Monthly Review - February (revised)

My net worth increased by 3.1% in February.

This was a big and surprising result. I had expected a much smaller increase after watching the markets fall in the last few days of the month. Here are the highlights:

1. most of my funds actually ended the month higher than they started. Even though there were losses in the last few days, the gains made before Chinese New Year were greater;

2. I continued to dollar cost average into Asian and European small companies funds;

3. I made no other investments;

4. I received a nice boost to my work related income (business has been good recently);

5. I have fully provided for tax, our next holiday and some minor repair work on one of my properties;

6. my investment in silver did very well;

7. my balance sheet is kept in Hong Kong dollars (which is pegged to the US$). Currency movements where in my favour this month and made a major contribution to the increase in net worth.

So far the year is off to a very good start.

Notes:

(1) I mistakenly published a draft before month end which did not reflect the changes to asset values on the last day of the month. The result was a small downward adjustment to the increase for the month from 3.2% to 3.1% (very close to January's increase);

(2) properties have not been revalued for some time and the values shown in the balance sheet do not represent current values. I have no plans to sell, so see no need to "guess" at current values.

Why is the media calling this a crash?

As someone who is old enough to have experienced both the 1987 share market crash, the recession which followed the 1987 crash and the Asian crisis, I was more amused than bewildered to see the media describing yesterday's downturn in a number of markets as a "crash". It was nothing of the kind. Of course, I have no idea what will follow and cannot rule out the possibility of a much larger downward movement that may, in due course, merit being called a "crash".

As far as my personal financial planning is concerned, I would view the possibility of a large fall in asset values and a recession as follows:

1. liquidity: the world is awash with liquidity. The fact that central banks have been talking so much about tightening liquidity (with very few actually doing anything about it) is itself evidence of the amount of liquidity available. Central banks may use liquidity measures to deflate a bubble, but they are very unlikely to use them to promote a recession. All that money has to go somewhere and I would expect it will eventually flow back into investment assets (stocks, bonds, real estate etc). The question will be "when?";

2. inflation: inflation is still with us. Unless something happens to shift to a deflationary environment, cash remains a losing investment in real terms. The South China Morning Post ran an article about having negative real interest rates on deposits and the expectation that this would lead to a surge in property prices;

3. opportunity: I am a net accumulator of assets (and hope to remain so all my life). Last year it was difficult to find assets that met my investment criteria. The Hong Kong property market has firmed over the last few months (and the lower interest rates have contributed to this) making it even harder. Any reduction in values/pricing will provide opportunities to acquire assets at more attractive valuations;

4. debt management: a weaker economy significantly reduces the risk of increases in interest rates. It may or may not effect rent levels, but with only two properties with leases due to expire before 2008, I am not overly concerned about being able to service my mortgage obligations. Of greater concern would be banks tightening their lending criteria which may affect my ability to make further acquisitions;

5. job security: I consider my job to be quite secure. My income may suffer if there is a downturn, but I have few concerns about losing my position. Worst case, I will get several months notice and a pay out large enough to pay the bills for several more months. Mrs traineeinvestor's position is less secure, but we can get by on one reduced income if we have to;

6. work life balance: for the last three years my work life balance has been unbalanced. A softer economy is likely to result in lower income but will offer the benefit of shorter working hours. I would welcome this;

7. net worth: if asset values go down my net worth will go down with it. Although painful in the short term, it is just that: short term. In the longer term, for the reasons given above a recession is something that will offer more opportunities than threats to my financial plan.

100% Occupancy - but not for long

I am delighted to report that our rather modest property portfolio now has 100% occupancy.

Unfortunately, it's a situation that will last for a total of 2 days as one property will become vacant at the end of this month.

Life was a lot easier before I took up investing as a hobby.

Interest Rate War Intensifies

HSBC fired the first round in the latest battle for market share by mortgage lenders. Other banks have followed and prime based mortgages are now available at rates as low as prime - 3 per cent or prime -3.18 per cent. Most will also offer cash back of between 0.3% and 0.8% of the loan amount. This brings the effective rate for new mortgages down to around 4.85% (less cash back). In reality this only brings the prime based mortgages to a level similar to HIBOR based mortgages. We have also seen some reduction in HIBOR products with rates as low as HIBOR + 0.6% being offered.

