The Case for Renting a Home Part I

Canadians really like real estate. It’s hard not to be excited when prices in hot markets like Toronto and Vancouver have been making global headlines. Around two-thirds of Canadians own their home, and the perception is generally held that owning your home is a smart investment.

Many Canadians feel that they need to buy a home as soon as possible because they are throwing their money away by renting. I’m sure you have heard the line that renting is “paying someone else’s mortgage.” On the surface this seems to make sense, but there are some important factors that need to be considered.

Let’s think about the benefits that renting has over owning. If there is a possibility that you could move within ten years of purchasing a home, you are taking on enormous risk. It is true that over the long-term real estate tends to go up in value, but in the short-term, its value can go up or down unexpectedly. Combine this price risk with the fact that most people borrow a significant portion of the money needed to buy their home, and ownership gets pretty risky for anyone with a short or uncertain time horizon.

A renter is paying a set cost in exchange for a place to live. Explicitly knowing the cost of your housing has its advantages, and the predictable monthly expense is useful in planning your finances. A homeowner can easily plan for their mortgage payment and property tax, but they may also have expensive maintenance costs that appear unexpectedly. These unexpected costs may result in the need to borrow money, or the need to carry a large cash reserve - both inefficient uses of capital.

Owners get sucked into the idea that their home is an investment. Based on this thinking, they will often spend heavily on renovation or maintenance projects on the premise that they are increasing the value of their home. Unfortunately, there is no guarantee that expensive home improvement projects will actually pay off. In his book The Wealthy Renter, real estate analyst Alex Avery explains that his “Golden Rule of Investing in Real Estate is that buildings never go up in value. Ever. Period. Only land can go up in value”.

Those were three benefits of renting that are important to keep in mind: Less risk, predictable cost, and no investment illusion. Of course you’re still wondering, isn’t renting throwing money away?

When you’re renting you’re just exchanging money for the use of something without any expectation of a residual value. Paying rent for a place to live is obvious. You give money to the landlord. They give you the keys. You get nothing back. What many people fail to consider is that homeowners are also paying forms of rent. They are renting services from the city in the form of property taxes, they are paying unrecoverable maintenance costs just to keep their house inhabitable, and they are renting money from the bank while they have a mortgage. But surely when the mortgage is paid off a homeowner’s cost of living is much lower than a renter’s. Not so fast.

Let’s think about someone with a paid off house worth $500,000. They could sell that house, keep around $475,000 after costs, and invest the money. Let’s say that they could expect to earn a 6% annual average long-term return on their investments, while the long-term expected return on real estate is closer to 3%. That 3% difference in expected returns is an opportunity cost. The opportunity cost of owning this home is around $14,000 per year. You don’t actually see the opportunity cost in any of your accounts, but it’s there. Add to that property tax and maintenance costs, and we can easily arrive at a total monthly cost of ownership of over $2,000. That’s $2,000 of unrecoverable costs with no residual value. Renting doesn’t look so bad anymore.

So far we have established that renting has some advantages, and owners also have substantial expenses with no residual value, so why does home ownership have such a good reputation?

The real estate and home improvement industries have obvious self-serving motivations to make home ownership look good. The Canadian government has programs in place to encourage home ownership, making it seem like a good idea. Most importantly, there are a lot of people in Canada who genuinely believe that their home has been their best investment. It is common for well-meaning friends or relatives to encourage home ownership based on their perception of their own experience.

It’s no wonder why many people think that their home has been a great investment. The numbers are big, and investment returns are not always easy to understand. The average Canadian home purchased in 1980 for $62,000 would be worth $496.500 in 2017. That seems like a great return. Over 38 years it works out to 5.63% per year on average before costs. When a homeowner is standing back after 38 years and admiring the appreciation in the value of their home, they aren’t usually accounting for the costs incurred along the way, but the costs were definitely there.

Property taxes and maintenance could be reasonably estimated at a combined 2% per year reducing the annual return to 3.63% after costs and before inflation. Canadian inflation over this time period was 3%. So that seemingly massive gain from $62,000 to $496,500 was really only equivalent to a 0.63% average annual return after costs and inflation. For context, the S&P/TSX composite index returned an annual average of around 5.9% after inflation over the same time period. The long-term after-inflation returns to US and UK real estate are similarly low, barely beating inflation over the past 115 years, while stocks in those countries have far exceeded inflation.

Hmmm so real estate returns aren’t actually so great. Home ownership does have one big benefit that really does build wealth. A mortgage forces discipline. It is much easier to stop the monthly contribution into your RRSP than it is to miss a mortgage payment. That discipline does pay off over the long-term, but it does not actually make home ownership an inherently great investment. People can be disciplined renters and investors, too.

I have started to make the case that renting a place to live is a sensible alternative to home ownership for building long-term wealth. In my next post, I will lay out the numbers that prove my case.

For more see my PWL Capital white paper on renting.

Debunking Canadian Dividends for Taxable Investors

Canadian eligible dividends are tax efficient for taxable Canadian investors. This is one of the reasons that the mystical dividend investing strategy continues to have a cult-like following. As attractive as the tax rates on dividends are, dividends do still produce taxable income. A dividend-focused strategy will likely have most of its return coming from dividends. This means that even if the portfolio is producing more income than you can spend, you are still paying tax on the excess. There are also structural issues with a dividend-focused portfolio: a portfolio constrained to Canadian dividend paying stocks cannot possibly be sufficiently diversified. Structural issues aside, in this paper we will look at the capacity of a Canadian dividend focused portfolio to build wealth and fund retirement expenses on an after-tax basis.

Making some assumptions

We will assume that a taxable portfolio worth $1,500,000 is the only asset of a 65-year-old individual with the goal of funding a $4,500 monthly after-tax living expense for the next 31 years. We will assume that their expenses are funded from a combination of their portfolio and Old Age Security.

Setting up the analysis

For the first part of the analysis, we will compare the ending wealth, assuming straight line returns, of a Canadian dividend focused portfolio to a globally diversified and rebalanced total market portfolio. In applying the expected returns to the analysis, we assume unrealized capital gains remain unrealized unless a sale in the portfolio triggers a gain. Realized capital gains are assumed to be triggered annually regardless of any specified withdrawals to simulate the tax costs of rebalancing. The dividend focused portfolio is assumed to only earn Canadian dividends and unrealized gains.

Table 1 - Expected Returns (Equities)

Foreign Dividends Canadian Dividends Unrealized Capital Gains Realized Capital Gains
Canadian Dividend Focused 0.00% 4.04% 2.00% 0.00%
Globally Diversified Rebalanced 1.31% 0.80% 1.97% 1.96%

Data Source: PWL Capital

Looking into the future

Running this scenario for 31 years results in an ending net worth of $3.18M for the dividend focused portfolio, and $3.35M for the globally diversified and rebalanced index fund portfolio. This result is primarily driven by the relative tax efficiency of the globally diversified portfolio. While this may seem counterintuitive, the taxation of each scenario can be seen in Table 2. The dividend gross up results in an adverse interaction with both the age credit and OAS clawback.

Table 2 - Income Tax Projection

Dividend-Focused Portfolio Globally Diversified Rebalanced
Foreign Dividends $0 $19,650
Taxable Canadian Dividends $83,628 $16,560
Taxable Capital Gains $0 $14,700
OAS Income $6,453 $6,453
Total Income $90,081 $57,363
OAS Clawback $2,126 $0
Taxable Income $87,956 $57,363
Federal Tax on Taxable Income $15,468 $9,169
Tax Credits (Non-Refundable)
Personal Credit $1,771 $1,771
Age Credit $0 $641
Dividend Credit $12,561 $2,487
Total $14,332 $4,900
Regular Federal Tax $1,135 $4,296
Ontario Income Tax
Basic Ontario Tax $7,392 $4,087
Ontario Tax Credits $8,886 $2,285
Ontario Surtax $1,619 $0
Total $2,369 $1,803
Total Tax (Including OAS Clawback) $6,462 $6,099

Data Source: NaviPlan

Sequence of returns

We have now seen that a dividend focus is not a sure-fire way to build after-tax wealth. One of the other risks that dividend investors are exposed to is a false sense of safety. The notion that you will be paid to wait by collecting dividends when stocks are down can make dividend paying stocks seem safer than they are. Dividend stocks are still stocks. Based on the history of the DJ Canada Select Dividend Index we can estimate an annual standard deviation of 11.80%. That’s a lot of volatility for a retiree, but volatility is only one measure of risk. A more tangible measure of risk might be the risk of running out of money. From this perspective we can use Monte Carlo analysis to compare the outcome of an investor using an all-equity dividend focused strategy to an investor using a globally diversified 60% equity 40% fixed income portfolio.

It is clear that, on average, an all-equity dividend-focused strategy can be expected to outperform a 60/40 portfolio on an after-tax basis in terms of building wealth. This is simply due to the higher expected returns of stocks more so than the tax attributes of dividends.

Table 3 - Expected Returns (60/40)

Foreign Dividends Canadian Dividends Unrealized Capital Gains Realized Capital Gains
Canadian Dividend Focused 0.00% 4.04% 2.00% 0.00%
60/40 Portfolio 1.70% 0.48% 1.33% 1.33%

Data Source: PWL Capital

Based on these expected return assumptions we would expect an ending net worth of $3.17M for the dividend investor, and $1.95M for a globally diversified 60/40 investor.

The story gets much more interesting when we also consider the impact of the expected volatility on the long-term outcome. The Dividend-focused portfolio has an expected return of 6.04% with a standard deviation of 11.80%. The 60/40 portfolio has an expected return of 4.84% with a standard deviation of 7.09%. Based on a $4,500 per month draw, we can compare the results of relying on each of these portfolios using Monte Carlo analysis.

Table 4 - Probability Analysis

Goal Success Rate 90th Percentile Ending Wealth 50th Percentile Ending Wealth 10th Percentile Ending Wealth Earliest Age Assets Depleted
Canadian Dividend Focused 94.40% $6,198,188 $2,182,697 $312,337 83
60/40 Portfolio 98.40% $3,063,997 $1,544,148 $458,468 91

Data Source: NaviPlan

Despite a lower average return and therefore lower average ending wealth, the 60/40 portfolio offers a higher probability of achieving the ultimate goal of funding retirement expenses until death. The 60/40 portfolio also offers a higher average ending wealth in the 10th percentile of outcomes. Most importantly, in a worst-case scenario, the 60/40 portfolio lasts 8 years longer than the dividend-focused portfolio. If the primary goal is to build wealth, then it is true that an all stock portfolio is likely to provide the best result. However, the volatility of equities may be sub-optimal for funding retirement income.

Idiosyncratic risk

So far, we have shown that a dividend-focused Canadian equity strategy is suboptimal in terms of building wealth (compared to other equity portfolios) and funding retirement goals (compared to a 60/40 portfolio). The other risk that needs to be considered is idiosyncratic risk. It is not possible to sufficiently diversify using only Canadian stocks that pay dividends. Idiosyncratic risk cannot be planned for or modelled, but it can quickly wipe out a portfolio.


As we have seen from the preceding analysis, a Canadian-dividend-focused investment strategy does not necessarily result in superior tax efficiency. We have also seen that the statistical reliability of an all-equity portfolio may be suboptimal for a retiree. Finally, the idiosyncratic risk of a dividend portfolio is a substantial risk that is easily mitigated through proper diversification.

Not all index funds are created equal

I talk a lot about index funds in this video series. I have told you that low-cost index funds are the most sensible way to invest, and that you should do everything that you can to avoid the typical high-fee mutual funds that most Canadians invest in. Great, well that’s easy then. Buy index funds. Where do I sign up? Unfortunately the financial industry does not like making things easy for investors.

With the increasing popularity of index funds, index creation has become big business. There are sector index funds, smart beta index funds, equal weighted index funds, and many others, making it that much more challenging for investors to make sensible investment decisions.

Let’s start with the basics. An index is a grouping of stocks that has been designed to represent some part of the stock market. Most of the indexes that you hear about day to day are market capitalization weighted. Standard and The S&P 500, an index representing the US market is a cap weighted index. This just means that the weights of the stocks included in the index reflect their relative size. A larger company, like Apple, holds more weight in the S&P 500 than smaller companies, like Under Armour.

You can buy a fund that just buys the stocks in the index. When the index changes, the holdings in the fund change. This all sounds great so far. Low-cost index investing is what it’s all about. One problem for investors is that the big name indexes like the S&P 500 only track large cap stocks. Historically, large cap stocks have had lower returns than small and mid cap stocks, so excluding them from your portfolio could be detrimental.

The Center for Research in Security Prices, or CRSP, is another index provider. The CRSP 1 - 10 index is a market cap weighted index covering the total US market. While the S&P 500 offers exposure to 500 stocks covering 80% of the value of the US market, the CRSP 1 - 10 offers exposure to over 3,500 stocks, covering the vast majority of the value of the US market, including the smaller stocks missed by the S&P 500.

An index fund tracking the CRSP 1-10 is what you would call a cap weighted total market index fund. This is the building block for an excellent portfolio. There are total market indexes, and index funds that track them, available for Canadian, US, International, and Emerging markets stocks. The MSCI All Country World Index is.. What it sounds like. A total market index covering the whole world. An ETF tracking this index can be found in the Canadian Couch Potato ETF model portfolios. Total market index funds are well-diversified and extremely low-cost to own. That is exactly what you want as an investor. The Canadian Couch Potato ETF model portfolios, which are globally diversified total market index fund portfolios, have a weighted average MER of around 0.15%.

