Saturday 31 May 2008

Benefits of a Diversified Portfolio in Retirement

Whew! I was pretty sure that holding a portfolio of uncorrelated assets would be just as worthwhile in retirement when withdrawals are being made as it is in the build-up phase before retirement but now I've found someone has crunched the numbers to demonstrate the fact. And the results are impressive.

Retirees are much more concerned to avoid downside risk, the risk of loss that cannot be recovered when poor returns occur, especially several years in a row of negative returns, such as happened in stock markets from 2001 to 2003. The opportunity to make up for losses by working harder or longer is not available to retirees. Capital preservation comes before everything. That fear is the reason many retirees stick to safe bonds, GICs, money-market funds. Unfortunately, such investments have low rates of return too.

In The Benefits of Low Correlation, Craig Isralesen shows that a balanced diversified portfolio is an attractive alternative. He calculates the results from the point of view of a US retiree withdrawing 5% a year (and adjusted upwards by 3% a year for inflation) from a hypothetical portfolio consisting of equal weights in seven different asset classes: large cap US equity, small cap US equity, non-US equity, intermediate term US bonds, cash (T-bills), REIT and commodities. He uses actual return data from 1970 to 2006. He works out the portfolio return and volatility but also shows - and this is the key part for a retiree - how much and how often the portfolio would go down, considering that the withdrawals were also taking place. What is particularly interesting and instructive (after all, he is a university prof) is that he starts with a portfolio of only two assets (the US equities) does all the calculations and then adds another one till the full seven are included. The progressive benefit of downside risk reduction, portfolio stability and return enhancement (or reduction, when a lower return asset like cash is added) comes out very clearly.

It is not the actual numbers he calculates that are important - a real portfolio would have transaction costs and tracking error and the future will not be exactly like the past. Plus a 4% withdrawal rate would reduce even further the risk of a reduction in the portfolio's value in any year, enhancing its sustainability. It is the effect and the magnitude of the effect of diversification through uncorrelated assets that is worth noting.

Here is part of Israelsen's conclusion:
"There are several quantifiable benefits of lowering the correlation of a retirement-withdrawal-mode portfolio's component assets. First, there is a dramatic reduction in the volatility of the portfolio's performance (i.e., lower standard deviation of return). Second, there is a significant reduction in the worst-case portfolio loss, or maximum drawdown. Third, the likelihood (or frequency) of loss is minimized. Fourth, performance does not suffer if sufficient diversification is achieved."

As a mini example of the benefits touted by this study, in my own portfolio, shown at the bottom of the blog, the huge rise in commodities and emerging markets has partially offset the fall in US and European equities, providing stability in the past year.

The lesson I draw is that a diversified portfolio is a viable alternative for a retiree, close to the safety of cash but with much higher returns. Happily, passive index mutual funds or ETFs provide a practical way of implementing such a portfolio. Finding new uncorrelated assets to put into the portfolio, such as inflation-indexed bonds (RRBs in Canada TIPS in the US), which Israelsen did not consider, will have similar benefits of further risk reduction or return enhancement, or both.

Wednesday 28 May 2008

Everybody's Talking Globalization and Oil Prices but Inflation is the Real Worry

Judging by the number of media that have reported the story, and the comments on the CBC website, a report by Jeff Rubin and Benjamin Tal, Will Soaring Transport Costs Reverse Globalization?, has revealed the hatred of globalization many people seem to harbour.

What they should really be worried about is the rising specter of inflation, which will do everyone a lot more harm. The same CIBC World Markets report contains a prediction that 2009 will see much higher inflation. Already, a BBC report says world economies are being hit by higher oil prices. Who cares where the steel in your toaster comes from if it costs 15% more along with everything else you buy and your job gets downsized in a slowdown? CIBC notes that Canadian inflation has only been kept at bay so far by the rise in our dollar.

Perhaps oil costs will cause a slowdown or even a partial reversal in the growth of world trade (aka globalization) but it won't be more than temporary. The transport industry will adjust - e.g. in the short term by slower steaming (see this study of optimal ship speeds and oil consumption) and in the long term by building ever larger containerships (not faster ones as this website shows) that lower unit costs or by adopting nuclear power (see this serious assessment by a US government body) as Sir George Thomson predicted more than 50 years ago in his remarkable book (so many of his predictions, based on physical laws - he was a nuclear prize winning physicist - are spot on) The Foreseeable Future "I think that we may expect shipping to go nuclear about the time that the natural oil gives out."

Tuesday 27 May 2008

Faster Electronic Payments in the UK ... Possibly

An article on the BBC website Faster Bank Transfers Underway lets us know of the start-up today of a worthwhile service that allows people to make same-day transfers from their own bank account to someone else's bank account. The existing electronic payment service (called BACS) saw the money disappear from the sending account and then show up three days later at the recipient's account.

The drawback is that not all the banks are starting up at the same time (see this previous BBC article How Fast is Faster Payment Plan?) and some are phasing in the amount that can be transferred, starting with small amounts now and upping it later to the eventual maximum of £10,000. This is apparently to avoid the "Terminal 5 Effect" (thank you British Airways for enriching our language with a delightful new phrase that denotes big bang cutover disasters). Instead of Terminal 5, we have the equivalent of a gradual shift from driving on the left to driving on the right - motorcycles the first week, trucks and buses the following week, cars the third week and so on. It will likely be mid-2009 before we can count on the new service.

The launch is so low-key that Lloyds TSB, one of the first banks supposedly offering the service today, makes no mention of it on its website, or even in the payments function inside an account.

