Book Review: Pragmatic Capitalism

Pragmatic Capitalism: What Every Investor Needs to Know about Money and Finance was first published in 2014 by Cullen Roche (publisher of pragcap.com). It is an interesting blend of discussions of personal finance and financial market behaviour, integrated with top down macro views. On the macro side, he introduces what he calls "Monetary Realism."

Links: HFT

There has been a fair amount of discussion of High Frequency Trading (HFT) as a result of Michael Lewis' new book. For example, see the discussion on Leo Kolivakis' blog on the HFT debate. I was never directly involved with HFT as part of my job, but I see the effects in the trading of my personal retail trading account. I think the views of "Kid Dynamite" (who used to work on Wall Street as an equities trader) is the closest to my position:  HFT may be causing problems for big existing institutions, but it's largely a non-issue for retail investors (but speculators may be unhappy). But the rise of HFT means that you should never use market orders, only limit orders.

Inequality In Savings Drives Wealth Inequality

Paul Krugman discusses the dynamics of wealth inequality in a recent blog: Notes on Piketty (Wonkish). (Note: The article is behind a New York Times paywall, but you can view a number of their articles free within a month.) In it, he uses the standard Solow model to explain rising inequality. Although I do not have a formal model, my reading of a stock-flow consistent models implies that his analysis is not quite correct. The driving force behind wealth inequality is the differential in savings amongst households, and with a second order effect being that larger portfolios may have greater returns on their assets.

Do Bonds Make Sense For Long-Term Investors (Part II)

(This is the second part of a discussion of how long-term investors should view bonds. The first part is available on Seeking Alpha. I want to repeat one point here – I am looking at what should be the default weighting for “bonds” within the portfolio of an investor with a long investment horizon. For example, a young person who has built up a cash buffer already, and is now building up a retirement portfolio.)

In the previous article, I argued that the problem with bonds is that long-term bond yields are quite a bit lower than expected long-term equity returns.  I argued the main reason to hold long-term bonds is the uncertainty about those equity market returns. I will now list a few other reasons to hold bonds. (One other issue that is the question of taxation. In many jurisdictions, equity returns are privileged over bond returns by the tax system. However that is a very country-specific discussion, and tax shelters can nullify this disadvantage for bonds.)

Do Bonds Make Sense For Long-Term Investors (Part I)?

In this article, I look at why long-term investors would want to hold investment grade  bonds in their portfolios. The main justification I see is uncertainty about equity returns, but it is unclear whether this is enough to justify a significant bond weighting in bonds in the policy portfolio. I cover other less obvious reasons to hold bonds in a follow up article.

Theme: Personal Finance

This post is a list of links to articles I have written which discuss personal finance. I would not consider this a personal finance blog, rather I have a few points that I hope may be useful. (This article will be expanded over time.)

Handling Cash Within Personal Portfolios

This article is the follow up to this article about money and uncertainty. In the previous article, I discussed how money was used to reduce uncertainty for spending decisions. In this article, I discuss the role of cash within investment portfolios.

Primer: What Is A Policy Portfolio?

This is a short description of what a policy portfolio is, and why you should have one for your personal investment portfolio.

Money As A Weapon Against Uncertainty

One of the insights associated with Keynes is the view that money acts as a weapon against uncertainty. If we knew in advance what all future scenarios are, and their associated probabilities, we would not need to hold money. However, the future is uncertain, and so we hold money as a way of reducing the risks associated with that uncertainty. In this article, I discuss how money and cash should be thought about in personal finances, in light of these insights.

Looking At Food Inflation

The Canadian Consumer Price Index (CPI) was released last Friday, and it continued the trend of remaining well below the Bank of Canada target of 2%. This was not too surprising, so I will instead examine the behaviour of food inflation in some more detail. Although I will look at Canadian data in this post, the behaviour is similar in other developed countries. What we see is that following social trends can be increasingly expensive.

Houses And Portfolio Allocation

Introduction

How should people view a house within their personal portfolio? For many North American households, their residence is their most important asset. As a result, it is a very important factor to take into account when planning for retirement. In this article, I explain how I prefer to view a house within a personal portfolio. (Throughout this article, I will use the term house, but the logic applies to condos as well.)

This article is generic, and is going to be read by an international audience. As such, I do not attempt to give advice whether buying a house is a good or bad idea for a particular individual. Additionally, my logic is based on conditions that may be particular for Canada and the United States; some factors I discuss do not apply in other regions.

The analysis framework is aimed at people who are a long way from retirement. Such people have a great deal of uncertainty in their financial planning due to the uncertainty about their future employment income, and their choice of where they live is driven by the location of their employer. A retiree has less ability to recover from a bad decision, but they should have more flexibility in choosing where to live.

