Sunday, March 30, 2008

Book Review: The Exchange Artist

The Exchange Artist is Jane Kamensky's story of Andrew Dexter, the building of the Exchange Coffee House in Boston at the beginning of the 19th century and America's first banking collapse.

As an historical narrative of the workings of America's banking industry during the period from about 1790 when Andrew Dexter begins his scheme until about 1837 when Dexter's last attempt to engineer a fortune collapsed, The Exchange Artist makes for interesting, but not compelling, reading.

During that era, banks were established by charter from the local legislature and, crucially, issued their own money. With unlimited ability to create money simply by running the printing presses, the operation of banks was largely an exercise in confidence. As long as merchants, workers and others had confidence that the notes issued by a bank would be honoured on presentation at the bank (i.e. redeemed in specie) and accepted by others, the bank could issue as much money as it wished.

In his efforts to finance the construction of the Exchange Coffee House (at the time the largest building in Boston by a huge margin), Dexter took the ability of banks to create money by printing notes to extreme levels. By buying control of a handful of distant banks and establishing a central clearing facility for the exchange of notes issued by different banks, he was able to make the notes issued by less familiar and more remote banks acceptable and also to delay and frustrate the process of presenting notes for conversion into specie. Crucially, the resulting delay enabled those more distant banks to run the printing presses and put huge numbers of notes into circulation to pay for the construction costs. With nothing to back the notes in issue, eventually the scheme collapsed and Dexter was forced to flee to Canada to escape his creditors. The Exchange Coffee House itself would burn down in 1818, less than a decade after it was completed.

As mentioned above, I found The Exchange Artist interesting but not compelling from an historical perspective on the American banking industry. The personal story of Andrew Dexter and the telling of the building and burning of the Exchange Coffee House was rather bland.

Thursday, March 20, 2008

Silver sold

I sold the remaining portion of my investment in silver today. In part I have allowed myself to be affected by the general sell off in commodities over the last few days. I also recognise that the supply of silver is expected to exceed the demand for silver for uses other than investment purposes. In other words, if the investors head for the exits then it has the potential to fall back even further than it has already.

My investment in silver dates back to January 2005 when I purchased most of my total investment at around US$6.00 per ounce. More was added from time to time on the way up. With an average exit price at just above US$17.00 per ounce it has been a very profitable speculation. That said, it will be some time before I get over the regret of not selling at prices above US$20.

From an emotional perspective, the ups and downs in the silver price which I have experienced over the last three years have been a huge roller coaster. There have been nights when I have been kept awake either with worry or excitement as the price has gyrated up and down. I certainly now understand why silver is known as "the restless metal".

Of course, I now have another problem: what to do with the cash I am now sitting on?

Wednesday, March 19, 2008

Surviving a downturn (3)

In part two of this series of posts on surviving a downturn I considered financial survival. The next issue is financial opportunity.

Downturns are the best times to buy investments. You get lower prices, better yields and lower risks. Paradoxically, you get the opportunity to invest with the expectations of higher returns combined with lower risks. In a sense a downturn gives everyone a much better chance of finding values that will deliver excellent returns over extended periods of time.

As always things are not that simple. The first issue is the need to overcome the fear that typically pervades the financial markets at times like these. Putting your hard earned cash on the table at a time when the financial press is preaching doom and gloom, when you are worried about your job and when you have red ink all over your portfolio takes a huge amount of emotional fortitude. This becomes even more of an issue if you are buying using leverage.

Of course it also goes without saying that reduced risk does not equal no risk. Based on previous experience, the safest approach to buying amidst the gloom is to stick with quality. Quality in this context means security of cash flow. In the case of a company sustainable free cash flow and in the case of a property sustainable yield from tenants.

It is also necessary to accept that you will not pick the bottom of the market and may face a period of time, often a lengthy one, where you have depleted the security of your cash reserves for an assets which is declining in price. This is not fun. Of course in the longer term, the alternative is even worse - if you sit on your low return cash for too long you will be cursing yourself for the missed opportunities.

Mortgage rates now at 2.5%

The Hong Kong Monetary Authority followed the US Federal Reserve and cut interest rates by 75 basis points today. To a certain extent, it has no choice in the matter if it wishes to maintain the Hong Kong dollar's peg to the United States dollar at current levels.

At least some of the leading commercial banks have followed by cutting their prime lending rates by 50 basis points. Assuming that my lending banks do the same and that the rate cut gets reflected in the HIBOR rates, this is obviously good news for me as it reduces our mortgage payments and improves cash flows. I expect most of my mortgage fixings to end up at around the 2.5% level.

With inflation in Hong Kong expected to rise even further as a result of the US$/HK$ weakness, the case for continuing to hold real estate in Hong Kong and not repaying debt early just got stronger.

For savers, deposit rates also dropped but by a lesser amount for the simple reason that they cannot go below zero which is what will now be paid on small deposits and call deposits. Larger deposits and term deposits will still earn some small amount of interest.

Question: if the Federal Reserve cuts again, could we see Hong Kong lending rates reach the point where it pays to borrow Hong Kong dollars to invest in other currencies? Put differently, could the Hong Kong dollar become the new lending currency for the carry trade?

