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The Four Deadly Sins of Personal Finance

December 5th, 2006 at 12:51 pm

An very interesting article in the NYT reminded me, again, of the four deadly sins of personal finance:
1. Greed - "just a little bit more" can easily become "too much", whether it be chasing higher investment returns, pinching pennies, or getting "top dollar" when selling or "a bargain" when making a purchase. Remember the old adage that if it "looks too good to be true it probably is". When looking for "overlooked" investment opportunities it's also worth bearing in mind that there are several billion other human beings out there, millions of whom are also looking for the "overlooked".
2. Sloth - most people apparently spend more time planning the annual holiday than they do on planning their finances. Aside from generally financial planning, you also have to put in sufficient effort to analyse each potential investment on its merits. Buy things purely on the say-so of a friend or relative and you will have no-one to blame but yourself if things don't work out.
3. Trust - yes, BLIND trust can be a very bad thing. As they say in auditor-land "trust but verify" - don't take anyone's word for something that you could verify. And if there is nothing to back-up someone's verbal assurance, flag this mentally as having an "unknown amount of risk"
4. Envy - just because every one else seems to be making a fortune investing by in "X" doesn't mean you should try it. It doesn't even mean that they are actually making any money from "X". Not only can appearances be deceiving, I'd say that they usually are deceiving.

personal finance, investing

Sheer Lunacy

December 4th, 2006 at 11:01 am

In yet another example of "off the wall" market timing theories, academics Ilia D. Dichev and Troy D. Janes have postulated that returns in the 15 days around new moon dates are about double the returns in the 15 days around full moon dates. A similar result was reported by Lu Zheng in the paper "Are Investors Moonstruck? Lunar Phases and Stock Returns" which showed that stock returns are lower on the days around a full moon than on the days around a new moon - the magnitude of the return difference is 3% to 5% per annum.

As is often the case in such academic studies, there is little likelihood of creating a profitable active trading strategy out of this information due to the cost of trading 13 times a year compared to the magnitude of expected outperformance (3-5% pa). However, it may be worth bearing the lunar calendar in mind when you are thinking about buying or selling shares in your portfolio, provided that there is no urgency in completing the trade. If you are routinely adding to your portfolio in the week immediately before or after the full moon, and selling within a week of the new moon adds 3-5% to your overall returns (pa?) it could be a worthwhile strategy.

The article in the NYT shows the lunar cycle effect for various markets around the world:



investing

A Very Interesting FREE Home-Study Personal Finance Course

December 2nd, 2006 at 01:59 pm

"Investing for your future" is a basic investing home-study course available online. The 11-unit home study course was developed by the Cooperative Extension system for beginning investors with small dollar amounts to invest. It is aimed at those who may be investing for the first time or selecting investment products, such as a stock index fund or unit investment trust, that they have not purchased previously.

It has some valuable information and some cute graphics, such as the "investment pyramid" (reminiscent of the "food pyramid"):

And it also has some exotic terminology that I haven't come across before, such as "loanership"!

All in all, a good read for a cold winter's night in front of the PC with a cup of hot chocolate.

personal finance, investing

Try This Investment Risk Tolerance Quiz

December 1st, 2006 at 12:44 pm

Want to improve your personal finances? You risk tolerance is one of the fundamental issues to consider when planning your investment strategy. Start by taking this quiz from Kansas State University. Choose the response that best describes you - there are no "right" or "wrong" answers. Just have fun!

Take the Quiz

ps. I scored 33 - "a high tolerance for risk", which is what I expected. The score ranges are:

Score Risk Tolerance Level
0-18 Low tolerance for risk
19-22 Below-average tolerance for risk
23-28 Average/moderate tolerance for risk
29-32 Above-average tolerance for risk
33-47 High tolerance for risk


personal finance, investing, risk

How to Make an Extra Million for Your Retirement in three easy steps

December 1st, 2006 at 12:43 pm

1. Start when you are 20

2. Earn an extra $3 each and every day

3. Invest it via a regular savings plan with 100% gearing ($100 borrowed for every $100 invested) into the following asset mix:
40% Australian Shares
20% International Shares
20% US Shares
10% Property Securities
10% Australian Bonds
Based on the historic returns for the past 20 years, and typical margin loan borrowing costs of 3% above the cash rate, this would result in $3,687,250 by age 65 - or $975,000 in today's money (assuming inflation averages 3% pa).

OK, this may not work out exactly as planned, but finding an extra $3 a day should not be too hard for anyone. And, as this is "extra" money, there shouldn't be any problem using a geared savings plan and a high-growth, high-risk asset allocation. For those that are risk-averse, just close your eyes and don't check the balance on your annual statement until you turn 65. In practice you may have to save up the $21 a week into an online savings account until you have enough to start such a geared savings plan - probably an initial amount of $1000 and then regular contributions of around $100 each month. Also, if you don't live in the "lucky country" you should probably change to asset mix to include your local shares and bonds instead of the Aussie versions, and switch the others as needed eg. from US shares to Asian for US readers who would be including US shares as their "local" share component.

There may be some tax due when you cash in a 65, but there shouldn't be much tax impact along the way, as the interest on the gearing loan will consume all your dividend income (more or less).

Set for Life: Children's Retirement Accounts

November 30th, 2006 at 02:30 pm

There is much to be said for starting an investment portfolio as soon as possible - compound interest works it's magic over long periods, and you can set your asset allocation to a much more aggressive "high-growth" mix if you have a very long time horizon. So, starting an investment portfolio for your kids is one of the best possible strategies, and is even more so with the proposed changes to superannuation tax in Australia - ie. that there will be no tax on superannuation withdrawals made during retirement.

This means that if you set up a child superannuation account into which you (or any relatives or friends of the child) can contribute up to $1000 each year. (There is a cap of $3,000 every three years PER ACCOUNT - if you wanted to save more than $10 per week you just setup several accounts for your child). There will be no tax due on deposits (as they are made as undeducted contributions), no tax on pension or lump sum payments over 65 years of age, and a maximum 15% tax rate on earnings (likely to be reduced below 15% due to the benefit of franking credits on share dividends).

For example, if you contribute around $10 each week ($250 per quarter) into a child superannuation account from birth until 18 years of age, and then no additional contribtions are made, at retirement age (65) the account would be worth $2,218,843 (or $317,898 in today's dollars) - assuming an average return of 10% pa for a high-growth asset mix (shares (preferably geared), some bonds and some property), and an average inflation rate of 3% pa.

For a total contribution of $18,000 your child's retirement fund will have added $300,000 (in today's dollars) by the time they retire - with no further contributions required after they turn 18. This will let your child concentrate on paying off a mortgage or investing outside of super when they start working.

personal finance, investing, money, saving, wealth, investment

The Eight Best and Worst Money Moves You Can Make

November 29th, 2006 at 10:50 am

Here is a list of the eight best and eight worst money moves you can make, and why:

Eight Best Moves:
1. Pay Yourself First - no matter how much you earn, you should put aside a fixed percentage of your income as savings each pay day. This will develop good savings habits. You can start off with a small and painless percentage and build up slowly to a significant amount, for example when you get a pay rise.
2. Cut up your credit cards and pay cash for everything. This will ensure you never run up credit card debt.
3. Borrow against your home equity. You can borrow at very competitive interest rates and invest this money in high-growth assets, boosting your returns using gearing. Home equity loans also have an advantage over margin loans because they aren't subject to margin calls.
4. Invest in index funds. The market is reasonably efficient, and studies have shown that very few professional fund managers can "beat the market", after allowing for the higher fees compared to index funds.
5. Invest in managed funds. Some managers (Buffet, Lynch) have consistently produced superior returns, so it is worth seeking them out.
6. Diversify to reduce risk without reducing your returns. Your portfolio asset mix should be on the efficient frontier.
7. Put all of your eggs in one basket and watch the basket carefully. You should spend enough time and effort to identify a few excellent companies and buy them at the right price for the long term. This is what Warren Buffet does.
8. Borrow to invest. Also known as "gearing" this will boost your returns and can provide tax benefits if the interest on the loan is tax deductible and long-term capital gains are taxed at a lower rate than current income (dividends).

