Dumb Wealth | I did the math

December 4, 2019December 4, 2019

Time to Stop Loving That “Hot” Portfolio Manager

…and by “hot” I’m not referring to looks.

Rather, I’m referring to a portfolio manager who is having a hot streak of outperformance.

The fact is, manager outperformance is not persistent and it is not a predictor of future outperformance. Indeed, most portfolio managers see their hot streak come to an abrupt end within a year. Almost all meet their demise within two years.

The lack of outperformance persistence suggests any hot streak is the result of luck and not skill. Therefore, the active management fees charged by portfolio managers are not worth paying. Investors would be better off using low cost index funds.

This is all based on research performed by Standard and Poors:

For funds categorized as top performers in September 2017, 47% maintained their top-quartile performance the subsequent year. However, there was a dramatic fall in persistence afterward—just 8% of domestic equity funds remained in the top quartile in the three-year period ending September 2019. This result (8%) is consistent with the notion that historical performance is only randomly associated with future performance.

They continue…

An inverse relationship exists between the time horizon length and the ability of top performing funds to maintain their success. Less than 3% of equity funds in all categories maintained their top-quartile status at the end of the five-year measurement period. In fact, no large-cap fund was able to consistently deliver top-quartile performance by the end of the fifth year.

What about poorly performing fourth quartile funds? Could they experience a swing into outperformance territory in subsequent periods? Unfortunately not.

Fourth-quartile funds were most likely to be merged or liquidated across categories over the five-year horizon. This supports the view that underperformance typically precedes a fund’s closure.

Yet another nail in the coffin for active managers and the exorbitant fees they charge. You’re clearly better off ditching that hot portfolio manager for a portfolio of low cost index funds.

December 3, 2019December 3, 2019

Investing Fees Will Leave You Broke During Retirement

If you’ve been paying attention you probably know that investment fees will reduce the value of your retirement portfolio over time.

For example, Questrade argues that by switching to a lower cost investing platform you could retire 30% richer.

All this is true. Essentially, whatever you pay in fees is foregone wealth. I.e. if your annual fees are 2% and your gross return is 8%, your net return is reduced to 6% after fees.

Remember: fees can be layered (often covertly) into your portfolio in multiple ways – advice fees, investment management fees, tax, operating expenses, and so on. Sometimes the fees are bundled, sometimes they’re charged separately. Buyer beware.

Unfortunately, high fees will do much more damage than leave you ‘less well off’ at retirement. High fees could mean the difference between going broke or not.

Check out the following example for Joe Smith retiring at age 65 with a $1,000,000 portfolio. Sounds like plenty of money for retirement, right? Well, the level of fees mean the difference between Joe eating ham sandwiches and cat food for lunch.

Start with the following assumptions for Joe:

Requires a frugal annual income of $40,000, adjusted for inflation
Will live until age 95
Builds a balanced growth portfolio consisting of 80% stocks and 20% bonds
Has a 10% average tax rate

What are the odds Joe goes broke before he dies?

Calculation methodology for the data geeks: Using data made available by https://engaging-data.com/ , the probabilities are calculated by using stock and bond returns between 1871 and 2016. For example, if an investor expects to be live for 50 years in retirement, all historical 50 year periods are analyzed. One historical cycle would be from 1871 to 1922, another one from 1872 to 1923, and so on until 1965 to 2016. Thus 95 different historical cycles are considered (in this example).

The chart below shows the portfolio failure rate, based on historical precedent, for Joe Smith at various fee levels. “Portfolio failure rate” essentially shows how often during the historical periods the portfolio ran out of money before the end of the period (in Joe’s case 30 years).

Investment fees have a significant impact on the portfolio failure rate. In Joe Smith’s case, the portfolio failure rate rises from 18% when the investment management fee is 0.30% to a whopping 42% when the investment management fee is 2.50%.

Hold up…think about what this really means. Imagine what it would be like to run out of money as a senior citizen.

This is a deadly serious issue and a catastrophic failure of the wealth management industry. The average retiree is getting screwed out of their money leaving them completely broke during retirement. This creates massive hardship, as a broke retiree often has no way of recovering and has to rely on the state, charity or family for food and shelter. Dignity and independence, however, are lost forever.

While the difference between 0.30% to 2.50% sounds very wide, this is the realistic range for investors in Canada.

For example, Cambridge Canadian Equity Fund charges an MER of 2.48%. AGF Global Strategic Balanced Fund charges 2.63%. Mackenzie Canadian Growth Balanced Fund charges 2.29%.

Meanwhile, at the other end of the spectrum, Questrade provides all-in portfolio services for 0.38%. Finally, a DIY investor can combine Vanguard’s FTSE Canada All Cap Index ETF, which has a 0.06% fee and Canadian Aggregate Bond Index ETF, which has a 0.09% fee.

Investors who do a little investigating will better understand their costs and be able to shift from one end of the spectrum to the other.

Bottom line: Pay close attention to fees, as this is one of the few parts of investing that is totally within your control. Over the long run it will have a huge impact to your standard of living and independence.

November 27, 2019November 27, 2019

I’m Shocked This Money Myth Still Exists

I’m shocked at how frequently people make this money mistake.

I’m referring to a common misunderstanding of how income tax rates work.

Many people say some variation of the following: “You don’t want a higher income because you’ll jump up into a higher tax rate and end up actually taking home less money after tax.” People have even refused career advancements based on this misconception.

This line of thinking is pure poppycock. Hogwash. It’s a fundamental misunderstanding of how marginal tax rates work.

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I can understand why people make this mistake. After all, marginal tax rates do increase as you earn more income. What people don’t understand is that the higher marginal tax rate ONLY applies to the income earned above certain thresholds.

To help illustrate, here’s a simple example: Let’s say the marginal tax rate on the first $50,000 earned is 20%, and above $50,000 the marginal tax rate jumps to 25%. Based on this tax structure, if you earn $70,000 you pay 20% tax on the first $50,000 and 25% tax on the next $20,000.

What people mistakenly assume is that once (using the above example) they earn above $50,000 they’ll pay 25% tax on everything.

Simply put, regardless of higher marginal tax rates the more income you earn the more you take home after tax.

A Real-Life Example

The four tables at the bottom of this post provide real-life examples of this for residents of each of the ten provinces in Canada. The detailed tables show after tax income, average tax rate, marginal tax rate, etc. on income levels of $50,000, $75,000, $100,000 and $125,000. For the purposes of this exercise, the only column you need to pay attention to is the ‘After-Tax Income’ column.

In case you don’t want to go through each detailed table, I’ve summarized the results for an Ontario resident below. Here are the after tax incomes for all four income levels: