Earning, Saving, Spending, Investing: Toward a Common Goal

Have enough for today's necessities and save for retirement's necessities. Those are the basic personal financial goals, and while "necessities" is wide open for interpretation, the exact definition is not essential for this discussion. I'll define it as things required for a physically and mentally healthy life.

Earning, Saving, Spending, and Investing money are all contributors (that you have some control over) to your financial situation. They are all related, and it is worth looking at each one.

Commonly when we talk about saving money, we talk about not spending. Not buying unnecessary things is a great way to keep your money for other things later in life. But it's not the only way.

Earnings: It's a time consuming process to increase your earnings. You can re-train for a different job, earn a raise, or do extra work on the side. It must be earned and involves work, so most people will not pursue this avenue after finishing school, but achieving this will put you in a better financial position that will likely stick for the rest of your career. Note that increasing your earnings does not mean an increase the cost of your necessities.

Investing: Is related to saving. What do you do with the money you save? Investing idle cash is a smart move. Learn how to do it properly!

Spending: Spending smartly makes sense. Realize that although advertising can be funny, entertaining, and/or carry a meaningful message, the real goal is to push your buttons and convince you to part with your cash. Learn how to make smart decisions on what products you buy. Consider the price, the relative quality (diminishing returns is probably in effect), and the cost versus how much you will actually use the product. Too many times, we convince ourselves to buy something based on how much it can potentially do instead of thinking about how we will actually end up using it.

Suggested Schedule For Lazy Investing

There are many blogs, news outlets, and advice channels providing the average Joe with a constant stream of financial news, opinions, and noise. What is a good way for a normal person to deal with all this information?

As horrible as it may sound, I would recommend that anyone who is serious about managing his own investments start by ignoring it all until he understands the subject matter. If you take the matter seriously, you can educate yourself quite thoroughly in 6 months to a year. Maybe that sounds like a long time, but it's a huge money-saver if your alternative is to pay someone 1% of your assets to manage your investments for the next 30+ years of your life.

How do you know that you've gotten to a point where you understand your investments? A test is to ask yourself whether you understand how a product is priced, what different parts make up the cost of owning that product, who issues the product and why, how liquid is it, what are the risk factors and how risky is it compared to other products, what is the expected return, what do you actually own, how can the product be taken away from you other than your selling it?

Understanding your investments is one part of freeing yourself from the constant barrage of questionable financial advice. Have a scan through some financial articles. You will find them peppered with non-committal words like "could", "maybe", and "looks like" with regards to current events. This is not really a knock against the articles themselves, since nobody knows for sure how things will pan out. However, once you understand your investments, you will be able to read these articles as opinion pieces instead of concrete tips.

Next, learn about investing history. Learn about the mass hysteria that has gripped investors in the past. Most people don't bother to learn about history and we find ourselves getting tripped up by similar problems later on. Our memories are so short that we even manage to crash the markets twice in the same lifetime.

[The above two points are very well covered and expanded upon in William Bernstein's book, "The Four Pillars of Investing". His four pillars are:

1. Theory of Investing
2. History of investing (how did people handle things before)
3. Behaviour of Investing (how your can emotions ruin your chance for success)
4. Business of Investing (how the mutual fund / brokerage / middleman industry bleeds you dry).]

Read books that are based on scientific research. "Educating" yourself by reading about hot investing methods that have no repeatable success is a waste of time.

So you understand investment products, you know how the markets can act, and you know how you should behave. Now is the time to form a plan. Spend some time to make it a good plan based on your researched knowledge, and then implement your plan. Just as it's not a good idea to invest without a plan that you understand, it's also not worth it to hold off executing a good plan because you are searching for the perfect one. Except in hindsight, there is no perfect plan.

You now have a plan, probably for your retirement that is many years away. If you've done a good job educating yourself, and you have confidence in your plan, you're free to let your plan run. If you want to continue learning more, by all means go ahead. If you like reading blogs and keeping up with the news, you now know enough to separate the good stuff from the noise. Tweak your plan every 6 or 12 months, and use the rest of your time to do something that will bring you better returns in some other area of your life.

Expert Opinions and Market Timing

Research into investor performance has shown quite convincingly that for the average investor, market timing does not work. I don't think that this statement is so controversial that I should spend time providing supporting information on this blog. (Search engines will provide plenty of reading on the topic.)

If this is such a well-known fact, why do we so enthusiastically consume speculative commentary on the markets? Or rather, why do we believe that we can make the jump from "expert speculation" to successfully timed investment?

The field of behavioural finance strives to answer questions like these with a scientific approach. On an individual level, we can also perform a thought exercise to find our personal stumbling blocks. Here's my list. I encourage you to think about your own, and share them in the comments.

