In the book Lifecycle Investing, authors Ian Ayres and Barry Nalebuff propose an investing strategy for diversifying across time that involves all-stock investing with 2:1 leverage while you are young. Many readers would be tempted to quickly dismiss this idea as crazy, but the authors are not crazy and they do a good job of answering (almost) all objections.

Common advice is to think about all of your savings together as a single portfolio. Even if you have multiple accounts, your focus should be on having a sensible overall asset allocation; the allocation within any one account is less important. Ayres and Nalebuff take this a step further to say that you should take into account future savings as well.

So, if you are destined to save $200,000 over the course of your lifetime, and a 50/50 split between stocks and bonds suits you, then ideally you should have $100,000 worth of exposure to stocks and $100,000 exposure to bonds for your entire life. If we treat your future savings as a kind of bond, then your focus should be on maintaining $100,000 exposure to stocks.

The problem is that while you are young and have modest savings, you don’t even have $100,000 in savings. The authors’ answer to this is leverage. However, they recommend limiting the leverage to 2:1 using margin at a brokerage or using deep-in-the-money call options. The authors caution that the interest rate (or implied interest rate) must be low for this strategy to make sense.

By limiting leverage to 2:1, you wouldn’t be achieving $100,000 of exposure to stocks for your whole life, but it would be closer than any other commonly-advised investing strategy. With this approach, your investing life has 3 phases: (1) 2:1 leverage until stock exposure reaches the right level, (2) gradual deleveraging, but still owning no bonds until your portfolio holds more than you need exposed to stocks, and (3) holding a mix of stocks and bonds.

The authors perform many simulations comparing this strategy to more common strategies showing that the lifecycle approach has lower volatility and higher returns due to its superior diversification across time. This is true even when the asset allocations are adjusted so that both approaches have the same overall stock exposure.

The authors give some practical information about how to follow their advice using margin or stock options. They also show how to calculate the implied interest rate on borrowing when using stock options.

Objections

1. Future savings are more stock-like than the authors suggest.

Although the authors point out that if your income is heavily tied to the stock market then early leverage isn’t for you, they portray future savings for most people as more or less bond-like. It is easy for someone of baby boomer age to look back and think that their life’s path was more or less destined to happen. But this is just 20/20 hindsight. A 25-year old can’t know that he or she will have stable employment and be able to save money steadily.

Back in 1990, how many people predicted the demise of Nortel? Yet tens of thousands of people were thrown out of work. Only a tiny fraction quickly found new jobs at the same pay. A much more typical scenario was a 2-year search ending with a new job paying 75% of what Nortel paid.

The authors address this objection partially saying that while total lifetime savings may be uncertain when investors first start out, even conservative estimates mean that 2:1 leverage makes sense to start. As investors age, their lifetime saving picture becomes more clear and it becomes easier to decide when to move to the second and third investing phases. In my opinion, the future is more uncertain than the authors portray it to be.

2. Life events drive many people to spend some or all of their retirement savings before they reach retirement age.

This is the most serious objection. Continuing with the Nortel example, thousands lost their jobs at the same time that stock prices crashed. If these people had been lifecycle investing, their savings would have been decimated at the very time that they needed to withdraw some of it to live on. In effect, lifecycle investing would have forced them to sell almost all of their stocks when prices were lowest.

The authors could counter that lifecycle investing is not suitable for people in volatile careers. However, viewed through the eyes of people in their 20s, almost all future career paths are volatile, even if they don’t realize it. Few Nortel employees in the 1990s would have believed what was waiting for them.

3. People have proven that they cannot handle huge drops in their portfolios.

Most experts advise people to have some bonds in their portfolios to moderate big drops in stock prices. This may be bad for long-term returns, but it stops some people from panicking when stock markets crash.

I recognize that some investors are more able to handle volatility than others, but asking a young person to stay the course in lifecycle investing can be a tall order. Imagine that a young person struggles to save $20,000 and watches it drop to $8000 because of 2:1 leverage and a 30% drop in stock prices. How many people could remain rational in such circumstances? Far too many would sell everything and swear off stocks for life.