Eight Worst Moves:
1. Pay Yourself First - if you have any "bad" debt (loans for non-investment items such as clothes, toys, cars, holidays etc.) you should pay this off before you even consider a savings plan.
2. Cut up your credit cards and pay cash for everything. Several reasons you should keep your credit cards and learn to use them responsibly
- they can act as your "emergency fund" so you can be fully invested without having to keep an "emergency fund" in a low-interest cash account.
- they are much safer than carrying wads of cash around, and are especially convenient overseas.
- by paying off the balance in full each month you can get up to 55 days interest free credit on your day-to-day purchases, so you can keep an extra month worth of expenditure invested.
3. Borrow against your home equity. People who borrow against their home equity or against the 401K to pay of credit cards often run up the credit card debt again. Others use HELOC to spend more than they earn on things like cars, holidays and lifestyle. You can end up still having a mortgage when you retire, or, in the worst case could put your home at risk.
4. Invest in index funds.You are condemning yourself to mediocre (average) investment returns. Some managers (Buffet, Lynch) have consistently produced superior returns, so it is worth seeking them out.
5. Invest in managed funds. Although some managers (Buffet, Lynch) have consistently produced superior returns, you have Buckley's chance of picking who are the superior managers - last year's (or five year's) performance is no guide to next year's winners (but everyone can identify them in hindsight).
6. Diversifying your portfolio (also known as "di-worse-ification") will drag your investment returns towards back down to the average.
7. Put all of your eggs in one basket. If you make one or two bad calls you'll put your portfolio in the toilet. Do you really think you're the next Warren Buffet?
8. Borrow to invest. Gearing will magnify any gains or losses, but, if the market tanks you can get a margin call and be totally wiped out, so you never get to benefit from the magnified gains when the market recovers.

Confused? Well, it just goes to show that there are no "one size fits all" answers in personal finance. Some would argue that this is why you need to get help from a financial planner. My view is that you need to learn enough about yourself, your position, and available options to form an educated financial plan. The fees you'd pay a financial planner are high enough to eat into your investment returns, and, at the same time are too low to buy enough time and effort from a professional financial planner to really get to know you and your situation well enough to give an optimum plan customised for you. The best you'll get is a fairly vanilla plan that is "reasonable" for your situation.

OK, these probably aren't the top eight anyhow - I just wanted to make the point that in personal finance there are many shades of gray. If you read about technical analysis and want to try day trading, first read all the evidence supporting the weak version of efficient market theory, and, remember, in day trading it's a zero-sum game, so you have to be smarter than more than 50% of other traders (allow for trading costs) to hope to make a profit. If you like fundamental analysis, remember that companies makes honest mistakes in their reports, they sometimes obfuscate (or downright lie), and, even if the figures are correct, they are historic, so are a pretty poor guide to the future.

I spent a lot of time for my first decade of investing learning everything I could, and trying to find out the "truth" about investing - what is the "correct" way to invest, and the "best" strategy. What I've come to realise is that no-one knows - especially not what is best for YOU. So, just keep learning all the time, and remember, it's always just going to be your "best guess", so always evaluate and manage your investment risk.

At the end of the day, you've really got no-one to blame for your investment performance but yourself. On the bright side, at the end of the day, we're all dead, so it doesn't really matter anyhow Wink

Baby Boomer Retirement Crisis

November 29th, 2006 at 10:48 am

Yet another article about the abyss facing baby boomers in retirement - there won't be enough tax payers to fund pension payments for everyone, and baby boomers haven't been saving nearly enough to have a "self-funded" retirement.

An article in the Sydney Morning Herald lays out the problem very clearly. Some of the points are universal, applying equally to baby boomers in the US, UK and Australia:

"To give you some idea of the challenge, to retire on 45 per cent of your pre-retirement income you need to have contributed 12 per cent of your salary every year for 40 years."

"With the male retirement age averaging 58 years, drawing on retirement savings at 60 per cent of salary will see the money run out at age 72. But, if retirement is postponed for only two years (until 60), the money would last until 79. Working an extra two years funds a further seven years of retirement."


An interesting read, though everybody should be thoroughly familiar with all this by now, and have an action plan in place to look after themselves in retirement.

personal finance, investing, money, saving, wealth, investment

Asset Allocation: Is There a Place for Gold in Your Asset Allocation?

November 29th, 2006 at 10:38 am

Asset allocation is the process of selecting an appropriate "mix" of asset classes to maximise expected return for a chosen level of risk, or alternatively, to minimise the likely risk (volatility) accepted in attempting to attain a desired rate of return. Some modeling by the World Gold Council showed that gold bullion can play a beneficial role in asset allocation. Although gold bullion produces a negative income (it costs money to store and trade, and pays no "rent" or dividend), it can produce significant returns via capital gains, and has the virtue of responding positively to events that generally have an adverse effect on the performance of other assets classes. By including a small amount of gold bullion in your portfolio (less than 5%) you can achieve significantly reduced volatility with only a slight decrease in performance.

It should be noted that how well gold adds to you portfolio diversification depends on what other assets you hold - as can be seen below, Gold showed much less covariance with the ASX300 Industrials Index that it did with the ASX300 Resources Index. So, including gold for diversification purposes would make more sense if your portfolio includes US or UK stocks, than, for example, Canadian or Australia stocks, where there is a greater exposure to the resources sector.
Gold vs ASX300 Industrial Index

Gold vs ASX300 Resources Index

It is possible to buy gold bullion or gold coins and store the physical gold - but storage costs can be significant. Although there's nothing stopping you burying some gold coins in a zip-lock bag in your back-yard, Europe is littered with caches of medieval gold that was buried for safe-keeping and never recovered by the owner!

One alternative would be to buy and sell gold bullion online, for example through BullionVault.com. This company stores gold bullion in high-security Brinks vaults at various locations around the world (London, New York, Switzerland). Because the gold doesn't move it is safe, secure, cheap and easy to trade online. Client holdings are reconciled each day and published online using anonymous aliases. You need to fund your account by transfers from your bank account in order to start trading gold. New accounts get a "free" 1 g of gold credited to their account (worth around $15), but it only becomes "yours" once you fund your account and can start trading for real (you can trade your 1g for practice, but it will get forfeited if you don't fund your account within two weeks).

The main screen at BullionVault.com shows the current buy and sell prices for gold in any one of three currencies (USD, GPB or EURO) for the three vaults. The buy/sell spread seems to be around 0.4% and BullionVault.com charges a tariff of 0.8% for each buy or sell order. So the round trip cost of buying and selling bullion would be around 1.9% (There are lower tariff rates if you trade a large amount during the year).

This option may suit some investors in the US, UK or Europe. Personally I've previously bought 1 oz gold bullion "bar" from the Perth Mint and stored it at home. For larger amounts I'd trade the gold "warrants" issued by the Perth Mint that are listed on the Australian Stock Exchange (ASX code ZAUWBA) as you don't have the storage and security issues that relate to physical bullion. The only difficulty is that to trade warrants you need to have completed the required paperwork with your broker, as a normal share trading account can't trade warrants.

I personally haven't opened an account with BullionVault.com. If I was going to, I'd try to evaluate the risk of losing your investment if the company went out of business - the same sort of risk analysis you'd do before investing in, say, Prosper.com. I generally don't like funding internet purchases direct from my normal bank account, so I'd recommend opening a new bank account with just the amount you wish to invest, and use that account for use with Prosper.com, BullionVault.com etc.

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Will You Live Long Enough to Enjoy your Wealth?

November 27th, 2006 at 12:22 pm

There's not much point in applying all the wonderful tips you learn reading PF blogs if you end up a millionaire but die at 50!. Aside from the obvious health tips - don't smoke, drink in moderation, drive carefully, avoid high-risk activities (unsafe sex, drug use, freestyle rock climbing, cave scuba diving etc.) the most important keys to living long (and healthy) enough to enjoy your wealth are getting enough exercise and maintaining a healthy body weight/BMI.

Personally I'm overweight and need to modify my diet to a more healthy one so I can get down to my ideal BMI in a healthy way (no crash dieting!) and then maintain it for the rest of my life. I've read up a bit on CRAN (calorie restriction with adequate nutrition) which basically means reducing the amount of calories you eat while watching out that you are still getting the optimal amounts of vitamins, protein, fat (yes, some IS needed) and carbohydrates. Up to now CRAN has been mostly theoretical, based on observations and experiments with short life-span animals. This research showed that when a test animal's diet was restricted to about 25%-40% less calories than would be eaten in a totally "unrestricted" diet, the average life-span was extended (up to 50%) and a more healthy old age resulted (although there's not much evidence that it increases the maximum possible life-span).

It now appears that longer-term experiments with longer-lived species that are more similar to ourselves are providing more evidence that CRAN is likely to be beneficial to humans wanting to live longer and healthier life-spans. See this article for a very interesting update that shows the very positive effects of CRAN on monkeys.