Nice try APACS (the UK payments association), which has a checker to verify if your sort code is able to receive one-day payments. We' ll rate this 5 out of 10 for now. Why could the existing same-day transfer service called CHAPS not have been made free and expanded to everyone? Does it have to do with another hoary but true axiom of the IT world that describes the difficulty of modifying an operating application, "God could not have created the world in seven days if He had had an installed base"?

Sunday 25 May 2008

Two HighQuality Web / Blog Sites

Here are two sites worth bookmarking:
  1. CXO Advisory Group - run by Steve LeCompte, former US Navy man with a physics degree, this site reviews research studies and draws out the investing implications. Good for a chuckle is his Guru Grades, where he tracks the accuracy of forecasts by various stock gurus, showing that some do ok and some are worse than the proverbial dartboard.
  2. - a very thorough primer for the UK investor, covers just about everything you could want to know; no eye candy illustrations (and almost no ads either), just well-organized with lots of intra-linking and well-written text for the person willing to read; use it as a reference or read it from end to end.

Saturday 24 May 2008

Lessons of a Failed Endowment

An acquaintance here in the UK recently received the annual statement for a Life with Profits Endowment policy. An endowment is a kind of investment whose purpose is to provide a target lump sum a specified number of years in future, when it matures. Most often, as in this case, it is meant to pay off an interest-only mortgage when the mortgage ends. The word "Life" means that there is also a life insurance policy that pays off the lump sum if the person dies before the policy matures. The "with Profits" bit refers to the method of crediting the profits generated by the underlying investments in stocks and bonds (the details of which are hidden and unknown to the investor). The profits are dribbled out in the form of so-called bonuses to smooth out returns from year to year. The proceeds are normally free of further tax in the hands of the investor since the life insurance company has already paid taxes. Endowments were often touted as "tax-free" investments when all that really meant is that they were tax-prepaid. For a longer explanation, read this page at

In this case, the endowment was to generate £24,000 over the twenty years, starting in 1992 and maturing in 2012. My acquaintance would pay £49 a month during the twenty years. That's about a 6.5% rate of return. It would actually be a little more since the insurance component costs something and not all goes into the investment component, but the insurance cost is minor - less than 10% of the premium.

"RED ALERT: HIGH RISK OF SHORTFALL" read the top of the statement in big bold (though not red) letters. You're not kidding! The plan as of May 2008 was worth £13,162. That's about 4% return per year. The statement also provides low/medium/high projections of possible value at maturity in 2012 were £16,400, £17,500 and £18,600 using 4%, 6%, 8% growth rates. Hmm, wonder which one to count on? High risk of shortfall? Is this the British fondness of under-statement?

To put this abysmal rate of return since 1992 in perspective, consider that the FTSE 100 index has risen about 5.3% a year since 1992 (see EconStats for the numbers). That's not even counting the 3% or so per year in dividends distributed by those companies, which would give an annual return of 8.3%. In that context, the 6.5% per year that would have been required to produce £24,000 seems quite achievable, even if lower yielding bonds were added to the mix.

I suspect that fees and expenses ate away the returns as much or more as Standard Life's investment incompetence. Whatever the cause, the result is awful, especially since the person is still locked in and cannot cash out, or even suspend payments, without paying severe penalties that would be worse than simply sticking with it for another four years. Caveat emptor indeed!

The lessons I draw from this:
  • don't invest in something merely for tax savings or a tax-free payoff
  • fees and expenses are a critical investment evaluation factor, the lower the better
  • passive index-type investments will more often do better for the average person than any type of active fund management, even when the approach of the fund company is conservative - the fund performance is just under a lower bar
  • a complicated product like an endowment should be subject to much skeptical scrutiny - e.g. why is an endowment better than simply buying term life insurance separately and getting a repayment mortgage? If you cannot understand what you are buying, there is a significant chance you will be taken advantage of - see ThisIsMoney article amongst many, on how mis-selling of endowments caused enormous criticism and compensation for some has come about.

Wednesday 21 May 2008

US Tax Gotchas for Canadian Snowbirds

Came across this write-up by frequent Financial Webring and forum contributor Keith Cowan on some little-known dangers for Canadian snowbirds who spend anything more than 122 days a year on a regular basis in the USA. It is about unintentionally getting caught up in the US income tax net. Yikes!

Monday 19 May 2008

Ins and Outs of Mortgage Investment Corporations

A reader brings up an interesting question:
"I'm interested in investing in real estate, but the market is pretty volatile right now and I don't want to put a large lump some of money into real estate at this point but still would like to 'play' the market. What do you think about mortgage investment corporations like ACIC? I found their website ( Could you do a review of ACIC or products like this?"

I must admit to not knowing about MICs before now, so I am approaching this cautiously and don't pretend to have a final answer or a blanket answer that applies to every MIC. A due diligence process is very much in order.

What is a Mortgage Investment Corporation? (good place to start, huh?)
A MIC is a corporate structure recognized in Canada's Income Tax Act (thus the use of MIC as a proper noun) that enables small investors to pool funds and invest in (i.e. act as a lender of) mortgages. The Act allows the MIC itself to be exempt from income tax as long as it passes along all its income to the investors, in whose hands it is, of course, taxed.

A picture is worth a thousand words (perhaps more, the way I write). Here is a good summary of the flow of various funds into and out of a MIC from one of these outfits Magenta Mortgage Corporation.

Just below the diagram on the Magenta explanatory webpage is a succinct summary of the Income Tax rules about what a MIC can and cannot do. Or you can try deciphering the ITA section 130.1 yourself. Here is Magenta's summary:

(btw, to me the availability on a company's website of clear and complete information is a good sign, though by no means a final answer)

MICs go back to the 1970s, that alone being a favourable point. If their format/structure itself were bad, they should have disappeared, right?