Conclusion

The authors’ contention that investors should include a time component in their thinking about diversification makes sense. However, I think Ayres and Nalebuff vastly understate uncertainty about the future. I’m not sure whether this objection is fatal to lifecycle investing. I’d like to see the authors include in their simulations the possibility of having negative savings due to job loss at the same time as the stock market crashes. Until they address this possibility adequately, I can’t recommend that young people follow their lifecycle investing plan.

The dream of many people as they approach retirement age is to derive a safe and steady monthly income from their savings. One fund that seems to fit the bill is the popular BMO Monthly Income Fund that holds nearly $5 billion. However, investors may be in for a nasty surprise.

Let’s start with the positives. This fund has a very nice looking performance chart. Apart from the blip around the end of 2008, it has been on a steady uphill climb. Another great thing is that it has paid a steady monthly distribution of 6 cents per unit per month since the beginning of 2002.

So, what’s not to like? Many people would be surprised to learn that the unit price for this fund has dropped from $9.63 in January 2002 to $7.65 on 2012 March 8. How is this possible? What happened to the nice chart that mostly went up? Well, charts like this assume that distributions are reinvested. If you spend the monthly income, your remaining money does not follow this nice chart. I wonder how many investors mentally double-count the distributions.

What’s worse is that there has been a total of 24% inflation since January of 2002. Overall, the purchasing power of an investment in 2002 has dropped 36%. With the fund yield now at 9.4%, if the distributions stay the same, it is all but certain that investors’ principal will keep dropping at an ever increasing pace. The alternative is to reduce the monthly distributions. Either outcome would be an unwelcome shock to naive investors.

Even though this fund has a respectable 10-year return of 5.58% per year, the monthly distributions have been more than the returns. It is reasonable for people to dip into their principal as they approach end of life, but this should be carefully planned. Naive investors who use this fund from too young an age without understanding the erosion of principal may be in for a shock.

The idea of rebalancing a portfolio to maintain target asset allocation percentages is simple in theory, but tricky in practice. It is not obvious how far asset class percentages should be away from their targets before it makes sense to rebalance. I have developed a scheme that I use myself that I fully automated in a spreadsheet. Instead of obsessing over my portfolio’s returns, I can just check whether one cell is red to indicate that I need to rebalance.

Investors should use any new savings or withdrawals they make as opportunities to rebalance by buying low asset classes or selling high ones. However, as a portfolio grows, rebalancing with new savings and withdrawals is unlikely to be enough to maintain balance when asset classes have big swings.

Common advice is to rebalance a portfolio on a fixed schedule, such as yearly. This has the advantage of allowing investors to avoid obsessing over their portfolios all the time, but has the disadvantage of missing potentially profitable opportunities to rebalance. Computing thresholds automatically in a spreadsheet permits me to check one cell in the spreadsheet for a glowing red “rebalance” once or twice per week without having to look at anything else. This gives me the advantages of threshold rebalancing without the disadvantages.

When choosing rebalancing thresholds, most experts advise investors to either use percentage thresholds or dollar amount thresholds. For example, you might rebalance whenever you’re off target by more than 5%, or alternatively by more than $2000. However, these approaches don’t work for all portfolio sizes. Percentage thresholds lead to pointless rebalancing in small portfolio, and dollar amount thresholds lead to hourly trading in very large portfolios. We need something between these two approaches.

Computing Thresholds

When asset class A rises relative to asset class B, and then A drops back down again to the original level relative to B, rebalancing produces a profit over just holding. I compute rebalancing thresholds based on the idea that the expected profit from rebalancing should be 20 times the ETF trading costs.

All the mathematical details of how I compute rebalancing thresholds are in a 6-page paper “Portfolio Rebalancing Strategy”. I’ll just give the results here.

