Home Bias

Posted by Preet on Feb 9, 2010 | 11 comments

I was speaking to some American financial advisors once and we started talking about geographic diversification. I mentioned that it wasn’t uncommon for Canadians to have extreme home biases, and many Canadians only invest in Canadian stocks. They said the same thing for American investors.

Considering that the US has traditionally been 50% of the world’s stock market (by size) it’s less of a stretch for Americans than it is for Canadians (Canada has traditionally been about 2 to 4% of the world’s stock markets by size). Some of the American financial advisors fell of their chairs during our discussion since it would be akin to an American investor putting their entire portfolio into handful of US mid-cap, industrial stocks (for example).

On the world stage, Canada is more akin to a small-cap and mid-cap market (there are only a few large cap companies on the global stage’s standards), and we all know our market is dominated by energy, financials and materials (they account for the vast majority of all companies by size in Canada – leaving out 7 other major sectors).

So why do we have such a home bias?

Partly because there is a slight tax advantage to holding Canadian stocks, but mostly its psychological. You tend to feel more comfortable investing in companies whose names you know and whose signs you see all the time. As reader Connie also points out, currency fluctuations between your home currency and foreign investments denominated in other currencies adds another variable to the mix (which can help or hurt).

Advisors and investors bring biases to their portfolios all the time. For example, I can tell you that investors and advisors who have immigrated from the Far East have 2x to 3x the allocations to emerging markets than born and raised Canadians. This is just from experience, I don’t have any stats to back that up empirically, but it’s true. :)

So what are the right allocations? Well, that would take a long time and is best saved for some future posts. There is no perfect allocation, but you do have to understand what risks you are exposed to with the allocations you take – and my point is that people, generally, don’t.

Guest Article: DSC Index Funds

Posted by Jim Stark on Feb 8, 2010 | 2 comments

This is a another guest article by Jim Stark. Jim Stark is a pseudonym for a practicing Canadian financial advisor.

Why are there no DSC Index Funds? On one hand, pretty much any advisor knows that there is no such thing as a DSC index fund and why that is so. On the other hand, many retail investors probably never thought about it- and likely wouldn’t be able to accurately explain why this little wrinkle exists even if they did. There’s likely a pretty severe disconnect on this- a topic that could have applications in the fields of practice management, ethics, client suitability and advisor ‘value propositions’ to name a few.

(Note: there actually are DSC Index funds these days, but they are far from ubiquitous – Preet)

In order to be clear, it needs to be underscored that mutual fund companies “manufacture” products, while financial advisors “distribute” them. Obviously, no one could be expected to distribute a product if no one is manufacturing that product in the first place. So, to modify my original question in the interest of specificity, “why don’t mutual fund companies manufacture DSC index funds?”

I’ll try to grapple with the question by confessing my concern right off the bat. To me, this is a case of undue bias. I would hope that all readers would agree that in an advisory relationship, the interests of the client should always come first. Still, advisors are absolutely allowed (indeed, expected) to advocate for whatever products and processes they feel are best and are absolutely allowed to choose their own business model, too.

Many advisors insist that they are “independent”. When asked by someone who understands the industry, however, one quickly finds that many “independent” advisors have an attitude that is similar to Henry Ford’s early take on car colours: “you can have any colour you want, as long as it is black”. My take on those advisors who use mutual funds is that they effectively tell their clients that they suggest that they can: “have any mutual fund they want, as long as it pays an embedded compensation”.

This isn’t a topic that is confined to index funds, obviously, since there are dozens of credible actively-managed mutual funds available that never make it on to many advisors’ product shelves, either. I chose to explore index funds because in the case of actively-managed funds, advisors can always find a similar fund that offers an embedded compensation and skirt the ‘advisor value’ conversation that might otherwise ensue.

The problem, as I see it, is when the business model drives the product recommendations to the potential detriment of the client interest. The implicit premise of much financial advice is that the advisor is more likely than a layperson to reliably identify outperformers in advance. Indexing drops all pretense of doing that. As such, it begs the question of what one might reasonably expect from an advisor. It has been suggested that the three primary functions of good financial advisors are to:

1. Spot problems and identify solutions.

2. Motivate people to act/change their behaviour.

3. Help people to emotionally detach from investment market events.

Notice that picking stocks and picking people who pick stocks (i.e. picking actively managed funds) is not on the list. When talking about index funds that offer no embedded compensation, there’s no product alternative available today that has a similar mandate, but with advisor compensation built in. In essence, advisors that use a commission model simply do not offer index products to their clients.

