Mariusz Skonieczny asks a question that many pondered in late 2008: why are we so clueless about the stock market? Written during at the height of the great recession, Skonieczny dissects the fundamental problem with most unsuccessful investors: they fail to understand the difference between stocks and businesses. Stocks are evidence of ownership but such ownership is only worth something if the underlying business is healthy and growing.

Taking this difference as a starting point, Skonieczny walks the reader through the basics of financial statements and the characteristics of a what makes a good business, quoting Pat Dorsey’s 4 factors that economic moats consist of intangible assets, switching costs, networking effects and cost advantages.

Every good investing book has one $10.00 moment. This book’s is found in advice on when to buy. Observing that most money managers are inherently short-sighted, the author notes that many institutional investors will pass up good long term deals if the short-term price movement does not play to their advantage. Money managers measure success in financial quarters whereas the retail investor should measure success in years. Therefore, a good investor should pursue opportunities with short-term uncertainty but long term certainty. In other words, avoid the noise and concentrate on the longer term.

The book is divided into short, easy to read chapters addressing issues such as how to value a company, diversification, investing in IPO’s (the short answer is don’t) and determining when to sell. This is also my criticism of the book. Some complex concepts are addressed very quickly to move onto the next topic. Some chapters could have been fleshed out a little better; for example, the diversification chapter is only 2 pages long- that’s one heck of a short free lunch. The case study chapter, arguably the juiciest portion of the book, was thoroughly educational and it would have been ideal to flesh out this section even further.

There is a little bit of math and finance in the book but it is presented in a straight-forward manner without too much reliance on complex financial equations.  Other than a brief boast in the beginning about the author’s return during 2008 and 2009, the book avoids the two big narrative cliches of investment books: the “look at me” syndrome and the “let me tell you a story” format (this format probably jumped the shark multiple books into the Rich Dad, Poor Dad series). It is to the point and concise in its writing style.

The ideal audience for this book would be someone who has mastered their budgeting and is interested in learning how the stock investing works with no fear of some simple math.

The conventional wisdom on starting your own business is that the odds are against you. The frequently cited statistic is that 75% of all businesses fail within the first 5 years. However, the devil is in the details. The typical methodology of measuring business failure is to tabulate the number of employer accounts opened with the U.S. Department of Labor and the number of employer accounts closed in any particular year and using employer account openings and closing determine how long a typical employer account will remain open. A closing of an employer account is generally marked as a business failure.

However, employer accounts close for a wide variety of reasons other a termination characterized by bankruptcy. Businesses merge. Businesses close down voluntarily. Owners retire. Businesses move. In a 1996 study, researchers found that if business failure was solely defined as bankruptcy, the business failure rate drops to under 1%. The same study found that small businesses cumulatively failed 64.2% in a 10 year period but less than 6% due to bankruptcy. This is a far cry from 75% failure rate within 5 years.

(admittedly, given the difficulty in tracking a sector as large and diverse as small business, the statistics tend to be everywhere. Entrepreneur Magazine found an average life of a small business to be 11.2 years and 40% of small businesses survive after 6 years).

What the statistics tend to bear out is something I saw quite often as a lawyer. Businesses fail because the opportunity costs of doing something else outweighed continuing to run the  current business rather than the common perspection of some cataclysmic event ending the business. Owners found jobs. People retire. People sold out.  Entrepreneurs start other businesses (serial entrepreneurship is a common “ailment” among entrepreneurs. As Milton wrote: “better to rule in hell than serve in heaven.” There is a certain addictive quality of being the fool in charge as opposed to listening to another fool).

Beyond the statistics though, my professional opinion is that many business owners bail out too quickly; a non-tech business generally does not gain traction until year 2. Alternatively, owners shut down businesses quickly for two major reasons- poor cash flow planning and a failure to appreciate sales cycles properly (the quick and dirty is if you are in a high volume, low margin business you have to measure turnover carefully.  If you are in a low volume, high margin business your expense control and cash velocity are key).

This impatience draws a certain parallel to the average investor. The Dalbar Qualitative Analysis of Investor Behavior found the average holding period of a stock fund ranges from 2.46 years on the low end to 4.31 years on the high end. In most cases, this is far too short of a period of time for most retail investors to benefit from an investment.

Regardless of whether an entrepreneur stays a short or long time, how do they end up doing? The National Federation of Independent Business estimates that 39% of businesses are profitable, 30% break even, 30% lose money and 1% cannot be determined. This statistic, like all statistics, is subject to some debate.

