14. Other General Finance Stuff

You can't save anything otherwise.

This should be an obvious principle, but doesn't seem to be followed very well.

Corollaries would include:

• Don't spend all of your raise; save some of it.

• Don't spend all of your bonus; save some of it.

Credit card finance charges are higher than interest rates on virtually any other form of credit, and are almost never tax deductible. Paying off credit card balances is typically the best investment that you can possibly make of your investment dollars.

$1000 put away today tax-free at 10 is worth as much as $2600 put away ten years from now.

"Beating the market" is hard; smart people try to do it and fail.

Life is a lot simpler if you merely expect to participate in broad creation of wealth. This favors index-based investments. You won't get richer than average, except for the important point that if you're doing everything else right (spending less than you make, saving regularly and making sure you do get decent returns on investments) you'll already be doing a whole lot better than average.

Market index funds typically have lower administration fees than other kinds of mutual funds, and are quite attractive diversification mechanisms.

If you have made good choices up to here, but then throw it into one ill-advised investment, all the disciplined savings in the world can disappear with one ill-timed event. No single investment option should contain enough of your resources to reduce you to penury should it fail.

My mother is paranoid about investing because she has friends who have a history of making unfortunate investment decisions that broke this "discipline."

• If all you own is a house, then you're vulnerable to downturns in the real estate market. Contrary to popular claims, real estate values can go down.

• If all your investments are in bonds, then you're vulnerable to increases in interest rates; that will make your investments' values fall.

• If all your investments are in the corporate stock purchase plan, then you're exposed twice over to any changes in your employer's fortunes.

• In general, be aware of the risks associated with any investment.

  All investments involve some sort of risk, even government-guaranteed bonds with payment terms engraved in stone. (Holders of British "Perpetuity" bonds complained bitterly when interest rates rose, and their bonds dropped significantly in value despite the fact that nobody was proposing any sort of forfeiture.)

  More commonly and more importantly, "sure thing" investments involve massive risks that the promoter certainly does not wish to tell you about.

• If you have enough value in your portfolio, it is highly desirable to find ways to not blow most of your returns on administration fees. It is not uncommon for Canadian mutual funds investing in stocks to have MER rates of on the order of 2%, which means that:

  • They take 2% of your total investment, each year!

  • If average earnings on the fund are 8%, then they're chewing out, like termites, something like 25% of your earnings.

  If you only have a few thousand dollars, there's not much alternative to this, of course, "only a few thousand dollars" won't go terribly far at retirement time...

  Here are some possible alternatives:

  • Purchasing stock, and holding it for a long time, means that you only incur commission fees at the start and at the end. You certainly won't have a diverse portfolio if you have only $5000 to work with, but if you have $15000, spending about $1500 per stock will provide some diversity.

    Once you have about $15K invested, buying stocks for the long term is a worthwhile mechanism. Buying $1500 worth of something new each year will add up over a period of time.

  • Index Funds ought to be an attractive way of getting an already-automatically-diverse investment platform.

    They generally invest a portion of the money in index futures, which provides something highly variable that tracks the index, and spend on the order of 80% of the funds on bonds. Even with the need to regularly rebalance the futures portfolio, commission costs may be expected to be way less than for mutual funds that invest in stocks.

    Unfortunately, there isn't a decent selection of them in Canada; apparently we haven't a diverse enough set of indexes...

  • An Inside Look At ETF Construction

    ETFs, Exchange Traded Funds, are an interesting alternative to mutual funds. They generally have very low MERs, on the order of 0.25%, rather than 2%, with the downside that you pay an trading commission at both the time of purchase and of sale.

    They are attractive alternatives to mutual funds as long as you hold them for several years.

    Unfortunately, the number of ETFs has ballooned, and some have emerged that invest in index and such derivatives so as to dramatically increase exposure to the risks of particular sectors. It's not necessarily bad to buy a little of that sort of thing, but betting a lot on such means accepting a pile of risk that you mightn't have expected.