Tuesday, March 18, 2008

Surviving a downturn (2)

In part one on this topic I raised the possibility that the current financial difficulties, declines in the market values of many asset classes and some of my informal leading indicators could mark the beginning of a prolonged economic downturn. I identified three key points to focus on. This post addresses the first of those key points: financial survival.

By financial survival, I mean the ability to maintain my current lifestyle (more or less) without adversely affecting our future financial plans to any material extent. In a different context, I might be concerned with bankruptcy, a mortgagee sale of our home or other traumatic financial calamities. However, at this point such extreme outcomes can be disregarded. Instead, I can focus on preserving our current lifestyle and our financial future. I asked myself three questions:

Question 1: when would the cash run out?

This is the personal finance equivalent of a liquidity test. If I lost my job, for how long could I continue to meet monthly expenses without having to sell assets? In answering this question, I came up with three answers. The first answer looks at cash on hand only which would last us about 12-14 months. This is a worst case scenario. The second answer takes into account Mrs Traineeinvestor's income which extends the time line out to about 15-16 months. The third answer takes into account the fact that my employment is subject to a minimum notice period and that some of my remuneration is paid in arrears. Even if I was given a pink slip tomorrow, I would not have to start drawing on existing cash reserves for at least 6 months which means it would at least 21-22 months before we would run out of cash.

As a final point is my savings rate. Assuming I just put my salary into the bank, with each passing month, I can save enough money to extend the zero cash point by close to one additional month.

Question 2: what is the risk of permanent downside to my assets?

I considered the possibility that each asset had the potential to suffer a permanent or very long term diminution in value. Any assets which I consider have a meaningful potential to go down and stay down should be sold - regardless of whether they look attractive at these prices or not. This is a lesson which has been repeatedly drummed into me in 1987, in 1997 and at other times.

For index funds and diversified ungeared equity funds I have no concerns. History has shown that markets as a whole will bounce back. It's just a question of how much pain you have to endure while waiting. I have similar views on real estate as an asset class with the qualification that leverage has the potential to create a permanent loss of equity value. I do not see a Japan style extended deflation in property values or even a repeat of the Asian crisis based on current fundamentals.

This leaves my residual share portfolio and my commodities. I have seen plenty of stocks go to zero and the prices of commodities remain at depressed levels for very long periods of time. I will carefully review each of my individual shares (only two that matter) and my commodities over the next few weeks before making any decisions.

Question 3: what else could go wrong?

This always the hard question. We have medical insurance. There is not much I can do about defaulting tenants or vacancies at the end of leases. De-pegging of the Hong Kong dollar? Interest rates rising? Inflation running rampant? I have been running all kinds of economic and personal problems through my mind. The issue is that many of them would be best dealt with by contradictory courses of action. I am not planning to arrange my life around financial fears which, as things stand, I consider myself reasonably well placed to address if and when they eventuate.

In general terms I have concluded that we are in reasonably good shape to withstand a downturn lasting 1-2 years. Beyond that and conditions will be more uncertain, but our margin of safety will improve with each passing month.

US$10 million to be considered wealthy?

I finally got around to reviewing the Barclay's Wealth Insights Vol 4: "The True Value of Wealth".

In a number of respects it made rather depressing reading. It was not so much the observation that US$10 million is the modern equivalent of a "millionaire" (not a surprise) but some of the other observations and responses by the individuals surveyed for the report. In particular, the focus on consumption and luxury brand goods was something of a disappointment.

Key comments:

1. the cost of living for the wealthy has been rising at the rate of 6% pa. While it feels like it has been doing that for the rest of us as well, the message I take from this is that lifestyle expansion is a very dangerous road to start down;

2. most respondents valued prestigious label goods for their exclusivity. This was really depressing. Save when buying gifts or where I believe there is a clear reason for choosing a recognised luxury brand (e.g. reliability), I will buy whatever is cheaper;

3. people consider their peers when evaluating their own level of income. Sadly this is true. I suspect that the same could be said of personal wealth levels;

4. time is the ultimate luxury. Very true;

5. a majority of respondents (78%) claimed that wealth made them happier. This is in contrast with academic studies which show only a "slight" increase in well being as income levels rise;

6. the use of personal services has continued to rise. This is no surprise. If you are time poor it can often make good sense to pay someone else to deal with certain matters for you.

While the report was interesting, it gave no insights into how the wealth manage their money.

Monday, March 17, 2008

Book Review: Speculative Contagion

Speculative Contagion is subtitled "an antidote for speculative epidemics". The book essentially comprises edited reprints of the extensive commentary provided by Frank K. Martin to clients of Martin Capital Management (MCM) during the period from 1998 - 2004 which covered the tech boom and subsequent bust. The final section is a list of key principles largely drawn from their experience during this time. MCM actively manages client portfolios using a value based stock selection philosophy. At times they will be heavily invested in cash while they attempt to identify investments which meet their criteria.

The commentary makes for very interesting reading. Several key ideas can be drawn from the commentary:

1. it is better to miss out on a speculative boom than to be caught in the subsequent collapse : of course it would be even better if you could catch the upside and get out soon enough to avoid the worst of the bust which is what trend followers would attempt to do. Perhaps the better lesson is to avoid being caught up in the euphoria of a speculative frenzy;

2. modern portfolio theory and the efficient markets hypothesis are wrong: while the jury is still out on this one, unless I could persuade myself that I could really out perform the market, low cost indexing is still the safer option for me;

3. the lessons of history are valuable to investors: this has to be correct;

4. high return and low risk go together: this argument is persuasive. Essentially, if you the price you pay relative to valuation is sufficiently low you effectively lower risk while generating the possibility of a higher return at the same time.