MICs are thus a legitimate investment vehicle, though naturally that doesn't mean every MIC will be successful and a good place to invest money.

The Prospectus and Audited Financial Statements
MICs are securities and as such, are bound by the securities regulator in its home province to send a prospectus to all potential investors. The Prospectus details everything about the MIC and is essential reading. Most of the MIC websites are coy and require you to give them your name and contact info before giving you a copy (no doubt so they can do some selling). One exception is Westboro, whose very readable Prospectus is on this Documents page.

The audited financial statements tell you how the company is succeeding, how much profit it is making, how big and diversified is its lending, how much leverage it is using, percent of loans in arrears and so on. It's necessary and highly useful reading to understand a potential investment.

Each to Its Niche
Within the tax rules, MICs vary quite a lot in the types of loans and borrowers they focus on. Among the possibilities: first mortgages, second mortgages, multi-unit residential buildings, construction loans, individuals or companies, commercial properties (up to the limit), people the banks won't lend to like poor credits, bankrupts, self-employed, undeclared income

Rates of Return
This is the big carrot, naturally. The historical rates claimed went from a minimum of 8% a year up to c. 12%! That's impressive! This is cold, hard cash either paid out, either monthly, quarterly or semi-annually, as a cheque / deposit into your bank account or reinvested. That's pretty darn good considering that these cash distributions have been steady for years. For instance, check out Cove MIC's table of its returns , which averaged 10.53% since 1999.

What are the Risks?
Check out the sensible questions that the OSC suggests you ask in this information page on the Westboro site.

- less likely since a MIC must produce audited financial statements every year. Check out the financial statements and see if the MIC is subject to any lawsuits.

Losing MIC Status
- failing to keep within the Income Tax Act rules would cause the MIC to have its income taxed before being distributed to shareholders and would lower returns considerably

Manager (In)competence
- the success of the MIC depends to a critical degree on the experience, expertise, judgement and good faith of the managers. Do they know the business, do they know their market and do they have a record of success? Can and will they find a steady flow of new mortgages to keep the income flowing in? Think of it as a job interview.

Leveraging - the rules allow the MIC to borrow money but some do more than others. The spread between the lower rate of the MIC's borrowing and the lending will boost the ability to generate shareholder returns but it also increases risk. The audited financial statements will show how much the MIC has borrowed. The prospectus will say if the MIC has a policy to cap what it will borrow. Many of the MICs are fairly short term lenders - 24 months or so - which reduces interest rate risk and should allow the MIC to continually readjust its lending rate to match increases or decreases in general interest rates and keep the spread between its lending and its bank borrowing rates constant.

Default on Mortgages
- mortgage borrowers may not pay back what they owe; all the MICs claim to be very careful about who they lend to but some are explicitly in a niche where the banks don't tread or in second mortgages. The MIC gets a higher interest rate but that is associated with the higher risk. At least one MIC - Cooper Pacific - has two funds, one that lends out first mortgages with an 8% return and another with second mortgages with a 12% return. "You takes your picks and you takes your chances."

Market Downturn / Geographical concentration
- some MICs, the smaller ones, are concentrated in very limited markets, like Westboro in Ottawa or Edgeworth in northern Alberta. Ottawa is a stable market but what happens to Edgeworth if the oil industry cools off considerably, as it has done in the past? A general economic recession would everywhere increase the number of borrowers having difficulty to repay.

Liquidity (Can't sell)
- the basic method to get your money back is not a sale in some market since MICs are not (with one exception, I found) publicly quoted companies but for the MIC to redeem the shares; the restrictions vary by MIC, whether funds can be sold / withdrawn immediately, or with 30/60/90 days notice; for smaller MICs, the Income Tax Act restriction that each MIC must have at least 20 shareholders might come into play;

A Partial List of MICs - there seem to be a lot of these around

Taxes and Which Account to Hold the MIC Investment
A registered account such as an RRSP or a RRIF is the natural place for a MIC investment since it will generate all its income only as interest (and not as dividends, despite some use of the word dividends to describe the cash distributed; and don't be fooled when they are called preferred shares - the dividends are interest for tax purposes), which is taxed at the highest rate. I don't know for sure but I would hope and expect that a MIC could also reside within a LIRA or an LRIF but that would need checking out.

Some MICs want or allow you to hold the MIC investment withing your own self-directed RRSP. Others want you to set up an RRSP with a connected financial services provider.

Minimum Investment Amount
This may be the key practical point that blocks the average investor from getting into a MIC. The lowest minimum investment I found was $5,000 at ACIC and that only for a non-registered account. There is the publicly traded Quest Capital whose shares sell for about $2.05-$2.10, so you can get in for less ... but is it a good MIC?

The MIC's Place in a Portfolio
A MIC is fixed income. But unlike a bond, the value of your principal stays the same. If you invest $10,000, that's what you get back when you redeem shares and cash out. Bond value will fluctuate with interest rates, which affects their return. The MICs return is only the interest. As for other asset classes, like real estate investment trusts (REITs), various types of equities, real return bonds (RRBs) and short term cash (i.e. things like T-bills and GICs), the MIC is most like latter - little or no variation in principal value or in returns. There is more risk however, due to the nature of the mortgage investment.

I would suspect there is little correlation of returns with any other asset class, which means that MICs offer the happy prospect of adding true diversification to a portfolio by either reducing overall variability or increasing returns, or a bit of both.

Being ever the compromiser, I would therefore tend to replace some of my cash-type holdings and some of my corporate bonds, perhaps up to 10% of my overall portfolio.

For others like retired folks who want a steady, high income stream and don't mind the tax rate, MICs may be a good vehicle.