Personally, applying CRAN means reducing my average daily calorie intake from around 3,200 kcals down to a healthy 2,000 kcals by eliminating junk foods - I tend to snack on icecreams, sweets, chocolate, biscuits etc. which are all totally unnecessary (and expensive!). I'm hoping to reduce my BMI from 31.5 (100 kg) down to 22.1 (70 kg) by the middle of next year. I think I'll add this goal as another bar graph in my blog to help track my progress!

How to succeed with your budget!

November 27th, 2006 at 12:18 pm

The mechanics of creating a budget are well-known, and, while not very enjoyable for many people, not hard to complete. The difficulty lies in implementing and sticking to your budget. You can greatly increase your chance of sticking with your budget if you give careful thought to the CHANGES that need to be made to get from your old budget (starting position) and the new budget you hope to implement. Each change should be classified as either a ELIMINATION or a SUBSTITUTION.

An elimination is when you have to totally get rid of a particular spending behaviour - for example, quitting smoking or cutting up your credit card. These changes are very hard, and should only be done if absolutely necessary. A lot of changes SHOULD be classified as a substitution - for example, drinking filtered tap water and tea rather than softdrinks and Starbucks. These are usually much easier to implement as you are not having to eliminate a behaviour pattern 'cold turkey', but are still able to follow your normal routine with minor changes. Generally, after a week of substitution it will become a habit and can be followed without any further effort of will needed.

Many people make the mistake of classifying intended changes as an elimination when they should be aiming for a substitution instead. For example, if you wish to save on entertainment costs, it is far better to substitute your cable TV subscription with borrowing DVDs and books from your local library, substituting gym membership with lunchtime walks and so on. Trying to eliminate spending without introducing a suitable alterative will leave you in a permanent state of "deprivation" and you are more likely to fall back into old spending habits.

money, saving

Income: Is higher education a good investment?

November 25th, 2006 at 11:56 am

One of the fundamental tenants of wealth creation has always been to invest in your education. Latest figures (released Thursday by theUS Census Bureau) confirm this. The figures show that the average bachelor's degree is worth about $23,000 a year - that is the average gap in earnings between adults with bachelor's degrees and those with high school diplomas. College graduates made an average of $51,554 in 2004, compared with $28,645 for adults with a high school diploma, an average of $19,169 for those without a highschool diploma, and an average of $78,093 for those with an advanced college degree.

Of course, this study didn't determine how much of the increased earning power is due to having the intelligence to obtain the qualification, and how much is due to the education/qualification/networking of getting the further education.

The potential effect on your net worth is even greater than the raw salary figures suggest. There is a fixed "overhead" cost of living, so, assuming that you can exert some self-control and limit your spending as your salary increases, an increase in salary has a great effect on your ability to accumulate wealth. For example, if your basic cost of living is $30K pa, then a 50% pay rise from $40K to $60K has the potential to triple your ultimate net worth (saving and investing $30K rather than $10K pa).

personal finance, money, wealth

Gearing: Risk vs. Reward - the last 10 years

November 25th, 2006 at 11:52 am

Using gearing to increase your returns in the long term has a couple of problems:
1) The interest rate charged directly impacts on the extra return generated
2) The extra risk (volatility) generated by gearing is large compared to the extra return

To get a better feel for how good a strategy gearing is, I've first looked at the current interest rates available for margin loans (and how it depends on the amount borrowed) and the current spread between the margin lending interest rate and the target cash rate set by the reserve bank.


The graph shows that the interest rate charged on a margin loan varies considerably between the different margin lenders, so it pays to shop around. Generally, the interest rate is reduced for clients with a large loan balance, so it's probably worth having one large loan rather than spreading it between several lenders (this is something I need to fix over time, as I currently have three different margin loan accounts. The problem is the tax effect of realising capital gains when transferring holdings from one lender to another).

It can be seen that the current spread between the target cash rate (6.00%) and the typical margin loan interest rate on a $500,000 loan is about 2.5% - so I've assumed this was the typical spread during the past ten years or so.

I've then used the changes in the target cash rate over the past decade (see below) to calculate the average margin loan interest rate each year since 1997, and compared that to the change in the All Ordinaries Index each year:
Average ----with gearing----
Year cash ML XAO XAO % % gain w/out 50% LVR 67% LVR
rate rate start end change or loss ML 100% D:E 200% D:E
1997 5.48% 7.98% 2411.2 2609.1 8.21% 0.23% 8.21% 8.43% 8.66%
1998 4.98% 7.48% 2609.1 2832.6 8.57% 1.09% 8.57% 9.65% 10.74%
1999 4.79% 7.29% 2832.6 3124.1 10.29% 3.00% 10.29% 13.29% 16.29%
2000 5.93% 8.43% 3124.1 3205.4 2.60% -5.83% 2.60% -3.22% -9.05%
2001 5.06% 7.56% 3205.4 3384.5 5.59% -1.97% 5.59% 3.61% 1.64%
2002 4.56% 7.06% 3384.5 2996.2 -11.47% -18.53% -11.47% -30.00% -48.53%
2003 4.81% 7.31% 2996.2 3309.8 10.47% 3.16% 10.47% 13.62% 16.78%
2004 5.25% 7.75% 3309.8 4060.7 22.69% 14.94% 22.69% 37.62% 52.56%
2005 5.46% 7.96% 4060.7 4721.1 16.26% 8.30% 16.26% 24.57% 32.87%
AVG 8.13% 0.49% 8.13% 8.62% 9.11%

This table confirms that the use of gearing would have boosted your returns during the past decade - from an average of 8.13% pa without gearing, to 8.62% using 100% debt:equity (a 50% loan:value ratio), and 9.11% using a higher gearing rate of 67% LVR (close to the normal lending limit of 70%).

However, it also clearly shows that the use of gearing greatly magnified the ups and downs of a portfolio - the relatively modest 11.47% drop during 2002 would have meant a 48.53% drop in value of a portfolio using 67% LVR, and probably would have required more cash being added into the account to avoid getting a margin call.

In the long term, getting a return of 9.11% instead of 8.13% will have a large effect on your final net worth - if inflation averaged 3% this would result in a real return of 6.11% rather than 5.13% (an improvement of 19%).

It is important to watch your LVR when using gearing, be conservative when the market is setting new highs, and be prepared to manage your portfolio to avoid any margin calls. It is also very important to shop around for the best possible interest rate - possibly using home equity to obtain lower rates.


personal finance, investing, investment, stocks

Retirement Fund Asset Mix

November 24th, 2006 at 10:02 pm

I generally think a 40% domestic shares, 35% foreign shares, 15% property, 10% bonds is the basic starting point for working out a long-term investment mix, provided this weighting towards growth assets matches your risk tolerance. Since my retirement fund is definitely a long-term investment(20 years till retirement age, then maybe another 20 or so during retirement) this was my starting point. I did decrease my weighting in shares and increase the % in property during the bear market in 2001, and then weighted my asset mix more towards shares in 2003 when the market seemed to have bottomed out.

My current investment mix in my retirement account is as follows
BT Business Superannuation
Investment Option wt %
Colonial First State Diversified 1.91%
Westpac Australian Shares 19.68%
Colonial First State Australian Shares 25.53%
Westpac International Shares 1.93%
BT Core Global Shares 20.48%
MLC Global Share 20.13%
Westpac Australian Property Securities 10.26%
Westpac Australian Fixed Interest 0.06%
Intech High Opportunity 0.03%
Overall the asset allocation works out as:
Asset class wt %
Australian Shares 43.52%
International Shares 37.93%
Property 10.13%
Bonds 0.38%
Cash 8.03%
The cash component isn't really intentional - it's just that all the stock funds tend to have a cash float at all times. I've got less in bonds than my "plan" requires - but with interest rates still quite low the risk of capital loss with bond investments seems more towards the upside, and the coupon rate is nothing too exciting. If interest rates here go up another 0.25% or .50% and the economy slows down, I'll reweight from stocks to bonds. I think my "model" retirement portfolio is around 40% AU shares:35% INT shares:15% LPT:10% bonds:0% cash

Hopefully these Asset classes should return something like the following in the long term:
Asset class return %
Australian Shares 9.5%
International Shares 9.0%
Property 8.0%
Bonds 5.0%
Cash 3.5%
This would give my "model" portfolio an expected return of around 8.65% (after fees and charges)

personal finance, investing, investment, stocks, real estate

Asset Class - Fine Art

November 24th, 2006 at 10:00 pm

The lack of correlation between the stock market and the art market makes Fine Art a possibly attractive asset class to use to diversify a portfolio beyond the traditional stocks, bonds and real estate. However, while art can hedge against some of the movements in the stock market, it has a similar level of risk and, for most individuals, it is too expensive to invest in individual art works. Even funds such as the popular London-based Fine Art Fund require investors to hand over a minimum of $250,000 in order to play the art market. And those investors will have to be willing to wait at least three years before they can cash out of their investment.

