Archive | Financial planning

How Contributions Affect Your Rate of Return

Whenever I update the returns of my model portfolios, readers ask how the performance would have been different had they added money to the portfolios money each month. This question gets to the heart of the difference between time-weighted and money-weighted returns, which I introduced in my previous post.

In our new white paper, Understanding Your Portfolio’s Rate of Return, Justin Bender and I explain the differences between these two methods using two hypothetical investors with a $250,000 portfolio: the first makes a single $25,000 contribution while the other makes a $25,000 withdrawal. Now let’s look at a different example that includes monthly cash flows.

A tale of two accounts

Meet Buster, an investor with an RRSP and a TFSA that both hold an index fund of Canadian stocks (I’ve used the MSCI Canada Investable Market Index for the calculations). At the beginning of 2014, Buster’s RRSP had a balance of $200,000 and he made $500 monthly contributions throughout the year. Buster’s TFSA has valued at $30,000 at the beginning of the year and he made a single lump-sum contribution of $10,000 in September.

At the end of the year,

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Calculating Your Portfolio’s Rate of Return

Perhaps no number is more important to investors than the rate of return on their portfolio. Yet this seemingly simple calculation is fraught with problems. If you’ve made contributions or withdrawals during the year, calculating your rate of return is not straightforward. What’s more, there are several ways to perform the calculations: the results can differ significantly, and each method has strengths and weaknesses. No wonder so many investors have no idea how to measure or interpret their returns.

In our new white paper, Understanding Your Portfolio’s Rate of Return, Justin Bender and I introduce the various methods used to calculate a portfolio’s rate of return, explain how and why they can produce different results, and help you determine which method is most appropriate to your circumstances. Justin has also updated his popular calculators, which you can download for free on the new Calculators section of the PWL Capital website.

Time and money

Rate of return calculations fall into two general categories: time-weighted and money-weighted. If a portfolio has no cash flows (that is, the investor makes no contributions and no withdrawals),

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How Budget 2015 Will Affect Investors

Yesterday’s federal budget included several changes that will affect investors—in the future if not immediately. Let’s look at the three most important announcements, with a focus on how they may apply to those who use an index strategy with ETFs:

The biggest headline was the increase in annual TFSA contribution room from $5,500 to $10,000, beginning immediately.

Minimum withdrawals from RRIFs were reduced significantly.

Investors who hold foreign property (including US-listed ETFs in non-registered accounts) will be able to report this to the Canada Revenue Agency in a more efficient way.

Asset location just got more interesting

If you’re juggling TFSAs, RRSPs and non-registered accounts, asset location is a challenge. To manage your portfolio in the most tax-efficient way, you should consider which asset classes (equities, bonds, REITs and so on) are best held in which type of account. This isn’t straightforward. You can make a strong argument for holding bond ETFs in a registered account because they are so tax-inefficient. But if a TFSA can shelter you from taxes over an entire lifetime, shouldn’t it be reserved for assets with the highest growth potential—in other words, stocks?

There is no single right answer: an awful lot depends on individual circumstances such as your current tax rate,

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Tax Loss Harvesting Revisited

No one likes to see their investments plummet in value, but it’s going to happen many times over your lifetime. If you’ve got a strategy for tax loss selling, you can make the best of the situation by harvesting capital losses that can be used to offset capital gains. That gives you an opportunity to reduce or defer taxes in the future, or even recover taxes you paid in past.

In a blog post on September 26, I noted that Canadian equities had fallen by about 5% since the beginning of the month, which could have triggered one such opportunity. (A useful rule of thumb, courtesy of Larry Swedroe, says a security should be sold when the loss is at least 5% and at least $5,000.) If you had recently made a large purchase of the Vanguard FTSE Canada All Cap (VCN), for example, you might have sold it that week to realize a capital loss and then repurchased the iShares Core S&P/TSX Capped Composite (XIC) or a comparable fund. As long as the replacement ETF tracks a different index you’ll maintain your exposure to Canadian stocks while also steering clear of the superficial loss rule.

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An Interview With Wealthsimple: Part 1

Wealthsimple is one of several online investment firms that have launched in Canada this year. They’ve often been referred to as robo-advisors, though they reject that name, and with good reason. While some parts of the process are automated, clients of these new firms do interact with humans, and all the trades are made by a flesh-and-blood portfolio manager.