As far as ACIC goes, I cannot offer an opinion since I didn't feel like giving them my name and details just to have a look at their prospectus and financial statements and get into their guts a bit more.

MICs are definitely worth consideration and will get a close look when I do my portfolio review shortly.

Thanks for the great question.

The Hot Vancouver Condo Market

Fancy investing in a condo where prices have gone up steeply in the last four years (a hefty 13% in 2007 alone)? Got the cool $1.1M price tag? Then Vancouver is the place for you. Such are some of the fascinating tidbits in the well-illustrated and well-packaged presentation Vancouver Condo Update given in mid April by CMHC analyst Robyn Adamache to the Mortgage Investment Association of BC.

Interestingly, Adamache forecasts a moderation of price increases to only 8% in 2008 and 5% in 2009 as speculative activity is decreasing and construction activity is at a very high level. No mention is made of the 2010 Olympics. That surely cannot dampen demand in the next few years but then what happens, especially as the stock increases with construction? Another boom to end and a flat or bust period to start again?

Thursday 15 May 2008

An Investing Lesson from Greek Mythology

There is one ancient Greeks myth that we investors would do well to heed even today thousands of years later. Like Odysseus, we must resist the seductive songs of the investment Sirens luring us to financial destruction.

A case in point is mutual funds. Many times has the disappointing truth been told that most mutual funds' investment returns are worse than their reference index. Worse, far worse in fact, than this are the investment returns of the actual investors in mutual funds. Vanguard fund founder John Bogle recently wrote in his Bogle's Corner May/June issue (thanks to the Bylo where I found this link) of evidence of shocking under-performance of investors in a group of 200 US mutual funds.
"... the 200 funds with the largest cash inflows during the five-year period 1996–2000—essentially the duration of the late, great bull market—reported an average return of 8.9 percent for the 10 years from 1996 to 2005. But the dollar-weighted return of those 200 funds— the return actually earned by their shareholders—was just 2.4 percent, only 25 percent of the annual returns reported by the funds themselves."
After inflation and taxes, that wouldn't be much!

To continue the analogy, the Siren song was the advertising of the mutual fund companies touting their recent past investment performance. Sadly, the cash inflows are evidence that the investing public listened. (Others call this chasing returns but I like the Greek analogy.)

The way to resist is to do as Odysseus instructed his sailors - build a plan, stick some wax in the ear and don't deviate when the temptation is strongest.

Wednesday 14 May 2008

"Bouncers" Author Interview

Back in December I posted a review of the fine book Learn to Bounce by Anita Caputo and Lee Wallace. The book gives valuable advice on how to overcome a job loss and again find fulfilling work.

Anita agreed to answer a few questions I had after reading the book. Here are the answers. There are some especially valuable comments about how to deal with finances before and during an unexpected job loss.

1) Why did you and Lee write this book? What was lacking out there that you felt it worthwhile to put all that effort into a book?

We wrote the book to provide hope and inspiration to people who are in job search mode. We decided to write the book when tens of thousands of people had been laid off when the bottom dropped out of the global high-tech industry. The unemployed had no productive outlet in a market that offered few, if any, jobs that suited their skills and experience. We wanted to restore people’s confidence and encourage them at a time when there was little good economic news. We wanted to highlight that some individuals did find work – not just any job, but work that fit them well. We wanted people to know that “If they can do it, you can do it!” even during the worst of economic times.

FYI, as the USA moves into recession and thousands of jobs are being lost, particularly in the financial sector due to the credit crunch, the stories and solid advice apply equally to anyone experiencing unemployment.

2) What surprised you the most, or differed the most from your preconceptions about the realities of being laid off?

First of all, I never imagined that it could happen to me. Isn’t that typical? And I still believe that if we had not had such a huge economic downturn, I would still be working in high-tech wondering what I would really want to do.

When I saw others being laid off, I always thought how lucky they were to be collecting a severance package and having time off, particularly if they were laid off during prime vacation times. Here is what I learned.
a) Being laid off is not a vacation. Finding another job is a full time job!
b) Severance/redundancy payments are not winning the lottery. If you are out of work for an extended period of time, and/or if you have large financial obligations, you will need every penny of what you were paid and maybe even more.
c) I find myself being more empathetic and I will “go out of my way” to help someone who is laid off. There is nothing like “walking a mile in another man’s shoes” to know what it is really like. Providing someone who is looking for work with connections to other people who can help them, or to potential jobs is very important to me.
d) I will treat someone who is laid off from a job the same way I would treat someone who has resigned from a job. When someone is laid off, I recommend you have a celebration, take them out for lunch or follow whatever ritual you would normally follow. Often when someone loses their job, they feel like they have done something wrong (even if/when they haven’t). Treating them equally helps to reduce the stigma a laid off person feels. It helps to bring proper closure to what was an important part of their life. There are two things people did for me are very memorable. One, a colleague that I worked very closely with sent me flowers saying “This is the first day of the rest of your life”. Secondly, when I went out for lunch with someone who was employed, I was very grateful when they volunteered to picked up the tab.

3)What was the greatest challenge in writing the book?

Getting it done! As we have often said, Lee Wallace and I had real jobs. We did not get paid to write. We had to make the money to pay for the book.

Staying motivated was also a challenge. Working as co-authors had many benefits. One significant benefit was “picking up the slack” or helping to motivate the other person as/when required.

4) What are the main financial bits of wisdom coming out of the experiences of the layoff-ees?

Save while times are good. Definitely save and cut back on expenses, particularly “if the writing is on the wall” and you think you may be laid off.
Pay off any debt that is not tax deductible, i.e. invest in something that makes you money. If you are debt free, you will have the financial flexibility to pursue the work and life style you want without feeling pressured. If required, have the courage to ask for financial assistance from family and friends.