  • When to Dump Your Index Fund [Fool.com: Commentary] June 20, 2006

    The answer is, "when there's some alternative fund with equal return characteristics that has lower management fees." Pointedly, there are mutual funds that invest in ETFs; it's downright stupid to pay the fund a MER on top of the ETF MER when you could invest in ETFs directly, avoiding the fees...

Use tax sheltered savings plans such as (USA) IRAs, 401(k), or (Canada) RRSP as extensively as possible to further compound savings rates. 401(k) plans often provide employer contributions, thus adding to your savings.

Not only do you want to avoid the tax man; mutual funds with hefty administration fees can also, over time, eat up most of your gains. The not uncommon 2 percent administration fees will, over 30 years, transfer half of your wealth accumulation to the fund managers.

From this it is manifestly obvious that mutual fund administration is a massive money-maker for those that run the funds. On a $1B fund, the managers receive on the order of $20M per year regardless of whether the fund made money or not. (This may suggest, to the truly devious reader, that investing in mutual fund administration is a neat idea!)

Once your portfolio reaches a reasonable size, probably something on the order of $20,000 or so, it may (repeat: may) be a better strategy to invest $2000 apiece directly in ten securities, thus only paying commissions at beginning and end of the process, than to buy a mutual fund that charges a 2 per annum management fee.

Assuming that the $20,000 grows to $40,000 over ten years in both cases, the mutual fund would charge approximately $30,000 x 10 x 2 or $6000 in administrative charges, consuming nearly a third of the profits.

Holding the stock yourself, thus creating your own little "mutual fund," you would pay only for commissions on 20 trades, which at the not-uncommon rate of $50, would add up to the much lesser amount of $1,000.

In effect, owning the stocks yourself kept $5,000 in your pocket. And selection of stocks isn't too difficult; just select 10 securities across various industry lines that are commonly held by credible mutual funds.

My personal portfolio presently includes. as a major component, about 9 stocks, taking this approach. As time-based investments expire (there are some bond-like instruments as well as mutual funds), I am gradually moving more of my portfolio into stocks and index-based funds, thus avoiding significant amounts of administration fees.

Venture capital funds that invest in small companies that are riskier ventures and international funds are complex for an individual to manage, and it probably necessary for a small investor to pay someone else to do so. Just be aware that administration fees for these funds tend to be rather high.

Always keep in mind that the people that push mutual funds the hardest are salescritters that probably receive commissions from the deal. Index-based funds are among the cheapest to run, and correspondingly tend to have low management fees.

When the car salesman calls anything about a car an "investment," beware, because at that precise moment, he or she is trying to mislead you.

Paying an extra $5000 today so that the car is worth an extra $3000 three years from now costs you at least $2000, and probably considerably more, particularly if finance charges must be added to that. That same $5000 would grow to close to $7000 in three years if invested in a money-making investment; watching it instead fall to $3000 as an investment is simply foolish.

The amounts that should be compared are the post-tax cash flows. Anything other than that leads to analytical garbage that confuses rather than illuminating.

A corollary to this is that doing a correct analysis of financial "transactions" is a nontrivial task. It requires getting quite a lot of details right.

DUA does encourage good discipline in saving, which is valuable.

But the notion that it reduces the cost of investment just doesn't make sense. Proponents always show examples where DUA reduces costs; there are always equal and opposite situations where it will cost more.

The only way that it might be expected to be beneficial is in that regular investing gradually injects capital into the capital markets, thereby meaning that there aren't the sudden shocks of larger amounts going in all at once. But there is a big fallacy in that: capital markets might have trouble coping with a "larger amount" if that "larger amount" was a few billion dollars. But for your couple hundred dollars, there's no "shock."

There is one reason to expect DUA to have a negative effect, and that relates to the handling of commissions. Commissions on stock trades don't substantially grow as the size of the transaction grows, so that if trades are smaller and more frequent, you might expect to pay more in commissions.