The Counterintuitive Nature of Financial Planning Advice
Mick Lord, CFP?
Advice for C-Suite executives and senior professionals to build and maintain their wealth
If you have questions about this article,?I would be happy to help.
Everyday, I face the challenge of trying to explain financial concepts to clients to help them make better financial decisions, decisions that wealthy people already understand.
Personal finance is riddled with unclear, unintuitive, seemingly backward concepts and strategies. As a result, many (or most) people do the opposite of the right things throughout their lives. In some cases, they do the right things but at the wrong times. If someone or a family consistently makes the right decisions over a lifetime, their financial outcomes will be much better than their neighbours.
This article will try to spell out, in very short form, my most popular discussions:
Dollar-cost averaging and compounding rate of return
Benjamin Franklin once said "Money makes money. And the money that money makes, makes money."
There is a reason why the vast majority of the most wealthy people in the world are octogenarians – it takes time to amass wealth. Yes, there are exceptions, but they are all business people with EXTRAORDINARY business ideas (Elon Musk, Jeff Bezos, Bill Gates or Ern? Rubik, the inventor of the Rubik’s Cube). Time may be the most valuable asset in financial planning.
Imagine you purchased 100 units of an investable asset. I am going to assume that the price of the asset remains constant and you’re not buying any more units with your own money. At the end of the first year, it is announced that all unitholders earned a 2% dividend. You use that 2% dividend to buy more units, so at the end of the first year, you now own 102 units. At the end of year 2, all unitholders earn another 2% dividend, and again, you buy more units with the dividends. Two percent of 102 units is 2.04, so now you own 104.04 units. That 0.04 is very important, because over typical periods of time (e.g. 35 years of contributing to a retirement plan, and 25 years of living in retirement), this small 2% example results that those 100 units turn into 328 units (that is, 228% growth over 60 years). Imagine, 4-6% rates of return....!
The concept of dollar-cost averaging has been around for some time. It refers to the practice of systematically buying an investment asset with equal dollar amounts (e.g. $500), at regular intervals (e.g. on the 10th of each month), regardless of the price of the asset you’re buying. The “magic” advantage of this strategy is that as the price fluctuates, so does your purchasing power. As the purchasing price goes up, you buy fewer units; as the price goes down, you buy more. Isn’t that how you’re supposed to buy toilet paper – buy more when it is on sale? Over a lifetime, this will allow you to reduce investment risk and enhance your rate of return.
Holding a mortgage in low interest environments
Some people don’t seem to understand that money being used to pay down a mortgage may be better used where it can earn a rate of return in an investment.
Every time you pay down more than the minimum required amount on your mortgage, you are giving away your liquidity. Liquidity is the ability to access your money to buy the things you need today. You can’t eat bricks. The money on your mortgage is no longer accessible. This low liquidity is what banks want, because when (not if) you need your money back, you must borrow it back at higher rates (lines of credit, loans, or the worst - credit cards).
There was a time when mortgage rates were sky high, such as in the 1980s. If and when those conditions ever return, then paying down mortgages quickly is a good strategy.
In low interest environments as we’ve seen since 2009, the wealthy hold mortgages even if they could buy their homes with cash. That is because their money is likely better off invested elsewhere. In simple numbers, a long-term diversified balanced portfolio of 50% stocks and 50% fixed income securities can be expected to earn 4.64%* annually whereas even a fixed rate mortgage (as of the date of publishing this article) costs about 3%. Ignoring taxes, simple comparison dictates that 4.64% is greater than 3%.
*FP Canada’s 2021 Projection Assumption Guidelines
Variable rate mortgages
People don’t seem to understand that banks set the interest rate on fixed rate mortgages to ensure that they will not make less profits than a variable rate mortgage. They are also taking advantage of people’s tendency to prefer budgeting with a nice steady mortgage payment.