Obviously, the absence of a DSC index option would be a complete non-issue if actively managed products were demonstrably superior. But what if substantial evidence suggests otherwise? What if there are a number of clear and compelling reasons for a rational, self-interested investor to prefer an index product? That brings us to what I believe is one of the fundamental questions in our industry today. Where does one reasonably draw the line in regard to required disclosures regarding the risks and limitations for competing products and strategies where the relative efficacy of two or more alternatives is not obvious?

When giving presentations to ten or more members of the public, what if the following disclaimer was used:

The views expressed are those of (advisor name) and are not necessarily shared by (firm name). Debate regarding market efficiency, the usefulness of fundamental and technical analysis, active vs. passive management and the efficiency of payments is ongoing. To date, neither side has been able to claim unchallenged victory.

I cannot help but notice that people who favour active products and strategies, but fail to compare the two are not required to use the disclaimer. The question that it begs is: “if neither side has been able to claim unchallenged victory, then how can an independent advisor recommend only one side to clients with a clear conscience”? The corollary is: “how can it be acceptable to avoid an important disclaimer by simply avoiding a direct comparison”? At the very least, shouldn’t all advisors be required to disclose that both alternatives exist, irrespective of the approach they favour- especially if there’s a reasonable possibility that the alternatives they favour is inferior to the one being recommended? The industry hides the ugly truth by tolerating the non-disclosure of material considerations that could alter the decision-making process.

From my vantage point, the issue is not whether or not advisors should be allowed to advocate for one product line or business model or another. Clearly, they can do whatever they feel is best. The issue is whether or not they should be allowed to deliberately withhold credible and viable alternatives from their clients and still be considered independent professionals.

Thanks Jimbo. So what do you guys think? I realize this is written more towards advisors (as Jim’s articles usually are), but there is certainly food for thought for everyone.

A Lap Of The Blogs

Posted by Preet on Feb 4, 2010 | 7 comments

If you are new to WhereDoesAllMyMoneyGo.com, every Friday I run a post called “A Lap Of The Blogs” which provides links to articles I found interesting and think that others may want to read for themselves. I also sometimes include some commentary on what’s going on in my personal life and a weekly “racing video” since my former life was in the auto-racing industry. The name “Lap of the Blogs” is in reference to “A Lap Of The Gods” which is an old video series which chronicled on-board footage of the world’s greatest F1 drivers lapping various racetracks from around the world. NOTE: you have to visit the actual website to see the embedded video – it may not appear in your email. Just click on the title of the email to see it…

I made a 24 hour commando-mission to Atlanta last weekend and the result is that I will be co-authoring a new book which we hope to have published in May. I’ll fill you in on details as we near the end of the project, but I think I will have another book in me for 2010 or early 2011 as well which will be focused on sharing some horror stories with the hopes of helping figure out what NOT to do when it comes to managing personal finances – that was inspired by Larry MacDonald – who writes a blog here.

Mentions In The Media

Financial Post Magazine: 2010 RRSP Playbook

National Post: Investors have met ‘the enemy in the mirror’

Toronto Star: Requiem for a Bay Street Titan.

From Around The Blogosphere

Dan Bortolotti has recently launched an entire blog devoted to Couch Potato Portfolios. I see it quickly becoming a very popular website.

Rob Carrick talks about Post-Traumatic Stress Investing.

Jonathan Chevreau discusses a poll which found that 20% of people hope CPP and potentially winning the lottery will be enough to fund retirement. Yikes!

Ellen Roseman says it’s time to stop the madness.

Michael James elaborates on Ellen’s thoughts.

Canadian Capitalist links to an exposé on the Rich Dad, Poor Dad seminars. A must read.

Thicken My Wallet explains why the Latte Factor doesn’t work.

Million Dollar Journey shows us how one could save 70% off their grocery bill.

Four Pillars has an interesting post on bank accounts and dating.

Big Cajun Man wants a financial GPS.

This Week’s Racing Video

Rally drivers are bonkers. This short 22 second clip shows one driver jumping half a football field during an event. Holy moly guacamole!

Research or Marketing Gimmick?

Posted by Jim Stark on Feb 2, 2010 | 2 comments

This is a another guest article by Jim Stark. Jim Stark is a pseudonym for a practicing Canadian financial advisor.

So I hopped on to my computer one morning and typed in the phrase “scientific method” into my search engine to see what came up. Click here for the definition that our friends at Wikipedia use. Then read the following:

As far as I can tell, the preponderance of evidence supports the notion that the majority of active products and strategies fail to outperform and that the ones that do cannot be reliably identified in advance. It’s sort of like lottery tickets. The majority of tickets sold are losing tickets and the ones that are actually winners cannot be reliably identified until the winning numbers are called. The obvious rhetorical question that begs asking is: “Should advisors actively encourage their clients to buy lottery tickets?”

