Blessed by the Potato

I’ve been trying to write this post for a long while, and will likely end up writing several iterations, so bear with me. Basically, I’m caught on the edge of active (value) investing vs passive (index) investing.

There are a lot of good criticisms of active investing out there, which strongly suggest that even if it is possible, it is not easy to beat the market. I was hoping I’d get a chance to read the Quest for Alpha before this post, but I don’t know when I’ll find the time, and I can always change my mind in the future (which is fodder for a second post!). Anyway, one of the things that sticks with me in the active vs passive debate is that much of the evidence against active investing comes from looking at actively managed mutual funds, which fail to out-perform their indexes net of fees to a ridiculous extent. A common (and useful) trope is that mutual fund managers are professionals who eat drink and breathe the markets, so if they can’t out-perform, then what hope do you have? However, that raises the question of whether actively managed mutual funds are the same as actively managing your own portfolio, and I think that there are key differences.

So we know then from all the studies at the very least not to invest like a mutual fund. What are some of their characteristics? High turnover. Being forced to hoard cash at market bottoms to fund redemptions. Chasing performance. Short-term (yearly or even quarterly) outlook. Avoidance of portfolios that are radically different than the index (there’s no point in being a closet indexer unless you have ridiculously low costs — just index). A focus on large, liquid companies. Window-dressing with hot companies.

Another, disciplined, approach might work then. Indeed, there are some investors out there who have consistently beaten the indexes which suggests to me it is possible to do so. I’m a numbers guy and not a people person, so I figure I have a much better chance of being one of the few investors that can beat the market than finding one who’ll manage my money for me. Though I have to endorse Michael James’ view that most people will not be able to do either, so the best option may be to not even try.

Theory aside, how have I actually done as an active investor? The first two years: not bad. I was down in a down market, but less than my benchmark indexes. Then the market came raging back, and so did I — again, a little bit better than the market, but nothing really to brag about. Then in 2010 the market had a decent year, and I had a blow-out one, nearly tripling the market return, though much of that was admittedly luck. All the while I was sticking to my principles: low turnover (~3-4 year portfolio turnover) and low costs (I figured my trading costs were around 30-40 bp, very comparable to index funds — partly a function of concentration, but mostly of a lack of trading). But then 2011 came along.

I’ve made a lot of mistakes in investing this year: TRE, TEPCO, YLO being some of the worst, but I had a few moments of stubbornness and what can only be described as idiocy (one particularly bad case of anchoring). I also had some real under-performers that I don’t yet know how to classify (IDG, SPB, NFI). If you had asked me in the summer, I would have estimated my “alpha” at something like -15% this year — it was looking so bad CC quipped “is there a pooch you don’t own?”. To be sure, I made mistakes in 2009 and 2010 too, but they were offset by some real winners, so overall alpha was positive. This year the last few months helped make up for a disastrous middle, but only a bit: in the end, I was down about 9.3%, vs the Canadian e-series fund down 9.8% and the US one up 2.0%, for a benchmark of -3.9% (I have not accounted for the impact of luck in terms of withdrawals/investments – that’s my IRR vs. a straight annual total return for the index funds). That was a relative under-performance of 5.4%.

“I didn’t do it right” is not a strong defence of active investing — I need results in the real world, so if active investing leads me to make more mistakes and under-perform passive investing at the end of the day, then I should be passive investing, even if active investing “would have” done better “if only” I didn’t make such-and-such a mistake. Would have and if onlys are great for study, but lousy for results. And the hard-and-fast of it is that by attempting active investing, you open the door for more mistakes to be made.

But I also know that even successful active investing has its bad years – partly due to mistakes, partly due to trading off higher risk for more rewards, partly due to just setting up for the future (buying what’s beaten-up only to watch it continue to get beaten up for a while).

I also know that index investing has one thing that’s a little tough to stop thinking about trying to improve: how the indexes are made up. It’s an arbitrary process — one that works great, don’t get me wrong, but no less arbitrary for that. Why does S&P get to choose which companies go in the index and which don’t, rather than say, me? The Dow is a total black box, and the TSX composite is widely regarded as over-weighting some sectors and under-weighting others. Some quasi-passive funds have emerged to put a “fundamental value” tilt on a large index with a simple weighting formula, but those look like they have flaws too (e.g., taking the already poorly balanced TSX composite, and skewing it even further towards financials).

