Archive for October 3, 2009

| October 28, 2009
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ETFs Compensate for Lack of Knowledge

I have never believed in using ETFs. But when many authors, whose viewpoint and experience I respect, including Warren Buffet, recommend that the average investor would be well-served by using ETFs, there must be a good reason. Since the “debate” hasn’t, and probably won’t be, resolved either for or against passive investing, it makes sense to view each side for its merit.

The case for passive investing can be summed up as follows: it compensates for lack of knowledge. There are other steps that are more important than the investment decision. If you’re not saving any money or making any progress on reducing debt, making great investment decisions won’t make up for those failings. However, making bad investments, where your capital is lost, will cause a permanent setback, whether your plan was on track or not. One way to avoid making bad investments (think: too risky) is to buy a passive investment. Later, after you have developed good habits of saving and reducing debt, you will be able to develop skills in choosing wise investments.

There are a number of reasons that I do not believe in passive investing. The first is that passive investments are almost always based on a market-cap weighted index. A market-cap wieghted index was original intended to represent the aggregrate experience of investors, as a reporting mechanism. It was not intended to perform as an investment and makes no sense from that perspective. It has been shown that an equal-weighted average generally outperforms the index, probably because small-caps tend to perform better over time (with higher risk).

Further, index investing does not decrease the volatility of stock market-based investments. People who have experience owning term deposits will probably be surprised at the fluctuations in the value of the market. For example, the S&P 500 return was negative between 1999 and 2009. People who are comparing their ETF return to the guaranteed interest of a term deposit would hardly be comforted by the idea that their return is the same as that of millions of others (the average).

Finally, an investor may have reasons for investing other than purely for profit. Profit is, of course, the first motive, without which no one would invest. But you may also invest in order to own a portion of companies that you believe in. If are loyal to a bank, a gas station, a grocery store or buy a certain brand of household product, you may want to own a portion of the company and profit from something you believe in. At the same time, it may be easier for you to understand the financial situation (and management’s commentary) of a company that you are familiar with.

A side-benefit of choosing the companies that you invest in, is that you can develop a better understanding of their profitability and outlook. If the market value crashes, you will be more likely to know whether the fall is justified or irrational selling and in a position to make a better informed (usually more profitable) decision. Having an emotional attachment will likely make you slower to sell, which makes it more difficult to sell losers, but easier to ride out the inevitable market crashes.

Buying an ETF is like investing with training wheels. While it’s low-cost and efficient enough for beginners, it’s not fool-proof. As you increase in experience and get the rest of your financial plan in place, you will probably benefit from taking more of an active role in selecting the companies that you choose to own. You will benefit from aligning the types of investments you own (bonds, preferred shares, common shares, trusts) with your goals (growth, income, speculation).

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| October 21, 2009
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More Mortgage Timebombs?

Benjamin Tal, one of the pre-eminent economists in Canada, explained in a presentation that I attended why Alt-A and Option-ARM mortgages won’t be timebombs the way sub-prime mortgages were. He described being in New York as the credit crisis unfolded and he gave his opinion that the entire American financial system was teetering on the edge of total collapse. It was apparently a big mistake to allow Lehman Brothers to fail, since the big banks are the oxygen that keeps the financial system alive.

The problems with the sub-prime mortgages are well-known. They were offered to people with inadequate credit, bearing teaser rates that would reset in two years. This allowed people to buy houses much larger than they could afford. Then, between 2004 and 2007, interest rates rose by about 4.0%. When the interest rates reset, not only were they higher than the teaser rates, but they had also increased, making the payments unaffordable. Homeowners (in the loosest sense of the term) walked away as values fell, and foreclosures jumped.  Because 95% of sub-prime mortgages had been securitised, anyone who held the securitised loans took an immediate write-down (due to mark-to-market rules) and banks found their capital impaired. Could the same vicious cycle be repeated as interest rates reset and payments come due on Alt-A and Option-ARM mortgages?

Alt-A mortgages also offered teaser rates, generally with a reset period after five years. After the crisis that was precipitated by loan defaults in the sub-prime mortgages, there is one major difference. In order to save our financial system from collapse, the US Federal Reserve has pushed interest rates to 0.25%. As the interest rates on Alt-A mortgages reset, they will be based on the new rate of 0.25% and payments will remain essentially unchanged from the teaser rates.

Option-ARM mortgages offered borrowers a choice of three payment plans: principal + interest, interest-only or minimum payment. The last option, minimum payment, was below the level of interest-only and thus resulted in negative amortisation. Put another way, borrowers who opted for minimum payment would see the balance of their loan grow and the interest cost was added to their loan. Whether or not we believe it’s irresponsible to take a negative-amortisation loan, about 85% of borrowers chose that option. These loans also generally had a reset period of five years, but there are a couple reasons Mr. Tal doesn’t see them as a ticking timebomb. The first is that only about 50% were securitised, while 50% remained on the banks’ balance sheets. This means that future earnings will be negatively affected, but defaults won’t necessarily result in an immediate write-down and the related capital impairment. Of the 50% that remain on banks’ balance sheets, roughly half is owned by Wells-Fargo (from the purchase of Wachovia). Those loans had a special feature: they don’t reset for 10 years.