Unfortunately, there is no immediate benefit for me. The new rates only apply to new loans. Given that most of my mortgages are already on HIBOR linked pricing or are still in the penalty period, there is not enough in it to justify refinancing.

Note: confusingly HSBC, Hang Seng and BOCHK have set their prime rate at 7.75% while all other banks are at 8.0%. This is an important point to bear in mind when comparing offers. Also, if the two best offers work out the same, I would take the one from the bank with the lower prime rate over the one from the bank with the higher prime rate.

Could we see a tax cut?

Singapore recently reduced its corporate tax rate to a level much closer to Hong Kong's 16.5%. Given that Hong Kong's only competitive advantage is its low tax rate, there has to be some chance that the Hong Kong government will use the next budget (due out soon) to reduce taxes. Given the size of both the government's reserves and the annual budget surplus, there would be a strong case for reducing taxes anyway. The move by Singapore to boost its attractiveness as a regional centre should give the Hong Kong administration added incentive to follow.

That said, I would expect any reduction in the personal tax rates to target lower income groups in the form of increased allowances (which will not benefit those who are subject to the standard tax rate).

Unfortunately, it would be unrealistic to expect any reduction in the 80% duty on wine.

Dell - No Service At All

My Dell lap top decided to die on me over the weekend. Needless to say it did it a matter of weeks after the 12 month warranty had expired.

After exhausting the self help options, I have discovered that Dell provides no service support whatsoever:

1. on-line support is only available if your warranty is current;

2. the telephone help line only provides perpetual hold messages (in Cantonese only);

3. nowhere on the site is there a physical address I can go to.

Needless to say there is zero chance of me ever purchasing anything from Dell again.

At least I have a back up of all my important documents.

What is an acceptable rate of return (2)?

The rate of return that I need to achieve in order to retire at 50 has dropped to 6.1% pa.

In April last year I asked myself what rate of return was needed in order to achieve my objective of retiring at 50 with sufficient resources that there would be no draw down in capital? After using a number of different on line calculators and playing around with assumptions regarding future income levels for myself and Mrs Traineeinvestor (flat from present levels), inflation (3%) , current net worth and future financial needs, I came up with a required rate of return (before and after retirement) of 6.6% pa.

Having just watched another birthday come and go, I now have nine years left before my intended retirement date. Time to run the numbers again.

I think I have made the same assumptions as for last year's calculation subject only to increasing the nominal post-retirement required income to allow for a year's worth of inflation since the last calculation.

I was very pleased to find that he required rate of return had dropped to 6.1% pa. The reason for the drop is that our net worth increased by more than expected last year due to a combination of solid (if unspectacular) returns on our investments and increased savings (due to a rise in my income rather than any efforts at cutting expenditure).

While it is premature to start celebrating yet, a lot can go wrong over a period of nine years, my confidence in being able to retire at 50 is growing. Quite frankly, I would be disappointed if my investments only returned 6.1% - historical returns on the major asset classes have been higher than this. If a return of greater than 6.1% is earned, it raises the possibility of either (i) retiring before I turn 50 or (ii) increasing the standard of living in retirement.

The case for not repaying debt #3 - my strategy

The two previous posts on this topic summarised the arguments for taking on, and not repaying, as much debt as possible and the risks inherent in that strategy .

While I recognise and wish to take advantage of the benefits of gearing, I do not wish to have to explain to Mrs Traineeinvestor why our house is being sold out from under us. My strategy is to strike a balance:

1. reduced exposure to volatility in investment values: while property prices can and do fluctuate (Asian crisis anyone?), loans secured against real estate are almost never called in by the banks unless a default has occurred. All my loans are secured against real estate;

2. building equity: although interest only loans are better for cash flow and allow for higher gearing, I recognise that eventually I will want to pay off the loans and use the cash flow from my investments to fund my living expenses. P+I loans are also available for longer terms than interest only loans which reduces roll over risk. Accordingly, all my loans are on P+I terms with one exception. The one exception was done deliberately as part of a tax arbitrage strategy. The more equity that has been built up in a property the greater the scope for renegotiating terms should the need ever arise;