These days, a variable mortgage rate is normally a rate set as the bank’s prime rate minus some amount of interest. The bank’s “prime” is the benchmark against which all their lending rates are set. The bank’s prime is normally the Bank of Canada rate PLUS a markup set by the bank. This “markup” is their margin, much like how a shoe store buys a pair of shoes for $40 and sells them for $100. The bank’s variable mortgage rate is linked to the bank’s prime rate, and “floats” or moves whenever the bank prime rate moves. As a result, a borrower’s payments are “variable” and may change over time.
Compare this with a fixed interest rate. Lenders know that borrowers prefer steady payments versus fluctuating payments. To be able to offer a steady payment, and to ensure that the bank will not sacrifice any profit as compared to the variable lending rate from the Bank of Canada (which is the bank’s real cost of borrowing), they will add an amount to their variable mortgage rate to a point where THE BANK is comfortable with the potential risk of rising interest rates. This is in effect a second “markup”. In other words, they are setting up the rules in their favour to ensure they will make their target profits either way. The borrower gets what they want (a steady payment) and the bank is assured of hitting their profit targets. Over the term of a mortgage, because the banks are very good at predicting this (it is their job, after all), a borrower has very low risk of paying more out of pocket with a variable rate mortgage as compared to the fixed rate mortgage.
Here is another way to look at it:
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Over the years, variable rate mortgages have generally provided a better outcome than fixed rate mortgages. One study by Moshe Milevsky, a professor of finance at York University in Toronto, found that Canadian homeowners would have been better off with a variable mortgage almost 90 per cent of the time between 1950 and 2000. That is compelling evidence to take a variable rate mortgage.
If one is prepared and can afford to pay the fixed mortgage rate (the most expensive rate, with 2 markups), I propose this potential strategy. Choose a variable mortgage rate, then save the difference between your payment and the fixed rate you were already prepared to pay. For example, if your 5-year fixed rate mortgage would have payments of $1774/mo as compared to the variable payment of $1656, you could opt to take the variable rate mortgage while saving the difference ($118/mo) to your TFSA with a reasonable investment in accordance with your tolerance for market fluctuation. Over time, if you never spend the TFSA money, you will most likely have a higher net worth over your lifetime as compared to having taken the fixed mortgage. Ignoring rate of return, you’d have $7080 set aside over 5 years and the same principal paid down. If you ever need some money in an emergency, you will have some tucked away. If rates ever rise above what you can afford for the mortgage payment, you can use that money to offset it. Had you taken the fixed rate mortgage, you’d have to borrow money for that emergency at a rate much higher than the rate you’re paying on the mortgage. Win/win.
Buy/hold with rebalancing
Some people don’t seem to understand that timing the market to buy and sell mutual funds or other fluctuating assets is next to impossible, and that scheduled rebalancing is effectively similar to market timing without the anxiety.
Definition: an investment is an asset you own where long-term benefits are expected from ownership of that asset.
Note that an investment is long-term. Patience is required when investing. A tree does not bear fruit on Day Two. If it is not long-term, it is not investing – it is gambling.
Your portfolio’s asset allocation is the percentages of different asset types within the portfolio (x% equities, y% bonds, z% real estate…). Rebalancing is the act of adjusting your portfolio from time to time to account for changes in the markets, normally to return the portfolio to its original allocation percentages that you set up at the beginning of your investment journey. Rather than trying to time "buys" and "sells" by trying to anticipate market movements, investors are typically better served by designing portfolios that can weather market conditions with asset classes that complement each other, that behave differently under the different conditions, and where the whole portfolio will fluctuate only within an amount that the investor is comfortable with. Different conditions could be bull/bear stock markets, rising/falling interest rates, rising/falling exchange rates…. Rebalancing allows the investor to buy low and sell high at times when the portfolio's underlying assets have had differing rates of return (e.g. bonds doing better than stocks, or one stock doing better than another stock). Rebalancing is best done on a schedule, such as once/year. This steadies the investment risk, reduces investor anxiety and helps rates of return over the long term.
