Hong Kong Mortgage Interest Rates

Christianpsu raised a query about Hong Kong interest rates in response to my post about the financing of my latest propety purchase (unfortunately this comment was inadvertantly lost along with a few other comments when I was cleaning up my blog).

For home buyers and small investors like myself, the Hong Kong market offers two main choices for mortgage finance:

1. a rate linked to the "prime" lending rate of the lending bank. Currently banks are offering rates mostly in the range of "prime - 2.5" to "prime - 3.0" percent. Some banks will offer a better rate for the first year but then a less attractive rate for the rest of the term. The prime rate is a floating rate which is set by the bank. While the bank has an absolute discretion to set its prime rate at whatever level it wishes, in practice the prime rates for all banks will be set at market driven levels. It used to be the case that every bank would have the same prime rate. That changed in 2006 with there being two different prime rates now used in the market. This can be confusing because it means that not all "prime" based rates are comparable - you have to check what prime rate is being used by each bank in order to compare the cost of different products;

2. a rate linked to the Hong Kong money market (known as the Hong Kong Interbank Offer Rate or HIBOR). Currently banks are offering rates mostly in the range of "HIBOR + 0.6" to HIBOR + 1.5". HIBOR linked rates are floating rates which are effectively set by the market. HIBOR interest rates are quoted for terms ranging from as short as one month out to as long as five years. In practice most banks will use the three month HIBOR rate as the default option.

Which is better?

My personal experience is that HIBOR based rates are better. The effective interest rate on my HIBOR linked mortgages has consistently been either about the same or lower than the prime based mortgages. There is no guarantee that this will continue in the future, but I have essentially concluded that HIBOR based rates with the shortest possible fixings (one month where offered - not all banks will do this) are the lowest cost product available. My understanding is that there are two reasons for this:

1. HIBOR rates are set by the market. Prime rates are set by the banks themselves. Needless to say the rate set in an open competitive market is more likely to be lower;

2. both HIBOR rates and prime rates tend to respond quickly to rising interest rates. Because of the fixing periods associated with HIBOR, it is a matter of luck whether a HIBOR based interest rate or a prime based interest rate will adjust upwards more rapidly. HIBOR rates tend to adjust downwards to falling interest rates quicker than prime rates.

At leats one bank (DBS) now offers a product that sets the interest rate based on the lower of a prime based formula and a HIBOR based formula. I came accross this for the first time when shopping around for my last mortgage in November.

This brings me to a final (and important) point. The Hong Kong banking system is awash with liquidity. The lending banks are competing quite intensively for business. It pays to compare offers from various financial institutions when looking to borrow.

Property Purchase Update

Property Purchase Update

The bank finally approved the finance today. The terms are sightly better than originally offered:

Gearing:70% on purchase price

Term: 20 years

Interest Rate: HIBOR = 0.65% or Prime - 3% whichever is the lower

HIBOR: one month fixings

Cash back: 0.6% of loan

Early repayment penalty: 3%, 2%, 1%

Each time I have taken out a loan in Hong Kong, the terms seem to get better and better. Completion is next Friday. I have approved the budget and works for the refurbishment but am holding out until early next week in the hope of trying to negotiate slightly better pricing.

Refurbishment project

My latest propety purchase is due to complete in less that two weeks time. I am intending to completely refurbish the flat - it is a mess - and have just reviewed the quote from the contractor. The total cost, which includes rearranging the internal partitions and replacing the kitchen and bathroom is equal to about 12% of the purchase price. I will try and figure out ways to trim a few dollars off the cost without affecting the quality of the finished project. While I have redecorated flats before, usually I do the minimum in order to be able to rent a property out. In this case, I went for the total refurbishment option after looking at the numbers for a similar project for a nearly identical flat in the same building.

I am also arranging for the contractor to start work on the completion date.

It should be an interesting learning experience as well as, I hope, a profitable one.

Principle #20 - Investments Must Be Understood

When investing it is important to understand why you are parting with your hard earned cash. Understanding an investment can and should be done from several different perspectives.

What makes the investment attractive? This is fundamental. If you do not understand why you are buying an investment then you should not be buying it. If you cannot articulate in a few short sentences why you are buying something, then you are not investing - you are gambling. In evaluating an investment, both the potential return and the risks need to be considered. The reasons for buying should be both clearly understood and should be sound reasons. My benchmark test for having a sound reason for investing is a simple one. Before making the investment I ask myself if, should the investment lose money, I could explain to Mrs Traineeinvestor how I had lost some of my hard earned savings without sounding either reckless or stupid.

Individual investments do not exist in isolation. They are part of a portfolio and part of an overall financial plan. If an investment, however attractive, does not fit with the portfolio or the plan, ask whether it is an appropriate investment. There are plenty of other investment opportunities out there. If you find a compelling investment which does not fit with your financial plan, it may be worth revising the plan before proceeding.

Lastly, an investment will be made on the basis of an expected return and identified risks. It follows that you should understand when or in what circumstances you should be liquidating the investment (either for a gain or a loss) before you make the investment.

Principle #19 - Keep Good Records

In my view, good record keeping is a habit that is highly desirable for all investors.

Good record keeping includes not only keeping accurate records of what you have earned, spent and saved and your investments, but also your financial plan and objectives.

Good record keeping serves many useful functions. The most valuable is that putting things down on paper faclitates more objective and reliable review of what hase been achieved - the good and the bad. As an example, preparing and reviewing net worth statements is an invaluable tool in measuring progress towards a goal. It also facilitates the assessment of how well your approach to investing is working (or not as the case may be).

Other reasons for keeping good record keeping include:

1. complying with tax obligations: as someone who recently had a tax return queried, having good records was highly valuable in dealing with the query quickly and confidently;

2. preparing a will: a list of assets and obligations is needed;

3. insurance: having the receipts for the insured property makes this a lot easier;

4. loan applications: having all the documents which a lender is likely to want to see easily accessable can save a lot of time;

5. not missing payments: late charges and penalties are a needless cost;

6. making sure assets are being properly utilised: not managing cash balances is a mistake I made for several years before I realised how much it was costing me.

I would also add confidence to the list. Knowing what my financial position is and how I am progressing towards my goals is a great confidence booster.

Property Purchase Update

My latest property purchase is is due for completion on 11th November. Since I will be travelling at the time, I will need to have all the completion and finance documents signed a week in advance (which should not be a problem).

The competition amongst mortgage lenders continues to work in my favour and I am expecting the bank to provide the finance at HIBOR plus 0.6% with a cash refund of 0.4%. The cash rebate is close to one monthly p+i mortgage payment. The penalty period for early repayment will be three years. I can get the penalty period reduced to two years by sacrificing the cash rebate. However, I would rather have the cash rebate - if I want to pay down debt early I have other loans which (i) are more expensive and (ii) are no longer in the penalty period I can pay down.

The interest rate curve has flattened and there is not much difference between one month and three month HIBOR rates. I will go with one month fixings on the theory that a normal yield curve is, well, normal.

The effective interest rate will be 4.85%.

On these terms, I should consider refinancing one of my older mortgages which is based on the prime rate. The numbers will be marginal, but it is worth keeping under review.

I am intending to do a full fit out on this property. Having seen the numbers (fit out cost and rental achieved) for a similar unit, the case for doing a full fit out is quite strong. The net yield of gross cost should be somewhere between 6-7%. This is before allowing for depreciation on the fit out which is something of an unknown quantity for me. Cash flow will be positive, in part due to the 20 year term.

Hopefully I will get the fit out completed by the end of the year and the property rented by mid-late January.

What's next?

Book Review: The Handbook of Personal Wealth Management

The Handbook of Personal Wealth Management is a publication comprising 41 chapters covering a variety of topics related to the subject of personal wealth management. The chapters are written by a number of different authors from several different financial institutions or service providers.

Contributors include a few well known names like TSB Lloyds and PricewaterhouseCoopers. However, most of the contributors were companies that I had never heard of - a fact which may well be a function of the fact that I have never lived in the UK.

The positives

The book coves a range of subjects. In most cases the chapters are well written and accessible. Material often (but not always) starts with the basics but then moves on to discuss more advanced issues. The latter makes those chapters of the book useful for people with limited backgrounds in the subject material as well as those looking for a little bit more in depth discussion. The range of subjects covered in a single publication is impressive. Subjects covered include: wealth management, ethical investing, portfolio management, mainstream investment alternatives, angel investing, private equity, pensions, real estate, coloured diamonds, gold, art, forestry, wine and race horses. There are also sections on selecting advisers and (UK) taxation.

At a personal level I found the sections on coloured diamonds and forestry most interesting as they are areas that I had not considered before. While I do not see myself investing in coloured diamonds any time soon, forestry may be worth a closer look.

The chapter on the Yale investment management model also raised my awareness on the issue of asset allocation. I have since purchased a book on this subject.

A few negatives

The book has a strong UK focus which renders several chapters irrelevant to my personal circumstances. Given that it is a sponsored publication, written by organisations selling the services that they write about a certain amount of caution is needed when reading each chapter.