I’ve often thought about the possibility of being “passively active” (or actively passive?) — embrace the passive philosophies of low portfolio turnover, low costs, and broad diversification, but create your own index (one that could be even better weighted by sector than the TSX, for example). Simply attempt to create a representative sample of the universe of stocks. Unfortunately, just as I was drafting a post focused on that idea a month or two ago, Michael James started talking about volatility drag and how that might not work as planned. Drat.

So once again I find myself on the fence about the active-vs-passive debate. For sure, passive investing is all I recommend to beginning investors, and all I cover in my book. Most people don’t have the OCD or emotional deadness or the je ne sais quoi that makes for a decent active investor. I don’t know myself if I’m most people or not yet. But I’m not yet ready to write off active investing as nothing more than futile hubris.

Nonetheless, I have to protect myself from overconfidence, so I do have a passive indexed portfolio to complement my active one. I do track my returns and compare how I’m doing. I use Potato’s Valve to stop myself from throwing good money after bad, and to ensure that an essential core of my portfolio is following the logical passive portfolio, so that at least my minimum goals can be met even if I blow up my active portfolio through mis-management.

Anyway, a rough year for active investing in the Potato household. Lots of mistakes were made, and though I could write many posts on what they were and how to try to avoid them in the future, the simple fact is that attempting active investing makes mistakes possible. Yet I’m still on the fence, and not quite ready to go all-passive. Like Warren Buffett said, sometimes value investing just grabs you, immediately clicks, and you can’t stop thinking about buying a dollar for fifty cents.

I was going through my archives, trying to find out exactly when I started BbtP, since it’s been lost to the fog of memory. I know when I first got the holypotato.com domain (November 2001), and when I first got the current incarnation running on WordPress (October 2005)… but all I could remember was that I started working on something approximating the current blog format — with regular updates — sometime in early undergrad (back then, it was all done in Notepad), and that the title dated back a year or two before then (the original concept involved more humour & creative writing and fewer parentheses). Well, I’ve found the answer: Potatomas break, 1998 is my oldest site backup. So this would be my 13th anniversary (or 14th, depending on how long the site languished with just a few html files and no backups). Let’s say 13th anyway. Hurray!

Now for a little retrospective.

What a hell of a year 2011 was.

I started off by looking at some alleged stock frauds, then by the middle of the year got caught up in one myself, losing a fair bit of money. We fought UBB and won. I realized that the internet is far more interested in a 1-minute photoshop filter of a panda bear than a year’s worth of thoughtful short-form writing. Japan was rocked by an earthquake and tsunami, but it’s the nuclear accident we remember. I wrote a book, and a guide for TD e-series. I wrote a lot more about real estate than I ever thought I could fit into one year. I had my first problem with the Prius.

I got my doctorate.

2012 will likely be even bigger, as I’m going to have to find a new job. And we’re expecting our first child in the spring!!!!11one!!

So you know that of course, things are going to change around here. I’m going to have to round off and pad all the sharp corners on the theme, and all future posts are going to become exclusively about cleaning up puke, stroller reviews, and complaining about sleep deprivation. Which is fitting, seeing as how the site started as a result of (and complaining about) severe sleep deprivation.

Here’s to a great 2012, everyone!

There is some truly bad advice out there on the internet, some of which can be expensive. I see a lot of it in the fall as pertains to the seemingly mandatory “list of things to do to your car to get ready for winter” articles pop up. One particularly egregious example encouraged people to rotate their tires (but not change-over to winters), change their coolant every year (most cars only need a change every other year, and many newer cars have formulations that last 5 or more years, and a coolant flush isn’t all that cheap), add fuel line antifreeze with every fill-up (winter gas eliminates this need, and when have you ever heard of someone getting a gas line freeze-up in the last 10 years?), and get an oil change and inspection.