3. cash flow management: I have geared most of our investment properties to the point where they have close to zero cash flow after all outgoings (including P+I mortgage payments) and allowing for vacancies. Interest rates and rents will fluctuate, repair bills will come at unpredictable times as will vacancies which means that the actual cash flow for each property may be positive or negative at various times but, taken as a whole, the geared part of the portfolio should be slightly cash flow positive. This cash flow should grow over time as rents increase. My other income (including rents from one ungeared property) is then free to fund new acquisitions;

4. mortgage duration: for a while I tried to time the duration of each mortgage to mature at or slightly before my intended retirement date. Unfortunately, this objective conflicts with the cash flow management approach (which I regard as being more important). While this can be addressed by increasing the initial equity, I do not always have enough cash available for this. The result is that I have a mix of loans that mature at or about my intended retirement date and loans that mature after my intended retirement date (in the case of my home loan, nine years after);

5. no early repayments: I have elected not to make early repayments on any of my mortgages, not even those which mature after my intended retirement date. Any additional cash flow is allocated to other investments. With interest rates at 5% or less and expected returns being higher, this makes sense so long as I have a sufficiently long time period to work with.

The above should be taken in the context of a household that has two income earners and a reasonable level of unencumbered liquid assets that could be drawn against if needed.

I actually think we are being too conservative with our use of debt but I see little risk of ever getting into financial difficulty either. I would consider borrowing to purchase a fund or portfolio of equity funds but to keep the interest costs as low as possible and to avoid margin calls will secure the advance against a property rather than the equities. Also, I would only be prepared to do so after the markets have had a meaningful correction.

The case for not repaying debt #2 - the risks

In part 1 of this post, I set out the case for maximising debt and minimising the amount of debt that is repaid. Essentially, the logic is that there is a reasonable expectation that other investments such as equities will produce returns which are higher than the interest rate being paid on borrowings.

Of course, nothing is that easy and part 2 of this post attempts to explain the pitfalls:

1. it assumes that the historic long run average returns in equities will continue to be achieved in the future. There is no certainty that this will happen. At least part of the historic long run returns on equities can be attributable to expanding valuations (e.g. higher price earnings ratios) rather than expanding earnings. This is not something which I believe can continue indefinitely;

2. it relies on average returns being achieved. Financial plans which rely on achieving average returns each year have a high probability of failure (a subject for another post I think). There have been several periods where below average returns have persisted for many years. The recurrence of a lengthy period of below average (or negative!) returns would be highly prejudicial to this strategy;

3. the interest rate on the debt is floating. Given that fixed rates are difficult to obtain in Hong Kong for periods longer than five years and prohibitively expensive even for periods less than five years, there is little that can be done to mitigate this risk. If borrowing costs rise, then the positive carry will initially shrink and may well become negative making it a losing strategy. Also, the economic conditions that produce rising interest rates (as well as the rising interest rates themselves) are the same economic conditions that may well result in a decline in the value of investments;

4. cash flow may be negative. Even though the total return on equities may be greater than the cost of borrowing, the yield received through dividends is almost certainly going to be lower. Also, interest payments will typically need to be made every month (I have one mortgage on fortnightly payments) while dividends may be received only once or twice a year. Cash has to be found to meet the payment schedule on the debt and that cash will not always be available from the investment in equities;

5. opportunity cost. Carrying high debt levels may make it harder, if not impossible, to take advantage of attractive investment opportunities as and when they arise. In particular, at times when the markets are depressed and valuations are most attractive, your loan to value ratio is likely to be at its worst and the banks are likely to be most conservative in their lending policies and practices making it harder to fund acquisitions. Another opportunity cost is that carrying high levels of debt will reduce career opportunities - in effect moving to lower paying or part time employment may be more difficult.

I have not addressed tax issues as these are more likely to be a benefit than a burden for me as a Hong Kong resident. However, investors domiciled in other jurisdictions may have to take the effect of tax into consideration in doing their own analysis.

I have also assumed that all the debt raised is secured against real estate which, based on current lending practices, will avoid the risk of a margin call.

In part 3 of this post I will look at how I balance the potential returns from using debt against the risks identified above.