If I took one lesson from this very interesting and entertaining book, it is the value of patience. When it comes to investments this is something I am often sadly lacking.

I am not persuaded that stock picking is the right approach for myself (or indeed for most individual investors) for the simple reason that by definition only half the investors can beat the market averages and I have no basis for assuming that I can compete with the legions of professionals attempting to do the same (even assuming I had the time to make the attempt). That said, I remain very sceptical about the validity of the efficient markets hypothesis and modern portfolio theory. Even as a small investor with limited resources, I should have the common sense to stay out of grossly over priced markets and to invest more heavily in markets which look fundamentally cheap. The emphasis here is on the market or asset class rather than the individual asset.

Surviving a downturn (1)

Since the US sub-prime initiated credit crisis began making its effects felt in the third quarter of 2007, I have been generally optimistic that (i) the effects would be limited and (ii) the effects in markets outside the US would be even more limited. I have also allowed my optimism to combine with my fear of rising inflation and the low returns on cash to dictate my investment strategy. In particular, I have minimised my exposure to cash and deposits as an asset class. So far that has proven to be an awful decision - only the currency effect (benefiting from a weak US dollar), positive cash flow from properties and a small exposure to commodities have held portfolio losses to very modest levels. However, this is false comfort. Some of my mark to market investments have fallen by 30% in local currency terms.

A combination of the reduction in value of my mark to market investments, rising uncertainty regarding my income and my employment generally and a some leading indicators have lead me to belatedly consider the implications should the markets and the economy in general experience a prolonged downturn.

During the last 20 years I have been through three downturns (i) the 1987 share market crash (ii) the Asian crisis and (iii) the SARS epidemic (the tech crash was sandwiched between the last two but had relatively little effect in Asia). In spite of each of them being both financially and emotionally stressful events, experience has given me a degree of confidence in terms of our ability to get through the downturn and emerge in good financial shape on the other side. That said, it must be acknowledged that each down turn has presented its own unique challenges and issues. While the phrase "this time it is different" may be a generally dangerous belief to hold when asset values are rising, if my (limited) experience and reading of history is anything to go by, the phrase may have some validity during a downturn.

Downturns need to be addressed at three levels:

1. financial survival;

2. financial opportunity; and

3. mental health and personal opportunity.

I will review my position on each of these in successive posts.

Saturday, March 15, 2008

Book Review: Way of the Turtle

The Way of the Turtle is essentially a book about momentum investing (or trend following). The author (Curtis M. Faith) was one of a group of 23 individuals who in 1983 were trained by two highly successful traders in the art of trading futures.

By reputation the turtle traders as they were known were very successful traders. The fact that they were systematically trained to trade futures in a specific manner using specific techniques and succeeded is what makes this an interesting case study. Essentially, if the premise of the story if true then anyone should be capable of being trained to succeed as trader. Since derivative instruments are zero sum games (actually, negative sum games once transaction costs are paid), by definition not all participants in the market can make money as momentum investors. That said, the author presents a good deal of statistical evidence to support his contention that with the right approach an investor should have a high degree of confidence in his ability to succeed as a trader.

Given the logical impossibility of all traders making money from the futures market (even allowing for the role of hedging participants),I remain sceptical of the merits of momentum investing as an investment strategy. That said, the book is well written and the arguments presented are both logical and well supported. Also in the back of my mind is the fact that both the economy and the prices of investment asset classes move in cycles. Viewing momentum trading as a tool for identifying and capturing these cyclical movements does make sense to me.

One other point I liked about the approach to investing described in the book is the importance of deciding when to exit an investment, both for the purpose of preserving capital and for the purpose of exiting a successful investment. For all investors (whether active traders or not) preservation of capital has to be the most important rule of the game - something that I have lost sight of in the last six months.

Maybe, just maybe, this book has done enough to make me take another look at the question of momentum when making my investment decisions.

Friday, March 14, 2008

Some good news amidst the gloom

Yesterday the Hong Kong government revised its forecast for the supply of new flats in Hong Kong this year downwards by more than 30%. The number of new completions is expected to be 10,980. This compares with the previous forecast of 16,000 units and the 10,470 units completed in 2007 and a forecast on 12,670 for 2009. These numbers contrast strongly with the average of 27,000 new units a year completed between 1998 and 2004.

With very low mortgage interest rates (2.8%), rising inflation (3.4-4+%, depending on which numbers you look at), rising incomes and high levels of liquidity in the banking system, the reduction in the forecast supply of new properties is good news for property owners.

Of course, history has shown that confidence is also an important factor in the demand for property and the prices people are willing to pay. The declines in equity markets and generally gloomy economic news from the United States (and, to a lesser extent, other markets) has the potential to be a drag on the market. Whether this will overcome the underlying fundamentals remains to be seen.

Thursday, March 13, 2008

India ETF purchased

For long term potential India has a lot going for it. The demographics are very favourable, the economic growth rate is impressive and potentially sustainable and there is considerable room to improve the economy though infrastructure development and deregulation.

