Nov 162017
 

Why Do Governments Target 2% Inflation?

The Bank of Canada maintains an inflation rate target of 2%. The official websites of Central Banks in the U.S., in Europe, and in Japan all appear to target this magical number when deciding how to conduct their monetary policies. But why? Inflation isn’t necessarily a good thing. There are ways to grow the economy and generate prosperity without increasing the cost of goods and services. But inflation does provide the government with two major advantages!

Governments tend to target 2% inflation rate

1. Taxation by Inflation

In the book, The Greatest Con, author Irwin Schiff explains that, “inflation is the government’s silent partner,” because it allows the government to earn more tax revenue, without officially increasing tax rates. For example, a mechanic who made $40,000/yr in the 1980s could be making $80,000/yr doing the same work today due to inflation. If his cost of living also doubled then this looks fine on the surface. However, an $80,000 income is subject to a higher tax bracket than $40,000. Since his marginal tax rate went up, the mechanic will pay a larger proportion of his earned income to taxes today than in the past. This is how federal income tax rates can remain the same, but workers end up paying more tax over time.

2. Eroding the Value of Debt

Inflation reduces the value of money. Let’s say we owe $100 to a friend and inflation is at 2%. We can pay back the $100 after a year. But by then its value would only be $98. Just about every major country in the world owes debt. The U.S. owes about $20 trillion. At 2% inflation, the value of this huge liability would fall by $400 billion a year. That’s a lot of debt to be forgiven. 🙂 The typical investor who buys fixed income funds would likely have government bonds in their portfolios. Unfortunately as a result of inflation, the bond holders (savers) get the short end of the stick while the government (borrower) becomes better off.

“As inflation shrinks the value of currency, it increases the relative value of equity investment. Thus, inflation is a process by which purchasing power is shifted from the middle and lower classes, who have their savings in fixed dollar investments, to the upper classes, who have the bulk of their wealth in equities.” ~Irwin Schiff

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Jul 132017
 

Lending Loop Update

Earlier this year I blogged about investing $20,000 in a peer-to-peer lending platform called Lending Loop. My goal was to make 8% return overall, net of fees and write-offs. To be frank I was a little apprehensive at first when I learned about the high interest rates.

I wondered if it was really possible to earn 15% or higher rates of return consistently. Being greedy, I decided to give Lending Loop a try. I primarily invested in B and C loans because they are relatively safer, although the returns are lower than loans in higher risk categories.

Here’s what my Lending Loop portfolio looks like after half a year of investing. This screenshot was taken at the end of June.

As we can see I have made about $846 so far. Yay! 🙂 That’s about 4.2% return, or 8.5% annualized return. This is very much in line with my expected 8% return I had initially set as my goal. I have invested in roughly 30 different loans so far on the platform, each loan averaging $700 of principal. Thankfully none of them have missed a payment yet so I’m really pleased about that. 😀

If this trend continues I should be able to earn a double digit return by the end of the year! But this rosy picture assumes there are no defaults on my loans for the next 6 months. 🙂 Anyway, I will update again at the end of the year so we shall see what happens.

Unlike investments in a tax advantaged account, my Lending Loop returns will be taxed at my marginal tax rate, which is about 30%. This means if I earn 8.5% from the P2P investment, I will only end up making roughly 6% return after tax. To me 6% after tax is pretty good and certainly beats many alternative options out there. 🙂 As interest rates are starting to climb slowly in North America, fixed income investments such as Lending Loop should continue to be attractive for investors looking for yield.

 

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Random Useless Fact:

Due to the lower surface gravity of Mars, if you weigh 100 pounds on Earth, you would weigh only 38 pounds on Mars.

Apr 242017
 

Today we’ll explore a common question I get asked all the time: What is my thought process behind leverage?

The short answer is simple. I want to make high returns without being exposed to high risk. Normally the two go hand-in-hand. But leverage allows me to separate them.