In no particular order:

1. It's comforting to believe that someone has an expert handle on this stuff. In many parts of our lives, we make use of products and services that we do not fully understand. In many ways this requires a leap of faith. For instance, that cell phones are safe and are not causing us brain tumors, that the formula we feed our babies is a good substitute for breastmilk, or perhaps that the water filter we just bought makes the water more fit for drinking (how many people know what those filters actually do?). We assume that somewhere along the way, some experts have proved that the products we use do what they say the do (and don't do anything else). In financial matters, where are our experts, and where is their proof?
2. We're all above average (the Lake Wobegon Effect). Since I'm smarter than the average person, I can make use of information to formulate and execute a superior plan.
3. Spectacular stories of people who have made it big. Is it luck? Is it skill? I don't know, but every once in a while, we'll hear about someone who bet it all and made a fortune. We all want to be that person.
4. Market timing is fun and exciting. Feel the thrill of a money-making trade! Quickly forget the rest.
   
5. Not tracking personal portfolio after-tax performance against a representative benchmark. You might think that you did a great job earning a 10% return, but if your benchmark (not a benchmark of your choosing, but a representative benchmark) returned 12%, you actually did poorly.
6. Lack of understanding of the investment products. Sure, you could read about bonds, stocks and other investment instruments so that you could judge investments for yourself, but isn't it easier to just take the recommendations of experts? They're experts, after all.
7. We don't know the track record of experts' opinions. This is a complicated issue:
1. We need to separate a commentator's own advertised performance (maybe through the fund he/she manages) from the performance of the expert's recommendations that we hear or read about.
2. The "experts" may make frequent recommendations. Make enough guesses frequently enough and you'll eventually get it right. Maybe we should count each recommendation as a buy or sell execution in our tracking system.
3. Recommendations on an investment does not make a portfolio. Did Mr. Expert recommend buying ABC 5 years ago? Has he said anything about it since then for those who added it to their portfolio? Maybe your expert concentrates only on tech stocks and consequently a portfolio of his recommendations would be unbalanced.
   
4. No indication of investment horizon. This is linked to (b) and (c) above. Maybe you buy something based on a recommendation. How long is that recommendation supposed to stand for? Maybe a new recommendation (based on better information, of course) will be made soon (b). Or perhaps your expert will become bored with that particular security and you'll never hear about it again (c).
   
5. There are lots of other issues I invite you to think about, but the point is that until we have a good way of tracking the experts' opinions, we don't have a basis for taking their recommendations.
   

When it's so easy to make very close to benchmark earnings, and study after study shows that the average investor is making less than that, it is really an interesting exercise to think about your own situation and decide how average you want to be.

BMO ETFs Have Started Trading

Four ETFs from BMO started trading on June 4, 2009. Descriptions directly from the press release:

• BMO Canadian Government Bond Index ETF (BGB) has been designed to replicate, to the extent possible, the performance of the Citigroup Canadian Government Bond Index.
• BMO Dow Jones Canada Titans 60 Index ETF (BCA) has been designed to replicate, to the extent possible, the performance of the Dow Jones Canada Titans 60 Index.
• BMO US Equity Index ETF (BUE) has been designed to replicate, to the extent possible, the performance of the Dow Jones U.S. Large-Cap Index (CAD hedged).
• BMO Dow Jones Diamonds^SM Index ETF (BDJ) has been designed to replicate, to the extent possible, the performance of the Dow Jones Industrial Average (CAD hedged).

BUE and BDJ both hedge exposure to the USD. The MERs for the funds are pretty low, undercutting iShares funds. Here's a comparison vs comparable iShares offerings:

Ticker	MER	# Holdings	Comments
BGB	0.341	28	Weighted Avg Duration 6.49; All Federal holdings; All AAA rated
XGB	0.35	86	Weighted Avg Duration 6.34; 63% federal, 34% provincial, 2% municipal; 68% AAA, 19% AA, 12% A
BCA	0.158	61
XIU	0.17	60
BUE	0.231	250
XSP	0.24	501	Invests in IVV, which has 501 holdings
BDJ	0.242	31	No iShares equivalent

BMO also plans to launch 3 other ETFs at a later date covering International Equities, Emerging Markets, and Global Infrastructure.

There isn't that much to say after only a couple of days of trading, but I will keep my eyes on these ETFs. There are only a few ETF sponsors in Canada, and before these BMO ETFs started trading, iShares was the only one tracking traditional market-cap indices. Here's hoping some competition gives rise to better (and lower cost) products.

Bond Investing

For the bond portion of my portfolio, I prefer to use short term bonds and the DEX Short Term Bond Index is probably the closest index to my bond strategy. In Canada, iShares' XSB is the best single ETF tracking the DEX Short Term Bond Index.

However, it still irks me to pay ongoing MERs on bonds when I could buy them individually and just hold them. I also don't like that bond funds' NAVs fluctuate such that it is quite possible to lose money holding bonds through a fund. Bond funds do, however provide the kind of diversification that is not really possible for anyone with less than $500,000 (or some big number like that) to invest.