The following tips are direct quotes from the people we interviewed in Learn to Bounce:
  • Control your costs if you get laid off, to minimize your debt.
  • Be prepared to start at the bottom if you go into a new field.
  • Pay attention to your finances. A projection of expenses and income will tell you where you stand.
  • Cut back expenses if necessary.
  • Save and invest when times are good.
  • Accept support from your family and friends.
  • Don’t expect the same salary you were making in high tech before the downturn.
  • Be prepared to start again from the bottom, if you are changing fields.
  • Get your finances in order when times are good. Those who were prepared didn’t panic when they got laid off.
  • Be financially prepared in case you get laid off. If you do, cut back immediately.

5) What proportion of the people in the book would still be happily in high tech if the meltdown had not happened?

Your guess is as good as mine. I suspect almost all. The reason I say that is that each and every one of the people we interviewed were relatively content with their work until the down turn happened. If you like challenge in your work and a positive work environment, which most people do, then the high tech environment satisfies your needs. High tech is a fast paced, challenging and exciting sector to work in. When people were laid off from high-tech during the early part of this decade, due to the terrible job prospects in the sector, people had the time, opportunity, and in some cases the financial means to explore other career options.

6) Is there any way to prepare people for a world of layoffs; who should do it - the employer, schools?

Interesting question. Being prepared for “a world of layoffs” is really being prepared for “a world of job change”. The only difference between being laid off and quitting a job is who chooses to initiate the job change. I think life experiences have prepared generations Y and perhaps X to live in a world of change and to expect a portfolio of careers. Younger workers typically do not expect to spend the rest of their life with one employer and certainly not in one job.

Regardless of who initiates a job change, the keys to landing another job quickly and easily are clarity of what you want to do next, and leveraging your social network to land the work of your choice.

7) Do you think there's a conflict between loyalty to the employer and loyalty to yourself?

Not at all. Loyalty to yourself is loyalty to your employer. Assuming that loyalty to yourself be working in an area of interest and doing work you are passionate about, then you will love your work. In turn you will do your best and your employer will love your work too! As long as what a person enjoys doing and the environment they like to work in, matches what an employer requires and what they offer, everyone wins.

8) Is loyalty to the employer an outmoded concept? How do you think people should manage the balance between what the employer wants you to do and what you want to do? Has your experience being self-employed influenced your perception of doing what you want vs what the employer wants? For instance, as a self-employed person are you able to do exactly what you want all the time?

Loyalty to an employer is not an outmoded concept. See #7. The definition of loyalty in the dictionary is “a feeling of devotion, duty, or attachment to somebody or something”. No where does it say for “how long”.

It is up to you to be clear about what you enjoy, what you want and what you don’t want in a job. Likewise it is up to an employer to be realistic and clear of the kind of work expected and the work environment it can offer. The key is to have a perfect match. If there is an aspect of a job that you perceive as not being totally aligned with what you think you want to do, it may be worth taking the risk and trying it. The reality is that until you actually try something, you really don’t know how much you may enjoy doing it. Recently a reporter told me and Lee Wallace a story of how she accidentally fell into a career of writing. She never thought she would enjoy writing until she did it.

There is always “stuff” that we prefer not to do. For some it can be the basics of caring for yourself, like cooking, cleaning or exercising. If you feel like you are leading a fulfilled life, you are finding a way to get the necessary things done, while staying focused on the things that fulfill you; doing the things you value and enjoy most. Work is part of living your life in a manner that fulfills you.

With respect to myself and self-employment, self-employment gives me flexibility in my schedule that suits my family life most of the time. I am usually here for my teenage daughters, the other relationships that I value, and for my volunteer activities. That being said, there have been many times that I have missed parent teacher interviews or other important school events because I was out of town. Those important responsibilities get completed at another time that suits my schedule or my husband is able to fulfill a responsibility for us. Just like everyone else, I am always managing my life and my schedule to strike that right balance.

9) Any more book projects on the go or in your head?

There is definitely more to come. We live in a world filled with opportunity. The challenge is choosing the work/project that I want to do next, the work/project that I am passionate about, and the work/project that will provide the financial rewards and life style that I desire. The beauty and challenge of self-employment is that the choice is mine. That choice comes with 100% responsibility for the results too.

As I write the answers to these questions, I am leveraging my network to determine what I will be doing next and how.

Tuesday 13 May 2008

Currency Risk in an International Portfolio - Extreme Value Theory

On his Investment Ideas blog post Currency Hedging Necessary? of May 7th, Larry MacDonald cites the Chou funds annual report 2007 letter and several academic studies ((The Performance of Currency-Hedged Foreign Equities by Lee Thomas and (Hedging Currencies with Hindsight and Regret by Meir Statman and Kenneth Fisher) referred to therein saying that removing the risk arising from currency exchange swings is unnecessary. The long term (15+ year) returns were about the same for portfolios with and without hedging, as was the traditional measure of risk, standard deviation.

Is that the end of the story, the definitive answer for the investor who wants to hold a diversified portfolio that includes substantial international holdings? Apparently not.

Gary Klopfenstein and Fred Stambaugh of BancOne Currency Advisors show in Currency Risk Management in International Portfolios that the traditional measure of risk - standard deviation - used in the above studies does not adequately reflect currency movements. Big swings / extreme events in currency occur far more often that standard deviation based on a normal distribution says they should and this causes big, hidden downside risks. Instead they apply Extreme Value Theory and show that portfolio returns can be significantly improved while risk is reduced. This is accomplished not through traditional methods of currency futures or options (assumed in the hedging done in the traditional studies) but through something termed active currency management, which Banc One conveniently offers as the Banc One Currency Advisors Currency Overlay Program (a fancy label is required to market this to the target institutional investors).