Yesterday I finally made the decision to make a long term investment in the India growth story by purchasing some units in the Lyxor India ETF. The other reason for making this investment was to increase the diversification in my equity portfolio.

While the Indian SENSEX stock index was about 22% off its peak in early January, I have no idea whether the index will fall further. Accordingly, this is a relatively small initial purchase which I will consider adding to in the future.

Tuesday, March 11, 2008

Platinum - position sold and loss taken

With the South African power shortage resolved (at least for the time being) and the price of the metal moving sharply downwards, I have decided to take the loss and sell the position I recently opened. The loss was about 8% of my original investment. Not the result that I hoped for but better to take the loss and move on than to risk a greater loss in a very volatile market. In one respect, taking the loss represents a positive development - historically I have sat on losing positions for far too long.

Monday, March 10, 2008

It's not the market that I want to beat

Beating the market would be nice. But, realistically, why should I expect to beat the market when so many professionals fail to do so? I don't have their training or resources and I have a very full time job. The only way I am going to beat the market (other than through luck) is to cheat and invest in things which fall outside the "market" that I am comparing my performance to. As an example, I might compare a portfolio that includes emerging market stocks and commodities with the S&P500 index. That is not an apples to apples comparison but it is still a valid one for the purpose of deciding whether to continue to manage my own investments or to passively put my money into index funds and periodically rebalance.

Even though my objective is not to beat the market, there are plenty of things I do want to beat:

(i) under performance: if I consistently under perform, then it is time to rethink my investment strategy. Of course the difficulty in accessing low cost no load index funds makes investing in the market a challenging exercise;

(ii) inflation: if I fail to generate real returns over time, then something is seriously wrong;

(iii) the fees, charges and expenses of financial intermediaries (well, as many as possible): I'd rather the money was in my pocket working for me. Unless the intermediaries are going to add value, they are a drain on my wealth;

(iv) reliance on welfare in my old age: the real value of social security will continue to decline. It has to. That makes it unsafe to rely on anyone in my old age;

(v) lifestyle erosion due to financial constraints: once I retire, it is essential that I do not have to worry about downgrading my standard of living ;

(vi) my own bad judgement calls: I have made enough bad investment decisions in my life to know that I will make some more bad ones in the future. Getting caught up in the euphoria of a boom is easy to do - resisting the urge to throw money at the market in expectation that someone else will be the greater fool is not as easy as it sounds. That said, I am getting better at controlling my emotions as I age.

Certainly, many people do beat the market and the many well reasoned challenges to the efficient market hypothesis make it tempting to try, but the blunt reality is that I have neither the time nor the skills to justify trying to do so. At least not through judgement based market timing or stock selection (not that I am allowed to trade individual stocks). There are other ways to enhance returns.

Another way of looking at things is that I do not really care if I "beat the market" or not. What the market does is largely irrelevant to my investment objectives. I am interested in only one thing - generating returns which are sufficient to enable me to retire in 3-4 years time and support my desired lifestyle without drawing down my capital during that retirement. That said, if I consistently under perform the market, then it is time to simply buy the market in the cheapest manner possible and develop some new vices. Until then, I will pursue my investment objectives with as little fee paying assistance from the financial services industry as possible.

What a difference six months makes

For a period of about four years from late 2003 through to the peak of the equity markets in October 2007 (give or take a bit depending on which market you are talking about) it seemed that every investment decision I made was a good one. The only bad (i.e. loss making) investment I made during that time was a Vietnam equity fund. In the six months since the equity markets peaked, the reverse has been true. Most of the investment decisions I have made have been poor ones, either losing money (at least in the short term, and fortunately not much) or taking money off the table in a rising commodity market. Some of my earlier investments which had made me money in the bull market have turned out to be not as good as I had once believed (actively managed funds which I have hesitated to sell due to high entry/exit costs).

It's been something of a wake up call in a number of respects:

(i) markets can move against you quicker than you think;

(ii) high entry/exit cost investments are much less likely to be sold than investments with low entry/exit costs;

(iii) the value of diversification and cash flow has been proven;

(iv) the previous four years of excellent returns were as much due to good luck as good management. In other words, I may have been guilty of overrating my investment management skills.

In spite of the zero cash strategy (driven by inflation concerns) having served me exceptionally well during the bull market, I have begun to doubt at least the short term wisdom of that strategy in the face of falling equity markets.

In a sense, I have been fortunate that the decline in value of my equity portfolio has been partially offset by favourable currency movements, positive cash flow from properties and rising commodity prices. In effect, the lessons of the last six months have been learned with relatively little pain.

Saturday, March 08, 2008

Are commodities today's bubble?

Commodity prices have been advancing upwards since late 2001/early 2002. The CRB index has more than doubled since then. By historic standards both the absolute price levels and, at times, the rate of increase in the prices of certain commodities has been extreme. The big question is whether commodities are the latest bubble? The alternative is that rising commodity prices are a reflection of demand growing at a rate which supply is unable to match.

Unfortunately, there is no clear answer to either question. The principle pro-bubble and anti-bubble arguments are summarised below. As a small investor with no better ability to foresee the future than anyone else, I have no idea which view point is correct. It is also possible that some commodities are in a bubble while others are not - meaning that the selection of individual commodities rather than a basket of commodities is the preferred approach to investing in this sector.