However, what is striking about this number is it parallels surveys of real estate profitability. The U.S. Census of property owners and managers found 41.4% of those surveyed reported they made a profit, 16.2% broke even, 26.7% lost money and 15.7% did not know how they did (not knowing whether you made a profit, broke even or lost money is probably a good indication its time to think about not being in real estate anymore).

There is clear overlap between small business owners and property owners since the latter is a subset of the former. However, the larger point being that the degree of risk of starting a business is not materially different than investing if you believe the statistics to be true.

As a society, we tend not to embrace entrepreneurship given a minority of the population are entrepreneurs (in North America, self-employed taxpayers compromise less than 20% of all taxpayers) and our ignorance tends to impart a greater degree of perceived risk. Yet, in the same breath, those who dismiss entrepreneurship as too risky turn around and flip their stocks too quickly or become real estate investors with relatively the same success rates.

Entrepreneurship is not a lifestyle choice for everyone. Certain people are destined for business failure.  However, it is unfair to gloss entrepreneurship as a riskier investment choice. It is risky if you don’t know what you are doing but the same concept applies to investing as well.

To state this another way, what determines the risk of starting a business are the same factors that would make investing risky: lack of knowledge and education, lack of emotional control, lack of understanding of the market. Just because investing in stocks and bonds is more popular than investing in starting a business does not make the venture any more or less risky.

As an editorial note, it is important to continue to nurture small businesses even if you are not an owner manager. After all, small businesses are job creation machines and the economic recovery will not coming from big business but from small business and a better indicator of a main street recovery will not be stock prices but small business hiring numbers. As I stated before, my true metric of an economic recovery will be small business hiring numbers.

One of my goals this year is to be a better employer. I have had a lot of conversations with people who recruit or hire more employees than I do about this issue. I can boil their advice down to the following: find employees who are good fits first and foremost rather than looking for a particular skill set, set expectations early- as early as the job interview and follow through on those expectations especially in the first 60-90 days. If you do not, you have lost the employee and neither side is very happy for what is typically a short stay.

How does this relate to you if you are not an employer and actually looking for a job?  What I have noticed more often than not is that employees tend NOT to ask questions about fit, corporate culture, support and expectations at the job interview. If you are looking for a job only for the monetary consideration and not necessarily for career development then I would stop reading now.

If you are looking for a career then it is important to discuss these issues during the job interview. Otherwise, although you will be gainfully employed, I suspect the employment will be unfulfilling and merely another employer on your resume.

After getting some sage advice from others about this issue, I looked back on people I interviewed for non-entry level positions who had multiple employers on their resume in a short-period of time and recalled their interviews. Most of their questions were about compensation and not expectations or fit. It is perfectly acceptable to negotiate the best deal possible but, if a potential employee does this at the expense of attempting to determine whether they will be happy and gain more skills, that job will become another short stay.

As the Financial Blogger points out, the “do you have any questions?” portion of the job interview is supposed to be an opportunity to show your prospective employer that you know something about the employer (and the linked post is a perfect example of asking questions about fit and expectations correctly). It is also in my experience the part of the interview where most potential employees need to improve. Either they ask no questions or they are not attempting to see if there is a future with the employer/overly focused on compensation.

Based on my experience, if you truly want a place to work where you will be fulfilled professionally and personally, these are some questions to ask (this works better if your interviewer is not from the HR department).

1. “What skills will I learn in this position? Will these skills be learned early on or are they part of a life-long learning experience? If it is part of a life-long learning experience, can you tell me specifically how I will learn this- do you have in-house training or an external training budget?” In other words, after the first 6 months of the job, am I just doing the same thing over and over again?
2. “Walk me through the first 60-90 days of the position. Tell me how you typically incorporate a new employee into your organizations?” In other words, do you have a plan in place to make me part of the team or am I a disposable asset in your mind who you will not devote any time or attention to unless I am doing something wrong?
3. “Without naming names, can you tell me about employees who have succeeded at your organization and why they have succeed? Can you tell me about employees who have not and why they did not fit?” Essentially, you are asking your future employer to tell you about their corporate culture and who thrives and who fails. Remember that employers hire for skill but fire for fit.

These are certain probing questions. Some of you may be reading this and saying “Are you crazy? You want me to ask these questions in this job market?” The practicality of the situation is that some job seekers need the money right now worst than career development. It is entirely understandable to ask questions to get you the position and avoid the hard questions.