The greatest quibble I have with the book is that it is effectively sponsored by the organisations whose employees write each chapter. The majority of the chapters are well written and contain a useful primer on the relevant subject. However, a few chapters seem a bit weak in comparison, lacking factual support for the assertions made. A handful read much like paid advertisements which detracts from both an objective understanding of the subject matter but also from the overall quality of the publication. The sponsored nature of the publication also gave rise to a certain degree of caution regarding all of the contributions.

Overall, a useful introduction to many of the subjects covered although UK residents would be likely to derive more benefit than I did.

Principle #18 - Diversification Is Mostly Good

Diversification is a concept that many people like and a minority of people hate. Who is right?

There are plenty of academic studies that show that diversification reduces risk. Diversify enough and the risk to your portfolio is reduced. The greater the degree of diversification the greater the reduction in risk (although the benefit starts to drop off quite sharply after a relatively modest degree of diversification). This makes sense. Take a portfolio of shares as an example. If the portfolio (Portfolio A) consists of a single share and that share goes down in value (even to zero) the portfolio will go down by the full amount of the loss on that one share. However, if the share only represents one out of ten shares in a portfolio (Portfolio B) , then Portfolio B will only lose one tenth as much as portfolio A (assuming equal weighting).

Diversification is a good risk management tool.

However, diversification comes with a price. Each addition to a portfolio has at least three things going against it:

1. Cost. Depending on how you hold your investments, fees and charges may be incurred for each position that you hold. The more positions you hold the greater the costs;

2. Time. Each investment takes time to research and time to monitor. Adding to your investment portfolio reduces the amount of time you can spend researching each investment before parting with your hard earned cash and the amount you spend monitoring each investment. This increases both the risk that you will make bad investments and the risk that you will fail to exit losing investments on a timely basis;

3. Quality of investments. Investors will pick the best investments for their portfolios first. By definition at a certain point additional investments have to be less attractive than earlier additions to the portfolio. It has been famously described as "diworsification".

There are plenty of very real case studies that show that having a relatively small number of investments in a portfolio can result in returns which exceed those available by investing in the market as a whole (index returns). History is also littered with examples of people who failed to adequately diversify their investments with spectacularly awful consequences. Barings (Nikkei futures) and Amranth (natural gas) are two of the better known examples of risk concentration going wrong.

The traineeinvestor is an individual who is in paid employment with a limited amount of time to spend on his investments. He is also unwilling to risk significant loss on his investments - significant losses or even inadequate returns will delay his departure from the ranks of those who are forced to work for a living. Diversification is an essential tool to overcoming both of these limitations.

At the same time he must be conscious of the risks of taking diversification to excess. Max Gunther got it right when he said that diversification protects you from the risk of just about everything - including the risk of being rich.

Principle #17 - Stay Focused

Anybody and everybody can and does get enthusiastic about their finances and investments when things are going well. When things are not going so well - when the markets seem to be implementing a personal vendetta against you and you get hit by a seemingly endless stream of unexpected or larger than expected expenses - people tend to lose interest.

It is human nature to devote more attention to successes than to failures. You could call it the emotional equivalent of cutting your losses and letting your winners run.

It's also something in the nature of a character flaw that can and should be remedied.

Adverse market conditions and bad investments are a fact a life. Even Warren Buffet gets things wrong from time to time. One of the things that keeps me focused when my investments are heading south is the knowledge that the market conditions that caused the pain are the same market conditions that provide opportunities to find investments at attractive valuations. Staying focused is exactly what you should be doing at this stage.

A run of expenses or other events that blow the budget - not just for a month but for a whole year? These things also will happen - marriage, children, changing jobs, buying your first home etc. But that is no reason to lose your self discipline. Managing expenses is a life long discipline. When things are going against you is the very time that you should be most focused on extracting as much out of your income as possible.

Staying focused through good times and bad times is an important habit for those looking to achieve financial independence.

Mortgage Wars Intensify

Hong Kong banks have problem. They have too much money. For most of us that would be a nice problem to have. But not if you are a bank. In simple terms, Hong Kong is awash with liquidity (and has been for several years) . As a result, bank deposits have been growing faster than the banks can lend the money out.

HSBC (the largest lender in the Hong Kong market) has initiated a new round in the bid to win market share by offering prime minus 2.75% with the first two months interest free. With HSBC's prime lending rate at 8%, this means an effective interest rate of 5.25% before adjusting for the interest free payments at the beginning of the loan's term.

HSBC is not the cheapest lender in the market. Other banks are offering P-3% or HIBOR + 0.5% with 0.4% cash rebate. These are better deals than HSBC's. Also, the penalty period for early repayment has dropped from the standard three years to two years with some banks.

Most significantly from my perspective as an investor, the terms offered by some banks on residential investment properties are now the same as for owner occupied properties.

With rents rising on the back of strong demand and effective interest rates falling due to competition from the lending banks for market share, it is a good time to be an investor.

Principle #16 - Invest In Your Education

There is a statistical correlation between formal education and both income levels and wealth. This is logical - education makes better paying jobs accessible. People who earn more do, on average, accumulate greater wealth than those with lesser degrees of education. There are, of course exceptions. But the averages show a positive correlation between academic achievement and financial achievement.

Education does not start and stop with schools and universities. Education, especially self education, is a life long affair. The world changes. Financial markets are in a state of constant change. Ideas that were profitable or sensible investment strategies at some times can and do become unprofitable or imprudent at other times. Education means keeping your knowledge of the markets and the forces that move the markets up to date. It means being ready to adapt to new ideas.

We live at a point in history which has been described as the information age. The internet and other technologyl advances have made more information available to more people more quickly and cheaply than at any point in history. This makes it both easier to keep on top of developments and inexcusable not to. How many books on investments or related matters do you read each month? How much time do you spend reviewing the wealth of information which is available for free on the internet? How much time do you spend discussing investments with your friends and other acquaintances? All of these are forms of education.

Principle #15 - Procrastination Costs Money

Procrastination will usually cost you money. Procrastination takes many forms. The most extreme is simply to put off saving and investing. A simple understanding of the power of compound returns and the time value of money will show how expensive a mistake this can be.

As an example: a person who saves $2000 in the first year (increasing at 3% a year to simulate wage increases) and who earns a return of 8% on her investments will amass a nest egg of $738,499 after 40 years. A person who delays starting the same savings program will end with a nest egg of $677,931. The early saver ends up being $60,569 (8.9%) better off. Not bad for a mere $2000 extra saved. (The example is a bit simplistic in that it assumes that all the savings are contributed at the end of each year. Monthly savings would result in a larger difference.

In the quest to get even a small increment in return on investment, more subtle forms of procrastination can also be expensive. Examples abound:

1. leaving money in accounts which pay no interest or lower rates of interest than can be obtained elsewhere;
2. taking out longer term loans than are needed (although this one does depend on what you do with the additional cashflow);
3. failing to pay the credit card off in full each month.

Any others?

Principle #14 - Deal With Your Mistakes

Mistakes are a fact of investing life. We will make investments which turn out badly - either because we made poor decisions or simply because the future did not turn out as we expected.

Mistakes cannot be avoided. Even putting your money in the bank or buying government backed securities does not make you imune from the possibility that your investments will turn out badly. Consider what happened to investors in bank deposits and bonds when the first and second oil shocks arrived in the 1970s - the real value of both deposits and bonds suffered a noticable decline.

The way to deal with mistakes is to recognise that some investments will go wrong and accept that risk as the price for trying to achieve a more meaningful return on your investments. One of the critical issues in dealing with mistakes is to deal with the mistake quickly. Usually this means taking losses early and not letting a bad situation get worse or allowing capital to be tied up in a losing investment for long periods of time.

Principle #13 - Be Open To New Ideas

Investing involves making predictions (or guesses) about the future. Frequently we make our predictions by extrapolating the present and the past. Trend following or momentum investing is a clearly defined investment strategy that does exactly that - take a present price trend and use that trend to predict the future price.

However things change. Anchoring and near term bias are two factors which make investors slow to adapt to change or to accept either new ideas or that the market has changed - unless in a state of panic. Some trading systems recognise that change is inevitable and deal with it with stop loss orders or a trading rule that seeks to identify when a trend has ended. A recent example is the commodities boom. For a long time, twenty years, commodity prices were in a cyclical and apparently terminal state of decline. But things changed. Emerging markets grew and consumers in developed markets spent at an unprecedented pace. Increasing demand met a relatively inelastic supply with soaring prices as the result. Those who identified that there had been a fundamental change would have made a lot of money.

I have no idea what the future will bring, but it will be different. Being alert to change and to new ideas and ways of looking at and evaluating investments is a key attribute of a successful investor.

Refinancing Completed

We have (finally) refinanced one of our properties. The refinancing involves:

1. a reduction in the interest rate of 0.5% (from prime - 2.50% to prime -3.0%);
2. a shift from monthly to fortnightly payments;
3. a cash rebate of 0.4% of loan principle (about 3 times the legal fees involved in discharging the old mortgage and registering the new mortgage);
4. a reduction in term by 16 months.

The principal amount and the payments are about the same.