Pro-bubble arguments

(i) prices have reached historically high levels (records in some cases) and the rate of increase is unsustainable;

(ii) investment money makes up a sizable proportion of the demand for commodities (in part fueled by the increasingly easy methods of investing in commodities) and that demand will not continue (and is likely to reverse) once prices pull back;

(iii) the US economy is in recession and this will result in reduced demand for commodities, not only in the US but also in other countries due to the impact that an economic slowdown in the US will have on its trading partners.

Anti-bubble argument's

(i) inflation is back. Commodities (particularly those with supply side constraints on increased production) offer a good hedge against inflation. In effect, investors should still be buying commodities;

(ii) prices may be high in nominal terms but in inflation adjusted or real terms are still well below previous peaks;

(iii) demand from emerging economies is genuine end user demand and growth in that demand will continue despite any slowdown in the US. In effect there is at least some degree of decoupling;

(iv) supply side constraints limit the ability to increase supply to match demand (at least in the short term) and, further, supplies are subject to disruption from a variety of causes. Falling inventories in at least some commodities can be pointed to.

While I do not have an answer to the big picture question, I have allocated a small proportion of my assets to commodities. In part, I have done this because I believe that demand exceeds supply in at least some commodities and in part because I believe that there is at least some degree of decoupling from the US economy. The other reason for investing in commodities is diversification. While diversification alone does not justify holding a particular asset class, so far my limited forays into the world of commodities have been financially rewarding.

Going forward, I intend to maintain at least some exposure to commodities either through a commodity fund or by selecting individual commodities. For the latter, there are two approaches which can be adopted. The first is to join the momentum investors and buy commodities which are trending upwards. The second approach is to buy commodities where the demand from end users exceeds supply and where inventories are limited.

Friday, March 07, 2008

A very small speculation (3)

I executed a very small day trade today. I purchased put warrants on the Hang Seng Index (code 5441) at the opening of trading and sold them back in mid afternoon. Entry price was HK$0.205. Sale price was HK$0.213. Given that the amount involved was very small ( I am not inclined to invest meaningful sums of money on something as speculative as day trading), the profit was correspondingly small. After transaction costs I made enough to take Mrs Trainee investor out for a nice dinner so long as we don't want wine with the dinner.

Needless to say, the small profit made on this trade was considerably less than the declines in value of my other investments today.

Tools for enhancing returns

My previous post considered what in absolute terms would be an acceptable rate of return (6.7% pa in my case) and which asset classes would be best suited to providing that return (predominantly equities and real estate with some room for commodities).

There is more to achieving an acceptable rate of return than simply allocating capital to an asset or assets within a preferred asset class. Here are five tools that can be used to manage portfolios and, potentially, enhance returns:

1. risk concentration: when we think of long run returns on asset classes, we are usually thinking of the average returns over a lengthy period of time. However, returns for specific assets and for shorter time periods and for future time periods are unlikely to replicate the long run historical returns for a given asset class as a whole. Sometimes the returns for specific assets over a given future time period will be better than the historic class average and sometimes they will be worse. Diversification and lengthening your holding period will (or should) produce results which are closer to the average result for the asset class as a whole. In simple terms, if you want to achieve higher returns, one technique is to concentrate your investments in a narrower pool of specific assets within a class. However, in doing so you necessarily take on a higher level of investing risk (similar to stock picking - see below). As practical examples, at one end of the spectrum is Warren Buffett who became the world's richest man at least in part by avoiding excess diversification. At the less successful end of the investing spectrum are employees of companies like Enron who kept a disproportionately high percentage of their assets in the stock of one company;

2. market timing and stock picking: there is a lot of press about how hard it is to time the market and how hard it is to stock pick. The reality is that a lot of very successful investors do beat the market through timing and stock picking. The reality is that timing the market (like picking stocks) is very difficult. As a matter of statistical definition, for every share that beats the market there must be one that underperforms because collectively all investors will hold all the stocks (both good and bad) that comprise the market. Put differently, not all investors can beat the market and for every investor who does beat the market there must be one who underperforms. Underperformance based on stock selection can be avoided by simply buying the index. However, the same cannot be said for market timing. All investors to some extent or another must indulge in an element of market timing. Choosing when to invest, when to rebalance, deciding to stay in the market or to set up an automatic monthly payment to an investment fund are all examples of market timing. The question is not whether you will time your entry to and exit from the market but how you will do so. Some investors reduce the timing decisions to arbitrary rules (which reduces the scope for misjudging the market). Others will attempt to be more pro-active and make more thought out decisions. Risk and potential return tend to both rise as investors move away from relatively passive market timing systems to more judgement based approaches;

3. benchmarking against the market: investors (and fund managers) will often benchmark performance against the market. This is sensible for the simple reason that if you cannot beat the market you would be better off parking your money in low cost index funds and spending your time on other activities. That said, there are some issues with benchmarking. The first is deciding what index is an appropriate benchmark. Benchmarks are usually selected on the basis of being a comparable measure of performance for your portfolio. An investor who wants to measure the performance of an actively managed portfolio of US large cap stocks may benchmark against the S&P500 index. However, an investor who is investing in a broader range of asset classes should benchmark against a different index (or even create their own) if they wish to measure relative performance. Of course, investors seeking absolute returns can still benefit from benchmarking, but need to be careful not to be distracted from their chosen strategy by short term comparative divergences from the selected benchmark;