However, if you are interviewing from a position of strength or want more than just a mere job, then ask the above diplomatically. It is also worth noting that in positions which require a high degree of skill there continues to be a demand-supply imbalance in favor of the employee (my colleagues continue to grumble they cannot find good lawyers, accountants or mid-level trading management). In my last round of interviewing, the leading candidate asked question #1. It set her apart from all the other candidates since it showed me she was wanted to contribute.

Interviewing is a two-way street, if your potential employer cannot answer these questions then at least you know what you are getting yourself into rather than going in with false expectations. To continue the two-way street analogy, interviewing is dating on a professional basis. You would not want to enter into a long term relationship with someone unless you understanmd the expectations and your meaning to your potential significant other’s life beforehand.

Best of luck.

Larry McDonald raised an interesting question last week: do homeowners need a greater allocation of bonds? The rationale for such an asset allocation is that housing and stocks are similarly affected by the economy and an allocation of bonds would, theoretically speaking, would not be correlated with the return on housing/stocks.

It is an interesting theory. I am not sure there are any right or wrong answers in the abstract since everyone’s situation is unique but a greater allocation of bonds for homeowners is premised on two assumptions, mainly:

1. Does housing have an equity like return? The thought that housing can produce an equity like return is a relatively recent phenomenon.  As Robert Shiller noted, housing appreciation over long periods of time has a return similar to gold; housing hedges against inflation and gives you a few points of return (there are exceptions based on local effects).
2. There is a strong correlation between the equity market and real estate. I am not certain this is necessarily true (readers?). Looking at the period of 2000-2002, Dimensional Fund Advisors found that the return of U.S. Large Stocks was -9.25%, -12.09% and – 22.23% while the return on REITs in that same period was 28.39%, 13.16% and 4.18%. In other words, equity and real estate actually headed in opposite directions (does anyone have any longer term trending? I readily admit this is much too small of a sample size).  I would take this statistic with a grain of salt since REITs are not perfect proxies for the housing market.

We are, by nature, bad historians. If the new normal is a reversion to a pre-1991 (or pre 1979 depending on whether you believe former Federal Reserve Chair Volcker or Greenspan’s policies created  the conditions for historically anomalous returns), housing should be what our parent’s thought it was; a source of shelter and security and a hedge against inflation and not an asset to be flipped and leveraged. In other words, more like bonds than equity.

However, if you believe the new normal looks a lot like the recent past, than homeowners should own more bonds as an effective asset allocation strategy.

Regardless, I would argue that homeowners should concentrate on their cash allocation- the often over-looked asset class- and debt loads. There are many things to be learned from the housing bubble popping in the U.S. One such lesson is that households who held too much debt, too little equity and too little cash were the first to be wiped out.

A recent homeowner with modest investing acumen and who has little equity in their home may be better off with an aggressive mortgage reduction plan rather than thinking about investing in the market. The counter-argument to this approach is that paying down one’s mortgage gives you lower returns in a low interest rate environment than investing in the market.

This argument is true if the homeowner is a relatively successful investor. If they are not, one may be better taking the bird in the hand and paying down the mortgage (the same argument holds true if the investor is still in shell-shock from 2008; you should not force someone to do something they are not psychologically prepared to do regardless of economic considerations).

What constitutes “aggressive” repayment of mortgages is subject to some debate. The general rule is attempt to make at least one more payment than necessary a year to your mortgage.

The more practical consideration is that housing is a cash cow. It sucks up money like crazy. Thankfully, the winter has been mild and foundation leaks and burst pipes have been few and far between. However, anyone who owns a house knows that every so often you basically burn through cash on something or another. Again, especially for older homes, the building of a large emergency fund first may be more a more practical allocation of investable income than to the bonds and stocks (remembering that bonds do carry the risk of being sold for less than face value).

Two further points about building the emergency fund. If you have to sell your house, you have to put some money in making the house presentable which requires cash. If you have to sell your home because you lost your job, where is that cash going to come from (unlike the States, Canadians cannot simply walk away from a house without some personal liability so some TLC has to be put into the home)?

Secondly, if you never use your emergency fund for housing related purposes, you still have it in the event you lose your job.

Having said all of that, one has to be careful how much of an emergency fund to keep since in a low interest rate environment funds kept outside tax sheltered accounts are basically yielding nil to negative return. They key is to find balance between security and being economically rational. The general guide is typically to keep 3-6 months of fixed costs in an emergency fund.

I have noticed lately I am receiving a lot of credit card offers. The offers are for new credit cards or cheques to be drawn down on my existing credit cards. When I pick up the mail in my condo, there are recycling bins by the mailboxes. My first instinct is to toss the offers into the recycling bins. However, I end up taking them to my condo and shredding them.