I put up my winter driving prep list last year, and as expected the number one tip was get winter tires. I should have bolded it then, too. The up-front cost is a little high (few hundred dollars, either for a dedicated separate set, or the incremental cost over all-seasons to get winter-rated all-weathers), but well worth it in terms of safety, and also saving some wear on your summer set of tires and rims. You can even get a discount on your insurance from many providers.

Then along comes Marianne, who earlier in the fall was on a tight budget, and somehow prioritized rustproofing, an inspection, detailing, and winter mats over a safety feature like winter tires (and don’t get me started on other things she decided were better uses of her money than snow tires). She complained of the cost, and of only using them for 4 months (though Nov, Dec, Jan, Feb, Mar seems to be 5 months to me, and possibly 6 if you do your driving at night and it’s chilly through half of October and April — and fully half the mileage if you do more trips by bike in the summer).

That attitude may have changed as she now relates to us a harrowing tale of a near-miss spin-out on snow-covered roads over the holidays.

I will say it again: I know people with all-season tires who don’t think the cost of winter tires is worth it, and people with winter tires who think it is worth it, but no one with winter tires who thinks it’s not worth the cost. They give you such a large margin-of-safety on cold and slippery roads, it is easily worth the few hundred bucks.

The other things on these perpetual winter driving lists are good, but can be expensive advice. Winter tires should be the #1 point on all those lists, and despite the up-front cost, are the least expensive advice there is. I won’t come out and say that regular inspections are a bad idea, but if there’s nothing suspicious happening with your car, the money is better spent elsewhere. For a car that’s driven regularly in most of the populated regions of the country, a gas antifreeze additive is a waste of money. Coolant is good for a few years; if you need to, you can push it a little bit (and it’s much cheaper to get tested than indiscriminately replaced). Rustproofing has its advocates, but if expenses have to be prioritized and deferred, it can be put off until the spring, or even for a few years. And as much as I love rubber winter mats — I leave ’em in all year long — no one ever died of salt stains on their carpet.

I mentioned a few times that it’s important to look at a range of different assumptions before making a large decision, such as deciding whether to rent or buy. It can sometimes take a fair bit of research to get to those assumptions in the first place (what’s an appropriate range? Why can’t I just assume 20% returns or no inflation?).

But as handy as a spreadsheet/calculator is for figuring that stuff out, it’s hard to show multiple outcomes, so here is a little graphical depiction of when it’s better to rent vs when it’s better to buy after 20 years, and by how much, under various assumptions — holding the others constant with the “base case” numbers. It’ll give you an idea of how sensitive the analysis is to various factors.

The “base case” being the numbers I put into the rent-vs-buy calculator spreadsheet in this post: namely, 2% rent inflation, 2% house appreciation, 7% investment return, mortgage rates of 2.8/4.5/5.5% over the first 5, second 5, and remaining years, and of course, a price-to-rent multiple of approx 215X.

The shaded green areas show where it’s better to rent, and by how much, while the shaded purple areas show where it’s better to buy, and by how much. I’ve put them all on the same scale for easy comparison. You can see there’s a lot more green than purple. Yes, purple does exist, and there are scenarios where buying is better (high house price appreciation, high rent inflation, low investment returns, low price-to-rent, etc). But based on what I think are the likely range of outcomes, it is much more likely that renting will be better for us, and by fairly significant margins.

Here’s the impact of different outcomes for appreciation, with all the other factors as in the speadsheet posted before (i.e. 215X price-to-rent multiple, etc). You need to be quite bullish for quite a long time to get into the purple region at the right side of the chart (in effect saying that you think a $500k house today will be $1.3M 20 years from now).

The different outcomes for investment returns:

With several time points to pick from (0-5 years, 5-10 years, 10-20 years) it’s tough to make a fully-featured chart, but here are a number of options. Even assuming very low rates lasting for a very long time (2.0/3.0/3.5) only barely nudges owning ahead; in the green triangle, no truly scary rates are featured (nothing above 6%). The impact of mortgage rates:

I was a little surprised to see that the outcome was so sensitive to rent inflation:

And how the outcome changes with different price-to-rent multiples (the base case was 215X in the previous posts, more on that below the figure):

Perhaps unsurprisingly the biggest single factor is the price-to-rent ratio. Fortunately, this is the one with the least uncertainty: identify your comparables — your living arrangement options — and then you’ll have the two prices to use rather exactly. I was attempting to be generous in the original post, using “just” a 215X multiple when I have seen plenty of examples in the 250X-275X range, and could probably cherry-pick even higher. I thought 215X was more defensible: though there may be some outliers, that seems to be about the floor in Toronto, so I could trust that you could go out and do your own comparisons and find similar or higher multiples. The original point was that even with generous assumptions, it’s hard to make the case for owning.