Lately I've been thinking about how to solve this little problem, and I think I'll try it this way: Government bonds do not really require the diversification that corporate bond holdings do. There is only one issuer of Canada bonds, and only a handful of Provincial issuers. So for government bonds, it is easier to buy individual bonds without worrying so much about diversification.

Thus, appeal of something like iShares' XSB (MER 0.25%) is the diversified holding of corporate bonds. Looking at the iShares offerings, there isn't anything especially appealing for corporate bonds. XCB (MER 0.40%) has a duration that is a bit too long for my liking. Looking over at the Claymore offerings, though, we find the 1-5 Yr Laddered Corporate Bond ETF, CBO (MER 0.25%). CBO is fairly new, but trading volume is not bad for a Claymore fund. I do like that Claymore is offering DRIPs on all their funds now, so that is another plus for CBO.

CBO seems to hold about 70% A-rated bonds, and 30% AA bonds. The number of holdings is somewhat low, at 25, but 25 is also more than I would be able to buy on my own. The duration of the fund is 2.65, which I like. On the down side, there is no getting away from the possibility of losing money in the fund since its value fluctuates, but I think the diversification makes up for it as a corporate bond fund.

So in effect, my short term bonds will be split into government and corporate holdings. Asset allocators will probably like the opportunities to rebalance that this will allow for. There is only one ETF involved, so only one set of transaction fees are incurred when buying or selling. On the down side, when buying bonds from a brokerage, you don't really have a good idea what commissions are being charged. However, in Hank Cunningham's 2nd edition of In Your Best Interest, he investigated the bigger discount brokerages and found that TDW and BMO Investorline were the best for prices and in general found that discount brokerages were charging reasonable commissions on bonds.

The pros and cons of this approach:
Pros:

• Lower overall MER paid.
• Government bond component can be held to maturity.
• More control over allocations to government vs corporate bonds.
  

Cons:

• Overall less diversification than XSB.
• CBO has less diversification than XCB for the corporate component.
• A bit of a hassle to maintain the ladder of government bonds.
  

Preparing To Invest: Read Some Books!

For many of us, the web has become an important learning tool. Search engines have made it wonderfully easy to find information on specific topics. But to me, the web, with no promise that content has been edited or is correct and complete, is not a great tool for getting comprehensive information on broad topics, which is exactly what you want as you prepare to invest.

There is also the question of how the site stays in business. For most, it means selling advertising, which raises issues of conflict of interest. For instance, can I trust a review of credit cards to be fair if the site also runs ads for certain credit card companies? How do I know that a comparison of brokerages is not biased when I see ads for banks running on the site?

The use of hyperlinks on web sites, while at the very core of what makes the web great, means that users can read about whatever pages they like on a site. But it also means that they will probably read only what they like. So structuring information on a broad topic is very difficult.

Newspapers and magazines have similar issues, and also need to constantly generate new content. It does not matter if there are not any new and useful ideas to write about--staying in business for them means writing new articles.

There are plenty of other learning methods, each with their own issues, like learning from chats with friends, or from TV.

To me, the best learning tools are books. Here's why I think so:

• Content is structured: Unless this book was written and edited carelessly, the content is presented in a logical progression. Focus is given to points that are important in the context of the broader topic. Articles on the web and in magazines and newspapers lose this context.
  
• Content is comprehensive: To many people, investing means buying stocks. I'm always surprised by how many people do not understand or consider bonds or other asset classes like real estate. A good investing book will teach you about the different asset classes and how they may (or may not) fit into your portfolio. Articles from other sources mainly focus on one point (usually stocks) and are not as able as books to present information in the context of the full spectrum of investing options.
  
• Once the book is in your hands, the sale is complete. Unless you've picked up a book that is trying to sell you another product, the content is not as influenced by advertisers.

To be sure, there are some books out there that are real stinkers--books written to evangelize the latest mania, to sell another product, short-sighted books, and just plain bad advice books. But all these problems also exist in the pages of non-books, without the positive points that books enjoy.

There is still a place for non-books, especially for doing quick research into specific topics or getting the beat of current trends. But while you are building a foundation of knowledge as you prepare to invest, go read some books!

More Increases To Vanguard ETF Expense Ratios

It looks like the expense ratios on many of Vanguard's ETFs have changed recently. It wasn't that long ago that the expense ratio for VWO was raised by 0.02%.

Some other Vanguard ETFs of interest to Canadians have changed in the last few weeks:

• Vanguard's Total Stock Market ETF (VTI) has raised its expense ratio from 0.07% to 0.09% as of 04/29/2009.
• The expense ratio for the Vanguard Europe Pacific ETF (VEA) was raised from 0.15% to 0.16% on 04/24/2009
• All of their bond ETFs now have an expense ratio of 0.14%

Vanguard's expense ratios are still very low, but I hope this trend doesn't continue.