Financial Jungle

From what I gathered around the web, this type of product apparently benefits the lenders more than you.

A mortgage insurance is a group insurance policy offered by banks and lending institutions at the time you take out a mortgage. It’s similar to a regular term-life insurance, but with 2 exceptions: the payout equals your mortgage balance, and the lender is the named beneficiary.

What’s wrong?

What’s the alternative?

Term insurance. The advantages are overwhelming. Both your premium and coverage are fixed. Your beneficiaries have complete control over how to spend the payout. You can lock in a 30 year term. Last but not least, term policies are about 33% cheaper.

You can get term-life insurance quotes from the following brokers:

• Term Insurance Canada
• Life Insurance Canada
• Term4Sale

Research: Perils of a mortgage life policy by Ellen Roseman

Recently, I received requests from readers asking for some advice on finances. One of them being a Vancouverite who is feeling a little lost in the investment jungle. Please realize that I’m only blogging for fun, and I have no official training in financial planning. Therefore, always consult your independent financial advisor prior to any investment decisions.

To protect the reader’s identity, we’ll refer to him as “MJ”. You can view the full letter here, but here are the highlights:

All my RRSP holdings (which don’t exist anymore for reasons not worth mentioning here) were just some dumb mutual fund that made me negative 2 frickin percent. Anyways, got rid of those. A few months ago, I started off with Credential Direct for 1000 loonies and then jumped ship and took all my holdings to questrade where I had to purchase another 1000 loonies. I started off with Activision which just recently lost me money but am holding Apple and Microsoft. Apple is doing well. Problem is.. I have no idea what I am doing really. I am just going by gut instinct and learning what I can about company activities..etc… I am also thinking I should look into IPOs and signed up yesterday to a fool.com insider’s tips.

Help! I feel like a small tuna in the wrong fish tank. I need tools and education before I end up drowning myself. O so many questions!

Don’t feel bad, MJ. Most of us are in the same boat. As hard as it is to imagine, I think you’re making great progress by realizing that investors traipse when they don’t have a set of principles to adhere to. Sooner or later, you’ll have to decide what type of investor you are. Are you a passive, fundamental or technical investor? Draft up your own investment philosophy, and sign it with your blood. In investing, it’s rarely profitable being the jack of all trades and master of none. Similar to how Derek Zoolander having the patented pose, Blue Steel, every investor should have a circle of competence as coined by Warren Buffett. Stick to the one thing and do it well. Without this contract, it’s too easy to succumb back and forth between the various investment styles.

The contract doesn’t have to be fancy, since the only audience is you. I started my clean canvas over 2 years ago, and till this day, I’m still augmenting it with new tools and concepts that embrace my guiding principles. It’s worth the effort, as it crystallizes your thinking.

I don’t want my own biases to sway you toward one particular investment style, and perhaps one day you’ll return and challenge my own investment philosophy. But, to get you started, I recommend reading the following books and websites:

• The Four Pillars of Investing
• A Random Walk Down Wall Street
• The Investment Zoo: Taming the Bulls and the Bears
• Contrarian Investment Strategies
• The Five Rules for Successful Stock Investing
• Money Chimp
• Investment Strategies for the 21st Century

Regarding the Fool.com Insiders’ Tips, I know nothing about it. Rather than squandering hours and dollars experimenting with the different investment newsletters out there, I recommend checking out the Hulbert Financial Digest, since they’ve done the leg-work for you already.

Please take a moment to browse through my Favourite Blogs widget to the right. Many of these financial bloggers (including Canadian Capitalist, Investoid, Yaser Anwar and SteadyHand) have ample investment experience, and I have no doubt you’ll find their insights quite gratifying.

Investors are licking their wounds as the TSX is struggling over the past 2 sessions and finishing off 3.1% lower. I’m not much of an economist, but word on the street is that south of the border, Treasury yields and mortgage rates are edging higher. Higher rates mean less borrowing, which slow the economy. That’s economy 101 for you.