How has Fine Art performed as an asset class compared to, say, stocks? The Mei/Moses Fine Art Index, the creation of NYU Stern School of Business finance professors Jiangping Mei and Michael Moses, tracks 9,000 pieces of art that were auctioned by Sotheby's and Christie's since 1950. The index measures the value of the art market by analyzing repeat sales of the different pieces of art that comprise the index. While it is generally considered a fair benchmark for art valuation, it excludes transaction fees, works that fail to sell at auction and certain styles of art, such as photography and prints.

Over the last 50 years, stocks (as represented by the S&P 500) returned 10.9 percent annually, while the art index returned 10.5 percent per annum. As can be seen below, there is a low covariance between the Art Index and the S&P500 index:



One of the problems of consideraing Fine Art as an investment asset class is that in the art market, only about 30% to 50% of the works that change hands in any given year do so on the open market, at auction, where the public can see the prices. In the contemporary market, that figure plunges into the single digits. In addition, access to the market isn't always easy or cheap -- the supply of contemporary works is controlled by dealers, for instance, while hefty auction fees make it hard to compare the art market to any securities market. Therefore, the entry fee and management fees of any Art Fund are likely to be high - similar to that of Hedge Funds, but with performance that has historically been more in line with the stock market.

Some thoughts about the use of gearing

November 24th, 2006 at 09:58 pm

How can you use gearing as part of your investment strategy? I hope to increase the returns of my portfolio with the least possible increase in risk by using borrowed funds to increase my investment. A simple example would be to invest a total of $200,000 in an index fund (eg. Vanguard) via a margin lending account, so that you've put in $100,000 of your own savings, and have borrowed the other $100,000 from the lender. The income from the $200,000 investment would cover part of the interest on the borrowed $100,000. Any extra I have to kick in from my cash flow to cover interest payments is tax deductible.

I prefer this approach (use of gearing) to that of boosting returns by including more risky assets in my portfolio because, theoretically, using gearing can provide more increase in return for an increased level of risk than just including a larger proportion of high-risk, high-return assets in your portfolio. Apparently it has something to do with the tangent of the line from the interest rate on the borrowed funds to the point on the efficient frontier corresponding to your asset mix having a steeper slope compared to just moving along the efficient frontier... Don't ask me to explain! As far as I can tell it looks something like the diagram below:


The idea is that you can increase the return of your "efficient" portfolio more by taking on extra risk through the use of gearing (ie. along the red line) than by changing the asset mix to include more risky assets (moving along the efficient frontier, assuming you have the right asset mix).

I don't worry too much about the details, as the entire concept of the efficient frontier seems fairly academic. In practice, you don't have precise data about all the assets in your portfolio (historic standard deviation, return, and covariance for all of the assets in your portfolio) or for determining the efficient frontier (such data on all possible assets mixes). Also, the usual problem of predicting the future using historic data applies. In practice, it seems that a sensible, well-diversified asset mix lies pretty close to the efficient frontier, and the use of gearing will be preferable to the inclusion of more risky assets in your portfolio (provided the interest rate on your investment loan isn't too high).

The other benefit of using gearing is that by having a larger total investment you are more able to make use of diversification.

Several things about the use of gearing (borrowing to invest) seem important to me:
1. You have to manage your risk - it is stupid (very risky) to borrow to invest in just one particular stock, or sector (eg. tech, oil, bio etc). I was amazed to learn that around 15% of margin loans are for accounts that have only one stock in them! The chances are you are not the next Warren Buffet (I know I'm not), so it's much more sensible to diversify - either via a portfolio of at least 10-12 stocks (not all in the same sector), or else via an index fund. Or a combination of both.
2. You have to borrow at the best possible interest rate - over time I've opened new margin lending accounts with lenders that offer a lower interest rate and that allow you to trade on your margin account via an online discount broker. Interest rates may be lower if you borrow a larger amount. I also have a margin lending account with the bank that provided my home and investment property loans - as a preferred customer I get 0.25% knocked of the standard interest rate. Most recently I used a "portfolio loan" secured against the equity in my real estate assets (similar to a HELOC?) to borrow at the standard home loan rate and invest in a portfolio of US shares (see my posts about my "Little Book" portfolio).
3. You should borrow less than the maximum so that you have a buffer against getting a margin call when the next market correction/bear market/crash happens. If the average margin for the stocks in your margin lending account is 70%, then you probably shouldn't get your loan-to-value ratio (LVR) above 50%.

The table below shows what % drop in the market would trigger a margin call for different starting values of gearing:
Assumptions:
Average 70% margin
Margin Call occurs if loan > 105% of margin value

% drop to initial initial initial
Capital Loan Total get a call LVR MU DER gearing
$100,000 $ 50,000 $150,000 54.6% 33.3% 47.6% 50.0% 1.5
$100,000 $ 60,000 $160,000 48.9% 37.5% 53.6% 60.0% 1.6
$100,000 $ 70,000 $170,000 43.9% 41.2% 58.8% 70.0% 1.7
$100,000 $ 80,000 $180,000 39.5% 44.4% 63.5% 80.0% 1.8
$100,000 $ 90,000 $190,000 35.5% 47.4% 67.7% 90.0% 1.9
$100,000 $100,000 $200,000 31.9% 50.0% 71.4% 100.0% 2.0
$100,000 $110,000 $210,000 28.7% 52.4% 74.8% 110.0% 2.1
$100,000 $120,000 $220,000 25.7% 54.5% 77.9% 120.0% 2.2
$100,000 $130,000 $230,000 23.0% 56.5% 80.7% 130.0% 2.3
$100,000 $140,000 $240,000 20.6% 58.3% 83.3% 140.0% 2.4
$100,000 $150,000 $250,000 18.3% 60.0% 85.7% 150.0% 2.5

LVR = loan-to-value ration (amount borrowed / total value of portfolio)
MU = margin utilisation (amount borrowed / max. amount allowed)
DER = debt-to-equity ratio (amount borrowed / your equity)
Gearing is basically the "muplitplier effect" that will apply to any losses or gains made by the portfolio on your equity. For example, if the gearing used is 2.0, then if your portfolio went up 10% your equity will have increased 20%. Similarly, if the market "corrected" -15% causing your portfolio to drop -15%, your equity will have gone down by -30%.

As the loan amount stays constant, any drop in the value of your portfolio will decrease the margin value (eg. 70% of the portfolio value). This also means that your margin utilisation increases. Most lenders will give you a "margin call" if your margin utilisation exceeds 100%. (There's often a "buffer" of 5%, so you'd get a margin call if the MU was >105%). When you get a margin call you have to bring your MU back down to less than 100%. This can be done in several ways:
* put some cash into your account (ie. pay off some of the loan) - this is best
* put in some stocks (eg. if you had some unencumbered stocks you could add into the margin account) - this is second best, as only the margin value of the stock (say, 70%) counts.
* sell off some stocks - you may not want to sell at the price prevailing when you get a margin call.

The most interesting column in the table is the % drop required to trigger a margin call. Looking at daily closing price data for the Australian All-Ordinaries Index (similar to the S&P500), I calculated the maximum % drop ever experienced after buying on any particular date for the past ten years. This period doesn't include any once-in-a-lifetime crash like '87 or '29, but does include the major bear market of the early noughties. I then grouped all the maximum decreases into bands - for the 2,531 days studied (1996-2006) I counted how many times the maximum drop was 0-5%, how many times it was in the range 5-10 % and so on. The tabulated results are:
max drop count probability
0% - 5% 1,069 42.2%
5% - 10% 438 17.3%
10% - 15% 480 19.0%
15% - 20% 439 17.3%
20% - 25% 105 4.1%
25% - 30% 0 0.0%
30% - 35% 0 0.0%
35% - 40% 0 0.0%
>40% 0 0.0%

TOTAL 2,531 100.0%
This shows that, at least for this past ten year period, if you'd invested on any randomly selected day for had a small (4.1%) chance of experiencing a drop of 20-25% before things began to improve.

You had a much bigger chance (21.4%) of experiencing a drop of over 15%. And drops of less than 15% are quite common.

This emphasises why it is important not to use excessive gearing - you have a significant liklihood of getting a margin call if your LVR is much over 60% (remember, an 18.3% drop will trigger a margin call if your LVR was 60%). Using gearing conservatively (say less than 50% LVR) with a well-diversified portfolio reduces the chance of a margin call significantly.

