Wednesday, March 07, 2007

Wishing I Had More Cash

I am not a fan of cash and bank deposits as a form of investment. The returns are poor - in fact right now bank deposits show very low or even negative real interest rates which makes them a losing investment. I even take this to extremes and do not have a planned emergency fund.

However not holding a lot of cash has two problems:

1. opportunity cost: when opportunities arise, you need to means to exploit them. If markets continue downwards I may end up wishing I had more cash to buy investments cheaply;

2. exposure to market risk: a no (or low) cash position means that I am fully invested. This means I am fully exposed to market fluctuations. Most of the time this is a good thing as markets tend to trend upwards over time. However, there are times when the markets go down and being fully invested is, in the short term at least, painful.

I know I can't expect to time the market with any degree of accuracy, so have no plans to change my approach. The above represents nothing more than a wish to have my cake and eat it too.

6 comments:

Raphael said...

Hi Trainee,

I've been thinking about this lately and have come up with what I think is a way to have your cake and eat it to.

In my case I have a mortgage back in Australia with an offset account, so I save 7.25% interest by leaving my cash in that account. At the same time I'd like to get exposure to the stock market.

One approach I'm contemplating now is to use futures to buy stock (and get exposure to growth) without needing to immediately outlay cash. If I get a margin call then I always have the cash available in my mortgage offset account which can be drawn down, in the mean time I'll leave it there to save myself interest.

So for example, with 10% capital growth in a stock, plus 7.25% interest I am saving on my mortgage I already achieve 17.25% return. This approach can be geared to borrow say 2 or 3 times they cash you actually have on hand. There's more risk, but the returns are substantially greater too. All comes down to managing the risk and leaving enough buffer not to get burnt.

I find that this is a much better way to achieve gearing than through margin loans which tend to have very high interest rates. Anyway, I'm still doing research, yet to implement this, but something interesting to consider.

After all, why have cake if you can't eat it? :)

traineeinvestor said...

There are two different issues to consider:

1. do you want to borrow to invest? This is what you are doing when you draw down against your offset account. If you do want to borrow to invest, then the cheapest source of funds is the way to go and a loan secured against property is usually the cheapest available for retail borrowers like you and me. Margin loans are more expensive and higher risk as they may be subject to calls;

2. is investing in directly in shares or investing in the futures contracts more efficient? Professional fund managers will often switch from one to the other. The main consideration is whether the dividends received on the physical shares will be more or less than the interest earned on the money that is not required to maintain the futures position. Given that listed company dividends are not paid out evenly through the year there may be some arbitrage opportunities but with so many managers trying to do the same thing, the margin would be very small. Transaction costs and taxes also need to be considered. Intuitively, I would prefer the shares unless there is a very good reason to use futures. If I was resident in Australia it would clearly favour the shares for tax reasons (franking credits on dividends and tax realisation on roll over of futures contracts would be decisive advantages).

Short answer: I like the source of funds but would prefer to own shares rather than futures contracts.

moneymonk said...

Cash and Debt both has it advantages. We all would want to have our cake and eat it too. But I always say stick to what you know/like and you will be OK

Raphael said...

Hi Trainee,

What I find amazing is that some futures, e.g. HSBC have a price below the current price. This means the effective 'interest' you are paying is less than the dividends forgone, ie. < 4.2%. I can definately get a much better return than this by paying my mortgage in Australia, and I'd imagine it's a similar case for you too. Put another way, you can save around 5% interest paying your mortgage, and the opportunity cost of lost dividends (since you hold a futures contract not the actual stock) is less than 5%, so you're making money.

I guess it's harder in HK since the banks don't offer mortgage offset accounts here (or they charge a higher interest rate if you want this option, the banks in HK really do rip us off!).

Taxes on the roll-over of futures is indeed an issue, but not for us since we're in HK.

As for sticking to what you know, I know basically nothing, but am willing to learn about anything, so I'm always happy to try and find a new approach that might cut my costs.

The benefits with futures could be substantial, ie. 6% effective interest with margin loan (after dividends subtracted out), vs. 0% interest with futures. That's 6% higher return on each dollar, and if you're gearing at 75%, that might be a 18% higher return.

Anyway, I'd love to hear your thoughts on this topic. Thanks!

traineeinvestor said...

I agree with sticking with what you know, although it is healthy to step outside your comfort zone once in a while.

If the futures work out to be cheaper after doing the calculations then the case to buy futures over stocks is very logical. (Many fund managers do exactly that.) Óne risk which you would have with futures is getting a margin call when you are away and not able to monitor the acocunt or arrange payment. I suppose this could be addressed by leaving a standing instruction with your bank?

Banks in HK do indeed charge too much in some ways but they are more reasonable in some areas (such as monthly account fees) than banks in other countries.

Some banks do offer revolving mortgages (basically a very large overdraft secured against a property). The last time I looked at this the interest rate was about 25 basis points higher than the standard home loan rate which is not too bad. The only problem is that, unlike an offset account, you lose the ability to tax deduct the mortgage everytime you pay down and do not get it back when you redraw.

Raphael said...

Hi Trainee,

The revolving mortgages sound really interesting. I had spoken to HSBC but I got the impression they didn't offer anything like that (they wouldn't even cross-collateralize one property against another).

Is the revolving mortgage you mentioned available in Hong Kong? Which bank is offering it?

Thanks!

BTW do you think the fact that the land leases in HK are only 50 years will cause the property values to erode at an accelerated pace or is this not an issue?
In other words, is there a 2% reduction in property prices p.a. offsetting the other growth because of this?