That is exactly why fund companies have had to come up with other index products to try and sell you. They need a reason to make you pay higher fees. One way that fund companies have been able to increase the fees on their index funds is by focusing on indexes that track specific sectors. The Horizons MARIJUANA LIFE SCIENCES INDEX ETF captures a sector that many people are interested in right now. It has an MER of 0.75%. There is no rational reason to buy this ETF other than to speculate on a hot sector, but Horizons is cashing in.

Another buzz word that fund companies have been using to charge higher fees on index funds is smart beta. Smart beta funds attempt to find characteristics of stocks that seem to have explained higher returns in the past. Some of these factors are extremely well-researched.

A 1992 paper by Eugene Fama and Kenneth French, “The Cross-Section of Expected Stock Returns,” pulled together past research to present the idea that a large portion of stock returns could be explained by company size and relative price. In 1997, Mark Carhart, in his study “On Persistence in Mutual Fund Performance,” added to the Fama/French research to show that momentum further explains stock returns. Finally, in 2012, Robert Novy-Marx’s paper, “The Other Side of Value: The Gross Profitability Premium,” showed that profitability further explains stocks returns.

Together, those characteristics are responsible for the majority of stock returns, so owning more stocks with those characteristics in your portfolio might be a good idea. Fund companies have tried to build products around this research, but the execution has not always been great.

In a 2016 blog post, my PWL colleague Justin Bender analyzed the iShares Mutifactor ETFs, ETFs tracking indexes that target some of the well-researched factors. Justin found that they did not deliver on their promise of factor exposure - disappointing considering their relatively high cost compared to a total market ETF. There are other fund companies, like Dimensional Fund Advisors, with a long history of capturing the well-researched factors. recommend products from Dimensional Fund Advisors in the portfolios that I oversee.

I keep saying well-researched factors because there are companies building indexes based on factors that are not as well-researched. They may be based on bad research, bad data, or data mining. In their 2014 paper, “Long Term Capital Budgeting,” authors Yaron Levi and Ivo Welch examined 600 factors from both the academic and practitioner literature. Not all of these factors would be expected to give you a better investment outcome, but they do give fund companies a reason to charge you a higher fee.

For most investors, a portfolio of market cap weighted total market index funds is all that you need. Many of the other index fund products out there claiming to track some special index are gimmicks designed to convince you to pay extra.

Ignore Market 'Experts'

People want certainly. David Freedman, in his 2010 book “Wrong” offers the example of a person suffering from back pain. He visits two doctors to review their MRI. One doctor says that he has seen many similar cases and that it’s hard to say exactly what’s wrong. He suggests trying out a treatment and going from there. The other doctor says that he knows exactly what is wrong and knows what to do. Which doctor do you choose?

Most people will choose the doctor who seems certain about his diagnosis, but that doctor may very well be wrong. As much as we crave certainty, it rarely exists, and it definitely does not exist in the world of financial markets where returns are driven by events that cannot be consistently forecasted. Market experts want you to believe that their insight can help you make better investment decisions. Sell this, buy that [point side to side for animations of stocks to buy].

It may be interesting to listen to market experts, but should you actually believe anything that they say?

Let’s start off by remembering that there is a tremendous amount of evidence that actively managed funds, on average, consistently fail to outperform their benchmark index. Actively managed funds are groups of market experts working together to outsmart the market, and, on average, they are not able to make the right calls based on their own predictions. So why would some person claiming to be a market expert online, on the radio, or on TV be any different? Well, guess what? They are not any different.

There have been two comprehensive efforts to aggregate and analyze the predictions of stock market gurus. One data set from CXO Advisory Group looked at the forecasts of 68 stock market experts spanning 2005 through 2012. They collected a total of 6,582 forecasts for the U.S. stocks market. Some of the forecasts had been made as far back as 1998, ending by 2012. The forecasts were then compared to the S&P 500 over the future intervals relevant to the forecast. The analysis found that the aggregate accuracy of all forecasts was less than 50%.

The other study of predictions is called the Gurudex. It looks at the 12 month period ending in December 2015. Rather than focusing on individual market gurus, the Gurudex looks at the stock predictions of large institutions. Not only does the Gurudex assess the accuracy of the forecasts, but it also compares the return of an investor who had acted on all of the predictions to the return of the S&P 500 over the same period.

For the twelve months ending December 2015, the Gurudex shows an average stock prediction accuracy of 43% for the 16 institutions that they tracked. It’s not like these are no-name institutions, either. RBC Capital Markets, BMO Capital Markets, Goldman Sachs, and UBS were all included. Only 4 of the 16 institutions had greater than 50% accuracy over the 12 month time period. One of those four, a Japanese institution, batted 60%, while the other 3 were right 53% of the time, barely better than a coin flip. The accuracy numbers drop sharply from there.

