This Chapter and all appendices were last updated on Dec 3, 2016.
APPENDIX to CH 1.7; Revenue Real Estate.
This Appendix can be skipped by most investors.
A full discussion of investing in revenue-producing-real-estate is too broad of a topic for this manual. Real estate investing in Canadian provinces west of Quebec has generally been a good investment for several decades, for me, and for a smart minority of investors, depending upon: the location, the purchase price, mortgage rates, rental rates, and in particular, whether one has the temperament for the hassles of being a Landlord. (Many initially think they do, and later “poop-out”).
The main advantage of Real Estate is that it represents a conservative use of “leverage” whereby the investor’s gains can be “magnified” through the use of borrowed money. Even with the coming demographic greying Baby-boom phenomenon, most forecasts for household formation, and the number of required homes in most areas of Ontario and the West, predict that real estate will continue to be a sound investment for most investors for decades to come. (But note that the Economist Magazine, and Robert Schiller- the dean of realestate bubble forecasting, both think that Canadian real estate is pricey right now, especially in Toronto and Vancouver, and due for a big drop. They could well be correct).
The absolute keys to real estate investing are: (1) buying properties with positive or neutral cash flow; (ie., rent that covers the mortgage and taxes); (2) buying properties at below market prices (see again the present over-price warnings above below); (3) buying in a good location allowing for price escalation; (4) the opportunity to identify and add value to a property (perhaps by buying the shabbiest house in a good neighborhood), and making inexpensive cosmetic repairs which increase the resale value to another prospective buyer; (5) the ability to wait-out tough economic cycles, which sometimes takes many years; (6) tenant selection and relations. (I could write a whole book on the mistakes I made by not doing enough due diligence in my first year of tenant selection; and about the crazy excuses I heard from tenants for why their rent was late or short – which excuses I learned only to hear twice before eviction, in landlord-friendly Alberta).
In terms of finding the right advice on these, and the finer points of real estate investing, quality bookstores have a whole series of books in the personal finance section with titles such as “Buy, Rent, Sell” which are very good. (But make sure the author is Canadian).
A better resource of information, tips, and techniques is to join the Real Estate Investment Network (REIN), or to at least read one or more books by its smart promoter, Don Campbell, who sensibly says that over-priced markets are regional, and not-country wide). REIN has often been criticized as being a “cult,” but if you know that going in, you can presumably benefit from their expertise, without falling prey to the idea that real estate is the one-and-only-one-true-path to wealth in Canada, — (which sadly, does seem to be a prevalent attitude among REIN members).
Where does revenue property fit within the hierarchy of investment priorities such as RRSPs etc set out in Ch 1.3 to 1.7? That depends on the factors listed, above, and how successful one is at your other investments, and especially whether one has the temperament for being a landlord. Most Canadians will never face this decision, because few have the temperament for dealing with tenants. (If you think that you do not, please do not attempt to talk yourself into becoming a real estate investor; because, after paying realtor’s commissions, real estate is not typically a good short-term investment). But for most Canadians without a company pension, investing in RRSPs, RESPs, and TFSAs should take priority, in my view, to all other unregistered investments, including real estate. (See Ch 1.3 to 1.7) . Moreover, I believe in diversification between several types of investments, including investing in all of the priorities set out above, together with revenue-real-estate for those with a temperament well-suited for tenant relations.
APPENDIX TO Ch 5.5; The Merits of Momentum Investing
As noted above, in Ch 5.4, I believe, like the couch potatoes, that index ETFs are a very good building block for one-half of the equity portion of many portfolios. I like and use them extensively, but not exclusively, like the index-only portfolio advocates. I believe that the index zealots have unecessarily imposed a rule on themselves that they will never invest in a Sector ETF, or dividend paying stocks, and thereby stupidly limit themselves to a few broad based index ETFs, which they MUST HOLD FOREVER, REGARDLESS OF POOR PERFORMANCE.
In their rigid dogmatism, many index–only advocates have wrongly converted, “most mutual funds (which must follow a specific mandate — ie. invest only in Canadian Large Caps etc – don’t consistently beat an index” (which is true), into “NO SMART INVESTOR CAN EVER CONSISTENTLY BEAT AN INDEX,” (which I know to be untrue, because I rotate amongst mandates, and which I have done for 13 years).