4. leverage: leverage is both a wonderful tool and a deadly poison. If it works for you, it can magnify returns significantly. If it works against you it can be financially fatal. It is no accident that many of the world's most successful investors (and most of the successful investors personally known to me) use a reasonable amount of leverage. Equally, it is no co-incidence that many investors who suffer catastrophic losses (including some well known hedge funds) do so because of the effect of leverage. My own rather conservative approach is to gear my real estate investments (no margin call issues and rents can meet mortgage payments) but not my investments in equities or commodities;

5. derivatives: much like leverage, derivatives can increase the risk and returns on your portfolio. I tend to use them very sparingly for a number of reasons. The first is the premium and the second is the roll over costs associated with longer term investing (as opposed to short term trading). As exciting as trading derivatives sounds, it is something which, in my view, is best left to the professionals (or at least people with more time to devote to their investments than I have).

All of the above are tools which investors can use if they wish to increase the returns on their capital. In doing so, investors will be accepting a higher degree of risk. A random look at wealthy investors is that most, if not all, of them (or at least the ones known to me) do not blindly put their money into index funds. They use all or some of the five tools mentioned above to improve investment performance.

At a personal level, I have used all of these at various times (these days I tend not to benchmark) and, although my returns have been volatile at times, on the whole the use of risk concentration, an element of market timing and leverage has been very worthwhile.

Tuesday, March 04, 2008

What is an acceptable rate of return (2)

Back in April 2006 when I started this blog, one of the first questions I asked was "What is an acceptable rate of return?" Nearly two years later, it's still a question that I keep coming back to. Obviously, higher rates of return are better than lower rates of return. Equally obviously, if a higher rate of return is only achieved at the cost of being exposed to higher levels of risk, then it has to be asked whether the additional return is justified?

The problem can be approached from two different directions:

1. what rate of return is needed to achieve a given financial objective?

2. what rate of return is it reasonable to expect from a given asset or asset class over a given period of time?

Assuming that the answer to question #1 is a sensible one, the answers to question #2 can be used to construct a portfolio of investments that should both individually and collectively have a reasonable expectation of achieving the desired rate of return (preferably with a margin for error).

As an example, in November 2007 calculated that my investments had to return about 6.7% pa (net) in order to retire in about five years from now. Accordingly, I should be looking to invest in assets that can be expected to show average rates of return of at least 6.7% pa over a five year time period. The main asset classes available to retail investors are:

1. equities. Recent months have seen equities taking a beating and sentiment is currently very negative. Although valuations are much more reasonable now than in the middle of 2007, they are not at bargain levels. That said, long run returns on equities have traditionally been in the range of 8-12% pa (depending on which market you are looking at). Even the lower figure gives an adequate margin for safety. The key issue is to make sure that the return does not get eroded through transaction costs, management fees and other avoidable expenses;

2. real estate. Hong Kong real estate has driven the returns on my portfolio over the last four years. I do not expect those rates of return to continue. However, a reasonable expectation for ungeared property is a total return equal to net yield + the rate of inflation. This would currently be about 7-8% pa. Again, this gives me a margin for safety. The key issues are transaction costs, vacancies and longer term maintenance etc. Buying needs to be very disciplined to ensure that only purchases that adequately allow for these factors are made;

3. bonds. The best I will do on a HK$ bond with a high credit rating is about 3%. This is below both the required rate of return and below the rate of inflation. I cannot see any justification for holding bonds;

4. cash/deposits. HK$ deposits pay negligible amounts in interest. Every dollar sitting in the bank is a dollar that is not only losing money but dragging down the rate of return on my portfolio as a whole. This is not to suggest that putting money on deposit in the short term is a bad decision. It may take a while to identify suitable investments or you may take the view that equity markets will decline further. In those situations, holding money on deposit makes sense. The point is that in the longer term, cash and deposits are a losing investment;

5. foreign currencies. Several currencies have shown rates of appreciation (+ interest) well above the required rate of return. This is one way to achieve diversification. The decline of the the US$ has been a significant contributor to returns on my portfolio over the last 12 months or so;

6. commodities. Today's hot sector. So far, my limited investments in commodities have shown rates of return well above the required rate of return. As I am much less familiar with commodities as an asset class than items #1-5 above and I wish to keep my exposure limited until I have a much better understanding of commodity markets. The one thing I do understand is that they have historically been highly cyclical investments. This means that unlike (for example) an equity fund which could be held forever, it is unlikely that commodities should be simply held and forgotten.

Actually, I need to look well beyond a five year time horizon as the same assets will need to support us through our retirement. For the purposes of asset allocation, this longer time horizon is actually helpful as reduces the risk of short term volatility forcing me to adopt a sub optimal asset allocation strategy.

Platinum - position increased

With no sign of South Africa's power shortage easing or the demand for commodities abating, I made a small addition to my position in platinum this morning. This was largely an exercise in putting what would otherwise be idle cash to work.

My position in platinum is held through a notional precious metals account with Bank of China (Hong Kong) Limited. This was chosen in part for historical convenience and in part because it offers lower transaction costs/spreads than the ETCs listed in London or the inconvenience of physical metal. My position in silver is held through the same account (and yes, I am really kicking myself for selling part of my silver position back in January).

