February 2009

Recently the Canada Mortgage Trends blog had a post discussing the current economic environment with the author of one of the most influential studies on fixed and variable rate mortgages, Dr. Moshe Milevsky. He brings up some interesting points such as how you can calculate the breakeven interest rate for deciding between different types of mortgages (where’s the online calculator for this?). It seems that variable rates may no longer have the same advantage that they did in recent history, something I’ve started to suspect.

One of the things that jumps out at me is the discussion of short terms – even going as far as calling a 5-year term “long”. With the number of people who can’t renew their mortgages at the end of the term now, and the probability that interest rates can’t stay this low forever, I would hardly think of 5 years as a long term.

I recently read The Subprime Solution by Robert Shiller, which discusses some of the things done after the great depression. One of the surprising facts is that at the time many people had short terms for their mortgages, with less regard for matching the term to the amortization (apparently many people weren’t that concerned about when it would be paid off). With the increasing length of amortizations now this is sounding very familiar.

During the depression the US government created a new institution that gave lenders incentives to use longer terms and match them to the amortization instead of renewing and refinancing constantly. Many people seem to think this is the new way to finance houses, but if it’s caused problems before it may not be that great. I’ve been thinking that way myself – I don’t have much of a preference for a term greater than 7-10 years and will strongly consider a 5-year term if the rate is lower, but I have to wonder if I would be protecting myself from future risks well enough.

A short term could have advantages if it means you can negotiate a better rate due to a change in your situation later on, or you can take advantage of it to reduce the principal before renewing. However it’s always dangerous to take a short-term loan for a long-term liability, a lesson which has apparently been learned and forgotten in the past.

As always the only real solution is to consider your needs and think for yourself.


With all the personal finance blogs available now it’s not hard to learn that an easy way to secure your finances for the rest of your life is to earn more than you spend and invest regularly in stock and bond index funds. By investing 5-10% of your income throughout your career you’ll have a good chance of being able to afford a comfortable retirement after 30-40 years. The results of this approach are a very reaonsable definition of being rich. Although many people spend a lot of time and effort trying to do better than this – for example by finding investments with higher returns – it’s difficult and often backfires.

Still, some people criticize this plan because they think it’s too slow. Although they may be impatient they can’t do much about it because you can’t simply modify the formula to get 50% annual returns and carry on as usual (unless you’re willing to bet everything on very unlikely events). In truth, this approach is one half of the only two reliable ways to get rich.

If you follow this plan it’s simple to predict what will happen. With real stock market returns of 6-7% (maybe a bit lower if you want to have a high bond allocation) and monthly investments over a long period you can calculate how much money you’re likely to end up with after some time. You can then use a safe withdrawal rate to figure out how much income you can generate from your portfolio.

Most people don’t have much control over the factors that influence the results – the rate of return, the amount invested, and the time period. If you don’t want to wait a long time, the only option is to change one of the other two factors. For reasons that are discussed endlessly in many places the rate of return won’t vary much just because you want more, which leaves the amount invested and the best way of getting rich quickly.

The plan looks very different if you invest a much larger portion of your income. You can see this in two ways – either as trying to invest 40-60% of your gross income, or planning to draw a much lower income from your portfolio than you receive at the time you’re investing (in truth both need to be done). The simple fact is that readily available investment returns only allow two possibilities. You can invest a small portion of your income and wait a long time until your porfolio can match it, or you can invest a large portion of your income and expect your portfolio to provide even less than the remaining amount (but you may not have to wait very long).

Investing the second way doesn’t work for most people because they spend a large portion of what they earn, which means they can’t invest much of it or live on a significantly lower income. To do it without living a very minimal lifestyle you also have to work aggressively to increase your income. If you can keep your expenses low while rapidly increasing your income and giving yourself more investment capital you may have a shot at living off your portfolio much sooner than most people can.

Although it’s difficult to do, this is one of the few ways to get rich that doesn’t contradict simple math as well as economics and the entire history of investment. The time you have to invest before you can live off your portfolio is determined by the amount you put in, the rate of return, and the amount you want to get out of it. To get big results you need to make big changes to one of more of those factors.

It’s a common principle of investment that returns have to come at a cost – whether it’s having your money locked in for a period of time or risking a loss. Due to many economic forces any investments that have a good chance of producing higher returns without more risk, work, or inconvenience typically don’t last long enough for the average person or even someone who manages billions to get access to them.

It’s even difficult to pay someone else to do this, given the poor performance of money managers at all levels. Diversification is often brought up as the only way you can get higher returns without more risk. Like it or not, this means that most investors who don’t want to dedicate a large part of their life to managing their investments can’t expect to do better than the market average for their chosen asset classes.

