The debate about fixed rate vs variable rate mortgages has to be as old as Canada’s oldest bank. For just about as long, people have been comparing fixed rates to insurance. You get some certainty but the bank makes a profit from you on average. And they know enough to come out ahead. Is that still true?
If you’re talking about an institution that finances its mortgages from deposits then it’s true that they would want to set a fixed rate that avoids creating a loss for them and gives them a bit of protection for future changes. But those institutions are rare these days. And if the interest rate they pay on deposits doubles from 0.001% to 0.002% it’s not a big loss. It seems much more common for fixed rate mortgages to be financed by selling bonds now.
That means all those 5-year mortgage rates are really in competition to get money in place of other 5-year bonds. Which means the interest rate would be driven by the bond market, which is affected by things such as how believable the government’s fiscal policies are and how scared people are of stocks this week. Even institutions that don’t issue bonds could use an interest rate swap to take advantage of low yields in the bond market.
Not that the bond market is dumber than banks. “Bond market vigilantes” have brought light to empty promises many times by demanding rates that reveal the bond issuer’s lie. But for all the smart money in the bond market, it’s still open to be driven down to ridiculously low (or high) rates when uninformed people panic over incomplete information. This won’t happen all the time, but is it more likely than a bank setting a 5-year rate that costs them money?
To summarize, if fixed rates are influenced by bond markets and bond markets are driven by millions of emotional investors then you’re not betting against the bank by taking a fixed rate. You’re really betting against what other investors feel. And if you think the emotions are going in the wrong direction it just might be a wise bet to take advantage of low interest rates while they’re available if you have a need to borrow.
On that note, after 1 year in a 5-year fixed rate mortgage we have switched to a new 5-year fixed rate of 2.99%. This is from a local credit union and I don’t think they issue mortgage bonds. Does this mean we’re betting against them? I don’t know the answer, but we don’t have much to lose by holding on to today’s rates for a few more years.
The recent gains in the US stock market have a lot of people calling it overvalued. Various analysts have pointed to many indicators that seem to show danger in the near future. Some investors are even taking their gains for the years and leaving the market. Is this the time to get out?
While the great buying opportunities of the last few years are rapidly vanishing, there are also good signals. Many individual investors still seem to be scared of stocks. If they jump back into the market after seeing these gains, they would drive it even higher.
Being cautious and informed is always good, but leaving the market entirely at this point seems premature. While I believe that gains aren’t real until you sell, this also doesn’t look like the kind of bubble peak that should keep long-term investors out of the market. The problem with leaving the market is that you limit your gains while keeping yourself open to unlimited losses. Gains that are locked in also aren’t real unless you can buy back in at a lower price later or find something else to invest in that’s just as good.
Locking In Gains
Consider the strategy of selling and going to cash or short-term bonds when you’re up 10% for the year to lock in your gains. If you did this in the early months of last year you wouldn’t have been exposed to the losses later in the year and you would be ahead of everyone else. You could do it again right about now to get the gains two years in a row. But how will it work over the next 20 – 40 years?
A book I read last year pointed out that it’s more common to have large gains or a loss than a moderate gain. If there is a loss you shouldn’t be selling (if you were comfortable owning stocks before, it only gets better when the prices are lower). So you’ll take a full loss in bad years, but if there’s a gain of 20%, 30%, or more you’re limited to getting 10% even in the best years. That gives you a higher possibility of under-performing the market.
You might try to improve the strategy by deciding to sell at a certain point when you’re losing, so your gains and losses are limited and you have more predictable returns. To make this simple you can use options to do exactly that. By using put and call options at the same price you can limit your upside and your downside with no extra cost other than the commission on the options. This WSJ article shows that with the S&P 500 index at $1364 recently you could use this strategy so your losses are stopped at $1160 and your gains are “locked in” (and limited) at $1430.
That’s a nice predictable investment return… except that your potential losses are 3x as big as your potential gains. You could protect yourself all the way to $0 with payoffs like that. To be fair gains are more common than losses so you might have a series of gains before a loss and you can reset your protection each time. You could also adjust the option strike prices and pay a bit more so you can keep more gains. In the end it’s still a bet on a rising market and I suspect that if you did that you would spend a lot of time and commissions to get a return similar to just staying invested with no options.
No Secret Tricks
It’s wise to reduce your exposure to stocks when their prices rise quickly since they can’t continue like that forever. But if you want to get the gains that the stock market produces you need to take the risks one way or another. And getting all the risks while limiting the gains doesn’t sound appealing. Unless you’re one of the 5 people in the world who knows exactly what will happen in the next year the simplest approach is to take a long-term view of the stock market.
Anyone who has a consistent strategy based on reasonable principles has a good chance of doing well over time. But how many people who like the idea of selling now would also have sold in March 2009 to “avoid further losses”? I can’t work out a way that I could apply this consistently and get better returns than those from long-term ownership with small adjustments along the way.
One of the ongoing debates I have with myself is whether it’s worth including a bond component in a long-term portfolio. Andrew Hallam’s book Millionaire Teacher points to an interesting study showing that a 60% stock / 40% bond portfolio in the US, from 1973 to 2004, would lag an all-stock portfolio by only 0.7% per year. To compensate for that, the worst drop in 1 year is -9% rather than -20% for the all-stock portfolio.
Studies like this show that even a moderately large bond component may not be all that bad. The Canadian Couch Potato Portfolio from MoneySense shows that with 67% in stocks and 33% in bonds from 1975 to 2010, a balanced portfolio would beat the stock market on its own.
This seems to conflict with evidence from others such as Jeremy Siegel who finds stocks beating bonds every time over periods of 30 years or longer. If you’re going to put $1 in the market and not touch it for 30 years, does it make sense to put it in stocks alone and get a slightly higher return over time? Or can you do even better with a good balanced portfolio?
Despite all the evidence from studies, this is a trick question unless you can precisely plan the next 30 years of your life. You could have financial emergencies and unexpected expenses. I could need a couple of years of investment income while starting a new business. Someone might find out they can afford to retire 10 years earlier than expected or can’t work as long as they thought.
Money in the stock market only grows as long as you leave it in the stock market long enough to grow. It doesn’t matter if the stock market goes up 300% if this happens to be in the late 90s and you don’t sell before it comes back down. With the many uncertainties in markets and life there’s something to be said for paying a small price and gaining the ability to access your portfolio when you have a true need rather than having it locked away. And if this safety allows you to invest twice as much because you can take out a little when needed, you can do better than someone else who gets a slightly higher market return.
However even a balanced portfolio requires discipline and courage to manage well. To take advantage of the growth potential you need to re-balance when needed, which could still be hard for some people. Andrew Hallam shows the potential as he stuck to a disciplined plan with his balanced portfolio and became the Millionaire Teacher. If you follow that path consistently there is no reason for envy over other peoples’ investment returns.