Monday, March 03, 2008

Economic slowdown - one leading indicator turns down

We all know the problems with economic data being backward looking. Data about rates of unemployment, GDP growth, inflation etc are all historical. They do not tell you what is happening right now. Nor do they tell you what is likely to happen in the future. You have to guess (usually by extrapolating trends, which has its limitations).

Having been through a few economic cycles over the last few years, I have seen some indications of either a slowing or improving economy. One of those indicators is taxi queues. It may seem trivial, but when the taxi queues get consistently shorter at peak times (usually the early morning rush to get to work and the early- late evening rush to get home), its an indication that things have slowed down. The theory is that many of the professionals (investment bankers, lawyers, accountants) whose work is transaction driven will leave work earlier or leave home later when there is less work to do.

Well, the taxi queues have been noticeably shorter both before and after Chinese New Year than they have been for most of the last year or so. Maybe things are beginning to slow down a bit? (That said, my own work (which is usually correlated with economic activity) has shown no sign of a slow down yet and recent transactions indicate that property prices are still rising.)

If the economy is slowing, maybe I should rethink my policies of being fully invested at all times and not making early repayments of debt?

Sunday, March 02, 2008

Inflation assumption critical to retirement planning

Inflation has significant implications for retirement planning. If we define inflation as the rate of increase in the cost of living, then it is fairly obvious that we need to allow for inflation in future living costs when we save and invest for our retirement. The longer the time horizon the greater the effects of inflation.

Inflation is like compound interest working against you

Through much of the last 10-15 years people have been generally unconcerned about inflation - after all the official inflation rate (known as the consumer price index (CPI)) was running at around 2% or so a year. This was often misleadingly described as "benign". But even at 2% pa, over a working career of 30+ years and a retirement of similar duration, any annual increases in the cost of living will have a significant effect. Look at it this way - long term inflation is like compound interest working against you.

Inflation is rising

The last few years have seen a material increase in the rate of inflation and a growing awareness that the CPI number is an unreliable measure of the cost of living. Accurately guessing the rate at which your living expenses will increase in the future is now a more critical component of retirement planning than it has been for some time.

Worked example - 3% v 4% inflation rate

Consider the difference between rates of inflation of 3% pa and 4% pa over a lifetime of working and a lengthy retirement.

Using this calculator I took as an example a 30 year old person who starts with a salary of US$80,000 and savings of $50,000 and who wishes to retire at age 60 with replacement of 80% of pre-retirement income. Rates of return both before and after retirement of 8% pa have been assumed and social security has been disregarded.

If the inflation rate is set at 3% pa, our future retiree needs to save 17.5 % of his or her annual income to achieve the desired level of income in retirement.

What happens if the inflation rate is raised to 4% pa? The required savings rate increases to a staggering 26% of annual income.


This shows just how vital it is to get the inflation assumption correct at the beginning of a savings plan. If you want to understand just how damaging delaying savings can be, try running a spreadsheet where you start with a savings rate based on 3% pa inflation and realise 5 years later that inflation has actually been running at 4% pa. The amount of extra savings needed to "catch up" with the resulting shortfall is quite sobering.

The blunt message is that not only does inflation matter but the assumptions you make about the rate of inflation in your personal cost of living over the course of your working life and your retirement are critical. A person who underestimates the long term effects of inflation runs the risk of living on a diet of cat food in his or her old age (or not being able to retire at all).

Note: doing your own spreadsheet and playing with different assumptions and other input variables is a good way of learning how sensitive your retirement plans are to changes in those variables.

Currency investing (3) - alternatives to consider

If I take the view that the US$ will continue to decline (and the HK$ will remain pegged to the US$ at its current level), it would make sense to invest in assets which are not denominated in US$. Here are the options under consideration:

1. South East Asian currencies such as INR, MYR, THB, PHP and SGD. All of these currencies have appreciated significantly against the US$. All have GDP growth rates higher than the US or the Euro zone and are characterised by rates of inflation which are rising to levels of concern. Allowing their currencies to appreciate further would help manage inflation but, possibly, at the price of making exports less competitive.

2. RMB. China has been under pressure to allow its currency to appreciate at a more rapid rate. There is no shortage of forecasts that the RMB will appreciate by 8-10% in 2008. FX controls limit me to RMB 20,000 per day in conversions. I already have a token investment in RMB. Interest rates for RMB deposits are very low, meaning I would be relying on meaningful currency appreciation to make a profit.

3. AUD/NZD. These currencies are appreciating and have recently reached their highest levels against the US$ for many years (but not all time highs). They also offer attractive interest rates. The central banks in both countries have been consistent in giving priority to combating inflation which requires a high interest rate policy. The AUD/NZD have been perennial favourites of carry trade investors.

4. CAD/RUB. These are less familiar to me, but with economic growth being fueled by the on-going resources boom, these have to be of interest. One option for me here in HK is the Lyxor Russia ETF which gives me an investment in RUB combined with exposure to what is probably the most resource rich country in the world. That said, I need to learn more about the Russian market before doing this.

Longer term (and this would require very different economic conditions than at present), buying a property in Australia or New Zealand financed in a low interest rate and weak currency such as Yen would be attractive. With both the property markets and the currencies at historically high levels I am not comfortable doing this now.