Identity theft can occur in many different ways. Someone steals your wallet and becomes you. Someone hacks your computer and steals vital information. However, identity theft can also occur as simply as going through your garbage or recycling bin and taking your credit card offers and applying in your name but with a different address. It is so simple yet so effective.

As a practical tip, please make sure you shred all your personalized junk mail. Offers from your existing financial institution, credit card companies or investment advisors provide key insights into where you keep your money to strangers.  These solicitations are both junk mail and insights into your life so guard your privacy accordingly.

I am on a business trip for the remainder of the week so no more posts this week. Have a great week.

In August 2008, I mused that the implementation of a 31.5% tax on previously tax exempt Canadian issued income trust would force many income trusts to convert to corporations before January 1, 2011 (the day the new tax regime is effective) and lead to distribution cuts in the range of 40-75%. In a January 15 research note, RBC Capital Markets noted that 35 income trusts have already converted to corporations. 22 of these conversions have been accompanied by a distribution cut with the average cut being more than 60%.

The act of conversion alone is not to blame for such a large distribution cut. Revenue and earning decreases in a down economy have only poured salt into the wound of income trust investors. As the drop dead date for the new tax regime looms, will increased income trust conversions lead to yield chasing by investors seeking alternatives?

Income trusts typically have higher yields than conventional stocks. For example, the long term adjusted funds from operations (AFFO) yield for REITS is historically at 8.1% (AFFO is considered a truer measure of a REITs cash flow). If investors, weaned on high income trust yields, decide to substitute income trusts for alternatives, will their baseline analysis be to other high yield products?

One hopes not for several reasons. As many commentators have noted, dividend growth is more attractive than dividend yield.  Dividend yield is calculated as annual dividend paid per share/price per share. Thus, high yields are a function of high dividend payments, low share price or a combination of both which means the company has little room to pay out more or the expectations of growth are limited. This may not be a large factor for someone with a short investing horizon but it is important for long term investors who can increase returns by receiving constant dividend increases.

The other issue is what are the substitutes? The natural substitute is to move to a REIT (generally exempt from the new tax regime) but REITs are not value plays (at least in Canada; on the income side, Canadian REITs are paying out 94% of AFFO meaning do not expect large distribution increases) or are facing some serious short-term issues (American REITs suffering from increased vacancies and refinancing concerns where the asset already possesses a high loan to value ratio with the value continuing to erode).

The other natural substitute, dividend paying financial stocks, also have their well publicized issues. When JPMorgan Chase announced that its loan loss provisions in the last quarter have not significantly declined, it confirmed what many suspected. The banks are a long way out of the woods yet.

This is not to suggest that pursuing a high yield substitute is, in and of itself, a wrong strategy to pursue; for example, heavily regulated utilities tend to have high yields and some margin of safety given electricity is a necessity. However, a dogmatic chasing of yields could lead to trouble. The prudent approach is to find a balance between yield and growth and to wait out a large movement of cash out of converting income trusts to other high yield products.

I wrote earlier this year that New Year’s resolutions tend to fail because goals are set which ignore the realities of the market. Many commentators have also wondered how perfectly intelligent people can buy into Ponzi schemes promoting unrealistic returns. Therein lies the problem. Most average investors have no conception of what an “average” return on stocks or real estate should be. As a result, there is no internal metric to determine risk/reward and a statement such as “you can return 12% in stocks” are thrown about causally without some context to determine whether this statement is realistic are not.

What then are realistic expectations of return on stocks and real estate?

STOCKS

Jeremy Siegel notes that total nominal return (return before inflation) for stocks from the period of 1802-2006 was 8.3%. What we witnessed from 1985-2006, where nominal return was 12.4%, was a historical anomaly. To use an often-quoted phrase of 2010, the “new normal” should be a reversion to historical mean.

However, one never uses the past to predict the near future. To realistically predict future expectation of growth, one uses the Gordon Equation which is (dividend yield + dividend growth rate). The S & P 500 dividend yield was 2.0% in 2009. It has been predicted that the S & P 500 dividend growth rate will be 6.1% in 2010 (according to Business Week, the historical dividend growth rate is 5.56%) . In other words, the “experts” predict expected equity return of 8.1% which falls within the historical range.

Practically speaking, and let’s assume high single digit growth does come true, subtracting inflation and transaction costs, a realistic real return for most retail investors should be in the range of 5-7% if one tracked a broad based index; aim for this sweet spot and one has a reasonable expectation of return without subjecting oneself to above average risk.