The spreadsheet starts by computing the following quantities for each ETF:

m – Current portfolio total value times the target allocation percentage. This is the target dollar amount for this ETF.
s – Bid-ask spread divided by the ETF share price.

Other parameters are

c – Trading commission.
f – Desired ratio of trading costs to expected profits. I use 0.05 so that the expected profits from rebalancing are 20 times the trading costs.

The dollar amount threshold for rebalancing then works out to the following formula which may seem a little intimidating, but it only has to go into a spreadsheet once.

t = [m/(2f)] * [s + sqrt(s*s + 8*f*c/m)].

So, it makes sense to rebalance an asset class if its dollar level is below m-t or above m+t. As long as there are at least two asset classes far enough out of balance (with at least one too high and at least one too low), it makes sense to rebalance.

Currency Conversion

When holding some ETFs denominated in Canadian dollars and others in U.S. dollars, rebalancing may involve currency conversion, which can be expensive. To deal with this, I actually think of the Canadian and U.S. portfolios as separate portfolios with their own asset allocations. Then I think of the sub-portfolios as asset classes in a meta-portfolio that has its own asset allocation.

So, I do the same calculations on the meta-portfolio using target allocation to each currency. An important difference is that he meta-portfolio has higher trading costs than the sub-portfolios have. When using the idea of converting currency by buying and selling a stock that trades in both Canadian and U.S. dollars, rebalancing requires at least twice as many trades, and the total spreads have to include the spreads on trading the inter-listed stock.

So, instead of c=$10 for regular rebalancing, I use c=$20 for currency rebalancing, and instead of a value close to s=0.0005 (2-cent spread on a $40 ETF), I use s=0.002 for rebalancing with the ETF DLR because the spreads are about 2 cents on a DLR price of about $10. The result is that rebalancing between currencies happens less often than rebalancing in the sub-portfolios.

Conclusion

It took me a while to work all this out, but now I don’t have to pay much attention to my portfolio. When I have some money to add, I buy the asset class that my spreadsheet says is furthest below its allocation, and I periodically check one of the cells for the word “rebalance” glowing in red. Only when I see red do I have to investigate further and make some rebalancing trades.

My own spreadsheet is too specific to my situation, but if there is interest I may put together a generic spreadsheet that captures the ideas here.

A guest post at Where Does All My Money Go? described a strategy for selling your home where you offer a low price in an attempt to create a bidding war. This type of strategy may or may not help the homeowner get a better price, but it will definitely help the real estate agent.

In a nutshell, the strategy is to price a home at the bottom end of a reasonable price range and advise buyers that all offers will be reviewed on a particular day less than a week away. The hope is to generate a lot of interest quickly and create a bidding war that takes the price up to the top end of the price range. Note that this is likely to create a fast sale.

Real estate agents benefit most from fast sales rather than higher selling prices. Higher selling prices increase commissions a little, but faster sales lead to more sales and this helps agents a lot.

In almost all scenarios, this low-ball strategy helps the agent. If it works as planned, the house is sold quickly, and both seller and agent win. If only one offer comes in at the asked-for price, the seller must either accept the low offer or pay the agent’s commission. Either way, the agent gets paid. If no offers come in, then there wouldn’t have been any offers at a higher price anyway, and the agent can focus efforts on new opportunities instead of wasting much more time on this house.

Some might argue that agents would only try this if it is in the best interests of the seller. For this to be true, the agent has to be both competent and honest. I’m sure this is true in some cases, and I’m also sure that it is false in some cases. Overall, I would be very wary if a real estate agent suggested this strategy to me.

Canada Mortgage News warns of banks making no-so-great offers to mortgage clients trying to get them to renew their mortgages early. Calling them “banksters” cracked me up.

Larry Swedroe says that tactical asset allocation (TAA) is a rip-off. What do you really think, Larry? Swedroe says that TAA is just another name for market timing and the evidence shows that it hasn’t worked. What he missed is that “tactical asset allocation” sounds smart and it makes investors feel superior when they use it – as long as they don’t compare their returns to an appropriate benchmark.