The case for not repaying debt #1 - the returns

My previous post considered whether it was a good idea to make early repayments on my home mortgage and concluded that I was probably going to be better off not making early repayments. The logic for not making early repayments is (i) that the expected return on other investments is higher than the cost of the interest on the mortgage loan and (ii) with a reasonably long time period to work with, the risk of being undone by a run of below average returns on investment can be substantially (but not completely) discounted. In practical terms, the cost of mortgage finance is currently between 4.7% and 5.0% and the long run average return on the stock market is around 10%.

If this logic is correct then there also has to be a case for:

1. moving to interest only debt. This frees up more cash flow for those other investments;

2. increasing debt levels as high as the banks will allow and you can comfortably service. This puts the maximum amount of dollars to work exploiting the spread between borrowing costs and expected returns on other investments;

3. carrying debt into retirement. This would enhance my retirement income.

If the debt was used to acquire an investment property and the money not spent on principal repayments is invested in equities then, as a private individual in Hong Kong, the spread is increased by the effect of tax. The interest will be tax deductible but I will pay no taxes on the equities.

Looking through the lists of the richest people in various countries, it will be evident that many, if not a clear majority, of the people listed use considerable amounts of leverage in their investments or their businesses. Coincidence? I don't think so. In my view it is no accident, that there is an apparent (I have not verified this with a hard analysis) correlation between the use of debt and wealth. Put differently, while striving to be debt free may appear to be a worthy objective, it is unlikely to be a strategy that will maximise your return on investment or your financial wealth.

I recognise that this strategy carries with it increased risk which I will consider in part 2 of this topic.

No Early Mortgage Repayments?

Super Saver at My Wealth Builder posted about his strategy for making additional payments on his home mortgage to ensure that it is repaid by the time he retires.

We have the same issue with the remaining term of our home mortgage extending nearly 10 years beyond my hoped for retirement at 50. I do not wish to carry a home mortgage (or any other debt) into retirement. There are four ways of dealing with the issue:

1. I could make additional monthly payments calculated to achieve full repayment when I turn 50. This option may not be practical because there is a minimum partial repayment threshold;

2. I could make periodic lump sum payments every 6-12 months to achieve full repayment when I turn 50. This is the approach that Super Saver has adopted;

3. I could direct the money that would have been used to make early repayments under option 1 or option 2 into other investments. The logic behind this approach is that with mortgage interest rates well below the long run returns on equities (and some other asset classes), my net wealth will be higher at the end of the day (although not without some risk). When the time comes to retire, the other investments will be sold and used to discharge the residual balance of the mortgage (hopefully with a bit left over);

4. sell our home and buy something smaller. As our children will still be living with us at that time, this will not be an option until much later and can be excluded for present purposes.

With the interest rate on our home mortgage currently at 5.0% (it is a floating rate) and the long run return on equities averaging around 10% pa (+/- a bit depending on which market you are looking at) and a reasonable time period to work with (9 years), we have elected option 3.

We recognise that this is not a risk free proposition. Equity markets can be volatile. There have been bear markets that have lasted a long time. Even though the odds are in our favour, it is possible that the lump sum we accumulate will be less than the residual value of our mortgage. If this happens we can (i) carry a small mortgage balance into retirement (er...no thanks), (ii) sell some other investments or (iii) defer retirement until the balance has been cleared (I would not expect this to be long).

I ran some numbers comparing annual lump sum additional repayments with annual investments in other assets returning 8% per annum. The difference (after adjusting for inflation at 3%) is enough to fund a long weekend for two at a good hotel in Sanya once a year which is a nice addition to our retirement lifstyle.

Kung Hei Fat Choi

Happy Chinese New Year.

Kung Hei Fat Choi is the traditional Chinese (Cantonese) greeting for the Chinese New Year. In keeping with tradition we spent the day visiting relatives, giving and receiving Lai See packets (red envelopes containing new bank notes) and eating (including traditional foods such as turnip cake). Over the next three days we will also get to see a great fireworks display over Victoria Harbour (as well as a few less spectacular illegal ones in other parts of Hong Kong if we wished), watch dragon dances and eat more than is good for us.