Unfortunately, how that works is not described, nor is the study named that purports to show a 0.5% per quarter improvement in returns while eliminating "calamity risk". So it's hard to tell if this is a real prophylactic for a foreign investor or just another magic elixir. And then of course, can the individual investor do something similar or are there reasonably priced products that do so?

Monday 12 May 2008

Beware of Financial Advisers offering Nasal Spray

Came across an amusing tidbit in GlobeInvestor magazine enticingly titled The link between your love life and your investments. It was based on a serious research study called Oxytocin Increases Trust in Humans (do a Google search and see how often the article shows up).

The researchers found that men would become more socially trusting and readier to take risks when the "love chemical" oxytocin was squirted up their nose. The experiment is described this way by GlobeInvestor:
"An investor could choose to give any amount of money to a “trustee.” Once invested, that sum would be tripled, but the investor couldn’t control how the trustee used the funds. Enriched by this windfall, the trustee could opt to share the proceeds with the investor, and both players would then get a nice payoff. Or, the trustee could be selfish and hoard the profits."

Nice way to describe how investing works, huh? The adviser triples your money without queston, the only doubt being whether he/she will steal it.

Now I know to refuse all nasal spray when meeting with financial advisers or brokers no matter how bad a cold I have! (Can it be laced in coffee at investment seminars!? Will anti-oxidants counter the effects?) We'll also have to monitor the progress of efforts to transmit smell through the Internet. Imagine receiving a spam investment solicitation email laced with oxytocin.

Or, maybe the technique could be reversed to develop a risk aversion blow test, sort of a risk breathalyzer. It could be descriptive - "you have a very low risk tolerance, sir" - or prescriptive - "your oxytocin level is wayyyy too high, no investing for you for a month."

Have a good day. ;-)

Friday 9 May 2008

A Worthwhile Investment: Real Return / Index-Linked Bonds

An investment portfolio is like a house. It may be complete and look fine overall but there is always some improvement to be done. In my investment portfolio, the next renovation project will be to rip out some of my regular fixed income and install some real return bonds. Here's why I'm going to do it and how. I think it's something everyone should do, much like a kitchen renovation, since it always adds value.

What are Real Return Bonds (RRB)?
To quote Bylo, whose primer Real Return Bonds for Canadian Dummies I highly recommend (many of the links cited below I found at his website),
"Real Return Bonds (RRBs) are Government of Canada bonds that pay you a rate of return that is adjusted for inflation. Unlike regular (nominal) bonds, this feature assures that your purchasing power is maintained regardless of the future rate of inflation."
Their other name, often used in other countries - index-linked bonds - comes from the fact they are linked to an inflation index like a CPI (Consumer Price Index). Both the principal and the coupon aka interest payments go up with inflation. Another excellent brief description of inflation indexed bonds, with reference to the US version called TIPS is in the Investopedia article titled Inflation-Protected Securities - The Missing Link.

Inflation-adjusted Interest vs Real Yield
It is important to keep straight that there is difference between the inflation-adjusted coupon interest return and the real yield return you get when you buy the bond on the market. When you buy some of the Canada RRB maturing Dec 1st, 2021 with a 4.25% interest coupon (set in 1991 at original issue), you do not receive 4.25% as the real return on your investment, nor do you receive that as the cash payment of interest every six months on June 1st and December 1st.
  • Real yield: supply and demand in the market sets the yield through changes in the price you have to pay for the bond. For instance, the price quoted (at the time I looked it up) on in the Real Returns tab in the bottom panel of the page showed that the current real market price of $130 for every real $100 of bond works out to a real yield of 1.75% per year. You can check the recent real prices at the bottom of this Bank of Canada web page .
  • Inflation-adjusted cash payment: the Bank of Canada publishes here the inflation adjustment factor to multiply times the interest coupon. It changes every day as inflation marches on, slowly or quickly. For May 9, 2008, the factor is 1.35179. The semi-annual interest payment is notionally 1.35179 x (4.25% / 2) = 2.8726% though it is only paid on June 1st when the inflation factor will be 1.35537. The holder of $1000 face value of this RRB will receive interest of $1000 x 1.35537 x (4.25% / 2) = $288.02.

That 1.75% sounds pretty low compared to other government of Canada bonds seen on the same page at around 4% but those other bonds will not be adjusted for inflation by the government and so the expected inflation rate is factored into the price, i.e. about 4 - 1.75 = 2.25%. If inflation is actually lower over the next 13 years than 2.25% then the RRB is not as good a deal but if it is higher than that the RRB wins.

In retrospect, we should have loaded up on RRBs ten years ago when the real yields were 4%! The Bank of Canada publishes data on the real yields of the federal government RRBs back to 1998. Yields have drifted steadily downwards ever since 1998. The average during 1998 - 2008 is 2.94% and the last time it was 3% was 2003. Another BoC page shows yields in recent months and illustrates the fact that fairly significant changes can occur in a few months - it was up to 2.2% last June/July.

What would it take to send yields back up to 4+%? Frankly, I'm not sure but the period when yields were highest was during higher inflation in the 1990s.