At Weathsimple, that portfolio manager is David Nugent, and we recently sat down to discuss the firm’s advice model and investment strategy. Here’s the first part of our interview.

The first step in building a client’s portfolio is determining an appropriate asset allocation. How do you do that?

DN: The first step is a 10-question risk assessment clients do online when they sign up for an account. After that they book a call with me—or, as we grow, someone else on our team. We try to get an understanding of their past investing experience and any biases they might have, and then we talk about the asset mix. The real conversation happens over the phone.

Surprisingly, we’re more likely to see people increase their risk level after the phone call.

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How to Estimate Stock and Bond Returns

Even the simplest financial plan requires assumptions about how your investments will perform. We know these assumptions can never be perfectly accurate, but they need to be thoughtful and reasonable. If you’re just assuming a balanced portfolio will return 7% every year, then your projections aren’t likely to be useful.

So what exactly are reasonable assumptions for stocks and bonds? In Great Expectations—a new white paper I’ve co-authored with Raymond Kerzérho, PWL Capital’s director of research—we explain the methodology we use when creating financial plans.

There are two main approaches one can use when estimating future returns. The first is to rely on history: for example, if the average return of global stocks over the last century was 8%, one could simply assume the same going forward. The second approach uses valuation metrics to estimate future stock returns based on current market conditions. You can also apply these two methods to expected bond returns, using either the long-term historical average or the current yield on a benchmark index.

As you’ve probably figured out, both methods are flawed. But as we argue in the white paper,

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Do Bonds Still Belong in an RRSP?

It has long been conventional wisdom that bonds should be held in RRSPs wherever possible, since interest income is fully taxable. Once you run out of contribution room, equities can go in a non-registered account, because Canadian dividends and capital gains are taxed more favorably. But is this idea still valid? That’s the question Justin Bender and I explore in our new white paper, Asset Location for Taxable Investors.

Here’s an example we used to illustrate the problem. Assume you’re an Ontario investor with a marginal tax rate of 46.41%. Your non-registered account holds $1,000 in Canadian equities that return 8%, of which 3% is from eligible dividends and 5% is a realized capital gain. You would pay $8.86 in tax on the dividend income ($30 x 29.52%) and $11.60 on the realized capital gain ($50 x 23.20%), for a total of $20.46. Meanwhile, a $1,000 bond yielding 5% (or $50 annually) would be taxed at your full marginal rate, resulting in a tax bill of $23.21.

In this example, even though the total return on the stocks was higher (8% versus 5%) the amount of tax payable on the bond holding was significantly greater.

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Ask the Spud: Is My Pension Like a Bond?

Q: My wife and I have been using the Couch Potato strategy for a few years now, but something has always nagged me. I am fortunate enough to have a defined benefit pension that will pay me $50,000 a year in retirement. Should I consider this the fixed income portion of my portfolio and put the rest in equities? – Brian

This a critical financial planning question for anyone with a pension, and yet it’s often framed in an unhelpful way.

A popular school of thought says you should think of a pension as a bond, presumably because both bonds and pensions pay predictable amounts of guaranteed income. The problem is, there is no way to put that idea into practice when managing a portfolio.

In this case, our reader has a pension that will pay him $50,000 a year. What would an equivalent bond holding be? Let’s assume he also has $300,000 in personal savings, and that it’s all equities. What would his overall asset allocation be? Even if he did establish a present value for the pension, how would that be helpful when it was time to rebalance the portfolio to its targets?

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Will Robo-Advisors Ever Come to Canada?

Every investor who’s fired a bad advisor and become a do-it-yourselfer has probably had mixed feelings. On one hand, it’s liberating to get away from a costly strategy that was performing poorly. But if you’ve never managed your own portfolio, it won’t take long to realize it’s not as simple as you first thought. In the last couple of years a growing number of US investors has been bridging that gap with online services that design, implement and manage ETF portfolios for a fraction of the cost of a human advisor.

These so-called “robo-advisors” take you through a series of questions to determine your goals and your risk tolerance and then build a diversified portfolio using an appropriate mix of equity and bond ETFs. The service looks after rebalancing and reinvestment of dividends: all you do is contribute regularly and the software does the rest. Wealthfront, which bills itself as “the largest and fastest growing software-based financial advisor,” even includes tax-loss harvesting for accounts over $100,000.

The cost for all of this? At Wealthfront you can invest your first $10,000 for free, after which the fee is 0.25% annually.

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