The penalty period for early repayments is two years.

Emergency Funds Are Wasteful

A lot of financial plans include building up an emergency fund. My view is that, save in respect of one specific circumstance, an emergency fund is wasteful and money put aside in an emergency fund is better deployed elsewhere.

The logic behind emergency funds is that unexpected expenses could be incurred which you are unable to meet from current income or that your income stream could be disrupted so that you cannot be assured of meeting your expenses. The standard advice is to build up an emergency fund sufficient to meet living expenses for a short period (three months is common). The advice usually goes one step further and says that the emergency fund should be in the form of cash or on call bank deposits.

My view is that this is both too simplistic and wasteful.

A financial plan should address the question of how unexpected expenses or loss of income will be covered. But saying that the issue can be addressed by putting aside the equivalent of a fixed number of months salary is too simplistic. For people with a low savings rate it may be too little and for those with a high savings rate it may be too much. Consideration also needs to be given to the possible length of the disruption to income and the size of the unexpected expenses.

In my own case, I concluded that we did not not need any emergency fund at all. Relevant factors in this decision were: a two income household, a good savings rate (with room for improvement), several items of discretionary expenditure which could be cut, three months notice being required under my employment contract and the fact that at least some of our investments are in liquid form.

The second issue is the form of the emergency fund. Cash or call deposits are often recommended. While I appreciate the need to have an emergency fund kept in a form in which it can be readily accessed, cash and call deposits are lousy investments (most of the time). The after tax rate of return is usually less than the rate of inflation and, over the longer term, less than most other asset classes. Bonds, money market accounts, short term CDs and short term deposits all provide better rates of return than call deposits with relatively little additional risk. Many listed shares and many mutual funds are also highly liquid - price may be an issue but the liquidity is there.

Given that, by definition, an emergency fund is for the unexpected, I take the view that the additional return which can be achieved by investing the emergency fund in better performing asset classes more than justifies the additional risk involved. The only situation where I might take a different view is where my monthly income is expected to be both highly variable and uncertain.

Principle #12 - Be Vigilant

Many people have an interest in your money. More specifically, many people have an interest in getting their hands on some of your hard earned money. In contrast, only one person has exclusively your own financial interests at heart - yourself.

The people who want to get their hands on your money can be broken down into three categories:

1. people selling a product or service: brokers, agents, bankers, financial planners, fund sales people, accountants, lawyers etc. These people can be useful (some are essential) but you do need to think hard about whether you actually need what they are selling and, if you do, both the cost and the quality of the product or service being offered;

2. people who think they are entitled to a share of yor money: tax collectors, ex-spouses and the like. Sometimes they are legally or morally (the two are not the same) entitled to a share of your hard earned money - but sometimes a little bit of advance planning can reduce the damage these people cause;

3. the outright dishonest: con artists ranging from people like Charles Ponzi to the authors of the the all too common advance fee letters and phishing e-mails purporting to come from banks. Sometimes the people who fall into this category present themselves as financial planners, seminar presenters, property developers and the like. Some are very clumsy and obvious. Others are very slick. They are all crooks.

The best defences against these attempts to separate you from your money are education, clear thinking and vigilance.

Could I Be Gazumped?

I mentioned that I had signed a provsional agreement for the purchase of a small residential property. Until the formal sale and purchase agreement is signed by all parties, either party can back out by paying liquidated damages equal to the amount of the preliminary deposit I paid (about 5% of the purchase price) plus agency fees and costs for both parties.

The price I have agreed to pay was, in comparison to a recent sale of a comparable unit in the building, a discount to market price. The size of the discount looks bigger than it is because the comparable unit has been redecorated to a very high standard whereas my unit needs to be completely gutted. I was told last night that the original purchaser of the comparable unit has been gazumped to a new buyer who paid about 6% more. As things stand it would pay the vendors of my unit to gazump me.

The vendors' right to cancel the contract and pay liquidated damages will end once the formal sale and purchase agreement is signed by all parties. I will sign tomorrow. The vendors are required to sign by 24th August. Until they do, I will be sweating on this one.

Principle #11 - Do Your Own Thinking

Every day we are bombarded with advice, either solicited or not, on how we should invest our money. This can be helpful. It can also be dangerous. Information that helps us to think about our investment decisions is helpful. Relying on someone else (even a professional) to do our thinking for us is stupid. By all means listen to what the slick sales person or your friends have to say about investments, but then think it through for yourself.

Principle #10 - Small Things Are Meaningful

When it comes to saving and investing, small things can make a big difference to your longer term returns. The old saying "don't sweat the small stuff" could not be more wrong.

A penny saved is a penny earned is another old saying. It would be more accurate to say that a penny saved is $0.01 * (1+((100-marginal tax rate)/100)) earned. A penny saved and invested each day for 40 years is $457.81. This is a lot more that the $144 actually saved. (Assumptions: $0.30 invested at the end of each month for 40 years at a 5% rate of return.) If we do this with dollars instead of cents, the numbers get very big very quickly. Increase the saving from $0.01 per day to $1.00 per day and the end result after 40 years is $45,780. Somebody once used the example of a poor couple who had smoked a packet of cigarettes a day for most of their adult lives. If the money they had spent on that packet of cigarettes each day had been invested in Phillip Morris they would have been multi millionaires - instead of near broke. Small things add up and are meaningful.

Another example is rates of return. You might think that the difference between earning 6% pa on your money and earning 7% pa is quite trivial. It's not. Over a long enough time period its the difference between out living your money and a comfortable old age.

Do sweat the small stuff.

Principle #9 - Be Passionate

Most of the people I know who do well financially are passionate about investing but not about individual investments.

Building your financial net worth takes time and dedication. You need to have a passion for saving and investing money over a long period of time (usually decades) if you want to become wealthy or simply to avoid poverty in your old age. This does not equate to having a love of money (although I do know plenty of people who I suspect do so). It means making managing your financial affairs a part of your life, a hobby if you like, that you enjoy. It means thinking about ways to increase your savings or to improve your investment return on a regular, if not constant, basis. It means being prepared to sacrifice time and short term gratification in order to achieve a longer term goal. It means reading books on investing and on line resources on a regular basis not because you feel you have to but because you enjoy reading them.

Being passionate about investing does not equate to having a passion for individual investments. Quite the opposite. As investors we cannot afford to fall in love with any of our investments. Falling in love with an investment is an obstacle to correctly managing that investment and, when the time comes, disposing of it. Falling in love with individual investments has the potential to be harmful to your investments as a whole.

As a final point, there is a fine line between passion and obsession. Building wealth is not meaningful if it comes at the expense of other important parts of our lives. I know people who are obsessed with building their wealth. They may end up being truely wealthy. They may also end up with rather bland and empty lives.

Another property purchase

Early last month I said that the case for investing in real estate was less compelling than earlier this year. One of the facts which influenced this view was teh rise in interest rates and the prospect of further interest rate increases. The subsequent fall in interest rates has changed things and it is once again possible to get positive carry on residential properties.

I still kept looking at properties although less frequently. This week I saw an apartment which was available at slightly below bank valuation (rare in the current market) and at a discount to the market value. Succumbing to temptation, I put in an offer. After a small amount of haggling a slightly higher offer was accepted.

The flat is in a building that is in the process of completing a refurbishment of common areas. It has open but unspectacular outlook, including a limited view of the smog that hangs over Victoria Harbour. The interior of the flat is a dump. It will need to be gutted and completely refurbished.

The good news is that a mirror image flat in the same building which had been refurbished to a high standard just sold at a price which should allow me to achieve a reasonable profit if I decided to refurbish and on sell rather than retain for long term rental income.

The bad news is that while I can complete the purchase with bank funding, I will not have the cash available to undertake the refurbishment until January or February next year unless I either sell something else or use the money I am setting aside for my taxes (due in January). The alternative is to do nothing until January - I would have to hold the flat and meet the mortgage and other outgoings with no rental income. I negotiated a three month settlement which means that it is only the period from mid November until early January that I will not be able to pay for the refurbishment. That six to eight weeks is going to be painful but I am more inclined to do that than to sell something else. Raiding the tax money is not really an option.

Principle #8 - Understanding Influences

As investors we are constantly subject to a number of external and internal factors which influence our decision making. These influences and the way we respond to them can have a powerful effect on the decisions which we make. While it is unlikely that we could make any decisions without external influences, we also need to recognise that both internal and external influences can be detrimental as well as beneficial to our decision making process.

Spending a few minutes considering what has influenced a decision before making an investment can help avoid costly mistakes. Investors who allow themselves to be influenced by the hype and stories of other people making fortunes have usually ended up losing money whether it was on tulips (1635-37), the South Sea Bubble (1711-1722), Japanese equities (late 1980s) or technology companies (late 1990s). It is so often the case that if investors simply asked themselves "does this make sense?" before they part with their hard earned money they would have been a lot better off.

Here's an example. What kind of person buys shares in companies that have no earnings, no established business, no track record and which expects to run out of cash in a few years? The answer is a lot of people who allowed themselves to be influenced by hype, stories of quick and easy wealth and glowing recommendations from "professionals" and brought into the dot com boom. Sure, some people made a lot of money but a lot more people lost out as well.