So maybe even though I thought I was being realistic, you thought the investment return assumption was a little high, or the long-term appreciation a little low — that’s fine, since the price multiple is a huge factor that may trump those smaller quibbles. Especially when a more realistic multiple for Toronto may be 250-275X.

Oh, and BTW: Wayfare has found out from the old landlord that indeed, the place did not get rented out at the original asking price of $2100, but rather $1950 (after a few months of vacancies chasing that higher rent). Plus she also says I’m way too conservative on the valuation (that was the lowest priced listing in 2010, again to be conservative/generous) and that $550+k would be more fair, i.e. a price-to-rent of 280+X. Our current place would be about 270X.

So how big of a difference does that make? Below I’ve created a little matrix looking at how the outcomes change based on different scenarios, here focusing on different house appreciation assumptions across in columns, and different investment portfolio returns down the rows. The cells have been colour-coded green (renting better by $100k or more after 20 years), yellow (either choice within $100k of the other), or red (owning better by more than $100k).

You can see that for a 215X multiple — the example used in the previous post — my base case scenario would be in yellow (2% appreciation, 7% investment returns). Being off by just two points (5% investment returns, 4% appreciation, or one percent to each) can flip the outcome from renting being better to owning being better. Enough that if you’re concerned about negative equity, or a flat-lining housing market, renting may indeed be a better choice. But not the hands-down outcome you may have been expecting given how important I feel the topic is. Perhaps I shot myself in the foot with my “even being generous to owning” strategy by giving people an out there.

So then look at how it all changes with a 275X multiple: very few scenarios where owning is better. At that price, you need to be both very pessimistic on equities and very optimistic on house prices to be dipping your toes into the real estate market. Again, you can find parameters where owning will yield a superior outcome, but how likely are those parameters? How big is the pain if you’re wrong?

In my rent vs. buy analysis, one of the factors that has a particularly large impact on the outcome is investment returns. I looked at a range of nominal returns of course, but the one I chose as my “most realistic” scenario and highlighted as the default value for the calculator was 7%/year. It could be 5 or 6 percent, or maybe even 8 or more, but for a mostly equity, low fee investor like myself with a time horizon of several decades, I figured that was pretty reasonable.

Now, that little rent vs. buy calculator (though it may take the form of a spreadsheet, at its heart it’s just like the other web-based calculators around, except you can see the formulas, and tinker a little more) has got a few people talking. Some are bashing the very notion of attempting the analysis. Others are raising very salient points, and one that keeps coming up in multiple forums is what an appropriate expectation of future investment returns should be. A surprisingly large number are saying that 7% is too high, and so far none have stepped up to say no, it may be too low and that 8 or 9% should be used instead.

So, did I aim too high? Is that not a realistic expectation? Yes, the world may be facing problems now, but it has faced problems before, and two or three decades is a long time to right the ship. But if I’m making a huge mistake by somehow vastly over-estimating market returns, that’s something I need to know. Tell me what you think is reasonable, and why.

What is your expectation of an appropriate long-term equity return?

Some data to have before voting: according to the Libra total returns spreadsheet, both Canadian and US markets have returned about 10% per year nominal CAGR over 40 years in Canadian dollar terms (vs. Canadian inflation of 4.5%). The 20-year returns up to 2010 — so including the tech wreck, 9/11, the 2008 market meltdown, and appreciation in the CAD — are about 8% from both Canadian and US markets, vs inflation at 2%. CC links to a few other reports, like a recent one in the WSJ that suggests 6.5%. Or another that says that moderate returns are in our future: 3-3.5% above government bonds. Depending on which bond is meant by that paper, that could imply stock returns of 4-6%.

Let me know in the comments, and/or visit the quick online survey.