After these explanations, Mr. Tal said that he was confident that Alt-A and Option-ARM mortgages are not timebombs and will not endanger the equilibrium of our financial system the way the sub-prime mortgage meltdown did. Having said that, he is not optimistic about the future profitability of US banks.

Another common concern is commercial real estate loans. Commercial real estate tends to lag residential real estate and I have heard anecdotes of falling values and reduced loan-to-value ratios. Together, these can make it impossible to refinance. Combine that with securitisation, and forced selling results. Mr. Tal predicted that commercial real estate mortgage defaults will cause 500 regional banks to fail. To put the number in perspective, he referenced the 900 banks that failed in the Savings & Loan crises, and around 2000 banks failed during the Great Depression.

His conclusion was that the US administration is doing the right thing. They are buying time and buying jobs. In fact, he believes the Chinese administration is also buying time and buying jobs. That should give the private sector time to find its footing and recover from the present deleveraging.

This gets me excited about buying US real estate. There has been a phenomenal opportunity to buy US real estate cheap, and it’s not over yet. On the other hand, I’m not optimistic about the Canadian manufacturing sector, or anyone looking to export to the US. American consumers are simply not purchasing like in the past and the American government will definitely not buy from foreigners, when there’s a choice. At the same time, given the government spending and the industrialisation of China and India, as well as other emerging markets, the commodity and natural resource story seems to remain intact.

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| October 14, 2009
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A Prediction

I will make a bold prediction about whether or not you will ever become wealthy. But first, you need to give an honest answer to the following two questions. Are you happy? Do you live a healthy lifestyle?

I really believe that it takes the same qualities and characteristics to build wealth as it does to be healthy and happy. And I believe that everyone has the capacity to achieve each one. I think that most people know what it takes to be happy. Most people probably also know what it takes to be healthy. But the secret is to actually do more of what we know.

If you are happy, you probably do many of the things that increase happiness. You probably make an effort to keep in touch with family, see friends and treat people with respect. You may be involved in a meaningful cause where you work to improve your community, or you may have a hobby that allows you to create something of value. These all require a few common characteristics: you have found something you value and you spend your time and energy there.

If you are healthy, you probably make choices that keep you healthy. That’s not to say that you never indulge, but you can find a balance. You probably eat a variety of healthy foods. You may have a regular exercise program, or you may focus on creating healthy mental habits. These all require a measure of self-discipline and the ability to balance your choices.

If you are happy and healthy, I am confident that you can become wealthy. All you need to do is add a couple habits to what you’re already doing. Set goals. Save. Invest. Check that you’re on track and make any necessary adjustments. This is even easier if you get advice from an advisor that you can trust.

If you are not yet happy or healthy, ask yourself: would you rather have wealth or happiness? Would you rather be rich or healthy? I imagine that wealth without happiness and without health would be useless, so I will assume that you can understand the priority I will suggest.

I am not sure that it’s possible for most people to make an abrupt change to become happy and healthy. When I decided that the course of my life needed to change for the better, I started by gathering many ideas for improvement. Then, I tried implementing one at a time. With several false starts or improvements followed by regressions, I slowly replaced bad habits with healthy habits. As examples, I started eating more balanced meals, then I worked on treating my family members with more respect, followed by an increased effort to have a positive outlook on life and other people, before adding a regular exercise routine. If I had tried all of these improvements at once, I would have quickly become frustrated. But as I strengthened my resolve, I experienced success and increased my confidence, which strengthened my resolve again, in a virtuous cycle.

Building wealth is much the same. It wouldn’t be practical to try and tackle every area of your financial life all at once. You could become overwhelmed and discouraged. Instead, choose the one area where change will have the greatest impact. Develop a new habit and appreciate your success. Then, choose a new area to work on. If you find you are not motivated to make the effort required in a given area, such as curbing compulsive shopping, choose another area to work on, such as choosing wise investments. Seeing success in your investments will build your confidence that you are capable of success and will also motivate you to save more, so that you will have even more funds to invest.

If you have the strength of character and conviction to take the necessary action that will create a life of health and happiness, I am certain that you can become wealthy. After all, developing habits that lead to wealth requires similar discipline to forging habits that create health and happiness. Work on all three simultaneously, because wealth is meaningless without your health and your happiness.

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| October 7, 2009
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A Four-Step Financial Plan

I have decided to present a simple list of four steps that constitute a basic financial plan. As I think about how I have made progress toward becoming wealthy, I realise that most of my choices are specific to my situation. I can’t tell you to buy stock in XYZ Inc, because it won’t necessarily present you with the same opportunity it presented me. I can’t tell you to set aside a certain amount of money each month, or buy investments before paying down debt, because your situation is likely very different from mine.