If an investor had acted on each of the stock predictions that these large institutions made in 2015, they would have earned a -4.79% return while the S&P 500 was relatively flat at -0.69%.

In an attempt to explain such low accuracy for these supposed experts, the author of the CXO Advisory analysis points out an important perspective on forecasts. The market expert making a forecast may have motives other than accuracy. For example, some market gurus may be making extreme forecasts to attract attention to their institution or publication. This is an important thing to keep in mind when you read or listen to market experts - they don’t care about you. Their motivation might be driving traffic to their publication, or bringing attention to their product or service, but their focus is almost certainly not on giving you financial advice that is in your best interest.

One notable market expert, Andrew Roberts, the Royal Bank of Scotland’s research chief for European economics and rates, made headlines in early 2016 by advising investors to ‘sell everything’ in preparation for a ‘cataclysmic year’. This was sensational enough to be picked up and written about by the Telegraph, CNN, the Wall Street Journal, and the Financial Post, among many other publications. Of course 2016 went on to be an excellent year for investors. So did 2017. Woops.

Warren Buffett famously said “We have long felt that the only value of stock forecasters is to make fortune-tellers look good. Even now, Charlie (Munger) and I continue to believe that short-term market forecasts are poison and should be kept locked up in a safe place, away from children and also from grown-ups who behave in the market like children.”

While it may be tempting to listen to those who prognosticate the best stocks to buy or the future direction of the market, it is important to remember that the data refutes their ability to improve your investment decisions. Market experts are not regulated. There is no licensing body or minimum level of education to call yourself a market expert and start making predictions. Even if there was, the evidence shows that no level of education or intelligence makes it possibles to beat the market consistently. Market experts should be viewed as nothing more than they are: a source of entertainment.

Should you buy Bitcoin?

In my last video I told you about Bitcoin. What is it? Bitcoin is a relatively new thing called a cryptocurrency. Some people think that you can compare it to a traditional currency, or gold, while others describe it as a new asset class. Whatever it is, excitement about its potential for future adoption has lead to a rapid increase in price, which has a lot of people wondering if they should be buying in.

How Bitcoin is going to perform in the long-term is anyone’s guess. Without long-term data on Bitcoin, or any other cryptocurrency, it is not possible to make an evidence-based decision about investing in it.

Let’s look at Bitcoin from the perspective of it being a currency. Are currencies good investments? Traditional currencies do not have a positive expected return. In a 2016 essay titled Long-Term Asset Returns, Dimson, Marsh, and Staunton showed that over the last 115 years, currencies have jumped around a lot in relative value, but you would not have been any better off with exposure to one currency over another.

Bitcoin has also drawn comparisons to gold. Unfortunately, that does not mean that you should buy bitcoin. The evidence for gold as an investment is not very good. Some people argue that gold is an inflation hedge, and that bitcoin could be the same. In a 2012 paper, Claude Erb and Campbell Harvey found that while gold has been an inflation hedge over the very, very long-term, “In the shorter run, gold is a volatile investment which is capable and likely to overshoot or undershoot any notion of fair value.”

So if Bitcoin is a currency, it probably isn’t something that you want to invest in. The price volatility of currencies, and gold, does mean that while they do not have a positive expected return as a long-term asset, you may still be able to profit by trading them - buying low and selling high as the price fluctuates. Of course, the problem with trading currencies is that they are random and volatile, leading to extremely unreliable outcomes.

In a Medium post, Adam Ludwin from Chain, a company that builds cryptographic ledgers, explains that he views bitcoin not as a currency, but as a new asset class altogether. Much like stocks and bonds currently serve public companies, Ludwin writes that cryptocurrencies are assets that serve decentralized applications. A decentralized application is service that no single entity operates due to its utilization of the blockchain. Ludwin explains that, in general, a decentralized application allows you to do something you can already do (like make payments, in the case of bitcoin) but without the need for a trusted central party.

While decentralization sounds like a good thing, there is a catch. By nature of being decentralized, decentralized applications are slower, more expensive, and less scalable. They also have worse user experience, and volatile and uncertain governance. When a service is completely decentralized, there is no customer service center. There is no help line. There is no way to get your bitcoin back if you lose it. In contrast, if you damage your US dollars in a fire, you can bring the scraps to the US government and they will try to identify the bills and reimburse you. That type of centralized service is lost with decentralization.

Ludwin explains that bitcoin isn’t best described as “Decentralized PayPal.” It does not compare to PayPal in terms of user experience or efficiency. It’s more honest to say it’s an extremely inefficient electronic payments network, but in exchange we get decentralization. The obvious question follows: who cares about decentralization enough to put up with a slow, inefficient, and inconvenient method of payments? The most obvious answer is people who want their transactions to remain anonymous and who do not want to be censored by, say, a government.

