Posts made in June, 2008
Lap Of The Blogs
Just a reminder to Feedreaders: if you can’t see pictures or videos, you can click on the title of the post at the top of your email to read the post in it’s original form on the website.
From Around The Blogosphere…
You always hear the advice that you should check your credit report yourself, but you’ll get it again courtesy of The Canadian Capitalist PLUS you’ll get instructions on how to do it. Now you have no excuses.
The Quest For Four Pillars explains the ins and outs of the Canada Child Tax Benefit program. They even include a link to a calculator from the government that will help you determine what your benefit might be.
Canadian Financial DIY brings up an often neglected topic of personal finance as he discusses 6 reasons for using testamentary trusts. My coverage on estate planning is pretty weak, so I’ll start to ramp up the number of articles focussing on estate planning myself in the future.
Michael James on Money shows you how to get rich. No fancy schemes, just good old fashioned discipline.
The Million Dollar Journey offers an introduction to double exposure ETFs – these have been in the media a lot, and have also been covered by many of the personal finance bloggers as of late – and will continue to be for some time I gather.
This Week’s Racing Video
Every week on WhereDoesAllMyMoneyGo.com, I have a weekly “Lap of The Blogs” post on Friday that provides links to other articles that I found interesting or that I think would be of interest to my readers. I also include a racing video simply because my other passion in life is auto-racing.
This week’s video gives some perspective as to how much faster racecars are than regular street cars. Specifically it compares an A-Series Mercedes Benz versus an E-Series Benz versus a McLaren Mercedes F1 car. The F1 car gives the A-Series Mercedes a 70 second headstart on a 3.2 mile course (and still wins).
Read MoreAn Interesting Fact About Private Equity
I’m experimenting with a video blog entry today. The text follows below the video…
Private Equity in it’s loosest definition is the ownership of companies that are, well, private. This would be as opposed to ownership in companies that are public – such as any company that is listed on your favourite stock market – which is a public exchange. Another way of putting it, is that if a company does not have shares trading on a recognized public stock exchange, it is a private company.
Here is some interesting data about Private companies that you may not have known:
- Of the 171,606 companies in the United States with revenues above $10 million per year, fully 151,345 of them are privately held companies – that’s 88%
- Of the 30,120 companies in the United States with revenues above $100 million per year, fully 22,696 of them were privately held companies – that’s 67%
Data taken from 2002 research by Dun & Bradstreet’s Market Identifiers Database
So, when you invest in a portfolio of US stocks (active or indexed), are you missing out by only investing in 12% of the companies with revenues over $10 million per year if you “limit” yourself to publicly traded stock?
Read MoreThe Reverse Dispersion Equity Collar
This is an advanced level topic (i.e. it may put you to sleep)
The reverse dispersion equity collar is a strategy to reduce the cost of portfolio insurance through two main mechanisms: 1) Implementing an equity collar and 2) Putting option pricing theory to work in our favour through reverse dispersion.
The Equity Collar
First, let’s have a backgrounder on the equity collar. If someone wants to protect their portfolio from loss without selling out the portfolio (for example the investor has a large unrealized capital gain and only expects short-term market volatility), they can purchase put options. The put options gain in value if the portfolio falls and the gain on the puts offsets the loss on the portfolio.
However, purchasing a put option contract costs money. To reduce that cost to the investor, they can in turn SELL call options. This gives someone ELSE the option of buying away the portfolio if it hits the strike price. The investor will receive money for selling these call option contracts which can offset in part, or in whole, the cost of the portfolio insurance (the put options). What this does is serves to limit the downside AND upside of the portfolio’s performance for the length of the options – this is known as the equity collar.
The Reverse Dispersion Strategy
In a nutshell, option pricing is heavily influenced by volatility of the underlying security. Generally speaking, the more volatile the underlying security (or portfolio) the higher the price of the option since more volatility means more chance of the underlying asset hitting the strike price.