My plan is to maintain an LVR of around 50%, giving me a gearing ratio of 2. Assuming I can borrow funds at around 7.5% on average, and my portfolio return averages around 9.0%, I would expect my return on equity (ROE) to be 9.0% + (9.0% - 7.5%) = 10.5%. Assuming inflation averages around 3.0%, this extra 1.5% return would mean my real (after inflation) return is increased by 33% using fairly modest gearing. And this would have a big impact on the final balance.

The types of Investment Risk

November 24th, 2006 at 09:52 pm

A key component in deciding the asset mix you want to include in your total investment portfolio is "risk". In financial planning terms, market risk is defined as the variability of returns from an investment, or "the uncertainty of a future outcome". Although we are really only concerned by the likelihood of a LOSS, using volatility to measure risk is OK, as the standard deviation of investment returns is used to measure volatility, and this is directly related to the risk of an exceptional LOSS as well as the "risk" of an unusually GAIN.

Total risk = General risk + Specific risk
= Market risk + Issuer risk
= Systematic risk + Nonsystematic risk

The total risk of an asset is a combination of the many possible sources of risk.
Inflation risk - the chance the money you have invested will
decline in real value due to inflation.
Principal risk - the chance that your original investment will
decline in value or be lost entirely.
Credit risk - the chance a borrower will default on an
obligation.
Market risk - the likelihood that a broad investment market,
such as the bond or stock market, will decline
in value.
Liquidity risk - the possibility you won't be able to sell or
convert a security into cash when you need the
money.
Interest Rate Risk - the variability in a security�s return resulting
from changes in the level of interest rates
Regulation Risk - The risk of a regulatory change that could
adversely affect the stature of an investment
(eg. changes to the tax law)
Business Risk - the risk of doing business in a particular industry
or environment is called business risk
Reinvestment Risk - the risk that dividends/coupons will not be
reinvested, or cannot be reinvested at the same
rate, so that yield to maturity (YTM) isn't attained.
Exchange Rate Risk - the variability in returns on securities caused by
currency fluctuations (aka "currency risk")
Country Risk - the chance of loss due to stability and viability of
a country's economy (aka "political risk")
Valuation Risk - the chance that a an investment is overvalued
(eg. bubbles)
Timing Risk - the chance that other factors cause you to buy or
sell an investment at an inappropriate time
Forced Sale Risk - the chance that an investment is liquidated
involuntarily eg. takeover, fund closure
Some of these risks overlap eg. the principal risk may be a combination of market risk, business risk and regulation risk. It is not possible to measure of estimate some of these risks accurately, but it is still important to mentally run through this list whenever you are considering a new investment.

Standard deviation is a measure of the total risk of an asset or a portfolio, including therefore both systematic and unsystematic risk. For any investment, the "total risk" can be calculated from data on periodic (daily or monthly) valuations (prices) using the formula:

std dev = SQRT[{1/N}xSUM(Xi-mean)^2]
where;
N is the number of data points,
Xi is the ith measured value,
mean is the mean (average) of all the values,
and the SUM is for all values (for i=1 to N).

Standard deviation for many investments is available online or in magazines. If you have an investment and have periodic (eg. daily) unit prices you can caluculate the standard deviation yourself. A tutorial on how to calculate standard deviation for your investment data using excel is available here.
Typically, the standard deviation of the annual returns for various asset classes are as follows:
Money market (cash): 2%-3%
Short-term bond: 3%-5%
Long bond: 6%-8%
Domestic stocks (conservative): 10-14%
Domestic stocks (aggressive): 15%-25%
Foreign stocks: 15%-25%
Emerging Markets stocks: 25%-35%
A couple of points to be in mind are that
a) standard deviation is a measure HISTORIC risk - ie. if you use this in your planning, you are automatically assuming that risk in the future will continue at the same levels as in the past - this isn't always true (the collapse of several hedge funds provide examples of coming undone when risk levels suddenly change).

"Although standard deviations based on realized returns are often used as proxies for expected standard deviations, investors should be careful to remember that the past cannot always be extrapolated into the future without modifications. Historic standard deviations may be convenient, but they are subject to errors. One important point about the estimation of standard deviation is the distinction between individual securities and portfolios. Standard deviations for well- diversified portfolios are reasonably steady across time, and therefore historical calculations may be fairly reliable in projecting the future. Moving from well- diversified portfolios to individual securities, however, makes historical calculations much less reliable. Fortunately, the number one rule of portfolio management is to diversify and hold a portfolio of securities, and the standard deviations of well-diversified portfolios may be more stable."
- Learing for Life.

b) you had to pick a particular period to use for calculating risk - did you use data for the past year, past 10 years, all available data?

If you have a figure for the risk level of a particular investment, and know its expected rate of return, and its covariance with the other investments in your portfolio you could then work out where your current/planned asset allocation sits in relation to the efficient frontier, and make any sensible adjustments.

Your Tolerance for Investment Risk

Each individual investor has a different level of tolerance for risk. This may depend on your age, salary and expenses, health, family, and personality.
Conservative investors are more concerned with safety of principal and minimizing risk, and can accept a lower rate of return in exchange for added peace of mind.
Aggressive investors prefer to maximize the return on investment with a more flexible strategy, and are willing to accept a higher degree of risk.

You should ask yourself the following questions to assess your risk tolerance.
- What Are Your Investment Goals?
- How much you can invest, and what rate of return on investment will you need to achieve these financial goals?
- When Will You Need the Investment Income? ie. What investment timeframe are you looking at?
- Are You Comfortable with the Possibility of Losing Money?

Once you know your own risk tolerance, you are in a position to evaluate any new investment in light of it's expected risk and return.

One school of thought is that it is best to be more aggressive and take more risks when you are starting out/younger as you will have more time to "catch up" if things go wrong. I personally think that even young investors should start out with more conservative investments and then start to add more risky investments into their portfolio over time. This way you'll get to know your risk tolerance based on actual experience rather than questionaires etc.

Common mistakes in Personal Finance

November 23rd, 2006 at 09:33 pm

Some common mistakes people make when planning their finances:
Not setting measurable financial goals.
Thinking that only the wealthy need a financial plan.
Thinking that you can avoid starting to plan until you get get older.
Thinking that financial planning is the same as retirement planning.
Confusing financial planning with investing.
Making a financial decision without understanding its possible effects on other aspects of their finances.
Neglecting to review their financial plan periodically.
Waiting until a money crisis to begin financial planning.
Expecting unrealistic returns on investments.
Thinking that you can leave decision making to a financial planner.
Not understanding what a financial planner is advising.
Paying excessive fees for the sake of convenience.
Believing that financial planning is primarily tax planning.

My thoughts on Prosper.com

November 23rd, 2006 at 09:29 pm

As I don't have a US SSN I can't invest in Prosper.com, but I've seen quite a lot of posts by PF bloggers considering investing this way. Although the idea is interesting, and I might be tempted to invest a few hundred dollars myself if I could (bear in mind this would only be a tiny % of my total invested assets), I have some concerns which I posted as comments on Fearless Money.

I think they have general application to anyone considering putting money into Propser.com loans, so I'll repeat my comments here:

Please review the concepts of "there'no such thing as a free lunch" and the trade-off between "risk vs. reward" before investing in Prosper.com

And remember that buying 11 small lots of a single risky investment class does NOT reduce risk, as you are not actually diversifying if you stick within a single asset class/sector. eg. if the economy tanks then ALL Prosper.com borrowers have an increased chance of defaulting.

Also, remember that they're lots of investors looking over the Prosper.com opportunities, so to "win" a slice of debt you have to underbid the others- ie. you were willing to take the LEAST return for the estimated risk.

You may luck out and have 10x$100 invested at 11% and get it all back with interest. But, based on the current "riskless" rate of around 5%, it's more likely that you'll not get paid the full interest due on several of these parcels.

There's also a risk that you might not get your $100 capital back either. Did you notice the following bits in the Prosper.com FAQs?

"There are no guarantees that your loan will be repaid"

and

"Prosper is not directly insured by the FDIC, but lenders' deposits are covered up to $100,000 by FDIC pass-through insurance provided by our banking partner, Wells Fargo Bank."

The bit about NOT being insured by the FDIC is clear. I've no idea what FDIC "pass-through" insurance is - it might just mean you're insured against Wells Fargo losing your money during transit from your account to the borrowers! If you intend to invest in Proper you should know exactly what this means, and get confirmation from Wells Fargo in writing.

The first rule of investing is "if it looks too good to be true, it probably is". I'm not sure if that's covered in "Secrets [sic] of the Millionaire Mind" or "Millionaire Maker's Guide..."

It's probably also worth remembering that back in the good old days of "community lending" a run on the local bank often meant that the depositors ended up losing their entire life's savings.