Prior to this decade of baby boomer retirement, and resultant lessened demand for equities, our Equity Strategy mostly ignored dividend paying stocks, and successfully focussed on higher-flyers, averaging 11% per year from 2002. Our equity strategy was called the the October Strategy, because we sold our equities every Sept and October, in recognition of the well known fact that markets tend to drop in the fall due to the “Scary October Phenomenon”, in which almost all of the great crashes have occurred in Oct, resulting in skittish investors like us cashing out every fall, causing demand for equities to fall, and with lower demand, causing markets to fall in 7 of every 10 autums. That strategy has, and should continue to be succesful for the non-dividend component of our portfolios; (we don’t cash out of dividend stocks and thereby miss a dividend payment). Now that dividend-payers are such a big part of our programme, not all investors take on the paperwork to “fall-out”; but I do.
But the bigger reason for our success averaging 11% per year was the “price momentum” aspect of our Newletter Strategy. Index-only potato worshippers won’t admit this fact; but in many circumstances a smart investor can easily find:
soaring Index ETFs in certain industry-sectors, (like oil and gas, or banks, or consumer product makers), or country-specific-funds, which upward price momentum is likely to continue for at least the next 6 months.
How do we do this even though the majority of potato advocates say that it is impossible? Read closely. Our economy and markets continually move in cycles, and narrow industrial or country-specific cycles — (and the sector ETF funds that invest in them) — tend not to reverse their cycles suddenly, and dramatically over the next 6 months. For the riskiest/momentum (non dividend) half of our equity portfolio, we invest in ETFs for 6 months at a time, based on their performance in the preceding 3 months. Investing based on momentum thereby tilts the odds in our favour, because we can pick the sector funds that are out-performing in any investment cycle, and then sell our hot ETFs when they turn lukewarm or go cold. This is our “secret.”
The amateur index-only zealots say that it can’t be done. They mis-quote studies showing that last year’s hot mutual funds are often this and next year’s dogs. This is true enough, but the sector specific ETF stars from the last 3 months typically continue their “winner-persistence” for at least the next 6 months, when we are ready to sell if they turn lukewarm or cold. (Note the important differences between “months” and “years”, and note that we pick ETFs and not mutual funds . Sadly, in their reverance for mediocrity, the index-potato-zealots do not focus upon the right data. (See Dr Appel’s book and those of other brainiacs outlined 3 paragraphs below for those academics who haven’t mucked this up).
We also do better for another reason. Although most fund managers are not allowed to invest outside of their chosen industry or country mandate; we can, (and do rotate amongst the winners); and that is one reason for why so few mutual-fund managers do well from one calendar year to the next. But we are not as limited as one particular fund manager, and we are allowed to find the out-performing ETF funds, from various different industries or countries, from time to time; we then only stick with them for 6 months (or later, until they turn luke-warm or cold). To borrow a sports/probability/coaching analogy, for 1/2 of our equity portfolio, we are like a hockey coach using a “hot goalie” in the playoffs; come next season, we may well have chosen a different starting goalie.
So, the studies that say that last year’s “hot” mutual funds do not stay hot for another whole 2 calendar years are both true, and irrelevant to what we do. We don’t pick “last year’s” hot funds, and we don’t necessarily keep our ETFs for “years”.
A good textbook on the merits of Momentum Investing is Dr. Appel’s 2008 text, Beating The Market 3 Months at a Time, available at most bookstores, including Chapters. Almost all of the better academic market wisdom also acknowledges the efficacy of momentum investing. For a good summary of the data in support of momentum investing see Andrew Lo and Graig MacKinley in their 1999 Princeton Cult Classic text, A Non-Random Walk Down Wall Street. Even the godfathers of the index-crowd acknowledge that momentum works, but they have not harnessed it because of the “transaction costs” (trading commissions). BUT now, with the advent of no load funds and $5 ETF Commissions, those concerns are over. (See Page 170 of one of the Indexer’s Bibles, Dr Bernstein’s Investor’s Manifesto. See also pages 302 and 303 of the Indexer’s Other Bible, Dr Siegel’s Stocks For The Long Run). For the non academics, the Sept/Oct 2010 edition of the Canadian Moneysense Magazine found Momentum Investing to be the top method of six strategies examined, including index/couch potato-worship. (See the editor’s summary, and Norm Rothery’s 4 page article on Momentum).