Morgtage rates cut

In the latest move in a highly competitive battle for market share, Bank of China has cut its Hong Kong prime lending rate by 25 basis points to 8.0%. Bank of China's new prime rate is the same as HSBC and Hang Seng Bank. Most other lenders have kept their prime lending rates at 8.25%. Mortgage loans are now generally available at prime - 2.9% or prime - 3.0% resulting in effective interest rates of 5.0% or 5.1%.

Older mortgages priced at a smaller discount to the prime lending rate will still benefit from the reduction (including us - we have one mortgage loan with Bank of China).

At the same time, this week has seen a noticable decline in HIBOR rates. When my two HIBOR linked mortgages next roll over in September and October, the combined effect of the lower HIBOR rates and the switch from 3 month fixing to 1 month fixing will cut my funding costs on these loans by about 0.6%.

This has to be positive for the Hong Kong property market.

We have cashflow!

The property I purchased last month is now let. While it is disappointing that it took about a month to find a tenant, the good news is that the rent is at the high end of my expectations.

We now have 100% occupancy on our properties. However this will change towards the end of September when one tenant moves out.

A meaningful saving

I have belatedly realised that I can reduce the interest rate on two of my mortgages at no cost and very little risk by taking advantage of the yield curve.

The mortgages are linked to HIBOR (Hong Kong Interbank Offer Rate). These are floating rate mortgages (as is usual in Hong Kong). The interest rate is periodically fixed to HIBOR (plus a margin of 0.8% or 0.7%). The default option is based on the three month HIBOR rate. Every three months it rolls over at a new rate of interest based on the prevailing three month HIBOR rate. My last fixing resulted in an interest rate of 5.1045% (being three month HIBOR of 4.3045% plus 0.8%).

However, I do not have to accept the default option of using three month HIBOR. I can choose any available HIBOR term that I want. Interest rates in Hong Kong are currently showing a normal yield curve which means that shorter term rates are lower than longer term rates. The shorter the HIBOR option I elect the lower the interest rate. If I elect one month HIBOR instead of three month HIBOR I will end up paying an annualised interest rate which is (currently) about 0.44% less than I am currently paying. On both an annualised basis and over the remaining lives of the mortgages, the savings are meaningful.

The risks of being worse off if I elect one month fixings instead of three month fixings are both small and remote. When these mortgages next come up for fixing (in September and October) I will refix using one month HIBOR and count the savings.

Interest Rates Down

Interest rates in Hong Kong have risen over the last two years. Borrowers are typically paying 5.25-5.6% for new loans at the moment. The days of a positive carry on yield are mostly gone.

Hong Kong has not followed the last two increases in interest rates imposed by the US Federal Reserve. Given that the Hong Kong dollar is pegged to the US dollar this is a little but unsual. Classical economic theory would suggest that if the two currencies are to remain linked interest rates should be similar.

There are a number of reasons why Hong Kong has not followed the Fed. The main reason is liquidity. In very simple terms, Hong Kong banks have excess deposits and those deposits have grown faster than their lending portfolios. This partially explains why deposit rates are lower than the deposit rates in the US and why interest rates have not risen as far.

In fact, interest rates have shown signs of falling in the last two months due to competition amongst the lenders. As an example, the interest rate on one of my mortgages which is linked to three month HIBOR has just dropped from 5.4056% to 5.1045% for the next three months.

Negative Equity Cases Still Declining

Negative equity is a situation that arises when the amount owed on the mortgage(s) is greater than the value of the property against which the mortgage is secured. This can arise either because the amount owed has grown to an amount higher than the property's value due to capitalisation of interest or because the value of the property has declined (or a combination of the two). Occasionally it may be the result of borrowing more than the purchase price but such situations are very unusual.

Negative equity is not a good situation. It means that if you sell the property, not only will all of the sale proceeds go to the lender as partial repayment of the debt, but you will still owe the lender money and have to pay the costs of sale out of your own pocket. Property owners with negative equity who are unwilling or unable to meet the shortfall and costs are usually forced to wait out the downturn until values recover. Whether this is the smartest decision to make is another matter. Although I cannot speak from personal experience, I would expect that being in negative equity is a very worrying situation.

Negative equity cases in Hong Kong are estimated to have peaked in June 2003 (the time of the SARS epidemic) at about 106,000 cases. This figure has declined to 8,777 cases at the end of June 2006. In three years the number of negative equity cases has fallen by 92%. The delinquency rate for those still in negative equity remains an insignificant 1.13%.

Although it was a long, painful six year decline from the 1997 peak until the 2003 low, the massive decline in the number of negative equity cases and the persistently low delinqency rate shows how robust the housing sector can be in times of adversity and how rapid a recovery can be. Contrast Hong Kong's experience with Japan's to see a very different example of how long downturns can last.

Principle #7 - Stress Testing Your Investments

Investing means assuming risk. Risk can mean either the possibility of loss or simply the variance of returns from expectations. All investments carry risk - there are no exceptions and, in the real world, there is no such thing as a risk free rate of return. Also, as a general statement, the higher the expected rate of return, the higher the risk (although the relationship is not always a linear one).

Predicting returns on investments is difficult. Measuring the corresponding risks is also difficult. Many extremely intelligent and very experienced investors and academics have been on record as making some spectacularly bad decisions. I have no reason to suppose that my ability to predict the future is any better than average. However, in order to make sensible investing decisions, in order to plan for contingencies, it is necessary to make an attempt. This will give you an indication of the potential for things to go wrong and, if they do, how badly. This analysis is particularly important in situations involving debt financing (e.g. mortgaged property) or where there is a possibility of losses exceeding the amount invested (e.g. futures trading) or where your ability to tolerate a loss is limited (e.g. if you are near retirement).

An example of my approach to stress testing my investments in real estate is here. In reviewing this part of the private portfolio, I listed the things that could go wrong: vacancy, rising interest rates, falling net yields and declining market value being the obvious potential sources of danger. There are of course other potential risks, but I considered these sufficiently remote to be ignored. Looking at the list of risks, I then considered the portfolio's ability to service the mortgage obligations should they eventuate. I concluded that rising interest rates and falling yields would have only a limited effect on debt servicing capability. As an investor looking for long term yield who starts with a positive cash flow and a healthy level of income, I was not overly concerned about the risk of declining market values. It would hurt, but would not ultimately affect the cash flow. The most substantive risk was the risk of vacancy. It is a small portfolio and even a single vacancy would result in negative cash flow.

Having identified the risks and made some attempt to quantify them, I then considered a contingency plan to deal with them should the need arise.

I still need to do the exercise for the rest of the private portfolio.

Save Money - Do Not Buy From Amazon

I read a lot of books, although not as a many as I used to do before we had children. Amazon has a lot to offer, most notably an inventory which is much much bigger than any book store in Hong Kong. Frequently, the discounted price of the books on offer will be competitive. However, it is expensive once the cost of shipping is taken into account.

When I find a book that I want which my local book store (Dymocks) does not have in stock, I simply ask them to order it for me. I do not have to pay for shipping. Delivery time is similar to Amazon and the price is less than Amazon's price + the shipping I have to pay when ordering through Amazon.

Principle #6 - Challenge Assumptions and Beliefs

All financial plans and investment decisions are made on the basis of a number of assumptions and beliefs. Assumptions and beliefs are not facts. They cannot be taken for granted. With the benefit of hindsight they may be proven wrong. They may be just plain wrong and, with a little thought, can be seen to be wrong even without the benefit of hhindsight. A little time spent identifying and evaluating the assumptions that are being made (expressly or implicitly) and the beliefs held can prevent costly mistakes from being made and help identify opportunities.

Several examples can be found in calculating the amount of money a person or couple will need in order to support themselves in retirement. The calculation is usually based on the following factors (among others):

1. your life expectancy;

2. your cost of living (typically being either a budgeted amount or a percentage of current expenditure);

3. the rate of return on your investments;

4. the rate of inflation.

Each of these factors contains a number of assumptions including:

1. your life expectancy: you could live longer than the actuarial tables suggest - they are, after all, average life expectancies. With advances in medical science and some healthy living,you could live a lot longer;

2. your cost of living: many plans assume that your cost of living will be less in retirement than when working. This will not be true for everyone. Medical expenses will probably be higher. You may take up some new hobbies or travel more and so on;

3. the rate of return on your investments: most plans assume and average rate of return based on historic rates of return. This is a seriously flawed way of preparing a financial plan. An average is just that - in some years the return may be above the average and in some years it may be less than the average (or even negative). If a plan relies on draw down of capital, then below average returns (even if still positive) in the first few years can destroy the plan. Money that would have lasted 30 years if the average return had been achieved every year can run out in 20 years or less with just a year or two of below average returns at the beginning. Above average returns later on will not rectify the problem;

4. inflation: even if you believe that CPI numbers represent the true rate of inflation, why assume that your personal living expenses will rise in line with the average inflation rate? Medical expenses, rates, utility charges and travel expenses (all big budget items for retirees) have risen faster than the official rate of inflation in recent years.