When someone tries to “time the markets”, they hold cash until they think the market has hit a “low”, and then they buy the assets. Holding cash rather than a diversified investment portfolio is a form of shorting the market, which is a form of betting. The investor is “betting” that the market is about to go into a downward spiral and that they will be able to identify the bottom of the spiral. We know from historical records that this is nearly impossible to predict, even for experts. Strategic disciplined investors are not gamblers. There are many studies that show being out of the market and missing the best days in market cycle can drop your rate of return dramatically (go ahead, Google “miss the best days stock market” - I'll wait...). Market timing simply doesn’t work, period. Be a strategic investor.
Life insurance
Life insurance is not a gimmick. It is not a scam. It is a financial tool used to flatten financial risks due to someone’s end of life.
Notwithstanding that individual life insurance benefits are 100% tax-free in Canada, there are differences between term and permanent life insurance. Term life insurance is used to offset time-limited financial risks (e.g. paying debts, children's education, lost wages). If someone dies, their dependents or business partners suffer great loss. Dying younger than the average lifespan is thankfully a very low probability event, but when it does occur, the outcome for the people around them can be catastrophic. Term policy rates or “premiums” rise with age because as people age their probability of death rises. The owners typically surrender their policies as rates rise and become unaffordable and they are unlikely to die while the policy is in place. As a result, there is only a 2-3% likelihood that a term policy will pay out its benefit. Because this is such a low risk for the insurance company, term life insurance is the least expensive type of life insurance.
By contrast, permanent life insurance is used for long-term tax (e.g. offsetting capital gains on a cottage) and estate strategies (e.g. the risk of lost pension income if a pensioner dies young). Permanent life insurance will pay out 100% of the time. Permanent life insurance, over a lifetime, is much less expensive than term, normally with a steady payment premium and a growing tax-free benefit.
Permanent life insurance is just another type of financial asset. People often think that they would be better off to simply invest the premiums instead of funding an insurance policy. Most people calculate such an investment with an average lifespan. One simple problem with that strategy is that more than half the population dies earlier than the average. Another problem is taxes on investments (recall that life insurance benefits are tax-free). Life insurance levels off that risk by front-loading a large payout in the early years (the base benefit) and building up the benefit amount over time (the growth). It is like starting a race with a huge head start. If two individuals used the same out-of-pocket money to fund 1) a whole life insurance policy or 2) a tax-free investment, and both lived long lives, then the outcome would be about the same. No one knows ahead of time how long they will live. Also, the tax benefits of life insurance are hard to beat (you can’t do better than tax-free). And yes, you can invest in a TFSA for tax-free investments, but what if you want to invest more than your TFSA limit? There are no such limits with life insurance, and most policies have some measure of access to your money before death.
Is life insurance perfect? No. Neither are cars, investments, houses, supermodels, TVs.... It seems the most frequent reason people don’t invest in life insurance is because it isn't “perfect”. Perfect is not even on the menu. Nothing in life is perfect, and life insurance is no different (pun intended). Money is agnostic and has no memory. Provided the money was obtained legally and morally, your family or charity will not care where it comes from. It could be from a salary, a business, equity, interest, dividends or life insurance. Whether you save $50 on a blender or a car, it is still $50 in your pocket. That money doesn't remember its source, it doesn’t care, and nor should you. You don't have to like insurance. It may even seem unfair that your family could receive such a large benefit for the low premiums that were paid. You'll simply be viewed by your loved ones as having made a very smart decision. Most people don't like colonoscopies, but if someone needs one, I hope they get one. The real question is - can you obtain the insurance?
Honourable mentions
One article can’t take care of all topics, but the following are the ones that got away:
Conclusion
No financial tool comes with an instruction manual. Life is like a golf course. You have a bag of clubs, and they represent the tools at your disposal - different accounts, different strategies, mortgages, insurance... A good financial planner is like a caddy, helping you use the right club and strategy at each hole, helping figure out the lie for each shot. But you're still in control, you're the one taking the shots.
Personal finance is all about decisions. A good financial planner will help you navigate the decisions you need to make and the tools at your disposal to help achieve the personal or business goals you set for yourself. You’ll be the one holding the trophy at the end.