Steadyhand’s Tom Bradley illustrates what’s wrong with CEO compensation. I’m glad I just sold the last Canadian bank shares I own (except for those included in VCE and XIU).

Rob Carrick makes a strong case that buying a nice house can mess up your retirement.

Canadian Couch Potato has some fun recommending a coma as the best state to invest in.

Big Cajun Man rants about people paying exorbitant interest rates to get instant tax refunds.

The Blunt Bean Counter says that there really aren’t any advanced tax planning strategies available to most Canadians.

Preet Banerjee says that good drivers are still subsidizing car insurance for bad drivers. His description of tracking devices in cars to measure the safety of your driving creeps me out, though.

Canadian Capitalist describes the process for making a claim against your credit card purchase insurance.

Million Dollar Journey explains testamentary trusts.

A while back Canadian Capitalist described a “foolproof method to convert Canadian dollars to U.S. dollars” using a version of the so-called Norbert Gambit. This involves buying the exchange-traded fund DLR with Canadian dollars, journaling it over to the U.S. dollar side of your account to make it DLR.U, and selling it to get U.S. dollars. I decided to try this at BMO Investorline. Overall it worked, but there were a few surprises along the way.

Note that each unit of DLR just holds US$10. This is true whether it is DLR or DLR.U. The difference is that DLR trades in Canadian dollars and fluctuates with the exchange rate, and DLR.U trades in U.S. dollars.

I don’t normally like to talk numbers about my personal accounts, so for the rest of this article, I’ll scale all the numbers down as though I was converting C$100,000 to U.S. dollars.

The bid-ask spread on DLR was C$9.79 to C$9.81. I placed an order to buy 10,100 units of DLR at a limit of C$9.81. This trade was filled at C$9.81 almost immediately. I then called Investorline to see whether I would have to wait until the trade settles in 3 days to complete the currency conversion. This is where things deviated from Canadian Capitalist’s recipe.

The Investorline representative told me that their online systems can’t handle selling DLR in U.S. dollars, but that he could do it for me over the phone for the online commission of $9.95. He also said that I didn’t have to wait the 3 days; he could do the trade immediately.

Curiously, the spread was US$9.95 to US$9.97. I’m not sure why this makes any sense when each unit is worth US$10, but at US$9.95, I was getting an implied conversion rate of 9.81/9.95 = 0.9859, which was quite close to the fair exchange rate at that time of 0.9852. So I had the representative place a limit order to sell my DLR.U at US$9.95, which was filled almost immediately at US$9.95.

After the transaction was complete, the representative told me that my implied currency-conversion rate was 13 basis points (0.13%) better than the “market rate,” which I took to mean that if I had called to ask Investorline to do the currency conversion without using the Norbert Gambit, I would have received a rate of 0.9872. This is only about 0.20% off the fair exchange rate.

It seems that you get a better rate when calling a representative than you get when converting currency online. I checked the Investorline online rates for converting $100,000, and the spread is 1.2%, or 0.6% lost for each conversion. This is a lot worse than the 0.2% cost that the representative could have given me. On $100,000, the difference is $400 for each conversion.

I found a minor glitch after the representative sold DLR.U for me: my account continued to show that I had DLR, but also showed that I had U.S. dollars from the sale. So my overall account balance shown was high by about $100,000. This was corrected the next day.

One thing that makes me nervous is that after a week my account continues to show a long position in DLR and a short position in DLR.U. The representative led me to believe that the sale of DLR.U would consume the DLR units and not create a new short position. This whole exercise won’t achieve the goal of reducing the cost of currency conversions if I have to pay margin interest. So far they haven’t tried to charge me any interest.

My complete list of transactions was to sell Canadian shares, buy DLR, sell DLR.U, and buy U.S. shares. I was able to do this all in one day and save on currency conversion costs. What could make it better would be allowing me to do the DLR.U sale without having to make a phone call. Even better would be to tighten the currency conversion spreads to make the Norbert Gambit unnecessary.