For example, a speculative marijuana stock may grow 20% to 50% a year. But it could just as easily lose half its value. The potential reward is tempting. But the high risk is not worth it.

Instead, I’m looking for a lower return, lower risk investment such as an established pipeline company known for its predictable earnings, dividend growth, large economic moat, and low stock volatility. Using historical data and fundamental analysis I may determine that there is a very high probability this stock will appreciate 4% to 10% a year. I can then apply a leverage multiplier of 5 times on this investment which means my actual expected rate of return is 20% to 50%.

In other words, I do not subject myself to the high risk that is typically associated with juicy returns. But I still get those juicy returns! Awww yeah. 😀

That’s pretty much it. The long answer requires some further explanation. Let’s start with the 3 criteria I look for before I borrow to invest.

 

The 3 fundamental rules of practicing leverage

  1. A 10+ year investment time horizon.
  2. An adequate diversification strategy.
  3. An asymmetric risk-return opportunity.

The first and second rules are straightforward. Billionaire Jeff Bezos recommends we think in 7 year terms to remain competitive. I suggest taking that up to 10 years just to be safe. 🙂 In terms of diversification it can mean more than just having stocks and bonds.

 

Seek Out Asymmetric Returns

Now comes the fun part. Rule number 3. As we all know there is no investment without risk. The third rule is about knowing which investment has a favorable risk to reward ratio. This simply means comparing the odds. For example, let’s say we are asked to roll a normal 6 sided die. If it lands on 1, 2, 3, or 4, we win $10. 🙂 But if it lands on 5 or 6, we lose $10.

So should we play? The answer is a resounding yes every time! 😀 We have a 66.7% chance (4/6) of success. So from a rational perspective this has an asymmetric probability in favor of us winning.

 

Analyzing Probable Returns with a Bell Curve

We can use a normal distribution to help identify favorable investment opportunities. In statistics, a normal (bell curve) distribution outlines all the possibilities with the most likely outcome being in the middle. The standard deviation can be used to measure the variation in a set of data. Let’s see how we can put this bell curve to use when we overlay it on top of a chart that shows how many times the stock market returned a specific amount over any 10 year period between 1916 to 2016. (source)

So over the last century, any 10 year period of investing in the S&P500 index would have returned somewhere between 6% to 11%, 40% of the time, or within 1 standard deviation of a normal distribution curve. Additionally, returns were between 3% to 14%, 72% of the time, within 2 standard deviations from the mean.

This strongly suggests that we have a 95% chance (95/100 possibilities) of making at least 3% annual return from the stock market in any given 10 year period. Pretty neat eh? 😀 Time in the market reduces risk in the market, and creates a huge asymmetric advantage to investors!

But enough theory. Let’s see this at work in a real life example.

 

Banking on Leverage

A couple of years ago I used leverage to buy RBC Royal Bank stocks. Let’s go through my thought process behind this decision.

Large cap, blue-chip dividend stocks are ideal to use leverage on. They don’t come much bluer and larger cap than RBC. It’s the largest company in the country. Plus, there’s a lion in the logo. That’s how you know it’s a top quality company. 😉

I borrowed $4,000 to buy 55 shares of TSE:RY and contributed $0 of my own money. I wrote a full analysis on RBC and explained why I thought it was a good stock to buy at the time. The reason I used leverage was because I didn’t have any cash and the investment fits my 3 rules of leverage.

  • First rule: I planned to keep RY stock for the next 10 years.
  • Second rule: I made sure RY would only be a small part of my total portfolio.
  • Third rule: RY’s P/E ratio, peg ratio, and other fundamental measurements looked appealing in 2015. The stock was expected to grow 8% to 10% a year for the foreseeable future. Historical data showed strong earnings growth and stock appreciation. RY’s dividend would be enough to cover the interest cost of the debt. Thus, this would have a favorable asymmetric risk-to-reward ratio.

