Wednesday, May 31, 2006

Are we frugal?

This is a question which I have been asking myself a lot over the last few years without coming up with a definitive or even satisfactory answer.

I know that there are people who manage to account for every dollar that they earn and for every cent that they spend. Unfortunately, I am not one of them. I operate a lazy man's budget (separate post to follow) and do not track expenditure closely. So long as my expenditure is roughly within the budget, I pay relatively little attention to my spending on day to day items. Larger items do get closely scrutinised. Some examples:

1.We shopped around for mortgages to get the best terms available each time we borrowed;
2.We do not own a car, prefering to rely on public transport.

I do save a respectable portion of my income each year - but I do not know off the top of my head exactly how much or what percentage of my income is saved each year. I suspect it would be possible to do better.

I can only give myself a C or, at best, a B grade for frugality. In future posts I will examine my budgeting system and selected items of expenditure to see where improvements can be made.

A tax audit.....

Well, not quite a formal audit but the Inland Revenue Department is querying the tax return for the 2003/4 tax year on an investment property we used to own.

Fortunately, I have supporting documents and the numbers add up to what I put on the tax return so I do not anticipate any problems.

Saturday, May 27, 2006

What a difference a week makes.....

Having been away for just over a week, it is quite interesting how much volatility the markets and the value of my investments experienced in a relatively short space of time. The value of the share portfolio, the unit trusts and silver all dropped by amounts that were noticable but, in the overall scheme of things, not significant.

I have asked myself whether this volatility marks the end of the bull market or is merely an overdue correction in a bull market? Commentators seem to be divided (as usual). Given that my investment strategy would not vary considerably whatever the conclusion, I decided that I do not need to worry about short term market timing issues to any great extent.

With at least 10 years to go to retirement (unfortunately), I am a net accumulator of assets (mainly shares and property). My investment strategy mainly involves acquiring assets which offer reasonably yields that have the potential to grow over time to counter the effects of inflation. Although the short term effect of a decline in the value of the private portfolio can be painful, if not discouraging, a more rational approach is to recognise that weaker markets provide opportuities to acquire assets at more favourable prices.

Monday, May 15, 2006

Market commentary

Today was one of those days which makes me wonder if I should be making any investment decisions at all.

Asian equity markets took a hit. In Hong Kong the Hang Seng index fell by more than 400 points in one day.

Silver has fallen by US$0.98 per ounce, also in a single day.

To round it off, there was a report in the papers today about the Hong Kong property market cooling in the face of rising interest rates.

Is this the beginning of an economic slowdown? We have had 2-3 very good years: stock markets, property prices and commodity prices have all provided what are outstanding returns by historical standards. Most of the economic indicators that are perceived as having a material influence on investment makets have been favourable: employment growth has been strong, inflation (the offical numbers at any rate) has been low, interest rates have been low by historical standards, consumer spending has grown, capital is readily available and relatively cheap and the list goes on.

So why would things slow down now?

Interest rates have risen. They are still low by historcial standards, but have advanced to the point where borrowing costs are now materially above the yield on most properties and shares. Prices have had a good run and in many (but not all) markets valuations have become stretched. Many people (myself included) have concerns about the United States currency and housing markets. Given the huge role that the US economy has played in the world economy in the last few years (both as a source of demand for consumer products produced elsewhere and as source of capital for the world), any problems wth the US economy could have important negative consequences for the rest of the world. Lastly there is growing concerns about the possibility of another war in the middle east over Iran.

What to do about a downturn? The short answer is nothing. I have no plans to sell anything (possibly excepting my silver). I do not want to attempt to time the market. If there is a downturn in the markets (either with or without an economic downturn), I will view it as an opportunity to acquire assets at better prices (i.e. yields) than at present. If all else fails and I am losing sleep at night, I can just start paying down debts at an accelerated rate.

Property purchase update #2

I signed the formal Sale and Purchase Agreement today. It is a standard form document prepared by the vendor's solicitors which, unsurprisingly, is very one sided in favour of the vendor. This is a situation which I find very odd but it is the market practice for conveyancing here in Hong Kong. At this stage most of the risk of owning the property is effectively on me as the purchaser.

DBS has accepted that my wife will not need to give a guarantee. I have in any case signed the documents to convert the company into one shareholder/one director company so I will not have to deal with this request in the future.

The next issue to consider is whether I should redecorate the apartment before I rent it out or not. Instinct suggests that I should but I need to sit down and work through some numbers before making a decision.

Thursday, May 11, 2006

Property purchase update #1

I have instructed solicitors to attend to the purchase. I have used the same firm before and do not anticiapte any problems here.

