reasoning is that their time is not worth $24/hour. It must be worth less than that, of course, or else they would not be so eager to give an hour of time to their employers in exchange $24. Consider: if their employers were to cut their pay to $23.50, would they quit? If their time was worth $24/hour, they should!

This kind of reasoning is really nothing more than elitism practiced by people with well-paying jobs: if I make $24/hour, and you make $12, then my leisure time is worth twice as much to me as yours is to you. If that's the case, we should all be working around the clock to make sure Bill Gates gets all the leisure time he can.

A second important flaw occurs just a few paragraphs later:
For four hours of cleaning at $22 an hour, you’d be spending $88 to have your house cleaned by the company – saving you $212 worth of your own hours spent on cleaning (300 – 88 = 212) biweekly. That’s a savings of $424 per month, or $5,088 per year.
Here is the common fallacy that spending money is a form of "saving". Saving money means not spending it. It doesn't mean you've spent less than you could have. It doesn't mean earning yourself something that's "worth" money. Saving money is the opposite of spending money. The only way for the couple in this scenario to save money is to use cheaper cleaning supplies.

The proper way to evaluate a maid service is, of course, to compare the alternatives available, just as in any other purchase decision. Using Ms Bellaire's figure of $88 biweekly, the couple in her example would be spending $2288/year on housecleaning services. Here are a few ways to reason about that amount:
  • Using Ms Bellaire's figure of $24/hour, they would need to work an extra 8 hours overtime per month (or 5.3 hours at time-and-a-half) to pay for the maid service. If they're willing to do that, it may be worthwhile.
  • Using opportunity cost, consider that $2288 buys a pretty nice little vacation every year for two people. If you're willing to give that up, the maid service may be worthwhile.
  • Using investment opportunity cost, consider that $2288 spent on a maid this year could have been invested in stocks, where its real value could be expected to double each decade. If you have three decades until retirement, you've just spent over $18k of retirement money on the maid this year. To put this in perspective, note that amount would be greater than the couple's final RRSP contribution.
  • Using the 4% rule, that amount is equivalent by the income produced by an investment of $57,200. If you could imagine saving up that amount, and then cheerfully handing it over to someone for a lifetime of maid service, then it's worthwhile. (The trouble with this argument is that I don't think it will be very convincing to anyone who doesn't happen to have $57k sitting around, because it's too easy to spend imaginary money.)
If you can look at all four of these lines of reasoning and still feel comfortable spending that money on a maid, then go for it.

Apr 28, 2010

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.

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.

Jan 31, 2010

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.

Jan 20, 2010

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?


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.


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.


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!