There are other variables that affect option pricing as well: 1) Time – the longer the option contract the more chance the underlying asset has to hit the strike price. 2) Distance to Strike Price – the closer to the strike price the underlying asset is, the more it tends to be worth (again, since it is more likely to become “in” the money).
So here is the reverse dispersion strategy in motion using a basic example:
1. You buy put options on the entire portfolio for 1 year, that are perhaps 10% out of the money
2. You sell call options on the separate stocks that make up the portfolio for 1 month, that are perhaps 5% out of the money, and keep rolling them over every month for the year
A more concrete, although more cumbersome, example would be owning the TSX/60, buying 1 year put options that are 10% out of the money on the index and selling monthly, 5% out of the money call options on each of the underlying 60 stocks, every month.
Less Volatility on the Portfolio = Lower cost on the puts
The volatility of the TSX/60 as a portfolio of stocks would be less than the volatility of any one constituent stock since at any time some of the 60 stocks are going up, and some are going down and some are not changing much. Since all the 60 stocks are not perfectly positively correlated, the volatility of the portfolio is decreased. Since volatility is decreased, the put option on the entire portfolio as a whole costs less than buying put options on each individual portfolio constituent separately.
On the other hand, we are selling call options on each of the individual 60 constituents of the index, instead of selling call options on the entire index. Each of the constituent stocks separately are more volatile than the portfolio as a whole, hence the options are worth more and hence they are going to generate more income to offset the cost of the puts.
Taken together, we have bought 1 set of put option contracts for 1 year which is 10% out of the money versus selling 720 sets of call option contracts (60 per month, for 12 months) which are each 5% out of the money. The odds of a stock hitting the 5% out of the money strike price in one month are low, maybe around 15%. That means you will have some additional turnover in the portfolio and you will need to replace some stocks every month, and write new calls. However, by using a lower strike price distance you increase the income received from the call options. If you pick your spots, you can earn more income from the calls than you spend on the puts, implementing a net-credit collar.
What would be a situation for considering this?
Let’s say you are a large, active investor on the fence about energy in Canada. You see that it’s been on a tear, but so many people are convinced it is a supercycle. You have a large unrealized gain, and want to protect against a near term correction, which could be severe, and still participate in any continued upswing. This might be appealing as you could in essence get free portfolio insurance (with a 10% deductible – which is another way of saying the puts are 10% out of the money). Further, a portfolio manager who runs this strategy often tells me that the time and distance-to-strike differentials of the reverse dispersion allows for only writing calls on half the positions to offset the cost of the put contract – which means only half of the portfolio may be capped on the upside in case there was an across the board surprise bull run.
Please do not attempt to engage in a reverse dispersion equity collar without first consulting with a qualified financial advisor. This is a complex strategy, normally reserved for large portfolios or institutional money management. (Imagine having to enter 720 call option orders!)
Read MoreMarket Mavens
Market Mavens
Again taken from Malcolm Gladwell’s The Tipping Point: Market Mavens are people who truly enjoy helping others when making purchasing decisions. For example, if you were looking to buy a new car you may consult with a friend who is a ‘car-guy’ – who will tell you about all the features about the car you are considering buying. However, this is NOT necessarily a market maven. The ‘car-guy’ will talk to you because they like talking about cars, whereas the market maven will talk to you because they genuinely enjoy helping others and enjoy disseminating the information they collect to others solely for the purpose of their empowerment.
Malcolm Gladwell talks about the ‘maven trap’ in his book, The Tipping Point: How Little Things Can Make a Big Difference
Many Personal Finance Bloggers are Market Mavens
Many personal finance bloggers would be market mavens in that they are very passionate and knowledgeable about personal finance and investment products and strategies, and are gladly willing to share that information with very little personal gain (for the most part, income from the advertisements on blogs are not enough to persuade one to quit their day job). In addition, many personal finance bloggers are also price vigilantes (see yesterday’s post) – quick to point out the price-to-value ratio of various investment products.