Are you being "managed" out of your money?

November 23rd, 2006 at 09:26 pm

I recently had a chance to look through the training materials provided by a leading financial planning/wealth management company (it "fell off the back of a table"). It confirms my suspicions that the main target of most "wealth management" services is to manage as much money as possible from your account into their pockets - hopefully while providing you with sufficient residual return on your investments (after fees) that you don't take your business elsewhere.

For example, due to increased competition reducing the margin available in the traditional stock-broking based model which focused on equities research and transactional fees (read "churning"), they are aiming to move to a fee-based "scaleable wealth management" model. The target is to move from having 200+ clients per advisor yielding $4K in revenue per client (from brokerage), to having fewer, high net worth clients - 100 clients yielding $30K+ revenue each (from fees). This is to be achieved by putting such clients into "high margin, high sophistication" products. (read "expensive and hard to understand")

The main driver for this move is a graph showing that the average brokerage rates have dropped below trailing commisions - so it is better for them to push managed products rather than direct equity investments.

An interesting part of the transition plan was how to eliminate current clients that are "small" and "unscalable" by shifting them to a discount broker or "other advisor" . And the methods for finding new "scalable" clients included:
* Internet Research
* Relationships with accounts and lawyers who focus on sales of businesses
* Look for ads of business sales in newspapers
* Relationships with Private Equity companies who will be buying businesses

I found it intriguing that the entire focus was on how to maximise fees from clients, and not a word about maximising returns for their clients, or any relationship between fees and performance.

In a similar vein, the Sydney Morning Herald recently had an article written a student financial planner. It gives a stark insight into just how much the financial planning industry is oriented towards maximising fee revenue, with just enough consideration of the clients needs and situation to avoid running afoul of the regulating bodies. Read Confessions of a student planner.

personal finance, investment, investing, wealth

My "alternative" investments

November 22nd, 2006 at 09:31 am

Aside from the main part of my investment portfolio being in stocks and property, I have a minor portion of my portfolio (around 5%) invested in some "alternative" assets:
Hedge Funds - Ord Minnett OM-IP 220 series 1,
OM-IP 320,
OM-IP Strategic Ltd.
Agribusiness - Timbercorp Timberlots (1999),
Rewards Teak Project (2005),
Rewards Sandlewood Project (2005)
Other - Macquarie Film Investment Fund (FLIC)
While these are possibly good "diversification" assets, and, at least in the case of the agribusiness investements, assisted with tax planning, they have several substantial drawbacks:
* illiquid - the units in the hedge funds can be redeemed upon request, but it takes at least a month. The agribusiness units are "locked in" until maturity, unless you want to try to sell them privately (at a bargain price).
* difficult to value - the hedge funds publish a monthly "unit price". The others I just value at "cost" (except the FLIC which I wrote off ages ago) and hope for the best in the long term. There's really no way to guess what the prices for woodchips, teak and sandlewood will be in 5-10 years time (although the sales brochures have some really fancy looking graphs!)
* management fees - think of the worst possible combination of insurance "up front" sales commission, followed by the sort of on-going fees the hedge funds charge for "outperformance"! Boo, hiss.
* risk-adjusted return - the return (after fees) is probably insufficient for the amount of risk involved, although it's hard to evaluate with them being a part of a diversified portfolio. For example, my $5,000 FLIC investment provided an immediate tax deduction, but has since only returned around 15% of the amount invested and is being wound up with no residual value. At least I may be able to claim a capital loss on my tax return this year.

In terms of reporting, the hedge funds are held in one of my margin loan accounts, so I just include their value in my "equtities" total, along with a notional "value" ie. cost base) for my agribusiness investments.

So far, the Hedge funds have performed pretty well:
Fund Date Date Unit Price ROI
Issued Matures (Aug 06) pa
OM-IP 220 Aug '97 Jun '15 $3.9465 15.35%
OM-IP 320 Dec '98 Jun '07 $1.7648 7.43%
OM-IP S/L Aug '99 Jun '08 $2.1426 10.93%
and have a low co-variance with my share investments, thus reducing overall "risk" (volatility).

I bought them without any gearing (debt), and have since transferred them into one of my margin loan accounts to provide extra collateral. As I'm not using making use of the increased borrowing capacity, they act to greatly reduce the chance of getting a margin call.

I also have a tiny amount of other "alternative" asset classes like coins and gold bullion - but I don't bother trying to include these (or my cars/household items) in my net worth calculations as they're not really liquid.

personal finance
investment
investing

Real Estate - How to pick the bottom of the "Property Cycle"

November 21st, 2006 at 01:18 pm

What causes house price "boom and bust" cycles? How do you pick the bottom? In "The Wealth Power of Property" Fred & Brett Johnson* discuss the underlying causes of the "boom & bust" housing cycle. Property prices generally oscillate (in real terms) with a period of between 8 and 11 years, and the cycle is driven by excessive construction (greater rate of increase in available housing than the rate of increase in demand) causing oversupply and a decrease in the real (inflation adjusted) price of housing until construction drops off and the surplus stock is consumed. The next "boom" commences when shortage of supply starts to drive up prices, followed by an increase in construction as it becomes more profitable for developers. While it can be obvious that a property boom has ended, it is harder to determine when the market is poised for another period of higher rates of growth. Generally the tail end of a "bust" is accompanied by loss of convidence in real estate investing, tales of woe appearing in the papers, and predictions that they'll never be another run-up in property prices...

Picking the bottom of the cycle is easier if we use objective data to plot the cycle and see where we are. The data needed are monthly median house prices, an adjustment for inflation (CPI data), and Quarterly building approvals. As an example here is such data plotted for the Sydney residential property market:



The housing boom of 1998 was very sharp, triggered by the stock market crash of '87. House prices in Sydney doubled in a couple of years, and then stagnated through the '90s.

The boom in 1999-2003 was longer, and had a slight "pause" mid-way through before gathering pace again. As repayments are more sensitive to interest rates than house prices, the lower interest rate environment of the late '90s helped prices reach a higher level in real terms and as a multiple of average weekly wage than in previous cycles.

The current slump in house prices appears to have now bottomed out, and, based on the very low level of housing construction, could start to pick up again sooner than many people think. Although house prices in Sydney are still high relative to the average wage, more home buyers are dual income families, and so can better afford higher repayments. The shortage of land available for development (based on Sydney's geography and lack of state government spending on infrastructure) could easily spark another round of price increases when interest rates start to trend down again.

* Fred & Brett Johnson own the property investment company "Quartile Property Network" which has been investing in Sydney real estate since 1953.

Article of Interest

November 21st, 2006 at 01:14 pm

The SMH (Sydney Morning Herald) had a good article "Eased tax rules tempting more into margin loans" that summarises the benefits and risks of gearing into share investments via a margin loan.


"...153,000 brave souls [are] now leveraged against the stockmarket."

"The concept of negative gearing is relatively simple. It's "gearing" because you borrow money to buy a bigger portfolio, pocketing the full benefit of any after-tax capital gain.

It's "negative" because it's designed to run at a loss, which you can claim each year as an offset against your income from other sources to reduce your tax burden."

"The end of the housing boom has sparked a hunt by investors for the next pot of investment gold."

"While the median price of houses in Sydney has fallen 8.5 per cent since peaking in December 2003, the sharemarket has surged more than 50 per cent."

The main benefit of negative gearing is that you are able to convert income taxed at your marginal tax rate, into capital gains, that are taxed at a reduced rate:

"Back in 1999, the Federal Government halved the tax on capital gains for assets held for more than 12 months."

However, gearing into shares is more risky than borrowing to invest in real estate, due to the possibility of getting a margin call if the market slumps:

"After falling pretty steadily for the last two years, the average number of daily margin calls doubled in the June quarter, from one in every 4000 accounts to one in 2000.

A margin call is particularly devastating because as a consequence shares are often sold at depressed prices, magnifying losses."

Diamonds are for never?

November 20th, 2006 at 01:33 pm

Traditionally diamonds have been a terrible "investment" for small investors - usually restricted to just buying a mounted diamond engagement ring of dubious quality from a retail jeweller, all the while knowing that at best you're going to end up paying twice what the stone is worth, plus a small fortune for the setting. As a "real" investment diamonds were disadvantaged both by the mark-up charged by retailers for unmounted gems and by De Beers having a virtual monopoly until recently - marketing around 80% of gem quality diamonds and controlling the supply of gems in order to "support" prices. [The was an urban myth that De Beers had a large concrete slab poured to "lock away" a huge amount of gemstones to keep them off the market...]