Any investment that is advertised to yield greater than this  range requires a greater risk tolerance on the investor. Thus, anyone pitching an investor a product returning 10-15% this year is not lying but is implicitly asking the investor to undertake a large amount of risk. The question is not whether the 10-15% return is realistic but whether one has the stomach to suffer loss in the event the manager reaches too far to attempt to produce such return.

Remember one of the key rules of investing: never invest any money you cannot afford to lose.

REAL ESTATE

Admittedly, since all real estate is local, the following is a broad based review and not an indication of local conditions.

Appreciation

To quote William Bernstein:

“..the best data on house price suggests that after taking inflation into account, the answer [to how much a house appreciates] is slim to none. These data focuses on historical data from three nations.  Real house prices (TMW- in other words after inflation return) in the United States did not rise at all between 1890-1990…Thus, at most you will receive a 3 per cent real (1 per cent price increase plus 2 percent net ‘dividend’) return on your home …”

The study Bernstein cites on real returns from 1890-1990 is a 2006 piece by Robert Shiller. Shiller, as many of you know, was one of the more famous economists who called the housing bubble before it burst.

Income  from real estate

The standard way to measure return on real estate is to determine the capitalization rate or cap rate. A cap rate measures expected asset level return. It is calculated by: annual net operating income/cost.  For example, a rental property nets $10,000 of rental income on a $100,000 purchase. Thus, the cap rate is 10%. There are downsides to using cap rate to determine return but it is generally viewed as a standardized measure of income production from real estate.

It is difficult to determine cap rates for smaller rental properties or non-institutional real estate investors. Collection of data would be difficult given the hundreds of thousands of real estate investors who would have to give honest feedback to someone.  However, data is much more readily available for institutional based commercial real estate. To this end, the National Council of Real Estate Investment Fiduciaries states that historical commercial real estate cap rates is approximately 7.6%.

Cap rates for most retail real estate investors may be lower than 7.6%. Most commercial leases work on what is known as a triple net basis. In plain English, the tenant has to pay for all of its proportionate costs of the leased premise including taxes, operating costs/maintenance and insurance. Most commercial leases  grant the landlord the right to adjust these costs retroactively if their estimates were off.

Smaller real estate investors, especially operating in rent control regulatory regimes, are granted no such right to full recovery (not to mention the opportunity costs of tending to the property which commercial landlords hire managers to carry out). Accordingly, small scale real estate investing may have a cap rate lower than 7.6% analogous to stock return being eroded by transaction costs.

If we assume that there is some slippage between institutional and non-institutional real estate investors, one is left with a cap rate within the range of 5-7%.

WHAT DOES THIS MEAN TO YOU?

The above suggests that “magic beans” promising returns of double digits over the medium to long term is accompanied with higher than average risk tolerance. If one cannot stomach such risk, then Jack- he of a long investing horizon and no assets to lose- may be better off buying the beans instead.

What strikes me about the data is how unrealistic investors became about expectations of return over the last 10-15 years. A real return of 4-6% in the stock market or in real estate investing is nothing to sneeze at (consider that most non-managerial salaried employees receive raises of 3-5% in good times which is really a 1-2% raise after inflation; this tends to suggest prudent investing yield greater year over year return than human capital). Perhaps there is nothing wrong with the stock market or real estate market. There may be, instead, something wrong with our expectations.

It is interesting to note that nominal return on stocks and real estate are similar; if you add in the 1% appreciation plus the 7.6% cap rate, you end up at 8.6% nominal real estate return vs. 8.3% nominal return on stocks.

What it suggests is that, in a vacuum, opportunity costs between the two assets classes is not material different. However, what Bernstein overlooks is that real estate appreciation, small as it is on a global basis, is tax-free in many jurisdictions as it pertains to the principal residence.

There may be a greater tax effect on stock sales depending on what jurisdiction you live in (some jurisdictions outside North America have no capital gains tax on stock sales).  Stock investing is a “passive” compared to real estate investing. This raises the question of whether the government tax policy on real estate is a recognition that sweat equity has been contributed which should be rewarded with better tax incentives.

To go back to my initial point, the above are average expectations of return based on historical data. There are obviously local effects and greater or lesser than average returns in short-term transactions. But again, the question is not whether one wants higher returns- we all do- but  does one have the risk tolerance to pursue such returns?

I am pleased to introduce my guest-post today from Brian Poncelet from Right Insurance. Brian is a Certified Finance Planner who specializes in Life Insurance, Critical Illness Insurance and Disability Insurance. Brian takes his time today to write about common misconceptions and mistakes when buying term life insurance.