Based on Ludwin’s arguments for bitcoin as a separate asset class that serves a decentralized payments application, its value will be derived from the adoption of Bitcoin as a means of exchange. Buying bitcoin in hopes of benefitting from its widespread adoption, keeping in mind the very specific type of person that would value bitcoin enough to put up with its shortfalls, would be very speculative.

In an interview with Coin Telegraph, Eugene Fama, the father of modern finance, explained he believes that bitcoin only has value to the extent that people will accept it to settle payments. He explains that if people decide they don’t want to take it in transactions, it’s value is gone. When Fama’s interviewer tells him that bitcoin also derives value from its censorship resistance component, Fama says “I guess that for a drug dealer that has a lot more value. But otherwise, I don’t see the big value about that.” While Fama’s answer may seem flippant, it touches on the same point that both that Ludwin made - Bitcoin’s price depends on its adoption.

So why has bitcoin’s price seen such a sharp increase? It's safe to say that the future supply and demand of bitcoin are highly uncertain, but the expectations of future supply and demand are factored into the current price. Each time someone pays a little more to own a bitcoin, they are injecting their future expectations into the price. The recent rapid price increase is due to people’s expectations that bitcoin will be widely adopted in the future. The fact that the number of bitcoins can reach an upper limit is an often-used argument that bitcoin will retain its value over the long-term. That may be true in isolation, but the future supply of cryptocurrencies is a big unknown. New cryptocurrencies have emerged that attempt to improve on bitcoin's design, potentially reducing the demand for bitcoin as a payment system.

Bitcoin is either an inefficient currency in the early stages of adoption with plenty of disadvantages and one big advantage over traditional currencies, or its a new type of asset that serves a decentralized payments application. In either case, the long-term value of bitcoin will mainly be derived from from its adoption as a mainstream currency by the people who value decentralization enough to put up with all of the downsides.

There is no doubt that bitcoin is based on an exciting new technology with potentially widespread applications. Investing in bitcoin is a bet that this technology will meet or exceed the expectations that current market participants have for it. Just like I would be wary about investing in gold, an individual stock, or a specific currency, I would be very hesitant about buying bitcoin. And I’m not the only one thinking that way. Warren Buffett, one of the greatest investors in history, recently said "In terms of cryptocurrencies, generally, I can say with almost certainty that they will come to a bad ending,"

If you must buy bitcoin, keep in mind that its market capitalization is still less than 1/3rd of 1% of the global market capitalization of stocks. You might consider allocating bitcoin to your portfolio accordingly.

What is Bitcoin?

It is next to impossible to avoid hearing or reading about bitcoin. Within the past decade, it has gone from being a fringe idea proposed in a paper written by a mysterious author, to being a mainstream technology that some people are treating as a new asset class. Bitcoin is now getting attention from the media, individual investors, and even large financial institutions.

As bitcoin continues to surge in both popularity and price, investors will naturally wonder if they should own some. This is an important question to ask, but to frame the decision about owning bitcoin, we first need to know what Bitcoin is.

Bitcoin is a cryptocurrency. Cryptocurrencies are a relatively new technology that has emerged within the past decade. Unlike traditional currencies, cryptocurrencies do not rely on a central issuing body or sovereign government. Instead they rely on blockchain technology. The blockchain is an open, distributed ledger that records transactions in a way that is public, verifiable, and permanent. While there are now countless different cryptocoins available, Bitcoin was the first, and it continues to be, by far, the largest cryptocurrency by market capitalization.

You can buy bitcoins using traditional currencies, or you can mine them. Mining means receiving newly created bitcoins in return for using your computer power to compile recent transactions into new blocks of the blockchain by solving a complex mathematical puzzle. There is a finite supply of bitcoin, with a total of 21,000,000 that can be mined. More than 16,000,000 of those are currently in existence.

For a long time, cryptocurrencies were pretty obscure, and mostly popular within a very niche crowd. More recently,  the sharp increase in the market value of bitcoin and other cryptocurrencies like Ripple, Litecoin, and Ethereum has contributed to intense attention from the media and investors.

Being such a new technology, it is challenging to draw evidence-based conclusions about what bitcoin is. We can try to work around this issue by finding things with longer histories that bitcoin might share characteristics with. On his blog, Aswath Damodaran, a professor of finance at NYU, explains that things can fall into one of four groups: a cash flow generating asset, a commodity, a currency, or a collectible.