This year is the year of the pig, which is supposed to symbolise wealth and prosperity.

Tax time - ouch!

My tax bill has finally arrived. Unfotunately, I miscalculated the provisional tax catch up which means my tax bill is higher than my expectation. I suppose I should not complain too much since I am only paying tax at the rate of 16%.

I will have to pay in two installments at the end of March and the end of April (instead of at the beginning of January and the beginning of April).

It's not the money. It's the time.

Many writers rightly point out the corrosive effect of fees and charges on investment returns. The case is often illustrated with examples showing the effect of a difference in annual fees of, say, 1% over a lengthy investment period of 30 or 40 years. This analysis is fine (and does demonstrate the effect of even marginally higher fees or lower returns over the longer term). Some go further and explain the adverse effect on the level of income a person will have to live on in retirement.

However I have yet to see an article which addresses the other implication of higher fees (or lower returns) - the additional time it will take to reach a savings goal. For those who are striving to achieve a given financial goal (in my case, early retirement), the objective does not change. What does change is the length of time it will take to achieve the objective. Put differently, the price of higher fees/lower returns is more time spent working full time in a very demanding job and less time pursuing other activities. Depending on what your objectives are and what time frame you are looking at, boosting returns by as little as 1% per annum could allow a person to retire years earlier. Personally, I would rather spend those extra years travelling than working to over pay an under performing fund manager.

Time is more valuable than money.

Inflation Data Manipulated

I have a healthy and, on occasion, slightly paranoid mistrust of governments. One particular concern is the calculation of the consumer price index (CPI) which is commonly used a proxy for the general rate of inflation of consumer prices. My personal experience is that the official CPI figures understate the true rate of inflation. Some more evidence to support my personal experience can be found in the most recent adjustments.

Consumers' spending changes over time. This is due to a number of reasons, including the introduction of new consumer products ( iPods and digital cameras are two recent examples of new consumer goods) and changes in the relative prices of other goods (as examples, people now spend relatively more on insurance and health care). The government recognises this and updates both the components of the CPI index and the relative weightings of those components every five years. Almost without exception every re-weighting results in a downward adjustment in the CPI index.

The most recent re-weighting took place in 2006. Needless to say, the effect of the reweighting was to reduce the level of increase in the CPI index. One the more interesting changes was in the basket of miscellaneous goods and services where the weighting given to jewelery was reduced by nearly 80%. If this is right it means that Hong Kong people spent only a fifth as much of the their incomes on jewelry as they did five years ago. This is not credible. Five years ago Hong Kong was in the depths of the Asian economic crisis. Many retail shops were closing down. Real incomes were falling (in spite of deflation). Unemployment and personal bankruptcies were rising towards record levels. In 2006, Hong Kong was (and still is) experiencing an economic boom. The adjustment essentially says that Hong Kong consumers spent five times as much of their discretionary expenditure on a luxury good like jewelry during a severe recession as they did during an economic boom.

That is simply not a credible position for the government to take.

A Difficult Tenant?

For the first time, a potential tenant for one of my residential properties engaged a lawyer to negotiate the lease for them. It has been over a decade since I purchased my first residential property and this is the first time this has happened. Some of the changes they demanded were ludicrous and I came very close to telling them to get proper legal advice. Among the requested changes:

1. that the Tenant would not be responsible for damage caused by their guests;

2. to delete the provision making the lease conditional on the approval of the mortgagor (this is a standard condition of all mortgages in Hong Kong);

3. to state that the mortgage is subject to the lease (no bank will agree to this as it impedes their ability to conduct a mortgagee sale if I default);

4. to replace the gate on the front door because they did not like the design.

Needless to say, I said no to all of these (and a few others). I will be watching this tenant very closely and will issue default notices if they ever fall behind in their rent payments without any discussion.

The IRD Is Late

Mr & Mrs Traineeinvestor normally receive our separate tax demands sometime between September and late November and are required to pay tax in two installments due in the first week of January and the first week of April in the following year.

So far we have not received our tax demands for the 2005/6 tax year. We have checked with the IRD and have been told that they are still working on them (we have no idea why).

So the money which we put aside for our taxes continues to sit in a bank account earning tax-free interest.