However, although De Beers still mines around 40% of the world's rough diamonds, and is by far the largest seller of gem-quality diamonds, it was allegedly "decartelised" in 1999-2000 when Ashton Mining (owner of the huge Argyle Diamond mine in Western Australia) decided to start market its own diamonds. Unfortunately, Argyle's diamonds are mainly of industrial grade, so even today the competition with De Beer's is rather limited.

Since 2000 De Beer's excess stock of diamond gemstones has slowly been released into the market, which has depressed prices somewhat at the lower end (smaller stones), as can be seen in the International Diamond Exchange IDEX index below:



As the De Beer's stockpile slowly unwinds, is it now time to look again at diamonds as another alternative investment, similar to gold and silver? A few things make me think not (yet):
1. I'm not sure what fraction of De Beer's huge store of diamond gemstones has actually been sold off - there could still be a huge, unknown oversupply.
2. The trading of individual stones is problematic due to each stone being individually valued based on the "4Cs" (colour, clarity, cut and carats) with the evaluation of these being more art than science. The same stone can get slightly different appraisals from the various certified diamond valuers.
3. Trading the IDEX index would be an option (excuse the pun) to overcome this, but I don't think this index is actually traded anywhere - it's used mainly for diamond merchants to monitor changes in the market for physical diamond gemstone trades.
4. Artificial diamonds may reduce the demand for natural gems in the future.
5. They're still huge, relatively untapped diamond fields off-shore along the coast of africa, and new fields may be discovered such as the ones fairly recently developed in North Australia and Canada.
6. Diamond gemstones are not "consumed" (apart from some loss when they are recut into more fashionable shapes), so each year production is adding to the total "pool" of available gems. At the same time the population in the developed world is aging, and birth rates in the rapidly developing countries trending down, so demand may diminish over time.

Goals

November 20th, 2006 at 01:23 pm

If you want to do a quick "high level" plot of your net worth goal, there are many calculators available on-line, such as this one from National Australia Bank. You just plug in your current net worth, expected annual savings, average investment return and period. It provides a value for each future year, which would be print out and use to check yourself against each year going forward. For more detailed modelling (eg. breakdown by asset class, sensitivity analysis for the expected variability (risk) of returns, annual review of expected vs. actual position) I use an excel spreadsheet. But this is good enough for a "back of the envelope" calculation of your overall goal:

Article of Interest

November 20th, 2006 at 01:20 pm

For all my readers who don't live in Sydey, here is an informative article from today's Sydney Morning Herald: Road to wealth may lie in marching out of step. Nothing revolutionary, but a nice reminder of some of the aspects of behavioural finance that prevent us acting as "rational" investors all the time. The bit about "oversold" (low p/e) stocks ties in with my "Little Book" Investment Portfolio (see previous posts 1, 2)

The "Smith Manoeuvre"

November 19th, 2006 at 11:48 am

Canadian Capitalist has a post about the "Smith Manouevre" - basically just paying off your undeductible home loan as quickly as possible, and simultaneously borrowing to invest in the stock market. Apparently there has been "a fair bit of discussion going on about The Smith Manoeuvre (SM) in Jonathan Chevreau’s columns in The Financial Post and on his Wealthy Boomer Blog"

I wasn't even aware that this basic idea had been given a name! Wink

Canadian Capitalist goes on to say "I doubt that there is a causal link between leveraging and wealth and what wealthy people do after they have accumulated assets is immaterial to the argument.

Personally, I want to keep things simple. Sock away the maximum possible in a RRSP"
[retirement account] "and pay down the mortgage with the rest of the savings. The way I see it, I can earn a guaranteed, risk-free, after-tax return of 5.25% (our mortgage interest rate) by paying down the mortgage, which I think is pretty darn good."

I generally like what CC blogs, but I didn't realise he was so conservative an investor. Sensible levels of tax deductible debt to invest via gearing (eg. into a rental property, or diversified stock portfolio) is a well accepted method of improving your investment returns. If you use the extra amount invested to increase your diversification you can even boost your returns without increasing risk (variability of returns).

One thing I that I don't like about gearing is that the interest rates are generally 1-2% higher than those available for investment property loans (which are the same as for a home loan). These days I'm trying to reduce the average interest rate I'm paying for my investment loans, by only adding to my leveraged portfolios with the margin lender that has the lowest rate, and also doing my direct US share investments using funds from a St George Porfolio loan - which is secured against my equity in my home and investment property, so is at the same rate as a home loan.

Gearing can have significantly improve your portfolio performance over time - for example, if an ungeared, diversified portfolio of local and international shares, property, bonds etc. returns as average of 9% pa, you borrow to invest at an interest rate of 8%, and you gear 100% (LVR of 50%), you would improve your ROI from 9% to 10% - over 20 years this would mean a $100,000 portfolio had a final value of $611,000 rather than $514,000 - an improvement of 18%!

What I would like to do one day is compare the average interest rate charged for margin loans (I think it's around 3% above the cash rate, but I'll have to check the current average interest rate vs. cash rate and look at the past 10 years figures to see how consistent this is) vs. the average return on a range of typical portfolios eg. conservative, balanced (cash/bonds/stocks/property), and somewhat aggressive. I suspect gearing is only worthwhile if your risk tolerance allows you to invest aggressively, as the return on a conservative portfolio would probably average less than the interest being charged on a margin loan.

One of the unsung benefits of using gearing is that it provides a means to reduce taxable income (eg. dividends, rental income, wages) by providing a tax deduction for the margin loan interest, and effectively converts this into capital gains which are tax deferred (until the CGT event eg. sale) and ultimately gets taxed at only 50% of your marginal tax rate (if you hold the asset > 12 months). Of course, the main reason for gearing should be to boost your long term ROI, not to reduce your tax bill!

With the recent changes to superannuation taxation, gearing is probably less attractive compared to salary sacrificing into superannuation, but it doesn't have as much legislative/political risk as super.

Personal finance, Money, Investing, Investment, Wealth.

AU shares - trading update

November 19th, 2006 at 11:43 am

Disclaimer: I'm not a financial advisor, so DON'T take anything I write as advice! When I mention specific securities (such as in this post) I obviously have an financial interest in them.

As previously mentioned, most of my investments are in real estate, index funds, or stock funds in my retirement account (superannuation). But I occasionally dabble in trading via the small fraction of my portfolio that is in direct share investments via margin loan accounts. It stops me getting bored and doing something silly with the asset allocation of the major part of my portfolio!

I had bought 2,500 shares of ING Private Equity Access Limited (IPES) when they first were floated as stapled securities for $2.00 each`(15/11/04), and then bought another 1,500 for $1.77 on 11/8/05 .

They stapled securities converted into 2 ordinary shares (IPE) and 1 option (IPEO) to buy an IPE share for $1.00 (option expiry date is 31/10/07) on 7/11/05 for each stapled security. So I ended up with 8,000 IPE shares and 4,000 IPEO options.

After bottoming out around $0.80 per share, IPE has started to trend up in the past few months, now trading around $0.94. So I've just about broken even on the average cost of my holding.

The interesting thing is that the shares are trading for way under the reported NTA value of around $1.20 per share, and the are still 75% invested in a mix of top 100 listed equities, with only a quarter or so of their funds committed to private equitiy investments so far. Even so, the private equity investments made so far have gained around 5% in value, which is a good result considering private equity investments are meant to perform over the longer term.

Of course, listed investment companies usually trade as a discount to NTA, but their price should trend towards the value of the underlying assets in the longer term, and you get a good dividend yield in the meantime. The IPEO options have over a year until expiry, and will be really worth something if the price of IPE gets above $1.00

Based on a few heroic assumptions (guesses), I decided to buy 50,000 IPEO yesterday at $0.039. With Comsec brokerage of $19.95 and the $10.00 margin loan account transaction fee, the total cost of the parcel was $1,979.95 - ie. average cost of IPEO 3.96c

Last time IPE was trading close to $1.00 the options were around 6c- presumably based on the time value of not having to pay the $1.00 execution price until 31 oct 2007. Of course, this "time value" will slowly dissipate between now and 31/10/07 (Slowly at first, then very fast towards the end). If you wanted to try some more precise modelling of the option price over time I think the Black-Scholes equation is available online somewhere (I can't be bothered).

My guess is that the general market could rise 10% or so above it's current level at sometime between now at 31/10/07 - which should push the IPE shares to over $1.06 This should give the options a value upwards of 6c each. Any increase in the price of IPE shares above $1.06 should translate directly into a further gain in the IPEO price. eg. If IPE reached $1.10 by early next year, the options should trade around 12c - 15c each.