However, a possible exception to this recently came to mind. I receive emails periodically from an investment management company that serves institutional investors. Just for fun I signed up for their regular long-term asset class forecasts, which never fail to indicate how much they expect to outperform the index in each class through active management. I can’t take the index forecasts or the active management expectations too seriously, but after receiving the lastest one I started thinking about it.

It’s virtually impossible to find a money manager guaranteed to beat an index by a significant amount consistently. It seems that no salary can buy better talent – someone always has to lose if there is to be a winner, and it changes every year. So what’s the back door? Career risk – which is discussed frequently in the emails I get.

Blindly following the market wherever it goes and taking extra risks along the way is the surest strategy to lose money, so to get above-average returns consistently you need to do things that virtually everyone disagrees with at times. For an individual investor this can be frightening and it’s difficult to hold your position when you constantly act against conventional wisdom.

For an institutional investor it’s far worse however. If you follow the market (find a hot asset, borrow everything you can, and buy in!) and get bad results you can at least say that you couldn’t forsee problems. If you go against conventional wisdom and don’t do well you’ll never get a second chance. This is the core of career risk. Whether it’s for job security or emotional security the majority of people would prefer to do poorly than to act on their own investment decisions and have better chances.

The great thing is that if there are money managers or mutual funds that consistently act against the current market “wisdom”, career risk will keep many investors away from them and leave the opportunity open to those who can see it. They are in fact risking their own careers by doing this. If they don’t perform they have no excuses.

Of course if they demonstrate exceptional returns over a long period of time people will eventually start to listen to them. Past performance seems to drive a lot more investment decisions than reasonable expectations of future performance. But until that happens, career risk may be the only way besides luck to have your money managed by the best before they’re “discovered”. That is if you can stand everyone you know thinking you’ll wind up broke for a decade or two.

Even mutual funds that attract large numbers of performance chasers can follow a cycle after they’re discovered – new money floods in, returns diminish or the strategy produces a couple of bad years, and the fund returns to its original size. Simply holding such a fund for a long period would give you much better results than the average fund flipper.

I still plan to be 100% indexed for the forseeable future, but this seems like one of the ways I may eventually be able to find a truly competent manager to increase my returns.

When an investment article or blog posts starts by attacking the “widely accepted buy-and-hold strategy” it’s usually a good sign that you’re in for some flawed arguments. It’s true that some mutual fund salespeople may try to convince people to buy and hold (with the funds that pay them a commission of course), but in general it’s a good plan.

I’ve noticed several such articles that bring up a good objection though; a lot of people talking about buy-and-hold only focus on the buying side. With all the stories now about people just about to retire who were still depending on short-term stock market returns it might be a good opportunity to reminder investors that they should only hold the investments as long as they match the specific plan and timeframe.

There is occasional commentary on various rules for increasing bond allocation. I’ve always found ideas like allocating your portfolio based on your age to be a bit abitrary and too generalized, but at least it’s a start. A problem with executing strategies like that is that they may assume fairly smooth investment returns. If they’re executed over a short period of time the outcomes will vary a lot depending on when the transition is made. As history shows stock markets can have trends that last a decade or two – a good part of most peoples’ investment timeframe.

If you’re planning to invest in stocks now and fixed income later this would be a good time to think about how you’ll reduce your exposure before it’s too late. Stay tuned for my more unconventional solution 🙂

While the news has recently given us lots of evidence that even large and liquid markets aren’t fully efficient (and that’s before the liquidity disappears), I learned something very interesting about the efficient market theory while reading The Snowball. It appears that several proponents of the theory more or less tried to publicly disprove Warren Buffet’s investment results after the fact. It’s hard to believe a theory that doesn’t allow for the existence of Buffet.

Since then I’ve read Irrational Exuberance by Robert Shiller, which also has several warning about how efficient capital markets really are. It appears that only a perfect market where everyone knows everything would really be efficient. Even expecting good efficiency most of the time may be a bit too much for current markets.

While this may not mean a lot to the average mutual fund investor it’s clear that anyone who wants to develop their own investment plan can’t build it on the idea that investments are always bought and sold at the “right” price.  For those drawn to stock picking this is good news, since it means they can in theory expect the market to misprice assets (perhaps more commonly that most people believe).

I’m not a stock picker – for something involving that much work I’d rather be involved in the business itself – but this does give more importance to my earlier post about changing asset allocations in light of long-term trends.

In some very weak forms you can consider the market to be efficient. If you don’t want to spend a lot of time managing your investments then regularly buying index funds will give you something close to an efficient market, although it’s still not perfect. But if you really want to get into the details it seems like there’s no way you can assume the efficient market hypothesis is always right.