Saturday, March 01, 2008

Currency investing (2) - ways and means

If I wish to invest on the basis of anticipated currency movements, what are the choices? There are several, each with their own advantages and disadvantages:

1. FX deposit. Simply ask your bank to convert some money into the currency of choice and place it on call or term deposit. It's simple, quick and easy. The risks are largely one dimensional (i.e. the FX fluctuations between the two currencies). The downside is that banks can be uncompetitive when it comes to FX spreads (the cost of conversion) and the interest rate you are offered will not be the best available.

2. FX structured deposit. This is essentially a deposit in one currency against which you write a out option in favour of the bank to convert to a second currency. If the currency stays above the strike price, you get back your money in the original currency together with a return which equals the interest on your deposit and the option premium. It's a good way to earn higher rates of interest so long as you are prepared to accept the second currency at or below the strike price if things move against you. Probably best to pair your local currency against a currency that you expect to appreciate if you want to do this.

3. Invest overseas. If you invest in another country, you are investing in the currency of that country as much as the asset (shares, property etc) that you buy. If you can find an attractive investment in a country whose currency you expect to appreciate, that gives you a degree of leverage.

4. Derivatives. You can buy or sell futures and options on a wide variety of currency pairs. The implied leverage and magnified volatility are not for everyone, but if you can accept the higher risks involved then the rewards can be correspondingly high.

5. Carry trade. This has been a favourite of investors for many decades. The idea is that you borrow money in one currency and invest it in an other currency. In order for this to work, the trade usually requires either an expectation of favourable currency movements between the pair of currencies you are working with or a yield differential or both. Borrowing yen to invest in high yielding Australian or New Zealand dollars as been a popular choice.

6. Offshore debt financing. Taking out a mortgage in yen to finance a property in Australia or New Zealand (where the interest rates are a lot higher) has been a widely used strategy. If the currency movements work in your favour you not only reduce your interest cost but may get a capital gain on the principal component of your mortgage.

To date, I have only done #1 and #3 and I am comfortable with both of those forms of investment. I am not terribly interested in speculating in FX derivatives due to a combination of personal time constraints and risk appetite. Likewise with #5. #2 is a derivative by any other name and, as I said above, I would only be interested in pairing HK$ against a currency I was very confident would appreciate against the HK$. (It would also help if I intended to make other investments in that second currency at some point in the future.) #6 effectively adds another layer of leverage to your investment. It's the sort of thing I would consider if I wished to buy a property in a country with high domestic interest rates but has little appeal in the shorter term.

Currency investing (1) - decline of the US$

One of the recurring themes in my monthly reviews has been the effect of changes in foreign exchange rates on my investment returns. With the Hong Kong dollar pegged to the US dollar, every dollar I have invested outside Hong Kong has benefited from the prolonged decline in the US currency. My net worth has been materially enhanced as a result (at least in Hong Kong dollars - like Flexo at Consumerism Commentary I have to query the extent to which the local currency gains in my portfolio are accurate reflections of real gains given the decline in value of that currency). The decline in the US$ has benefited me in other ways as well (higher income, lower interest costs etc) and hurt me in others (higher prices for most of the goods and services that I consume). On a net basis, the decline in the US$ has been a clear winner for me.

I can take very little credit for reaping the benefits of the US$'s decline. The extent to which my portfolio has benefited from currency movements has been largely a matter of historic accident and historic and on-going asset allocation decisions made with little regard for possible future currency movements.

The question I have been asking myself for some time is whether I should consciously allocate more of my investments to currency plays. As things stand, I would be betting on the US$ continuing to decline. A search on the internet failed to turn up any forecasts favourable to the US$ at all. That in itself makes me wonder how close to bottom the US$ is? Of course, I have no idea but it is very hard to make a bullish case for the US$. There are concerns that the US is heading into recession (or may even be there already). The US is expected to cut interest rates still further. Sub-prime related losses are still showing no signs of going away. The housing market in parts of the country is still in decline. Non-financial companies are showing signs of profit margins being squeezed by higher input costs. The almighty US consumer is widely believed to be spending less. The debt and the twin deficits continue to grow into unimaginable numbers. The list of negatives goes on.

The positives are harder to find. US corporates are becoming more competitive as a result of the weaker dollar. Lower interest rates and government bailouts are reducing the impact of the sub-prime and housing related problems. The complete absence of positive views on the US$. That in itself may be indicative of all the bad news and bad expectations already being priced into the currency.

The two uncertain factors (which could be either bullish or bearish) are foreign exchange reserves held by overseas countries and the fact that few countries wish to see their currencies appreciate too rapidly. With the US$ still the world's reserve currency of choice, it remains to be seen whether countries which are still accumulating foreign exchange reserves will continue to buy US$ as in the past or whether they will invest elsewhere. I suspect the answer is not whether they will invest outside the US but the extent to which they will diversify their holdings. (This already happening but has attracted surprisingly little recent commentary in the media.) As to countries preferring to keep their own currencies weak, there are signs that governments of at least some countries may allow their currencies to appreciate as a means of combating inflation.

It would take a braver man than me to bet against a continued decline in the US$ at this point. This leads on to the next question - if I assume that the US$ will continue to weaken, where should I invest my money?