That said, Momentum investing isn’t always a perfect predictor of future 6 month performance; some trends do uncharacteristically reverse abruptly. Momentum doesn’t always pick all of the future winners all of the time. But it does predict most of them, most of the time. Although we have picked a few dogs, our stars have typically outshone our dogs by a wide enough margin that momentum has been a very successful strategy for us — 11%, per year since 2002.
The “tricky” part of momentum investing is to identify, and stay away from, certain types of funds, like hedge-funds, leveraged funds, and some fund managers who have a history of such wild short-term fluctuations that they should be avoided. This is where I think I add value; by knowing which wild-swingers to avoid. That said, I believe that others could, and probably do replicate my results. I don’t claim to be the most brilliant investor in the universe; and I didn’t even invent momentum investing or Autumn Abstinence. All I have done was to weave these pro-active, sensible probability strategies into a format which works to keep transaction costs down, and which has yielded an average yearly rate of return of 11%.
APPENDIX to Ch 6; Equity topics that deserve to be discussed summarily: Leverage, The Smith Maneuver, Options, Annuities, Hedge funds, Tax shelters, and Charitable super write-off Scams.
APPENDIX 6.1; Leverage and the Smith Maneuver
This Appendix is only for “keeners”. “Leverage” means using borrowed money in order to earn returns that you expect to exceed the interest you are paying on the borrowed money. The interest on the borrowings is tax deductible, if the assets are not held in a registered account. In the late 90s borrowing from a Heloc on your home at low rates, and investing in the go-go stock market was all the rage, until we started to suffer equity corrections, which showed the ugly flip side of the lure of leverage. That is, if your investments tank, you losses are “magnified”, because you have to repay the loan with money that is “lost”. For me, leveraged stock market investing is too risky, and that is all that I will say about the previously popular “Fraser Smith maneuver”, and “leveraged 2-times-the-action-bull-and-bear-ETFs”, for fear that some will find a discussion to be an endorsement. (Part of Smith’s attraction is that an investor can also convert all or a part of his/her mortgage interest into a tax deduction; if you are interested, a Google search will lead you to several discussion groups). To me, — (and after much soul-searching and consideration of possible leveraged investments, using a HELOC at prime), – the desirability of sleeping soundly at night has meant that my use of leverage has been limited to the purchase of revenue real estate; see Ch 1.7.
APPENDIX 6.2; Trading in options; (only for “keeners”).
Trading Options is another lesser-known niche investing technique, in which very few average Canadians will become involved, but of which they may wish to have some understanding.
Because few average Canadians will have the time or expertise to engage in options trading, this discussion will be brief. Every time that I have devoted any serious time committment to studying options-trading, I concluded that, in many ways, options “trading” isn’t really the type of part-time “investing” at which many of us can excel, and still have time to hold a job. Rather, Options “trading” seems to require a huge time commitment that would cause my golf-game to go bad.
That said, if you are a stock-picker with the time to properly devote to options, the following example is one type of simple and safe strategy, in which an investor can often collect premiums (money for nothing) by writing a “covered call” on a stock they already own. (You are selling the potential obligation that you will be required to sell your stock to a buyer, if it hits a higher “strike” price). The buyer pays you for the privilege of taking your share if it increases to that strike price. If the price of your share does not hit that strike price, you still own your share, and you pocket your premium. (“Money for nothing”!). If you lose the share at the strike price, and you want it back, you can re-purchase it at its new higher price. That is the down-side, apart from the fact that you need to closely track your options expiry dates etc, and find opportunities suitable to you.
Naked” options strategies—(in which you do not own the share you are betting on) – is more like “gambling” to me.
Derek Foster recently wrote a book called Money For Nothing, in which he extolled the alleged virtues of selling “put” options on dividend achievers you like, but don’t yet own, for ordinary folk like him and me. But many have accused Derek of some mathematical voodoo. Even if not, I can’t imagine most folks having enough time before their full retirement to properly analyze opportunities, based on prices of the underlying asset, and the amount of the premiums offered. I do not.