As worst case example, if life expectancy is underestimated, cost of living is underestimated, the return on investment is over estimated and your personal inflation rate is underestimated, the combined effect on the amount needed to fund retirement is huge. Given that we cannot predict the future with any degree of certainty, this is one of the reasons why I have opted for a "no draw down" retirement plan.

A similar analysis can be made for individual investments as well.

One of the problems with this sort of thinking is that it can lead to decision making paralysis. It is helpful to remember that challenging assumptions and beliefs is intended to help make better decisions, not to provide and excuse not to make any decisions at all.

Principle #5 - Understand the Meaning of Time

Time is a commodity that affects almost every aspect of financial planning and investing. At times time is an ally and at times it is a remorseless enemy.

Time affects our financial planning and investments in many ways. For some purposes it is a commodity that can be purchased and sold. Think of a time deposit. You are lending your money to the bank for a period of time. The time which you commit to let the bank have the use of your money is a commodity as much as the money itself. The longer you leave your money on deposit the more interest the bank pays you. Usually the rate of interest will be higher for longer term deposits as well - reflecting the longer time commitment made. Similar considerations apply to the pricing of many other investments including bonds, stocks, options and futures contracts.

Time affects financial planning in many other ways as well. Compounding is one example. The more time investments have for returns to compound the greater the value of the final investment. Compounding is largely a function of time - the longer the time period the greater benefits of compounding are likely to be.

Another example is our lives. The amount of time we have to accumulate savings for retirement and the amount of time we expect to spend in retirement are two of the six critical factors which define how much we need to save for our retirement, when we can retire and what standard of living (financially) we will have in our retirement. (The other four critical factors are our savings rate, the return on our investments, inflation and expected income from other sources such as Social Security). Ultimately, it is time that dictates the advantages of starting to save for retirement early in life.

Thinking about how time affects my financial planning and my investments has had a significant influence over my investment behaviour and financial management.

Principle #4 - Avoid Unnecessary Erosion of Value

Investments are vulnerable to many evils. Among the most insidious are fees, charges and other things which, at first glance, appear to be small and insignificant. In reality, they are neither small nor insignificant and can have a massive negative effect on the value of investments. Ultimately these "small" things can have a material adverse impact on when and how you retire and your standard of living.

Let's look at some examples.

1. Front end load. If anyone tries to sell me an investment that has a front end load, my immediate reaction is to invest somewhere else. If you have a choice between two investments: Fund A and Fund B. Each fund is projected to earn 8% per annum compounding monthly. Fund A has no load. Fund B has a 1% front end load. You decide to invest US$500 per month into each fund. The amount of your investment will be increased in line with inflation of 3% per annum. That sales charge doesn't look too bad does it? It's only $5.00 per month. Fast forward 30 years to retirement and we see that the value of your US$180,000 investment in Fund A has grown to US$1.225 million while the value of Fund B has grown to US$1.017 million. That US$5.00 per month made a big difference in the end. Similar principles apply to management fees and any other charges that are being deducted from your investments. Fight these things.

2. Idle money. I am frequently guilty of leaving money lying around. No, not in stacks for my children to play monopoly with but in bank accounts that either earn sub-optimal rates of interest or, worse, none at all. Money comes in from a variety of sources and ends up in various bank accounts in different currencies (one of the joys of being an expat). Eventually it gets utilised, but often it takes time - typically months - before I get around to using it and even longer before I use it in the most productive manner. In one case I found I had several hundred dollars sitting in an account earning no interest for nearly a year. None of the amounts are large (possibly excepting my salary and term deposits at sub-optimal rates). However, if I add them all up, take into account the time the money is sitting unutilised or underutilised, look at what the money could have done had it been applied more productively and factor in the effects of compounding, the numbers are very meaningful. In my particular circumstances, I worked out that over a ten year period more efficient management of cash balances could have reduced the term of one of my mortgages by a several years. Over a twenty five year period I could just about have purchased a (very) small investment flat and repaid the mortgage. How much difference to your retirement would the income from an additional investment property make? That's decent holiday in Europe each year for Mr and Mrs Traineeinvestor.

I now regularly spend time reviewing the small stuff. I sweat the small stuff. Take a few small gains here and there, add the power of compounding, and the results can be truly impressive.

Principle #3 -Understand the Risks

When it comes to making investment decisions many people (including the traineeinvestor) are apt to focus on the potential rewards. To an extent this is only natural - there has to be a belief that an investment will prove to be profitable before we will part with any of our hard earned money. In analysing investments, risks generally get less attention than rewards. This is often a mistake. Professional wealth managers try very hard to produce portfolios that have low volatility (i.e. limited risk).

The old saying that there is no such thing as a free lunch applies as much to investments as it does to other aspects of our lives. One of the most basic rules of the investing universe is that economic rewards can only be achieved by accepting exposure to economic risks. (The relationship is not necessarily a linear one.) Also, the higher the potential rewards the higher the risks which must be accepted to try and achieve those rewards. Even the most secure of investments carry risk. As an example, Treasury bills (often used as a surrogate for the risk free rate of return in financial models) carry risks that are not properly understood. These include:

1. reinvestment risk: the risk that interest rates will drop and it will not be possible to reinvest in securities that will offer the same return;

2. inflation risk: the risk that inflation will erode the real value of your investment;

3. currency risk: if your "neutral" currency is not the US$;

4. opprotunity cost: the cost of not being able to invest the money invested in this investmet in a better investment.

All investments can be analysed in these terms. The next step in the process is to consider the probability of each of the risks occuring and to quantify the extent of the capital at risk should the relevant event transpire. My personal experience is that this is more art than science - maybe smarter people than me can do a better job - but I find that I am often guessing (especially on the probability of occurance question). I do pay very close attention to investments which carry certain risk characteristics:

1. gearing (e.g. leveraged property) ;

2. wasting assets (e.g. options);

3. long lock in periods (e.g. term deposits);

4. high exit or entry fees (e.g. property).

Planning how to respond to certain risks should they eventuate is a key part of any investment decision. Sometimes it can be as simple as setting a stop loss order on a trade when it is entered into. Other investments may require a more sophisticated approach.

A last point about risk is that it needs to be considered in terms of both individual investments and the potfolio as a whole. Professional investors and managers love to include investments which show returns which have low correlation with the general direction of the markets in their portfolios as a means of managing risk.

Principle #2 - Have a Back Up Plan

I previously wrote that having a plan was a fundamental part of financial planning and investment. Even with the best plan in the world, things can and will go wrong. The blue chip growth stock you purchased ends up in Chapter 11 (Enron) , the market drops 20% in a week (October 1987), the stock market experiences a 14 year decline (Japan) etc. Bad things happen in the world of finance just as they do in other parts of our lives.

Spending some time thinking about things that could go wrong and having a back up plan to deal with contingencies is also a good idea. Having a back up plan serves at least three useful purposes:

1. it preserves self confidence. When your investments head south, it is not only the balance sheet that suffers. If there is one thing that investors and do it yoursef financial planners must have, it is the confidence to back their own judgement. Without that things get a lot harder. Stress levels would probably go up as well;

2. if the back up plan is good, then your ability to react quickly and appropriately will be enhanced. It is easier to make sound decisions when you are not experiencing the stress of an investment turing out badly than when it was all gone horribly wrong;

3. preparing a back up plan forces you to look hard at the risks associated with your financial planning and investments before you put your money on the table.

An example of a back up plan for a long range financial retirement plan is here .

Principle #1 - Have a Plan

Having a plan is a fundamental part of personal finance and investing. Financial planning without a plan can be chracterised as good intentions resulting in random investing. The absence of plan will often lead to a loss of focus. Specifically, without the discipline imposed by having a plan (and executing it) there will be delays. Given my view that time is one of the most critical influences on financial planning and investing, delay (or procrastination) is usually a bad thing.

Financial plans come in all shapes and sizes. Some are good and some are bad. Some are simple and some are complex. Even the most simple of plans can be sound. For someone who does not want to spend more than a token amount of time on their personal finances, a simple yet effective plan could be to automatically have a fixed percentage of monthly income paid directly into a life cycle fund. Its a plan and in the right circumstances it could be a very good one.

A plan should be in writing.

My own approach to planning is:

1. keep a balance sheet of assets and liabilities. This should be updated on a regular basis. My earlier post on this stage of the planning process is here;

2. work out what the long term goal is. A common goal is putting aside enough money to maintain a desired standard of living in retirement. An earlier post on evaluating long term goals is here;

3. work out a strategy for getting from the current position to the desired future position. An example is here . A budget should form part of this stage of the process as will an investment strategy;

4. conduct periodic reviews of 1-3 above including each of the assets and liabilities contained in the balance sheet. One of the most important part of a review is to take a good hard look at the assumptions underlying your plan. If the assumptions on which the plan was made have proven to be incorrect then the plan may need to be revised.

A plan will not be static. It will need to be updated from time to time.