But because I give financial advice, I want to generalise to find the steps that everyone can take that will move them toward success. It must be a simple list that will not be overly specific, but which will give you areas to work in. Each of the following four areas will be expanded later.

In Lewis Caroll’s Alice’s Adventures in Wonderland, Alice comes to a crossroad and asks the Cheshire Cat which way she should go.

“Which road should I take?” she asked the cat.

“Where do you want to get to?” the cat asked helpfully.

“I don’t know,” admitted Alice.

“Then,” advised the cat, “any road will take you there.”

1. Where are you presently?

Your present financial situation entails knowing how much debt you have, what your assets are worth and what your income and expenses are each month. This gives you a snapshot of which direction you’re facing and how fast you’re moving.

2. Where are you going?

The finish line is very individual. It’s not even a race, but simply where you want to end up. For some people, they want to spend six months of the year on the beach starting at age 65. Others simply want to be able to stop work at age 55, to spend more time with their family and serving in their community. If you have a clear vision of your future, it will motivate you to take action now.

3. How do you get there?

Most people start with this step, because there are so many possibilities. I’ve talked with people who don’t want to plan for their future, they just want to know which stock to buy. It makes me think of the Cheshire Cat because, without a purpose, any one will do.

Your plan to get from your current situation to your goals can be as simple or complex as you like. At it’s simplest, there are two steps: save and invest. As you make progress and either develop skills or get advice, you may address aspects such as safety, taxation, charitable giving and inheritance.

4. Put it into action.

There is no difference between having no plan and having a plan that you do nothing with. However, there are probably a couple simple steps you can take that will have a large impact. For example, opening accounts and setting up automatic monthly payments. The more the actions are automatic, the more likely you will continue to make progress.

A good plan should be written and reviewed from time to time. You will make note of the information that goes with each of the steps above. Reviewing your goals regularly will keep you motivated, and seeing your progress will feel rewarding. Making a few good decisions soon will greatly increase the probability that you will reach your goals.

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| October 3, 2009
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The Secret to Wealth

There is actually no secret to being wealthy. But so few people become wealthy, that it might as well be a secret. The question is not, “Does this work?”, but rather, “Am I willing to do this?” You don’t need to know more, but to do more of what you already know.

There are three aspects to becoming wealthy: how much you spend, what you spend it on and how you think about your spending. Most people have little control over how much they earn. Your pay depends on the job you have, what your education was and what your experience is. It may also depend on who you know. There are things you can do to increase your income, but more income does not guarantee more wealth. I personally know people who earn over $1 million dollars in a year, who burn through all of it. Most people will agree that living paycheck to paycheck is not wealthy. And it doesn’t matter what the size of your paycheck is, if it’s all gone at the end of the month.

The first part is spending less than you earn. This means that, almost ironically, becoming wealthy means spending less than you could. If you spend everything you earn, or more, you’re not moving ahead towards wealth; you’re either standing still or moving backward. Different people have different strategies for saving money, and it’s important that it suits you. Saving money shouldn’t be about sacrificing your happiness or your health. But as long as you ensure there’s money left over almost every month, and then put it away somewhere, you’ll be making progress.

The second part is what you do with the money you save every month. There are many choices and, especially early on, it doesn’t really matter what you do, as long as it holds its value. Using it to buy a new boat or car would cause your savings to lose value (unless you are restoring an antique). If you put the cash in a bank savings account, it’ll still be there when you want it. At first, the difference between saving $1200 per year and $2400 per year is much greater than putting $1200 to work at 4% vs. 8%. If you don’t see that, figure out what each would be worth at the end of three years. Becoming wealthy takes a collection of skills, but saving is the base. After developping that habit, you can then focus on investing wisely. If you’re still saving $100 per month, but have accumulated $200,000, the difference between 4% and 8% return in a year becomes much more significant.

The final part is the way you think about your wealth. It may be a cliche, but it really is the difference between seeing the glass half-empty or half-full. If your family earned over $10.00 per day ($3,652/yr USD PPP) in 2005, you had more income than 80% of humanity or 5.1 billion people (source). Do you think of yourself as rich? Some people will never be rich. Maybe they’re trying to keep up with the neighbor that has a big house, the neighbor who has a fast car and the neighbor who has a boat. The problem is, those three are separate families and it’ll take a lot of resources to keep up with all of them. Or maybe they’re just married, trying to have the same lifestyle as their parents, who are 30 years ahead. Or maybe they just think of themselves as always needing more. Other people will never be poor. They’re grateful for what they have and they always think of themselves as having enough. If I see a five dollar bill on the ground, I’ll leave it there, because I don’t need it and I bet someone else needs it more.

To be truly wealthy is a frame of mind. It means knowing that  you have enough, through spending less than you earn, through being productive with your assets and through being grateful for what you have.  Instead of comparing your situation to those who have more, you will be mindful of the vast majority of humanity who lives on much, much less.

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