Getting the finance together is taking slightly more effort. The competiton among the lending banks is quite intense and I have been offered a choice of HIBOR + 0.7% or Prime - 2.75% which are, by historical standards for investment property loans, quite attractive rates. I will go with the HIBOR option as it is slightly cheaper (and has been consistently so over the last two years). I have also settled for a term of 11 years and a gearing ratio of about 40%. This will show a positive cash flow with a sufficient buffer to cover interest rates rising another 1.5%.

The only minor irritation is the requirement that my wife guarantees the loan because she is a director of the company that is purchasing the property. She also holds one share on trust for me. This arrangement is a legacy of the time when Hong Kong companies were required by law to have at least two shareholders and at least two directors. I will deal with this problem by updating the company's articles of association and asking my wife to resign and transfer the one share back to me. Given that the bank did not require this last time I borrowed through this company, I am slightly irritated by this change in policy - only slightly though.

Monday, May 08, 2006

One month of blogging

It has been one month since I posted my first blog entry.

So far I am enjoying the experience.

Equally as important, I am finding that it is helping with my primary objective of clarifying thinking about investments and my retirement in general.

New property investment

I have signed a provisional agreement for the sale and purchase of a small apartment in the Mid-levels. Completion is scheduled for late June.

I have to admit that I thought long and hard about whether this was a good time to be purchasing another property. The positive factors that influenced the decision:

1. limited supply of new properties coming on stream in general and in the Mid-levels in particular (although one of the few new projects is right across the road);
2. Hong Kong is awash with liquidity. The market slowed in the second half of last year but is now showing positive signs of picking up again;
3. yields are higher than bank deposit and bond rates (although less than interest rates on mortgage loans).

The property itself is attractive for a number of reasons:

1. good transport links which will improve should the MTR extension go ahead;
2. a good view. The apartment used to have good views from both the original living room and the bedroom. The view from what used to be the bedroom has been largely built out by a new development. The view from the living room on the other side of the apartment is unlikely to ever be completely built out;
3. a reasonable projected yield of about 4.6% (net yield on gross cost). This is based on what it should rent for in its current condition. If I spent some money redecorating this could be improved;
4. I have the option of configuring the apartment as a studio (current layout) or a one bedroom (original layout).

The only negative factor was the rising interest rates.

I also considered the reported softness in the property markets in some other countries such as the US but found it hard to see why weakness caused by oversupply in one market should affect the market here? Lastly, I disregarded my dislike of holding cash in an inflationary environment - that would be a reason for investing somewhere but not necessarily a reason for investing in Hong Kong residential property.

Saturday, May 06, 2006

Alternative asset classes - art

I like art (well some of it anyway). The asthetic attraction combined with the potential for investment returns is appealing. How does it stack up in reality?

The Mei Moses All Art Index has shown a return of just under 10% pa over the last 50 years. This is about half a percent less than the S&P 500 index (and considerably better than bank deposits and bonds over the same period). I suspect that transaction costs (buyers premium and insurance costs) mean that the return on art as an investment is overstated but could not find figures to back that belief up.

Nearer to home, the stories of investments in Chinese artists over the last few years make for very exciting reading with prices often being said to have gone up by multiples in a few short years. The case for investing in Chinese artists is a very logical one. Rapid economic growth has resulted in the emergence of not just a massive middle class but a very significant number of wealthy people looking for places to invest. At the same time, the supply of works by recognised artists is finite. The result - rapid escalation of prices.

Art is a very different medium from investment than shares or property. The market is a highly specialised and, compared to equity markets, suffers from a huge lack of both transparency and liquidity. Other negative factors include huge transaction costs, lack of income and holding costs. The fact that art prices are often driven by emotional factors - making future price prediction difficult - makes rational analysis difficult, if not impossible. Lastly, fakes abound in the art world and are sometimes good enough to fool the experts.

As a matter of simple economics, leading artists are outside my price range (well outside). With only a limited knowledge of the market, buying less recognised (and affordable) artists represents something of a leap of faith rather than a carefuly assessed investment decision. The track record on art funds is patchy to say the least - a situation not helped by the associated expenses.

My lack of expertise combined with the factors mentioned above leads me to conclude that art is not a suitable investment in my particular circumstances. That said, I like art (in particular oil paintings) and would like to add to the handfull of paintings in our apartment. In doing so I will limit myself to affordable works purchased for one reason only - they appeal to me as works of art. I will treat the purchase price as an expense rather than an investment. If the paintings happen to appreciate in value that is an added bonus but that potential is not a motivation for acquisition.

Tuesday, May 02, 2006

Inflation - part 3

In the previous two posts I summarised the significant effect that even a relatively low rate of inflation can have on the real value of savings over time and pointed out that the true rate of inflation may currently be higher than the 2-3% currently indicated by CPI data in many developed countries (about 1.8% in Hong Kong). A figure of 6+% has been suggested as the true rate of inflation in the US.