This whole area of currency conversion seems quite murky to me. The costs are not at all transparent. Doing transactions with large amounts of cash makes me nervous, but I’m reasonably confident that I paid significantly less than the default cost of $600 if I had gone the easier route.

Many of us would be thrilled to be able to retire from our regular 9-to-5 jobs long before the standard retirement age of 65. There is a vibrant community of people dedicated to finding a way to retire when still quite young. However, most of the early retirement enthusiasts have plans without a large enough safety margin to suit me.

One blog dedicated to early retirement is Canadian Dream Free at 45 (http://blog.canadian-dream-free-at-45.com/) run by Tim Stobbs. Stobbs has a detailed plan to retire at age 45 on savings of $1.1 million. He and his wife plan to live on $2000/month, which sounds low, but they “both plan to do some work on the side after pulling the plug to fund some luxury items and trips.”

Most readers of this blog who plan to retire early and have described their financial plans online expect to have roughly the same low spending levels as Stobbs, seemingly without the plan to work on the side. In general, these plans look quite realistic as long as these people are able to keep their costs down to the planned levels.

I definitely understand the desire to leave the rat race and enjoy life. For several years I did consulting work that paid sporadically and gave me tremendous freedom. However, even though I have a larger net worth right now than most of those planning early retirement expect to have when they retire, I continue to work.

This is in part because I enjoy the type of work I do, but it is also because I’m quite conservative about my possible future spending needs. I had been thinking in terms of being able to spend $5000/month (after taxes). When I was young I lived extremely frugally, and I know I could do this again, but I don’t think I want to. There is also the possibility of age-related health issues leading to increased spending.

Some time ago I made a projection based on conservative spending needs and conservative investment returns, and I found that there was a risk that if I retired immediately, I might run out of money some time in my early 70s. I have very marketable skills right now, but I doubt that employers would be as interested when I’m over 70.

So, while I wish the early retirement crowd the best of luck with their dreams to amass the lump sum they think will allow them to retire permanently, I will work toward a larger lump sum.

Many commentators preach the benefits of choosing an asset allocation strategy, sticking with it, and rebalancing regularly. This is good advice, but some investors overestimate the benefits of portfolio rebalancing. If done properly it can certainly increase returns, but the gains are usually quite modest.

Consider the following example. Emily starts with a balanced portfolio worth $22,000, half in a stock ETF and half in a bond ETF. Initially, both ETFs trade for $50. Emily’s starting portfolio looks like this:

Stocks: 220 shares @ $50
Bonds: 220 shares @ $50

Now, suppose the stock ETF goes up 10% and then comes back down again. If Emily does nothing, her final portfolio value will be $22,000, the same as it was at the start. But, if she rebalances, she will make some money. Let’s see how much she can make (ignoring commissions and spreads for now).

After the stock ETF has gone up 10%, Emily’s portfolio looks like this:

Stocks: 220 shares @ $55
Bonds: 220 shares @ $50

To rebalance, Emily sells 10 shares of stock and uses the resulting money to buy 11 shares of bonds. Her portfolio is then balanced again with $11,550 in both stocks and bonds:

Stocks: 210 shares @ $55
Bonds: 231 shares @ $50

Then stocks drop back to $50 and Emily’s portfolio is now

Stocks: 210 shares @ $50
Bonds: 231 shares @ $50

Her total portfolio value is now $22,050. She has made $50 from rebalancing. This is a gain of only 0.23%. She’s happy to take this money, but it’s not a huge gain. And in reality, she will lose most of this to trading commissions and the bid-ask spreads.

The moral here is that rebalancing is useful, but it cannot make up for differences in the expected returns of different asset classes. If you choose to own different asset classes to reduce your portfolio volatility, this can be a sensible choice, but don’t think that rebalancing can make up for big differences in the expected returns from different asset classes.