MISTAKE: Failing to buy enough insurance while you are still healthy.

Medical evidence is required when you buy life insurance.  This evidence usually consists of a list of questions to elicit your medical history, a brief exam by a nurse, a blood and urine specimen and possibly a report from your doctor.  If at a later date you decide that you really need more coverage, the process begins again.  If your health has changed you may have to pay higher premiums.

MISCONCEPTION: Cheapest is the best.

That term policy premium might be cheap in year one.  But most term policies renew at regular intervals (every 10,20 years) and the renewal premium rises at each interval because it reflects your new age.

In general, a 10 year term policy is the cheapest but by year 13 it is actually more expensive than buying Term 20. In other words, if you think you need coverage beyond 10 years, it is better to chose a 20 year term now.

MISTAKE: Failure to understand your options

So on each renewal the premium rises at each interval as stated above.  But you do have options.  Most term policies include a free option to convert your policy to permanent coverage before age 65.  Converting to permanent coverage make sense especially if you have had a change in health. Even better, you will not require a medical to convert.

The types of permanent coverage eligible for conversion usually include whole life and universal life but these also vary by company.  If you buy term coverage do so with a company that offers several options for the converted policy.

MISCONCEPTION: Buying through the internet is cheaper (no commissions to be paid)

Insurance comparison services on the internet say “buy direct and save money”. The fact is, you cannot receive a discount in the price of life insurance by avoiding a life insurance agent.  Sales charges and costs (such as commissions) are built into the premium that you pay for any life insurance policy that you buy. You will be paying those built-in charges regardless of where you buy the insurance.  Finding and using a local life insurance agent will not cost you more than dealing with someone in another city or province by telephone or mail.

MISCONCEPTION: Association insurance has cheaper rates.

Associations include organizations such as universities, credit card companies and consumer groups like CAA.  Sometimes association rates are cheaper but in many cases the rates go up every five years.  Associations are like groups where several insureds are lumped together and pay a premium relative to the group being covered.  Even where limited medical questions are asked, the premiums reflect the inability for the insurance company to fully assess individuals and the group like rates is charged.  Association groups also may offer very limited conversion opportunities.  Therefore if you cancel your credit card or if you are no longer a CAA member you coverage is cancelled.

As a smart consumer, obtain an individual insurance quote and compare the products for price, renewal options and conversion options.

MISTAKE: failure to understand that buying term is like renting life insurance.

Permanent (whole life) plans are more expensive in the early years but the premium stays the same for the duration of the contract.  Because you pay more in the early years, you have some equity (cash value) in the policy.  If you decide to cancel the contract you get the cash value back.  However, you have no equity in a term policy.  You pay premiums applicable to your age and this rate rises at every scheduled renewal.  Because you are paying the true cost of coverage, there is no equity in the policy.  If you cancel the coverage 10 years down the road because the renewal rate is too expensive, then you walk away.  Bottom line, you are renting coverage briefly and won’t have it when you need it or more importantly when your family needs it!

MISTAKE: paying your insurance premium on a monthly basis

The insurance company charges extra to those who pay monthly as they incur extra expenses to administer monthly payments.  If you are able to pay the yearly premium it can save you up to 10%.

MISTAKE: paying extra for benefits (the frills) that you may never use

Waiver of Premium Benefit: the insurance company will waive the premiums if you become disabled.  Few people understand that you must be totally disabled in order to be eligible.  Also if you have term insurance the insurance company will usually pay only to age 65 while for some types of permanent insurance they will pay the premiums beyond age 65.

Guaranteed Insurability Option: In a nut shell you pay more now just in case you want to buy more insurance in the future without having to provide proof of health.  It essentially insures your insurability.  However, your premium for the new policy will be at current age rates.  One more reason to buy all of the insurance that you need now and at your current age.

Accidental Death Benefit: This benefit guarantees that if you die in an accident, your beneficiary will receive an additional predetermined amount of money on top of the base policy amount Again, I’d say if you need accident coverage buy it rather than depending on an ADB rider hopefully supplementing the amount of coverage your family really needs now.

MISTAKE: buying coverage because no medical evidence is required.

This might sound appealing but in actual fact you will pay more for this insurance and the amount of coverage available will be limited.  If you are healthy, take the time to prove it and pay premiums that truly reflect the good risk that you are.

MISCONCEPTION: the premium I see on the internet is what I get.

Insurance companies offer several classes of standard rates.  Those in the top physical condition and with no risk factors will get the best rate.  Premiums on the internet usually default to the top preferred category (the cheapest).  However, keep in mind, only a certain percentage of applicants will actually qualify for the best rates.