If the true rate of inflation is higher than the reported rate, and the rate which is widely believed to represent the rate of inflation, this has implications for portfolio management.

The first (and obvious) conclusion is that the nominal return which investments must generate needs to be higher to compensate for the higher rate of inflation. It makes it harder to justify investing in deposits and bonds and more essential than ever that investments which can grow over time be selected.

The second (less obvious) conclusion is that the real cost of debt is less than the CPI data would suggest. In fact, if the true rate of inflation were 6+%, it would follow that real interest rates on mortgage finance in Hong Kong are currently negative (mortgage rates are typically 5.25-5.75% at present). In this situation, it makes sense to borrow as much as can be comfortably serviced and to delay repaying that debt as long as possible. Put differently, does this mean that debt is underpriced? If so then full advantage should be taken of that mispricing - with the caveat that the possibility of interest rates rising has to be taken into consideration when borrowing.

Inflation - part 2

The first part of this article on inflation identified why financial planning requires an awareness of inflation and how it can affect the value of savings over time. The second part looks at the question of exactly what is inflation and how much inflation are we experiencing?

The two most widely used definitions of inflation are:

1. the rate of increase in the supply of money (M3 being the broadest measure of the money supply is commonly used for this purpose); and
2. the rate of increase of prices in an economy.

The Federal Reserve stopped publishing M3 data in march 2006 effectively making it impossible to accurately measure the rate of increase in the money supply in the US. In the 12 months prior to the last set of M3 data being published, the money supply grew by a little bit less than 8%. The official explanation for ceasing to publish M3 data was because it was no longer considered to be useful. Many commentators have suggested other reasons.

The rate of price increase is harder to measure. Consumer price indices (CPI) are the most commonly quoted measure of inflation in an economy. The problem with CPI figures is that they represent only a selection of the goods and services consumed in an economy. Unfortunately they do not reflect all goods and services in an economy - only selected goods and services. It follows that we need to consider whether CPI data is an accurate representation of the rate of inflation.

Last week Tocquville Asset Management L.P. published an report showing the effect of the numerous adjustments to the way in which the US CPI data is calculated during the current administrations of presidents Clinton and George W Bush. The report draws on work published by John Williams at . (Unfortunately I have not been able to access the website yet.) As a snap shot, currently the CPI is increasing by a little more than 3%. If CPI were calculated on the same basis as it was at the start of the Clinton administration, the number would be closer to 6.5%. This is a massive difference and one that has huge, and scary, consequences for everybody. Williams gives a practical example that the effect of the succession of downward manipulations of the CPI data is the effect on Social Security payments which should be about 43% higher under the old methology.

A further question which merits consideration is how accurate (or not) the CPI figure was at the start of the period under review.

By coincidence, the Hong Kong government announced last week that it was reweighting the components of the Hong Kong CPI data to reflect changes in consumption patterns. The effect of the reweighting was to reduce the inflation rate by about 0.2%.

While inflation indices should change over time to reflect changing patterns in consumer spending, I am highly suspicious of changes that habitually work in one direction only - downwards and, further, do not include a number of significant expense items.

A couple of questions follow from my ramblings on inflation. The first is whether it is possible for an individual such as myself to know with any degree of accuracy exactly what the rate of inflation is. The second, and more important, question is this. If the true rate of inflation is materially higher than the 2-3% often quoted, what implications does this have for financial planning and investing?

Monday, May 01, 2006

Inflation - part 1

Inflation is an issue that anyone concerned with planning for their financial future has to think about. It is also an issue that anyone who has to meet their own living expenses has to deal with.

In very simple terms inflation can be used to describe the rate at which prices increase over time. (Yes, I know economists use a different definition and will write about the definition of inflation in part 2 of this article.)

Depending on where you live, inflation in many developed economies has been described as being relatively benign for a period of several years now and typically is said to be around 2% pa. In the US, an increase in the inflation rate to slightly above 3% pa has largely been blamed for the series of interest rate rises implemented by the Federal Reserve.

An inflation rate of 2-3% pa may not seem like much but it can have a significant effect on the value of savings over time. An inflation rate of 2% pa over 20 years effectively reduces the value of savings by about 32%. An inflation rate of 3% pa over 20 years reduces the real value of savings by 44%. This is huge!

One of the implications of an inflation rate of 2-3% pa is that, if the inlflation rate is 2-3% pa, then savings have to earn 2-3% pa after taxes and expenses just to break even. Currently, bank deposits and bonds more or less do this but fail to generate a meaningful rate of return. Put differently, deposits and bonds just do not provide an accepetable rate of return and, over the longer term, can only be viewed as a temporary place to park money pending the search for a more suitable investment.