Some examples of Market Mavens and Price Vigilante personal finance bloggers are:
The Canadian Capitalist
Michael James on Money
The Million Dollar Journey
Canadian Financial DIY
Thicken My Wallet
The Quest for Four Pillars
…to name but a few.
Read MorePrice Vigilantes
The Tipping Point is a very popular book written by psychologist Malcolm Gladwell which discusses the phenomenon of how ideas, products and behaviours can “tip” in explosive ways. Some examples he cites in his book are: the seemingly instant drop in crime in New York, the resurgence of Hushpuppy footwear, and how the book Divine Secrets of the Ya-Ya Sisterhood went from selling 15,000 hardcover copies but then slowly gained momentum until it “tipped” a year later into selling 2,500,000 copies.
There are many very interesting concepts discussed in the book such as the Law of the Few, the Power of Context and the Stickiness Factor which Gladwell posits are necessary for a behaviour or product to “tip”. I found the concepts and message behind The Tipping Point to be incredibly eye-opening and thought provoking. If you are looking for reading material, click here for more information on The Tipping Point: How Little Things Can Make a Big Difference
In any case, the reason for this post was to regurgitate a concept Gladwell in turn has borrowed from economists which is the concept of ‘price vigilantes’ and later, ‘market mavens’ (mavens will be discussed tomorrow).
Price Vigilantes
Grocery stores normally have many items that go on sale and are placed in plain view – naturally the sales volumes of these items increase when they are on sale and offered at a discounted price. However, Gladwell cites research in which items which are erroneously marked as being on sale even though no price discount is applied will have similarly increased sales volumes. In other words, the fact that signs indicating that a product is on sale is the reason for the increased sales, not the actual price discount.
A price vigilante is one of the few people who would notice this and complain to the manager or someone else within the grocery store organization. While price vigilantes represent such a small percentage of the consumer public, if it were not for the price vigilante, more grocery stores (and by extension other retailers) would have false sales which would drive you to buy more even though you would not be saving any money.
Read More2008 Personal Tax Calculator
This handy calculator is maintained by Ernst & Young and allows you to calculate your marginal tax bracket, tax rate on capital gains, dividends and interest for any province or territory in Canada. Updated for the 2008 tax year.
Click here to use the 2008 Personal Tax Rate Calculator for Canadians
Read MoreYour Personal Savings Rate
Your personal savings rate is simply the percentage of your income that you put away for long term savings. There may be some debate as to whether you should use your gross income (before taxes) or your net income (after taxes) when making the calculation. For example, someone earning $50,000 per year has a gross income of $50,000 and assuming roughly $10,000 in income taxes payable will have a take-home pay (or net income) of $40,000.
Again, your GROSS income is your income before income taxes and your NET income is your income after income taxes.
If this person was putting away $4,000/year for long term savings then their personal savings rate is either 8% or 10% depending on which number you use for your total income. Many people will use the rule of thumb that you should save 10% – they don’t really say of which number, but if you can manage it, try to aim for 10% of your gross income. For the example person above, this would mean saving $5,000 per year instead of $4,000.
10% is just a rule of thumb remember – if you can save more than that, even better. And no, it’s not easy. You may only be saving 5% right now, or perhaps even less. The average personal savings rate in the United States was negative in 2006. That means the average person spends more than they earn, which means they pile on more and more debt (or eat into savings or home equity).
As with many aspects of personal finance, this is mostly a psychological phenomenon. We have a tendency to spend what we earn, and most people will tell you that when they get their next raise, they will put it towards savings (or paying down debt), but in reality they have probably already decided what they will spend their raise on – which means they will never get ahead.
The personal savings rate used to be much higher but has steadily declined – due to easy access to credit, a lack of personal finance education in school and the glamourization by the media of spending excesses. If there is only one thing you need to do to be successful financially, it start with savings. Until you can get a handle on that, you don’t need to worry about investing (you’ll have nothing to invest).
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