Why Own Them in a Portfolio?
  1. Inflation-protected interest and principal - for those who want or need cash flow and principal, e.g. for income in retirement, guaranteed to be free of inflation risk and default risk (is the Government of Canada likely to default on repayment in 2021?) RRBs are a godsend. A big risk with long term nominal bonds is inflation since higher rates, over and above what is assumed and built into the nominal rate, can destroy the principal value of long term fixed income investments as surely as default. RRBs are a superb tool for capital preservation if held to maturity. Meantime, the cash flows are automatically increased for inflation so your purchasing power is conveniently maintained. Back in November 2007, journalist Jonathan Chevreau published this interview with finance prof and author Zvi Bodie who strongly believes in RRBs. As inflation threatens again to start accelerating, the value of RRBs is rising.
  2. Asset class diversification benefits - RRBs have the wonderful property of being uncorrelated or even somewhat negatively correlated with regular fixed income, equities and real estate, as well as Canadian currency fluctuations vs the US dollar. See the Altruist Financial Advisors Reading Room page listing of articles under the heading Inflation-Indexed Bonds for the academic research that demonstrates these effects. The diversification benefit refers to the opportunity to lower the overall volatility i.e. risk, of a portfolio through including RRBs. One of the studies in the list - TIPS As An Asset Class by Peng Chen and Matt Terrien - (TIPS are the US version of RRBs) concludes that "TIPS offer investors an option for portfolio diversification that no other instrument can replicate. ... For investors with most of their portfolios invested in traditional financial assets, the inclusion of TIPS reduces the risk and increases the return of the entire portfolio."

How to Fit Inflation-Indexed Fixed Income into the Portfolio
  • the research studies indicate that RRBs should replace a portion of normal bonds, especially the longer maturities; this makes sense given that RRBs themselves are long maturity bonds
  • the exact proportion of normal bonds vs to hold is not a single number; at Libra Investment Management these calculations show that the RRB allocation can be anywhere from 15% up to 100% of fixed income and the previously cited TIPS As An Asset Class study indicates it should be most of the fixed income allocation in the portfolio.
  • since RRBs are taxable as interest, which attracts the highest tax rate (see the description of the tax treatment in the Prospectus at the BoC), RRBs should be held in a tax-deferred registered account like an RRSP, RRIF, LIRA etc
The Mechanics of Buying
Bylo's previously mentioned webpage neatly describes the choices. The only thing to add is that in Canada there are not many offerings to choose from. The Government of Canada has five series outstanding:
  • 4.25% 01Dec2021
  • 4.25% 01Dec2026
  • 4.00% 01Dec2031
  • 3.00% 01Dec2036
  • 2.00% 01Dec2041
The Dec2041 issue seems not to be quoted on the Canadian Fixed Income site and may not be readily available. Similarly, bonds from the Quebec, Ontario and Manitoba governments may not be available. Phone the bond desk of your broker to find out what they have. The provincial RRBs will yield slightly more than the federal ones. It doesn't really matter as it is not necessary to hold more than as the default risk is not an issue.

In calling my broker, the minimum purchase amount was indeed $5000, not the $1000 the Bank of Canada prospectus says (in the secondary market where you and I trade, the BoC's prospectus rules do not apply).

The biggest issue with buying them now is the low yield. Between the time I looked up the current rates and the end of the day on Friday, the yield on the Canada 2021 issue had fallen from 1.75% to 1.68%. That's the mid-market rate, halfway between the buy and sell. Factor in the higher price (meaning a lower yield to you) from the broker and the real return is even lower. It's a tough choice between holding off and waiting for a better rate in the 2% range or going for the diversification benefits now.

A quick follow-up note - found this Bank of Canada research paper World Real Interest Rates: a Global Savings and Investment Perpsective, which concludes that low real rates are a global phenomenon and that changes occur slowly over years. From their graph on page 2, it would appear a 1% shift in a year is about the most that could happen.

Since the real rate is driven, according to the paper, largely by the balance of global investment vs savings, if we are in a period of economic slowdown, what are the chances of a resurgence in the real rate soon?

Wednesday 7 May 2008

Manulife One: a Mortgage-Banking Combi Product to Like

So often one comes across financial products that sound good in principle but are not good value for money. It looks to me that Manulife's ONE Account is a winner that every aspiring homeowner should have a good look at. Back in 2007, Million Dollar Journey did a review of Manulife One and generally seemed to like it, though not as much as me.

How It Works: The account combines a mortgage with a normal chequing and savings bank account. Every day, Manulife sums the positive amount on deposit on the bank side with the negative amount in the mortgage to arrive at a net amount borrowed, and then calculates interest at the mortgage rate on the net amount. There is no interest paid on the savings while the mortgage is not yet paid off and the daily balance is negative. Meanwhile the bank account can be used like any normal chequing account to pay bills, write cheques, withdraw cash at ATMs, the whole bit. If you ever suddenly need to spend extra, and go overdrawn, that is possible too, up to 90% of the appraised value of your home according to Manulife.

As an aside it is surprising that these types of accounts are not more prevalent in Canada. In the UK they have been around for many years and are commonly known as offset mortgages or current account mortgages (because the savings offsets part of the debt).

The Key - Staying Positive: The account works best when there is a positive bank balance however small and variable, because this accelerates paying off the mortgage. It does so not just by a bit but by a surprisingly enormous amount, in many cases years off the time it takes to pay off the mortgage. Manulife has a calculator on its site in which you can plug in your own numbers to see by how many years and how much interest is saved. If you have your pay deposited into the account and then use it till the next pay for normal household spending, then there could/should be a net balance throughout, which reduces the net debt and the interest charged.

Earning a Higher Rate with Savings: One of the neatest aspects is how a positive bank balance works in your favour. Instead of having your money sitting earning around 0.5%, the going rate these days on many chequing accounts, and which is taxable (perhaps taking another third off that, making it more or less zero), it saves interest at the much higher mortgage rate, currently around 4.75% for variable mortgages, which is after-tax dollars by the way. That's the equivalent of earning 4.75% on your bank balance. Getting no interest paid to you on the bank balance even saves the hassle of reporting the puny interest to the CRA of your annual tax return.