One important point to bear in mind is reality. A plan that is overly ambitious has a much greater probability of failure than a more modest plan. My own plan written in January of this year runs for 13 pages. It could easily be reduced to half that length. It is also now six months old and needs to be reviewed.

My earlier post on planning is here .

Investment principles 1-20

As an active investor I spend a lot of time reading about, well, investments and personal finance. There are many theories and approaches out there. Some are obviously better than others. Some of the material that gets published is rubbish. Some is excellent. I reached the conclusion a long time ago that one of the most important things about investing is to formulate some clear principles to use as guidance in managing my investments. While I had a lot of thoughts about what worked and what didn't, I never attempted to put those thoughts in writing. In an effort to be more disciplined in my financial planning and to improve my investment decision making, I have now done so. Here they are:

1. Have a plan. Saving and investing should not be a random process.

2. Have a plan for when things go wrong. Murphy's Law applies to investing as much as it does to everything else.

3. Understand the risks as well as the rewards for each investment and the portfolio as a whole.

4. Understand the costs, charges, fees and other ways in which the value of your investments can be eroded.

5. Understand how time affects you and your investments.

6. Rigorously challenge all assumptions and beliefs.

7. Stress test your investments and your portfolio.

8. Understand the role that external and internal influences play in your decision making.

9. Be passionate about investing, not your investments.

10. Remember that small things are meaningful. A penny saved is $0.01 * (1+((100-marginal tax rate)/100)) earned. A penny saved and invested each day for 40 years is....well, you get the picture

11. Listen to other people, but do your own thinking.

12. Nobody is as interested in your financial well being as you are. Be vigilant. Scams abound.

13. Be open to new ideas.

14. Be willing to admit that mistakes will be made...and must be dealt with sooner rather than later.

15. Procrastination will usually cost you money.

16. Invest in your education.

17. Stay focused when things are going badly.

18. Diversification is mostly good.

19. Keep good records.

20. Every investment should have a purpose, an objective and a clearly understood basis for its selection.

I did come up with a lot more but decided to limit the list to 20. I did try and rank the principles in order of importance, but decided that it was a task that was too subective to be meaningful. Consider the order random. Also, some of the principles overlap or a closely related with each other. An attempt to group the principles fell into the "too hard" basket and was quickly abandoned.

In a fit of enthusiasm, I intend to say something about each of these in future posts.

Gold - not a logical investment

Many advisers advocate having a portion of any portfolio invested in gold. I fail to understand why.

Over the longer term, gold has underperformed most of the mainstream classes of assets. Shares, property and bonds have all been better places to keep your money than the yellow metal.This is based on data going back to the 1930s. Sure, there have been occasions when gold has outperformed many other asset classes - but these have been rare (1979-1981 and 2003-2006) and the returns during this time have failed to compensate for the dreary return the rest of the time.

Gold is supposedly a hedge against inflation. Gold advocates point to the depreciating value of paper currencies as reason for buying gold. Often the arguments compare the price of gold against the value of a currency and adjust one or both numbers to reflect changes in purchasing power due to the effects of inflation. However, the analysis is often flawed as it does not make allowance for the return that would be earned on the paper currency in the period under review. Even a relatively modest return would show the paper currency doing better over the very long term (although taxes for some investors would affect the comparison).

Using selective time periods it is possible to produce numbers which show gold doing better than interest based investments - sometimes by a big margin. Using other selected time periods, you could show cash under the mattress outperforming gold. The point being that if gold is supposedly a store of value, it should be a reliable store of value. This is a test which gold fails. People who had the misfortune to invest near the peak of the last gold bull are still waiting to get their money back. They also would have missed out on the massive bull markets in stocks, bonds and real estate that served investors so well for most of the next two decades. People may wish to protect the real value of their investments, but over very long term periods, there are better options than gold. Over shorter periods, returns on gold are highly variable.

Gold's lacklustre performance over the last few weeks also calls into question gold's reputation as a safe haven in a crisis. At a time when world oil supply is barely keeping up with demand and a number of key supply sources are vulnerable to disruption, a shooting war in the Middle East should have given the price of gold a lift. It didn't - gold actually dropped. Instead investors flocked to the US$.

Most assets derive value from the fact that they can be used for something or produce a stream of income. So what gold is actually used for? The answer is not much. A huge portion of the gold produced annually is simply hoarded for investment purposes. Very little is used for industrial purposes. Add to this the fact that most of the gold ever produced is still in existence (a lot of it sitting in bank vaults) and I have to wonder why gold is priced as highly as it is? It seems to me that gold derives much of its value from the fact that people think it is valuable or because they find it pretty to look at. I certainly cannot see gold has having an intrinsic value which justifies its current price.

Maybe I am missing something here, but I really just do not understand why so many people advocate gold as a core investment.

Studies in Wealth - John D Rockefeller

This is the first of a planned series of posts about people who make interesting (at least in my view) studies in the creation or destruction of wealth. I have chosen John D Rockefeller as the first subject for the simple reason that he amassed what in real terms was probably the largest personal financial fortune of the modern era. By some estimates, his inflation adjusted wealth exceeded US$200 billion - almost 4 times Bill Gates' current worth.

John D Rockefeller is, in a word, a controversial figure. There are things to admire and things to revile. Whatever else may be said for or against this titan of the American industrial age, the impact he had on business in America was unprecedented during his life and has not been matched since.

Born on 8 July 1839, John D Rockefeller started life poor. At the age of 16, Rockefeller gained paid employment as an "apprentice bookkeeper" in Cleveland. After a series of promotions, Rockefeller left to establish his own produce commission business in partnership with Maurice Clark. Business profits were invested in other local Cleveland businesses. In 1863, he made his first investment in the oil industry - specifically a small oil refinery. At that time in history, the oil industry was a chaotic place characterized by many small operators and intense price competition. Within a short period of time, Rockefeller's business interests had become focused almost exclusively on the oil industry and in 1870 Standard Oil was formed as a partnership. Apart from John D Rockefeller himself, Henry M. Flagler was the most significant figure in the transition of Standard Oil from a small partnership into an industrial giant that so dominated its industry that it lead the United States Government to introduce what is now known as "anti-trust" legislation.

Standard Oil's business methodology could be described (perhaps overly simplistically) as having two objectives. The first was the relentless reduction in costs (something it had in common with other industries of the time). The second was the systematic removal of competitors - either by buying them out or forcing them out of business. Rockefeller himself believed strongly that competition was waste and this appears to have been a key driver behind his pursuit of a monopoly in the oil industry. The relationship between Standard Oil and the railway industry (which spent decades destroying shareholder value through intense competition) is itself a fascinating aside to the Standard Oil story. By the late 1800's Standard Oil effectively held a level of pricing power that enabled it to dominate its markets in refining, transportation and distribution of oil within the United States. By 1911 Standard Oil effectively controlled an estimated 64% of the oil industry in the United States. The rise of Standard Oil was followed by a period of decades of political and public opposition that eventually cumulated in the 1911 Supreme Court decision that required Standard Oil to be broken up into 34 separate companies. It is an indication of the sheer scale of Standard Oil that several of the companies created by the break up were among the largest companies in the United States - including Conoco, Amoco, Chevron, Exxon, Mobil, Sohio.

Independently from his career as a business man, Rockefeller was a deeply religious man. He became a deacon of the Baptist Church at the age of 19 and, at an early age tithed 10% of his income to charity. Religious (baptist) and educational causes dominated his philanthropic endeavors. At a personal level, Rockefeller lived a simple life free of vices. He was noted for his abstinence and his generally active and clean lifestyle. Another point which stood out was that he married once only and generally lived a quiet life away from the society pages.

As an investor, the two most significant lessons I took from the story of John D Rockefeller were that anyone can succeed financially with a willingness to work hard, save money and to take the risk of investing their savings. The second is that there is considerable advantage in investing in businesses that are able to command a degree of pricing power.

For further reading: Titan The Life of John D Rockefeller, Sr by Ron Chernow.

Book Review: The Next Big Investment Boom

I started reading this book with a certain degree of scepticism. A book advocating commodities as the "next big investment boom" is a little bit dated after the way commodity prices have surged over the last three years. Also, the fact that the author advocates a trend following approach did not impress me either given my distrust of technical analysis (too unreliable). I was pleasantly surprised.

The author (Mark Shipman) is a successful investor with a lengthy track record of doing what he preaches: essentially identifying a trend and following it as long as it continues and exiting when the trend ends. Mr Shipman writes in a tidy concise style without the waffle that many other investment books seem to be padded with. The chapter on the psychology of successful long term investing made some very good points and was the most useful material. The book also contains a smattering of useful insights into the way markets move. As an example, he makes the point that there really is no such thing as a steady return. This is a point which anyone planning to live of their investments simply has to understand if they want to be confident that their money will last.

By the end of the book Mr Shipman had just about persuaded me to add some commodities to my portfolio and to do so through the futures market (spead betting on commodities is not yet available in Hong Kong). More significantly, I am now taking trend following (also known as momentum investing) more seriously and am reading a second book in the subject. For those interested in reading more, Mr Shipman has his own website: Trend-follower/

Savings rate - known for the first time

I spent a romantic evening with a bottle of shiraz and my bank statements. It took a couple of hours but I know know how much I have saved in the first six months of 2006 and have a projected range for the year as a whole.