Finally, in order to keep this article from getting too long, I will not cover the macroeconomic impact of the micro decisions people have been making about housing. But I feel that most households do not analyse their housing decisions the way I do here, and this represents one negative factor that hangs over the North American economies.

Housing: Asset Or Liability?

The key principle to keep in mind about housing is that it is very different than financial assets. Housing is an asset that loses money every year, up until the house is sold. (In the lingo of fixed income, it’s a negative carry asset.) Generally speaking, the larger the value of the house, the bigger the cost of owning it. And this is not even counting the financing cost; houses are typically purchased using mortgages, whereas few retail investors use debt financing to purchase other financial assets. The mortgage size (and interest costs) will increase in line with the value of the house.

Typically, the increase in home value is based on increasing home size (keeping other factors like the neighbourhood or age of the home comparable). As a result, there are four main factors that lead to housing costs increasing with the value of the home:

1. Property taxes are proportional to the value of the home throughout most of North America. (As an aside, there are differences how property taxes generally are handled between Canada and the United States. American municipalities tend to keep the property tax rate fixed, so that the tax take rises and falls with the housing cycle. Conversely, Canadian municipalities decide what level of tax they want to extract, and then adjust the tax rate to hit the revenue target. This makes Canadian municipalities a much better credit risk, although this may be a small consolation to taxpayers.)
2. Heating and cooling costs are typically increase as the home size gets larger. (This may be less of an issue in more temperate parts of the world.)
3. The bigger the house, the more stuff you can (and probably will) squeeze into it. Stuff costs money.
4. Maintenance costs will rise based on home size. This is an important factor to keep in mind for aging wood-framed houses, which is the standard Canadian home construction method.

A larger home also entails more home maintenance, which is an increased drain on what may be the most precious resource for working households – their time. Less free time entails monetary costs to compensate (eating out, paying for home maintenance services, the “need” for expensive vacations to reduce stress levels, and less time for part-time work).

If your financial plan is to live your life in a home you own, a more expensive home will generate increased negative cash flows throughout your life. This meets the definition of increasing a liability, not holding a larger asset. Plus, you have to sell other assets that generate income, and/or borrow, for the privilege of holding the liability. The only time the increased value of a home will increase the cash flows that you receive is when you sell the thing – but even then, your transaction costs will probably also increase (particularly in Canada). If you do die a homeowner, your estate will be larger if you have a more valuable home. But that is based on the assumption that you had enough financial assets to cover your spending when you were alive in order to leave an estate.

I have not forgotten that “you need to live somewhere”. Owning a home eliminates the need for paying rent, and home ownership was historically relatively cost effective, as long you did not need the flexibility of being able relocate. (As many have discovered in the United States in this cycle, being locked into a home can cost you potential jobs.) But when doing the rent versus buy decision, the real comparison is not necessarily for renting the same sized residence as you want to buy; the comparison is for a sensibly priced rental unit, which may be much smaller. If you are renting, you should not be accumulating piles of material goods, as you will have to move the junk repeatedly. You only need to rent a large house if you have already locked yourself into the treadmill of accumulating a lot of stuff that you need to pay to keep somewhere.

In summary, your residence is not really a portfolio asset; it is a lifestyle decision like deciding which automobile to drive (or not). Housing expenses have to be held under control within a budget, allowing you to accumulate financial assets that actually pay you to hold them.

Rental Housing As An Investment

Without the particular details of the individual situation, I cannot really say how to view housing that you rent to others is a good or bad portfolio asset. Property investment has probably generated a lot of rich individuals, but that is not necessarily because housing is a great asset. It is the only asset that retail investors routinely buy with leverage, and the magic of Other People’s Money magnifies returns - and losses. It is also an operating business that is relatively easy to manage; you mainly just need to deal with renters and maintenance. Returns on operating businesses should be better than the returns on assets you hold passively, although it represents a loss of time (which as I noted above, is a very crucial resource if you are working).

Things to keep in mind are liquidity and diversification. You have to have a liquidity buffer to allow you to hold on the assets in a period of interrupted cash flows (vacancy or losing your job). As for diversification, it is a basic principle of personal finance to avoid “putting all your eggs in one basket”. If you own only a small number of rental units, even slightly bad luck could generate a horrible occupancy rate – having a larger number of units increases the odds of having a an occupancy rate near the average. Having a properly diversified portfolio along with rental housing is difficult to achieve, unless your portfolio is relatively large.

But in addition to portfolio diversification, you need to factor in diversification versus the risk to your overall financial plans.