Damodaran goes on to explain that Bitcoin is not an asset, since it does not generate cash flows. It is not a commodity, because, at least for now, it is not raw material that can be used in the production of something useful. This leaves currency or collectible, and of the two it is most likely that bitcoin could be classified as a currency.

A successful currency needs to be three things: a unit of account, a medium of exchange, and a store of value. As a unit of account, bitcoin is as good as anything. As a medium of exchange, bitcoin is still far being accepted as mainstream for transactions, and where it is accepted transaction costs are high. Bitcoin has struggled as a store of value due to its significant price volatility. While bitcoin has room to improve as a currency, we might be able to look at it through this lens.

There is one other currency in particular that draws comparisons to Bitcoin: gold. Gold would be considered a currency, not a commodity, because its value comes from its currency-like functions, not its use as a raw material to produce something useful. Like Bitcoin, the amount of gold that can exist is finite. As a currency, gold also has high transaction costs, and a volatile price. It seems like Bitcoin could be a digital substitute for gold.

But not everyone agrees.

In a Medium post, Adam Ludwin from Chain, a company that builds cryptographic ledgers, explains that he views bitcoin not as a currency, but as a new asset class altogether. He does not think that cryptocurrencies should draw comparisons to traditional currencies because their use case is so much different. Ludwin explains that in much the same way that that stocks and bonds serve public companies, cryptocurrencies serve decentralized applications.

A decentralized application is service that no single entity operates due to its utilization of the blockchain. Ludwin explains that, in general, a decentralized application allows you to do something you can already do (like make payments, in the case of bitcoin) but without the need for a trusted central party. The growth and acceptance of decentralized applications could mean enormous growth in the value of the cryptocurrencies that serve them.

Damodaran believes that Bitcoin could take one of three paths in the future. It could become the global digital currency, in which case its high price could be justified. It could become like gold for Millennials. A seemingly safe place for those who have lost faith in centralized authority. In this case, the price would fluctuate much like gold does. Lastly, it could prove to be the 21st century tulip bulb, a comparison to a speculative asset that soared in the sixteen hundreds before collapsing.

I have just told you that bitcoin can draw comparisons to traditional currencies like gold, but it could also end up being a whole new asset class if decentralized applications take off. Or it could fizzle out. Interesting, right? I know I haven’t answered what you’re really wondering. Should you invest? I will be talking about that in my next video.



Do active managers really protect your downside?

Active money managers want you to believe that they can act defensively to mitigate the downside of stocks during a market downturn. This is one of the ways that active managers may try convince you that index funds are too risky. No investor likes the idea of passively sitting by while their portfolio falls with the market.

Investing in index funds means accepting the market through good times and bad, but active managers claim that there is a better way. Should you listen to them?

An index fund will continue to own all of the stocks in the index regardless of the external environment, meaning that when stocks are falling in value, you will continue to own them, and your portfolio will fall in value. An active manager will claim that they can reduce your losses by making changes to the portfolio.

Remember that investing is a zero sum game. If one active manager is able to beat the market during a downturn, it means that another active manager is underperforming. This simple rule invalidates the claim that active managers will always be able to protect you when the market is falling.

Most actively managed funds underperform the market over the long-term, but active managers claim that in anticipation of a downturn they might sell some of the stocks in your portfolio to insulate you from the expected losses. You can always find active managers prognosticating the next market crash, and explaining what they are doing to prepare for it. Maybe they are holding cash, or only buying certain types of stocks.

If you can find an active manager that can offer protection in bad markets, that would truly be an advantage. The problem is that there is no evidence of the ability of active managers accomplish this consistently. During the 2008 US market downturn, 60% of actively managed US equity funds in the US outperformed the market. In the 1994 European bear market, 66% of funds were able to beat their benchmark. That seems promising. Better than a coin flip, anyway.

As promising as that may seem, a 2008 white paper from Vanguard looked at active manager performance during bear markets between 1973 and 2003. Of the 11 bear markets examined, there were only 5 instances where more than 50% of active managers outperformed. There is no evidence that active managers, on average, have been able to produce better performance than index funds in down markets.

Vanguard’s research did not stop there. The paper goes on to examine what happened to the funds that were able to outperform during bear markets in subsequent bear markets. The results showed that outperformance in one bear market had no statistical relationship to outperformance in other bear markets. This is an indication that the funds that did outperform were merely lucky as opposed to skilled. This result was corroborated in a 2009 paper by Eugene Fama and Ken French titled Luck vs. Skill in the Cross Section of Mutual Fund Returns. They found that, on average, U.S. equity mutual funds do not demonstrate evidence of manager skill.