The good news is that I saved about 42% of my pre-tax income in the first half of the year. The projected savings rate for the year as a whole will be less than this because (i) I will spend more on holidays in the second half than the first half and (ii) the wine bill (en primeur) was paid in July. My estimate for the year as a whole is somewhere between 35% and 39% of my pre-tax income. The range is largely due to the fact that my income is slightly variable and the cost of our Christmas holiday is unknown at this time.

I realise that there is room for improvement in these numbers and will look at ways to try and lift the annual figure to the upper end of the projected range (without compromising the planned holiday).

The calculations are based on pre-tax income and after-tax savings. They do not take into account income from sources other than my job.

My record keeping is a shambles

When I set out to review the abillity of the private portfolio to withstand an economic downturn, the first part (the review of the Hong Kong property portfolio) was easy. However, when I sat down to review the rest of the private portfolio I had a problem. I have an incomplete picture of what I own, only a rough idea of my exposure to various asset classes and could not remember what some of my investments cost. It also occured to me that I do not know how much I save each year (or month) both in dollar and percentage terms and have not done a net worth calculation since the end of 2005.

This is not acceptable. So over the next few days I will be going through the bank statements etc and creating a few spreadsheets to work out some of these matters.

Frustration with Funds

I am finding that the range of low cost no-load funds in Hong Kong is extremely limited. In fact, so far I have identified precisely three such funds. All the other funds which are available to retail investors are actively managed funds which charge a front end load. MERs are typically in the 1.5-2.5% range and the front end load is usually 2% (if you negotiate down from the advertised 5-5.5%). To make matters worse, many also charge exit fees. This is pretty outrageous and is a sad reflection on both the Hong Kong fund management industry and Hong Kong investors' understanding of the effect of such charges on their wealth. This may also explain why the penetration rate for funds in Hong Kong is low by developed market standards.

I have looked at the no load funds which are available (TraHK which tracks the Hang Seng Index and China Tracker and A50 China Tracker which track indicies relating to China shares). I hold TraHK. The other fund is the AHL Diversified Futures Fund which has no load but a quite steep MER and a trailing fee for the first 3 years. The AHL fund has averaged about 13% pa after fees and the returns appear to have a low correlation with general share market movement. I am having a close look at this one.

I have looked into some of the low cost funds which available in other countries and run into a brick wall - the fund managers will not sell to me because I am resident in Hong Kong unless I invest a very large sum of money in each fund (typically US$100,000). I have never been given a reason for the refusal. I will keep looking but I am starting to get rather disillusioned with the whole exercise.

As much as I hate the front end load and the high MERs, I feel that I need to invest in some of these actively managed funds. The alternatives leave me with too little diversification in the private portfolio.

In an ideal world, I would invest directly in stocks and create my own index or theme portfolio. Unfortunately, the terms of my employment prohibit dealing in listed securities (index tracking funds excepted).

New Tax - a correction

A correction to yesterday's post about the proposals for a goods and services tax (GST). The proposals exempt both the sale and the leasing of residential accomodation from the proposed GST regime. So my expectation regarding the impact of GST on housing values is at least partially incorrect. I say "partially" because I did not see anything that exempted the components used to construct housing. So, unless this changes, there will still be a partial GST impact on the cost of constructiong housing and, logically, some follow through for secondary market prices.

New Taxes - yes please!

The Hong Kong Government has released proposals for a 5% goods and services tax (GST). This will be controversial but I really hope it does go through. My reasoning is as follows:

1.it will result in a broader and more stable tax base - during the Asian crisis this was a factor affecting confidence in Hong Kong's ability to deal with the crisis;

2.it will enable the income tax rates to be cut, potentially to 11% (the standard rate is now 16%) - this will make Hong Kong more attractive as a place to do business (with some offset for higher rentals on office space etc);

3.it will encourage people to save more (I can hope);

4. more people (almost everyone) will be brought into the tax net. At present only a very small fraction of Hong Kong residents pay income tax which I view as being something of a moral hazard. Also, if more people have to pay tax we can hope that it will put the government under a bit of political pressure to make some long overdue cuts to its bloated payroll and silly spending projects.

GST is form of tax which generally favours savers over consumers. It is often introduced with the promise of matching cuts in income tax. Experience in other countries has consistently shown that the amount of tax raised by GST is always a lot higher than the tax revenue lost through the income tax cuts. In effect, the taxpayers lose out rather badly when GST is introduced. However, as I save a reasonable portion of my income I should be personally better off - if the tax rate is reduced to the proposed rate of 11%.

Hong Kong's greatest sustainable comparative advantage is its low tax rate for businesses and individuals who work for multinationals. This will help to build on that advantage and reduce the risk of losing it through future tax increases. The gains here may be partially offset by the increased accomodation costs for businesses (residential rentals should be exempt but I need to check this).

If the proposals become more definitive, it should provide a short term boost to economic activity as people rush to buy goods ahead of the tax (and a slow down after?). One longer term consequence is that housing prices should experience some permanent upward pressure. New properties will be subject to GST making them more expensive relative to existing properties and therefore boosting the price of the latter (at least that was the experience in other countries).

Stress Testing the Portfolio #1

A slightly dramatic heading, but with the equity markets being highly volatile over the last few months and, as I concluded in my last post, the case for investing in Hong Kong property being less compelling than it was 12 months ago, now is a good time to think about how the private portfolio would perform in a bear market. I started by looking at the investment properties which are located in Hong Kong. Hong Kong property makes up the bigger part of our assets.

1. Diversification: the Hong Kong investment properties are all residential apartments on Hong Kong Island. All are either small or medium sized units. Ages range from 4 to 30+ years. This means that there is no meaningful diversification in the portfolio;

2. Location: location is a positive. There is less scope for new developments on Hong Kong Island (especially in the Mid-levels) than in, say, New Territories or West Kowloon. In the longer term, two of the properties have the potential to marginally benefit from the proposed MTR extension.

3. Vacancy risk: lease terms are typically two years with the tenant having the right to terminate on two months' notice after the first year. Our termination dates are well spread out which means that the risk of having multiple vacancies at the same time is quite low. All tenants have paid two months rent as a security deposit which we hold. We have a small number of properties (very small, alas). This means that the impact of a single vacancy on our cash flow could be quite significant (depending on which property was vacant).

4. Debt: using borrowed money is great when things go in your favour and a disaster when they don't. Most of the property investors who have got into financial difficulties have done so because they have been unable to service their debts. So how robust is our debt servicing capacity? In this area we score quite well:

(i) Cash flow: assuming all properties are leased to paying tenants (one is currently vacant), we have positive cash flow on the portfolio as a whole - the rents will meet the mortgage payments and other outgoings. The excess of rent over outgoings is currently sufficient to cover some further interest rate increases (I need to work this out properly, but roughly at least another 1.5%). However, due to the small number of properties, a single vacancy would result in a negative cash flow;

(ii) Maturity profile: all mortgages are on P+I terms. The residual terms range from 6.5 years to 16 years. This means that we are paying more in principal each month than we are in interest. Our position improves with each passing month and, if things got tight, the possibility of rescheduling to interest only could be looked at;

(iii) Gearing: our highest gearing level (loan to value) is about 49%. The weighted average is about 35%. We have generally taken a conservative approach to the use of debt. At times this has held us back (we could own more properties and have a higher net worth had we been willing to gear higher) but it leaves us much less vulnerable to a downturn.

In summary, the risk of vacancy is a greater risk to the private portfolio's ability to service debt than the risk of higher interest rates. (If we had a bigger portfolio this would be different.) This risk can be adressed through either (a) changing some of the mortgages to interest only or (b)making early repayments or (c) meeting the shortfall from salary should the need arise. However, in general the Hong Kong investment properties are well placed to survive a moderate downturn without causing too much anxiety.

Property less compelling

I recently took another look at the Hong Kong housing market in the light of new statistics which have been released over the last two months. Specifically:

1. primary (i.e. new) apartments were selling a premium of, in some cases, 20-30% above comparable secondary (i.e. existing) apartment prices. Why anyone would pay a significant premium for a new apartment is beyond me. However, the developers have been cutting their prices and the premium is now appears to be much smaller (although I have not been able find any accurate data on what the current premium is);

2. property prices have softened in the first half of 2006 by 3-4% across the board (with the biggest falls in parts of the New Territories and the West Kowloon Reclamation area). Rising interest rates is the most widely quoted reason for the decline in prices;

3. the volume of property transactions has fallen in the second quarter of this year. Most notably, the number of transactions involving confirmors and other speculators has experienced a major decline. Declining volume is never a good sign;

4. there have been a reasonable number of defaults by purchasers of apartments in primary sales. Most of the defaulters are said to be speculators who purchased off the plan with the intention of reselling for a quick profit before the property was completed. With the premium for new apartments shrinking and the market as a whole experiencing flat or slightly declining prices, there were no gains to be had so they have been cutting their losses by defaulting on the completion (forfeiting their deposit).