Predicting the direction of interest rate movement is an impossible job as evidenced by the volatile bond pricing. Since my own performance has been mediocre at best, I’ll persevere by sticking to the buy-and-hold strategy, in good and bad times.

No one can predict the correction’s debut, duration or magnitude. One can only tell when the correction is already here, but by then it’s too late, and selling will not send him back in time to recover his losses. There has never been a correction not followed by a rally througout the the stock market’s history. By having the will power to stay invested, investors improve their odds of making a come back.

Yes, I know. It’s easier said than done, and I’m still haunted by the dreadful memory of the dot-com calamity, but I have something to prove.

The measure of a man is not where he stands in moments of comfort and convenience, but where he stands at times of challenge and controversy.

The challenge is here. This is my moment. I know I’m worthy of becoming a contrarian investor, instead of fleeing along side of the herds with my tail between the legs. In this article, I’ve compiled 5 simple reminders to resist the urge to sell. Of course, I love to know what you think.

1. Dividend investors crave for yields, not capital gains. A correction is a terrific time to accumulate more high-quality dividend paying stocks and income trusts at attractive valuations.
2. Over the short-term, the market price does not represent the intrinsic value. Behind the scenes, it is still the same business with the same working capital and earning power.
3. I’m a long-term investor. Volatility is part of the routine.
4. Most investors cannot time the market successfully. Selling would be an attempt to time the market.
5. History proves that the market always compensate those who stay invested during market setbacks.

There’s absolutely nothing that tastes better than a deferred capital gains tax. Many investors consider investment loans as good debts because the interests are tax-deductible, but the deferred capital gains tax is even sweeter. Never mind tax-deductibility; it is interest-free!

If you double your $10,000 investment to $20,000, you owe Canada $2,000 in capital gains tax assuming you’re in the 40% tax bracket. (Only half of the capital gain is included in your taxable income.) By being a buy-and-hold investor, you defer the tax indefinitely until you liquidate the investment. Effectively, you’re borrowing money for free. The fruits of your patience also grow over time. Due to the compounding effect, the longer you hold the investment, the faster you accumulate interest-free debts.

The deferred capital gains tax is much friendlier than margin loans because it has no margin calls, so you’re not forced to sell a piece of good business at the cheapest possible price. Furthermore, the capital gains tax acts as your first line of defense during market setbacks; the government generously forgives the loan before you start to lose money. On the other hand, when you borrow money on margin, it is your equity that fortifies the lender. Market correction is not the time to be brave.

When you have an embedded capital gains tax in your investment, think hard before trading it with another investment. In the above example, such a swap will trigger a capital gains tax and shrink your capital by 10%. Think about what you’re giving up. You’re losing a layer of cushion that absorbs the price volatility, and you miss out on future compounding on the 10%.

In investing, it’s rare to uncover a value stock compelling enough for you to abandon 10% of your capital, and hope it will catch up to the stock you just sold. Note the difference; the 10% loss is guaranteed, while the new purchase is an educated guess, but still a guess.

If the government offers to subsidize your investment, don’t be rude. Accept the gift graciously by holding on to your investment. As Charlie Munger puts it:

Just sit on your ass!

This morning, I was estatic to learn that Ellen Roseman from Toronto Star crafted a mavelous piece on Blogs offer new views on finance, which included Financial Jungle, Canadian Capitalist, Middle Class Millionaire and The Money Diva.

Ellen Roseman is a blogger herself, and I’m an RSS subscriber to her site to draw new inspirations. Thank you, Ellen, for making us famous!

Yikes! I just discovered that the new 5-year fixed mortgage rate had risen sharply to 5.69%. Wasn’t it only 5.25% just two weeks ago?

Readers are aware that I’m increasingly leery of Vancouver’s housing prospect. I still remember those cheap mortgage rates at 4.55% back in 2003. Since then the market advanced 60%, but that’s not the whole story. When you throw in the effect of rising mortgage rates, Vancouverites are actually paying twice as much mortgage interest.