To be absolutely clear, everyone (advisors and investors alike) is entirely entitled to do what they personally feel is best. My concern is when people make decisions (and recommendations) without a reliable basis of factual evidence and fail to disclose that lack of reliable evidence. Is the question of appropriateness of approach one of fact or opinion? If it is a question of fact, there is considerable empirical evidence in support of passive products and strategies. If it is a question of opinion, then surely it ought to be disclaimed as such. What I find particularly telling is the notion of full disclosure. Irrespective of how you might personally feel about this conundrum, do you fairly disclose this fact/opinion and bring both alternatives to your clients?

Thanks Jimbo – ’till next time! -Preet

A Lap Of The Blogs

Posted by Preet on Jan 28, 2010 | 5 comments

I’m heading to Atlanta this weekend, but just for Saturday. While it was 17 degrees there today, it will only be 4 degrees while I’m there – bah! Oh well, if anyone has any suggestions on what to do while I’m there let me know – otherwise I’ll just take a tour of the CNN studios and grab a slaw-dog. (I worked in Atlanta for a few weeks back in my racing days, but there was no time to do anything except work and eat slaw-dogs.) :)

From Around The Blogosphere

“Why are we so clueless about the stock market?” is a book reviewed by Thicken My Wallet.

Big Crotchety Man regales us of his misadventures in buying a new (to him) van.

Jonathan Chevreau writes a piece in which the TFSA account is shown to be a superior investment vehicle over the RRSP in some cases.

Rob Carrick discusses your mortgage options: fixed or variable? Yes.

Michael James on Money asks if people WANT to be fooled by car ads.

Four Pillars explains personal finance at Ridgemont High.

Million Dollar Journey explains that we don’t have to give up lattes to save money: there are other ways less painful (to some).

Canadian Capitalist highlights a recent documentary that looks into the world of credit card companies from the inside. Great video.

This Week’s Racing Video

Have you ever thought about strapping a jet engine onto a truck? Neither have I. Enjoy! :) (Email Subscriber: click here to view)

What is an RRSP?

Posted by Preet on Jul 30, 2007 | 0 comments

RRSP stands for ”Registered Retirement Savings Plan”. It is a type of savings or investment account which was designed for Canadians to facilitate retirement savings. It is “Registered” with the Canadian Revenue Agency.

Many people think that they “buy” RRSP’s every year – that the RRSP is the investment. NO – think of an RRSP as an “account”. You can hold a wide variety of investments INSIDE this account so long as they meet the definition of a “qualifying investment” as listed by the CRA (The Canadian Revenue Agency). But don’t worry, almost everything is a qualified investment.

You can of course use non-RRSP accounts to save for retirement, but the reason most Canadians choose the RRSP option are for tax purposes. There are three main tax advantages that exist:

1. Immediate Tax Relief

You can get a refund at tax time if you put money into your RRSP. The government will basically allow you to deduct your RRSP contribution from your total income for the year. Refer to the post on “What is a tax write off?” as this is the same principle. If you were in a 50% marginal tax bracket (for example purposes) then your $10,000 RRSP contribution will give you a $5,000 tax refund (all else being equal – assuming you don’t owe back taxes, and the normal amount of tax is deducted from your paycheque).

2. Tax Sheltering

While your investments remain inside your RRSP they are not subject to tax like your non-RRSP investments – that means that they can grow faster since there is no tax deducted from the value every year. And when your investments grow faster, you have more money when you are ready to retire – perhaps you can even retire earlier…

3. Tax Deferral

You only pay tax on the RRSP funds when you withdraw them. This really is just an extension of tax-sheltering, but you will find it listed as the third tax advantage for RRSP’s. The real reason it is listed as a stand-alone third advantage is that they assume that you are in a lower tax-bracket when you are ready to withdraw the funds. So if you were in a marginal tax bracket of 50% when you put it in, you got half your contribution back in the form of a tax refund. If your income is lower in retirement (usually) then perhaps you are in a 30% tax bracket. So when it comes time to finally pay money on that tax you earned when you were in a 50% tax bracket, they only charge you 30%.

I need to point out that while these tax advantages look very appealing on the surface their are many opponents to RRSP’s out there. Many have argued that your net overall tax bill will actually be higher over the course of your lifetime with RRSP’s versus non-RRSP’s. This debate is VERY complex and I will address it in a future Advanced Level posting. I can tell you that there is no clear divisor and that it really boils down to your personal financial situation – variables such as how much you have saved, how you plan to withdraw it, if you can split income, etc. all come into play.

But for beginners – remember: ANY savings is good savings. If you are just getting started and don’t know what to do, feel confident to start an RRSP account. Once you get more experienced with your finances and do some reading you will be able to determine yourself if you should continue to save to RRSP’s when you get older, or if you should switch to non-RRSP savings for retirement. Many people have both types of accounts.