There is also some suggestion that rising interest rates are starting to have an effect on consumer spending. This has yet to show up in any official statistics. Also, the volatility in the stock market in May and June would have affected confidence. Lastly, the days of having a positive carry on property investment are long past.

On the positive side, employment remains strong, both nominal and real interest rates are not that high (competition among mortgage lenders is still intense), there is upward pressure on wages, Hong Kong still has very high liquidity, real estate is still reasonably affordable by historical standards and China's economy is still growing rapidly. In other words, the economy looks sound.

Reports of problems with the US housing market (or at least parts of it) do not seem to have had any effect here. Nor has the implementation of austerity measures by China to cool its property market had any noticeable implications for Hong Kong.

In summary, the case for property as an investment vehicle of choice is not as compelling as it was 12 months ago and there could be better opportunities to invest later rather than now. Not a great conclusion given that I completed my latest purchase last month.

Shares v Property - which is better?

I have read many books and articles advocating shares as being better than property or property being better than shares. Harrison at Journey to Financial Freedom recently drew my attention to one such claim http://www.finandom.com/blog/ .

Often these claims are made by people who have an interest in promoting services (e.g. grossly overpriced seminars) relating to the form of investment that they advocate.

My view is that saying that one is universally better than the other is just plain wrong. There may be times and circumstances where one asset class has greater attraction as an investment than the other, but I do not accept that one will always be superior to the other. Each asset class has its advantages and disadvantages. Shares and property are no exception.

At least some support for the proposition that both shares and property are attractive investments can be found by reviewing the Forbes 400 list of America's richest people - there are examples of people who made their fortunes by investing in real estate and examples of people who did it by investing in shares. More fundamentally, if one asset class was universally "better" than another in terms of risk adjusted expected returns, then investors would bid up the price of the preferred asset class and shun the less popular asset class forcing vendors to lower their asking prices. Eventually, the relative prices of the two asset classes would reach the point where the risk adjusted expected returns were similar.

The following is a comparison of the key features of investing in shares and property.

Diversification: very easy with shares and harder with real estate (unless you have a large portfolio or invest in REITs)

Liquidity: shares are highly liquid. Property is not

Yield: net rental is generally better than the yield on shares but this may be offset by depreciation, maintenance and tax treatment

Potential for yield to grow or decline: yes for both

Capital gains and losses: yes for both

Potential to add value: property generally has some potential to add value. Shares do not

Time commitment: highly variable, but generally more with property

Gearing available: yes, but usually on more favourable terms for property

Outgoings (excluding debt service): only for property and these can be significant

Volatility: both can be volatile, but shares are generally more volatile than property

Risk of total loss of asset (ungeared): companies can become insolvent and do so with depressing frequency. Property is much less likely to go to zero value but it is still possible in extreme circumstances (e.g. flood, earthquake, war)

Transparency/availability of information: generally high for shares and moderate to poor for property (this one is highly debatable)

Transaction costs: very low for shares and very high for property

Taxes: depends on personal and property specific circumstances

Other risks and issues for shares: corporate misconduct, unfunded/undisclosed liabilities, removal from index, competition, lawsuits, overpaid executives, dilution. Any others?

Other risks and issues for property: vacancy, outgoings rising faster than rent, bad tenants, depreciation, changes to neighbourhood. Any others?

Personally, I find both asset classes attractive and prefer to diversify my assets with a mix of shares and properties.

Book Review - The Coming Economic Collapse

In The Coming Economic Collapse by Stephen Leeb (writing with Glen Strathy) sets out the case for a potential economic collapse triggered by a shortage in oil that may be a lot closer than is generally accepted.

The basic case for an oil shortage is in two parts. The first is rising demand, not only in emerging large economies (especially China and India) and emerging markets generally but also in developed markets and the oil producing nations themselves. The second is production levels which are already, or will soon begin, declining in many oil producing nations (including the USA, Norway and the UK) and the failure of the oil industry to discover new oil fields.

The author makes the point that, unlike the oil shocks of the 1970s, the oil price is being driven by supply and demand factors and not by political factors - meaning that the problem will be a lot harder to solve. In addition, surplus production capacity is very limited meaning that any supply disruption in a major oil producing nation could have an immediate impact on oil prices.

The section of the book dealing with alternative sources of energy makes interesting reading (he believes that wind power is the best long term alternative source of energy) as does the discussion on the choices which must be made at a political level to deal with the shortage. After noting that political leaders have been making all the wrong decisions to date (nothing new or unique there), the key conclusion is that political leaders have no choice but to accept a high inflation environment as the alternative to economic collapse. The greatest risk to correct political decisions to deal with the shortage is effectively the ballot box - political leaders may bow to pressure from lobby groups and consumers.

The final substantive section of the book looks at invetsments that will either thrive or will suffer in this high inflation environment. While it is difficult to quibble too much with most the conclusions I am slightly uncomfortable with the fact that the recommended course of action is generally based on the experience in the 1970s inflationary period. Instinctively, I am nervous about assuming that history will repeat itself. If we have another bout of high inflation, I would expect there to be some differences to the 1970s. Examples would include the fact that many developed nations have much higher levels of debt (at national, corporate and individual levels) than they did when the first oil shock took place and the effect of the retirement of the baby boomers.

The key recommendations are (i) gold and gold mining stocks (ii) stocks in Chindia or which have exposure to Chindia (iii) oil and oil service companies (iv) alternative energy companies (v) TIPS and (vi) real estate. He shies away cash, bonds (other than TIPS) and stocks generally (including small cap stocks). Leeb also recommneds investing in zero coupon bonds in case the inflationary scenario does not eventuate and we end up with a 1930s style deflationary experience.

There is a lot of thought provoking material packed into this short (196 page) book - the author cannot be accused of waffling. I do not agree with all of the conclusions or the arguments that he uses to support those conclusions. One major issue which the author does not mention is what I term "inflation by stealth" where the inflation numbers (CPI) are manipulated to produce official levels of inflation which are below the true levels. If this eventuates, then TIPS may not be such great investments and using more debt to enhance returns may be a sound strategy (so long as you can service the debt).

One weakness in the case for an oil shortage is the treatment of contrary opinions. In many cases the author does not properly refute opnions which diverge from his own - he simply dismisses the opinion holders of being guilty of "groupthink" and moves on.

Kicking myself - twice over

Markets in Asia have rebounded strongly since the sell off last week. So have commodity prices. By way of example silver has jumped from US$9.72 per ounce on 14 June to US$11.12 at the time of writing.

I am kicking myself for not taking advantage of the opportunity to buy some assets and kicking myself twice over for letting myself be so easily influenced by short term market movements and indulging in "should have" retrospective thinking. I think it is time to add some books on physcology to my reading list.

No interest rate rises here!

Hong Kong banks did not follow the Federal Reserve in raising interest rates this week. Given that the vast majority of mortgage debt in Hong Kong is at floating rates this is good news for me and good news for the the property market.

The previous increase in interest rates by the Federal Reserve also failed to have a follow through effect on interest rates in Hong Kong. Given that the Hong Kong dollar is pegged to the US dollar, I have to question whether the emerging yield gap between deposit and lending rates for Hong Kong dollars and those for US dollars is sustainable? My conclusion is that at this time Hong Kong does not need higher interest rates because:

1.Hong Kong's economy is still booming but shows no signs of over heating;

2. while property prices and the share market have had a good run over the last three years, there is nothing that could be described as a bubble;

3. Hong Kong as a whole is a very liquid economy and one that is not highly leveraged (either at the corporate level or the individual level). The laws of supply and demand currently favour of the borrower.

For information, while many markets have fixed rate mortgage products, in Hong Kong, fixed rates are less common and, generally, quite expensive.

What's next?

What should I invest in next?

I have just completed the purchase of a residential investment property. I have a modest amount of cash left over and will be back on the savings path again at the end of the month when I get paid on Friday. So I have cash on hand and more cash will become available for investment each month (excepting November and December when I need to put money aside for taxes and our Christmas holiday).

The question is what should I be doing with the money?

The longer term plan is to allocate about half my assets to real estate and half to equities. If it ends up being an unequal split that is not a problem. At present I am over weight real estate and underweight equities.

Preliminary thinking throws up the following choices:

1.save for the deposit on another property. I will need two more small residential properties to achieve the desired real estate component from my retirement portfolio (paying off the mortgages is another matter);

2.increase payments into equity funds. The recent pull back in a number of markets has made these more attractive than they were a few months ago;

3.search for an alternative investments. There are a few options available for retail investors like myself - a limited number of hedge funds, bullion - any others?

4. reduce debt. While the gearing in the real estate portfolio is relatively modest, paying off one of the mortgages with the resulting improvement in cash flow is always tempting;

5. build up some cash. I am not a fan of holding cash for the longer term because of the corrosive effect of inflation but it is a useful parking place for money pending identification of a more constructive use.

No decision as yet. In the short term option 5 (cash build up) is the default option. Beyond the short term this is not a sound choice. I'm starting to feel indecisive which is, itself, not a good sign.