Here’s a comparison. For simplicity, I assume an 80% loan-to-value mortgage.

If a house was worth $400,000 in 2003, the mortgage interest would’ve been $400,000 x 80% x 4.55% = $14,560. Today, the same house appreciates to $640,000. With the prevailing 5-year mortgage rate at 5.69%, the new mortgage interest becomes $640,000 x 80% x 5.69% = $29,133.

Ultimately monthly mortgage payments matter, not the sales price. Even if we assume prices remain idle, affordability is still deteriorating due to rising mortgage rates.

Related to this, Statistic Canada revealed some grim numbers on provincial weekly earnings:

Average weekly earnings for B.C. payroll employees are the third-highest in the country, according to Statistics Canada, at $755.70. That’s about $40 behind Ontario and $70 behind Alberta. But B.C. recorded the lowest percentage increase (2.4%) of all provinces when comparing the first quarter of 2007 to the same period last year.

As Vancouverites are facing the worst affordability measure (68.5%) in Canada, our solvency is in jeopardy unless we see a meaningful boost in wages accompanied by falling rates. Otherwise we’ll literally run out of cash, and possibly endure the “inconceivable” outcome of stagnating prices or even a broad correction.

I’m seeing a wave of bloggers and forum members proposing a radical way to redefine “net worth”, where the primary residence is removed from the formula. Say you own a $200k investment portfolio, a $400k home and a mortgage of $100k; the new net worth calculation would simply be the $200k investment portfolio. Everyone is entitled to her opinion, and I respect that. For my own net worth calculation, I prefer the more traditional definition, mainly because I don’t share the same rationales for redefining what’s been working all along:

“The home doesn’t provide me with income.”
The home is every bit an income-generating asset as your investment portfolio, albeit your primary residence operates in a stealth mode where you can’t readily admire its income as you would with your portfolio. That’s because the income generated is in the form of rents-saved. You’ve heard of the expression “a dollar saved is a dollar earned.” If your home is saving you $1,000 in rent, that’s equivalent to earning $1,000.

“I need a roof over my head anyway”
Similar argument here. The investment portfolio is every bit a necessity as your home, otherwise house-rich and portfolio-poor individual would simply starve. Moreover, many of the stocks in our portfolios do provide essential services. We shop for groceries Loblaw’s, pump gas at Petro Canada, bank at Royal Bank, insure ourselves at Manulife, and pick up prescription drugs at Shoppers, but we wouldn’t dismiss these stocks from our net worth, so why dismiss our homes?

Mental accounting
This can become a classic case of mental accounting where “individuals divide their current and future assets into separate, non-transferable portions. The theory purports individuals assign different levels of utility to each asset group, which affects their consumption decisions and other behaviors.”

I avoid compartmentalize my assets. When I receive a windfall, I’m indifferent whether to pay down the mortgage, or invest within my portfolio. In the end, money is fungible. The same wallet funds both my home and my investment portfolio to achieve the same common goal: financial freedom. I’ll conclude with a quick example outlining the awkward disparity when compartmentalizing assets into different buckets:

Twin brothers having identical balance sheets: $200k portfolio, $400k home and $100k mortgage. They both receive a $100k windfall. Brother A pays off his mortgage completely. Brother B decides to increase his “net worth” by topping up his portfolio to $300k.

Would you deem brother B having a richer net worth? But, he still owes $100k in his mortgage, while brother A is debt-free. Taking one step further, brother B becomes stock-bullish and plunges $200k worth of Home Equity into his portfolio. Now he holds a $500k portfolio, but clearly his is not thriving as the mounting debt is impeding his progress.

The example demonstrates that measuring your net worth solely based on the investment portfolio gives you a narrow view of your overall financial health. The proposed new definition curtails net worth as a tool to benchmark between peers, or to gauge of your financial progress.