1. For most working age people, their largest source of cash flows comes from their employment. Having a large real estate asset could create a toxic correlation with your employment risks.House prices often soften in recessions, when you are statistically most likely to lose your job.
2. If you work in a profession related to real estate, your job outlook could crater at the same time as your home value. (This career correlation hit technology employees who invested in IT stocks during the 1990’s tech bubble.)
3. North American one-employer small town property values can collapse if that employer shuts down the business.

Mortgages: A Short Position In Bonds

To use financial market lingo, a mortgage is a short position in bonds. In other words, a negative bond position. Given that bond yields are currently very low in absolute terms, this may not be that bad a thing. But this can be problematic if rates are at more typical levels. Bond values increase during recessions, which are bad times (on average) for households’ cash flows. This creates an unwanted correlation between your financial net worth and the job market. This is probably not too big a deal; U.S. mortgages can often be refinanced, and Canadian mortgage durations are very short. But it is something to be kept in mind when looking at your total portfolio, as many household’s mortgages are larger than their holdings of financial assets.

Housing As An Inflation Hedge

Housing is typically viewed as an effective inflation hedge. This appears extremely useful, as there are few assets that are cost-effective inflation assets (see my comment on equities as an inflation hedge here). This is most important for retirees, as they need to control their expenses, and they will not have wages that presumably rise with inflation.

But for people a long way from retirement, most of the advantage given by inflation is the result of the fact that they probably have a large mortgage (a short bond position). Your negative cash flows created by the house will be increasing with inflation. Since your payoff from selling the house is far in the future, the increase in the future house value from inflation may be swamped by the fact that long-term interest rates will probably be higher (i.e., the discounted value of the house proceeds may be lower if inflation rises). Therefore, if you are young, upsizing your house may be counterproductive financially if you are attempting to hedge inflation.

Now that I’ve scared everybody, Happy Halloween (and have a good weekend)!

(c) Brian Romanchuk 2013

Goods Versus Services Inflation Trends

In my view, one of the larger surprises of the past few years has been the stability of inflation rates. As I discussed earlier, the best intermediate-term inflation forecast technique for the last couple of decades (for example, a 5-year forecast) has been to stick with a 2% forecast. (Although 2.5% is probably a better level to use for the U.S. CPI instead of 2%.) As the chart above shows, although the 3-year annualised inflation has moved around a bit, it is still bouncing around this average level. This stability appears surprising given the magnitude of the slowdown in the United States economy. My guess is that a considerable number of inflation models have had to been scrapped over the past few years.

The path of least resistance is to not worry about inflation, and hope that policymakers (and the markets) will continue to hit a 2% level on average going forward. However, digging further into inflation trends is worthwhile if you are a financial market participant who has reason to care about macro trends, or for those who need to project a cost-of-living for personal financing planning purposes.

One thing highlighted by national statistical agencies is that the CPI index is not a cost-of-living index. In other words, personal expenses in a financial plan should not be expected to follow the trend in the CPI exactly. Within North America, there can be important regional differences due to diverging fortunes across the country. Another important factor is that one’s spending patterns will not match the averages used in the basket used in the CPI. That disclaimer aside, the CPI should shed some light on how your cost of living will change over time.

In order to project inflation going forward, we need to understand its historical trends. In a low-inflation environment, the divergences between different components of the CPI may become significant relative to the overall level of inflation. This behaviour is not captured in models that look only at the aggregate price level, in other words treating the economy as if only a single good was produced. And as the chart below shows, there was a considerable divergence in the relative pricing power of goods versus services.

What we saw was that goods* prices fell relative to the aggregate CPI (in other words, they rose less quickly) during the 1990’s. This was a general phenomenon across the developed world; I am showing the similarity of the U.S. and Canadian experiences in my charts. Since goods were falling versus the aggregate, services had to be rising faster than the aggregate. This is typically explained by the impact of increasing globalisation reducing the price of traded goods, while services are produced domestically. What is interesting is that relative price shift has slowed or even stopped over the past few years, first in the U.S., then Canada.

This is an area that I am still looking at, but my working hypothesis is that this is cyclical. The service sector was able to push through price increases more easily when the domestic economy was in better shape. Given that the economy remains in slow-growth mode, divergences in inflation rates may be suppressed for a while longer.  However, there is also a risk that if the deflationary forces from traded goods prices are finished, inflation rates could prove to be surprisingly strong when the economy eventually returns to being near full capacity.

* The Bureau of Labor Statistics of the United States refers to the goods component of the CPI as “commodities”, which I find is confusing.

(c) Brian Romanchuk 2013