It's not often that delays in tax matters represent good news.

Good Debt, Bad Debt

Debt is a subject that generates a lot of diverse opinions - for good reason.

My take on debt is that it can be both good and bad and it is not always possible to know in advance whether particular borrowings will be good or bad. I find it instructive that many very successful investors use debt (or use derivatives to achieve leverage) in the course of making investments. Some of them use a lot of debt. When things go well, the results can be spectacular. It is also instructive that many investors who get into financial difficulty do so because they borrowed money for their investments. The results can also be spectacular in a very different way when things go wrong.

Bad Debt

Debt that is not used to invest in assets that produce a return greater than the cost of borrowing is bad debt. It is damaging your financial position.

Good Debt

Debt that is used to invest in assets that produce a return greater than the cost of borrowing is good debt. It is improving your financial position.

Not so simple

The above distinction is simple - too simple. There are a host of factors that complicate matters. The most important (and obvious) of which is risk. It is usually very difficult to know in advance what return an investment will achieve. You may expect an investment to yield a given rate of return but it is rare to have an assurance that the expected rate of return will be achieved. If the actual rate of return is less than the expected rate of return and less than the cost of borrowing then using debt will damage your financial position - reducing the rate of return or increasing losses. There are, of course, many other risks and issues which arise as a result of borrowing.

Managing risk

I use debt. I like using debt on my investments. Use of debt means I can acquire more investments than I would be able to do without the use of other people's money. However, I am cautious and conservative in my use of debt (at least I think I am). My current borrowings all share the following characteristics:

1. they are secured against assets that are unlikely to fluctuate dramatically in value on a daily basis. At present, all borrowings are property related;

2. the assets acquired with borrowings are all ones that produce cash flow. At present, all the properties are rental properties;

3. all borrowings are on principal + interest repayment terms. The amount of equity in each property will build up over time. Eventually, each property will be owned outright;

4. gearing ratios are set at a level where the expected cash flow is greater than the loan payments. This is achieved either by increasing or reducing the equity component of the investment or increasing or reducing the term of the loan. Historically, my initial equity has ranged from 30% to 55% of a property's purchase price and the repayment terms have ranged from 7 to 20 years. In practice things do not always go as planned, but any shortfall in cash flow is likely to be too small to be of any concern;

5. all interest rates are set at the lowest available floating rate I can obtain at the time the loan is negotiated. I have looked into fixed interest loans but, in Hong Kong at least, the cost of fixing the interest rate has always been prohibitively expensive.

In summary, my approach to gearing on property is to use debt to achieve greater returns, but to limit and structure my debt so that, if things do not go as planned, I should be able to simply wait until either the debt is paid off from the rents or the market turns in my favour without feeling under pressure from lenders to accelerate payments or sell assets in unfavourable market conditions.

This approach represents my accepted level of risk in relation to borrowings. It will not put me among the ranks of the world's truly wealthy, but it should keep me away from the bankruptcy courts.

Financial Review - January

My attempt to track expenses more precisely last year failed after only three months due to a combination of silly working hours and apathy. For 2007 I have decided to put down in writing a short report on how my finances are doing each month.

My net worth increased by 3.1% in January. This is a big result - if I could do that well every month, I would be a very happy blogger. I would also be thinking about bringing my retirement date forward.

There were gains on most of my investments: my funds and equities were almost all up during the course of the month. Silver also rose. The only material exception was the new investment in a Vietnam fund which is currently down. I had no major expenses during the month which meant that I managed to save just over 54% of my salary (well above target). I have not revalued my properties.

In terms of investments:

1. my dollar cost averaging into an Asian and a European small companies funds continued;

2. I made a lump sum investment into a Vietnam fund;

3. I paid the contractor the second installment of 55% of the cost of refurbishing a property (this is treated as an investment not an expense because it adds to the value of the property). The balance of 5% is due in February;

4. I had to top up a mortgage payment due to some vacancies. I will need to do the same in February due to a timing gap between returning a deposit to a former tenant and receiving a deposit from a new tenant;

5. I made a small addition to my position in silver.

Apart from #4 above, I do not anticipate any major expenses in February.