Multiple Applications: Manulife suggests several other uses of the account
  • debt consolidation and reduction of net interest costs by moving higher rate credit card debt, car loans, personal loans into borrowing against the secured debt of the mortgage, which is the cheapest rate available
  • access to home equity or reverse mortgage replacement for retired people
  • emergency savings fund instead of keeping this in a savings account, term deposit or GIC, which will earn less than the interest saved on the mortgage
Life on Autopilot: The great feature of the account is the combination by Manulife makes it all happen automatically. So many good plans for paying down a mortgage early never happen through neglect or being too busy with life.

Value for Money: All these benefits would be lost if the pricing was bad, the mortgage rate too high, the options too restrictive or the account fees uncompetitive. Happily, Manulife's pricing seems to be very comparable and competitive all round.
Mortgage rate - the open variable rate at prime 4.75% matches the big lenders and the 1 year seems to be the lowest around (see table from Cannex that I downloaded today)

Banking fees - the $14/month fee looks roughly comparable to big bank chequing options e.g. Bank of Montreal's Performance Plan charges $13.95 per month unless one keeps a minimum $2500 balance, which earns a princely 0.5% per year; Scotiabank's PowerChequing is better at $3.95 month unless a $2000 minimum balance is maintained, which earns exactly 0%. Nevertheless, even at $10 / month extra, the thousands saved in mortgage interest more than makes up for it.

Downside - Debt Temptation: The only downside I can see is that anyone with a tendency to get too easily tempted to use the borrowing margin and increase debt instead of paying down the mortgage will find this account too convenient and easy to abuse.

Other than that, I say kudos to Manulife for a smart, flexible and good value product that enables Canadians to pay down their mortgage much faster and with money that they are actually using for their everyday expenditures.

Monday 5 May 2008

Correlation & Standard Deviation: Worthless Risk Tools for the Investor?

Retired mathematician and investment aficionado Gummy (see link to his great website in my Resources sidebar on the right) wrote a provocative entry (see the lower part titled Correlation means ... what?) on his website in which he casts doubt on the value of standard deviation for risk measurement and correlation for risk control.

He shows, and I am sure his math is impeccable, that an example portfolio with standard deviation of zero as a result of holding two perfectly negatively correlated assets, can lose a lot of money. Huh? Standard deviation as the accepted measure of risk is one of the bedrocks of finance theory. Negatively correlated assets are the foundation of hedging and building portfolios more protected against loss. What gives?

The basic reason I believe that we are ok continuing to believe in standard deviation and negative correlation as essential investment principles is that reality has not ever worked and by all logic should never work the way his example does. For one asset or asset class to produce negative returns in seven out of ten years and to have an average negative return of over 6% per year for a decade is very unlikely. For an uncorrelated second asset to exhibit the same steadily downward behaviour at the same time (Gummy's second asset goes down an average of 3.7% per year) is even more improbable. I went back and scanned Roger Gibson's book on Asset Allocation (my review here) for his many charts and tables of investment returns. Even in the worst period of the 1930s, while stocks were going down year after year, other asset classes like bonds were still producing positive returns. Over ten years, almost no asset class will average negative returns. For example, Seeking Alpha has just published charts of the latest Major Asset Class 1, 3, 5, 10 & 15 Year Returns. Not one had negative annualized ten year returns.

Any investment or asset class must ultimately be expected to have positive returns. Otherwise, why would anyone invest? The beforehand expectation is of course not always what happens, especially where individual companies are concerned. That's why I believe that I am better off with funds and ETFs that spread the individual company risk over many companies so that the expected pattern of positive asset class returns emerges.

With respect to correlation, the patterns are variable according to the choice of interval, as the upper part of Gummy's post shows in his analysis of correlation according to the number of days, and they are also unstable over time even for a set interval (which he does not explore). Even with these considerable imperfections, non- or negative correlation between asset classes yields diversification benefits in a portfolio in the form of a reduction of risk, or chance of loss.

To illustrate, I took Gummy's data and graphed the cumulative value of each asset X and Y, separately and as a 50-50 portfolio. The results are in the chart you see. Would you rather have owned asset X or Y or the portfolio of the two? Suppose along the way in some random year, unknown in advance, you had needed to sell, what would be you be better off with, one or the other asset or the portfolio? I think I'd rather have the portfolio despite the steady 5% loss year after year.

Just for fun, I also tried out another portfolio best practise, which is to periodically rebalance the portfolio back to the original 50-50 allocation to each asset. Lo and behold, rebalancing once a year after each year's return produces a portfolio whose individual assets vary much less in dollar value year to year and whose end value is considerably higher - 60% of the starting investment vs only 52% - than the non-rebalanced portfolio. To be more realistic, the cost of trades would have to be subtracted from the rebalanced portfolio but the impact would depend on the size of the portfolio - as the amount invested got very large the impact of that trading cost would become very small. In other words, even with trading costs, the rebalanced portfolio would probably come out ahead.

From a practical point of view, the only type of investment asset that one is likely to find with perfect and predictable negative correlation to another is insurance. e.g. through the use of options. But insurance comes at a net cost that will reduce overall returns. Conversely, no asset classes have perfect positive correlation, which means that at least some diversification benefit can always be obtained with different assets.

In the real world it worth remembering that there is no such thing as a risk-free asset. Even T-bills, though they are free of default risk, are subject to inflation and taxes that have at times in the past resulted in net losses in real purchasing power terms.

The practical world is messy and imperfect as Gummy found but the principle of using standard deviation as a measure of risk is still very useful to the investor, as is seeking out asset class combinations in a portfolio with positive long term returns as negatively correlated as possible.

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