MISCONCEPTION: waiting until you lose weight or stop smoking in order to get the best rate.

This is just procrastination.  Yes, you may pay higher rates now but did you know that if you quit smoking or if you keep the pounds off  for one year, you can apply to have your rate reassessed.

There is justifiably a lot of attention paid to the effects of fees on investment returns particularly MER charged on mutual funds and ETFs. While in no way should it provide a defense to high-fee products, this focus, taken to a myopic level, can obscure the two largest external factors eroding your net worth.

Taxes and inflation.

There are already many wonderful summaries of the tax consequences of each type of investment. Suffice to say, the general rule is this: low risk, low upside investments (think high interest savings accounts, GICs, T-bills, Bonds) tend to attract higher taxes than higher risk, higher upside investments (stocks, real estate (on sale and not rental income), investments in private business) which tend to attract lower taxes. The government does this on purpose. As an industrial policy, it wants to encourage taxpayers to invest in innovation and risk.

Stopping or slowing the tax leakage in your net worth, comes down to answering two questions:

1. WHAT are you buying? Is it, based on the totality of your income streams, increasing the tax leakage or lessening it? For example, assume you are at or near the top of the personal income tax bracket and all of your income and investments are cash/cash equivalents (high interest savings account, money market funds, income trust distributions characterized as income). Would you invest surplus cash into another vehicle that is taxed as income, potentially pushing you into a higher tax bracket and keeping less and less of each dollar earned? The more tax efficient approach may be to invest in products that pay dividend income or are eligible for capital gains tax.
2. WHERE are you buying it? Tax inefficient products (see above on low risk, low upside investments) bought outside of tax deferral plans (RSP, TFSA, 401(k)) erodes net worth. (as a side note, as an accountant said to me, it is interesting that the TFSA should ideally be used for stock market speculation given the gain is entirly tax free but the average investor opts instead not to fully top up their RSP and divert funds to the TFSA to buy money market funds. Certainly food for thought).

The Millionaire Next Dollar observed that taxes paid constituted 12.9% of the average American household’s income but the millionaires they studied had a rate at a mere 6.7%. How? To paraphrase the authors, average households carry too much cash or near cash equivalents which are eroded by taxes while millionaires tend to be invested in appreciating assets which are not taxed until sale.

Finally, in Stocks for the Long Run, Jeremy Siegel noted that real returns after taxes for someone making $50k based on returns for the period of 1913-2006 were 4.4% (stocks), 0.5% (bonds), -0.6% t-bills, 0.4% (gold). In other words, the tax inefficiency of fixed income over stocks becomes glaring over time which does not/should not concern an elderly investor with shorter investing horizons but is quite damaging to the shell-shocked middle aged investor parked in cash in a non tax-deferral account.

Inflation, the erosion of a dollar over time, is an equal opportunity eroder of wealth. Over the short term, there are few vehicles which truly can combat inflation. Real return bonds (or TIPS) are effective but its utility is diminished if it is held in a non-tax deferred account since the tax leakage has de facto inflationary effects on return.

Over the long term, some argue certain types of stocks are ideal to fight inflation. However, as history proves, over the medium term, high inflation can defeat stock market returns. Consider the period of 1966-1981, the Consumer Price Index, a measure of inflation, ran at 7.0 and the real return on stocks (return after inflation) was -0.4%.

However, during the same period, the real return on fixed income was -4.2%. If you made $50,000 during that period, after tax return was -6.1 which is a triple indignation since one could have bought government debt via a t-bill or GIC, received a real return which was negative and then get taxed on that return; the government got your money twice and you lost money!

What does this all mean to you?

Where stock market returns are modest, tax leakage and inflation can and will turn modest paper gains into losses. A flight to safety in uncertain times is a prudent tactic to adopt but as a long term strategy, as the above slows, at the wrong age and for the long length of time, it can actually move your net worth backwards.

What should you do?

1. Speak to your accountant about tax leakages in your portfolio. Don’t ask her if buying Apple was smart. She is not qualified to answer that question. She is, however, qualified to say where ideally any stock you buy should go or what should go into tax deferral vehicles. Looking at your life structurally for tax leakages is an often over-looked benefit of a good accountant.
2. Be aware of the effect of inflation on your returns. A 8% paper gain may sound great but if inflation is at 4%, the real return is actually 4%.  Hard assets, stocks of companies that can pass on cost increases to customers, inflation-protection fixed income products in moderations are products which should be studied to see if they fit within your portfolio.