More recent research, again from Vanguard, examined the performance of flexible allocation funds in bull and bear markets between 1997 and 2016. Flexible allocation funds are able to change their allocations at will to try and time the market. During that period there were three bull markets and two bear markets. During bull markets, only between 31 and 36 percent of the funds were able to beat their benchmarks. The numbers were better in bear markets, with 65% of funds beating their benchmark in the 2000 to 2003 downturn, and 45% of funds beating their benchmark in the 2007 to 2008 downturn.

While active fund performance is generally very poor on average, it appears to be slightly less poor during bear markets in this sample. The cost of active management is a heavy cost to carry for what might be a slightly greater chance at outperformance during bear markets. In the 10 years ending June 2017, only 8.89% of Canadian mutual funds investing in Canadian stocks were able to beat their benchmark index, and only 2.54% of Canadian mutual funds that invest in US stocks were able to beat their benchmark index.

Does income investing really increase your income?

In my last two videos I talked about high yield bonds and preferred shares. These are two alternative asset classes that investors venture into when they are seeking higher income yields. I told you why you might want to avoid those asset classes. Today I want to tell you why focusing on investing to generate income is a flawed strategy altogether, and why a total return approach to investing will lead to a more reliable outcome.

Investors often desire cash flow from their investments. There are blogs, books, newsletters, and YouTube channels dedicated to income investing. Income investing means building a portfolio of dividend paying common stocks, preferred stocks, and bonds in an effort to generate sufficient income to maintain a desired lifestyle. The idea is that if you have enough income-paying securities in your portfolio, you will be insulated from market turbulence and can comfortably spend your dividends and coupon payments regardless of the changing value of your portfolio.

There is a perception that if you never touch your principal, you won’t run out of money. It seems like a fool-proof retirement plan. But is it, really?

Let me start off by saying that there is no evidence that dividend paying stocks are inherently better investments than non-dividend paying stocks. There are five factors that explain the majority of stock returns. Dividends are not one of these factors. For example, we know that if you gather up all of the small cap stocks in the market, they will have had higher long-term returns than all of the large cap stocks. Based on this, company size is one of the factors that explains stock returns. The same evidence does not exist for dividend paying stocks.

If they aren’t better investments, why do people like them so much? In a 1984 paper, Meir Statman and Hersh Shefrin offered some potential explanations for investors’ preference for dividends. If they have poor self control, and are unable to control spending, then a cash flow approach creates a spending limit - they will only spend income and not touch capital. Another explanation offered in the paper is that people suffer from loss aversion. If their stocks have gone down in value they will feel uncomfortable selling to generate income. On the other hand, they will happily spend a dividend regardless of the value of their shares.

As much as a dividend may seem like free money, the reality is that the payment of a dividend decreases the value of your stock. If a company pays twenty million dollars to its shareholders as a dividend, the remaining value of the company has to decrease by twenty millions dollars. The investor is no better or worse off whether the company that they invest in pays a dividend or not. This is known as the dividend irrelevance theory, which originated in a 1961 paper by Merton Miller and Frank Modigliani.

I have just told you that whether returns come from dividends or growth does not make a difference to the investor, but there is an important detail for taxable investors. There is no difference whether returns come from dividends or growth on a pre-tax basis. On an after-tax basis, the investor without the dividend is in a better position because they could choose to defer their tax liability by not selling any shares if they don’t need to cover any spending. The dividend investor is paying tax whether they spend their dividend or not. This is a big problem for an investor who does not need any income at that time.

About 60% of US stocks and 40% of international stocks don’t pay dividends. Investing only in the stocks that do pay dividends automatically results in significantly reduced diversification. Dividend investing can also lead to ignoring important parts of the market. There are plenty of great companies that do not pay dividends. Ignoring them because they do not pay a dividend, which we now understand is irrelevant to returns, is not logical. A good example of this is small cap stocks. An income-focused investment strategy will almost certainly exclude small cap stocks, few of which pay dividends.

Now, don’t get me wrong, dividends are an extremely important part of investing. One dollar invested the S&P/TSX Composite Price Only Index, excluding dividends, in 1969 would be worth $14.37 today. The same dollar invested in the S&P/TSX Composite Index, including dividends, would be worth $64.59. If you are investing in Canadian dividend paying companies, you also receive favorable tax treatment on your dividend income. You should want dividends - they are an important part of stock returns. But you should not want to focus on buying only stocks that pay dividends.

Dividend paying common stocks are an important part of a portfolio, but a dividend-focused portfolio leads to tax-inefficiency for taxable investors, poor diversification, and missed opportunities. A total-return approach, accomplished by investing in a globally diversified portfolio of total market index funds, results in greater tax efficiency, better diversification, and the ability to capture the returns that the market has to offer.