APPENDIX 6.3; Hedge Funds
Hedge funds were originally conceived as safe investments for the wealthy, with off-setting “market neutral” (hedging, derivative) features, designed to allow investors to prosper in both bull and bear equity markets. However, at some point in time around 1999, these funds got out of control in their use of leverage, and made huge bets on certain risky sectors. The returns were sometimes in the triple digits, and sometimes a complete wipe-out. Many charged crazy-high fees. Most hedge funds folded, but some hedge-mutual-funds still remain, and are sold to ordinary Canadians, who are charged MERs on steroids. I am sure that there are exceptions, but most of the hedge funds left standing remain: wildly volatile, expensive, and to be avoided by most of us.
APPENDIX 6.4; Annuities
Annuities are a contract between an investor and an insurer, whereby the insurer takes a large sum of the investor’s money, and agrees to pay the investor a specific monthly cheque for the rest of that investor’s life (and/ or the life of his spouse, perhaps at a reduced rate). Annuities come in many shapes and sizes — with or without inflation proection etc. GMWBs and “variable” annuities are complicated new “products” that should be avoided — (see Ch 2.2); but plain old-style annuities are OK for unsophisticated investors, for a guaranteed (but costly) form of insurance against out-living your money, especially for people in their 70s and 80s.
Retirees are inundated with TV ads touting the simplicity and safety of never outliving your money. This is true; however, the downside is that compared to managing your own investments, the life-time guarantee is quite expensive in that your returns are pretty low – (someone is paying for the TV ads).
However, if you are not competent to handle your investments and/or you don’t have an employer sponsored pension plan, annuities may be all or a part of a sound-sleep-easy solution. If so, please shop around, because rates vary widely between institutions, as do the bells and whistles, such as inflation protection.
If you get heavily invested in annuities, please also buy from different companies, in case one goes bankrupt and keep your monthly payment from any one company to $2000 or less because that is the Assuris Insured limit. And please buy them at different times (years) to hedge your bets on interest rates. (Annuity rates vary in conjunction with prevailing interest rates; which is why I don’t like them too much at present– I don’t like the idea of locking in to an interest rate for LIFE; especially now with interest rates so low.)
Thay said, Annuity investing doesn’t need to be an “all-or-nothing-proposition”. Rather, many retirees buy an annuity for part of their needs – (perhaps their essentials) – and stay self-directed for the balance of their portfolio, in another example of the healthy salad bar of diversification analogy, — (which has now been over-used for the last time in this manual). Most studies say that people in their sixties shaould wait until their 70s to buy annuities, if they want to minimize the cost of their life guarantee.
The latest gimmick is a product called “Guaranteed minimum withdrawal benefits” (GMWBs) which give a non-inflation protected monthy sum for life with lots of “reset” bells and whistles designed to make the insurance industry rich. It would be better to buy a simple annuity with fewer hidden costs. (See Ch 2.2).
APPENDIX 6.5; Tax Shelters.
All you really need to know is not to buy any. “Tax Shelters” are the generic name for “investments” offering attractive tax write-offs, many of which are legitimate, but many of which are either scams, or are otherwise “too good to be true” from The perspective of Revenue Canada.
Many of the legitimate shelters are “flow-through” shares in the oil-patch, whereby an investor can write off exploration costs incurred by the exploration company, on his/her own individual tax return. My advice is that: if you are involved in the industry in question, and know the company, and the merits of the drilling program, such that the investment is attractive despite its tax benefits, then this can be an attractive investment. If any of these preconditions is missing, I would stay away.
Many of these shelter plays have been scams. Moreover, these investments are only suitable for highly taxed individuals, whose registered-investment-possibilities are all filled up, and whose mortgages are at zero.
APPENDIX 6.6; Charitable “Super” Write-Offs.
All you really need to know is not to donate to any scheme which seems too good to be true. The usual story is that you donate X hundred dollars to a charity buying drugs for the 3rd World, – (or some other worthy endeavor) — and you get a tax receipt for X PLUS, or even X TIMES your donation, – meaning that you can supposedly “come out money ahead,” – on an after-tax basis. Many such stories come with a dubious legal/tax opinion attached, that says that the scheme meets the tax-code. When these stories are pitched to you, I advise you to turn up the volume on your BS Detector. If it “sounds too good to be true”, Canada Revenue Agency will probably agree. If you think that enduring an audit, and possible interest and penalties sound like good experiences, then these charitable super-schemes are right for you!
Again, thanks for reading. May your investing both: allow you a long and happy retirement; and also allow you to sleep at night.
Dale Rathgeber, BA.(82), JD (1985).