The point is not to structure one’s life solely to pay less taxes and combat inflation. However, they should be factors which need to be paid attention to by most investors.

Best of luck.

If you follow sports long enough, a certain pattern emerges in any league. One person is anointed the franchise of the league (think Michael Jordan, Wayne Gretzky and, um, until recently Tiger Woods); they can do no wrong and the league does anything and everything within their power to maintain this image. Every league has a player or players who are the bad guys and then there are the court jesters- the guy the league brings out to show its fun, modern and hip.

In the National Basketball Association (the NBA) the court jester was Gilbert Arenas- until last week. Gilbert, or Agent Zero, was suspended indefinitely by the league for: (i) bringing unloaded guns from his house into his locker-room; (ii) had some type of conflict with a team-mate over an unpaid gambling debt which may or may not have involved one party pulling said gun (or guns) on the other (given an on-going criminal investigation, what occurred exactly in the locker-room is speculation rather than fact); (iii) going onto Twitter and joking about his situation; and  (iii) making light of the situation by pretending at a pre-game introduction to shoot his team-mates with guns made out of his fingers. Agent Zero may, in fact, be a reference to his level of common sense.

We can all learn from Gilbert Arenas as negotiators. Mainly, stop talking. Just stop.

What you do not say is sometimes better than what you do say especially in delicate situations. Here is an excerpt from Gilbert Arenas’ official press release before he was suspended:

“I told the detectives and prosecutors the whole story about my storing the unloaded guns at the Verizon Center and what I was intending to do when I took them out of my locker on December 21st.

As I have said before, I had kept the four unloaded handguns in my house in Virginia, but then moved them over to my locker at the Verizon Center to keep them away from my young kids. I brought them without any ammunition into the District of Columbia, mistakenly believing that the recent change in the DC gun laws allowed a person to store unloaded guns in the District.

On Monday, December 21st, I took the unloaded guns out in a misguided effort to play a joke on a teammate. Contrary to some press accounts, I never threatened or assaulted anyone with the guns and never pointed them at anyone.”

If what Gilbert Arenas said to the authorities was consistent with his press release, he admitted to the following:

• bringing firearms to a place of employment, a breach of the NBA’s collective bargaining agreement
• transporting guns over state lines, a criminal offense
• drawing a firearm on a third party, a possible criminal offense (whether you think it is a joke or not is irrelevant. In many jurisdictions, the criminal offense of assault compromises of the intended victim believing reasonably that you would attempt to carry out harm on them. Battery is the actual touching of someone unlawfully)

One is not exactly sure why he would admit these to the public. If he spoke to the authorities and then said nothing publicly, there would not be any sense of public outrage, or fear of public backlash, if the authorities declined to act further. By issuing the statement, the media is hounding the authorities to do something.

Perhaps, Gilbert Arenas wanted the press. Once a court jester, always a court jester. And, yes, he took down his Twitter account (I suspect his lawyer had a little chat with him about that).

For an example that applies to people who are not professional athletes, consider a mailer I received from a real estate agent who recommended that if you have to be at home during an open house, just smile and say as little as possible. We are wired to tell stories but sometimes our stories hurt us as negotiators. As the mailer continued, the vendor told everyone at the open house that the condo was full of nice old people. Problem was most of the potential buyers were younger couples who may not want to live in that type of building (having lived in both a younger person and older person condo, there is a huge difference).

The rule when being questioned by the authorities is always be respectful, be polite and only answer what is being asked. Don’t try to tell your story. All you are doing is giving angles to the other side to use against you. The same concept applies in negotiating.

To be clear, if there is something that needs to be disclosed legally or ethically, disclose it. However “stop talking” refers to not staying on point in negotiations and wandering off into what may be interesting facts or some self-need to spill your guts to strangers. It is ok to say you are selling the 2nd car to pay off some bills but I am not sure we need to know about all the good times you had in the backseat in graphic detail.

Stop talking also means keep a muzzle on your social media accounts (a rant onto itself). If you are selling your house, please don’t post on your Facebook page “Put our house up for sale. Hope someone buys soon. Bought another place already.” You never know who is reading your Facebook feed or what your privacy settings are.

Finally, stop talking refers to Four Pillar’s excellent post about bias and pointless arguing. Negotiations is much like sales. You are trying to get to a result. Good salespeople know that getting to a “no” is almost as important as getting to a “yes” so bias and pointless arguing may just annoy the other side and forgo the opportunity cost  of negotiating with someone who wants to negotiate a deal which, frankly, is much more desirable than hearing the sound of another’s voice drone on and on…