Anyhow, worst case is I loose the entire $1,979.95 if the options expire worthless in October 2007. Best case is I'll be deciding next October whether to take a capital gain on the options or pay the $50,000 to invest a significant sum in IPE at $1.00 for the long term...

nb. One thing to note is that IPEO options are VERY thinly traded, so even small trades can impact the pricing. My small trade yesterday was the entire volume for a typical week! And the current buy-sell spread is 34% (a buy quote of 3.3c {45,000 shares} and a sell quote 5c {22,500 shares})

Personal finance, Money, Investing, Investment, Real Estate, Wealth.

Boosting your savings painlessly (for wage slaves)

November 19th, 2006 at 11:38 am

Vanguard Australia had an interesting article last week describing a savings technique that I've been using myself for several years to painlessly boost retirement savings. The basic idea is to increase your savings by a tiny percentage each year - doing it so gradually that you never notice the extra amount you're putting away. That way you don't miss what you've never had (in terms of disposable cash flow), so it's entirely "painless".
I increase my savings rate each June by a fraction of what I expect my pay rise to be for the coming year - arranging to increase my payroll deduction into Superannuation via Salary Sacrifice before the pay rise comes into effect.

Incidentally, savings via a superannuation (retirement) account will get an even bigger tax concession from 1 July 2007 with the move to reduce the rate of tax on end benefits to 0%. So, if you're taxable income is more than $25,000 pa contributing via salary sacrifice means paying 15% contribution tax rather than 30%, and from next July there'll be no tax on your retirement income stream from superannuation. The savings are of course even more worthwhile for higher income earners on a higher marginal tax rate.

A couple of things to watch out for:
* maximum pre-tax contributions from 1/7/2007 are expected to be $50,000 per annum, and this includes the 9% Superannuation Guarantee Levy amount your employer already contributes. But this would only affect very high income earners!
* another $150,000 per year can also be contributed as an undeducted contribution. So it may be worthwhile moving some existing savings into your superannuation account. However, this strategy wouldn't be suitable for your "emergency" fund, as super can't normally be withdrawn until you reach retirement age. There's also a risk that the rules could change again before you withdraw the funds during retirement!
* check that your employer won't reduce the SGL amount they contribute if you salary sacrifice - the SGL amount should be based on your nominal salary, rather than the reduced amount left after deducting the salary sacrifice. Most employers are fine with this (they should be - salary sacrifice actually saves them money by cutting the amount of payroll tax they have to pay!) but technically they only have to pay SGL based on your wage.

Marginal Tax rates 2006-07

Taxable Marginal Tax Saved by using
Income Tax rate Salary Sacrifice
$0 – $6,000 Nil not a good idea!
$6,001 – $25,000 15% nothing up front, but the savings in super are tax sheltered.
$25,001 - $75,000 30% 15%
$75,001 –- $150,000 40% 25%
Over $150,000 45% 30%

(nb. these rates don't include the 1.5% medicare levy)

I was sacrificing 9.8% of my salary last year, and this year used my pay rise to increase it to 12.7%. Due to getting a small (3%) pay rise and the cut in income tax rates, I still ended up with a few dollars a week more in my pay packet - enough to cover the increased petrol prices at least. From now until I retire (approx. 20 years) this will mean around $50,000 extra going into my super account. This should add around $75,000 to my superannuation balance at retirement!

ps. For lower income earners (<$30,000) it's important to still make a $1000 "after tax" contribution so that you get the free money (co-contribution) on offer from the government. You can probably do this via B-Pay straight from your bank into your superannuation account, and the tax office will automatically determine your eligibility and arrange for the co-contribution when you lodge your tax return. For those earning between $30,000-$50,000 the co-contribution phases out. You still get $1.50 from the government for every $1 you contribute, but the maximum amount reduces, so you should contribute less than $1,000 if you earn >$30,000. eg. If you earn $40,000 you'd get the maximum $900 co-contribution if you made a $600 "after tax" (undeducted) contribution. The ATO has a simple
calculator available on their website. It's funny to note that a lot of the financial press regularly gets this wrong - suggesting that you still have to make a $1,000 contribution to get the maximum available co-contribution, even if you earn over $40,000!

Quo Vadis?

November 16th, 2006 at 02:33 pm

If you're aything like me, incorporating the level of risk that you believe you're comfortable with into your asset allocation could still result in unpleasant surprises in the long run.

I've often read that for the long-term investor, time heals all wounds - that is, while equity investments may have large year-on-year variation in performance (a.k.a. "risk"), over long periods of time this variability "evens out" and the long-term performance will display less variation. That is, "risk" decreases over time.

However, I'd recently read a contrary view (unfortunately I can't recall the reference) which stated that time won't decrease the amount of variation (in dollar terms) in your final outcome. This seems to be at odds with the generally accepted view, but in fact it is just a different way of looking at the expected results - concentrating on the variability in the final dollar value of your portfolio rather than in the percentage average return overall.

While it is true that over time the average return will tend closer to the expected long-run value over time, this does NOT mean that in the long run your portfolio will end up with a final value close to what you thought you could reasonably expect. Due to the effect of compounding, over longer time horizons even small variations in average return have a big result.

Even though I was aware of this fact (and have an understanding of the "magic of compounding") it really didn't hit home for me until I ran some simulations of my portfolio (using my current investment mix and projected returns and std deviations loosely based on data from Portfolio Solutions)

It turns out that while the most likely outcome is as I'd expected (around $3 million AUD by the time I retire around 2027), there are several "outlier" scenarios where the end value of my portfolio would be less than $1 million - which is pretty depressing compared to my current net worth and what I could achieve by just investing the entire portfolio in "safe", fixed interest assets! Of course, with my current portfolio mix there is a similar probability that I could end up with over $5 million.

Before we look at the results of my modelling (done in excel) I should point out that it was a bit rough and ready. I had to use guestimates as to reasonable return and std deviation values to use for my "alternate" investments (gold, agribusiness trusts, coins) and "hedge" funds (OMIP series and Macquarie Equinox Select Opportunities). For the other asset types I adapted the values listed by Portfolio Solutions. Because I didn't have any information on covariance between by investments I've lumped all assets of the same class together (ie. All Australian share holdings are lumped together as one total amount, combining my superannuation funds, direct share holdings and geared share fund investments in my model). Hopefully any covariance errors should largely cancel each other out - lumping the like investments together assumes a covariance of "1", whereas they would really have a value slightly less than "1". And the model also generates each years return for each different asset type independantly, based on the asset types return and std deviation values and the amount invested at the start of the year (see this site for an excel formula that can be used for modelling normally distributed returns using mean and std deviation values). This means that the different asset classes have an implied covariance of "0", when in fact some would have a covariance value in the range 0-1 (eg. Australian and International shares), and some of the others would have negative covariance values. According to MPT by having a mix of assets my total portfolio should have significantly less risk than shown in the model. But this is still good as a "worst case" scenario. If I get in the mood I may attempt to calculate return and risk values to use for my Hedge and Alternate investment classes using the monthly unit price data I have for OMIP funds etc.

I think the main take-home lesson from this exercise is to remember that ANY one of the projected scenarios is equally likely to happen, but that you'll only get one bit at the cherry. So you could end up with one of the less likely outcomes - either very good or very bad. While looking at average results and the most likely outcome is useful for planning purposes, if you are taking on increased risk in order to achieve higher returns, you have to have a hard look at what the end result could actually be, and be comfortable with whatever happens. Que Sera, Sera!

Table 1: My current Portfolio Asset Mix


ASSET Gearing Annual Expected Performance
Type PV % Mix (Loan) Addition LVR Return Risk (std dev)
Au Shrs $595,596.00 34.5% $262,719.20 $ 8,299.35 44.1% 8.00% 17.00%
Int Shrs $232,864.00 13.5% $ 92,572.80 $ 6,453.95 39.8% 8.00% 15.00%
Au Prop $761,770.00 44.1% $350,554.00 $13,559.70 46.0% 7.50% 14.00%
Hedge $ 88,100.00 5.1% $ 57,620.00 $ 0.00 65.4% 11.00% 20.00%
Fixed Int $ 2,770.00 0.2% $ 554.00 $ 0.00 20.0% 5.00% 3.00%
Alternate $ 44,500.00 2.6% $ 0.00 $ 0.00 0.0% 3.00% 3.00%


Excel Formula for calculating a random return from an assets expected return and standard deviation:
Rn = SQRT(-2*LN(RAND()))*COS(2*PI()*RAND())

Figure 1: A plot of two runs of the model showing the degree of variability over time.


Figure 2: A plot of the first 32 out of 200 simulations.


Figure 3: A histogram of the end value of my Portfolio in 200 simulations.


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