My return on this investment so far, net of margin interest cost, is about 37% or $1,500. Not too shabby. 😀 But this shouldn’t be a big surprise. After all, stocks are fundamentally priced based on their earnings. And RBC has an impressive history of consistent earnings growth. Back in 2015, RY was expected to earn $7.35 per share by 2017. Fast forward to today, it appears RY may actually be on track to hit $7.40 EPS this year. We shall see.

This leveraging strategy is also recession resistant. For example, let’s say I did the exact same thing in 2007 at the peak of RY’s market capitalization, (the worst possible time to use leverage) right before the greatest recession of our generation. Yikes! Well despite the unfortunate timing, 10 years later I would still end up with a 70% positive return, net of interest expenses! This is why I am not concerned about future recessions. 😉 I know I can just hang on to RY until the stock market recovers like it always does after a major correction.

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Nov 142016
 

If our employer gives us the option to collect our paychecks one month in advance, but charge a one time fee of 1% then I’m sure a lot of people would like the idea. Maybe we won’t use it, but it’s nice to know we have that option to get paid a month early if we want to! 🙂 This is similar to when a bank, car dealership, or credit card company offers us a loan that has a 12% annual interest rate.

Both examples are essentially the same thing. We receive some money in advance, accrue a small fee, and eventually pay back the full amount with either labour or cash savings. Workers are willing to pay that extra 1% fee if it means giving them the freedom to choose when to spend their money. Maybe they really want to take a family vacation now instead of next month before the busy and more expensive holiday traveling season. It’s nice to have the option to do so even if it means giving up 1% of their income because of tradeoffs. Some people are even willing to accrue a 5% charge. In that case, they can take a vacation 5 months in advance. When most people think about debt, they focus on the borrowing cost or interest charges. But when they think about getting an early paycheque, they focus on the financial benefits of the premature income. But both situations can be thought of as balancing time and money. 🙂

I think if people start to look at debt as a financial tool rather than a burden, they will see that borrowing money is a natural part of life and we shouldn’t be afraid of it or patronize debtors.

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Random Useless Fact:

Sometimes the best response to provocation is not to engage.

16-11-dog-cliff-bird

Oct 202016
 

Debt Isn’t Bad

Private debt was invented to facilitate convenience in trade. This principle was widely accepted for most of human history. But things have changed in the 21st century. Today, many generic debt bloggers will rant about how much they hate debt with a passion and want to pay off their debts ASAP. They seem to be very debt-icated to their cause. 😛 But why would they go into debt on purpose, and then become so upset about being in debt? 😠 Isn’t that exactly what they wanted?

16-09-grinds-gear-debt-loan-meme

We don’t borrow money and pay interest to a bank out of the kindness of our hearts. Instead, I believe most of us go into debt for one simple reason; to increase our own standards of living. We take on debt because we are motivated by self interest. 🙂

Would we go into $500 of debt to buy a football? Probably not, unless it’s one that’s autographed by Lionel Messi. 😉 But how about taking on $500 of debt to experience a 3 week, all-inclusive trip to the Great Barrier Reef? Heck yes, I sure would!

If our objective or desire is worth more to us than the cost of borrowing then using debt is preferable.

If it’s not worth the debt then we don’t borrow. The same can be said for practicing mindful spending. It’s really quite simple. 😀

Nobody can force consumers to use debt. It’s possible to go through life without using debt at all. But relying on savings alone to make every purchase means losing out on choices, and opportunities. By the time a saver accumulates enough cash to start college, all his friends who used student loan debt to get ahead would already be graduating. Why would anyone want to commit to a debt free life if it means depriving themselves of opportunities? This is why I concluded that I will probably never be debt free.

Of course it’s completely possible to have too much debt, just like it’s possible to overwork ourselves. But we should all learn from our mistakes and move on. Much like being mindful of our purchases, we should be mindful of where we should be on the debt spectrum.

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